Equity-- Why Not Have Enough?

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Why don't all publicly owned firms have a big enough equity cushion to avoid bankruptcy? They could then all pay lower interest rates. Modigliani-Miller says that evens out, but only in the absence of bankruptcy. Otherwise, clientele matters (well known?), as well as bankruptcy transaction costs.

Currently, a firm has $60M in equity and $40M in debt, with $100M invested in its business. Why doesn't it issue $200M more in equity, and invest the entire amount in index funds? Then it would have a cushion to protect the bondholders. Limited liability is good insofar as it means each shareholder doesn't have to be worried about being wiped out, but bad insofar as it means they can as a group rip off the bondholders.

The answer lies in agency costs, moral hazard by the managers and directors, I think-- mainly the directors. But it is surprising it is that big.

Maybe this is all in Michael Jensen's "equity cushion" work. No, it is not. "Free cash flow" is his 1986 idea.

Suppose investors who are daring have $20 million and investors who are timid have $20 million also. There are 4 investment projects, each able to invest $10 million in return for a 10% chance of ending up with assets worth $0 and a 90% chance of $20 million. This amounts to an expected return of .1(0)+ .9(20) = $18 million, an 80% return on investment.

Ideally, we would have one big firm with $40 million in assets, owned by the daring investors and owing $20 million to the timid investors. But let us suppose that we can't have more than one project per corporation, so we set up Firms Alpha, Beta, Gamma, and Delta. The daring investors are fine. They will spread their funds equally among the four firms to achieve diversification. The timid investors are not fine. Even if they spread their funds equally among the four firms, they risk one of the firms going bankrupt and being unable to pay them. It does not help if the other three have massive profits, because their upside potential is fixed.

What can be done? Let's be a little more precise about the capital structure. Let each firm have 5 million shares, worth $1 each at par. Now, let each firm print 6 million more shares and put them into its treasury. Each firm can take 2 million of its new shares and trade them for 2 million shares of each of the other three firms. Firm Alpha will end up holding $10 million in physical assets plus 6 million shares in three other firms, 2/11 ownership of each of those other firms. The corporate ownership of the firm's shareholders is unchanged; the daring investors had their wealth spread evenly over equity ownership of all four firms before, and that hasn't changed, even though the arithmetic of it is now more complicated.

The difference is in what happens if Firm Alpha goes bust. Now the bondholders don't have to lose anything. If Alpha's project fails and its $10 million in physical assets vanishes, it still has its 6 million shares in the other firms. Suppose none of the others has failed. In that case, the other three firms are each worth $20 million, so a 2/11 share of their combined value of $60 million is worth about $12 million and Alpha still has ample assets with which to pay back the principle of $5 million to its bondholders, plus room for interest. Even if Firm Beta's project fails too, Firm Alpha's stock in Gamma and Delta is worth about $8 million (plus Beta's stock is still worth something because of its shares of Gamma, Delta, and Alpha). So there is still no problem for the bondholders. Even if BOTH Beta and Gamma fail too, Alpha's bondholders are in pretty good shape. Alpha still has its 2/11 ownership of Delta, worth about $4 million, plus its 2/11 ownership of Beta's 2/11 ownership Delta and its 2/11 ownership of Gamma's 2/11 ownership of Delta, each worth about $600,000, so scraping all that together, the bondholders get all or almost all of their principle back. Only if all four firms's projects fail, which has a probability of 1 in 10,000, do the bondholders end up with nothing.

I told this story in terms of firms trading each others' shares. More realistically, we might think of there being a fifth firm, the Index Fund. This is a mutual fund which buys shares in the other four firms. I could tell a story of how the four production firms grow slowly, I think, though I haven't worked it out yet fully.

The basic idea is that investors should finance a firm well enough so that beyond its own productive assets it has ample capital to invest passively in index funds or safe assets-- it doesn't really matter which, since the purpose is diversification, not choice of risk level. Then, the firm can borrow at a lower interest rate from timid investors. It is a true pareto improvement, because the risk to the timid investors has gone down and the risk to the daring investors is unchanged or little changed. The market is now providing a safer asset than it could when the four firms were entirely separate.

We can go beyond that to other advantages. Bankruptcy has real costs-- the lawyers, the waiting period, the extra need to monitor for fraud. These disappear. And there are transaction costs that we endure to reduce risk and reduce bankruptcy costs--- debt covenant restrictions that hinder a firm from doing what would otherwise be optimal.

Why Don't Firms Do This?

So why don't firms do this? That's a great question. The benefits of a capital cushion are huge. What costs could be that big? It's hard to imagine-- but costs there are. The cost is moral hazard. The capital cushion is supposed to be a cushion, not a slush fund. But how can it be kept a cushion? The managers and directors will want to spend the money on pet projects, even though that defeats the purpose of the cushion and the projects may yield less than the market return. I would think that something like a debt covenant could shield the cushion, but perhaps not. I am not satisfied.

A Justification for Endowments?

This might be a justification for college endowments. They can borrow at lower rates because they have capital cushions. The taboo against using the endowments even for high-value investments might be justified. I doubt it, but it's possible.

How Would I Implement This?

Another approach to figuring out why this isn't done is to think how I would do it now. If I had a currently successful established corporation, it would be easy. Just keep retained earnings instead of reinvesting them or issuing dividends or making acquisitions, and invest them in an index fund. Set up a legal structure in debt covenants requiring that the index fund not be drawn upon except in bankruptcy. That is, when the firm issues bonds, include a clause saying that if the firm ever lets the Cushion Fund own less than 100,000 shares of Vanguard Index Fund, the bond principle can immediately be called in by the bondholders.

Of course, if the firm is currently healthy, maybe it isn't issuing bond anyway, and is so far from insolvency that the Cushion Fund is of limited value. So let's think about less stable firms.

First, what about a thriving but growing firm? It needs new capital anyway. This is perhaps the best case for the Cushion Fund, though. It's strange, because I would be (a) issuing new stock, (b) issuing new bonds, (c) buying new equipment, and (d) investing in the Cushion Fund.