What’s the future for capital-raising in global equity markets?
Investors’ desire to control the corporate governance agenda while also seeking short-term equity performance is belying the true function of capital markets, argues John Dawson.
Capital. In theory, that’s what equity markets are all about – raising capital to finance a growing business by offering attractive long-term returns on the investment. Over time a balance is struck between equity and debt by leveraging appropriately to reduce the cost of capital in line with perceptions of risk. When there’s a misalignment – of the need to finance attractive growth versus the risks that come with extra leverage – we’re supposed to raise more equity. If the business model is sound, then the investment is justified, and the equity can be raised.
For as long as I have been working with capital markets, hitherto as part of large corporate issuers, this has never seemed to be quite as straightforward as it should be. Large companies fear raising equity for organic growth, pushed instead to drive growth from existing cash flows or overpriced M&A, for some reason (probably fees) better tolerated by the market.
The modern wisdom is that shares are always supposed to be bought back, not issued fresh, as investors look to exercise more control over how they deploy capital – they make the decisions, not company management. As a result, growth opportunities are ignored or projects under-invested, providing weaker returns or not fulfilling their potential.
Capital-raising, by and large, still seems to be an area where our equity capital markets are letting established issuers down. Short-termism is principally to blame, if we follow the doctrines of recent years. On the face of it, this is recognised by many fund managers who question again the challenges of investing in long-term stories. Over my 20-plus years in investor relations, it has always been this way.
The pressures on money managers of missing market benchmarks etc have been very consistent. This has ebbed and flowed in corporate reporting (yearly, half yearly and quarterly reporting, KPIs and risk narratives etc.), in remuneration (alignment, short-term v long-term reward structures, payment by results, appropriate KPIs etc.), in the attractions of public ownership (M&A, LBOs, MBOs, private equity, secondary capital raises etc.) and now increasingly in activism and ESG agendas.
Brutal market forces
Larry Fink, chairman of the investment managers BlackRock, famously highlighted, in January of this year, the need for companies to focus more on sustainability. This is laudable, and it is good to know that many companies will be able to count on BlackRock’s support, but I was at Cadbury before and during the takeover, when the ethical behaviour of the business (investing in sustainable cocoa, resisting recipe changes to save basis points of cost, investing in packaging and obesity initiatives) was being discarded by investors under the critical pressure of a hostile bid for the company. Where was the narrative about supporting a company that had and continued to want to make the right decisions for the long term?
Sustainability can cost money – it’s generally a compromise to brutal market forces after all – and that needs investors’ support, alongside that of the employees and communities that already recognise it in how they behave. Fostering this in small companies is fine; the differentiation can drive [unprofitable] growth which is highly valued until it is absorbed into bigger businesses. Some are trying hard to repeat that ethos – Unilever on the face of it for one – but even they come under pressure from parties wanting more and more, or should we say less and less, when it comes to investing in sustainability.
Companies are now afraid of equity – it’s the source of their criticism, the pressures upon them for short-term performance and the challenge of financing future growth. Until the equity capital market demonstrates a greater willingness to support the innovation and investment needs of business, particularly larger traditional businesses trying to do the right thing, whether through equity financed growth, M&A or even supportive rights issues, it will continue to exist without a core sense of purpose and companies will live in fear of what it represents.
Part of this almost certainly comes down to how we price risk. Most risks, despite the ever increasingly bland and ineffective disclosures in annual reports, are ignored or left unsaid, because they involve complex judgments about the future.
Look at Carillion for a good example. What price proper disclosure around the balance sheet risk? What would have been the implications to boardroom discussions? At what point would an appropriate conversation about strategy or an equity raise have been on the agenda?
Capital markets hate the complexity introduced by risk. Risky investments as a result end up in private ownership or supported by incubators or venture capital vehicles or private equity.
Only when the risk has been eliminated or dressed up do they come to market, to release value for their owners and re-join (in many cases) their peers for the cycle to continue.
Capital. A purpose unfulfilled and the source of equity markets’ continued challenge for the next few years as we enter a period of uncertain regulation and change.
John Dawson is a partner at Statera Partners LLP
Published 28 March, 2018