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> Saddled with as much debt as possible, the business by design has been put in a position such that it cannot survive even a modest decline in revenue without

> Saddled with as much debt as possible, the business by design has been put in a position such that it cannot survive even a modest decline in revenue without raising significant additional capital. I agree, but I think it's important to qualify what you mean when you say the "business can't survive". Because this implies that if a company can't meet its debt obligations that it will cease operations. As long as operational cash flow is positive, then no amount of leverage or debt distress will halt the continued operations. The business might "fail" in the sense that the entity is legally re-structured and the equity owners, or even junior debt owners, are zeroed. But there's no reason in a country with well-developed bankruptcy law for this to have any impact on the employees, customers or operations of the business. The issue with coronavirus and failing businesses is that it's causing many businesses to have negative operational cash flow. In this sense the business may fail and the operations discontinued simply because revenue is no longer exceeding expenses. But if the operations are cash flow negative (and capital markets are unwilling to extend financing in the hope of future cash flow) then the business will fail regardless of its capital structure or leverage.

Decathect 7y ago
I'm really curious what your point is, since the willingness of capital markets to extend financing seems like it'd be very related to a company's capital structure and leverage. Like, were the businesses in question not over leveraged, they'd find it much easier to find the capital to continue operations during a downturn.
- dcolkitt 7y ago
  > extend financing seems like it'd be very related to a company's capital structure and leverage This seems intuitively appealing, but is misleading. The Nobel-prize winning work of the Modigliani-Miller Theorem[1] that a firm's capital or leverage ratio does not prima facie have any impact on its weighted-average cost of capital. [1] https://en.wikipedia.org/wiki/Modigliani–Miller_theorem https://en.wikipedia.org/wiki/Modigliani–Miller_theorem
  - SilasX 7y ago
    Well, you have to take into account more stuff than what's one the prima facie, like when all businesses have to run on 1/3 revenue, and (like in the example in the link) can't even afford the interest payments that are due. That tends to make capital more expensive.
  - clairity 7y ago
    but a firm's WACC doesn't tell you what the marginal cost of capital is. marginal capital costs generally correlate with the leverage ratio (not necessarily linearly). at some point those costs are prohibitive (greater than free cash flow).
- hogFeast 7y ago
  Financing isn't related to capital structure or leverage. Your assumption is kind of predicated on the belief that people lending to PE are making rational choices...they aren't. The reason why LBOs took off was because S&Ls needed high-yield paper (and, to a lesser extent, there was a big buildup of Middle Eastern funds in US banks). All these deals allow the lender to risk up their portfolio, and take (in retrospect) equity risk. If you were an LBO firm, you can just sit there, create this paper...maybe it works out, it probably doesn't, and (tbh) you don't care because you get fees either way (most PE firms aren't really fund managers, they generate transaction fees for principals...that is why they employ bankers, instead of people with any experience of business). Btw, if this isn't convincing this same dynamic also caused a bubble in emerging market debt (i.e. banks needed high yield paper, bankers went to EM govts and got it). And in a downturn, this process goes into reverse. People rush into cash, and sell whatever is liquid. It isn't anything close to rational (I feel like this should be obvious, I am seeing stocks with close to monopoly positioning selling at 3x earnings...is that rational?). Now, the complexion of these deals has changed but what really drives finance is supply and demand. Another good example is CDOs, that was all supply-driven...banks wanted paper (there was a huge build up of dollars in exporters like Germany/Japan...China too but the state controlled dollars domestically), Basel rules meant there had to be some trickery i.e. banks needed to say CDOs were AAA but there was not enough AAA supply so CDOs had to convert junk into debt...but the point is...they needed the paper, so it was supplied. Totally irrational, no-one looked or cared about fundamentals but...the fundamentals don't really matter. Liquidity drives everything (if you have liquidity, you buy anything...if you don't, you sell anything). Btw, understanding this is pretty key to successful investing. Once you realise what is occurring, investing is fairly straightforward. It is only when people try to introduce artificial concepts like rationality that they lose money in large sums.
xiaosun 7y ago
>As long as operational cash flow is positive, then no amount of leverage or debt distress will halt the continued operations. The business might "fail" in the sense that the entity is legally re-structured and the equity owners, or even junior debt owners, are zeroed. But there's no reason in a country with well-developed bankruptcy law for this to have any impact on the employees, customers or operations of the business. You're naively assuming the equity owners meekly turnover the operations to the debtholders in bankruptcy when business performance suffers but cash flow is positive. Equity holders are going to inflict a ton of pain on the employees and customers of the company first. They are going to layoff employees to the bare bones, sell otherwise performant assets, play games with vendors/receivables, and otherwise do anything else they can do to squeeze more runway before giving things up in bankruptcy.

Decathect 7y ago

I'm really curious what your point is, since the willingness of capital markets to extend financing seems like it'd be very related to a company's capital structure and leverage. Like, were the businesses in question not over leveraged, they'd find it much easier to find the capital to continue operations during a downturn.

dcolkitt 7y ago
> extend financing seems like it'd be very related to a company's capital structure and leverage This seems intuitively appealing, but is misleading. The Nobel-prize winning work of the Modigliani-Miller Theorem[1] that a firm's capital or leverage ratio does not prima facie have any impact on its weighted-average cost of capital. [1] https://en.wikipedia.org/wiki/Modigliani–Miller_theorem https://en.wikipedia.org/wiki/Modigliani–Miller_theorem
- SilasX 7y ago
  Well, you have to take into account more stuff than what's one the prima facie, like when all businesses have to run on 1/3 revenue, and (like in the example in the link) can't even afford the interest payments that are due. That tends to make capital more expensive.
- clairity 7y ago
  but a firm's WACC doesn't tell you what the marginal cost of capital is. marginal capital costs generally correlate with the leverage ratio (not necessarily linearly). at some point those costs are prohibitive (greater than free cash flow).
hogFeast 7y ago
Financing isn't related to capital structure or leverage. Your assumption is kind of predicated on the belief that people lending to PE are making rational choices...they aren't. The reason why LBOs took off was because S&Ls needed high-yield paper (and, to a lesser extent, there was a big buildup of Middle Eastern funds in US banks). All these deals allow the lender to risk up their portfolio, and take (in retrospect) equity risk. If you were an LBO firm, you can just sit there, create this paper...maybe it works out, it probably doesn't, and (tbh) you don't care because you get fees either way (most PE firms aren't really fund managers, they generate transaction fees for principals...that is why they employ bankers, instead of people with any experience of business). Btw, if this isn't convincing this same dynamic also caused a bubble in emerging market debt (i.e. banks needed high yield paper, bankers went to EM govts and got it). And in a downturn, this process goes into reverse. People rush into cash, and sell whatever is liquid. It isn't anything close to rational (I feel like this should be obvious, I am seeing stocks with close to monopoly positioning selling at 3x earnings...is that rational?). Now, the complexion of these deals has changed but what really drives finance is supply and demand. Another good example is CDOs, that was all supply-driven...banks wanted paper (there was a huge build up of dollars in exporters like Germany/Japan...China too but the state controlled dollars domestically), Basel rules meant there had to be some trickery i.e. banks needed to say CDOs were AAA but there was not enough AAA supply so CDOs had to convert junk into debt...but the point is...they needed the paper, so it was supplied. Totally irrational, no-one looked or cared about fundamentals but...the fundamentals don't really matter. Liquidity drives everything (if you have liquidity, you buy anything...if you don't, you sell anything). Btw, understanding this is pretty key to successful investing. Once you realise what is occurring, investing is fairly straightforward. It is only when people try to introduce artificial concepts like rationality that they lose money in large sums.

xiaosun 7y ago

>As long as operational cash flow is positive, then no amount of leverage or debt distress will halt the continued operations. The business might "fail" in the sense that the entity is legally re-structured and the equity owners, or even junior debt owners, are zeroed. But there's no reason in a country with well-developed bankruptcy law for this to have any impact on the employees, customers or operations of the business. You're naively assuming the equity owners meekly turnover the operations to the debtholders in bankruptcy when business performance suffers but cash flow is positive. Equity holders are going to inflict a ton of pain on the employees and customers of the company first. They are going to layoff employees to the bare bones, sell otherwise performant assets, play games with vendors/receivables, and otherwise do anything else they can do to squeeze more runway before giving things up in bankruptcy.