“Match long term assets to long term liabilities.” Throughout the annals of time, this was a tried and true strategy for companies that fund an asset heavy business. I heard it as a CPA, I heard it in Business School and today I hear it helping companies fund themselves, but not as often as one might think…
When the theoretical world of case studies collides with the real world of business, the real world will win every time. In the battle of education over experience, I’ll back the treasury team not the textbook. Asset-liability matching has its place, and is a fundamental cornerstone of any business funding strategy, but I can think of at least 10 examples where a company should fund shorter (or longer) than the asset life:
- Revenue from the asset is variable – Imagine if you run an oil extraction company that owns offshore drilling rigs and oil fluctuates in price (as it does). When prices are high, generally this means the world is in an inflationary environment, which means high interest rates. When prices are low, we’re in a recessionary environment, which means low interest rates. Imagine locking in a 30 year fixed rate long-term bond on a $650 million drilling rig, only to find oil prices plummet. The company’s interest cost stay flat, while 20, 40, even 50% or more decreases in the price of oil cuts revenue deeply! While many of these drilling rigs have a life of 50+ years, any company locking in rates that long is bound to get crushed at some point. Ultra long term asset-liability matching is about the worst thing one can do with that type of asset.
- The company is planning on selling the asset sometime during its useful life – Locking in for the duration of the life of the asset becomes a lot less appealing if you have to unwind the borrowing in the middle. This is particularly true if you’re funding the asset with fixed rate debt, which generally has hefty early repayment penalties associated with it.
- The business is a regulated monopoly – Regulation ensures that customers and suppliers each have a clear line of sight to one another. Customers have no other choice but to buy from the supplier; conversely competition never enters the equation for the supplier. Under this arrangement, the regulator needs to keep things fair. This means that prices are determined by a variety of forces besides supply and demand. In return for a protected territory a company often has to negotiate its revenue based on a variety of inputs, one of which is the cost to service its debt. These prices are often “reset” every three to five years, at which time the government agency will examine the cost of capital and adjust this up or down based on current market interest rates. As a consequence, a mismatch could be quite costly for the regulated business.
- It’s crystal clear interest rates are going up – The week after President Trump won the election in the United States, Treasury yields went up 50 basis points. The 10 year UST had been hovering near a historical low of 1.70-1.80% (+/-) for several months, the Fed Funds rate was at 0.25% and inflationary signals were kicking in. Likewise credit spreads were in the bottom quartile of the last decade. If that was not the time to lock in debt longer than the useful life of the assets of the company, then there never would be a good time! Many companies did.
- The company is planning a financial restructure – As companies grow, their debt often goes from a secured to an unsecured platform to give the organization more flexibility. The problem is that no current lender wants to go first. Those that do are structurally subordinated during the conversion, which means that if something goes wrong all the secured lenders get paid out first and what’s left over goes to the unsecured creditors. Not a great place to be. If however, a company knows that it will convert at a point certain in the future, it behooves management to ensure all secured debt does not mature past the conversion date, or it will face resistance from the unsecured lenders.
- The company is an M&A target or is planning on being sold – Some companies, particularly single product organizations, just make good add-ons to larger, more diversified companies in the sector. Creditors almost always have a provision that will force early repayment (often with a costly, interest rate true up called “a make-whole penalty”) if a company is acquired, or merges with a larger organization that is of a lower credit quality than today’s company. That is unless this issue is contemplated up front and the company can negotiate a “par change of control put” at the time the debt terms are agreed.
- It’s crystal clear interest rates are going down – When the Global Financial Crisis (GFC) hit the world in 2008/09, shortly thereafter central banks globally cut interest rates again and again and again, landing on unprecedented levels. Right before that happened, it was clear that nothing was going to be the same for a long time and that governments in most westernized countries would need to force (and keep) interest rates down for years to come just to keep a great depression at bay. With that clear foresight, locking in a large portion of the company’s debt long term, even to match long term assets, would have been a big mistake that just about anyone who was paying attention could have predicted. Fortunately, there has not been a signal that strong since, nor (knock on wood) will there likely be one in the near future.
- The company is transformational – Some companies (and many conglomerates) start their life looking one way, but reach the “mature stage” looking completely different (Avon was a book company, Starbucks was an espresso machine distributor). If the organization is open to “any and all opportunities,” then funding shorter rather than longer might make more sense even if the assets themselves are long lived.
- The industry is transformational – Industries adapt to change that occurs over time. Sometimes that change happens over decades, other times it happens over a few years. If management believes its industry will get caught up in the next wave of disruptive innovation, or even unprecedented technological growth, then assets that used to have a useful life of decades might become obsolete in just a few years.
- The company is struggling – It goes without saying but if, by extending the maturity on the company’s debt, the increase in interest costs associated with longer-term debt causes stress on cash flow or even financial covenants, think twice. Management needs to assess the downside as much as the upside of every decision when things are tough.
The 10 examples above are not all inclusive, but many are quite rare. Under many/most circumstances it makes sense to asset-liability match as a rule, rather than an exception.