Debt Versus Equity

There are many explanations for the recent popularity of debt particularly private placements of it. Greater recourse has been taken to debt because the equity route has been more or less shut for issuers. The small investor refuses to touch public equity issues. One look at the market tells us why. More than 90 per cent of the 365 equity issues placed at a premium in 1995 were last trading well below the offer price. The secondary market is littered with stocks where investors have burnt their hands. When a blue chip like the Industrial Development Bank of India (issued with a premium of Rs 120) trades at less than Rs 80 or when a recent Bank of India offering (Rs 45) trades at Rs 35, investor confidence is shaken.

 

It is perhaps incorrect to say that the public does not like equity any more. More correctly, it is not willing to pay the price asked for. It will not pay the kind of premiums that it was willing to earlier and issuers cannot pay more for funds beyond a certain point. When interest rates go down sufficiently and debt ceases to be attractive, then maybe the day for equity will return. It is idle to think that by closing the debt option, the equity market will be revived.

The popularity of debt need not have anything to do with borrower and lender at all and can be dependent on the overall economic situation over which neither has any control. Debt offerings boom in times of corporate earnings uncertainty. Unless growth prospects are really bright, no issuer will expand his equity which will put a strain on his ability to maintain earning per share. A fixed-coupon offering also sells better in times of uncertainty when the investor becomes more risk averse and favours the certainty of fixed interest income to the uncertainty of returns on equity.

Issuers also favour the private placement route as that lowers issue costs greatly. Managers fees, underwriting commission, bankers fees and the sundry other management charges often account for as much as 6 per cent of the total issue size. Moreover, there are the hassles of complying with the regulatory requirements. When the same amount can be raised through private contract, and at a lesser cost and with less bother, the attraction will be obvious. The choice between a public and private issue is really determined by size. Placing very large issues privately, unless on a rollover basis, becomes difficult. Hence the preponderance of financial institutions raising very large sums through a variety of paper, offering different kinds of fixed income plans.