What is the relationship between the value of a company and its financing activity? New research by Timothy Riddiough and Eva Steiner provides some answers
Financial economists have a number of theories as to why different approaches to financing should – or should not – affect the value of a company. In a recent project sponsored by EPRA, we have evaluated the empirical evidence from international real estate investment firms on this very question.
Our findings may assist financial managers in optimising financing to improve a company’s value, and may also provide guidance for investors in drawing conclusions about the quality of a company from the composition of its corporate capital structure.
We found that a prudent financing strategy that is committed to the following can make a significant contribution to a company’s value:
• Maintaining low leverage;
• Mitigating refinancing risk by matching debt and asset maturity;
• Supporting higher levels of leverage with collateral;
• Managing interest-rate risk using fixed-rate debt.
We studied a sample of international listed real estate investment firms from the US (1993-2012) and a selection of European countries (2001-12), including France, Germany, the UK, and the Netherlands. We wanted to explore the capital structure characteristics that strong firms have in common. We defined strong firms as those with high value of Tobin’s Q (a measure of a company’s assets in relation to its market value).
Having sorted the firms according to their annual Q ratios, we compared the capital structure of the firms with the highest of Q ratios to those with the lowest Q ratios. We conducted this analysis for all firms first, and subsequently for the firms from the US and Europe separately. This separate analysis allows us to explore systematic differences in the institutional background of the firms and through time.
What are the capital structure characteristics that strong firms have in common? Primarily, we found that the strongest firms in our sample maintained low levels of leverage, at approximately 35%.
The strongest firms in our sample on average had a leverage ratio of 35%, whereas the weakest firms on average had a significantly higher leverage ratio of 59%. Further, stronger firms on average had higher proportions of fixed-rate debt (80% of total debt versus 69%), suggesting that the reliance on variable-rate debt is a sign of weakness. Stronger firms hold lower shares of secured debt (53% of total debt versus 73%), suggesting that weaker firms are required to pledge collateral when borrowing capital, whilst stronger firms are able to rely on their corporate creditworthiness overall. Lastly, stronger firms hold less cash (2% of total assets versus 4%).
The analysis of the US firms provides more detailed insight into dimensions of capital structure that are unavailable or small in terms of the number of observations for the European sample firms from SNL. The focus on US REITs reveals that stronger firms have longer debt maturity (56% of total debt matures in three years or more versus 47% in the weakest firms). Further, stronger firms have higher line of credit capacity (15% of total assets versus 13%) but rely less heavily on drawing on these facilities (31% of capacity versus 50% of capacity). Stronger firms also have more UPREIT equity (5% of market capitalisation versus 2%). Lastly, stronger firms also have a higher funds-from-operations (FFO) payout ratio (70% versus 65%).
The analysis of the European firms reveals two additional findings. First, the European results confirm the inverse relationship between company value and leverage that was established for the US firms.
Second, however, the inverse relationship between firm value and leverage is the only significant finding in the analysis of the European sub-sample. This difference may be due to either one or a combination of two reasons. On the one hand, the differences between the top and bottom quintiles across the firm characteristics in the European sub-sample generally carry the same sign as in the US sub-sample, but they are numerically smaller. The characteristic quintiles of the European firms appear to be more homogeneous on average than the quintiles of the US firms.
On the other hand, it may be the case that investors in European firms are less sensitive to variation in capital structure characteristics and penalise firms with sub-optimal capital structure characteristics less heavily. This interpretation suggests that a firm characteristic-informed optimal capital structure is less directly related to firm value in Europe than in the US.
This perspective implies that there are other factors, such as the relative cost of different types of capital for example that may potentially be introduced by variation in the institutional environment, which have a stronger impact on firm value in Europe than they do in the US.
Relating debt and value
How does variation in individual capital structure characteristics affect firm value? Most importantly, with higher leverage in place, a higher level of debt secured against specific assets helps support firm value.
We have employed regression analysis to explore the marginal impact of changes in individual dimensions of capital structure on the levels of Tobin’s Q, after controlling for a set of other potentially value-relevant firm characteristics.
The results support an inverse relationship between leverage and firm quality. A one standard deviation increase in leverage results in a 14bps drop in Tobin’s Q across all firms. However, the marginal effect of leverage on firm quality varies across geography and time. Leverage is penalised more heavily in the US (14bps drop) than in Europe (five points drop). Similarly, higher leverage is penalised slightly more heavily during the crisis (15bps drop) than outside of the crisis period (14bps drop).
The results also support a positive relationship between fixed-rate debt and firm quality (three points increase in the Q ratio for a one standard deviation increase in the share of fixed-rate debt). Our finding may reflect the reduced refinancing risk involved in using fixed-rate debt.
We also found that higher shares of fixed-rate debt in the capital structure had a stronger impact on firm quality during the crisis (four points increase) than outside the crisis (two points increase). The recent financial crisis period saw significant restrictions in the supply of debt capital. Capital markets were characterised by increased uncertainty around the direction of interest rates. As a result, firms faced higher levels of refinancing risk, increasing the relative benefits of fixed-rate debt.
We also found that firm quality is inversely related to the share of convertible debt, but the effect is small in economic terms. Our finding is consistent with the notion that the issuance of convertible securities is a sign of weakness. Equity and straight unsecured debt issuance is expensive for the firm, so with a high current cost of capital issue convertible securities out of weakness firms, trading off a lower current rate for future convertibility. These firms are also likely to be financially constrained, restricting their ability to exploit investment opportunities and thus grow the value of the firm. However, as the use of convertible debt appears to be less prevalent in Europe, our evidence suggests that the US firms mainly drive this result.
In contrast to the unconditional multivariate analysis suggesting an inverse relationship between the share of secured debt and firm quality, our regression results for the US firms suggest that, all else being equal, an increase in secured debt is related to an increase in Tobin’s Q. However, there is a 39% correlation between leverage and the share of secured debt, and a strong and consistently negative relationship between leverage and firm quality. On an unconditional basis, both secured debt and leverage are separately related to lower firm quality. The conditional analysis reveals that highly levered, poorer quality firms whose capital structure exposes them to increased bankruptcy risk, may be able to mitigate the effects of leverage on measures of firm quality and continue to access debt markets by pledging collateral for debt capital.
We further find that in the US higher cash holdings are associated with lower values of Tobin’s Q. Research has shown that bank lines of credit are a substitute for cash in REITs, and that stronger firms with higher Q ratios have less need to hold cash because they have greater untapped longer-term debt and line of credit capacity. These firms also have more confidence in being able to consistently access equity markets. Therefore, because shareholders generally value relatively higher rates of dividend payout, stronger firms comply and reduce excess cash holdings, knowing they are secure in tapping capital and liquidity going forward.
This interpretation is consistent with recent studies on liquidity and capital structure, highlighting a crucial distinction between firms being cash constrained and financially constrained. However, we also find that during the recent crisis period, cash holdings actually supported higher Q ratios for all firms, suggesting that investors take a positive view on firms being able to rely on cash reserves when external sources of funds dry up as a result of capital market turmoil.
Our results from Europe continue to support the inverse relationship between leverage and firm value. However, we also find that there are significant differences in the extent to which investors penalise firms for higher levels of leverage. Our results suggest that leverage is penalised most severely by investors in Germany (38bps drop in Q ratio for a one standard deviation increase in leverage), followed by France (13bps drop), the Netherlands (7bps drop) and the UK (5bps drop).
The US analysis allows us to add two additional angles to our study. First, we are able to include data on debt maturity, line of credit capacity and usage, UPREIT equity, and FFO payout ratio as additional dimensions of corporate financial policy into the estimation. Second, given the longer history of the data in the US, we are able to split the sample into sub-periods during (2007-09) and outside of the recent global financial crisis. This analysis allows us to evaluate the differences in the relationships between capital structure characteristics and firm value across financial market regimes.
The analysis, however, reveals few significant differences in the relationships between capital structure characteristics and firm quality across the two sub-periods during and outside of the recent global financial crisis. The exception is the relationship between revolving credit facilities (capacity and share of facilities drawn) and firm quality. Revolving credit facilities (capacity) generally tend to be associated with stronger firm quality, as per our unconditional results. This effect appears to be reinforced in times of capital market turmoil, as evidenced in the recent global financial crisis, when those stronger firms were able to rely on previously granted credit facilities. During the crisis, we also find a positive relationship between the lines of credit drawn and firm quality. This finding may reflect that firms with internal debt capacity that could refinance by relying on previously granted lines of credit and were thus not forced to tap the external capital markets under difficult economic conditions fared better during the crisis.
In summary, we draw three main conclusions. First, we find that the strongest firms in our study have a number of capital structure characteristics in common: low leverage, long debt maturity, high shares of fixed-rate debt, low shares of secured debt. This suggests they are able to access capital markets against the backdrop of the quality of the firm without having to rely on collateral to mitigate lender concerns, and low cash holdings.
Second, institutional differences across geographies matter for firm value. For instance, investors in Germany appear to be most averse to the use of leverage.
Third, the prudent management of liquidity requirements during periods when fresh capital is scarce – by relying on previously obtained lines of credit – can support firm value amid challenging capital market conditions.
Timothy Riddiough is a professor in the Department of Real Estate and Urban Land Economics at the Wisconsin School of Business. Eva Steiner is a university lecturer in real estate finance and investment at Cambridge University