‘CEO/CFO Board Behaviors’

Corporate Bond spreads (additional yield over comparable US Treasury) have done a near full reversal from the wides reached in January (+147*). Today (+104*) we are very close to the tight spreads reached last year (+99*). The reversal brings our 2019 Theme #5 “CEO/CFO Board Behaviors” into play again.

We highlighted in our ‘7 Themes for 2019’ paper at the beginning of the year, the critical importance of capital structures and management teams’ focus on reducing leverage.

We believe there will be significant winners and downright losers in the capital structure management process, resulting in more significant dispersion within the credit market. We highlighted our belief that many management teams and Corporate Boards will be challenged in 2019.

We have seen early signs of deleveraging - dividends cuts, businesses sold with proceeds earmarked for debt paydown and new found verbal commitments of free cash flow finding its way toward debt reduction. In addition, some management teams have extended their debt maturities, allowing for greater financial flexibility. Other management teams are ignoring the warning signs.

We highlighted that we will learn a lot about the character and discipline of management teams and the fortitude of Corporate Boards. We will once again be reminded of the importance of leadership and the ability to adapt.

In the write-up that follows, we highlight our views on CEO/CFO behaviors around debt and the search for the perfect capital structure.

As an integral part of assuring the future health of their business, management teams must be effective capital allocators. Typically, the best run businesses have management teams that are very good, long-term capital allocators. Essentially, this responsibility is the prudent allocation of cash flows toward: reinvesting in the business in the form of capital expenditures (CapEx), managing debt profiles, engaging in Mergers & Acquisitions (M&A), and returning cash to shareholders via buybacks and/or dividends.

Low-interest rates and tight credit spreads often lure management teams into accelerating many of the aforementioned actions through the use of debt. Said another way, given attractive rates, we’ve seen an increasing appetite for corporations to use debt as an accelerant to “maximize shareholder value”. Furthermore, to our concern, management teams can become more complacent capital allocators and consequently increase the probability of putting their companies in a less resilient position for an unknown future.