10 June 2020 by and Corporate & Commercial Alert

COVID-19 cash flow crisis solutions: debt or equity?

As a result of governmental and voluntary restrictions imposed to mitigate the impact of COVID-19, South African businesses are facing liquidity constraints in the short to medium term. Reduced sales and operational closures have driven many entities to seek cash injections – in most cases, urgently. Whilst several entities are drawing down existing credit facilities and reducing discretionary capital expenditure and other non-fixed costs, it is expected that most will be required to raise more debt or undertake equity capital raisings in the near future.

Now, more than ever, directors and other stakeholders need to be proactive in conducting “best” and “worst case” scenario analyses to identify where capital requirements may exceed available cash in the next three to six months. A more immediate concern is servicing existing credit facilities in a sustainable manner. Where liquidity is required, it is helpful to consider the primary advantages and disadvantages of debt and equity financing.

Debt Financing

In its most simplistic form, debt financing refers to raising cash through the borrowing of funds (i.e. a loan or credit facility) to be repaid at some later date. In most cases, debt financing goes hand in hand with some form of security (for example, a pledge, a cession in securitatem debiti, a general or special notarial bond, a mortgage bond, etc.) and interest, in effect requiring the borrower to repay more than what was originally borrowed.

Although there are certain advantages to debt financing, such as speed, accurately forecasting non-variable future expenses, not relinquishing any control or ownership in the entity and being able to end the relationship with the financier once the debt is repaid, not to mention current low interest rates, debt financing is inherently reliant on an entity’s ability to generate enough income to repay its debt. In the current economic climate, financiers will be particularly risk averse and will scrutinise an entity’s potential to service its debt obligations.

Given the global impact of the pandemic, there is a shortage of liquidity, even if interest rates are low. To the extent entities are successful in procuring debt funding at reasonable rates, directors should still be aware of the solvency and liquidity requirements of the Companies Act 71 of 2008, as well as the entity’s obligations in terms of its financial and gearing covenants with current contractual counterparties and lenders. Due to write downs and low profitability, many entities are currently likely to be perilously close to breaching their financial covenants, even before trying to raise more debt.

Equity Financing

Equity financing, on the other hand, refers to capital which is generated by issuing shares. The main advantage of equity financing is that there is no additional financial burden placed on the entity to repay the funds acquired, thereby flushing the entity with capital to grow or sustain the business. However, unless capital calls are made on existing shareholders and all shareholders are in a position to contribute proportionately, equity financing will result in dilution for all or some of the shareholders. Whilst there may be no mandatory repayment as under debt financing, equity financing can become significantly more complex to implement, reduces the incumbent shareholders’ ultimate economic interest in the business and may also affect the decision making functions of the entity. Given the constraints on the availability of liquidity, the current economic climate gives potential equity investors the upper hand and they are likely to drive a hard bargain. Still, when faced with reduced economic interest or no economic interest at all, many businesses will opt for the former.

Looking Ahead

Most entities use a combination of debt and equity financing, or hybrid instruments which contain both debt and equity elements, such as preference shares or convertible securities. To decide whether to utilise debt or equity financing, or both, in a cost-effective manner, requires entities to consider and optimise their capital structure. To operate sustainably, an entity must earn at a minimum its costs of capital (the sum of its cost of equity financing (such as dividend payments to shareholders) and cost of debt financing (such as interest payments)). Where an entity’s cost of capital exceeds its returns on capital expenditure, it is effectively operating at a loss and needs to reconsider its capital structure.

Before a company wishes to raise cash through either debt or equity financing, it needs to consider whether the capital will be enough to cover the downturn in business or whether there is too much uncertainty regarding the financial impact and duration of COVID-19. The current economic volatility may render raising capital in the conventional manner impractical and too expensive. Until there is more clarity regarding the outcome of COVID-19, companies need to assess all avenues of reducing costs and obtaining cash, including the conventional and unconventional (such as recapitalisation, renegotiating fixed costs, requesting payment holidays or taking advantage of the Government-sponsored guarantee schemes which enable banks to assist their clients in restructuring their loans and interest rates, in certain circumstances).

It is suggested that entities obtain legal and financial advice as soon as possible to navigate the risks and opportunities facing their businesses as a result of COVID-19. Please stay up to date with our latest COVID-19 news here.

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