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Debt or equity –– The investor’s dilemma!

ZIMBABWEAN capital markets have been starved of liquidity to enable financial intermediaries to fund long-term projects.

There were expectations post-dollarisation of an increase in long term funding to the country’s industry as a result of the certainty the “discarding” of the Zimbabwe dollar created. Potential return on investment could now be established with a degree of certainty and “financial calculator wielding” international investment bankers could now work out the net present value on potential investments.
The question to be asked is what has been the trend thus far and where the inclination is in terms of debt and equity finance?
It is a well-known fact that the local financial industry has not been able to raise long-term deposits to finance any long-term loans. The average tenure of deposits for most banks has been 30 days with a maximum period of 90 days.
This has been partly a result of the loss of confidence in the banking sector by the man in the street who still has memories of the hyperinflation era. Any prudent bank in an effort to manage the mismatch between their assets and liabilities would not extend credit for a period longer than their deposits. This has seen the local debt market being very short-term with companies only utilising it for working capital requirements.
Long-term funding for capital projects has proved to be difficult to get. The only banks which have extended long-term credit have done so on the back of external credit lines which are perfectly matched to the tenure of the loans. There has also been a general risk aversion by the local financial industry towards lending especially from international banks.
Barclays for example had a deposit base of $110 million as at the end of March 2010 and a loan book of only $22 million with additional commitments to lend a further $18 million. This represented a loan to deposit ratio of only 20%. FBCH was also in the same region with a loan to deposit ratio of 23%. CBZ which is now the largest bank by deposit base with $360 million  in deposits made the most lending and had a loan to deposit ratio of 67,8% as at the of December 31, 2009.
The theoretical Modigliani-Miller theorem often called the ‘capital structure irrelevance principle’ states that in the absence of bankruptcy costs, asymmetric information and an efficient market the value of the firm is unaffected by how it is financed.
This also applies to the company’s dividend policy. In simplistic terms, the value of two similar firms financed by debt or equity is supposed to be the same. The general sentiment is that this has been used to justify the unlimited use of leverage.
The Zimbabwean scenario is somewhat different in that the cost of the available debt is significantly higher than global markets due to the market illiquidity. The average cost of even short-term debt has been generally expensive. Considering that Zimbabwe does not have a sovereign credit rating, the country risk premium would also need to be priced into the cost.
The local companies have been unable to raise long-term corporate debt which can be done through corporate bonds. The absence of a vibrant secondary market for these bonds thus making them illiquid in the short term has also dampened the ability of even blue chip companies to raise long term debt capital.
In normal environments the inclination towards equity finance would be prompted by the need to address the agency problem which is the challenge which arises from the different interests of managers and shareholders.
There tends to be a conflict arising from the fact that non-shareholder managers would want to maximise bonuses and short-term remuneration at the expense of the shareholders. This may also have been the main reason to the resistance by external investors in taking up equity stakes in local companies especially in the light of the Indigenisation Act which in essence does not give them control over their investments. In most scenarios investors will change management and request board representation.
The preference of equity is also prompted by the expected dividends from the company which is normally the basis for investment appraisals. The majority of Zimbabwean companies have a need to conserve cash to fund long-term projects since they are coming from a hyperinflationary environment and have “antiquated machinery” which requires replacement.
The equity market has seen some rights issues which have not attracted much interest due to the market illiquidity. The ones which come to mind are African Sun in December which had 61% subscription and StarAfrica which had an uptake of only 29,1%. By far the worst supported rights offer was for CFX which was under subscribed by 98,4%. Private equity transactions have been few and far between as a result of valuation issues and the perceived adverse country risk.
A new trend has emerged which is not vanilla lending or straight equity uptake but more of “structured finance”. The OK transaction is evidence of a structured finance deal. Under the deal Investec Asset Management’s Africa Frontier Private Equity Fund will acquire a stake of up to 20% in supermarket chain OK Zimbabwe. Investec will make a US$5 million convertible loan available to OK and underwrite a rights issue of US$15 million.
As the economy normalises and liquidity improves in the market we expect the trend to be more towards a combination of debt and equity. This will be a risk mitigation measure which allows investors the ability to hedge against the risk associated with vanilla equity or debt investments.
The argument for the shift towards debt is that it also tends to force managers to perform due to the fixed interest payments which would impact on the bottom-line, which subsequently reduces their remuneration which is normally performance based.
If there is an injection of liquidity into the market in the long run we could see the introduction of corporate bonds which could be attractive to foreign investors considering the fact that Zimbabwe is a dollarised environment which creates a stable foreign exchange volatility environment. There could also be more corporate actions in terms of rights issues and IPOs which could activate the equities market.

Precious Mhlandhla

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