The Phantom De-Leveraging of the U.S. Economy

by: Dr. Hugh Akston
There is a commonly held view that the US economy is in the midst of de-levering. Throughout the stock market, on a daily basis companies are raising capital through secondary equity offerings and using the proceeds to pay down the debt on their balance sheet. The “d” word has clearly become the buzzword of the moment in corporate American (maybe second only to “green shoots”).
I recently attended a Goldman Sachs conference and every presenting company commented on their de-leveraging efforts, plans to de-lever, or the benefits of de-levering.
Let us first understand what “leverage” means so we can agree what de-leveraging will look like. Leverage, for our purpose, is the amount of debt one has relative to the amount of income earned, it is not an absolute level of debt. For example, if Bill Gates has a $10m yacht loan, it would be incorrect to say that he is more highly levered than I am with my $100k in B-school student loans. Although his liability ($10 million) is larger than mine ($100k) his income earned is greater than the proportionate difference in our debts.
Let’s take a look at a simplified example of a secondary equity offering and the de-leveraging impact in the context of the current economy. The below example assumes our imaginary company, Ben’s Dance Academy, has $100 in debt, $100 in EBITDA in FY 2008, and has 100 shares outstanding. Looking into 2009 let us assume that EBITDA falls -20% to $80 for the year. Ben’s Dance Academy decides it wants to “de-lever” by selling 20 shares at $1 per share and use the $20 in proceeds to pay down debt resulting in $80 of outstanding debt.
With Equity Raise Without Equity Raise
FY 2008 FY 2009 FY 2009
EBITDA $100.0 $80.0 $80.0
yr/yr change -20% -20%
Debt $100.0 $80.0 $100.0
Shares Outstanding 100 120 100
Leverage (Debt/EBITDA) 1.00 1.00 1.25
Click to enlarge
Click to enlarge

As you can see the leverage profile of the business is the same post-equity raise at 1.0x debt/EBITDA that it was in FY 2008, in other words the business did not actually de-lever despite paying down 20% of their debt because of the drop in income earned (EBITDA). Without doing the equity raise, the company would have seen their leverage increase to 1.25x so the deal avoided making the company more levered but did nothing to decrease leverage.

The trading implication for investors is that economy-wide equity raises will have to be large enough to offset the fall in income earned (EBITDA) in order for any real de-leveraging to take place.
Using a universe of all US companies with market capitalizations over $200m, analysts expect EBITDA to fall roughly -10% in FY 2009 vs. FY 2008 which suggests the current level of equity raises are probably not even enough to offset the decline in earnings much less de-lever the economy. To borrow the over-used baseball analogy, it is highly unlikely that we are anywhere near the 9th inning in this de-leveraging process. The ramifications for equity investors are that these equity offering dilute the stake of current shareholders as more shares are issued.

Disclosure: No Positions