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Why equity can be so much more expensive than debt

I was recently leading a seminar for CEO’s and business owners, where a large number of participants could not understand why the cost of equity was so much higher than the cost of debt.  I had mentioned that the cost of debt (e.g. interest rates) were typically in the range of 4% to 8% for most mid-sized companies in Central Europe, denominated in euros, and the cost of equity (e.g. Internal Rate of Return) required by most private equity investors, was in the range of 25% or higher.   A number of seminar participants could simply not fathom why equity would cost four or five times as much as debt.  As one of the seminar participants said, “I could understand if equity were 40, 50 or 60% more expensive than debt; I cannot understand why it might be four or five times as expensive”.   This article attempts to explain this phenomenon.  There are three major reasons:

First of all, debt is typically secured by assets, whether real estate, machinery, receivables, inventory, or other things of value, which may be seized by the lender in case of default by the borrower.  Equity ownership, by contrast, is not accompanied by any kind of security interest in the company financed by the equity holder.  The equity holder cannot seize anything, the sole remedy of an equity holder generally being the right to vote at a shareholders’ meeting.   The aforementioned 4 to 8% interest rate generally assumes that there is significant security for the lender.  An unsecured loan would have a much  higher interest rate, assuming a lender would be willing to lend on an unsecured basis, (which is probably not the case).

A second reason why the cost of equity is typically much higher than the cost of debt is that in the event of bankruptcy of a company, debt holders are satisfied in full before equity holders receive any proceeds of liquidation whatsoever.  In other words, even an unsecured holder of debt will receive 100% of what is owed to him or her, before equity holders see a penny

Thirdly, a company must pay holders of debt an interest rate, even if the company is loss-making (and failure to pay interest or to achieve debt coverage ratios may put the company into default and force a liquidation).  Equity holders, by contrast, are paid dividends only to the extent that the company has been profitable, once all obligations in the ordinary course (e.g. servicing of interest payments) have been satisfied. 

So it boils down to a tradeoff between risk and reward.  Debtholders have far lower risk (for  the three aforementioned reasons).  If a company is highly profitable, on the other hand, such profits or rewards will typically accrue to exclusively to the equity holders.

I once had a client, the CEO of a publically owned telecom company, for whom we were carrying out a capital raising exercise, who kept insisting that he wanted to raise equity because equity was cheaper than debt.  It required a number of multi-hour sessions to understand his logic and convince him of the contrary.  Essentially, he saw that his company had to pay debt holders huge amounts of interest every month, whereas equity holders only sporadically received relatively modest dividends.  (The company was still reinvesting cash generated from operations in an expansion program).  Raising additional equity would have had a dilutive effect on earnings of existing equity holders, as any private equity firm willing to invest equity would have demanded a percentage of equity which would have allowed them to achieve a minimum 25% Internal Rate of Return on their investment.

In short, the fact that equity is much more expensive than debt comes back to the principle that the higher the risk, the higher the expected rewards.  And the risks associated with equity are significantly higher than the risks associated with debt.

Disclosure: No positions