Available choices to raise corporate finance

Companies reach a certain stage when they need to raise finance once owners’ equity injections diminish. There could be several reasons — positive and negative — to raise external finances. The reasons deemed positive include boosting investment to exploit more available opportunities, hiring new personnel, and procurement of equipment. 

The negative reasons include cash flow difficulties indicating that maybe the company’s operating model needs to be reconsidered.

It is, however, normal for companies to rely on bank loans for additional capital after reaching a certain size. Having an established bank relationship over many years often helps, as most banks are reluctant to issue loans to relatively new clients. Larger businesses have more choices, as they can also turn to either corporate debt or equity markets. However, while both approaches provide much-needed capital injection to a company, they are different in their impact on the business and the type of security asset they provide the ultimate investor.

Like other Gulf countries, Saudi Arabia is witnessing a veritable tsunami of initial public offerings on its main Tadawal market and Nomu, the parallel stock exchange. 

According to the Kingdom’s Capital Market Authority, the Saudi stock market is now four times larger than the Kingdom’s entire economy, even without taking the largest IPO — Saudi Aramco into consideration. The CMA revealed that there are a further 54 listing applications pending, 31 of which are direct listings on the Tadawul. The massive oversubscription of the existing and new offerings indicates that both individual and institutional investor appetite is there. It should be noted that qualified foreign investors are also keenly observing these developments and taking part in the ongoing investment spree.

Like other Gulf countries, Saudi Arabia is witnessing a veritable tsunami of initial public offerings on its main Tadawal market and Nomu, the parallel stock exchange. 

Dr. Mohamed Ramady

 

Equity investment provides investors a piece of the offering company, along with voting rights for certain share categories, which gives investors the right to be heard at both the ordinary and extraordinary general meetings. This right is now being successfully used by activist shareholders, especially concerning climate change concerns and whether their company is doing more in becoming ESG – environment, social, and governance – compliant.

Bond issuance is another option for such companies, or in parallel with equity raising. Purchase of bonds by investors does not give ownership rights but are merely debts that a company issues instead of getting a traditional bank loan. The relationship between the lender and borrower is straightforward — at the end of the bond’s life, ranging from anywhere between 1 and 30 years for well-established corporate names, the money invested comes back along with their yield to those willing to take that bond risk. 

To make such debt bond issuances more attractive, a credit rating from a rating agency can be obtained to ascertain the level of default risk, but this adds to the bond issuance costs. A high return makes bonds attractive for risk-averse investors, based on the assumption that the life of a company is perpetual and will not go out of business and default, making the bond worthless. However there is a market for both private and government  junk bonds  with speculative junk bond investors purchasing these at a significant discount hoping that the defaulting company can be acquired by others and turning it around, or that sovereign countries start to make payment on their junk bonds as happened with some Latin American countries in the 1980s.  This type of investment makes it a very different proposition to owning equity shares where investors hope to get dividends and gains from share price increases over time. Dividend payments are a matter for the company board to decide rather than an item in a fixed bond contract, and dividends offer more flexibility to companies unsure about their future cash flow. 

In Saudi Arabia, investors eagerly await dividend payment announcements, as such notifications affect a company’s stock price. It does not necessarily follow that a poor or nil dividend payment is necessarily bad for the company if the management sends out an explanatory message such as putting better use of the money for expansion, potential mergers, or developing new technologies. An example is Microsoft, which did not pay a dividend until 2003 despite many years of mega-profits, instead deciding to retain its earnings to develop new technologies to maintain its monopolistic position in some sectors. Interestingly, when Microsoft paid its first dividend, its shares fell as some investors concluded — somewhat wrongly — that only companies that are reaching maturity pay dividends. While small investors dependent on dividend payments to supplement their income will not agree to dividend delays, large institutional investors are more understanding. 

So which route — debt or equity — should a company follow? Debt capital should, in theory, be a cheaper source of funding for a company than equity capital as in some countries there is the more favorable tax treatment of debt, as interest payments are regarded as a business expense. Dividends are not regarded as such. Issuing bonds is also low cost when compared to the investment management fees for selling shares, and another factor in favor of bonds is that issuing shares is a highly regulated activity by the country’s stock market regulators. 

• Dr. Mohamed Ramady is a former senior banker and professor of finance and economics at King Fahd University of Petroleum and Minerals, Dhahran.