GUEST BLOG FROM WARWICK LIGHTFOOT

Thames Water’s challenges reflect over use of debt and leverage, the retreat from public markets to private equity and the huge credit risk of indexed linked debt in the private sector.

In a paper prepared for the European Tax Policy Forum in April 2008 Multinationals’ capital structures, thin capitalization rules, and corporate tax competition Andreas Haufler and Marco Runkel set out the issues of thin capitalisation neatly. 

The tax bias to debt and against equity 

This is that

‘existing corporate tax systems permit the deduction of interest payments from the corporate tax base, whereas the equity returns to investors are not tax deductible. This asymmetric treatment of alternative means of financing the capital stock offers firms a fundamental incentive to increase the reliance on debt finance. Corporations will thus trade-off the tax advantages of debt against its non-tax costs, where the latter arise primarily from an increased risk of financial distress and the resulting agency costs due to conflicting interests between debt and equity owners.’

Sustained international concern about erosion of the corporate tax base

Most of the official interest in thin capitalisation exhibited by national tax revenue authorities, the IMF and the OECD has focused on the scope that putting debt on a balance sheet may erode the tax base and revenue collection. It is particularly significant in relation to multinational firms and inward investment. Transfer pricing creates opportunities for international firms to load debt on subsidiaries located in high tax jurisdictions and to make interest payments to another subsidiary with a lower corporation tax rate on profits. Most advanced economies since 2000 have brought in thin capitalisation rules to reduce the scope for this.  It is generally considered that such rules put up the after-tax cost of capital and that there is a trade off between revenue collection and attracting inward investment, which is generally sought after because it is associated with technology transfer and a range of beneficial spillovers that increase productivity.

Debt finance and undercapitalised business 

There is however a further dimension to thin capitalisation: it results in corporate balance sheets with higher ratios of debt in relation to equity. This makes their balance sheets more vulnerable in the event of an adverse trading event or wider general economic shock. The increasing use of debt in company balance sheets for purposes of tax planning combined with readily available and cheap debt finance from bond markets has over the last twenty-five years interacted to increase company leverage significantly. It explains the growth in the role of private equity capital and has contributed to the atrophying of public equity markets in advanced economies such as the UK and US that traditionally have had large public equity markets at the centre of their capital markets. The wider aspects are explored in The atrophying of publicly traded equity markets: why stock markets no longer match up with the economy.

Cake shops with balance sheets as fragile as banks

The result has been that company balance sheets are loaded with debt and become vulnerable to adverse events. Firms such as chains of patisserie shops have the kind of leveraged balance sheets that expose them to the sorts of risks more usually exhibited by banks or insurance companies. Banks and insurance companies are subject to rules about capital because of the inherent risks in their businesses and their systemic role in the economy. Yet many ordinary firms appear to exhibit comparable risks without the full systemic implications of a major bank going bust. We saw this during the covid emergency where during the interruption of normal business, because of the debt on their balance sheets, many non-financial firms were desperate and needed the special fiscal measures to help them to keep going. Some help would have been necessary but the scale was amplified by the fragility of many company balance sheets.

Complex public sector infrastructure, rent seeking and the scope to ‘coin it’

Where public infrastructure investment contracts are involved there is huge scope for rent seeking. A consortium of normal infrastructure firms set up a specialist vehicle to carry out a major contract. They finance it with debt. That company then subcontracts with the normal construction and engineering firms who do the work at contracted prices. In practice the special purpose vehicle, loaded with debt, subcontracts with its shareholders. There are few profits in the firm that issues the contracts and a lot of debt. When something goes wrong at the margin the special vehicle set up or used goes bust. Its shareholders have made huge profits through the previous contracts. As one distinguished British transport economist put it in relation to the public-private partnership financing the modernisation of the London tube almost twenty years ago: they were ‘coining it’. The story was later laid out in the reports of the National Audit Office looking into the matter.

Thames Water’s history is an illustration of all the things mentioned so far in this article. An involvement with the public sector. Taking a previously publicly traded company private. Ownership vested in private equity. The aggressive use of debt and a vulnerable and unstable company balance sheet. Along with the use of debt to pay dividends to the private equity owners. The Financial Times Lex column reported on July 1, 2023, that Thames Water has £14 billion of debt, that its Australian owner paid itself £3 billion in dividends during its eleven year period of ownership. The Financial Times leading article on it succinctly summarised the position: ‘Problems at Thames show how sector was reshaped by financial engineering’.

We would all like some private index-linked bonds to invest in, but the credit risk is huge

For bond investors there are three risks. These are: will the money be paid back and interest be paid – credit risk; will interest rates go up reducing the capital value of existing bonds on the secondary markets, market risk; and will inflation erode the real value of the income stream and principal, inflation risk.

The use of debt by the owners of Thames Water also offers an interesting gloss on the properties of indexed linked debt in the private sector. For any long-term investor debt indexed to inflation is a very attractive proposition. In the long-term the biggest threat to the value of a bond holder in the long-term is unexpected inflation. A century ago in 1924, Edgar Smith published a monograph, Common Stocks as Long-Term Investments. Smith in his famous article showed that on the basis of investment returns from 1866 to 1922 that equities in the long-term albeit with variability of return outperformed debt. This is because an equity portfolio offered investors a share in future rising profits whereas debt offered a ‘fixed income’.

When inflation is put into the mix the disadvantage of bonds is amplified hence the cult of equity when inflation took off in 1950s

In the context of debt, the fixed income it provides is eroded in real terms by price inflation. Both the real value of the interest goes down and the real value of the principal that is repaid on redemption is reduced. A long-term debt instrument that protects an investor from inflation is therefore very attractive. This explains the attraction and the expense to the investor of indexed linked government bonds such as UK Gilt Linkers and US Treasury TIPS, and why the market in them is so illiquid. Yet the credit risk to the investor of whether the borrower really is able to pay is huge. Examples of such investors include pension funds, insurance companies and central banks that may choose to secure their indexed linked pension fund liabilities in this manner.

Governments are able to offer indexed bonds which in the event of inflation are expensive to service. However, before an investor accepts a higher rate of interest on a private corporate index linked bond, the credit risk they have to consider is very different. Thames Water has issued index linked debt. In principle, given that the price regulation it operated under is tied to inflation, this should be the sort of private sector index linked debt that a firm could comfortably manage. Yet it appears that the water company has a debt index to the RPI while its regulated income is linked to the CPI.

The challenge of meeting a commitment to service an index linked debt is illustrated by the benefits enjoyed by private retail investors in UK Index Linked National Savings Certificates. These were issued in the 1990s and are tax free. For higher income tax rate investors, on an after-tax basis, they are often the highest yielding part of their portfolio. Even after they matured and if unredeemed no longer paid a rate of interest, they just continued to be indexed for inflation until cashed in.

The heart of the matter

At the heart of this process of financialisation has been a tax system biased to debt and against equity, aggravated by a decade of very low interest rates and the micro-economic mispricing of credit for almost two decades.

Warwick Lightfoot