Equity or debt: which is cheaper?

The question—debt or equity?—is rarely raised in North American corporate boardrooms. A good part of the blame rests with the fundamental structure of the financial marketplace: both the brokerage industry and the retail investor segment is governed, almost entirely, by the need to trade instruments (stocks) which inherently incorporate substantial short-term upside. But corporate managements must also be blamed for failing to substantiate business models capable of reasonable analytical scrutiny; after all, without a clear direction, it is impossible to draw any qualitative distinction between the respective roles of equity and debt in a corporation’s growth strategy.

The traditional argument against the applicability of debt for juniors is premised on the notion that, without hard asset security (perhaps in the form of proven reserves), a debt issue is not a viable proposition. That notion is seriously flawed. On the one hand, convertibility can take care of debt default in instances where the value drivers influencing strategic success are unable to take concrete shape within a pre-defined time-frame. On the other hand, debt is invariably a consequence of pricing; whereas a developed mining company may be able to issue loan paper at 300 basis points over a benchmark rate (e.g. US treasuries or LIBOR), a junior may have to pay 700 or 800 basis points.

That brings back to the “debt or equity” question. Is debt at 15 % per annum more expensive than equity raised at current market price levels? No. There are any numbers of examples of well-managed juniors achieving five- and ten-fold increases in share prices over an 18-24 month period. Therefore, in plain percentage terms, the balance between limited dilution via debt and excessive dilution via equity must weigh in favour of the former.

In addition to the rather simplistic percentage-per-annum relative comparisons, sophisticated mathematical assessments of cost of capital produce the same results: credible business models make their own case for debt in favour of equity until such time that market capitalizations reflect underlying value. Such results may not hold in an environment where applicable interest rates exceed 20-25 % per annum, or where a company’s market capitalization far exceeds management’s perception of corporate value. But, in general, the conclusions hold good today.

Which brings us to the second question: Is junior-issued debt saleable?

Most certainly so; at the end of the day, debt placement is a function of price. And price, in turn, is a function of structure. Does the debt instrument offer convertibility into common shares? Will those common shares be tradable upon conversion? Will the debt paper undergo enhancement, potentially, during its validity, as exploration programmes lead to probable or proven reserves? Is the debt secured by a specific resource?

The exercise is not as complicated as it may appear in the first instance. On the contrary, most of the answers to structuring-related questions can easily be found in a company’s business model. For example, pricing depends upon where a particular company figures on the exploration-to-resource cycle, which impacts upon quality of the security on offer. To take another related example, the number of issued and outstanding shares—calculated on a fully diluted basis—directly impacts upon the conversion options.

All that said, what a junior requires today, at the very outset, is an acceptance of the fact that the sub-prime crisis has forced a total revaluation of pricing parameters, be it debt or equity, right across the investment spectrum.