WeWork debacle shows why bond investors should never rely on “dangerous” equity cushions

The collapse of WeWork’s overhyped IPO should act as a warning to debt investors not to rely on the “equity cushion” myth, according to Kames Capital’s fixed income investment manager David McFadyen.

In fixed income investing, a large equity cushion – the amount of equity value relative to its debts – is traditionally seen as a safety net to investors as well as a mark of a company’s popularity.

Part of why some bondholders felt safe lending to WeWork was due to a perception of safety offered by its massive equity valuation.

However, McFadyen warns that investors who rely on a company’s equity cushion are playing a “dangerous” game following the recent troubles of the co-working office specialists.

A combination of disappointing financials and suspect governance has seen WeWork’s valuation plummet by 70% in six weeks and caused it to shelve its much-anticipated IPO plans. 

McFadyen said the collapse of WeWork’s valuation demonstrates why bond investors should not place too much sway in the so-called “equity cushion”.

“Investors love margins of safety,” he says. “They give us confidence companies can overcome challenges and to buy or hold onto investments when times are tough. Some bondholders will happily say a large ‘equity cushion’ – how much the market loves a company – is a margin of safety.

“The theory goes that if a company has a significant amount of equity value relative to its debt then bondholders are protected – the equity market will support the company. But undue reliance on this is dangerous.”

McFadyen adds: “While the bonds haven’t traded particularly well, they looked like a slam dunk as an IPO loomed to provide confirmation of the market valuation, and typically comes with a debt reduction kicker.

“But WeWork’s valuation wasn’t what was hoped – investors balked at the price relative to the real fundamentals of the business. Its IPO is on the rocks, with a massive valuation cut from nearly $50bn to closer to $10bn.

“The equity cushion has been vaporised, and so has the supposed bondholder margin of safety.”

McFadyen warns that it isn’t just ‘new economy’ companies like WeWork that can suffer in this way. He points to state-owned Brazilian energy firm Petrobras as another example.

He says: “With Petrobas you had two ‘equity cushions’; a chunky market capitalisation – in 2013 this was $124bn of equity vs $95bn of debt – and the protection of state ownership.

“But in the energy crisis Petrobras’ market capitalisation was destroyed, and in 2015 it was only $22bn versus $124bn of debt. Equity cushions only work for as long as the market keeps believing in the story, and if there isn’t a meltdown.”

McFadyen says he won’t lend to companies solely based on the level of love they are shown by the equity markets.

“We lend to companies based on our bottom-up analysis, and which can clearly persist past their next debt maturity, whether the equity markets are in meltdown or not.

“A company that thinks it can rely on the equity market to fund it in extremis may find it cannot if faith in its story is lost.”