Let’s be optimistic and assume that one or more of the 11 COVID-19 vaccines currently undergoing Phase 3 clinical trials are found to be safe and effective by early 2021. Let us also assume that production can be ramped up quickly, so that countries can vaccinate a significant part of their populations by late next year.
In this rosy scenario, the current “special period,” when social distancing severely restricts economic activities – from schools to universities, restaurants to airlines, concerts to sports events, and religious ceremonies to wedding parties – will last only one more year. Once social-distancing measures are lifted, pent-up demand for celebrations, social gatherings, travel, and the joys of human interaction will likely fuel strong recoveries.
But for many firms that already have endured six months of pandemic-induced disruption, one year seems far away. Firms able to survive until then – especially in emerging markets – will have a bright future but weak balance sheets. They will have experienced 18 months of negative cash flows in which their equity will have largely evaporated.
True, many central banks have provided unprecedented levels of monetary stimulus, not only by driving down interest rates, but also by purchasing massive amounts of assets (quantitative easing) and committing to maintain this policy for a substantial period of time. This so-called “forward guidance” is meant to convince banks that they should lend more at lower interest rates, because these rates are not going up any time soon.
But banks will lend only to creditworthy borrowers – and creditworthiness depends not only on the brightness of borrowers’ prospects but also on how much equity they possess. Equity acts as a sort of guarantee that the borrower is good for the money. If things do not turn out as well as the spreadsheets suggest, the company can still repay a loan because it owes less than what it is worth.
In this sense, equity and debt are complements: the more equity a company has, the more it can borrow. Banks usually require borrowers to maintain their debt-to-equity ratio below a certain limit.
So, in the optimistic scenario described above, there will be plenty of firms with promising prospects but insufficient equity to warrant more borrowing. Their growth will depend on how fast they increase their equity – whether quickly, through an injection of equity capital, or much more slowly, through retained earnings. Clearly, a fast infusion of equity will make monetary policy much more effective and the recovery much more robust.
But equity is institutionally much more challenging than debt. Debt involves the commitment to repay a certain fixed amount of money at certain dates. It is easy for a lender to know whether payment has happened and to convince a judge if it has not.
Equity, on the other hand, is a claim on whatever is left after all other stakeholders have been paid, including not only debts to suppliers, workers, and creditors, but also the costs of managers’ salaries, bonuses, expense accounts, and corporate jets. Equity holders’ claim on the firm’s residual cash flow can thus evaporate very quickly.
Preventing this and assuring equity investors requires respected corporate governance and trusted judicial enforcement. Equity holders must be given some rights such as the power to elect and remove the board, control executive pay, and limit the number of risky ventures the company enters. They should also be entitled to be informed by independent auditors about what the firm is doing, and to ensure that insiders do not trade their stock on the basis of restricted information.
But establishing a governance structure that can provide these assurances is costly. In the United States, this has fueled the rise of the private-equity industry, which prefers to avoid such costs by delisting publicly traded companies. In most developing countries, equity markets, where they exist, comprise only the largest firms, including banks, insurance companies, telecommunication providers, utilities, and a few large manufacturers. For all other companies, equity comes from friends and family.
Unless they hold a majority stake in the company, global private-equity funds that have tried to enter emerging markets since the 1990s have often seen their claims disappear. Moreover, the absence of liquid equity markets means that when they want to divest, they find themselves in a Hotel California situation, in which they can check out but never leave. This is particularly problematic for private-equity funds that promise to return capital to their investors after a fixed time period.
The social cost of these inefficiencies will skyrocket during the post-vaccination recovery. Dealing effectively with them now can be one of the highest-return investments ever.
Part of the solution should come from private-sector-led financial innovation. Private-equity funds that trade like stocks do not need fixed redemption periods and hence are in no hurry to sell. In the US, special-purpose acquisition companies (SPACs) raise their capital through an initial public offering before they know what they will do with the money, and stand ready to invest as opportunities arise. They do not have to be listed in the country in which they invest, meaning that they can list in places with better institutions and more liquid markets.
Emerging markets would benefit enormously from resolving the coming equity shortage. Family businesses therefore need to consider the advantages of accepting new equity investors and the resulting dilution of family members’ decision-making authority, lest they see competitors that do accept such funds take their market away from them.
Meanwhile, emerging-market policymakers should seek to improve regulatory frameworks – making sure, for example, that pension funds and insurance companies can invest in the new equity vehicles. And global investors, with the encouragement of institutions like the World Bank Group’s International Finance Corporation and IDB Invest, part of the Inter-American Development Bank Group, should be establishing cross-country private-equity funds.
None of this is rocket science, and it can pay off handsomely in terms of a faster recovery. That is one more reason to be optimistic.
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