Fear Of Debt 5. June 2012 Rahul global perspective (0) Debt has become a complete pariah. The pendulum on debt has swung to the other extreme compared to 2007. The world cannot function without debt. All assets cannot be owned by equity. Investors have a desire for collateralized lending with first charge on assets cushioned by sufficient equity. They are willing to forego higher returns in exchange for reducing (substantially) volatility and risk. On the other side, entrepreneurs and managements have confidence in their abilities, their products and their markets to leverage up their scarce equity capital to enhance their equity returns. How much debt an asset can carry comfortably and how much interest it can service completely depend on individual situations, markets, economies and the general environment. However, when the markets start pricing assets as if all debt is poisonous and every leveraged company is likely to go bankrupt, large dislocations and mispricings start to appear. As banks and financial insitutions around the world (especially in Europe at this time) deleverage and start contracting credit, such an environment is starting to develop. I broadly divide companies into three categories. - The first category are those that have a small to reasonable amount of debt and whose earnings sufficiently cover interest payments and short and medium term repayment obligations. - The second category are those that are fairly leveraged or slightly overleveraged and have good assets. These companies are able to cover interest payments but have some stress in principal repayments or have need for refinancing. - The third category are those that are either faily leverage or overleveraged but have assets that are lousy or that have collapsed in value and have no ability to generate sufficient cashflows to either service interest or repayment obligations. The first category of companies are not affected by the stress/dislocation created by the ongoing deleveraging. The third category of companies are likely to go bankrupt and rightly so. However, the second category of companies and the space between the second and third category is where severe dislocations have taken place. These are companies that are being priced like category three companies but have more in common with category one companies. A word of caution. Not all companies are created equal and extensive research and diligence is required to understand which company falls in which category. The process is also very subjective. Mouthwatering opportunities present themselves when the difference between what is and what can be is very wide.