The geography of hidden leverage
Every major financial crisis appears to leave behind better financial reporting. Enron increased scrutiny of consolidation and special purpose entities. The financial crisis increased attention to off-balance-sheet exposures, securitization and liquidity. More recently, IFRS 16 brought most operating leases onto corporate balance sheets.
Each crisis makes part of yesterday's hidden leverage easier to see. Yet it seems that economic leverage remains materially greater than headline financial debt in some businesses.
We have seen companies deconsolidate property and lease liabilities while retaining long-term operating relationships with the underlying assets. Fixed lease commitments can effectively be replaced by management or contractual commitments that are less visible as leverage.
We also regularly encounter perpetual subordinated securities classified as equity despite characteristics that make them economically much closer to debt.
And leverage does not stop with financial instruments.
Leases, supplier financing, pensions, purchase commitments, guarantees and other fixed obligations all represent claims on future cash flows. We made this point earlier this year: reported debt is only one part of the company's true fixed-cost structure.
The problem is therefore not necessarily that leverage is undisclosed. It can simply be sitting somewhere investors do not immediately call debt. Most of the time, investors do not care much about hidden leverage until circumstances change and suddenly it matters again. As long as revenues grow and margins remain comfortable, fixed commitments are serviced and operating leverage works in shareholders' favor.
The problem appears when cash flows weaken.
This is why the current combination of higher energy costs and higher interest rates matters.
Higher rates increase the cost of financial leverage. Higher energy and transport costs pressure operating margins. And if those costs eventually reach the consumer, they can weaken the revenues available to support both.
Geographical split
The same oil and gas shock is not reaching consumers in the same way everywhere. And that geographical difference may determine where hidden leverage becomes visible first.
