Master Thesis
LLM in Law and Finance
Impact of Shareholder Loan Subordination on Company Capital Structure
Author: Peter Janiš, student no. 12757292, ptrjanis@gmail.com Supervisor: dhr. prof. dr. R.J. (Rolef) de Weijs
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Abstract
This paper analyzes the impact of shareholder loan subordination on company capital structure. It starts with a brief description of theory of shareholder loan subordination including a short policy discussion. To proceed to empirical analysis, it proposes three major hypotheses which postulate the impacts of shareholder loan subordination on company capital structure. To test the hypotheses, balance sheet analysis is performed on a selected sample of twenty-two companies in the Slovak Republic to compare their capital structures prior to shareholder loan subordination (2011) and after it was introduced (2012). It is shown that no substantial changes to company capital structures were recorded upon the subordination of shareholder loans. More importantly, these changes do not confirm any of the hypotheses. Three main clusters of explanations are offered for these results. First, methodological issues with the research are outlined as possible reasons for the observed results. Second, no decrease in the cost of debt upon shareholder loan subordination is offered as a possible explanation. Third, other more dominant reasons and external influences shaping the capital structures of companies are examined as possible reasons for the observed results. The paper draws toward conclusion with outlining the potential for further research: an analysis larger in sample and jurisdictional scope, research targeted on rescue finance, and research conducted as interviews with the relevant stakeholders at the time of shareholder loan subordination. Finally, the initial policy discussion shall be revisited, and the findings of this paper will be applied to the policy debate.
Keywords: shareholder loan, subordination, capital structure, empirical analysis, hypotheses, cost of debt, Slovak Republic.
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Table of Contents
Abstract ... 2
1. Introduction ... 5
2. Theoretical and Policy Underpinnings of Shareholder Loan Subordination ... 6
3. Hypotheses ... 9
3.1 Hypothesis 1... 10
3.2 Hypothesis 2... 11
3.3 Hypothesis 3... 11
3.4 Interrelation between the Hypotheses ... 12
3.5 Companies without Internal IB Debt ... 13
4. Analysis Design – Testing the Hypotheses ... 14
4.1 Sample Selection and Description ... 16
5. Results ... 17
Figure 1 ... 20
Figure 2 ... 21
5.1 Results Applied to Hypothesis 1 ... 22
5.2 Results Applied to Hypothesis 2 ... 23
5.3 Results Applied to Hypothesis 3 ... 23
5.4 Results Applied to Companies without Internal IB Debt ... 24
Figure 3 ... 26
6. Analysis of the Results... 27
6.1 Methodological Issues ... 27
6.2 No Change in the Cost of Debt ... 29
Figure 4 ... 29
Figure 5 ... 31
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6.2.1 Bank Financing ... 32
6.3 Other Factors Shaping Capital Structures ... 32
6.3.1 Capital Structure Decision-making ... 33
Figure 7 ... 33 6.3.1.1 Irrationality ... 35 6.3.2 Ownership Structures ... 35 6.3.3 Economic Situation ... 37 Figure 8 ... 37 Figure 9 ... 38 6.3.3.1 Rescue Finance ... 38
7. Implications for Further Research and Policy ... 39
7.1 Further Research ... 39
7.2 Policy Implications ... 40
8. Conclusion ... 41
Bibliography ... 43
Appendix 1 – Sample Description ... 48
Appendix 2 – Full Results... 52
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1. Introduction
The subordination of shareholder loans in insolvency is a topic which enjoys substantial attention in academic literature. This debate usually falls into one of two categories. First, predominantly legal scholars analyze and dissect the merits of shareholder loan subordination on grounds such as fairness or the adherence of a given legal rule to other pivotal principles of corporate and insolvency law. A comparison of the applicable rules of various jurisdictions and the legal justifications or origins thereof often follows. Second, an economic perspective is added by some who try to ascertain the nature of the most effective shareholder loan subordination regime when the maximization of general societal wealth (or a criterion of similar sort) is the objective. Such analyses then either present particular examples with rudimentary numbers to demonstrate their point1 or strive to design a theoretical model, switching random numbers for general variables2. Both of these types of analyses share one common characteristic: they are purely theoretical. There is certainly value and insight in studying and conducting theoretical analyses. Most importantly, they point to the optimal or desirable regime from the point of view of theory, principles, and logic. However, when it comes to an intricate subject such as shareholder loan subordination in insolvency, which is influenced by many factors and actors in reality, the theoretical approach must be deemed somewhat deficient. It is submitted that there is a lack of empirical research on shareholder loan subordination in insolvency which would test the theoretical concepts in reality and ascertain whether they unfold as envisaged, or whether market realities confine them to the realm of theory.
This paper is an endeavor in the empirical direction examining the real ramifications of legal rules on company finance. It strives to answer the following question: How does shareholder loan subordination impact company capital structure? Or, put differently, what happens to the capital structure of companies in reality and ex ante, when shareholder loans in insolvency are subordinated? Do the theoretical concepts manifest themselves, or does shareholder loan subordination have a different impact, if any?
To attempt to address these questions, this paper will begin with the theoretical underpinnings and policy considerations of shareholder loan subordination in insolvency. Second, hypotheses which
1 For example: Landuyt, 2018. 2 For example: Gelter, 2005.
6 postulate the impact of shareholder loan subordination on company capital structures will be examined. Third, the design of the analysis, which has been created to test the hypotheses in reality, will be outlined: the analysis will examine the impact of introduction of shareholder loan subordination on the capital structure of companies in the Slovak Republic in 2012. Fourth, the results of the analysis will be presented and applied to the hypotheses. Fifth, it will be attempted to explain and offer context to the results of the analysis. Lastly, the need for further research and policy implications of the present findings will be described followed by a conclusion.
2. Theoretical and Policy Underpinnings of Shareholder Loan Subordination
Traditionally, company owners finance their enterprises by equity. This means they insert capital into the company by share purchases or a similar mechanism3. In return, they get control rights over the company (voting, and nominating boards), the right to future cashflows (dividends), and the right to the remainder of the proceeds of company liquidation (if the company is wound up, the shareholders get what is left after all the debts have been paid off). Companies also have other sources of financing available: borrowing money from external creditors, debt. In return, company creditors get a fixed return (interest) on their investment and the priority of their claims over the residual claim of shareholders (equity) in potential insolvency proceedings. Therefore, unlike shareholders, creditors get a fixed return on their investment, whereas the potential profit of shareholders is unlimited (and due to limited liability, the potential loss is limited to the loss of investment4). Creditors also do not receive any control rights over the company apart from insolvency or possibly a situation approaching it (Nini et al., 2012)5. It can thus be stated that shareholders holding equity face more risk, but a higher potential return than debtholders holding debt (Berk and DeMarzo, 2020).
This division appears to be intuitive, simple, and fair. Interesting issues arise, however, when these two roles become conflated and one person acts both as shareholder (holder of equity) and creditor (holder of debt). This may occur when a shareholder starts to finance the company not just by providing capital (equity), but by extending a loan (debt) as well. In the absence of any rules dealing with such a situation, the shareholder loan is treated as any other in insolvency
3 This depends on the particular jurisdiction and legal form of the company, for example, contributions to the registered capital are used in some jurisdictions for companies other than joint-stock ones.
4 Disregarding the rare possibility of corporate veil piercing.
7 proceedings. This means that the shareholder will recover some of his investment in the company
pro rata along with other creditors thus diluting the payout from their claims6. Moreover, the shareholder could secure his loan by pledging some (or all) company assets. In such a scenario, the security will be used to satisfy his claim7 and the payout for other creditors will be reduced dramatically, as the assets which were previously divided pro rata among all creditors will now be used to satisfy only the claim of the shareholder while the remainder of creditors receive (pro
rata) whatever is left. In both of these scenarios, the same shareholder, but in a position of
shareholder rather than creditor, will receive any payout in insolvency proceedings only after every creditor has been paid off in full8. As the company is insolvent, which usually means there is negative equity9, there is not going to be any property left to distribute to the shareholders (it is only thanks to the doctrine of limited liability that they will not be obliged to inject fresh money into the company to achieve at least zero equity, i.e. the payment of all debts). A shareholder-creditor (company owner acting in this dual capacity) thus has control of and possibly unlimited financial profit (upside) from the company via his equity stake, while limiting his risk of loss of investment in case of insolvency. On the other hand, other creditors face more risk as their potential payout in insolvency decreases. Whether they are compensated for the additional risk (by raising the interest rates) depends on the ability of a creditor to adjust to the new circumstances.
To address these issues, some jurisdictions have introduced rules of varying kind. The Slovak Republic automatically subordinates all shareholder loans and sets aside any security interest pertaining to them so that in insolvency proceedings, shareholder loans are ranked below the claims of all other creditors10. Germany utilizes a similar approach11 of subordinating shareholder loans and setting aside any related security interests (Verse, 2008). In the United States, shareholder loans are not automatically subordinated in insolvency, but may be subordinated on grounds of inequitable conduct of the shareholder (Schulte, 1997). At the other end of the spectrum, there are jurisdictions such as the Netherlands, the United Kingdom, or the Czech
6 There are usually various classes of creditors in reality; this simple example to illustrate the principle only assumes one class of creditors, and shareholders.
7 In case the security does not cover the full value of the claim, the shareholder becomes an ordinary unsecured creditor with respect to the rest of the claim (in this simplified illustration).
8 This may not be the case in restructuring arrangements; however, this is not the present topic of interest. 9 Setting aside the possibility of insolvency triggered by a liquidity crisis (debt default).
10 See section 4 of this paper for more details.
11 There are two minor exceptions for shareholders who are not company directors and hold below 10% of the registered capital of the company and for new shareholders providing fresh capital to the company in a rescue attempt.
8 Republic, which do not feature any rules on shareholder loan subordination (de Weijs, 2018). In the United Kingdom, the situation persists despite the 1982 recommendations of the Cork Committee to the contrary (Ibid.).
It is now apparent what the problems of shareholder loans entail and that various jurisdictions approach these issues differently, ranging from complete subordination of shareholder loans in insolvency proceedings to no rules on this matter at all. What are then the policy considerations shaping these responses, or, if you will, the arguments favoring and opposing shareholder loan subordination?
The most pivotal argument in favor of shareholder loan subordination in insolvency is fairness. Non-subordination of shareholder loans distorts the basic relation between risk and return and shifts the risk to other creditors (Ibid.). The shareholder gets to enjoy many of the benefits of his position, namely the upside of equity if things go well, but limits the drawbacks, namely the loss of investment if things go wrong. The risk for which the shareholder is rewarded does not disappear, but is shifted to other parties, often without proper compensation.
Second, non-subordination of shareholder loans increases the risk appetite of shareholders (as the risk is shifted to other parties) which may result in “gambling for resurrection” particularly in cases of financially distressed companies on the verge of insolvency (Gelter and Roth, 2007). This is undesirable as it may result in the dissipation of assets and the remaining company value, both of which could be distributed to other creditors (Ibid.)12.
Third, it has been stated that one of the main aims of corporate (and presumably also insolvency) law ought to be providing default rules which parties would have bargained for themselves ex ante (Landuyt, 2018). As most shareholders and creditors would presumably ex ante agree to subordinate shareholder loans, this is the default position the law should adopt (Ibid.).
On the other hand, the most prominent argument against shareholder loan subordination is that it will ex ante restrict beneficial credit to companies as shareholders will be deterred by subordination (Ibid.) This may be particularly acute in cases of companies in crisis which require rescue capital (Gelter and Roth, 2007). Germany offers an interesting illustration of the (at least perceived)
12 The shareholder can lend money to the company and pursue a risky project. If things go well, he reaps the full profits in dividends. If the project fails, he can recover some or all of the value as a creditor in insolvency.
9 validity of this point. Due to the COVID-19 crisis, it suspended the automatic subordination of new shareholder loans extended between 1 March and 30 September 2020, although the disregarding of any security interests pertaining thereto still applies (Cobum et al., 2020).
Lastly, there are also the arguments of freedom of contract and no further obligation of shareholders to provide capital which may be summoned in opposition to shareholder loan subordination (de Weijs, 2018). Arguably, it must be stated that these do not stand in comparison to the acute issues of fairness on the principle level and severe distortions of incentives on the practical level (gambling for resurrection) which shareholder loan financing causes.
It is submitted that the most important considerations to be taken into account when deciding whether or not to subordinate shareholder loans in insolvency proceedings are fairness, the incentives the lack of subordination creates, and, on the other hand, the possible limitations on company financing subordination may cause. It is the opinion of the author than on purely theoretical grounds, the arguments of fairness and perverse incentive creation must prevail over possible decreases in company financing. This is because non-subordination creates the potential for permanent abuse harming other parties, whereas the damage caused by decreases in company financing seems to be limited to times of crises, or general lack of credit on the market. Moreover, even in these circumstance, non-subordination of shareholder loans may encourage value-destroying rescue attempts, whereas subordination may discourage some value-increasing ones (Gelter, 2005). It can thus be stated that arguments favoring subordination are generally applicable and strong in principle, whereas the arguments opposing subordination are rather inconclusive. It is now apparent that as there are no precise empirical data which would examine the real impact of shareholder loan subordination on company capital structure (financing), it is perhaps difficult to make a final policy judgement. Therefore, we shall now turn to examining the impacts of shareholder loan subordination on company capital structures.
3. Hypotheses
Subordinating shareholder loans in insolvency proceedings results in ranking such claims below the claims of other creditors, rendering shareholder loans virtually equal to equity in terms of payout. The payout to debtholders is thus not diluted by a payout to shareholders. If this is the legal status operational at the time of provision of financing by investors, several alterations to the
10 company capital structure may be expected to occur in comparison to the situation of no shareholder loan subordination.
Prior to proceeding further, it is necessary to distinguish between external and internal creditors of the company. External creditors, whether of interest-bearing (“IB”) or non-interest-bearing (“NIB”) debt, are the creditors who are third parties to the company dealing with it at arm’s length13. Internal creditors of the company (whether of IB or NIB debt) are its shareholders who may be either legal or natural persons. Lastly, internal company creditors also include other legal persons (affiliates) which are controlled by the same shareholders as the company.
3.1 Hypothesis 1
In case of external creditors of IB debt, the cost of debt may be expected to decrease when introducing shareholder loan subordination (for example: Landuyt, 2018, also Gelter, 200514). This is caused by the lenders facing less risk from the outset, as they know their claims in insolvency will not be surpassed or diluted by the loans (claims) of shareholders. Therefore, they may be more willing to lend more and to do so at a better price, driving the cost of debt (Rd) down.
If the cost of debt decreases due to shareholder loan subordination, it can be argued that external debt financing becomes more attractive to a company, relative to other options. In such a case, it can be expected that more external debt is present in the capital structure, i.e. a company becomes more leveraged.
Moreover, this effect can be compounded by the fact that there is no benefit to company shareholders in keeping the company financed by subordinated loans. This is because the payout from subordinated loans is (virtually) equal to equity in insolvency proceedings. Naturally, should the company never enter insolvency proceedings, shareholders will reap all the profits as equity holders regardless of the size of the equity stake: the difference in payout between financing by loans and equity is thus only relevant in insolvency. As a result of this dynamic, if the lack of subordination is the reason for loan financing, shareholders could be expected to switch at least
some of it for the (now cheaper) external debt (if the cost of external debt is lower than the cost of
subordinated loan/equity financing).
13 For the purposes of this analysis, only IB debt (but not NIB debt) has been divided into internal and external. Section 4 of this paper can be consulted for explanation.
11 It is not immediately clear how subordinating shareholder loans could impact external creditors of NIB debt, as these are often non-adjusting creditors, such as trade creditors, tort victims, or the government (Landuyt, 2018). If all NIB debt creditors are non-adjusting, it could be expected that the level of (external) NIB debt remains the same. However, if at least some of these creditors are adjusting at least in the amount of debt (e.g. goods on credit) they are willing to extend, it would be reasonable to expect the level of NIB debt to rise after shareholder loan subordination. This is due to the mechanism that has already been outlined: subordinating shareholder loans in insolvency proceedings renders the rest of the debt extended to the company less risky. If a creditor adjusts not in the price of debt, but in the volume of debt extended, external NIB debt levels could be expected to rise following shareholder loan subordination.
Therefore, the following hypothesis can be postulated (“Hypothesis 1”): Shareholder loan
subordination will increase the amount of debt financing of both external IB and NIB debt on the company balance sheet.
In order to find evidence supporting Hypothesis 1, a higher proportion of external IB and NIB debt relative to year 2011 on 2012 balance sheets would have to be observed.
3.2 Hypothesis 2
In case of internal creditors of the company, i.e. shareholders, it may be expected that subordination renders the internal debt a less attractive option for them, as has been explained above. A second hypothesis can thus be formulated (“Hypothesis 2”): Shareholder loan
subordination will decrease the amount of internal debt financing, whether conducted as internal IB or NIB debt, on the company balance sheet.
In order to find evidence supporting Hypothesis 2, a lower proportion of internal IB and NIB debt relative to year 2011 on 2012 balance sheets would have to be observed.
3.3 Hypothesis 3
Finally, the equity portion of balance sheets shall be examined. One of the cornerstones of shareholder (loan or equity) financing is that it is often finance which external investors (creditors) would not provide in the first place, or would provide at a prohibitive cost (Skeel and Krause-Vilmar, 2006). Therefore, it must be expected that shareholder company financing will be present
12 after shareholder loan subordination. However, it can be reasonably assumed that subordination minimizes the differences between equity and loan financing.
Therefore, a third hypothesis can be constructed (“Hypothesis 3”): Shareholder loan subordination
will alter the preferred method of internal company financing from debt to equity.
In order to find evidence supporting Hypothesis 3, a higher proportion of equity relative to year 2011 on 2012 balance sheets would have to be observed. The increase in equity shall be attributed to a decrease in internal debt financing, whereas external debt financing may still increase. 3.4 Interrelation between the Hypotheses
The Hypotheses which were constructed postulate the overall expected impact of shareholder loan subordination on company capital structure. Hypothesis 1 and its inverse formulation – Hypothesis 2, examine the impact of subordination on debt financing of the company, while Hypothesis 3 focuses on the equity portion of capital structure.
If we examine the hypotheses together, the following changes to company capital structure may be expected after subordination. Firstly, external IB debt level will rise and internal IB debt level will decline, possibly quite significantly. Secondly, the amount of NIB debt is expected to slightly increase (if at least some NIB debt creditors adjust in the volume of credit). Lastly, the amount of equity is expected to increase after shareholder loan subordination. These expectations can be visualized in the following way using an illustrative capital structure:
22% 20% 35% 30% 10% 20% 5% 5% 29% 25% A f t e r S u b o r d i n a t i o n B e f o r e S u b o r d i n a t i o n Equity Provisions Internal IB Debt External IB Debt NIB Debt
13 3.5 Companies without Internal IB Debt
The aforementioned hypotheses (and most of the analysis) did not (and will not) distinguish between companies on the basis of whether they have internal IB debt (shareholder loans) in their capital structures. It has been assumed that most companies have some form of internal debt. However, it should also be considered to what extent the hypotheses that have already been made apply to companies which have no internal IB debt.
It is submitted that we may expect Hypothesis 1 to fully apply to companies without internal IB debt. Even if there are no shareholder loans at the moment, external IB debt creditors of the company face less future risk of introduction of shareholder loans which would dilute their claims in potential insolvency proceedings. Therefore, the cost of debt (Rd) reduction should apply to this scenario in the same way, as has already been explained. This may be expected to result in more external IB debt on company balance sheets after shareholder loan subordination, since external IB debt becomes cheaper. Similarly, if NIB debt creditors adjust at least in the volume of credit (goods on credit) they are willing to extend, a slight increase in the amount of NIB debt on the balance sheet may be expected after subordination.
Hypothesis 2 is not directly applicable to companies without internal debt financing present in their capital structure. Notwithstanding, Hypothesis 2 is applicable even to such companies to the extent that an introduction of internal debt financing after subordination is not to be expected. Lastly, Hypothesis 3 is not applicable to companies without internal debt financing. In such cases, equity is already not just the preferred, but the only method of internal company financing. Moreover, if we expect the attractiveness of external debt financing to increase after subordination, the only place which can offset this increase is equity (if NIB debt and external IB debt both rise, and no internal IB debt is present, the amount of equity (as a proportion of the balance sheet total) must by definition decrease if provisions are not impacted). Therefore, the expected capital structure changes to companies without internal IB debt can be visualized in the following manner using an illustrative capital structure:
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4. Analysis Design – Testing the Hypotheses
The Slovak Republic is an interesting candidate for testing the hypotheses. Prior to 2012, shareholder loans had not been subordinated in insolvency proceedings, which are governed by Act no. 7/2005 Coll. on Bankruptcy and Restructuring as amended (“Slovak Bankruptcy Act”). As of 1January 2012, a new section of the Slovak Bankruptcy Act, §95 section (3), entered into force (by virtue of Act no. 348/2011 Coll. amending Act no. 7/2005 Coll.). The section 3 in question read as follows (author’s translation): A contractual penalty and a claim, which belongs
or has belonged to a creditor who is or has been affiliated with the bankrupt, shall be satisfied alike to a subordinated claim; any possible security of these claims by way of security law shall be disregarded in the bankruptcy. Therefore, as of 1 January 2012, the Slovak Republic went from
no shareholder loan subordination to full statutory subordination including the disregarding of any security rights pertaining thereto. The section has been further amended since 2012; however, its basic structure and function remain the same.
To test the hypotheses, a sample of Slovak companies has been selected (the sample selection process is described in detail in section 4.1 below) and their capital structures have been analyzed. A capital structure analysis based on company balance sheets has been performed both for the
22% 20% 43% 35% 5% 5% 30% 40% A f t e r S u b o r d i n a t i o n B e f o r e S u b o r d i n a t i o n Equity Provisions External IB Debt NIB Debt
15 years of 2011 (immediately preceding the change, i.e. the last year without subordination of shareholder loans in Slovakia) and 2012 (immediately following the change, i.e. the first year of shareholder loan subordination). The differences in company capital structure between 2011 and 2012 form the results of the analysis. The raw data, i.e. individual balance sheets of companies forming the sample can be examined in Appendix 3.
The analysis is performed on relative terms, comparing changes not in absolute numbers (which are influenced by changes in the balance sheet total, for example), but relative numbers – the proportion of capital structure the item comprises. For example: company X has a balance sheet total of 100 in 2011, 50 of which is external IB debt. In 2012, X has a balance sheet total of 200, 110 of which is external IB debt. The recorded change in external IB debt would not be +220% (110/50), but +5% (2011: 50/100=50% of external IB debt, 2012: 110/200=55% of external IB debt; 55-50=5%). These relative changes are then aggregated to comprise the results. As the balance sheet analysis examines the differences between capital structures of the same companies in two consecutive fiscal years, other influences, which could skew the analysis can presumably be minimized, even if not completely controlled for.
The Financial Mindmap has been utilized as a tool for performing the analysis (de Vries, 2019). Company liabilities have been divided into equity, provisions, and IB and NIB debt, rather than current and non-current liabilities. Furthermore, it has been possible to divide IB debt into internal – extended by the shareholders and the (legal) persons under their control, and external – provided by third parties at arm’s length. The additional data have been obtained by studying notes to the balance sheets, which are published as part of the full financial reports. Based on IAS (International Accounting Standards) 24, shareholder loans have to be disclosed in detail (IFRS Foundation, 2009).
NIB debt has not been divided into internal and external. Firstly, this is because it has been observed that no (outright) shareholder loan financing occurred in the form of NIB debt in the sample companies. NIB debt in the sample companies has predominantly consisted of trade creditors. Secondly, it is clear that many of the NIB (trade) creditors are related parties (although it is not always immediately clear whether these are also controlled by company shareholder(s)). However, it is not ascertainable whether these transactions (for example, purchases of raw materials or services from affiliates) are concluded at arm’s length or at some sub-standard terms
16 which could be said to amount to “shareholder loan financing” (longer periods for invoice payment, for example). For these reasons, it has been decided not to divide NIB debt into external and internal debt.
4.1 Sample Selection and Description
It is a well-known fact that different companies have varying capital structures. For example, technology companies such as Intel tend to have large cash reserves to invest in R&D and relatively little debt, whereas real estate companies maintain high debt to equity ratio as the costs of financial distress are low (Berk and DeMarzo, 2020).
Therefore, to create a meaningful sample of Slovak companies to be examined, various industries accurately representing all sectors of the economy need to be included. The Slovak economy is heavily dependent on automobile manufacturing and other types of manufacturing industry. If a simple sample of ten largest Slovak companies by revenue was taken, it would be heavily skewed: 40% of the companies would be automobile or automobile components manufacturers.
To address this issue, the Global Industry Classification Standard (“GICS”), developed by MSCI and Standard & Poor’s, was taken as the benchmark, as it divides the economy into eleven main sectors considered to encompass all economic activity (S&P Global, MSCI, 2018). For instance, the S&P 500 market index, regarded as an accurate proxy for the American economy, utilizes this classification as well. The GICS sectors are: energy, materials, industrials, consumer staples, consumer discretionary, health care, financials, information technology, communication services, utilities, and real estate.
Similarly, if only large companies were included in the sample, this could skew the results as companies of differing sizes (and corresponding ownership patterns) may have various capital structures. Therefore, both large companies and SMEs (small and medium enterprise) are included in the sample. The SME definition of the European Commission has been utilized for the purposes of sample selection: sample SMEs are companies which have both fewer than 250 employees and an annual turnover lower than €50 million (European Commission, 2003).
Based on the GSCI and company size, a sample of 22 Slovak companies has been chosen for the balance sheet analysis, two companies representing each GSCI sector. The largest company by revenue, which can be clearly attributed to the respective sector, has been chosen along with the
17 largest SME. In certain cases, the largest company by revenue which best fulfills other criteria has been chosen; for example, companies wholly owned and controlled by the Slovak Republic have been omitted as their capital structure is not representative of the market: often, such companies have a limited amount of debt and are financed directly from the state budget; or their capital structure, financing, and business decisions are formed by political, rather than business/finance considerations. A table of the companies used in the sample has been assembled in Appendix 1 along with a brief description (“Sample”). Moreover, to be able to observe differences between large enterprises and SMEs, apart from the aggregate results, separate results have also been assembled for the sample of 11 large enterprises (“Large Company Sample”) and the sample of 11 SMEs (“SME Sample”).
The revenue data used to identify and choose Sample companies are combined 2018 and 2019 data. Due to the COVID-19 crisis, some financial filings for 2019 have been delayed; therefore, 2018 data were used where necessary. These data were obtained from financial returns filed with the Tax Office of the Slovak Republic as reported by Finstat, a web portal which aggregates official reports on Slovak companies from the register of tax returns and the commercial register. Rather than 2012 revenue data, the current revenue data have been used to examine how statutory shareholder loan subordination altered the behavior of contemporary industry leaders in 2012.
5. Results
It can be observed that on average (for both observed years), companies in the Sample feature equity financing to cover on average around a third of their liabilities. Around 30% of the Sample balance sheets were financed by NIB debt, whereas IB debt constitutes approximately 31%. Almost 45% of the IB debt is internal, whereas about 55% is sourced externally; overall, approximately 17% of the balance sheet consists of external IB debt, and about 14% is financed by internal IB debt. The rest (less than 6%) of liabilities were made up by provisions. The average capital structure of a Sample company (on average, for both the observed years) thus looks as follows:
18 A breakdown of selected Sample analysis results is provided in Figure 1 below; the full results can be found in Appendix 2.
Separate selected results of Large Company Sample analysis and SME Sample analysis can be examined in Figure 2 below (the full results are presented in Appendix 2). As opposed to SMEs, large companies of the Sample tend to feature much more equity financing and less debt financing, IB debt in particular. Similarly, the composition of IB debt tends to differ. The Large Company Sample consists of approximately 60% internal, and 40% external IB debt financing whereas the SME Sample exhibits almost the exact opposite distribution. The results for the Large Company Sample and the SME Sample have also been visualized:
30% 17% 14% 6% 33% Av e r a ge S a m p l e C o m p a n y Equity Provisions Internal IB Debt External IB Debt NIB Debt
19 The results which are of even more interest for testing the hypotheses, however, are the changes between 2011 and 2012, not the absolute numbers of capital structure composition. Equity has risen on average by 1.10% in the Sample companies between 2011 and 2012, with a median rise of 0.07%. The majority of the equity increases in the Sample can be attributed to retained earnings, there was only a single minor share emission (in case of an SME joint-stock company) and no contributions to the registered capital (in case of private limited-liability companies) between 2011 and 2012. In the same period, provisions decreased on average by (-)0.16% with a median increase of 0.23%.
On the other hand, IB debt remained virtually constant. On average, it increased by 0.08% in the Sample companies between 2011 and 2012, with a median change of 0.00%. If we disregard three companies in the Sample with no IB debt on their balance sheets, both in 2011 and 2012 (Volkswagen, Eset, and Slovak Telekom), the average increase is similar at 0.10% with a median of 0.30%. Even more interesting is the change in the composition of IB debt (naturally, omitting the three companies without any IB debt from this part of the analysis). Internal IB debt (as proportion of IB debt) rose on average by 3.70% between 2011 and 2012, with a median change of 0.00%. As its mirror image, external IB debt decreased by (-)3.70% with a median change of
23.92% 25.89% 35.19% 35.29% 6.68% 7.58% 28.56% 29.67% 10.36% 9.85% 16.22% 14.56% 7.75% 7.61% 3.54% 4.01% 51.28% 49.08% 16.48% 16.48% 2 0 1 2 - La rg e C o m p a n y S a m p l e 2 0 11 - La rge C o m p a n y S a m p l e 2 0 1 2 - S M E S a m p l e 2 0 11 - S M E S a m p l e Equity Provisions Internal IB Debt External IB Debt NIB Debt
20 0.00% in the same period. If we express these numbers in proportion to the overall capital structure, internal IB debt rose by 1.18% and external IB debt decreased by (-)1.10% between 2011 and 2012. Lastly, the proportion of NIB debt on Sample balance sheets decreased on average by (-)1.03% between 2011 and 2012, with a median change of (-)0.72%. The average Sample Capital structure can thus be visualized as follows:
It can be stated that Sample data indicates that shareholder loan subordination in the Slovak Republic did not dramatically alter the capital structure of the observed companies. The changes which have been recorded are not substantial. Moreover, shareholder loan subordination does not seem to have altered the capital structures in the manner predicted by the hypotheses.
Figure 1
Selected Sample Analysis Results 2012 2011 Change
Equity as % of Total Liabilities Mean 33.88% 32.78% 1.10% Median 28.30% 25.55% 0.07% Provisions as % of Total Liabilities Mean 5.65% 5.81% -0.16%
Median 3.29% 3.34% 0.23% 29.56% 30.59% 16.52% 17.62% 14.39% 13.21% 5.65% 5.81% 33.88% 32.78% 2 0 1 2 2 0 11 Equity Provisions Internal IB Debt External IB Debt NIB Debt
21 Interest-Bearing-Debt as % of Total
Liabilities
Mean 30.91% 30.83% 0.08%*
Median 22.11% 23.34% 0.00%*
of which % internal (IB) debt (omitting those without IB debt)
Mean 46.57% 42.86% 3.70%
Median 20.53% 20.08% 0.00%
of which % external (IB) debt (omitting those without IB debt)
Mean 53.43% 57.14% -3.70%
Median 79.47% 79.92% 0.00%
Internal IB Debt as % of Total Liabilities Mean 14.39% 13.21% 1.18% External IB Debt as % of Total Liabilities Mean 16.52% 17.62% -1.10%
Non-Interest-Bearing Debt as % of Total Liabilities
Mean 29.56% 30.59% -1.03%
Median 19.87% 31.34% -0.72% *Change omitting those without IB debt Mean 0.10%
Median 0.30%
Figure 2
Selected Large Company Sample Analysis Results 2012 2011 Change
Equity as % of Total Liabilities Mean 51.28% 49.08% 2.21% Median 62.74% 49.90% 1.93% Provisions as % of Total Liabilities Mean 7.75% 7.61% 0.15%
Median 4.23% 3.47% 0.28%
Interest-Bearing-Debt as % of Total Liabilities
Mean 17.04% 17.43% -0.39%*
Median 12.01% 12.05% 0.00%*
of which % internal (IB) debt (omitting those without IB debt)
Mean 60.79% 56.52% 4.27%
Median 93.10% 76.08% 0.00%
of which % external (IB) debt (omitting those without IB debt)
Mean 39.21% 43.48% -4.27%
Median 6.90% 23.92% 0.00%
Internal IB Debt as % of Total Liabilities Mean 10.36% 9.85% 0.51% External IB Debt as % of Total Liabilities Mean 6.68% 7.58% -0.90%
Non-Interest-Bearing Debt as % of Total Liabilities
Mean 23.92% 25.89% -1.97%
Median 19.04% 24.01% -1.42% *Change omitting those without IB debt Mean -0.53%
22 Median -2.04%
Selected SME Sample Analysis Results 2012 2011 Change
Equity as % of Total Liabilities Mean 16.48% 16.48% 0.00%* Median 19.75% 16.41% 0.07%* Provisions as % of Total Liabilities Mean 3.54% 4.01% -0.46%
Median 1.90% 1.37% 0.11%
Interest-Bearing-Debt as % of Total Liabilities
Mean 44.78% 44.23% 0.56%**
Median 29.98% 29.90% 1.63%**
of which % internal (IB) debt Mean 36.23% 32.93% 3.29%
Median 4.90% 5.27% 0.00%
of which % external (IB) debt Mean 63.77% 67.07% -3.29%
Median 95.10% 94.73% 0.00%
Internal IB Debt as % of Total Liabilities Mean 16.22% 14.56% 1.66% External IB Debt as % of Total Liabilities Mean 28.56% 29.67% -1.11%
Non-Interest-Bearing Debt as % of Total Liabilities
Mean 35.19% 35.29% -0.09%
Median 39.55% 31.34% -0.70% *Change omitting those with negative equity
(Eurovea)
Mean 1.17%
Median 0.07% **Change omitting those with negative
equity (Eurovea)
Mean -0.53% Median 0.96%
5.1 Results Applied to Hypothesis 1
Hypothesis 1 postulated that shareholder loan subordination will increase the amount of debt
financing of both external IB and NIB debt on the company balance sheet. It is submitted that this
effect has not been observed in Sample companies, where the amount of IB debt remained virtually constant (+0.08%) and NIB debt levels slightly decreased (-1.03%). Moreover, the proportion of external to internal IB debt financing decreased (while the overall amount remained fairly constant, the proportions within it slightly changed), resulting in more internal IB debt (overall +1.18%) and less external IB debt (overall -1.10%) on Sample balance sheets in 2012 than in 2011. With respect
23 to Hypothesis 1, it can thus be concluded that the analysis of empirical data does not seem to support it.
5.2 Results Applied to Hypothesis 2
Hypothesis 2 predicted that shareholder loan subordination will decrease the amount of internal
debt financing, whether conducted as IB or NIB debt, on the company balance sheet. This
prediction does not seem to be supported by the observed evidence. Firstly, as has been discussed above, no outright shareholder loan has been detected to have been extended as NIB debt. In any event, the proportion of NIB debt on Sample balance sheets decreased (-1.03%) between 2011 and 2012.
Secondly, the amount of IB debt in Sample companies remained fairly stable (+0.08%). More importantly, the proportion of internal IB debt (financing) has increased in the observed period (overall +1.18%), unlike Hypothesis 2 predicted. It can thus be concluded that the analysis of empirical data does not seem to support Hypothesis 2.
5.3 Results Applied to Hypothesis 3
Hypothesis 3 stated that shareholder loan subordination will alter the preferred method of internal
company financing from debt to equity. At first, the basic postulation of this hypothesis seems to
have been fulfilled: the proportion of equity on company balance sheets indeed rose insignificantly (+1.10%) between 2011 and 2012. It needs to be remarked, however, that (virtually) the whole increase is attributable to retained earnings, and not fresh equity contributions. Nevertheless, one could (most validly) argue that if a shareholder wanted to increase equity financing of the company, retaining its earnings makes more sense than paying (and taxing!) dividends, followed by a fresh equity contribution.
However, the main problem of Hypothesis 3 arises after the examination of IB debt composition. Although the overall proportion of IB debt on Sample balance sheets of the observed period remained almost constant (+0.08%), its composition changed: the amount of internal IB debt
increased in 2012 (overall +1.18%). Therefore, it can hardly be said that the subordination altered
the preferred method of financing from debt to equity, as more internal IB debt was extended than before the subordination. Taking the above into consideration, it can be concluded that Hypothesis 3 does not seem to be supported by the analysis of empirical data.
24 5.4 Results Applied to Companies without Internal IB Debt
In addition to dividing the Sample into Large Company Sample and SME Sample, the Sample has also been divided based on the presence of internal IB debt financing in 2011. Sample companies which did not have any internal IB debt financing in 2011 were grouped together to form a separate sample (“External IB Debt Sample”). There were 9 such companies15, the rest (13) formed another sample which contained internal debt financing in 2011 (“Internal IB Debt Sample”). Afterwards, balance sheet analysis (as described above) was performed on these samples. Selected results of the analyses of External IB Debt Sample and Internal IB Debt Sample can be observed in Figure 3 below; the full results are presented in Appendix 2.
There are three interesting observations regarding the External IB Debt Sample analysis results. Firstly, there seems to have been a slight increase of (on average) 1.24% in external IB debt financing between 2011 and 2012. At the same time, however, NIB debt levels decreased on average by (-)0.74%. Secondly, the amount of equity decreased on average by (-)0.67% in the observed period. Lastly, a small amount of internal IB debt was introduced to External IB Debt Sample balance sheets in 2012 – on average 0.18% of the balance sheet total. The analysis results of the Internal IB Debt Sample follow the results of the overall Sample analysis although the differences in capital structure between 2011 and 2012 are more pronounced. All of these results can be visualized as follows:
15 These companies are numbers: 5 (Volkswagen Slovakia), 7 (Dôvera), 8 (Eset), 9 (Slovak Telekom), 10 (Slovenské Elektrárne), 11 (HB Reavis), 1.1 (Jukus Petrol), 2.1 (Alas Slovakia), 6.1 (Unimed).
25 With respect to companies without any internal IB debt, it has been postulated that Hypothesis 1 would fully apply. This hypothesis stated that shareholder loan subordination will increase the
amount of debt financing of both external IB and NIB debt on the company balance sheet. It is true
that a slight increase in external debt financing has been observed. However, a decrease in NIB Debt occurred as well upon shareholder loan subordination. It can thus be stated that in case of companies without any internal debt financing, there seems to be some support of empirical data for Hypothesis 1, although it is difficult to draw any firm conclusion. This is primarily due to the fact that the External IB Debt Sample is very limited: 9 companies, 3 of which have no IB debt at all. This means that the data pertaining to IB debt composition for the External IB Debt Sample is based on only 6 companies.
Secondly, it was predicted that we would not observe an introduction of shareholder loans (internal debt financing) after shareholder loan subordination. This has not been the case, as some internal debt financing was introduced in 2012. Therefore, there does not seem to be much empirical support for this postulation.
31.05% 31.79% 28.52% 29.76% 20.34% 19.10% 12.33% 14.55% 0.18% 25.78% 24.40% 8.32% 8.34% 3.80% 4.05% 40.11% 40.77% 29.57% 27.24% 2 0 1 2 -E x t e r n a l IB D e b t S a m p l e 2 0 11 -E x t e r n a l IB D e b t S a m p l e 2 0 1 2 -In t e r n a l IB D e b t S a m p l e 2 0 11 -In t e r n a l IB D e b t S a m p l e Equity Provisions Internal IB Debt External IB Debt NIB Debt
26 Lastly it has been explained that Hypothesis 3 does not apply to companies without internal IB debt as equity would be expected to decrease after shareholder loan subordination. Indeed, a slight equity decrease has been observed. However, not only equity has decreased to offset the increase in external and internal IB debt, NIB has as well.
Unlike in case of Sample analysis, it can be stated that the introduction of shareholder loan subordination coincided with more changes in the External IB Debt Sample capital structure in line with the expectations. These include a slight increase in external IB debt (+1.24%) and a slight decrease in equity (-0.67%). However, simultaneously, the opposite of some changes which were envisaged occurred: the introduction of internal IB debt (+0.18%) and a decrease in NIB debt (-0.74%). Therefore, and due to the limited sample size and insignificant nature of the changes, it is submitted that it is not possible to draw any firm conclusions from these deviations from the overall Sample analysis results.
Figure 3
Selected External IB Debt Sample Analysis Results 2012 2011 Change
Equity as % of Total Liabilities Mean 40.11% 40.77% -0.67% Median 40.40% 38.47% -0.15% Provisions as % of Total Liabilities Mean 8.32% 8.34% -0.02%
Median 3.98% 3.47% 0.23%
Interest-Bearing-Debt as % of Total Liabilities
Mean 20.52% 19.10% 1.42%
Median 13.85% 12.05% 0.00%
of which % internal (IB) debt (omitting those without IB debt)
Mean 0.88% 0.00% 0.88%
Median 0.00% 0.00% 0.00%
of which % external (IB) debt (omitting those without IB debt)
Mean 99.12% 100.00% -0.88%
Median 100.00% 100.00% 0.00%
Internal IB Debt as % of Total Liabilities Mean 0.18% 0.00% 0.18% External IB Debt as % of Total Liabilities Mean 20.34% 19.10% 1.24%
Non-Interest-Bearing Debt as % of Total Liabilities
Mean 31.05% 31.79% -0.74%
27 Selected Internal IB Debt Sample Analysis Results 2012 2011 Change
Equity as % of Total Liabilities Mean 29.57% 27.24% 2.33% Median 26.14% 24.80% 2.38% Provisions as % of Total Liabilities Mean 3.80% 4.05% -0.25%
Median 2.94% 3.21% 0.19%
Interest-Bearing-Debt as % of Total Liabilities
Mean 38.11% 38.95% -0.84%
Median 26.34% 29.09% -0.52%
of which % internal (IB) debt Mean 67.65% 62.65% 5.01%
Median 96.07% 80.39% 0.00%
of which % external (IB) debt Mean 32.35% 37.35% -5.01%
Median 3.93% 19.61% 0.00%
Internal IB Debt as % of Total Liabilities Mean 25.78% 24.40% 1.38% External IB Debt as % of Total Liabilities Mean 12.33% 14.55% -2.22%
Non-Interest-Bearing Debt as % of Total Liabilities
Mean 28.52% 29.76% -1.24%
Median 20.71% 29.02% -0.74%
6. Analysis of the Results
The above-presented results of the Sample balance sheet analysis have not found support for the hypotheses. There may be three dominant causes for these findings, each will be analyzed in turn. Firstly, methodological issues with the research could be invoked as reasons for the observed results. Secondly, the cost of debt (Rd) may have not decreased due to shareholder loan subordination. Lastly, there may be other more dominant reasons shaping the capital structures of companies besides the costs of debt as such.
6.1 Methodological Issues
It could be argued that methodological issues in analyzing the Sample skewed the results which led to the finding of lack of support for the hypotheses. Firstly, such criticism could be directed at the limited number of companies in the Sample. This objection is certainly valid; however, the aim of this work is not to provide a comprehensive analysis of a large sample, but rather to test a reasonably representative limited number of companies to see if a theoretical concept appears to be replicating in reality in some form.
28 Secondly, it could be objected that some (three to be precise) of the Large Company Sample companies assembled their financial returns pursuant to Slovak rules, whereas the majority assembled them pursuant to international (IFRS) rules. At the same time, all of the SME Sample companies assembled their financial returns pursuant to Slovak rules. This criticism is certainly valid, albeit not fully relevant. Firstly, based on a short examination of the two, the differences should not be material as Slovak rules are influenced and shaped by IFRS rules. More importantly, however, each company was compared only to itself, i.e. analyzed pursuant to the same accounting methodology it used both in 2011 and 2012. Differences in the capital structure between 2011 and 2012 were taken, and these were then compared. Therefore, a balance sheet assembled pursuant to IFRS methodology has never been directly compared to one assembled pursuant to Slovak rules. These differences should not skew the results very much. On a similar note, one could argue that four companies in the Sample have accounting years ending on the last days of January, February, March, and September, respectively. Unfortunately (at least for the purposes of this research), it is the case that Slovak companies may freely choose their accounting period (Finančné riaditeľstvo SR, 2013). Although most enterprises set their accounting periods to match calendar years, this is not always the case. However, as such deviation in the Sample was small (only nine months overall), it is submitted that any corresponding skewedness of the results must be negligible. Thirdly, it could be remarked that some balance sheet items were mischaracterized when conducting the analysis (for example, IB debt labelled as NIB debt). This risk is certainly present and cannot be fully eliminated particularly since companies often bundle many items into the “other” category on various parts of their balance sheets. After consulting notes to the balance sheets or full financial statements, it has been possible to ascertain what the nature of the majority of these items was. Certainly, this is true for major items with mandatory disclosure obligations, such as shareholder loans. However, it may have occurred that some minor items from a balance sheet category have not been properly separated, for example, when the “other” category on the current liability portion of the balance sheet has been categorized as NIB debt, whereas in reality, it could have contained an interest-bearing loan from a non-affiliated commercial party, which is not a bank. Nevertheless, it is submitted that substantial care has been exercised when conducting the analysis to ensure obtaining the most accurate financial picture of the Sample companies possible based on the available data. Therefore, the aforementioned risk has been minimized to an extent which ought not to skew the overall analysis and its results in a significant manner.
29 Lastly, it could be argued that the years of 2011 and 2012 are not ideal to examine the effects of shareholder loan subordination. The relevant act amending the Slovak Bankruptcy Act started its public legislative process in 2011; in the early fall of 2011, the act was voted on by the parliament and enacted. Therefore, it could be argued that since at least the fall of 2011, Slovak companies (and banks) knew that statutory shareholder loan subordination was coming in 2012 and could have already started to adjust their capital structures. On the other hand, it could be argued that the ramifications of statutory shareholder loan subordination could not fully be observed in 2012, as this was too soon for the effects to materialize. Being conscious of these deficiencies, it has been decided to examine the timeframe of 2011 and 2012 nevertheless. It has been concluded that examining the two adjacent years, thus minimizing other effects such as external economic factors, legal changes, and other factors which could manifest themselves in a longer timeframe skewing the results, takes precedence over the aforementioned deficiencies. In the end, the chosen approach should yield more meaningful results.
6.2 No Change in the Cost of Debt
If shareholder loan subordination in the Slovak Republic did not cause the cost of debt (Rd) to decrease, any changes to the amount of (external) interest-bearing debt in the capital structure of companies could hardly be expected. If this turned out to be the case, the attractiveness of external (debt) financing relative to internal debt or equity financing would not be expected to change. Hypothesis 1 directly builds on this premise of cheaper external debt. Hypothesis 2 and 3 focus more on the effects of subordination on internal financing; however, even the attractiveness of internal financing is shaped by the price of its alternative(s).
As part of the balance sheet analysis, profit and loss statements have also been examined to ascertain interest expenses in 2011 in comparison to 2012, in both cases expressed as a percentage of IB debt on the balance sheets. Naturally, the companies with no IB debt have been omitted from this analysis, the results of which can be seen in Figure 4 below. Figure 4 contains the analysis results of the Sample, but also just its part, the SME Sample.
Figure 4
Interest Expenses Structure – Sample Analysis 2012 2011 Change Interest Paid as % of IB debt (omitting
companies without IB debt: no. 5, 8, 9.)
Mean 7.10% 8.34% -1.24%
30 Interest Expenses Structure – SME Sample Analysis 2012 2011 Change
Interest Paid as % of IB Debt Mean 4.93% 5.55% -0.62%
Median 3.44% 4.25% -0.41%
Prima facie, the results of this analysis would suggest that interest rates decreased between 2011
and 2012. However, it is submitted that it is not possible to draw this conclusion from the available data because the majority of large companies in the Sample did not separate interest expenses from other financial expenses (it is not possible to obtain solely data for interest expenses). Even though each company was only compared to itself (i.e. financial expenses in 2011 to financial expenses in 2012) it is impossible to know whether the composition of other financial expenses to interest expenses has not changed. However, in case of the SME Sample, it has been able to obtain the precise numbers for interest expenses for each of the companies16. Based on the results (a mean decrease of (-)0.62% with a median change of (-)0.41%), it seems that a slight decrease in the cost of debt occurred between 2011 and 2012.
As most debt financing of companies in the Slovak Republic is done by banks (bond financing was observed in only one Sample company, HB Reavis), it is meaningful to compare the aforementioned observations to official data obtained from the National Bank of Slovakia (“NBS”). These data, which are reproduced in Figure 5 below, suggest that the average change in annual interest rates on bank loans (both new and existing) to non-financial Slovak corporations was a decrease of (-)0.59% between 2011 and 2012 (a number almost identical to the one of SME Sample). Of interest is also the comparison between average change in annual interest rates on bank loans (both new and existing) to non-financial Slovak corporations and households: whereas annual interest rates for Slovak non-financial corporations decreased in 2012, the interest rates for households increased by 0.04%. Naturally, one of the differences between households and corporations (in Slovakia between 2011 and 2012) is that the former did not undergo shareholder loan subordination.
However, if we examine the average interest rates (costs of borrowing) of non-financial corporations in the Eurozone in 2011 and 2012, we may observe a broadly similar trend: the
16 This is due to the fact that the financial returns assembled pursuant to Slovak rules, unlike the statements assembled pursuant to IFRS rules, explicitly separate interest expenses.
31 interest rates decreased by (-)0.28% in the given period. A similar trend has been observed even when it comes to the cost of borrowing of Eurozone households for house purchase in the same period17, full results can be observed in Figure 6 below. It may therefore be the case that statutory loan subordination in the Slovak Republic has not decreased the cost of debt for corporations in the Slovak Republic, but rather, the decrease in the cost of debt is due to other pan-European trends. This seems very plausible, since, firstly, Slovakia is a Eurozone member. Its monetary policy is thus set by the European Central Bank (“ECB”). Secondly, Slovak corporations (particularly as corporate group members) may easily lend from other European banks and so their financing costs are not exclusively shaped by the Slovak market (for example, in 2011 and 2012, the Slovak subsidiary of US Steel, owned via a Dutch holding company, had an available €100 million credit line with ING, a Dutch bank; similarly, some of the loans of Sample companies had floating interest rates based on LIBOR18).
To summarize, both the changes in the financing costs of Sample companies and the official data obtained from NBS seem to demonstrate that the cost of debt decreased slightly between 2011 and 2012. This change, however, does not appear to be significant and cannot be readily attributed to shareholder loan subordination, as the data from ECB and the next portion of analysis suggest. Figure 5
2012 2011 Change
Average interest rate of existing loans to
non-financial corporations 3.45% p.a. 3.90% p.a. -0.45% p.a. Average interest rate of new loans to
non-financial corporations 2.53% p.a. 3.25% p.a. -0.72% p.a.
Average change for non-financial
corporations 2.99% p.a. 3.58% p.a. -0.59% p.a.
17 Unfortunately, when it comes to composite cost of borrowing for households, this is the one the ECB reports: it excludes all other household debt categories (with much higher interest rates, such as revolving consumer (credit card) debt) apart from mortgages. The interest rates are therefore much lower than the Slovak rates and not directly comparable. This could suggest some interesting change (increase in price) occurring in non-mortgage Slovak household debt in 2011 and 2012, which could explain the (surprising) result (of increase in household costs of borrowing). As this topic is completely out of scope of this paper, it shall not be delved into any further.
32
Average interest rate of existing loans to
households 6.63% p.a. 6.82% p.a. -0.19% p.a.
Average interest rate of new loans to
households 7.09% p.a. 6.82% p.a. 0.27% p.a.
Average change for households 6.86% p.a. 6.82% p.a. 0.04% p.a. Source: (Národná banka Slovenska, 2020).
Figure 6
2012 2011 Change
Average interest rate (cost of borrowing) of non-financial corporations in the
Eurozone
3.22% p.a. 3.50% p.a. -0.28% p.a.
Average interest rate (cost of borrowing) of households for house purchase in the
Eurozone
3.47% p.a. 3.73% p.a. -0.26% p.a.
Source: (European Central Bank (ECB), 2020). 6.2.1 Bank Financing
The conclusion above seems to be bolstered by the fact that bank financing comprises most of the external IB debt of Sample companies (there were some minor amounts of derivative transactions, and one major outlier, HB Reavis). Anecdotal evidence and industry practice seem to suggest that banks, as sophisticated creditors, had been able to effectively reach shareholder loan subordination by virtue of contractual debt covenants even prior to January 2012. For example, it is suggested by some practioners that this is currently the practice in the Czech Republic whose legal system does not feature shareholder loan subordination, but is similar to the one of the Slovak Republic (Kohout et al., 2019). If these suggestions were even partially accurate, no change in the cost of external IB debt for corporations could be expected upon statutory shareholder loan subordination, since this would not yield any further risk reduction to banks and thus no associated interest rate reductions.
6.3 Other Factors Shaping Capital Structures
Even if no significant methodological issues were present and the cost of external IB debt actually decreased between 2011 and 2012 due to statutory subordination of shareholder loans, there may
33 be other reasons why subordination did not have the expected outcome on company capital structure, one which would support the hypotheses. These are examined below, starting with the most prominent one.
6.3.1 Capital Structure Decision-making
Based on the survey of 400 American CFOs, Graham and Harvey (2002) established a list of factors that form companies’ decisions when establishing debt policy, which can be observed in Figure 7 below.
Figure 7
Source: (Graham and Harvey, 2002).
The results suggest that that the most dominant factors driving the decision whether to issue debt are maintaining financial flexibility and credit rating. The level of interest rates has been cited as important when deciding whether to issue debt by less than 50% of the surveyed CFOs. Naturally, the direct applicability of these results in the Slovak context of 2011/2012 can be disputed. Moreover, criticism of the methodology of this study has been proposed (de Weijs, 2020). The professor argues that it is plausible the CFOs were not completely honest in their answers, as this
34 would adversely impact their image or company standing (Ibid.). For example, it has been suggested it is possible that capital structures are set in a profit-maximizing way by expanding the amount of NIB debt on the balance sheet to squeeze-out trade creditors and obtain interest-rate-free financing (Ibid.). Such a reason for a particular capital structure does not appear to be present as an option in the survey. Indeed, the most prevalent stated reason for a particular capital structure,
i.e. financial flexibility, seems to be a vague category which may encompass many reasons,
including ones along the mentioned lines. Despite the aforementioned criticism, this strand of research illustrates that there are many factors, some of which may be more important than the cost of debt, which shape company debt policy.
For instance, it has been argued that debt, unlike equity, provides tax shields and has much lower transaction costs than equity (Landuyt, 2018). In case of equity, expensive and burdensome share emission (or capital contribution) procedures, such as legal procedures relating to pre-emptive rights, have to be abided by, whereas taking-up more debt often (in principle) requires only executing a contract with a bank. Naturally, this distinction applies only in cases of fresh equity contributions, but not in cases of equity increases by virtue of retained earnings. Better still, internal IB debt minimizes even these burdens as transaction costs and time are minimal; it even happens that the money is simply wired without any proper documentation (Ibid.).
Therefore, the rather automatic assumption underpinning the hypotheses that a reduction in the cost of external IB debt will result in the increase of its amount in the capital structure may be wrong, or an oversimplification at best. As the research above suggests, there may be many reasons for a particular debt policy, i.e. a particular capital structure. This means that even if statutory shareholder loan subordination decreased the cost of debt, the result would not necessarily be the increase of its amount, for there are more factors at play driving the decision to increase (or decrease) debt levels. Such a conclusion appears to be quite intuitive; after all, even as a consumer, one will probably not be inclined to incur more debt only because the terms (interest rates) of borrowing have become more favorable, if there is no good purpose for such a decision. The above suggests the same logic applies to Sample companies and explains why we may not see more (external) interest-bearing debt on the liability side of balance sheets when interest rates seem to be favorable to borrowing.
