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Robust economic growth is imperative for sustainable employment creation.
And over the years, there’s been ample academic literature that proves the existence of a positive relationship between capital formation and economic growth.
But which asset class has the biggest impact on job creation?
Ultimately, the answer to this question is two-fold.
One needs to address the question of optimal capital structure, and how efficiently corporations deploy capital within an economy.
Broadly speaking, companies have two choices when it comes to the financing of investment projects.
They can either borrow money or use shareholder capital.
The different sources of financing have their advantages and disadvantages.
The challenge here would be to find an optimal mix of debt and equity in order to minimise overall cost of capital.
This would lower the hurdle rate of return required from investment initiatives for them to be attractive and, by extension, allow companies to take on more investment projects which will benefit economic growth.
Looking into the characteristics of the different sources of financing, debt offers the lowest cost of capital due to the tax deductibility of interest payments.
However, this comes with contractual obligations to make periodic payments to service the debt.
This means that too much leverage increases the financial risk to shareholders and the return they require when providing equity capital.
On the other hand, equity financing is expensive.
On a relative basis, an equity investment is way riskier than an investment in debt securities.
As such, shareholders require a return that fully reflects the riskiness of the investment.
Therefore, companies seeking financing for new projects need to find the optimal point at which the marginal benefit of debt equals the marginal cost.
Naturally, optimal capital structures will differ across business models and industries.
For example, companies in highly cyclical sectors might want to steer away from having too much leverage, while those in more defensive sectors – with more stable cash flows – would probably have more capacity to service debt through the cycle.
However, even with an optimal mix of debt and equity financing, for an investment to have lasting impact on economic growth and employment creation, management needs to allocate capital efficiently – by channelling resources to projects that will maximise value for all stakeholders.
Absent which, things like write-offs and impairments of assets might come to the fore in the future, as projects fail to deliver returns higher than the weighted-average cost of capital.
This would most likely result in job losses.
Having said that, there has been an interesting development in terms of companies’ preferences when it comes to different sources of capital.
Over the past couple of decades, alternative sources of funding such as private equity have been going mainstream – with growth companies having demonstrated the ability to attract significant sums of capital before flotation of their stock on public equity markets.
According to McKinsey, private equity’s net asset value has grown more than sevenfold since 2002, twice as fast as global public equities.
Moreover, the number of listed companies in the US has almost halved since 1996 – a trend that’s prevalent across most developed economies.
This implies that the significant growth in assets under the stewardship of private equity funds has allowed companies to remain private.
Understandably, going to initial public offering (IPO) and the subsequent maintenance of a listing can be quite costly and onerous from a compliance standpoint – resulting in costs outweighing the benefits of a listing.
A study done by Schroders suggests that the burdensome nature of maintaining a public listing has led to not only a reduction in the number of listed entities, but also an increase in the average age of companies going to IPO.
These developments have important implications for ordinary savers.
Public stock markets facilitate the person on the street’s participation in growth of the corporate sector.
It therefore becomes quite evident – with the de-equitisation trend becoming more strident – that ordinary savers will miss out on the exponential growth realised in earlier stages of companies’ life cycle.
This will have an adverse impact on the agenda that pushes for inclusive growth – deepening the problem of income inequality in the process.
However, even with its shortcomings, private equity funding does have its benefits.
Private equity investments are generally long term in nature – with the average holding period of an investment ranging anywhere from seven to ten years.
While it might not necessarily be the cheapest funding option available for companies (due to the illiquidity for which investors require compensation), the capital is very patient.
It therefore rids companies’ management of the pressure to hit analysts’ short-term earnings estimates as seen in the listed equity space, affording them breathing room while they execute their longer-term strategic objectives.
This, in our opinion, is the most important benefit of private funding markets.
It allows companies’ management to embark on long-term investment initiatives that will have lasting benefits for all stakeholders.
Taken together, private funding markets appear to be faring much better at promoting efficient allocation of capital as opposed to their public counterparts.
Given the benefits of the asset class and the de-equitisation trend in general, it is imperative for regulators to lighten the barriers of gaining exposure to the asset class.
For example, Regulation 28 imposes a limit of only 10% exposure to private equity in pension funds.
This clearly lowers the return expectations for ordinary savers.
In conclusion, it is our firm belief that both the bond and equity markets (public or private) are important for employment creation.
These are the conduits through which resources are channelled from savers to entities seeking funding for investment initiatives.
Public markets provide cheaper capital as there is no illiquidity premium built into investors’ return expectations, which lowers overall cost of capital, while private markets facilitate efficient allocation of capital.
Cash or commercial paper, on the other hand, is generally used to finance short-term needs.
While it is an important building block in the capital structure of almost every corporation, its most appropriate use is for funding working capital as opposed to investments.
It is prudent for companies to use long-term funding when undertaking long-term investment projects.
For this reason, we believe cash as an asset class (or short-term funding) has the least impact on employment creation.
Growth in gross fixed capital formation is the fuel that keeps the economic engine running, and the wheels of growth turning, ultimately leading to job creation.
Maitse Motsoane is a portfolio manager at Prescient Investment Management.
This article originally appeared in the Collective Insight supplement in the 9 May edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
