1. Key findings: Capital markets and corporate finance post-COVID-19
This chapter provides an overview of key issues in capital markets and corporate finance that will be critical for the recovery in the post-COVID-19 world. The chapter highlights the importance of having well-functioning public equity markets and appropriate corporate governance frameworks to support the recovery. It notes the increased leverage and excessive risk-taking in some parts of the non-financial corporate sector and the importance of the duties and responsibilities of boards in times of crisis. It identifies structural issues in the corporate bond market and the need to have insolvency frameworks to support the recovery and provide resilience. These key findings identify the direction, priorities and underlying principles for policies that will support the corporate sector recovery and long-term resilience.
The COVID-19 crisis is not only having immediate negative social and economic impacts. Importantly, it may also press for structural changes in the corporate sector and in capital markets. Some businesses will recover after a temporary downturn while others will be phased out. Yet other businesses and sectors will find new opportunities for innovation and growth.
Several industries saw sharp declines in revenues, in particular in the first and second quarters of 2020. The Energy sector was hit particularly hard, with a 44% decrease in revenues in the second quarter compared to the previous year. As the crisis caused sharp reversals in earnings expectations, credit rating agencies downgraded 537 non-financial corporations in March and April 2020 alone. This is almost equal to the total number of downgrades during the entire year of 2019.
The future trajectory of these structural adjustments is hard to predict. But what is known with certainty is that policies that support a process of adaption are themselves the best guarantee for a sustainable near-term recovery and for long-term resilience. It is also known that the road to recovery will require that substantial financial resources are made available for investment, and that an adaptation of corporate governance policies and frameworks can help both existing and new companies access the capital that they need.
Absent successful policies that support recovery and transformation, there is a real risk that the portion of under-capitalised and underperforming firms will increase and remain elevated. This is not a hypothetical scenario. In Europe, after the 2008 financial crisis and the subsequent euro area sovereign debt crisis, the ratio of non-performing loans and the share of non-viable firms increased steadily for several years, dragging down corporate investment and economic growth.
Again, as the COVID-19 crisis’ structural effects on corporate finance and its interplay with corporate governance remain to be fully understood, this report presents some trends and empirical evidence that already can be used to identify the direction, priorities and underlying principles for policies that will support the recovery. Considering the power of path dependency, when evaluating different policy options it is important that they should serve the dual purpose of supporting a near-term recovery as well as the longer-term objective of making the business sector more dynamic and resilient to possible future shocks.
Stock markets play a key role in providing companies with equity capital that gives them the financial resilience to overcome temporary downturns, while meeting their obligations to employees, creditors and suppliers. For example, in 2009, in the wake of the financial crisis, when bank credit became inaccessible, publicly listed non-financial companies raised a record USD 511 billion in new equity through the stock market. This pattern seemed to repeat itself during the 2020 pandemic, when already listed non-financial companies raised a record of USD 626 billion in new equity.
However, since 2005, over 30 000 companies have delisted from the stock markets globally, notably in the United States and Europe, which host some of the world’s largest stock markets. These delistings have not been matched by new listings, which has resulted in a net loss of listed companies in the OECD as a whole in every single year between 2008 and 2019. While many companies were able to instantly, and at relatively low cost, tap into equity markets after the 2008 crisis to overcome financial difficulties, this time several thousand fewer companies have been able to do so.
Moreover, the stock market’s ability to readily provide listed companies with new equity in times of crisis does not necessarily apply equally to established large companies and newer smaller companies. In many advanced markets, there has been a substantial and structural decline in listings of smaller growth companies, distancing a larger portion of these companies from ready access to public equity financing.
These trends have raised concerns that stock markets have increasingly become a source of funding for fewer but larger companies. Part of the explanation is the lower cost of debt financing and better access to private capital. However, other developments have also led to structural weaknesses in the stock market ecosystem. First, the shift from retail direct investments to large institutional investors has created a bias towards large listed companies. As shown in this report, in all advanced markets the average share of institutional ownership in large listed companies is significantly higher than their ownership in smaller companies.
Second, the new stock market structure, where privately owned for-profit exchanges rely heavily on income from trading and related information/data services, encourages a focus on large companies with liquid stocks. As a result, investors’ attention has been diverted away from smaller growth companies that in turn have been discouraged from going public. The lack of interest in smaller companies in the stock market is illustrated by the fact that also trading volume is highly concentrated in large companies in most markets.
Third, the structure of investment banking activity is an important factor behind high listing costs. Companies have been discouraged from going public by the high underwriting fees and stock price discounts that investment banks apply to their valuations before the public offerings. Fourth, it has also been suggested that systematic acquisitions of smaller growth companies - especially by large technology companies - have contributed to drying up the IPO pipeline of smaller independent companies that could potentially increase competition and challenge the status quo.
The COVID-19 crisis has made it difficult for many companies to meet some legal and regulatory requirements such as the organisation of annual shareholder meetings and disclosure of financial statements. In light of these constraints, governments around the world have taken steps to adjust certain key corporate governance requirements. Several of these measures are considered temporary in nature and have been introduced for the purpose of mitigating the immediate impact of the crisis.
However, some of these temporary measures may also have a lasting impact on how companies are governed, their capital structure, their ownership structure and how they manage their relationship with their shareholders and stakeholders. These are all crucial issues addressed by the G20/OECD Principles of Corporate Governance. For example, out of necessity the crisis has provided an opportunity for regulators to clarify or make changes with respect to remote participation in shareholder meetings.
The crisis has also given new impetus to the discussions on a number of long-term developments in corporate practices, ownership structures and capital markets that may call for an adaptation of corporate governance policies and regulations in the post-COVID-19 era. These include means to mitigate excessive systemic risk-taking in the non-financial corporate sector, the management of ESG risks, and provisions with respect to the concentration of corporate ownership and company groups.
Not all firms and not even firms operating in the same industry and in the same economy, have been affected equally by the COVID-19 crisis. The differences in impact of the crisis are to a certain extent related to the financial soundness going into the crisis, such as high leverage levels, that have made some companies more vulnerable.
It is the company management and board who are best placed to decide on the optimal capital structure of a company, subject to the approval of the shareholders. In doing so, they should consider the best interest of the company and ensure its financial soundness. However, the increase in borrowing by companies with lower quality credit ratings and high leverage levels over the past decade have raised major concerns about excessive risk-taking in some parts of the corporate sector.
One example has been the use of corporate bond markets to finance share buyback operations by high-risk non-investment grade companies, which increases the leverage ratio by simultaneously reducing the company’s equity base and increasing its debt. Since 2000, the share of corporate bond offering documents that explicitly mention share buybacks or dividends among the intended uses has increased from 2% to 11%.
Since the onset of the pandemic, corporate boards have been under intense pressure due to the uncertainty concerning the health crisis and the resulting adjustments of the regulatory landscape. In this difficult setting, shareholders and other stakeholders gradually began expressing discontent about some company actions through lawsuits. In some cases, shareholders have sued companies and directors for understating or not properly disclosing pandemic-related risks and allegedly known negative impacts of the pandemic on the company’s business and operations. Although most COVID-19-related lawsuits are yet to be adjudicated, their general focus is on inaccurate or misleading disclosure, stock price manipulation, insider trading and non-compliance with emerging health regulations.
In addition to litigations, boards have been subject to challenges in several other areas, including executive remuneration, cybersecurity and insolvency. First, given that many companies laid off or put employees on short-time working schemes during the pandemic, the level of executive remuneration has become an area of scrutiny; particularly in companies that receive some sort of direct or indirect public financial support. Second, there are also concerns that companies are adapting the conditions for executive bonus programmes, switching performance metrics and ignoring missed targets in order to evade or mitigate otherwise unavoidable reductions in executive pay resulting from the pandemic.
Third, remote working arrangements for employees can increase cybersecurity risks since employees’ home computers and networks are typically less protected against cyberattacks, requiring further board oversight of this critical issue. The fourth area of board responsibility that has been highlighted during the crisis is that the board should have the capacity to regularly evaluate and communicate how a crisis impacts the company’s ability to meet its upcoming debt commitments under different scenarios and different strategic alternatives to maintain the business continuity. The ability to serve these functions, particularly for large companies, may have general and longer-term implications for board composition and how the board organises its work.
The COVID-19 pandemic has brought increased attention to the importance of identifying systemic risks and unexpected shocks. The reason is that a corporate sector that is willing and able to assume risk is at the very heart of a dynamic and resilient economy. Consequently, as new types of risks emerge or become more salient, companies, their shareholders and society at large all have an interest in the proper identification, management and disclosure of these risks.
Lack of credible risk assessments not only increases uncertainty about expected performance and the long-term viability of individual companies, but also leads to inefficient allocation of economic resources, adversely impacting corporate and economy-wide resilience. The need for robust structures and procedures for risk management and high-quality disclosure, including environmental and social issues, is well articulated in the G20/OECD Principles. As the current pandemic brings new experiences at the company level, companies may for example be in need of new types of expertise, additional information channels, better analytical tools, and novel internal policies and practices specifically tailored to assessing their ESG risks.
At the same time, material information related to ESG risks that may shed light on the future performance of the company should be disclosed to the public. For the scope of information disclosure, many jurisdictions apply the concept of materiality, which can be defined as information whose omission or misstatement could influence decisions taken by the users of the information. The G20/OECD Principles recognise that material information can also be defined as information that a reasonable investor would consider important in making an investment or voting decision.
While the G20/OECD Principles address the implications of an increase in intermediary ownership, another important development with respect to corporate ownership structures is the increase in ownership concentration at the company level. While this is a global development, there are important country and regional differences with respect to the different categories of shareholders that make up the largest shareholders at the company level. These differences in turn have implications for the emphasis of any related regulatory considerations and priorities.
With respect to institutional investors, their assets under management have increased considerably during the last 15 years while the number of listed companies in many advanced equity markets has decreased. As a consequence of these opposite trends, a growing amount of money has been allocated to a diminishing number of companies resulting in a re-concentration of ownership in the hands of large institutional investors. This development has been particularly prominent in the United States, where the 3 largest institutional investors together hold on average 23.5% of the equity in listed companies.
Of particular interest to corporate governance is that the growth of institutional investors to a large extent is attributable to the use of passive index investment strategies. Extensive reliance on index investment strategies may limit the incentives of institutional investors to monitor risks and opportunities in individual companies. Consequently and on rational grounds, insufficient resources may therefore be spent on fulfilling one of the key functions of capital markets, namely to scrutinise individual corporate performance and to allocate capital according to growth potential and governance performance.
In some other markets, the concentration of ownership is not the result of increased institutional ownership but of company group structures. For example, in several Asian economies, including India, Indonesia and Singapore, and in some other emerging markets such as Chile and Turkey, private corporations and holding companies hold more than 30% of the total equity capital in publicly listed companies. This confirms the presence of private corporations and holding companies as an important category of owners in listed companies and in many cases also the presence of group structures. From a corporate governance perspective, company groups present the same agency problems that face stand-alone companies with defined control. Yet the more complex the structure of a group, the more complex is the agency problem and the scope for potential abusive practices, for example through related party transactions.
Inadequacies remain in many national frameworks related to the disclosure of capital and control structures and shareholdings of directors; and, divergences across countries with respect to the requirements for parent company board oversight of key risks. At the same time, the COVID-19 crisis has put additional pressure on listed companies that are part of a group structure. Since not all businesses are affected equally by the crisis, individual group companies that are in a relatively stronger position may be expected to play a role in supporting the parent company or other companies in the group, in particular with respect to intra-group financing. Experiences from recent reforms in a number of jurisdictions may provide useful guidance for improvements.
The increase in ownership concentration in listed companies is also attributable to the presence of public sector ownership, which poses its own challenges with respect to governance practices and how the government fulfils its ownership function. Globally, the public sector, including central governments and sovereign wealth funds, owns USD 10.7 trillion of listed equity, which amounts to 10% of global market capitalisation.
While the means and processes differ from those of shareholders, bondholders play an important role in defining the boundaries of corporate actions and the monitoring of corporate performance. This is particularly salient in times of financial distress, which many corporations are facing under the COVID-19 crisis. Like equity, bonds typically provide longer-term financing than ordinary bank loans and serve as a useful source of capital for companies that want to diversify their capital structure.
In the aftermath of the 2008 financial crisis, global corporate bond markets saw a significant and lasting increase in issuance. Annual corporate bond issuance by non-financial companies doubled from USD 890 billion in the period 2000-2007 to USD 1.87 trillion in the period between 2008 and 2020. In many countries the increased use of corporate bonds has been supported by regulatory initiatives aimed at stimulating the use of corporate bonds as a viable source of long-term funding for non-financial companies. The increase in bond usage has also been consistent with the objectives of the expansionary monetary policy and related unconventional measures by major central banks.
This surge in the use of corporate bond financing has further highlighted the role of corporate bonds in corporate governance. Covenants for example, which are clauses in a bond contract that are designed to protect bondholders against actions that issuers can take at their expense have a strong influence on the governance of issuing companies. Covenants may range from specifying the conditions for dividend payments to clauses that require issuers to meet certain disclosure requirements.
When the COVID-19 crisis hit, there were already widespread concerns about the declining quality of the outstanding stock of corporate bonds. In each year from 2010 to 2019, with the exception of 2018, more than 20% of the total amount of all bond issues by non-financial companies was non-investment grade. In 2020, almost one-quarter of all corporate bond issuances were non-investment grade. Importantly, between 2017 and 2020, the portion of BBB rated bonds - the lowest investment grade rating - accounted for 52% of all investment grade issuance. During the period 2000-2007, the portion was just 39%.
After the outbreak of the COVID-19 crisis, the bond market continued to be a significant source of capital for non-financial companies. In 2020 a historical record of USD 2.9 trillion of corporate bonds was issued globally by non-financial companies. As a result of this surge in corporate bond issuance, by the end of 2020, the global outstanding stock of non-financial corporate bonds had reached USD 14.8 trillion, up from USD 13.7 trillion at the end of 2019.
In contrast to the high levels of investment grade issuance, the total issuance by non-investment grade companies, in particular by those with lower ratings, decreased sharply in the immediate wake of the crisis. In total, non-investment grade companies only raised USD 5 billion globally in March 2020, corresponding to less than 13% of the historical 5-year average. Through subsequent support by central banks seeking to address this segment, non-investment grade issuance exceeded its average in April, and in every month of the rest of the year. The monthly average issuance of non-investment grade bonds between April and December 2020 was almost double that of the monthly average between 2015 and 2019.
In order to improve and widen the use of corporate bond markets by non-financial companies, some structural challenges in the functioning of the market and in the credit rating system may require further attention. First, the share of newcomers to the corporate bond market has declined over the past decade to the advantage of recurring active issuers. Even after the dedicated monetary policy initiatives to support corporate bond issuance, the share of first-time issuers was only 27% in 2020 and their share in total issuance decreased to an all-time low of 12%. This is of critical importance because evidence from both the 2008 financial crisis and the COVID-19 crisis suggests that having an active established relationship with the corporate bond market provides an advantage when it comes to attracting new capital, especially in the immediate period after a crisis hits.
Second, although there has been a global tendency towards a relative increase in the number of smaller issues over the past decade, this is not true for all markets. Notably, in the United States, the median debt issue size has increased successively and has remained above USD 500 million each year since 2014. A similar development can be observed in Europe during 2020, when the median debt issue size jumped sharply from its 5-year average of USD 316 million to USD 407 million and the corporate bond market became strongly dominated by large issues. Renewed attention to the objective of facilitating access to the corporate bond market for smaller companies may be warranted with a view to increase financial resilience and preserve productive capacity during temporary downturns.
One important factor to consider with respect to the dominance of larger issuers is the mechanics of the credit rating system. The scale of a company is typically an important factor for its credit rating, and holding other factors constant, a larger company size is associated with a higher rating. The dominance of rating-based investment strategies among bond investors may therefore automatically result in a higher allocation to larger companies because they tend to have better ratings. The same effect may be triggered by regulations that define or restrict corporate bond holding by financial institutions to certain rating segments.
Third, despite a significant increase of BBB rated bonds, before the COVID-19 outbreak there was a declining number of downgrades relative to upgrades, which may suggest that credit rating agencies are mindful of downgrading BBB issuers due to their special status just above the non-investment grade threshold. The one-year 1-notch downgrade probability is lowest for bonds rated BBB-, which is also the lowest rating notch before crossing the line to non-investment grade status. Such rating stability concerns may limit the credit ratings’ ability to properly inform investors about the risks of individual bonds.
Given the severe economic consequences of the pandemic and the likelihood that the current liquidity challenges will eventually turn into solvency problems for some companies, distinguishing between viable and non-viable companies is becoming increasingly important for a proper allocation of available resources. Under such circumstances, an insolvency regime that allows for efficient and swift exits of non-viable companies and successful restructurings of viable companies is crucial. Moreover, the differences in insolvency regimes across countries will likely affect how well companies and investors navigate through the pandemic and any future downturn in economic activity.
A company in default can resolve its financial distress through an out-of-court restructuring or by going through formal bankruptcy procedures. An out-of-court restructuring practice that re-emerged in the corporate bond market in 2008 and whose prevalence has significantly increased in the subsequent period is the use of distressed exchanges. In distressed exchanges, an issuer offers new or restructured debt consisting of a new package of securities, cash or assets to its creditors or bondholders, who may voluntarily accept the offer. Such exchanges have the effect of reducing the original debt burden of the issuer and can hence help avoid a bankruptcy or payment default.
Creditors and bond investors tend to agree to distressed exchanges because the recovery after a distressed exchange is more likely and higher than in a bankruptcy. Given that the recent high recovery rates in the corporate bond market are mainly supported by the frequent use of distressed exchanges, if the financing conditions for distressed exchanges deteriorate or if the frequency of distressed exchanges re-defaulting into bankruptcies increases, recovery rates could decline rapidly with overall negative effects on resilience.
Responding to the COVID-19 crisis, many jurisdictions have made temporary changes to their insolvency practices. These temporary changes have been helpful in protecting otherwise viable companies from filing for insolvency due to the difficulties arising from the extraordinary health measures associated with the coronavirus outbreak. However, if such temporary changes remain in force, in the longer-term they may undermine one of the most significant objectives of insolvency regimes, which is to ensure a timely initiation of workouts or insolvency proceedings. Delays in the initiation of insolvency processes can, in turn, increase costs, erode the final value of the firm and reduce the likelihood that viable firms are successfully restructured. Considering that the portion of non-viable firms will increase in the near-term, finding the right balance during the transition and the path to modernise insolvency regimes will be an important task for many countries to ensure that resources are not perpetually tied up in underperforming companies.