Ask yourself this question: is the amount of debt a company assumes, the rate of interest it pays, the events of default, the repayment date and all non-standard conditions (or ‘covenants’) vital to working out the value of that company’s equity? Any half-witted analyst or investor will emphatically answer ‘yes’.
Yet when I ask Damien Reichel, a partner at law firm Johnson, Winter & Slattery whether it is standard practice for companies listed on Australian Stock Exchange to disclose all the terms and conditions of their debt arrangements, he responds: ‘No, it’s not standard at all. It is, however, normal to disclose the amount of debt outstanding in the company’s accounts and maturity dates so that people know when facilities expire.’
This is a problem that weighs heavily on the minds of sophisticated investors. While market convention is to disclose little information about a company’s leverage, it is vital to determine its equity value even if lay retail investors tend to ignore it.
If a company’s capital structure is comprised of debt and equity, it is impossible to price one in isolation from the other. Debt directly subordinates equity in two ways: first, it has a prior ranking entitlement to the company’s earnings for interest repayments; second, debt ranks ahead of equity if the business is wound up.
The introduction of debt in the capital structure exposes shareholders to new risks. And individuals and companies default on their obligations all the time. When they do, the lender has the right to force asset sales at prices often far below fair value, which inflicts losses on those standing last in the queue- shareholders.
To price a company’s equity, it is imperative that you know the value of the debt, the rate of interest, repayment frequencies and all the key events that can trigger default.
So, the more debt a company has the more significant it becomes to valuing the residual equity. Any reasonable investor needs to be able to develop an informed view of the probability of the company defaulting and the losses shareholders will suffer if this comes to pass.
In every private equity transaction I’ve ever seen, investors demand access to all loan information precisely because they need to go through these steps. Yet most ASX investors are denied the same rights.
Between January 8 and 9, 2018, Allco Finance Group’s share price fell from $5.61 to $5.18. This pushed the company’s market value below a critical $2 billion milestone, about which the shareholders knew nothing. Allco’s directors had agreed to loan facilities that included a covenant which allowed lenders to demand repayment of their debt if Allco’s value fell below the $2 billion mark. Allco did not reveal the covenant’s existence until February 25. By that stage the game was all but over. While Allco’s assets were worth more than its liabilities, its share price tumbled to below $1 because investors knew that it would not be able to meet its debts when they fell due.
This is just a lesson about the hazards shareholders face when investing in leveraged companies that do not divulge the details of their debt facilities.
One high profile, billion-dollar fund manager, who requested anonymity, believes that ASIC should absolutely require all companies to disclose key loan terms and conditions.
Investors counter that if they are only informed about defaults once they occur, they have limited ability to take remedial action.

Required:

1. Do you think that parties such as investors and analysts can properly determine the risk of investing in an organisation if they do not have information about the various debt covenants the company has agreed to?  

2. Can ‘price protection’ properly function if potential investors are unaware of the existing debt covenants in a company’s lending agreements?

3. While debt covenants reduce the risk of the debtholders that negotiated the covenants, would they increase the risk borne by other creditors?

4. While the article suggests that the companies do not disclose, would the Positive Accounting Theory suggest that companies should publicly disclose information about existing debt covenants? Clearly explain your answer.

Answer rating: 100% (QA)

1 I think that parties such as investors and analysts can properly determine the risk ... View the full answer