Scarcity of capital, and what it means for industry

The current financial crisis has made capital, one of the key factors of production, a much scarcer resource. As long at this continues, it is likely to fundamentally alter the structure of many industries.

Scarcity of capital erects both a new entry barrier and a new exit barrier. This has implications for pricing power and industry consolidation.

There are three important factors that will determine which industries are most affected: 1) how much capital they need to operate; 2) the length of the capex/payback cycle; 3) the type of market structure.

A key question for investors is whether capital scarcity should be expected to subsist into the next cycle. If so, many market structures are likely to become substantially less competitive. This could present some interesting investment opportunities.


Scarcity of capital: what does it mean for industry?
Capital is now scarce. Banks are de-leveraging globally, and will surely continue to do so at least until the end of 2009. New debt financing will therefore be very difficult for companies who want or need it. Other sources of capital such as equity are also likely to remain scarce, or at least be very expensive, except for companies with highly rated shares. Furthermore, even once the deleveraging process it is over, it is questionable whether capital will ever be as freely available as it has been previously.

Capital scarcity has two important consequences for market structures:

1) A significant barrier to entry has been erected. While capital always becomes scarcer in economic downturns, it is increasingly becoming apparent that capital is going to be much scarcer now than it has been in past downturns.

The main consequence of this new barrier to entry is increased pricing power. The inability of competitors to enter markets should render the existing players very well geared to any upturn in economic activity.

2) The other side of the coin is that barriers to exit have also been raised. The inability to raise capital means that exit prices for uncompetitive or unprofitable assets are extremely low. There are few buyers. Moreover any buyers that do exist know that they have huge leverage over price.

The main consequence of this new exit barrier is increased industry consolidation. I would expect in many industries that the smaller, capital-starved operators will either end up going bust or being absorbed by competitors who still have a balance sheet. Of course this happens in any cycle, but it is likely to be more severe this time around.


Scarcity of capital: which industries are likely to be most affected?
I think there are three factors that will be particularly important in determining the scale and speed with which particular industries are affected.

1) The level of capital consumption in the industry. For example sectors that require lots of capital to operate successfully will surely run into problems first. We have already seen the banks affected, and now it is spreading to other financial balance-sheet businesses like asset managers and insurance.

2) The length of the payback period. For example, business models that require a continual inflow of capital for a (sometimes speculative) pay-off in the future are surely likely to suffer. Obvious examples here are biotech and tech. Venture capital generally is also likely to be affected. We could also see companies with very long capex cycles affected, perhaps leading to underinvestment, with implications for pricing in later years.

3) The market structure of the industry. Businesses that operate in markets characterised by “monopolistic competition” could see a significant change in terms of pricing power (assuming they survive). This is because monopolistic competition tends to ensure that pricing is reasonably competitive – despite the name, monopolistic competition is actually much closer to perfect competition (many buyers and sellers, limited level of non-price competition, low barriers to entry). However, if capital remains scarce, then the threat of entry is no longer a factor controlling pricing. It is therefore possible that many companies operating in industries previously considered to be very competitive may have a surprising amount of pricing power in the next cycle (examples of monopolistic competition include retailing, financial services, restaurants etc.).


Scarcity of capital: a visual interpretation
The following diagram illustrates my understanding of this process. Over time, I would expect more and more industries to be affected by the scarcity of capital. In the first stage, it is the balance-sheet business models that are most immediately affected. By this I mean companies that need huge amounts of capital to generate a decent return on equity – i.e. financials. In the second stage, it affects industries with long pay-back periods or long capex cycles. Finally, in the third stage it starts to even industries previously considered very competitive simply because there is little or no possible of entry. At the present time I would suggest we are about half way through stage 1.




Some additional thoughts and conclusions

This is only one of many possible outcomes
I am not arguing that the above is certain to happen. Indeed we may never make it much beyond stage 1. It all depends on whether capital remains scarce. Indeed, once capital returns we could expect the process to reverse itself. However, as long as capital does remain scarce, the process will continue, with more and more industries affected.

Are these changes in market structure permanent or transitory?
This is absolutely crucial for valuation. If capital is to remain scarce for the next cycle then many industries will be radically altered – they will move from being reasonably competitive to being more oligopolistic.

On the other hand, if capital returns as soon as the up-cycle starts again then many of the changes will be merely transitory. For example, insurance or asset management will revert to the monopolistic competition model, implying that any earnings or cash flow benefits will be temporary.

Lack of capital + lack of capacity = cartel
There is a possibility in some extreme cases of industries becoming almost cartelised in terms of pricing. If capital remains scarce and, importantly, there is also under capacity, then we should expect the incumbents to exercise their new found pricing power. They will not compete, they will collude. This could present some interesting investment opportunities for investors.

Which sectors could go this way? One possibility is banking – e.g Lloyds/HBOS’s should have huge pricing power in the mortgage market when/if the market turns up again.

What will be the attitude of the regulators?
It might be objected that market concentration and the exercise of pricing power will simply be blocked by regulators. This should definitely be a consideration. However, I also expect that the Government will turn a blind eye to many of these competition issues in favour of promoting employment and the survival of big companies and industries.