By Dominique Jacquet

Financial theory continues to express its perplexity in the face of the optimal level of indebtedness of firms.

We owe a considerable contribution to MM. Modigliani and Miller who demonstrated that, even if the financial creditor required a lower return than the shareholder because of risk, debt added nothing to the value of the company, except a tax gain quite limited. After this masterstroke, the theory focused on more “managerial” aspects. It is easier to convince a banker than a shareholder (the “pecking order”). Raising debt shows confidence in the future (signalling theory). Debt makes it possible to control managers (agency theory).

The financial markets are the first “customers” of these theoretical contributions which, while they all present very relevant informative aspects, leave the industrial activity and the business development strategy somewhat in the background.

Let’s take a look at business operations.

I have always tried to convince my listeners that it is strongly recommended not to take two risks at the same time. Concretely, adding a financial risk to an operational risk. For example, a firm that embarks on proactive external growth and takes the risk of not successfully integrating its acquisitions and, consequently, of not generating the anticipated synergies, must maintain a conservative financial strategy. We do not stack a financial risk on top of an operational risk.

The reason comes from the fact that the debt places the company in a position of vulnerability against its competitors, to a world which evolves in an uncontrolled and unpredictable way, to a technological disruption, or any others.

This is a very simple principle, but not often applied.

In the film devoted to Lafarge (February 2020), I took up the group’s sequence of acquisitions which was very successful, particularly in the United Kingdom, but financed by debt in order to limit the dilution of shareholders, a traditional strategic decision. As a consequence of indebtedness, the rapidly growing financial costs, fixed costs par excellence, have reduced the firm’s ability to respond to competitive aggression. The Cement division of the Orascom group tried to conquer market share by launching a price war, a determining factor for the act of purchase in a commodity market. Responding to aggression by adjusting prices downward has a direct impact on operating profit. Financial expenses are a downward limit, so Lafarge’s ability to react was limited by their increase, and the firm responded by buying the aggressor for 8.6 billion Euros, therefore 6 billion financed, again , by financial debt, with a deal signed in December 2007. The subprime crisis has already begun, even if the world has not yet suffered the Lehman shock. This ultimate debt financing, combined with a violent economic crisis, will lead Lafarge to asset disposals, a highly dilutive capital increase, and the merger with Holcim with a view to “creating shareholder value”… The big winners will be the short sellers who had bet on the fall of this industrial emblem.

The merger will be announced “among equals”, which will not delude you for long. Holcim will undertake (electoral promise?) to keep part of the activities of the head office in France, then will close them. Last act of the tragedy: Lafarge abandons its listing on the Paris Stock Exchange on December 30th. How to disappear by not respecting a financial rule of common sense…