Predictability

The difference between debt and equity from the investor’s vantage point is more or less the difference between an asset and an option.

In the simplified case, an equity issuance is a present value sale of future residual potential, after other obligations have been satisfied, the value of which residual potential nobody knows but many have opinions about. The market clears, in theory, where these opinions converge.

A debt issuance, on the other hand, is among the obligations that must be satisfied before that referenced equity residual and its potential can threaten to materialize. In the simplified case, debt finance supports the business asset, and equity underpins its optionality.

For a growing enterprise there is a balance that gets struck, the blending of an asset base that grows, augmented by the upside of its future optionality. The demarkation line between the growing asset and its option value isn’t always clear, just as certain financial obligations are more fixed than others.

The essence of the values and the underlying structures that are set boil down to their relative predictability. Asset value is enhanced by it as the cost of corresponding funds diminishes, while the opposite (i.e., volatility) enhances option value.

Financial markets, lately, seem to have been pushed by two related drivers: On one hand, declining borrowing rates, which imply increased predictability, and, on the other hand, rising business optionality for the dominant technology platforms.

We may, as a next phase, enter a financial period where these parallel events begin to manifest in structural enhancements and corporate finance creativity in capital markets, perhaps not dissimilar to the emergence of new debt instruments and resultant value builds that came with the birth of the junk bond market several decades back.

A couple of interesting editorials draw attention to this early trend (and opportunity):

Regarding Lambda School
Remains of the Day – Regarding Amazon’s revenue forecast

The data engineering which has grown and promises to dominate all major economic fields in years to come will give rise to financial engineering that may set new market norms and valuation models, not unlike financial innovation of the past.

Now that technology transformations of industry and economics are a foregone conclusion and more or less priced in, the next big wave will be driven by capital transformations.