Capital Management & Digital Assets
Buybacks, Token Burns, Dividends and Staking Rewards…
- Businesses, or any entity, can fund operations and growth in a number of ways — the mix of capital used to provide this funding is likely to have a material impact on the ultimate returns delivered to investors
- There is a fundamental reason equity buybacks lead to increased share prices — it is companies replacing “expensive” capital with “cheap” capital therefore increasing per-share profitability
- In the digital asset ecosystem, token buybacks/burns and dividends borrow from proven corporate finance strategies to return value to investors — both mechanisms should fundamentally support/grow a token price if underlying platform/revenue/fee growth is delivered
- The addition of these mechanisms to digital assets and the tangible relationship to underlying performance they provide creates an opportunity to use traditional valuation methodologies. We believe, over time, this will significantly increase the investor pools available to the sector
- Staking rewards are not a “yield” — they can increase the value of a holders investment but they are not a capital management initative, rather an innovative incentive for ecosystem participation
We beleive there are a number of misconcpetions about the fundamental drivers of value created from capital management initatives. Here we provide examples of the theory behind capital management in equity markets, why it is value-accretive for equity holders and how these established methods are increasingly being adopted, with appropriate reworking, by digital assets.
The addition of more tangible value transfer mechanisms has the potential to create a step-change in both the potential investor base investing in the sector and the valuations ascribed to tokens. As mentioned in our Outlook for 2020 article (in the “Tokenomics Re-engineered” section), we continue to beleive this is a material thematic across the digital asset sector for investors to monitor.
To make this more accessible/brief, we have made some generalisations with both our definitions and examples — please free to reach out to our team if you would like to discuss anything in more detail.
We define capital as any security that allows a business to generate value — we group it into two broad categories in the examples later in this piece:
- Debt — generally non-permanaent capital (ie has to be repaid at some point) that provides a fixed return to the holder. In a wind-up/bancruptcy it generally receives preferential treatment (eg it gets paid out the proceeds of any assets sales first); and
- Equity — permanent capital that provides the holder with a pro-rata (ie in proportion to their percentage ownerhsip) particpation in the ownership and returns delivered by a business as well as key decision making
Whole books are written on these topics and there are almost endless variants of both debt and equity (and hybrids inbetween!) but we have used simplistic definitions here to help standardise the analysis below.
Capital management is the “art” of optimising an entities capital mix (debt vs. equity) to balance risk against returns. When entities generate more profit than they want to reinvest in their growth or believe a rebalacning of the debt/equity mix in their capital base is appropriate there are generally two ways to execute this stratgegy:
- Dividend — a pro-rata payment , in the form of cash, to shareholders which is typically funded by profit and potentially the proceeds of increased borrowings; and/or
- Buyback — using profits or the proceeds of increased borrowings to buy back a portion of issued equity
We’ll assume everyone understands the general concept of a dividend but we dont beleive this is the case when it comes to equity buybacks — which is important as similar mechnisms are increasingly being used in digital assets.
The Fundamentals of Equity Buybacks
Below we have provided a simplified analsyis of how buybacks are analysed at a corporate finance level and why there are fundmanetal reasons it should result in an increased share price over time.
The example relies on a number of assumptions:
- The illustrative company makes a steady Earnings Before Interest and Tax (“EBIT”) of $15m;
- The company’s P/E multiple remains constant after the buyback (a fair assumption as a modest change in debt shouldnt impact P/E);
- Interest rate on new debt is 3%;
- Company tax rate is 25% and interest is tax deductible; and
- The buy-back is sized at 5% of shares outstanding
Whats happened here? The company borrows $5m to buyback 5% of it’s shares through an equity buyback. It is effectively replacing “expensive” equity capital with “cheap” debt capital, see the high-level math below:
- Debt: The pre-tax “cost” of the borrwoing is $150,000 per annum (3% interest on $5m of debt) BUT because interest is tax deductible its after tax cost is only $112,500, or 2.25% (remember equity holders get after-tax profits so this is the relevant measure)
- Equity: At a P/E of 8.89x, the “cost”of the equity (earnings yield) that the 2.25% debt is buying is (1/8.89), or 11.25%. Or alternatively, its costing $112,500 per annum to buyback equity that is entitled to $562,500 of earnings (5% of NPAT)
So the company is using capital that costs 2.25% to buy-back capital that costs 11.24%. Given this dynamic, the after tax profits of the company fall less than the shares on issue fall (as a result of the buyback). If the P/E multiple stays the same, which is a valid assumption all else being equal for only a small incremental debt increase, the share price should trade 4.2% higher. The “return” from buying back this equity will also compound in future years as profits grow and the cost of debt doesnt.
There is one complexty here — the Enterprise Value of the company has increased after the buyback and hence the EV/EBIT multiple will be higher, precedents however suggest the P/E impact dominates in the post-buyback share price determination.
This math also helps to explain why the amount of global on-market buyback activity has been so high recently — the “cost” of debt is incredibly low by any historical measure so shareholders and Boards are making the rational decision to reduce their overall cost of capital by replacing “expensive” equity with “cheap” debt. This clearly increases financing risk (ie risk of financial failure) as debt is not permanent capital but that is another discussion all together.
Applying this to Digital Assets
Similar logic can be applied to digital assets to show how a token buyback/burn model can also increase value for the remaining holders of the token. Whilst the dynamics around debt/equity are clearly different, the logic remains the same — buying back tokens today so the remaining tokens receive an increased portion of future growth.
The table below shows the dynamics for a theoretical token, XYZ, that executes a buyback/burn of fees it earns. The steady state assumes that interest is reinvested and earns interest for a fairer comparison.
From the table you can see, if the cash flow multiple is held constant under a buyback/burn model the token should trade c.4% higher under a burn scneario. Like the equity buyback discussed earlier, this is the differential in “earnings” between the two scenarios — in the “No-burn” scenario the Year 1 cashflow is invested at 3% and earns interest of $50k. This increased cashflow doesnt outweigh the benefits of a smaller token count.
CAUTION: We would also argue that the likelihood of the token price tracking the cashflow growth is materially enhanced if there is a buyback/burn model in place providing a tangible connection between cashflow and token. Put the other way, we would have less confidence in the token growing along-side cashflows without a burn in place as there is less relevance to the cashflow multiple itself.
The buyback/burn will not be acrcretive in all scenarios. This highlights a potential issue with these “programmatic” buyback models as they may be buying tokens back above rational, value-adding levels. In the above example, the buyback will be price neutral, at a CF multiple of around 46x and decretive at levels above — see example below at say 60x:
Under this scenario the buyback is decretive to holders and they would be better off, all else being equal, if the CF was invested for passive interest income of 3%. It is however worth considering the following in this scneario:
- As stated above, we think the liklihood of a token accurately tracking cashflow growth,longer-term, without a buyback/burn model is significantly lower; and
- As markets mature, they will likely act rationally over time and trade at prices that normalise for accretion
So does the buyback/burn model provide a link between underlying platform performance and token price? In our opinion there is an argument that tokens make a tighter actual link to cashflow than equity. If you are a minorty shareholder (remember equity is perpetual capital), there is a scenario, which we see playing-out with Amazon and Facebook, where a shareholder can never receive a cash return. The shareholder is entirely dependent on the market, through pricing of profitability or other measures, to increase the share price and therefore deliver a return. Under some of these examples, you can never control cashflows given the controlling shareholders and differing share classes even if you had the hundreds of billions of dollars required to try and buy the influence.
In a buyback/burn token model there is a clear “end case”. In the above token example, if XYZ is successful over an extended period, eventually a point will be reached where there is only one token holder left. Under this scenario, that token holder has complete control of the cashflows within the system and chooses at what price to sell their token (or a portion therefore) into the buyback. They can even determine the buyback mechanism assuming some governnance control. Under this scenario, they could theretically sell 0.00000001 XYZ into the buyback for 100% of the XYZ cashflow generated and continue to do so for decades to come. This token holder — by outlasting all other token holders and not selling (having the highest sale price), has gained 100% control of the cashflows of XYZ and extracts 100% of the future cashflow generated. They could also theoretically on-sell control of this cashflow readily by simply selling their token(s) (albeit it would be a negotiated transaction as no liquid market would exist) and potentially extract a control premium for doing so.
Ok, but this is theory and unlikely to play out in a realistic timeframe — we would argue its no less theoretical than a shareholder getting real access to Amazon’s cashflows and forcing a dividend be paid.
Models are emerging where cashflow will be returned directly to token holders (typically requiring some kind of commitment/staking to the network). Under this scenario, instead of using cashflow to buyback/burn the token from the tokenholder with the lowest price expectations (ie those selling into the buyback) and generating a gain for the remaining holders by increasing the token price (as shown by the math in XYZ example), here all holders are paid a pro-rata portion of cashflows. In our opinion, it is important that if this model is to generate tangible value, the payout, or dividend, is in a differnt “currency” to the underlying token — most examples we see or expect will use Ether. If it is solely paid -in-kind, it is either a form of selective dilution for holders or a quasi-capital riaisng mechanism (issue tokens/retain cash that otherwise would have been paid) — neither of which we see as capital returns.
There is centuries of experience proving that there is a tangible medium/long-term link between the price of a security, or a token in this instance, and the level of cashflow it is paid as dividends.
Why does this link exist? Ultimately all capital is seeking returns and investments are competing against each other — if a liquid market has determined that XYZ tokens should yield 3%, as earnings grow in-line with expectations, say by 10%, all esle being equal, a rational market is likey to continue to buy the token at increasing prices until it is again yielding 3%. This equates to a token price increase of 10% and the link between price/underlying performance has been created.
The math here is simple: If a token is paying 10c of dividends in Ether, if the market prices it on a 3% yield, it will trade at $3.33. If that dividend grows to 11c (10% growth) as a result of say increased user adoption, to maintain a yield of 3% the token price needs to rise to $3.67 (+10%).
We see no reason why these simple relationships should not hold in the digital asset ecosystem.
Staking yields are not the same as the buyback and dividend examples above. They do not involve an entity returning cashflow to investors — which happens through a buyback or dividend. They involve issuing more tokens to stakers generally at pre-determined rates. In a rational market, if there is no underlying value creation on the actual operating asset or system, the market should adjust the token price to keep the overall market cap the same.
So they dont create a return for token holders? In theory no, in practise, yes, but it is misleading to call it a yield and the ultimate return to stakers is typically well below that “advertised”.
See the example below:
If everyone stakes, new coins are distribued pro-rata and the value of the coins, all else being equal, will just be deflated at a rate to keep the new inflated number of coins (and token market cap) at the same level. HOWEVER, this changes as less than 100% of people stake, and returns start to accrue to stakers as new coins dilute non-staker ownership interests. The returns to stakers will get higher the less people stake (avoiding the obvious issue that the value of the chain is likely questionable if no one is staking). As the example above shows, the relative “yield” versus actual value accrual depends on the level of staking. Most well supported chains see staking at around 80%+ — at this level, the “headline” yield of 6% actually translates to an actual return to the staker of 1.4%.
Whilst this is a return, it is not underwriten by any fundamental cashflow or activity on the underlying asset. We would put this in a very different category to a cashflow derived return through a burn/buyback or dividend. Whilst we can see why this method is used and its effectiveness at encouraging network participation, we also beleive the use of the word yield is misleading.
Why is this Bullish for Digital Assets?
We beleive there are three key reasons growing sophistication and return-orientation of token models is bullish for the sector:
- The universe of investors in speculative assets is materially smaller than in fundamental growth assets. If investors can apply traditional fundamental anlysis, or versions of it appropriately adjusted for the nuances of digital assets, we beleive there is a materially larger pool of potential investors than the current sector attracts. We would also expect lower price volatility with these models as investors armed with fundamental valuation views typically show more conviction;
- On a fundamental basis using our internal analysis, a number of existing tokens compare favourably, on a growth adjusted basis, to listed equity market valuations — the more cross-asset analysis can be performed, the more we beleive the attractive valuation levels of some digital assets will attract new potential investors and see material price re-ratings; and
- These models encourage a focus on fundamental value creation amongst communities and leaders in the digital asset space. When token returns are driven by fundamental growth in fees/cashflows the full incentive for holders of those tokens is to deliver value-adding services and platforms to maximise that cashflow