664  Capital Structure, Dividends, and Share Repurchases reported return on assets. That is not a good reason to do it. Investors will see through accounting representations, as discussed in Chapter 7. Furthermore, as already mentioned, following the latest U.S. and international accounting standards, operating leases and special-purpose entities for off-balance-sheet financing need to be fully recognized on the balance sheet. Hybrid Financing Hybrid financing involves forms of funding that share some elements of both equity and debt. Examples are convertible debt, convertible preferred stock, and callable perpetual debt. In particular, issuance of convertible debt has seen strong growth over the past decades, and the amount of convertible debt outstanding surpassed €400 billion in 2014.52 Convertible debt, or debt that may be exchanged for common stock in a given proportion within or after a specified period, is an efficient form of debt financing when investors or lenders differ from managers in their assessment of the company’s credit risk.53 When the discrepancy is great, it may become difficult or even impossible to achieve agreement on the terms of credit. But a company’s credit risk has less impact on credit terms if the debt is convertible. The key reason is that higher credit risk makes the straight-debt component of the convertible less attractive and the warrant component more attractive, so the two components balance each other to an extent. Overall, convertible debt is less sensitive to differences in credit risk assessment and may therefore facilitate agreement on credit terms that are attractive to both parties. This also explains why high-growth companies use this instrument much more than other companies; they usually face more uncertainty about their future credit risk. In 2018, high-tech companies in the United States issued record levels of convertibles, often with so-called call spread overlays that raise the conver- sion price at which the bond can be exchanged for common equity shares (see Chapter 16 for an example). Do not issue convertible debt just because it has a low coupon. The cou- pon is low because the debt also includes a conversion option. It is a fallacy to think that convertible debt is cheap funding. This holds regardless of whether it is straight convertible debt, mandatory convertible debt, convertible debt with or without call spread overlays, or any other of the many variations pos- sible. Also avoid issuing convertible debt simply because it is a way to issue equity against the current share price at some point in the future when share prices will be much higher. That future value is already priced into the conver- sion options. Furthermore, if the company’s share price does not increase suf- ficiently, the convertible debt will not be converted to equity, and the company will end up with interest-bearing debt instead. 52 Bank for International Settlements, BIS Quarterly Review, September 2014. 53 See M. Brennan and E. Schwartz, “The Case for Convertibles,” Journal of Applied Corporate Finance 1, no. 2 (1988): 55–64. Summary  665 Summary Although a poorly managed capital structure can lead to financial distress and value destruction, capital structure is not a key value driver. For com- panies whose leverage is already at reasonable levels, the potential to add value is limited, especially relative to the impact of improvements in returns on invested capital and growth. Managers should refrain from fine-tuning for the optimal capital structure and from simply giving in to any shareholder demands for higher payouts. Instead, they should make sure capital structure and payout decisions are integral parts of a cash deployment that ensures the company has enough financial flexibility to support its strategy while at the same time minimizing the risk of financial distress.