Inflation or Deflation: RBF for an uncertain future?

Satirical country singers “Bretton Wood” and “Merle Hazard” have a real hit on their hands with “Inflation or Deflation:”

Their chorus, chilling in some ways if funny in others, is:

Inflation or deflation?
Tell me, if you can
Will we become Zimbabwe
Or will we be Japan?
Credit markets came undone
And still are in distress
Will the dollars in my mattress
Buy much more next year or less?

If you knew which of the two were just around the corner (and no consensus seems firm today), how might you invest?  Well, the usual answer looks like this:

Deflation:

  • Each dollar increases in value.
  • Generally considered the “third rail” of modern economies.
  • Debt securities (fixed coupon) become more valuable…
  • … if the debtor can still make its payments!
  • … Hence, Treasuries are the order of they day (as long as the Marines have ammo, they’re legal tender).
  • Equity securities theoretically deflate nominally…
  • … but the stresses of debt and falling prices might sink companies.
  • … Hence, stocks get a double-whammy.
  • A central bank can fight deflation by “printing money” (q.v. “Helicopter Ben”).

Inflation:

  • Each dollar decreases in value.
  • A little bit (say, 1-10%) is par for the course, if unpleasant.
  • So-called “hyperinflation” (over 25% a year, extended) renders traditional accounting unreliable.
  • Debt securities become far less valuable.
  • Equity securities should be relatively OK, if businesses can pass on inflationary cost pressure along with their prices.
  • A central bank can fight inflation by raising rates in a “hawkish” manner (q.v. “Paul Volcker”).

Revenue-based financing investments are somewhat different in character.  They have some debt-like characteristics (required, though floating, payments, and usually a fixed total return cap), and some equity-like characteristics (higher overall return, indexed to the company’s revenues).  How might an RBF investment perform under deflation or inflation?

Deflation:

  • Company’s revenue drops with general prices.
  • Hence, RBF payment streams drop.
  • However, the RBF total cap stays in place, so the total return, over time, is fixed (but it happens over a much longer period).
  • The company is not exposed to the “deflationary trap” of fixed debt service.
  • The investor “eats” the timing risk, but gets the same number of (ultimately more valuable) dollars eventually.

Inflation:

  • Company’s revenue increases with general prices.
  • Hence, RBF payment due increases.
  • However, repayment is capped at the RBF cap, so company is “off the hook” earlier than expected.
  • Investor receives fixed amount of (less valuable) dollars, but should receive them much faster.

(Note that all the above is generally applicable, in reverse, from the company’s perspective.  So inflation is good for the debtor, just as it is bad for the traditional creditor.)

Your comments are welcome, gentle reader, but I submit that the RBF model helps cushion the blow either way, as opposed to the very inflexible debt or the rather volatile debt model.

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About rlucas
Current entrepreneur and investor at RevenueLoan, doing growth financing for small businesses. Formerly with VC firm Voyager Capital in Seattle, startup Tercent, Inc. in Portland, and a variety of tomfoolery in Boston, MA (primarily skipping classes at Harvard to go down the river to MIT).

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