Magic pudding or regulatory arbitrageur's friend? The Use of hybrid debt equity securities by Australian listed corporations

The past few years have seen high levels of growth in the use of hybrid financial securities by Australian corporations. The conventional explanation for this phenomenon has been that hybrid securities represent a highly flexible tool capable of deployment towards the end of reducing overall firm cost of capital, whilst at the same time providing attractive return streams to investors. In this paper, we suggest that this approach to conceptualising and explaining the increasing popularity of hybrid securities is tantamount to asserting the existence of a financial magic pudding. Instead, we contend that the rise in popularity of hybrid financial securities can be better explained by their capacity to assist their issuers take place in sophisticated regulatory arbitrage. We find irony in this, given that the rise in the popularity of instruments whose key purpose is to circumvent regulation has taken place during a period of heightened focus on good corporate governance and transparency and consistency in financial reporting. We tender evidence to support our contention that hybrids are better understood as tools of arbitrage than tools of effective capital management by demonstrating that the cost of hybrid securities is not as low as has been conventionally thought. Further, we present evidence of the material distortions to measures of leverage, earnings and operating cashflows which result when firms use hybrids to play the regulatory arbitrage game. We conclude by arguing that further reform to the current regulatory regime is required in order to improve the quality of contemporary financial reporting.