Monday, June 17, 2013

Choose Wisely: Selecting a Capital Structure

The funding requirements for larger merger transactions frequently have important capital structure implications. The portion of debt to equity used is more important for strategic acquirers than private equity firms. Private equity acquisitions usually involve temporary capital structures utilizing the maximum level of debt with rapid debt repayment. Strategic buyers focus on longer term “permanent” capital structures, and are the focus of this post.

Capital structure decisions are usually expressed as credit ratings targets. The ratings are based on industry, firm size, debt-to-capital, and funded debt to EBITDA ratios among other factors. Selection of the appropriate ratings target is based on the following matching process:

                  Financing Need = product market opportunities + operating performance & strategy
                  Capital Structure = capital market conditions + financial preferences

It is important to get this right. Insufficient debt reflected in high investment grade ratings can result in excess taxes, higher agency costs and increased shareholder activism. Excessive debt expressed in non investment grade ratings can reduce flexibility and increase financial distress costs.

Some of the factors affecting the decision process are as follows:

1)    Taxes: are the debt related tax shield benefits important? Can the firm generate sufficient taxable income to utilize the interest deductions? Firms with limited existing or volatile taxable income due to rapid growth, high investment requirements, cyclicality, rapidly changing regulation and technology tend rely on higher equity levels compared to stable cash generating mature firms.

2)    Financial Distress Costs: the major financial distress cost is not bankruptcy, but the impact of higher leverage on the firm’s operations. This includes inability to fund the firm’s strategic plan, and the impact of higher leverage on the firm’s suppliers, customers, employees, competitors, and capital market access. High leverage can scare suppliers, customers, and employees.

3)     Peers: compare target structure against competitors. An overly aggressive debt level relative to peers can encourage adverse competitor responses. We saw this in HP’s comments about Dell’s LBO. HP stated they intended to remind Dell’s P/C customers that HP was investment grade while Dell would be highly leveraged.

4)     Discipline: leverage can motive management to be more efficient to meet debt service requirements. Also, lender covenant restrictions and excess cash flow sweeps requirements in noninvestment grade financings can minimize management prerequisites and empire building which is often at shareholder expense.

5)     Ownership and Control: firms worried about these issues tend to favor debt over equity.

6)     Dividends: higher leverage can pressure dividends. The impact depends on the firm’s shareholder base. Shareholders preferring a steady dividend may favor a more conservative capital structure despite potential ownership and EPS dilution.

7)     Relative Pricing: the Fed’s QEs have altered the relative pricing of debt compared to equity. Excess liquidity and low rates have lowered the cost of debt. The equity risk premium, however, has remained elevated making equity a more expensive funding source (see Cookbook WACC Estimates: Wrong Recipies?).

Many acquirers will undoubtedly use the same pre transaction rating target when setting their funding mix. Nonetheless, it can be useful to revisit the capital structure decision as part of the M&A discussion.

So chose wisely.


P.S. Readers of this post may also find many of our other capital structure posts of interest including: How Much Debt is Right for Your Deal and High Leveraged Deals, Capital Structure, and Common Sense.

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