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.
J
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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