Monday, August 19, 2013

Dynamic Capital Structure: A Long and Winding Road

How you fund an acquisition can have an important value impact. Usually, an acquirer has a static target capital structure tied to a ratings goal. For example, an industrial firm with a BBB ratings goal will keep its Debt to Capital ratio below 40%. Thus, it would either use excess liquidity or seek to raise capital for an acquisition in roughly that proportion to maintain its target.

This is largely the case for large, public, infrequent, strategic acquirers. More aggressive firms with concentrated ownership use transitory or dynamic capital structure which fits their short term needs and market conditions. They deliberately, but temporarily, deviate from their long term capital structure target to fund a particular action. Then, they rebalance to meet their long term target. Basically, debt is used as a plug to meet unanticipated funding needs. This allows them to avoid issuing possibly costly undervalued equity or maintaining extensive cash balances.

We saw this with Hudson Bay (SKS) , which leveraged up to high initial 5.7X FD/EBITDA leverage level to fund the SKS purchase. The expectation is they will rapidly refinance the debt from a REIT/Sale-Leaseback. Private Equity (PE) firms use a similar technique. They use high initial leverage and then rapidly retire the debt through operating cash flow. That is why most LBO related bank loans never go to maturity. They are either refinanced at a lower rate if they work according to projections or are restructured is they do not.

PE also uses capital structure changes as a substitute for an exit. Current weak M&A and IPO markets have complicated PE exits from portfolio companies. The average age of portfolio investments has reached a record 5+ years due to the financial crisis. This hurts IRRs and their limited partner investors (LPs). Thus, PE has re-leveraged portfolio companies to fund recapitalizations-special dividends to return capital to their LPs. The level of recaps is running at record levels. It is likely to exceed the record 2012 level this year. In fact, many deals are being rushed to market before the expected Federal (Fed) Reserve tapering begins.

Firms also deviate from capital structure targets based on market timing considerations. For example, firms will fund acquisitions with equity when they feel their shares are overvalued. Perhaps the best example of this is when AOL used its inflated shares as the acquisition currency in the Time Warner transaction. More recent examples are the MB Financial and PACW transactions (MB). 

IPOs exhibit market timing as well. They tend to occur when valuations are high, as reflected in elevated market-to-book ratios. This is the reason why IPO returns a year after the issuance tend to disappoint (e.g. Facebook).

Market timing related capital structure decisions affect debt as well. Debt issuance is favored when both rates and spreads are low. Post crisis Fed actions kept rates low. They also compressed spreads as investors are searching for yield. Equity costs, as reflected in the equity risk premium, have remained relatively high given macro-economic uncertainty. Thus, many firms engage in debt financed share repurchases whereby,”cheap” debt replaces more “expensive” equity.

Bottom line- the capital structure decision is more complicated than the widely held static view. Managers may have a long term target, but how they get there is a function of unanticipated investment and financing opportunities they encounter along the way. Thus, reaching their capital structure target can be a long and winding road.


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