M&A Blog #04 – capital structure (Part I - debt and equity overview)
Continuing with our home-buying analogy, for those of us who own a home, we know that we only own a portion of the home outright (assuming that the mortgage hasn’t been fully paid off). The bank owns the rest of the home that we don’t own. This is similar to how corporations are “owned” – a part of each belongs to banks and bondholders (collectively called “debt lenders”) and the rest belongs to shareholders (also called “equity holders”). In this post, we will discuss how debt and equity, which combined make up the company’s capital structure, impact company’s operations and M&A activities.
The term “capital structure” refers to how a firm finances its operations and growth from different sources of funds. There are two categories of sources: debt and equity. Debt comes in the form of short-term debt, long-term debt / long-term notes payable, and corporate bonds. Equity comes in the form of common stock, preferred stock, and retained earnings. When financial analysts refer to capital structure, they are most likely referring to the debt-to-equity (D/E) ratio – which provides an insight into how risky a company is. Usually, a company with heavy debt (also known as highly-leveraged) has a more aggressive capital structure, poses greater risks to investors, but the risk might be the primary source of growth.
Debt has tax advantages (interest payments are tax deductible to corporations), making it the preferred way to finance operations. It also prevents ownership dilution and at times of low interest rate, debt is easy to access. Equity is more expensive than debt, due to its lack of tax-deductible payments. The upside of equity is, when a company experiences earnings decline, no equity payments need to be paid (unlike fixed debt payments). Equity does represent a claim on future earnings, hence more equity (equity dilution) means less earnings for each shareholder.
In M&A, the availability of capital (along with the costs and constraints associated with each type) affects the acquirer’s ability to execute the acquisition strategy and take advantage of attractive opportunities. There is a feedback loop between this availability and corporate strategic options, and each impact the other both positively and negatively as we discuss below:
A company’s capital structure is a function of its capabilities and decisions. Capabilities mean how much money it can borrow, in what form, and what is the balance of debt and equity it should have to manage cyclicality of the business. Decisions mean management’s decisions on operating, investing, and financing activities. There is a feedback loop between capabilities and decisions, which requires constant managing and restructuring of the balance sheet as situation changes.
At the beginning, a company’s initial capital structure will be a function of its free cash flows’ size and stability. How much capital does the company need to run its business on an ongoing basis from both fixed assets (PPE) and working capital assets perspectives? Banks and bondholders will lend based on the likelihood of getting paid back. A highly stable utility (water / gas / electricity) company who is very predictable with little cash flow variation can get a lot of debt financing. A retailer with high seasonality and fickle customers needs a lot of financial flexibility, which means they have less ability to get debt financing. These two companies have very different capabilities when it comes to borrowing.
As time goes on, a company’s decisions will change its capital structure. As it distributes cash back to its shareholders in the forms of dividends or shares buybacks, as it reinvests back into the business for organic growth, and as it ventures into acquisitions; each decision will impact the capital structure. These impacts will provide more or less capital to move the business forward; forcing management to continually re-balance the availability of debt borrowing and equity. In other words, successful companies will generate and allocate capital. Surplus capital comes from:
Cash, from favorable historical earnings
Debt, from borrowing and repaying
Equity, from issuances based on projected cash flow and shareholders’ perception on management’s ability to earn returns above the firm’s cost of capital
The surplus capital will have to be allocated to pay expenses, repay debt, and reward shareholders. Each has significant impacts to management and shareholders as we see below:
As we see above, management has many options when it comes to capital allocation. It can choose to acquire, strategically invest back into business, fund up any unfunded pension liability, pay down existing bank debt, pay dividends (ongoing or one time – although dividends do come with shareholders’ expectation that it will continue), or engage in shares repurchases (also known as buybacks; on ongoing basis or one time large buyback). This constant need to re-balance the capital structure means continuous work to come up with the right amount of strategic investments, the right amount of debt and equity, and redemption provisions for shareholders that match the company’s operating characteristics.
In conclusion, the capital structure (debt and equity) impacts how a company finances its operations and growth. Each of these sources of capital has its pros and cons. The ability to do a strategic M&A program depends on the ability to continuously balance the capital structure, which itself continuously change as the result of doing business. The type of business a company is in (highly stable or highly dynamic) impacts how much rebalancing is needed. Companies have multiple ways to generate and allocate capital. Decisions on capital allocation dictate the amount of money available for a strategic M&A program. In the next post, we will discuss how an M&A deal impact the capital structure in reverse – creating yet another input in the never-ending work of rebalancing debt vs. equity.
