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Capital Structure Click to edit Master title style

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Capital Structure Key Considerations

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Why you should pay attention to the Capital Structure The capital structure of a company has substantial impact on the analysis of any type of transaction, Merger, Acquisition, Restructuring etc…  Each company has its own capital structure, with it are associated different constraints which will impact the strategic alternatives of this company

 A capital structure involves different type of players: equity holders, bond holders, loan holders etc.  Each level of the capital structure implies different level of claims on the assets of the company

Examples of Capital Structure impacts

Examples of impacts on types of analysis

 The cost of capital of the company

 Merger analysis

 Change of control

 Acquisition scenario (Corporate acquisition, LBO

 Ability to finance growth initiatives and acquisitions  Limitation on new debts which can be raised  Constrains on use of available cash  Allocation of risk and return among investors across asset classes

 Risk of financial distress

transaction)

 Restructuring  Refinancing options  Dividend payments  Interest payments  Liquidation analysis

Understanding the Capital Structure is paramount The Capital Structure of a company has substantial impacts on many aspects of a Merger or an Acquisition Capital Structure

Weighted average cost of capital (“WACC”)  WACC is impacted by the debt/ equity mix of the company

LBO valuation  LBO transaction valuation is very often dictated by the maximum leverage (amount of debt) and minimum equity requirements

Accretion/ dilution and IRR  Debt vs. equity  Dilution to existing shareholders  Convertible securities (i.e. bonds with the options to be converted into equity)

Enterprise Value

Comments

+ Market value of the equity (Offer price per share * diluted shares outstanding)

Convertible securities may have conversion rights upon change of control

+ Net debt

Book value of debt only approximates market value Prepayment costs etc.

(Total balance sheet debt - cash) + Others (Preferred, minorities and debt-liked items) CoachingAssembly. All rights reserved. Any unauthorised copying, duplication, reproduction, re-selling, distribution or other commercial use will constitute an infringement of copyright

Capital Structure Overview

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Risk and returns across the capital structure Risk and returns for a particular stakeholder depend on where it is located in the capital structure High

Common stock

High

Preferred stock

Subordinated debt Associated risk

Senior subordinated debt

Expected returns

Senior, unsecured debt Senior secured junior lien debt

Low

Senior secured debt

Low 6

Capital Structure basics To understand a capital structure, one has to well identify stakeholders by risk and reward allocation

 Equity instruments have a residual claim on

Returns for common stock

assets and bear the first risk of loss (i.e. shareholders will be the last stakeholders to be paid in the case of a sell of a company)

Equity

― In return of taking the highest risk,

returns associated to equity is usually unlimited ― Returns are in the form of dividends and

Purchase price per share

capital increase

 Debt instruments has a priority claim on the

Returns for bonds

assets of the company (i.e. in case of a sale of a company, debt holders will be the first to receive payment)

Debt

― In return of taking “low” level of risk,

debt returns are generally capped (interests and principal repayments)

Value at maturity

― Capital appreciation is possible if

securities are bought and sold on a secondary market CoachingAssembly. All rights reserved. Any unauthorised copying, duplication, reproduction, re-selling, distribution or other commercial use will constitute an infringement of copyright

Debt issuers classification Issuers can be divided in 2 main categories: investment grade and non-investment grade

 Risk associated to an issuer depends on 1) the macro-economic environment, 2) industry-specific factors and 3) company-specific factors

 Credit rating agencies such as Moody’s, Standard & Poors (“S&P”) and Fitch grade issuers based on criteria such as: ― Business and operational risk ― Financial risk (i.e. leverage  amount of debt and coverage  capacity to repay the debt) ― Company and industry growth (seasonality and cycles) ― “Certainty” of future cash flow (certainty linked to Macro economic, industry-specific or company-specific factors) ― Customers and suppliers concentration (a company A with 1 customer will be more at risk than a company B with

300 similar customers) ― etc.

Investment grade

   

Low total leverage levels Lower cost (i.e. lower interest rates) for the issuer Lower risk = lower return for the investor

Non-investment grade: “high-yield” / “junk bond”

 High total leverage  Higher cost (i.e. higher interest rates) for the issuer  Higher risk = higher return for the investor

Investment grade issuers tend to be larger and mature companies such as:

Amount of debt per sector Issuers can be divided in 2 main categories: investment grade and non-investment grade Cable TV

Industry characteristics

Broadcasting

 Industry size and growth prospects  Cyclicality and seasonality (impact

Cellular Aerospace & Defence Food Chemicals Consumer products

on working capital)

 Capital intensity  Strength of suppliers and customers

 Pace of technological changes and threat of substitution

 Regulatory environment

Industrial manufacturing Medical supply Restaurant Retail Technology Low

Debt/ EBITDA

High 9

Security: senior vs. junior securities Seniority matters when everything starts going badly and there is not enough money to pay everybody! Industry characteristics Common stock

Last to get paid

 Security can come in many form. It is a stakeholder’s claim on the assets of the company

Preferred stock

― Security on tangible assets (i.e. inventories,

property, plants, machines, real estate etc.) ― Security on intangible assets (IP, trade

Subordinated debt

marks, contract rights etc.) ― Security on stock of subsidiaries

Senior subordinated debt

Payment waterfall

 The greater the value of a collateral (plants, trademark etc.) the lower the risk to the lender (if a bank lends you £10,000 to launch a business and take your house as a collateral, the bank is not taking so much risk!)

Senior, unsecured debt Senior secured junior lien debt Senior secured debt

First to get paid Cash

A systematic approach to credit analysis - the 5 Cs You will find below the 5 key themes you need to focus on when looking at a credit

CHARACTER Focus on the firm, its management, brand name and strategy

CAPACITY Will the company generate sufficient cash flows for interests / debt payment?

COMPETITION Focus there on the competitive environment. Is the Company a leader?

CAPITAL Is the company well capitalized? What is the gearing ratio?

COLLATERAL What is the collateral? Quality? Estimated value? Estimated recovery?