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Is it time to think about using your capital structure as a buffer against abnormal events?
Vincent Ryan, CFO Magazine
February 1, 2011
A collapsed buyout deal, mounting defaults on student loans, a loss of federal subsidies, and landing on the wrong side of a large put option. Three years ago, those circumstances sent Sallie Mae hat in hand to the equity markets to do a poorly timed public offering. The sale diluted the value of Sallie Mae's existing stock by double digits, and the company's share price still hasn't recovered.
It's difficult for many CFOs to concede the possibility of such a perfect storm, or even to ponder an isolated catastrophe, such as BP's Gulf oil spill. That disaster cut BP's share price to an 18-year low and forced it to sell off billions in assets. While companies routinely protect themselves against all manner of small, unfavorable events — hedging interest-rate moves or currency spikes, for example — they rarely prepare for the larger risks that could flatten them.
True, those risks are hard to identify and quantify, and difficult to hedge. And some events, such as financial-market meltdowns, product liability, and acts of God, are often uninsurable (at least in the traditional way). And even if a firm can buy insurance, it could wait a very long time for a payout. "There is a certain degree of insurance you can buy against an underground well exploding, but you're protected against only that one risk. Also, there is a great deal of time and ambiguity surrounding the litigation and politics that typically follow these tragedies," says John Chirico, co-head of capital-markets origination in the Americas at Citi.
As an alternative, companies are beginning to consider how their capital structure can protect against a broad range of catastrophic risks. Such a buffer would be analogous to a health plan that pays out only for the most costly, life-threatening diseases. Did BP envision a circumstance in which a drilling accident would shut off its access to short- and medium-term capital markets and garner worldwide condemnation? If it did, it certainly didn't prepare accordingly. "Until recently, no one was addressing their capital structure in the context of disasters, such as three major hurricanes hitting in one season," Chirico says.
To design a capital structure for this purpose, management needs to stress-test it with high-severity scenarios, but executives rarely warm to the task of proactively assessing doomsday story lines. A true test of whether such brainstorming is on track, Chirico says, is when the ramifications of a given disaster are so bleak that "you almost want to look away rather than consider them." When that happens, he says, "that's the signal that you should put a task force on it."
Next, analyze how large a capital-structure shock absorber will be needed in such situations. Finance doesn't require a lot of sophistication to answer that question. "Layer on the obligations you have, the risks you face, and then calculate the cushion you need to meet the obligations," says Tim Koller, a principal in McKinsey & Co.'s New York office. Volatility in cash flows, opportunities for investments, expected dividends and buybacks, and the corporation's risk tolerance also need to be figured in. "Once you've decided on a level of safety, you then translate that into target levels of debt and equity," says Koller.
Dennis Arriola, finance chief of SunPower, a maker of solar-power components and systems, is the "person who is paranoid at all times," and ensures the company "has sufficient liquidity balanced by the cost of that liquidity."
After projecting capital needs, Arriola performs "what-if" analyses, including a scenario in which liquidity in the bank markets dries up. "We recognize that any projections the company puts together are wrong," he stresses. "The question is, how wrong can we afford to be? I try to look at the bookend of risks we can work with and how to manage around those extremes."
SunPower did some deleveraging in 2010, paying off $143 million in convertible debentures and $34 million in bank loans. It also deconsolidated $233 million in debt from a joint venture in Malaysia. The company's debt- to-EBITDA (earnings before interest, taxes, depreciation, and amortization) has dropped significantly, and its long-term total-debt-to-capital is within its targeted 25%-to-35% range.
While Arriola doesn't spend much time on events that are statistical outliers, he does consider their potential consequences in certain contexts. On capital projects such as SunPower's expansion in the Philippines and Malaysia or its building of solar-power plants, Arriola posits questions like, "What happens if we don't get the permits we need and we're extended? How much can I fund from my balance sheet?"
How Much Leverage?
Many companies maintain debt ratios consistent with a target financial rating. By running less-leveraged they have greater flexibility, in essence creating what might be called a "crumple zone" for large negative events. That can come in handy when the company runs the risk of, say, missing an interest payment, but it can be economically costly as well. "What's the right earnings-per-share hit in order to support a long-term, save-the-company strategy?" asks Chirico. "What's the right reduction in return on equity?" The answer will be different for every company.
Companies that don't want to take such hits from using less debt can pursue longer maturities, less bank debt, or roomier covenants (for a price). Considering leverage in light of other finance risks is another way to get comfortable with higher amounts of debt.
Terremark Worldwide, a cloud computing and hosting provider, has a healthy debt-to-EBITDA ratio of 7.0. The $320 million company tapped the bond markets twice in 2010, but CFO Jose Segrera says he's very careful about leveraging up the B-minus-rated company. He doesn't pursue incremental capital without knowing where the cash flow to support the additional indebtedness will come from. But because revenue is growing almost 20% a year and cash flows are annuitylike, "our visibility and comfort with the cash stream is very high," he says, even in prospective downside scenarios. "We're not working to sell more every quarter." Segrera also incorporates the creditworthiness of Terremark's customers into his risk monitoring.
In a shock-free world, debt may be a wise strategy, but McKinsey's Koller says that most companies — especially large ones — should have investment-grade balance sheets because the tax advantages of debt are small.
And if a company takes on so much debt that the tax benefits become substantial, it will pay higher interest rates and its flexibility will be greatly reduced. That doesn't make sense "unless you actually want restrictions on management's ability to make investments, you're willing to deal with the consequences with respect to customer relationships, and you are okay with passing up investments because you just don't think there will be many," says Koller.
If a company does choose to run more leveraged than its peers, it needs to protect itself in other ways, like lowering operational risk. Conversely, the greater the business risk of the company, say some experts, the lower its optimal debt-to-equity ratio. And companies have to periodically update their assumptions and adjust to financial-market movements. Witness the constant stream of companies paying down bank debt the past two years. "The lesson is to design capital structures that are coherent and tied to other financial decisions," says Chirico.
Another key to preparing for the worst is to assess how you will raise financing if your company has a severe drop in cash flow or negative cash flow. Having to raise equity during crises in order to keep a credit rating — a common event during the financial crisis — can not only be expensive but near-fatal, as Sallie Mae found out.
One insurance policy is to sell equity forward. It's a "brute-force mechanism" to avoid issuing shares when a stock price is dropping, says Chirico. In such cases, a public company commits to selling shares at today's price for the next three years when and if it needs equity. Citi's clients have used the product as an offensive weapon in M&A or as protection against the unpredictable, says Chirico. While the company (and perhaps the CFO) risks investor backlash if the stock climbs 40%, the insurance can be worth it, says Chirico.
"There's always something you give up; that's why, historically, people have just taken their chances and rolled the dice," says Chirico. "But now they've seen that over the last 24 months the dice tosses haven't worked out so well."
One problem with contingent financing is that credit-rating agencies don't work it into their ratings models. "They recognize that it's a really good thing for financial flexibility, but it's like the possession arrow in basketball," Chirico says. "It doesn't do anything for you right now." Contingent capital facilities usually don't have automatic triggers and are at the discretion of the company, explains Solomon Samson, chief criteria officer for corporate ratings at Standard & Poor's, so it's hard to incorporate them into ratings, "particularly when we don't expect there will be a need for a company to have to utilize them," he says.
Companies may be better off leaving their capital structures simple and straightforward anyway, says Koller. Complex financial contracts that could require big payouts, for instance, are dangerous in themselves.
The tricky part of capital structures is determining how cautious to be. In the current economy, Koller says, firms shouldn't be "overly conservative [with their capital structures], but they should be reasonably conservative." On the other hand, he adds, "I wouldn't want to pass up investment opportunities in order to build in flexibility for a once-in-20-years event."
And there's the rub: as the years pass and the recession fades, boards of directors may regard that once-in-20-years metric as being literally true, and regard a high level of flexibility as both costly and unnecessary. It will then be up to the CFO to explain why companies should insure against not only rainy days but also wholly unpredictable major storms.
Vincent Ryan is senior editor for capital markets at CFO.