Investment Banking - Capital Structuring

Capital Structuring is, simply put, how a company chooses to arrange its finances in terms of income, expenses, assets and debts.

How a company chooses to structure its capital is not dissimilar to how someone structures their personal finances.

On a daily basis people have to make decisions with regard to how they choose to spend their money and a company’s management is no different.

Some people may take a long-term view with their finances and save for a point in the future while others may decide to take the short-term view and enjoy themselves in the present. Of course both views have their own rewards and consequences.

Likewise, a company may choose to make maximum short-term profits (a fast buck) or invest for middle and long-term gain.

Of course on both a personal and business level, spending money in itself is not necessarily bad, rather it is what you spend your money on that counts.

Let’s take some personal examples.

There is a big difference, in terms of capital structuring, between spending money on a holiday and a car (besides the obvious material ones).

The holiday has a very limited value in that when the holiday is over you cannot get back any of the money that you spent on it.

A car, on the other hand, is an asset because, depending on general wear and tear, it has some re-sale value. A re-sale value that could at some point in the future be utilized.

Another good example would be the use of a mortgage to help purchase a home.

As the years go by the actual outstanding debt decreases, the owner holds more equity value in the house and eventually the owner will own the property outright.

Because both the car and the property purchases have an asset-based component to them, the type of borrowing offered is normally cheaper than non-asset based lending.

A mortgage-lending rate, for instance, may be a quarter of that charged by a credit card company.

The reason for this difference is simple – with asset based lending the risk to the lender is reduced because if the person owing the debt cannot meet the repayments then the assets that the loan was used to purchase can simply be resold and all or part of the debt repaid.

For the managers of a business the same choices apply when deciding how to spend the company’s money and how to finance those purchases.

The role of Capital Structuring is simply to get the right balance between equity (its own money) and debt (borrowed money).

Getting the right balance between what a company owns and how it uses those assets to fund itself is a complex task.

An investment bank can constantly review a company’s capital structure, assessing the requirements for change based on the company’s latest business outlook, investment requirements and financial market conditions.

This review is not just limited to raising funds for investment and expansion. It can also be done to ensure that a company is being as efficient as possible in managing its debt.

Let us use another personal example. If a person who has many debts (i.e. credit cards, store cards and personal loans) each with its own repayment amount then it can be cheaper to take out one new loan, with an asset or assets as security (i.e. property).

This new loan can then pay off all the other debts. Its repayment amount will be substantially less because unlike the other loans this new one is secured. The money saved, by having this lower repayment, can then be used to purchase something else or save.

An investment bank can offer similar advice to a company and thus can change the existing balance between equity and debt. This process is known as restructuring.

When it comes to funding an investment or expansion as a company then there will always be a choice between risk and expected return.

The modeling work done by an investment bank during valuation can help to map out what the risks and the expected returns might be and hence allow a company’s management to make fully informed decisions.

This work may also help convince potential lenders that this is a low risk venture (i.e. investors are likely to get their original money back with profits).

Just as with personal lending, the amount of risk attached to the lender will determine to a large extent the amount charged for the raising of funds.

As you can imagine, there is a vast amount of ways in which a company can raise funds, or restructure its debt, and the investment bank can use its expertise here to help the firm choose a path that maximizes its shareholder value.

The level of risk attached to lending money to a business in order for that business to expand or grow can be placed on the following spectrum:

► At one end of the spectrum are the expansion plans in which all the money lent will be used to purchase assets. A good example is the purchase of a new vehicle that will be used in the core business of the company. These types of projects are good candidates for low-cost financing
► Asset-backed loans, usually from one lender, are the most common type of lending for this type of expansion
► At the other end of this spectrum are projects in which a substantial portion of the money
lent is to be used to fund soft costs (i.e. they do not involve the purchase of assets – research and development being a common example). Because this type of expansion generates little in the way of assets, in the short term, it is more difficult to secure a traditional (secured) loan
The company may, therefore, issue securities (stocks and bonds) to fund this action.
Somewhere in the middle of this spectrum lie those situations in which the asset values are too low to secure asset-backed financing for the entire transaction, but in which the historic performance of the business is such, or the likelihood that the expansion effort will succeed are so great, that a senior lender will make what is termed a cash flow loan.

With a cash flow loan the lender holds his or her, metaphorical, breath for the period of the time that the loan is outstanding, hoping that the loan repayments hold up and the loan itself is repaid.
As you can imagine, cash flow loans are always more expensive than asset-backed, or secured, loans and are generally only available from larger, more sophisticated banks and financial institutions.