Capital AllocationTalking Shop

Talking Shop: Optimizing Models for Capital Structure and Allocation

By February 10, 2022No Comments

Editor’s note: NeuGroup’s online communities provide members a forum to pose questions and give answers. Talking Shop shares valuable insights from these exchanges, anonymously. This exchange is from NeuGroup for Growth-Tech Treasurers.

Member questions: “I am working on optimal target capital structure (debt/equity mix) analysis and framework. Any ideas on approach/model?

  • “I’m also working on creating a capital allocation policy and framework. Any sample allocation policies and framework approach or model ideas would be great.”

Peer answer 1: “There are several decision points to consider for capital structure:

  • Fixed vs. floating interest rates: consider your risk tolerance for fluctuating rates.
  • Type of instrument: term loan A vs. term loan B; secured vs. unsecured; bonds vs. notes, considering credit rating and the desire to have the flexibility to prepay vs. having more permanent capital.
  • Revolver needs: asset based vs. cash flow based, driven by the rating, amount of liquid working capital available, stability of cash flows, working capital cycle needs and seasonality. Size based on stress testing, availability of internal cash flow levers, and how much contingent capital is desired for any purpose or as backup funding.
  • Tenor: whether to stagger maturities, how long to go out based on how long-lived the fixed assets or IP are.
  • Domestic vs. international, based on where the assets or cash flow are generated.
  • How attractive a target you want to be for acquirers; consider things like tenor and certain provisions that make it more expensive to terminate financing should you be acquired.
  • Straight debt vs. convertible, based on how ‘richly’ the company’s equity is being valued and your appetite to keep coupon payments low.
  • The debt/equity mix, which should consider things like the optimal weighted average cost of capital (WAAC), what peers are doing, etc.

“S&P has a good primer on leveraged finance that I go back to frequently.”

Peer answer 2: “I have never liked the word optimal because I don’t think there is a perfect debt/equity mix, and if there were, then it’s always changing with the markets and other factors. We all know that as the amount of debt is increased, this lowers our WACC unless we push the leverage too high, and the perceived risk causes debt and equity investors to push up the costs.

  • Rather than try to find an optimal level, which could imply adding debt even without having a specific use for it, we added debt for specific use cases like share repurchases and M&A. We went from having no debt and no credit ratings to having lots of debt and ratings by the three main agencies.
  • The limiting factor for us on how high to go has been a combination of 1) how comfortable we feel with free cash flow generation and the ability to efficiently move it around the world to service debt and 2) the approximate limits that the rating agencies allow in order to maintain our investment grade (IG) ratings.
  • While the difference in cost of funding for IG and high yield has been small in recent years, we feel it is important to maintain IG as we all know things can change quickly. Consider your plans for the debt and what kind of credit rating you would like to target.
  • Aside from those, there could be a strategic reason why you might choose a much lower amount of debt (keeping dry powder for the future) or going past your debt target for a strategic acquisition.

“We have a general capital allocation strategy that is fairly common: free cash flow is first used for strategic purposes like investing back in the business or M&A.

  • After that, the uses would be repaying debt if we are temporarily over-levered and maintaining our dividend. If there is free cash flow available after that, then we might consider stock repurchases unless there is a strategic reason to build cash.
  • We have a capital return policy that doesn’t specify how much we do but is more about how we go about it operationally—like open market versus use of 10b5-1 plans, etc.”

NeuGroup Insights reached out to Lucia Greenblatt, managing director of technology banking at MUFG, who agreed with the points made by members and added these:

  • “Optimal is a dynamic concept, underpinned by a company’s objectives, growth cycle and the economic environment. We’ve seen the perception of what’s optimal being tested throughout the pandemic, with the most emphasized elements being liquidity, cash flow generation and access to liquidity (markets being open at reasonable terms).
  • “In normal times, companies with large excess cash balances can be subject to shareholder activism if they are perceived as inefficient capital allocators, with the cash being a drag on valuation.
    • “In volatile times, liquidity becomes a strong asset that provides the flexibility to perform though the cycle without the need to raise capital at unfavorable terms; it enables the company to explore market opportunities such as buying assets in distress, or add inventory when supply chains are dislocated.
    • In stable times, the company can choose to return a portion of the excess cash to shareholders.
  • “In the software space, as companies continue to mature, they tend to keep a large cash balance as dry powder; when they tap capital markets, they tend to target a comfortable leverage ratio or a leverage-neutral balance sheet. When valuations dip, they can signal to the market that they are undervalued by announcing large share repurchase programs.”
Justin Jones

Author Justin Jones

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