Capital structure is the method by which a company finances its assets and operations by using different sources of funds such as equity, debt, or hybrid securities.
While capital structure can include other types of leverages like hybrids, vendor capital structures and others, the main levers for a capital structure are debt and equity.
Equity Capital represents the ownership stake in the company. It includes funds raised by issuing common and preferred shares. Owners of equity (shareholders) are the residual claimants, meaning they have a claim to earnings and assets after all liabilities have been paid.
Debt Capital includes borrowed funds that the company must repay at predefined terms and rates. Debt can be in the form of bank loans, bonds, or other debt instruments. Companies have an obligation to pay interest on their debt, which is a fixed charge, regardless of their profit or loss situation.
Different sources of capital come with different costs. Generally, debt is cheaper than equity because interest payments on debt are tax-deductible. However, too much debt can increase the risk of default and bankruptcy. Companies with a high proportion of debt in their capital structure can magnify returns to shareholders when things go well. However, they also pose a greater risk when business isn't as profitable since the interest payments remain fixed.
Debt can act as a disciplining mechanism for management since they have to meet fixed obligations. On the other hand, excessive debt can lead to conflicts of interest between shareholders and debt holders, especially in cases of financial distress.
In theory, the optimal capital structure minimizes the weighted average cost of capital (WACC) to increase value. Investors and company executives have to factor in the macroeconomic environment as well as internal factors to determine their best capital structure.
How M&A Dealmakers Approach Capital Structures
Different investors employ different strategies.
Buyout investors rely on several debt and equity instruments with specific characteristics to fund a leveraged buyout (LBO). Venture capital (VC) and growth equity investors most often only use equity.
Private equity (PE) firms have a distinct approach to capital structure compared to typical publicly-traded companies, primarily because of their investment objectives, time horizons, and the nature of their involvement in portfolio companies.
Here's how private equity firms approach capital structure:
- Optimizing Returns: PE firms aim to achieve high returns on their equity investments. By using a significant amount of debt to finance acquisitions, they reduce their equity investment, which can magnify potential returns (or losses).
- Operational Improvements: PE firms often seek to improve the operations, profitability, and cash flows of their portfolio companies. By doing so, they enhance the ability of the company to service its debt and increase its value for an eventual exit.
- Recapitalizations: PE firms might engage in recapitalizations where they replace a portion of equity with debt or vice versa. This can be done to take advantage of favorable debt market conditions, return capital to the PE firm, or adjust the risk profile of the portfolio company.
- Exit Considerations: PE firms invest with an exit in mind, typically within 3-7 years. The capital structure must be manageable such that it doesn't hinder exit strategies, which might include selling the company, taking it public, or recapitalizing it.
- Covenant Negotiations: Given the high leverage often employed in PE deals, the negotiation of covenants (terms and conditions) with lenders is crucial. Covenants might include restrictions on additional borrowing, required financial ratios, or conditions for dividend distributions.
- Tax Considerations: Interest on debt is typically tax-deductible. PE firms can use this to their advantage to create a tax shield, reducing the overall tax liability of the portfolio company.
While private equity firms often employ higher levels of leverage than publicly-traded companies, their approach to capital structure is strategic, considering both the potential for amplified returns and the associated risks.
One of the most common investment strategies in private equity is the leveraged buyout. In an LBO, a PE firm acquires a company primarily using debt. The acquired company's assets and cash flows are used as collateral and sources of repayment for the debt. This high-leverage approach magnifies returns if the company performs well but also increases the risk of default.
Advantages of Structuring with Debt vs Equity
Leveraging more equity means there is no fixed obligation. Unlike debt, equity does not come with a fixed obligation to repay principal or pay interest. This can provide the company with greater financial flexibility, especially in downturns.
Similarly, there is no maturity. Equity does not have a maturity date like a bond or loan. This means the company doesn't face the pressure of refinancing or repaying principal at a specific time.
The biggest advantage to leveraging equity over debt is because it reduces risk. Equity investors, as residual claimants, share in both the upside potential and the downside risk. This risk-sharing can be beneficial for the company, especially when compared to fixed obligations of debt.
The three main advantages for leveraging debt are the tax deductibility, ownership retention, and a fixed repayment schedule.
- Tax Deductibility: In many jurisdictions, interest payments on debt are tax-deductible, which can provide significant tax shields and lower the effective cost of debt for the company.
- Ownership Retention: Unlike equity financing, taking on debt does not dilute the ownership stake of existing shareholders. Owners maintain control over company decisions.
- Fixed Repayment Schedule: Debt often has a predictable repayment schedule, allowing for better financial planning. Additionally, once the debt is paid off, the company benefits from the full use and returns of the assets it financed.
There are benefits to debt capital and equity capital, and also risks. While fixed repayments can be a benefit it can also be a liability. Debt requires regular interest payments, regardless of how well the company is performing. This can strain cash flows, especially during economic downturns or periods of low profitability.
For any capital structure, higher risk means higher returns.
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Capital restructuring cannot happen when first assessing a company. But the more information dealmakers have upfront means more meaningful conversations before and during the due diligence process. Grata is the leading proactive business development and research platform, giving dealmakers access to private company revenue estimates, employee location breakdown, operating models and more. Set up a demo to learn more.
