Understanding the basics of Capital Structure

Understanding the basics of Capital Structure

11 Jun 2021

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This informal CPD article Understanding the basics of Capital Structure was provided by WiseAlpha Technologies, the UK's leading digital bond market giving private investors access to the world of corporate bonds.

Understanding the basics of Capital Structure

Capital Structure is a vital element to fully understanding corporate bonds; the easiest way to get your head around this term is to break it down through a fictional company, let’s call it High Yield Ltd.

For a bit of background, High Yield Ltd is the number one retailer for cosmetics and perfumes in the whole of Europe. The company was previously publicly listed on the local stock exchange for four years, until it was taken private by a private equity group, Leveraged Buyout. The decision to go private was triggered by two consecutive years of declining earnings due to digital competitors aggressively discounting their products, as well as the introduction of another large fragrance retailer into Europe. Following the decision to go private, High Yield Ltd has been expanding, with three substantial acquisitions in Spain, France and Italy, as well as a web launch and a store refurbishment project. These were all funded by debt.

Now you might be looking at High Yield Ltd’s history and thinking, why would a successful private equity company like Leveraged Buyout buy a retail company with declining income? Well, the answer is really quite simple. Before purchase, Leveraged Buyout will have already considered synergies, cost savings and best practices which they believe will increase the company's value above its acquisition price.

Increasing a company's value

Increasing a company’s value can mean two things. Financial engineering, which includes things like tax savings and increased debt capacity, or operational improvement. This would involve improving revenue growth or reducing costs (or both).

In Leveraged Buyout’s case, they are looking to improve the fragrance company’s cost structure, by increasing sales in order to boost revenues. This will in turn strengthen High Yield Ltd’s competitive advantage. To renovate a company like this, however, takes money. So, the project will all be financed by debt. Let’s say Leveraged Buyout made an offer to the fragrance company which equated to a 20% premium to the market value of the firm. We call this price, paid by Leveraged Buyout, the enterprise value.

Enterprise value

The enterprise value is essentially the price you would have to pay for an entire company; this would not only involve purchasing the company itself, but you would also be assuming all of the shares, and significantly, all of its debts. It may go without saying, but when buying a company you subtract the cash. If you want to work out a company’s equity, or what some call the ‘Equity Cushion’, you simply subtract the cash from the net debt. When it comes to debt lenders, they prefer to lend to a company with a large ‘Equity Cushion’.

Capital Structure and leveraged buyout

Now let’s go back to thinking about Capital Structure, and what a leveraged buyout actually is. The definition of this term is as implied; it is an acquisition funded by leverage, meaning borrowed money. High Yield Ltd is a listed company, which means it has an Operating Company (OpCo)/Holding Company (HoldCo) structure. The OpCo is where all the operating assets are, so for the fragrance company it would be facilities like the stores and warehouses. The HoldCo on the other hand, is a financial entity which owns the OpCo. So in basic terms, the HoldCo is issued High Yield Ltd’s equity and debt, and this is subsequently used in the OpCo.

The OpCo then pays dividends to HoldCo which then distributes this cash to equity investors, for example through share buybacks. They also distribute the cash between debt holders, for example through redemptions. In this sense, the HoldCo essentially acts as an entry point to the business for investors.

Looking back at the example, High Yield Ltd was valued at a 20% premium and had €200m cash on its balance sheet at the time of the deal. In order to fund the acquisition, the company raised a total of €3,000m in financing. The additional €200m was used to cover costs. The ins and outs of how the cash is being raised is always recorded, and can be found in the “Sources and Uses” section of the bond documentation. This documentation is vital in terms of providing investors with key information regarding incomings and outgoings.

Following a leveraged buyout, different considerations need to be taken regarding the corporate structure of the company. The OpCo versus HoldCo structure is still present but there will often be additional entities which need to be considered, especially if the business has grown substantially, for example through acquiring other companies. These companies raise capital, provide tax efficiency and ensure equity funding.

HoldCo entities exist solely to buy and hold the shares of other companies; this is why debt issued by HoldCos is subordinated to debt issued by its OpCo. OpCos will then often guarantee HoldCo debt in order to provide HoldCo creditors security over operating assets.

Conclusion

In short, Capital Structure in corporate finance is the combination of all varying forms of external funds, known as capital, used to finance a business. You can essentially think about it as the core financial factors of a business, such as equity, debt and stock, being laid out on a balance sheet.

We hope this article was helpful. For more information from WiseAlpha Technologies, please visit their CPD Member Directory page. Alternatively please visit the CPD Industry Hubs for more CPD articles, courses and events relevant to your Continuing Professional Development requirements.

WiseAlpha Technologies Limited

WiseAlpha Technologies Limited

For more information from WiseAlpha Technologies Limited, please visit their CPD Member Directory page. Alternatively please visit the CPD Industry Hubs for more CPD articles, courses and events relevant to your Continuing Professional Development requirements.

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