The market disruption over the last several years has burned many organizations with little regard for their size, strength, or financial sophistication. The list of maladies is a long one: declines in equity values affecting investment and liquidity positions, the simultaneous failures of prominent bond insurers and the related failures of the auction-rate variable-rate marketplace, “underwater” interest rate swap positions—and for some borrowers with covenant issues, a significant hit to liquidity from collateralization requirements, the downgrading of bank credit enhancement providers and the forced enhancement substitutions at significant expense, the heightened cycle of risk aversion among credit providers, and the continued rotation of firms in and out of health-care risk. This unpleasant experience leads us to revisit the basics as well as to reflect on what lessons can be learned.
A Review of the Basics
- A primary goal of capital structure decision making is to create the lowest and most stable Weighted Average Cost of Capital, or WACC, within defined levels of risk tolerance. Since WACC includes both the costs of debt and equity capital and the relative proportions of both in forming an organization’s capital structure, WACC is influenced by target credit profile (leverage, liquidity, and cash flow) in addition to debt structure. Importantly, since WACC is the cost of the capital used to fund an organization’s assets, WACC sets the bar for accretive returns on existing assets as well as for new investments.
- Inflation is the enemy. Much of a health-care organization’s expense structure is highly exposed to inflation risk, for example, labor and supply expense. Cost of capital is one of the few expense categories that can insulate an organization from inflation risk, for example, through long-term fixed rate structures or asset/liability matching.
- Capital structure decisions are risk management decisions. Capital structure decisions necessarily incorporate myriad decisions regarding organizational risk, strategic risk, risks associated with financing structure and terms, and investment risk. An informed and systematic view of these risk areas is essential in making good capital structure decisions.
- Incremental capital structure decisions should be based on a clearly articulated and coherent long-term capital structure philosophy and goal framework shared by both management and the board.
- Continuously reground your organization in the basics—see above.
- Keep it simple. Many organizations have not assigned a “cost” to the complexity of their capital structures. This cost includes the cost of miscalculating the many risks of complex financing structures as well as the significant ongoing cost of managing a complex capital structure. In hindsight, the complexity and the savings at the time of many past capital structure decisions were not worth the costs incurred versus a more “vanilla” structure alternative.
- Know what you do not know. Sometimes, even the best have been humbled by miscalculated risks over the last several years. However, looking back, many also have realized that they oversimplified or simply did not fully understand or appreciate the risks they were taking. Conducting an honest inventory of “understandability” at the time of decision making can only improve the dialogue process and quality of the ultimate decision.
- Be careful taking advice from the financial institution selling the product. Disclosure of risk is different from the way the risk is conveyed. Enough said.
- Maintain good communications and relationships with the banking, creditor, and rating agency communities. During troubled or volatile times, a history of relationship investment pays significant dividends in resolving capital structure issues.
The painful experience of the last several years provides an opportunity for a shared board/management learning experience and a step toward improving capital structure decision making. Let us hope that the dust is settling enough to make this dialogue both timely and beneficial.
Apex advises organizations in the complex process of capital structure decision making. For more information, please contact us.