Rethinking Capital

To weather the credit crisis and a recession, CFOs will have to unlearn much of what they thought they knew about capital structures.

It may be the worst contraction of credit since the Great Depression. As the mortgage crisis has deepened, banks have been reluctant to lend money to anyone, including each other. Debt investors have fled to the safest corners of the bond market. And commercial paper has seized up, reducing a short-term financing option for working capital. Any capital that is available is, unfortunately, that much more expensive.

In this operating environment, CFOs must now wrestle with issues that required much less attention during the last few years: cost of capital, optimum leverage, debt maturities, even sheer liquidity. It’s time, in short, for finance chiefs to reassess their companies’ capital structures and manage them more tightly.

The choices won’t be easy. Pay down debt or build up a rainy-day fund? Increase leverage to scoop up competitors’ assets at bargain-basement prices or shrink it to preserve an investment-grade credit rating? Cover the entire financing deficit from operations now or wait three months to see if rates drop? Continue to rely on commercial paper or seek longer-duration capital with tight covenants?

In some ways it will be like turning back the clock. “CFOs now have to think about capital in 1950s terms,” says Mark Sunshine, president of factoring company First Capital. “Everything they’ve learned in the last 10 years about debt will have to be thrown out — that was an overheated market.”

Tapping Revolvers

The credit crisis has already led to a flurry of drawdowns of revolving lines of credit. Duke Energy, Bally Technologies, Goodyear Tire & Rubber, Caterpillar, and Winnebago Industries were among companies that drew down revolvers (or added new revolvers) in a span of two weeks in September.

Credit raters approved, because they are wary of assuming that companies will be able to tap undrawn amounts. “Having the actual cash on hand cements a liquidity position, given the risk of nonperformance by bank groups,” says Mark Oline, a managing director at Fitch Ratings.

Drawing on revolvers is risky, though. Companies subject themselves to significant interest-rate risk by using short-term debt, points out Susan Gordon, a managing director at Mackinac Partners, a restructuring advisory firm. In addition, “renewals are very expensive, and banks, if they’re not calling in lines, are lending on 70 percent of receivables instead of 80 percent,” she says. That means less credit. Also, higher default rates on receivables mean some companies have to make up a deficiency in collateral with an upfront cash payment.

For companies that can secure new bank debt, the concessions are substantial. Lenders are demanding a senior debt position and 100 percent warrant coverage. “They want a taste of the action if equity improves,” says Karl D’Cunha, a managing director at Houlihan Smith & Co., a Chicago-based investment bank.

A Disciplined Approach

Securing capital beyond bank debt is an option, but it requires long-term discipline. Consider McCormick and Co. The $3 billion consumer food company introduced a plethora of new products in 2008 — salmon seasoning, low-sodium rice, chicken glaze, Slow Cookers Soups — and along the way stoked its appetite for commercial paper. The strategy seems counterintuitive, given the state of that short-term funding market, but McCormick is sticking to it. The company has a highly seasonal business; 40 percent of its earnings come in the fourth quarter, when holiday cooks restock their spice racks. “We pay down most of our debt in the fourth quarter, but during other quarters we need access to liquidity,” says CFO Gordon Stetz.


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