Capital Crumple Zones

Is it time to think about using your capital structure as a buffer against abnormal events?

A collapsed buyout deal, mounting defaults on student loans, a loss of federal subsidies, and landing on the wrong side of a large put option. Three years ago, those circumstances sent Sallie Mae hat in hand to the equity markets to do a poorly timed public offering. The sale diluted the value of Sallie Mae’s existing stock by double digits, and the company’s share price still hasn’t recovered.

It’s difficult for many CFOs to concede the possibility of such a perfect storm, or even to ponder an isolated catastrophe, such as BP’s Gulf oil spill. That disaster cut BP’s share price to an 18-year low and forced it to sell off billions in assets. While companies routinely protect themselves against all manner of small, unfavorable events — hedging interest-rate moves or currency spikes, for example — they rarely prepare for the larger risks that could flatten them.

True, those risks are hard to identify and quantify, and difficult to hedge. And some events, such as financial-market meltdowns, product liability, and acts of God, are often uninsurable (at least in the traditional way). And even if a firm can buy insurance, it could wait a very long time for a payout. “There is a certain degree of insurance you can buy against an underground well exploding, but you’re protected against only that one risk. Also, there is a great deal of time and ambiguity surrounding the litigation and politics that typically follow these tragedies,” says John Chirico, co-head of capital-markets origination in the Americas at Citi.

As an alternative, companies are beginning to consider how their capital structure can protect against a broad range of catastrophic risks. Such a buffer would be analogous to a health plan that pays out only for the most costly, life-threatening diseases. Did BP envision a circumstance in which a drilling accident would shut off its access to short- and medium-term capital markets and garner worldwide condemnation? If it did, it certainly didn’t prepare accordingly. “Until recently, no one was addressing their capital structure in the context of disasters, such as three major hurricanes hitting in one season,” Chirico says.

To design a capital structure for this purpose, management needs to stress-test it with high-severity scenarios, but executives rarely warm to the task of proactively assessing doomsday story lines. A true test of whether such brainstorming is on track, Chirico says, is when the ramifications of a given disaster are so bleak that “you almost want to look away rather than consider them.” When that happens, he says, “that’s the signal that you should put a task force on it.”

The 10 largest follow-on equity offerings of 2010 boosted these companies' capital structures.

Next, analyze how large a capital-structure shock absorber will be needed in such situations. Finance doesn’t require a lot of sophistication to answer that question. “Layer on the obligations you have, the risks you face, and then calculate the cushion you need to meet the obligations,” says Tim Koller, a principal in McKinsey & Co.’s New York office. Volatility in cash flows, opportunities for investments, expected dividends and buybacks, and the corporation’s risk tolerance also need to be figured in. “Once you’ve decided on a level of safety, you then translate that into target levels of debt and equity,” says Koller.


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