Capital Crumple Zones

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

And if a company takes on so much debt that the tax benefits become substantial, it will pay higher interest rates and its flexibility will be greatly reduced. That doesn’t make sense “unless you actually want restrictions on management’s ability to make investments, you’re willing to deal with the consequences with respect to customer relationships, and you are okay with passing up investments because you just don’t think there will be many,” says Koller.

If a company does choose to run more leveraged than its peers, it needs to protect itself in other ways, like lowering operational risk. Conversely, the greater the business risk of the company, say some experts, the lower its optimal debt-to-equity ratio. And companies have to periodically update their assumptions and adjust to financial-market movements. Witness the constant stream of companies paying down bank debt the past two years. “The lesson is to design capital structures that are coherent and tied to other financial decisions,” says Chirico.

Extreme Measures

Another key to preparing for the worst is to assess how you will raise financing if your company has a severe drop in cash flow or negative cash flow. Having to raise equity during crises in order to keep a credit rating — a common event during the financial crisis — can not only be expensive but near-fatal, as Sallie Mae found out.

One insurance policy is to sell equity forward. It’s a “brute-force mechanism” to avoid issuing shares when a stock price is dropping, says Chirico. In such cases, a public company commits to selling shares at today’s price for the next three years when and if it needs equity. Citi’s clients have used the product as an offensive weapon in M&A or as protection against the unpredictable, says Chirico. While the company (and perhaps the CFO) risks investor backlash if the stock climbs 40%, the insurance can be worth it, says Chirico.

“There’s always something you give up; that’s why, historically, people have just taken their chances and rolled the dice,” says Chirico. “But now they’ve seen that over the last 24 months the dice tosses haven’t worked out so well.”

One problem with contingent financing is that credit-rating agencies don’t work it into their ratings models. “They recognize that it’s a really good thing for financial flexibility, but it’s like the possession arrow in basketball,” Chirico says. “It doesn’t do anything for you right now.” Contingent capital facilities usually don’t have automatic triggers and are at the discretion of the company, explains Solomon Samson, chief criteria officer for corporate ratings at Standard & Poor’s, so it’s hard to incorporate them into ratings, “particularly when we don’t expect there will be a need for a company to have to utilize them,” he says.

Companies may be better off leaving their capital structures simple and straightforward anyway, says Koller. Complex financial contracts that could require big payouts, for instance, are dangerous in themselves.

The tricky part of capital structures is determining how cautious to be. In the current economy, Koller says, firms shouldn’t be “overly conservative [with their capital structures], but they should be reasonably conservative.” On the other hand, he adds, “I wouldn’t want to pass up investment opportunities in order to build in flexibility for a once-in-20-years event.”

And there’s the rub: as the years pass and the recession fades, boards of directors may regard that once-in-20-years metric as being literally true, and regard a high level of flexibility as both costly and unnecessary. It will then be up to the CFO to explain why companies should insure against not only rainy days but also wholly unpredictable major storms.

Vincent Ryan is senior editor for capital markets at CFO.

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