Our commentary “Less Is More” in CFO last August focused on using the concept of scarcity, or a favorable supply-demand balance, as a means of shifting negotiating power in your company’s favor when raising capital. Many CFOs are more than comfortable taking an adversarial stance when negotiating with banks and investors, even when that means putting up with a lot more complaining. The counterpart to scarcity, however, is a principle we call alignment, and is based on the premise of finding common interests among financial parties. Most of our clients find that designing mutually beneficial transactions leads to the most successful outcomes. After all, as parents know, taking toys away from children instills some discipline, but positive reinforcement offers far more lasting results. Financial negotiations are no different.
Don’t misunderstand: there is a time and place to be antagonistic. On behalf of our clients we have argued, we have screamed, we have demanded, we have cut fees, we have pushed on pricing, and we have threatened to walk away. However, the vast majority of our work is nonadversarial. It is almost always preferable to develop strategies for working constructively with banks and investors. Most CFOs agree, and they sincerely strive to build long-lasting relationships with their financial-services providers.
Earlier this year, a client was concerned that its projected consolidated leverage had the potential to violate a covenant in its syndicated bank loan facility. The company did not want to request a waiver, which would have resulted in a significant fee to the banks. A violation or waiver also could have negatively affected the firm’s equity price. Furthermore, the client made it clear that it did not want to take a confrontational approach with the banks, because they had supported the company for many years.
With those constraints, we studied the company’s capital structure and financial philosophy to develop alternative strategies. We appreciated that the banks’ credit exposure was primarily at the secured-asset level and that the consolidated test provided them limited protection. We suggested the client create an alignment that benefited both the company and its banks. Our client offered to tighten the secured test in exchange for relief on the consolidated test plus a de minimis fee. Every bank accepted, and there were no negative stock-price implications. In fact, finding this common interest actually enhanced the company’s bank relationships.
There are many ways to create alignment. Companies can closely track the direct fees they pay, as well as indirect fees embedded in transactions, such as derivative swaps. Many attempt to use this fee information to align their fee wallet to reward their most significant capital providers. At the same time, CFOs also need to consider the value of certain transactions to a bank’s franchise or business model. Some banks might be focused on building their position in certain derivatives, underwriting, advisory, or cash-management businesses, and may be willing to offer discount pricing in return for getting certain assignments. Alignment does not even need to be economic, and could include structuring capital instruments targeted to different kinds of investors, issuing securities in the financial institution’s local market, structuring credit commitments to improve the bank’s regulatory capital position, or helping it to establish a leadership-relationship position. The biggest challenge is often to identify the potential alignments between the issuer or borrower, its banks, other capital-market providers, and investors. Each situation is unique.
Failure to find alignment can be as destructive as positive alignment can be constructive. Take the recent case involving Del Monte’s leveraged buyout. In that transaction, shareholders alleged that the investment bank deceived Del Monte officials about the bank’s dual role representing both the seller and the potential buyers. According to the claim, the bank’s interest in capturing incremental financing fees led to a structure intended to discourage other offers and was thereby misaligned with Del Monte’s interest in a competitive process leading to the highest price for shareholders. While these conflicts are common, they are not easily navigated. In this case, the parties recently agreed to pay nearly $100 million to settle a shareholder lawsuit.
For the best results, CFOs must understand not just their own goals but also their financial counterparties’ objectives. Developing deep knowledge of the other side’s position may be time-consuming, but it’s also extremely rewarding. By investing more energy in finding common interests with your financial partners, you will find that positive reinforcement will lead to optimal financial outcomes, and a lot less whining.
Reuben Daniels and Craig Orchant are founders of EA Markets (www.eamarkets.com), an independent corporate finance and capital markets advisory based in New York.