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Cash & Working Capital

Standard Chartered on Building a Capital Structure Framework

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August 13, 2019

Insights and perspective to help treasury construct an optimal, flexible structure.

5 and 10Ten years of economic growth, an escalating trade war and stock market volatility should have many corporates reassessing their optimal capital structure and whether it is sufficiently flexible and dynamic.

That was the message delivered by Shoaib Yaqub, head of financing solutions and advisory at Standard Chartered Bank, in a presentation to the Assistant Treasurers’ Leadership Group (ATLG) that examined key factors in building a capital structure framework.

Recession and debt. Among the reasons that now is a good time to reevaluate capital structures are rising corporate debt levels and mounting fears of an economic slowdown. Citing a spring survey by Duke University, Mr. Yaqub noted that 67% of American CFOs believe the US will be in recession by the third quarter of 2020. “Such a big number worried about a downturn is quite telling,” Mr. Yaqub said. Meanwhile, corporate debt is now 214% above the level in 2000, raising some red flags about companies’ ability to manage it.

Debt in perspective. Despite the absolute increase in corporate indebtedness, debt as a percentage of tangible and intangible assets has, on average, declined slightly since 2000, Mr. Yaqub noted. And indebtedness as a percentage of assets varies substantially by sector; for example, it rose in health care but fell in materials. An ATLG member noted that inflated acquisition prices in recent years likely inflated the asset side of that equation.

More comfortable with debt. The number of BBB-rated companies has more than tripled since 2000, indicating the market has become increasingly comfortable with more debt on the corporate balance sheet. NeuGroup Director Scott Flieger, a former banker, said much BBB-rated debt issuance is M&A related. Mr. Yaqub added that many of those corporate issuers decided it added little value to reduce debt and return to their formerly higher credit rating. “The difference between these thresholds is not as high as it used to be,” he said.

No link between lower taxes and corporate debt. Contrary to what one might expect, the lower corporate tax rate in the US has not resulted in companies paying down debt. Instead, much of the extra liquidity has been given back to shareholders in the form of buybacks and dividends, Mr. Yaqub said. He added, “This has happened in the past and in other geographies. You would think that in sectors where you find less taxation you would find less debt, but there’s no link there.”

One size does not fit all. Companies must be aware that sector and economic cyclicality can vary significantly and how that impacts their perceived debt capacity and financial flexibility, Mr. Yaqub said.

Categories of risk. In the Duke survey, CFOs identified three categories of risk prompting firms to experience a “downside”—economic, market and sector. The first two comprise more general risks that impact companies to different degrees. Sector risks can be sudden and profound and include changing customer preferences, unanticipated disruptions, perhaps prompted by new technology, or one-off events such as data breaches.

A capital structure framework. Mr. Yaqub created a dynamic and conclusive framework to help companies develop capital structure policies. It has three pillars:
  1. Maintaining financial flexibility. That flexibility should include identifying a business’s main risks, quantifying a minimum buffer to mitigate a black swan event, and ensuring sufficient headroom to accommodate ongoing bolt-on acquisitions as well as periodic transformational acquisitions. Mr. Yaqub said discussions with CFOs demonstrate that they are choosing to model “more realistic downside cases, not the extremes.” Annual assessments are typical, but corporates increasingly prefer in-depth reviews twice a year, he said. A point of interest is that more than 80% of CFOs “think they have moderate or a lot of financial flexibility,” Mr. Yaqub said, adding that increasing flexibility is less important than optimizing it.
  2. Rating-agency considerations. Mr. Yaqub noted that increasing indebtedness may breach credit rating thresholds, which in turn affects companies’ relative creditworthiness and how investors assess their credit quality. Corporates must determine their short- and long-term credit rating targets, define any possible credit events, and familiarize themselves with each agency’s sensitivities relevant for their business. Regular dialogue with the prominent rating agencies is key. In terms of corporates appealing ratings, Mr. Yaqub said, it is best to avoid a confrontational approach and instead provide agencies with information to gradually build a strong argument for change. Mr. Flieger emphasized the importance of approaching the rating agencies well ahead of an acquisition and making sure discussions involve the analysts who ultimately will hear the company’s presentation.
  3. Peer-group review. While corporates whose intrinsic value depends on future, robust growth have typically maintained more capital structure flexibility, in recent years there has been a reduction in this flexibility, Mr. Yaqub said. He added that reviewing how peers have adjusted their capital structures can provide “food for thought.” Companies must define “direct” peer comparisons, and peers in other sectors or special situations may be worth reviewing. Fundamental analysis may not change materially, he said, but conducting peer analyses on a regular basis is a good practice to maintain.

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