Published: June 01, 2008
The growth of private equity (PE) fundraising, which increased every year between 2002 and 2007, and exceeded $100 bn in 2007, has been phenomenal. PE investors led the vast majority of leveraged buy out transactions in the months leading up to the credit crunch when credit was readily available. With the markets now transformed and leveraged loans trading under par in the secondary market, banks are finding it difficult to underwrite large primary transactions on the one hand, while on the other, mezzanine finance is more constrained, resulting in increasing returns for these investors.
In this market, asset quality and the rationale behind a transaction become all important. So how are corporate treasurers responding to the new business environment in which they find themselves and how are financing structures changing?
With the decline of PE investment, the value of both traded assets and those held by industrial corporations has dropped, so companies hoping to dispose of non-core assets to PE investors will potentially find it more difficult to find buyers willing to pay an acceptable price. However, RBS has found ways in which corporates can improve the value of disposals given current market conditions, as the Home Depot example in fig 1 illustrates.
Naturally the decline in asset value is leading to corporates rethinking their M&A strategy. There are two elements of this - firstly, disposals may be less attractive due to lower proceeds; secondly, companies in a strong financial position can take advantage of more attractive valuations of acquisition targets, which can be an important way of increasing return on equity and fuelling business growth. This latter point is substantiated by a recent Economic Intelligence Report, sponsored by RBS, which illustrates that 82% of executives feel or expect to feel the positive impact of more attractive acquisition targets (fig 2).
Consequently, while the current market conditions may pose a threat for some companies, others see the opportunity to gain competitive advantage and fuel growth and return on equity during a period of high costs and dispirited consumers. This is particularly the case as acquisition premia have come down due to the reduced involvement by PE investors. However, as acquisitions often have to be accompanied by disposals both from the point of view of financing and cohesion of business activities, PE players are often still desirable business partners, but as the Home Depot example (fig 1) illustrates, companies may have to play a greater role in financing. In addition, market conditions are not the same in all parts of the world, and investors from the Middle East and Asia have taken advantage of reduced competition for assets and have been instrumental in recapitalising financial institutions in recent months and can provide important access to liquidity and participation as an equity partner.
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In general, the maturity profile of core debt should be balanced by the assets and liabilities of the issuer, together with refinancing risk and cost of funding. Cost of funding has been the most significant element in recent years, resulting in shorter maturities and more reliance on the CP market. The difficulty since the credit crisis is that CP maturities, and short term facilities, need to be refinanced at a far higher rate. This has affected the asset/liability balance for some issuers who then need to draw down on bank lines.
As a result of this, many corporates have avoided entering the debt capital markets in recent months bearing in mind the higher spreads than a year ago. However, it is not likely to be sustainable for most organisations to continue with their short term debt, which should encourage more new issues going forward as well as higher price volatility. However, as examples such as HeidelbergCement’s bond issue in January 2008 illustrates, there are opportunities for corporates to raise funds.
For most corporates, the most compelling question is how to determine the right balance between cost, risk and flexibility when determining the optimum maturity profile: for example, matching the debt maturity profile with underlying assets and cashflows and the risk reward balance between the cost of funding (both interest rates and credit spread) and refinancing risk.
Benign market conditions since 2001 have resulted in relatively low levels of corporate debt. While corporate scandals, tighter governance controls such as Sarbanes-Oxley and new accounting standards have contributed to conservative financial policies, companies are exhibiting more active balance sheet management. For example, Nestlé restructured its financial policies during 2007 leading to a loss of its AAA credit rating. There are various reasons why companies might choose to increase debt, even when it may not appear immediately desirable to do so; for example, it can be a way of delivering greater return on equity by taking advantage of tax shields linked to debt financing which can divert shareholder activism, as in the case of Carrefour whose shareholders called for a restructuring to release value from the company’s property portfolio.
Some of the considerations which corporate treasurers will need to make when looking at balance sheet efficiency include:
Capital structure. With market conditions substantially different from a year ago, treasurers will be considering whether the capital structure which was right last year remains so today. Even though debt may be expensive for some, shareholder activism is increasing to deliver return on equity. This may also be influenced by the company’s pension fund which, with lower interest rates, is likely to show a higher deficit.
Liquidity. Short-term maturities which companies intended to finance in the debt capital markets may now need to be financed through existing sources of liquidity. Similarly, large share buybacks may be more expensive or less readily available if they cannot be funded through the capital markets. It is likely that it would be better to wait until the market recovers before completing share buybacks in many cases.
Acquisitions. With lower valuations and less aggressive PE investment, there is the opportunity for some corporates to take advantage of attractive acquisition target valuations as a way of fuelling business expansion and deliver return on equity.
Corporates which still hold large cash balances after a long period of growth and low interest rates, plus investors in regions such as the Middle East and Asia, are in a position to gain strategic advantage from their position. However, as market conditions develop, treasurers will still be seeking alternative sources of funding which allow them to achieve an optimal capital structure and facilitate their strategic objectives.
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