Negotiating the RAPIDS

by Helen Sanders, Editor

The credit crunch has dominated the financial headlines for what seems like an eternity. Although it must (surely!) end eventually, in the meantime treasurers are having to hold their nerve and guide the company’s finances through a landscape eroded of traditional investment and financing opportunities. While balance sheet restructuring and share buybacks were frequent occurrences in the past to deliver return on equity, treasurers are now under pressure to deliver value in an environment where there would seem to be little available. So, with the expert guidance of Andrew Walker, Managing Director, Head of Financing & Risk Solutions at The Royal Bank of Scotland (RBS) - in this article we steer you through the difficult straits and exhilarating rapids of delivering return on equity.

According to a recent Economist Intelligence Unit study, sponsored by RBS, senior executives believe that a decline in business confidence, the challenge of delivering return on equity and the increased cost of borrowing are the most significant effects of the credit crunch on their organisations (fig 1). Fifty-eight per cent of respondents indicated greater pressure in these areas than a year ago. [[[PAGE]]]

Treasurers cannot do a great deal to influence business confidence, but return on equity and the issue of financing are intrinsic to treasurers’ role. Looking first at return on equity, bearing in mind low investment returns, limited investment opportunities and less room to manoeuvre in balance sheet restructuring, how can treasurers deliver value to shareholders? According to the same report, executives identified expanding revenues, increasing operational efficiency (including working capital) and reducing costs as the three key factors in driving return on equity (fig 2)

Return on equity and the issue of financing are intrinsic to treasurers' role.

While these three elements are considered the most significant over the coming years, pressure to increase revenue and reduce costs is a perennial issue, with only a small increase in focus on these areas compared to previous years. What is more noteworthy is the substantial increase in the importance of operational efficiency. Operational efficiency in treasury is not simply an issue of transaction processing (although of course there is considerable value in doing this effectively) but also of the efficiency with which cash is used within the business, including working capital. Working capital optimisation has been an issue of growing significance for treasurers, with treasurers taking a greater strategic role in the factors contributing to working capital levels, particularly cashflow forecasting, payables and receivables. We will not spend a great deal of time in this article on working capital, as this topic has already featured prominently in TMI this year and will form the basis of a major feature in the September edition, but the checklist in figure 3 highlights some of the areas of focus for treasurers who aim to improve operational efficiency and unlock working capital.

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Executives participating in the RBS sponsored survey expected issues such as refinancing of assets and restructuring the balance sheet to change the debt/equity ratio to have the same level of importance going forward as there has been in the past, with a small increase in the potential importance of divestments. However, as RBS experts illustrate in their two thought leadership articles later in this edition of TMI, the environment for restructuring the balance sheet is not the same as it was in previous years. The credit crisis has affected corporate capital structures in various ways, as Andrew Walker explains,

“In today’s challenging markets it is useful to understand how financing and risk management techniques are changing.

Firstly, an outcome of Basel II is that banks will potentially prefer to lend to highly-rated corporates as opposed to private equity (PE) houses. Consequently, we expect to see the exit strategy for certain PE deals being a trade sale to a highly-rated corporate buyer. Alternatively, some PE houses will be looking to IPOs (initial public offerings) in place of trade sales. One issue for these companies will be how the balance sheet should look post-IPO to deliver the maximum return to shareholders.

Secondly, while financial practices have been increasingly conservative in recent years, treasurers and CFOs are focussing increasingly on how to manage risk strategically to improve financial flexibility and achieve the company’s objectives.

Finally, while pension scheme deficits have not yet been significantly affected by the credit crisis, due to the relative stability of equities over the period which frequently make up a large proportion of most pension funds’ portfolios. Treasurers need to consider the potential implications of depressed equity markets, falling rates and increasing longevity.”

The environment for restructuring the balance sheet is not the smae as it was in previous years.

Corporate financing strategies are critical to delivering shareholder value. While there has been a view that debt is essentially a financing tool with tax advantages, this view has become outdated. Financing is changing in a variety of ways. Firstly, in the past, financing has been based on equity with bank debt and bonds/private placements. Over time, some types of debt have increasingly resembled equity and been used to underwrite risks that would historically have been underwritten with equity. Consequently, as Andrew Walker continues,

“Many corporates are seeking financing structures that provide greater risk transparency and clearer designation in the split between debt and equity. For example, subordinated debt or hybrid capital has been used successfully by both highly rated corporates such as Siemens and Henkel, and companies with lower ratings, such as TUI and Voestalpine. Companies such as Veolia Environnement have issued Index-linked and covered bonds. Pernod Ricard is an example of a company which has realigned its corporate risk layers, which in their case meant changing the pension seniority. Finally, corporates are seeking to tailor risk transfer so it meets their specific requirements, such as Tesco’s property sale and leaseback.”

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Secondly, asset-based financing is becoming more attractive, particularly for lower grade corporates, but factoring and receivables financing, for example, are becoming more universally acknowledged as a source of financing. Furthermore, financing of individual assets or businesses is becoming more attractive.

There are a variety of reasons why treasurers should focus on optimising the capital structure and this is an area of increasing shareholder scrutiny. For example, the share price may appear depressed if there is low growth in return on equity and an incorrect perception of the value of particular assets or business units. Shareholders may be concerned that the company could be an acquisition target where the acquirer, rather than current shareholders, reaps additional benefit by enhancing the balance sheet post-acquisition. Finally, the company itself may be hindered in its M&A ambitions if its balance sheet is inflexible compared with competitors. As Andrew Walker explains,

“More aggressive corporates are already moving in the direction of financing individual assets or businesses separately which we describe as The Multiple Corporate Financing Approach. This approach is being considered by companies across a range of sectors and with a variety of assets. “

Optimising the capital structure is an area of increasing shareholder scrutiny.

Failure to optimise the balance sheet runs the risk of losing competitive advantage and stagnating equity value. Following a long benign period of low interest rates, availability of financing and steady growth, many companies remain over-capitalised despite today’s less favourable financial environment. Increasingly, companies are recognising the potential return on equity gains by reducing asset investment and divestment, as well as cost controls and increasing revenue. As an example, Intercontinental Hotels Group has been selling hotels since 2003 with the aim of focusing the business on managing and franchising hotels rather than owning the premises. This has resulted in additional cash to distribute to shareholders.

As Andrew Walker describes it,

“The Multiple Corporate Financing Approach increases the scrutiny and visibility of returns for each business, which can enhance investment decisions and return on equity. While historically WACC (working average cost of capital) has been calculated at group level, and adjusted using a risk factor to apply it at business unit level, this approach can help calculate these metrics at an individual business level. This can in turn improve investment decisions and return on equity. Furthermore, debt capacity can be increased and cost of debt reduced.”

There are alternative corporate financing strategies, such as altering the maturity profile of debt, seeking new investors in regions such as Middle East and Asia and accessing alternative sources of liquidity which RBS covers in their articles later in this edition.

It is no longer enough to compare what a company is doing relative to its competitors but also how competitors are behaving. Andrew Walker concludes,

“Corporates are regularly leveraging, acquiring, disposing and re-engineering their balance sheets to deliver return on equity and there are increasingly sophisticated ways to use these techniques, as emphasised by some of the actions of best-in-class corporations. Treasurers should be considering the transactions their competitors are making and the risk management techniques which they are using to ensure that their own balance sheet remains healthy and flexible.”

No company is immune from acquisition, or from shareholder activism which could potentially destabilise the company and distract from its objectives. Which means getting wet if you’re in a canoe…