How to employ senior debt capital to optimize your capital management strategy.
Many companies realize the importance of setting strategic goals, especially regarding growth. While businesses commonly finance operating expenses with senior debt capital, it is also a viable resource to facilitate strategic growth.
Being well-versed on the types of capital available, along with the total potential availability of capital under various scenarios, enables management to improve strategic planning at the board level as well as create or quickly respond to opportunities, such as the pursuit of an attractive acquisition target.
Common Types of Capital Available to Companies
The image below illustrates the common types of capital available to companies, shown in order of priority. As a general rule, capital with higher priority has lower risk, and therefore, lower return expectations to the capital provider and cost to the company. Conversely, capital with lower priority has higher risk, and higher return expectations for the investor and cost to the company.
Capital Structure Strategy
A company’s capital structure should balance both short-term and long-term needs — optimized to fit the long-term vision for the business as well as position the company to take advantage of investment opportunities that could arise 3-5 years down the road. Companies that adopt this mindset will implement a capital structure strategy that reserves borrowing capacity for large or near-term expenditures and preserves capital structure flexibility.
Additionally, the appropriate capital structure for a company often evolves with changes to their overall strategy, the market environment, the competitive environment as well as their short-term strategic business plan.
When determining how much debt or leverage to take on, companies should ask themselves these questions:
- How much debt capacity can my company service?
- How much risk am I willing to put on my business?
In determining how a company can structure their balance sheet to maximize returns and balance risks, general qualitative factors include:
- Operating Leverage – Defined as the level of fixed costs in a business model; the higher the fixed-cost base, the higher the risk (i.e. variable earnings). Pairing high operational fixed costs with high leverage increases risk.
- Cyclicality – Defined as the normal variation of demand experienced by a business (vs. seasonality). Pairing highly variable earnings with high leverage increases risk.
- Concentration – Defined as a significant portion of revenue/earnings derived from a customer, product, location or operation. Pairing highly concentrated businesses with high leverage increases risk.
When making decisions on capital structure and leverage, financial leaders are also faced with balancing multiple (and sometimes conflicting) objectives of corporate constituents, juggling the goals of the company, the shareholders as well as debtholders:
Capital Structure Strategy Examples
There are several ways companies can use senior debt capital for strategic growth, here are 3 example case studies:
The Acquisitive Business
Challenge: Typically, acquisitive companies need to maintain debt funding capacity as well as access to a variety of markets that can quickly provide cost-effective capital. A common covenant threshold is to maintain senior debt at less than 3x EBITDA, and companies may prefer to operate comfortably within that range through cycles, but sometimes opportunities arise to spike above that for strategic acquisitions or capital projects. This is the issue ‘Junior Snacks’ came up against when looking to acquire competitor, “Tiny Snacks.”
Solution: Junior Snacks chose to optimize their target return on equity by using an appropriate amount of leverage to finance the acquisition. When raising debt to 3.5x to 4.5x for acquisitions, a company needs to be prepared to incorporate step-down covenants to make lenders feel comfortable that they will be returning to run-rate leverage to maximize their potential funding for future opportunities.
Result: Junior Snacks is now able to max out their usage of senior debt (to the extent possible) in acquisitions to drive accretion. By increasing the proportion of senior debt, Junior Snacks is able to lower its cost of capital return hurdle rate, thereby increasing the potential return of the acquisition.
The Seasonal Business
Challenge: ‘Wicker Sensations’ is a manufacturer and seller of outdoor furniture. Being that most of their sales take place in the spring and summer seasons, Wicker Sensations needs access to a large amount of working capital. It is typical to use revolving bank debt to manage short-term working capital needs such as this, however, Wicker Sensations observed that a working capital facility always has a drawn portion which seems to be permanent in nature and constrains potential liquidity for longer-term investments (e.g. acquisitions, capex projects, etc.).
Solution: Wicker Sensations obtained long-term senior debt financing to term out the amount of debt drawn under the revolving bank facility. By only terming out the core amount, Wicker Sensations retains the flexibility to de-lever through seasonal swings, while maintaining ‘dry powder’ for opportunistic financing needs in the future.
Result: Wicker Sensations has the capital they need to sustain themselves through seasonal swings while also enabling them to achieve their longer-term strategic goals.
The Cyclical Business
Challenge: The revenue of ‘Bolt Automotive Company’ closely correlates to economic cycles and new car purchase activity. Thus, Bolt Automotive needs to ensure it has access to capital when the demand for cars is there as well as when it isn’t, through varying market cycles.
Solution: Bolt Automotive diversified its senior debt by tapping into the bank market, the public bond market as well as the private placement market. Diversification of debt markets, rather than the number of lenders, is key for this type of business as different markets respond differently during cycles, and companies need to retain uninterrupted access to capital throughout market cycles.
Result: Bolt Automotive can access the private placement market if the bank or public bond markets tighten up during downturns, maintaining consistent access to capital.
When developing a capital structure strategy, it’s in the interest of the financial leaders of a company to familiarize themselves with the types of capital available, enabling them to make more tactical decisions about their company’s capital structure, better positioning them to accomplish both short-term and long-term strategic goals. Senior debt lenders are available to help you achieve your goals for growth, don’t be afraid to approach them as a partner.
Interested? We would be happy to discuss how senior debt capital could work for you.