Client Catch-Ups and Cost of Capital Reviews
Investment bankers are relationship managers and need to be on the pulse for when companies decide to undertake corporate actions such as issuing capital such as debt or equity or deciding on engaging in mergers and acquisitions.
If an industry is hot – usually the more cyclical industries – investment bankers will have no shortage of workflow. Mergers and acquisitions for consolidation or growing market share, new large capital expenditure programs that require debt, equity, preferred shares and more esoteric products, and hedging to stave off credit risk will fill up the calendars of senior bankers and the C-suite of the client.
However, a lot of the time, there is nothing on the horizon for companies that will result in meaningful capital markets business. There are times when operations are chugging along while major capex programs have been completed. Valuations are high so neither acquisitions or repurchases are particularly attractive, while corporates may not want to raise dividends as they are uncertain in regards to their sustainability.
If it has been 6 months to a year without having had a conversation, bankers will send an email out or conduct a quick call to set up a lunch or dinner along the lines of:
“Hey [client Treasurer/CFO], hope you have been well – we have some pretty neat ideas around your capital structure. Is there a time in your schedule that works out next week for a chat? If so [IB executive assistant] will coordinate with [client executive assistant]. Cheers”
The meeting is then set up. Even if the corporate has no intention of undertaking any corporate action, they will accept the lunch because 1) they need to keep the relationship in their bank group and 2) the middle management in larger corporates and senior management in small to medium sized corporates like to enjoy free dinners/drinks and sporting events. Some clients also admittedly find investment bankers to be humorous.
Bankers will go to a meeting with an idea book – much to the chagrin of the junior staff as the probability of transacting is often low while the “pitch” can be unfocused and all-encompassing (i.e. a lot of work).
WACC and the Optimal Capital Structure
The investment banker, being the corporate finance expert in the conversation, may find that the company’s capital structure is sub-optimal.
Theoretically, the firm’s capital structure is optimized when the weighted average cost of capital is lowest. Cost of capital is a rudimentary corporate finance concept that is included in all university and CFA curriculums – however, in practice it is much more art than science.
The cost of debt (interest) is necessarily lower than the cost of equity (ownership), with the cost of debt and the cost of equity being the return to debtholders and equity holders, respectively. This is because debt is senior to equity in the order of payment priority, and thus a safer asset. A riskier asset must yield a higher return to compensate investors.
Provided the cost of debt is lower than the current weighted average cost of capital, increasing debt will cause the cost of capital to fall. The cost of debt is also lower than the headline figure as interest is tax deductible in most business jurisdictions. If the cost of debt is higher than the current weighted average cost of capital, it suggests that the company is over-levered and makes sense to pare back debt.
As leverage rises, the cost of debt rises as the company is riskier and more likely to default. The levered cost of equity is accordingly higher as well.
This relationship is best characterized by two graphs – the value of the firm compared to the debt/equity mix and the WACC compared to the debt equity mix. At the optimal debt/equity mix, the WACC is the lowest and the value of the firm is the highest.
The conceptual WACC is easy to visualize – however, getting to the components of WACC is far more difficult.
Finding the Cost of Debt for a Corporate
The current cost of debt is ostensibly straightforward. An analyst could simply take the last or next twelve months of interest payments and divide it by the average debt outstanding. However, for firms with mature long-term debt outstanding, when their debt becomes due, the coupon that they refinance at may not be the current interest they are enjoying.
Using the current rate of debt versus the historical rate of debt is a decision that must be made in calculating the WACC. If a firm’s credit quality has improved vastly or interest rates have fallen substantially, a high cost of debt as evidenced by their interest payments may not be representative.
The debt capital markets team will have indicative current pricing for the company depending on how long dated the debt they want to issue is. As an example, if the company wanted to issue a 5-year bond today, this would be the coupon that DCM thinks that the company would have to pay.
This is based on appetite from prospective bond investors, where the company’s outstanding bonds are trading relative to risk-free government bonds (as the maturity will not match a new 5-year issue, for instance a comparable 5-year bond could have 4.3 years remaining – in which case a credit spread would have to be interpolated), and where peers are trading relative to risk-free government bonds (the credit spread to US Treasury Bonds or UST).
The tenor of the debt will also influence the cost of debt. For instance, 10-year debt will demand a higher coupon to 5-year debt. For the cost of equity, analysts will look at 10-year government debt as the risk-free rate, so is 10-year debt always appropriate?
It depends on the corporate finance philosophy of the analyst. A company that only has short-term debt with their longest tenor notes being 3-5 years should not use 10-year cost of debt. Likewise, capital intensive corporates with very long-dated debt heavily weighted towards 30-year maturities may consider longer tenors as well.
Finding the Cost of Equity for a Corporate
Likewise, calculating the right cost of equity is also an exercise that does not necessarily have a right answer – of course, this allows the investment banker some artistic liberty to support a corporate action.
Academically, the cost of equity is a function of its systematic risk relative to the market as per the CAPM – so this should be a simple regression against the market to find the stock’s beta or torque. This is obviously flawed in reality, but is still used regularly for corporate finance decisions and valuation.
In practice, there are multiple ways to go about this – how long should the stock returns be regressed against the index? What index should be used? Should the data be based on daily changes or rolling monthly changes?
Additionally, for illiquid stocks, stocks without extensive trading history or stocks that have a weaker relationship with the market because of firm specific or idiosyncratic factors as of late, this exercise will not return meaningful data. Private companies that are not trading on an exchange will not have any data to regress against.
In these circumstances, it is sensible for analysts to look at the beta of its comparable company universe, delever the betas so that it is capital structure agnostic (asset beta) before relevering the beta to correspond with the observed company’s capital structure. This of course will lead to more discretion for the analyst as it pertains to who the appropriate peers are, what outliers should be taken out and whether a median or average should be used.
Ultimately, what is seemingly a simple academic exercise also ends up having a lot of wiggle room.
Finding the Appropriate Weighted Average Cost of Capital
Even after the complication of the cost of debt and equity – in addition to possible preferred shares or hybrids, the calculated WACC should be evaluated for cyclicality and market timing. With the current market, WACC may be understated as the cost of debt would be materially higher under less favorable market conditions. For boom and bust industries, this is even more important.
Investment Bankers and WACC
This conversation is academic in nature, but will ultimately result in a recommendation to change the capital structure. Ultimately, CEOs and CFOs do not care about a chart that shows optimal capital structure, nor is it a concept that can be effectively communicated to their Board of Directors or shareholders. The investment banker must always illustrate the improvement from a metric perspective – for instance higher earnings per share.
If the WACC can be lowered by increasing debt, the corporate can issue debt for return of capital initiatives or M&A. If the WACC can be lowered by decreasing debt, the corporate can raise funds to pay down debt with common share or preferred share issuance. Alternatively, the rate on debt can be lowered through refinancing existing debt opportunistically.
The catch is that most of the time when a company has low debt, they are theoretically running on a sub-optimal capital structure. The less sophisticated the corporate, the more likely this approach is to work – which is also why boutique banks are always in pitch mode.
Some times, certain corporate actions may be sub-optimal in hindsight. There are occasions when corporations undergo debt-fueled share repurchases and dividend hikes at the advice of an investment banker, only to realize they are experiencing financial distress from high leverage. An investment banker will then tell the corporate to issue equity as they are too levered.