Chapter Thirteen

Sources of Capital

IN THIS CHAPTER, WE COVER the various aspects of capital markets and sources of funding. The chapter continues with an overview of the capital structure decision that is one of the typical core areas of focus of the Treasurer. Debt and equity markets are explored at length, and hybrids of the two are also introduced. We also present a case study with two interesting situations—one is that the entity moves from a debt-free capital structure to one with debt, and the second is that the entity itself is an educational institution, whose capital allocation and usage is not very different in concept from that of a corporate.

CAPITAL MARKETS

We introduce the capital market discussion with an overview of the various markets and their players in Figure 13.1.

FIGURE 13.1 Players in Capital Markets

The issuers are the entities that are raising capital. The investors can come from many categories, the biggest of them being:

• Sovereign wealth funds
• Mutual funds
• Private equity funds
• Pension funds
• Hedge funds
• Insurance companies
• High-net-worth individuals (HNIs)
• Banks
• Financial institutions
• Retail investors

The intermediaries make the transactions happen, facilitating the entire process end to end. They are:

• Brokers or agents. Act as intermediaries for deal closure
• Investment banks. Manage and execute the deals in the market
• Guarantors and credit support providers. Provide their credit strength to issuers for a lower cost or more liquidity
• Underwriters. Commit to subscribe should an issue not go through

Capital markets activity will be possible only with the underlying infrastructure to make the transactions happen. The next entities usually facilitate or supervise the markets:

• Regulators. Entities such as the central bank in the country of the issuer and investor, the Stock Exchange Commission, the relevant tax authorities in the jurisdictions, and the finance ministries (which pass the relevant laws) are the key entities that create the supervisory framework for all funding transactions.
• Exchanges. Exchanges where transactions are listed enable the public trading of the securities once issued.
• Commercial banks. These provide the necessary banking infrastructure in terms of payments, collections, accounts services, securities and custodial services, and so on.
• Securities depositories. Securities depository institutions or central securities depositories (CSDs) are central bodies performing roles such as holding securities to enable the book entry transfer of securities, centralised comparison, and clearing and settlement. The functions of a CSD may include:
  • Safekeeping, deposit, and withdrawal of securities
  • Processing of related dividend, interest, and principal payments
  • Corporate actions such as proxy voting
  • Pledging services
• Legal, accounting, tax support. An army of legal firms, accountants, and tax experts support the smooth functioning of the world’s capital markets and fundraising activities.

The world of capital is largely divided into three classes: debt, equity, and hybrid, which has characteristics of both debt and equity. Figure 13.2 provides an overview of these markets.

FIGURE 13.2 Classes of Raising Capital

CAPITAL STRUCTURE

Capital structure is the manner in which a company is capitalised (i.e., the proportion of debt, equity, and other sources through which the company finances its investments and core assets).

The optimal capital structure is one in which the firm has least risk and least cost in order to maximise firm value and hence shareholder wealth (see Figure 13.3).

FIGURE 13.3 Capital Structure in the Context of the Balance Sheet and Cash Flows

Theoretically, the cost of capital would be the one that would drive the decision of the type of capital to source. From a more practical perspective, there are other considerations including existing stakeholders, short- and medium-term management objectives, control, collateral, creditworthiness, risks, liquidity, market access, regulations, concentration, and others. We describe these risks in Part Four.

While more debt can enhance the return on equity in good times, it also poses a threat to cash flows, credit rating, the relative ability to raise debt, and relative cost during tight economic periods. Changing volatility and tax, regulatory, and market conditions have caused the capital structure decision itself to be a dynamic one, with companies preferring to remain flexible and tap as many sources as possible.

In this context, the key factors in the capital decision revolve around the optimal level of risk, cost, and other objective and subjective elements that, in the collective view of the management, will maximise the firm’s value in the long term.

FACTORS IN THE CAPITAL DECISION

There are many decision points on the capital structure and the final decision on any incremental capital raising. These revolve around:

• Drivers or the underlying need to raise capital
• How the capital will be raised or the mode of raising capital
• Where the capital is being raised and where investors are located
• How long the capital is required for
• The investor base

To make that decision, six factors that need to be assessed (see Figure 13.4), which are described next.

FIGURE 13.4 Factors in the Capital Decision

Overall Cost

The cost of capital, or average cost of capital weighted to the specific components of debt and equity (WACC), remains one of the most important factors to determine capital structure. Since a lot of excellent material written by gurus of modern finance is available for readers on this subject, here I merely highlight the various aspects of these costs and their practical relevance to the Treasurer’s decision making. Readers are encouraged to read further on this topic.

The WACC depends on the combination and proportion of the various components of the capital structure. A change in the proportion of different securities in the capital structure will cause a change in the WACC. Hence there can be an optimal mix of different types of capital for which WACC will be the least.

There are two issues with the WACC approach to continuously monitor and hence keep the capital structure tagged only to cost of capital.

The first is that markets, especially currency and interest rates, and the creditworthiness of an organisation are dynamic. Hence the cost component of each type of capital does vary. What seems lower priced at one point of time and would be a possible component of capital structure could change form and cost over a period of time—thus the capital structure, because it is dynamic, cannot be shifted consistently. If capital is being raised across subsidiaries and hence across locations and currencies, the relative strength of those currencies with respect to the servicing of capital repayments and cash outflows in those currencies will add to the cost of capital. For example, a company with debt in USD but revenues primarily in, say, Brazilian reals (BRL) will also have to factor in the relative appreciation of the U.S. dollar (USD) debt servicing into its cost of capital. The Treasurer must hence identify a broad capital structure, perhaps a band, and go with the plan.

The second issue with tagging capital structure only to the cost of capital concerns liquidity and refinancing—the moment a source of liquidity dries up, another alternative must be found. In turbulent times, dependence on the same kind of funding might not be possible for all firms.

Hence, while cost of capital plays a key role in determining capital structure, other fundamental factors must also be considered for a holistic structure. We discuss those factors next.

Locational Elements

Locational elements, especially taxation for investors (withholding tax, etc.) and issuers (stamp duty, registration, etc.) and infrastructural costs of setting up in that location, play an important role in the overall cost of capital. WACC includes not only the actual interest, principal, dividend, and so on being paid out but also the net outflow impact of the capital raising, including all related taxes and statutory payments and operational expenses.

Risk for Issuers and Investors

Various risk elements must be considered. For issuers, the risk element is on their own funding. To make the capital investment more attractive for investors and to trade off between pricing and other elements, issuers also consider the risk element for their investors.

Some of these elements are covered more in detail in Part Four of this book.

Issuers

Some elements for issuers to bear in mind are:

• Concentration of lenders or funding sources. Could pose a threat if that conduit is restricted or impacted.
• Control. Overdependence on equity could result in dilution of control for existing shareholders.
• Financial. Liquidity risk (lowering of availability of funds in the market); interest rate and credit risks (the uncertainty of interest rates and credit spreads changing and impacting overall cost of borrowing for the firm); and refinancing risk (potential issues of liquidity and rate risks when the time comes to rollover or replace the existing source) come into play.
• Covenants. Conditions (financial and operational) imposed by investors to ensure reasonable performance of the firm can impact incremental fundraising.
• Cross-default. A default on any obligation across a related party could trigger a number of events that could in turn impact the ability to raise further capital.
• Regulatory, tax or other environmental changes.

Investors

For investors, there are various risk elements to be considered prior to making an investment and also once the investment has been made. These are, broadly:

• Financial. These risks include:
  • Credit risk (of the ability of the issuer to repay or service the requisite cash flows).
  • Liquidity risk (of being unable to terminate the investment if required).
  • Cross-border risk of transferability and convertibility of the monies owed by an overseas issuer if there are clampdowns on conversion and transfer of money from that country.
• Ability to sell down. Any impairment to the ability to sell the investment to a third party could result in unexpected losses on costs for the investor
• Regulatory, tax or other environmental changes

Regulatory and Infrastructure

The regulatory environment and infrastructural elements play an important consideration in capital structure. As we mentioned, the location plays a role in the cost. In addition, the regulatory, infrastructure, and market environments play a key role in determining the sources of capital. In many cases, the location of the subsidiary or of the use of capital could determine the mode of capital owing to regulatory and market restraints that prevent access to global markets. Many global companies have the luxury of deciding the location after the capital decision.

Infrastructure, including presence of exchanges, efficient collections and disbursement mechanisms, and the accounting, tax, and legal aspects for execution, is an important aspect in the capital decision.

Regulations and the ability to raise funds with ease allow the company more and better alternatives to decide the type of capital to be raised. On the debt side, regulatory limits on exposure to single companies and groups, capital adequacy requirements for banks, and definitions of nonperforming assets, apart from restrictions on investment and overseas investors in locally issued debt, become determinants.

Market access in terms of both regulations and liquidity and the ability to tap into markets is also an important input.

Tenor

The need and the drivers for the capital must be aligned with the availability of capital for that tenor as well as the investor appetite. Different kinds of investors have different return expectations across tenors, and the presence of appropriate investors in the market will provide issuers with the choice of method of capital raising. Issuers could also evaluate the possibility of future liquidity issues and decide whether to be conservative or aggressive in the tenor of capital to be raised.

Liquidity

The available and future liquidity of the capital has to be explored in the context of the market of capital raising and the type of instrument. From the issuer’s perspective, more liquidity allows more flexibility with a possible impact on cost and refinancing.

Credit Rating and Support

Credit rating, support from group or external sources, and collateral required play an important role in the capital structure decision, especially on the debt raising side.

Next we discuss the various mechanisms of accessing capital through these classes.

DEBT CAPITAL MARKETS

We begin our discussion on debt capital markets with an overview of the various elements that drive the decision to raise debt. As noted in Chapter 12, the capital structure is one of the main characteristics of firms. Once the decision has been made to raise capital, the underlying drivers of business and funding play a strong role in deciding which alternative would work.

Figure 13.5 outlines various debt financing alternatives that we discuss in this chapter.

FIGURE 13.5 Debt Financing Alternatives

Syndicated Loans

A syndicated loan is one created through the pooling of funds from a syndicate of financial institutions and banks, typically for the short to medium term. This method is popular, especially for leveraged buyouts and other corporate activity. Institutions that are part of the syndicate could, at a later time, sell down the obligations to other investors.

Syndications can be of three broad types:

Commercial Paper

Commercial paper is a short-term (usually less than 180 days with some exceptions) money market instrument issued by rated companies for working capital and immediate liquidity needs. The paper is usually in the form of an unsecured promissory note.

Bonds

A bond is a fixed income market security issued by a borrower to a lender that brings with it an obligation by the borrower to repay interest and the principal of the bond value based on certain predefined parameters. The coupon payable on the bond could be fixed or variable.

A bond usually can be sold from the holder to another party for a value that is linked to the prevalent market interest rates and the perceived creditworthiness of the issuer and the country of the issuer.

Depositary Receipts or Notes

A depositary receipt (American Depositary Receipt [ADR] in the United States or Global Depositary Receipt [GDR] elsewhere) of a firm is a negotiable financial instrument issued by a financial institution in a country to represent the firm’s publicly traded securities to investors overseas. Depositary receipts usually trade on a stock exchange in the country and thus enable overseas investors to procure shares in local firms since the shares of the firms do not leave the country.

Medium-Term Note Programmes

Medium-term notes are 5- to 10-year senior unsecured debt notes issued through a programme that involves one-time documentation with flexible structuring and terms and conditions. The programme enables the issuer to draw down more flexibly and not have to negotiate terms, conditions, and documentation each time there is a need to borrow.

Structured Debt

Structured debt has many characteristics that use financial engineering, documentation and tax, legal, and accounting aspects to suit the cost, profile, and liquidity need of the issuer while matching payoff, risk, and maturity profiles of investors.

Mezzanine Issues

Mezzanine capital is a hybrid instrument in the form of subordinated debt or preferred stock, usually in the form of private placements and of higher cost than simple or vanilla debt (owing to the placement just above equity in the capital structure pecking order).

One of the differentiators of mezzanine capital is in the possibilities of return to investors. Investors can receive:

• Interest or cash payments
• Payment in kind, where the principal amount is increased to the tune of what is owed to the investor as coupon or other repayments
• Equity or increased ownership

Securitisation

Securitisation is the collective term for the pooling and sale of similar types of assets to investors as a package, which is serviced by the payment of coupons or interest and principal based on a repayment schedule of the pool of assets.

Trade-Related Financing

Various trade-related financial supply chain financing alternatives are available. They are covered in Chapter 14.

Distressed Debt

A new type of fund, a distressed debt fund, has emerged that specialises in the provision of high-yielding, high-risk debt to companies in dire need of capital.

We now direct our attention to equity capital markets.

EQUITY CAPITAL MARKETS

Some of the key drivers for raising equity capital remain long-term growth, building up the base of requisitions, adhering to regulatory conditions, or simply to provide an exit for the company’s shareholders with the long-term benefit of diversifying the company’s shareholding.

Figure 13.6 illustrates various equity issuances and modes. Two key deterrents to incremental equity are control and cost, but the pressure on cash flows to service the issuance is limited and at the discretion of the firm.

FIGURE 13.6 Equity Issuances

In public issues, the firm goes to the public, including institutional and retail investors, to request and convince them to invest in the equity of the firm. The initial public offering route is commonly taken. In this method, a firm that has been privately held thus far chooses to list itself on a stock exchange and be publicly traded. An offer for sale, as compared to a new direct issue, is a public invitation by a sponsoring investment bank. Subsequent issuances, also called further public offerings (FPOs), can also go through similar routes.

A rights issue is an issue of an additional set of shares to existing shareholders (based on their interest). This is used to reduce the impact of dilution and also to try to extract more capital from existing shareholders without having to involve a new set of investors or banks for borrowing.

Private placements, of private or public firms, are agreed-on over-the-counter transactions where the investor has agreed to come on board with additional motives of control or subsequent actions and value generation.

We now explore a very interesting case—interesting not only because we are talking about a university (and not a conventional corporation), but also because this entity has taken a decision to start taking on debt.

CASE STUDY: MOVING FROM BEING A SURPLUS ORGANISATION TO A BORROWER

The Experience of Inaugural Debt Facilities at the University of Auckland

Overview

In 2010, the University of Auckland crossed the path from being a surplus organisation to becoming a net borrower. The process involved the development of stakeholder support through research, modeling and development of appropriate Treasury risk management policy and procedures, through to the arrangement of funding facilities and ongoing active Treasury management.

Background

The University of Auckland is ranked among the world’s top 100 universities. To continue to achieve this standing, it needs to attract talented staff and students from throughout New Zealand and around the world, and provide them with an environment and facilities that enable and encourage them to teach, learn and research to the best of their abilities.

To support its objectives, the University has a robust programme of development and investment in student and teaching facilities, student accommodation and amenities. To facilitate such growth, within targeted timeframes, a borrowing programme had to be developed and framed.

The Path

The path to becoming a net borrower involves a number of phases. An overview of these phases is shown in Figure 13.7.

FIGURE 13.7 Bancorp’s Five-Stage Path for Evolution from Lender to Borrower

As the University had not previously borrowed funds, it was interested in the first instance to understand the level of debt likely to be considered reasonable/prudent and sustainable over the forecast period together with the funding options most suited to its requirements. This was then used to form the basis for a debt strategy or “policy.”

The Assessment of Capital Structure

Establishing an appropriate capital structure, and therefore debt thresholds, involved an analysis of “capacity” to service debt and “need” to take on debt.

The capacity to borrow was assessed by analysing:

• Commercial organisations
• Peer universities
• Indicative credit ratings
• Regulatory restrictions and benchmarks
• Indicative financial covenants

Two pieces of analysis were undertaken. The first involved assessing the relative position of the University against these benchmarks in term of whether it was projected to be in the lower, median or upper quartile; whether it was forecast to be in any ‘risk’ categories as defined by regulatory ratios; and what its indicative credit rating would be forecast to be and how that compared against the credit ratings of its peers (Figure 13.8).

FIGURE 13.8 Historical Debt to Capital Ratio

The second piece of analysis was to apply the key benchmark ratios in reverse by stating the University’s view of a reasonable debt level i.e. as being at one of the lower, median or upper quartile in relation to the benchmark group, and apply the selected ratios to determine what level of debt is consistent with that position.

As example of how this could be used is in setting policy, if it would be considered reasonable for the University to take on debt up to a level of, say, the upper quartile of the benchmark universities (assuming the benchmark ratios as set out in the Table 13.1, the corresponding policy would therefore set limits at:

• Debt to EBITDA < 3.1×; and
• Average annual Interest Cover Ratio no less than 6.1×.

TABLE 13.1 BENCHMARK UNIVERSITY DEBT INDICATORS

This could be applied to peak or average limits and potentially with different thresholds for each, for example a peak threshold of 6.1× Interest Cover and average of 7.8×. Alternatively, this dual threshold approach might be applied against annual variation over the entire forecast period or over periods through the forecast period i.e. a threshold equal to the median but allowance to go to the peak for no more than four years during the forecast period.

This analysis illustrated what the University’s projected position would be in relation to the benchmark group, but not what it should be. This raised the question of how to assess what it “should be.” Two things, broadly speaking, might be considered to drive a university or organisation to choosing a position relative to debt benchmarks: capacity and need. A university or organisation might take a lower quartile position if it had little capacity to support debt, or little need to borrow. Conversely, it might look at an upper quartile position if it had significant debt capacity, or if its strategy or position demanded debt-supported investment.

The need to borrow is more difficult to quantify and measure. The evaluation for the University was completed by considering drivers that might influence the University towards a particular debt position in terms of how much it needed to borrow, as opposed to how much it could borrow. By way of example, Figure 13.9 lists a number of the drivers that might influence a university towards either a lower or upper quartile, or median, debt position in terms of how much it needs to borrow, as opposed to how much it can borrow. The two, obviously, must be reconciled and a position consistent with each adopted, but they should be recognised as separate influences on a debt policy.

FIGURE 13.9 Drivers of Need for Debt

In interpreting Figure 13.9, a university has more need, or a greater imperative, to borrow if:

• low or falling revenue levels reduce its ability to fund capex from cashflow, and/or
• endowments fund relatively little capex, and/or
• it faces imperatives to improve its facilities, and/or
• it seeks to protect or improve its ranking.

The University’s position was then highlighted against these drivers. The view drawn was that while a number of areas indicated relatively little pressure to borrow, in the majority of instances the University’s current position was consistent with a higher than average need to invest, and a higher than average need to borrow to support the necessary level of investment.

Drawing this together with the debt capacity analysis and the fact that the University had strong and embedded financial management and planning disciplines and processes, the policy parameters were proposed.

Overall, the outcome of this review was:

Having determined the “right” capital structure, the University along with its advisers then reviewed various funding options which would meet the University’s objectives. This included consideration of bank debt, structured finance, project finance and capital markets funding. It had regard to elements such as funding source and diversity, maturity profile, funding characteristics (e.g. term, flexibility, security, on or off balance sheet, risk transfer etc.) and market environment including pricing and access/availability.

A further consideration in relation to funding options and implementation was whether a credit rating would be of benefit. For certain funding options it is essential and therefore the process and costs (both upfront and ongoing) were taken into account when assessing these.

The Development of a Treasury Policy

The next step involved translating the debt thresholds into a policy and establishing the governance necessary to manage debt. This required:

1. Consideration of Treasury management issues as they relate to a debt management Treasury policy including funding, liquidity, interest rate risk, and internal management/authorities as well as IFRS hedge accounting impacts.

2. Establishment and documentation of a debt management Treasury policy.

3. Liaising with regulatory bodies.

Implementation

The fourth stage of the process was the implementation of the preferred funding option. A tender approach was employed to maximise competitive tension and the prospects for optimal terms and conditions for the university. This involved, with the help of advisers, drafting of a request for proposal (RFP) and accompanying “Information Memorandum” and data pack for interested parties, the review of proposals, short-listing and selecting the preferred funding parties, and the negotiation of terms and conditions and management of external parties (e.g., legal advisers) to ensure the process was successfully completed and funding put in place.

Key Considerations for the University

Fundamental change in position. The University had been a net investor. The shift to becoming a net borrower presented not only a shift in mindset for the University and its various stakeholders, but also the need for development of the necessary policies and procedures to enable and continue to support this transition.

Aligned solution. The University had a number of key elements it [required/sought] from a funding solution. These included certainty of funding—the comfort that it had funding in place before embarking on such a significant capital programme; minimisation of cost—to recognise the capped funding environment and low operating margin; flexibility and the ability to match the university’s cash flow profile and growing debt profile resulting from the seasonal nature of student enrolments and the progressive development of capital projects.

Successful outcome. Given the position of the university and the scale of the financing and projects to be undertaken with the funding it was critical that the process was successful. A major factor in this was the development and buy-in by stakeholders—government, council, staff, students, and ultimately financiers—as to the rationale, prudence and then implementation and risk management

Outcome

The university issued a request for proposal for bank debt facilities in late 2010. Following strong interest from funders, the university successfully established bilateral bank facilities with two large regional banks.

Key Learnings

• Establish a robust strategic plan and financial planning model.
• Engage with stakeholders early.

Contributed by Dean Sharrar, director, Bancorp, Treasury Services, and Derek Phillips, director, Bancorp Corporate Finance. Bancorp (a provider of Treasury, banking and corporate finance advice) developed and implemented the end-to-end strategy and execution for the University of Auckland.

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SUMMARY

In this chapter, we looked at the capital structure and various modes of raising capital. We discussed why cost of capital may not be the only determinant of capital structure and other factors to be considered. Debt and equity capital markets and fundraising also were surveyed.