Given the impact of changing economic, debt market and company conditions on optimal capital structure, it is a wonder that any company stays close to its ideal debt/equity mix. By evaluating their financial structure and capital mix versus conditions and business plans, business leaders can ensure that they are using the most efficient capital with the right level of debt to provide them with the funding needed to meet business goals.
Capital Restructuring Opportunities
At a macro level, capital restructuring involves rebalancing the debt/equity mix and then adding, retiring or reissuing debt at the prevailing (hopefully more favorable than when securing previous loans) market rates. In the current climate, the cost of capital is historically low. These conditions offer the opportunity for a business to leverage with lower ongoing debt service.
Restructuring capital can also mean rebalancing risks. Given the risk repayment considerations in evaluating additional leverage, a risk analysis that delves into interest rate risks for existing debt makes sense when looking at capital. Caps, collars and swaps of floating rate for fixed securities can reduce exposure to interest rate changes.
A capital restructuring resets a company’s debt and equity mix closer to an ideal range. The low end of the range means the company’s returns aren’t being maximized because they’re using too much equity - where equity holders expect a much higher rate of return than debt holders - and not enough debt. Positioning at the lower end of the range might also lessen the company’s flexibility by reducing its access to capital and miss taking advantage of debt’s tax advantages. At the other end of the range, the additional repayment risk means a business only wants to be in the high range temporarily. A business might want to take out debt to make an acquisition and then have a specific plan to de-lever over subsequent years.
A lower rate environment offers an optimal time for restructuring. In addition to lowering interest servicing costs, companies can use leverage to support any number of short and longer term plans. They can leverage capital to provide flexibility to weather cash fluctuations as they fund growth. They can address their exposure to interest rate and debt repayment risk. And, if they are considering a sale or transition, they can optimize their debt to equity ratio as they prepare to present to potential investors.
Capital Restructuring Scenarios
Capital restructuring can benefit businesses in many situations:
Undercapitalized but growing companies may restructure their capital to secure cash to expand their operations. The cash to support growth can come from reduced servicing costs if lower interest rates are available or from increasing leverage by putting proceeds of a loan to work in the company.
Owners looking to retire can utilize dividend recapitalization as one means to secure additional liquidity from the business. Under the right conditions, the company can leverage the dividend payment as new debt in order to pay the retiring owner or exiting investor. An Employee Stock Option Plan uses a similar mechanism to secure debt to fund owner liquidity.
Companies looking to stabilize their financial structure can benefit from capital restructuring that will help retire excess debt. Substituting old debt with newer, lower interest rate loans can alleviate some stress from high interest debt and ultimately pad the bottom line.
Small businesses can leverage the goodwill of the company by restructuring the business ownership with a capital infusion for payout though a SBA 7(a) loan. This type of loan offers favorable down payment structures and rates.
Stable companies looking to buy back equity may choose to incur debt financing to repurchase equity sold during a growth phase.
How Capital Restructuring Works
Rationalizing Leverage. Debt can be restructured to benefit the business by refinancing existing loans or obtaining new ones secured by real property, equipment, receivables or in select cases, future cash flows. This process effectively reduces the cost of the debt in the long term and increases cash flow for the business. The increased cash flow can be reinvested in the company in a variety of ways that influence growth for the future. If an influx of capital is needed, a new commercial or business loan can provide for growth. This is considered capital restructuring as new leveraged debt capital is added to the company balance sheet.
Equity Buyback. Another restructuring method is for companies to buy back previously issued equity using debt financing. This would be accomplished by taking out a business, commercial, or bank loan in the amount of the equity buyback. In some cases, a company may have a capital structure heavily weighted towards equity. In such cases, buying back previously issued stock and substituting bank loans or other debt financing can optimize the capital structure resulting in a lower overall cost of capital.
Next Steps – Getting Started
The first step towards capital restructuring is taking stock of the current mix of capital employed by the company. Make sure to set any major decisions within the context of your strategic plan. Utilize your financial support system of financial advisors, attorneys and CPAs to help you determine the optimal mix of debt and equity. Your SunTrust Relationship Manager can lend valuable insight about capital structure and can guide you through this evaluation to help you secure the proper financing to meet your plans.