Until recently, building up debt on the corporate balance sheet has been a shrewd move for many businesses. With low financing costs and low refinancing risk, the returns available from growth have often been far in excess of the cost of debt no matter the credit profile of the business.
But there are signs that the successful, decade-long leverage strategy could be tiring. In recent months, the stock markets have been showing greater volatility and corrections. US high-yield interest rates have been rising. Perhaps more concerning, the US Treasury yield curves are flattening and could invert, which has historically been a signal of a coming recession.
Companies that have high levels of debt in relation to equity should be watching these developments carefully. If 2019 brings higher interest rates, lower corporate valuations and an economic recession, then highly leveraged companies could be caught in a financial squeeze – with higher debt costs and debt rollover risks as banks turn to more stringent requirements for extending credit.
The good news is that now is still a good time to use equity to deleverage: although we have seen corrections and volatility on the public markets, valuations are still high on a historical basis and the same is true for valuation multiples for privately-held companies.
By acting now, businesses of all sizes and across all segments can use these strong valuations to lower debt and solidify their corporate structure. Below are a few ways to strategically employ equity to help deleverage your business and keep your capital options open.
Listing on a small-cap exchange
IPOs are not just for large and multinational companies—nor are they the reserve of technology companies on the smaller scale. However, the route for smaller companies may be different. Rather than ringing the bell at the NYSE, many companies pursue ‘small cap’ listings on either established exchanges or some of the stock markets created specifically for small-capitalization businesses.
For example, the UK’s AIM is a small-cap index and many US companies have been listing on the exchange as its regulatory-light approach eases listing and ongoing costs. In response, US indices such as the Nasdaq have been improving their small-cap coverage (an IPO here, for example, could be an effective way to use some of the company’s equity to deleverage).
Even the small-cap IPOs, however, can be relatively expensive for smaller transactions and they also require a degree of reporting and transparency that traditionally-held companies may not wish to incur. Many often see the advantage in ‘private placements’—sales of chunks of equity to one or more investors. Not only are these transactions often more cost-efficient than public listings but they can also come with strategic shareholders that can help the business. Depending on the size of the equity sold, the new shareholders could receive a board seat, for example, and provide new and valuable governance and strategic perspective to the company—as well as providing the cash to lower debt burden.
Private equity is conceptually similar to private placements, but private equity investors are typically more proactive and ‘hands-on’—often bringing in executives to work alongside existing management on a day-to-day basis. Private equity’s growth expectations are usually more aggressive, as well, and the rewards can be large for companies that are open to more structurally significant equity transactions in the future.
Strong growth has led many companies over the last decade into new areas of operation that are tangential (or not!) to the core business. If debt is weighing on the company, then selling non-core operations as a means to deleverage can strategically be beneficial. And it doesn't meant you have to cut all ties—there are many operations that allow sellers to retain economic interest in the businesses being sold.
Companies with large assets can use sale/leaseback transactions to unlock the value of these assets while maintaining full operational control. Not only does this help balance sheet management from a debt perspective, but it can also often be efficient from a tax perspective.
Full-scale mergers and acquisitions are the most transformational equity transactions. The biggest challenge for the acquirer is creating shareholder value for the deal. But there are also significant challenges for the selling company—from finding an ideal buyer to managing operations during what can sometimes be a multi-year negotiation.
If you decide that a merger or acquisition is the best way to raise capital, employ your financial, legal and banking partners to support you during the process. Key objectives you'll want to keep an eye on are maintaining performance of the existing company, identifying buyers who are a good fit for your business, and implementing integration once the deal is complete. It's also important to stay focused on the outcome: ideally you want a buyer or partner who can invest more capital into the business.
Highly leveraged companies should be cognizant that a new debt approach could also be a key part of the deleveraging strategy. Is it the nominal size of the debt that is the issue or the short term refinancing risk? Working with a regional investment bank that can help optimize debt financing (by extending debt maturities and reducing the overall cost of debt) can be a significant step and can reduce or even eliminate the amount of equity financing required.
Set your business on firm ground
Whatever next year brings, those companies that proactively manage their corporate balance sheet will ensure they are on firm footing to meet the challenges and opportunities to come. The specific strategy will depend on company size and growth trajectory, so consider leveraging your partnerships to identify the best options and execute on the opportunities.