Not long ago, the real estate capital company I led acquired several properties from an established equipment rental company and then leased them back to that company in what is known as a sale-leaseback arrangement. I have been engaged in activities like this most of my career and there was nothing noteworthy about this transaction, except one thing: The equipment rental company was being sold. The proceeds of the real estate sale were used by the buying group to purchase it. This enabled the buying group to acquire the business with nothing down—no equity commitment required. Put another way, the original owners of the business could have consummated the same sale-leaseback arrangement with us, received the exact same proceeds and then continued to own their company.
Throughout my career, I have witnessed similar stories where company owners lose out because they do not understand the art of the possible when it comes to corporate financing alternatives. Finance people, and I am definitely among them, refer to the mix of assorted debt, lease and equity as the “capital stack.” The owners of the equipment rental company simply had paid insufficient attention to their own capital stack alternatives. The result of their oversight was a substantial valuation loss.
Maximize Equity Returns and Business Value
When considering how to maximize equity returns and business value, leaders are generally drawn to two important corporate efficiencies. The first of these is operating efficiency, which is the ability of the business to improve profitability through a combination of product pricing and expense controls. The second is asset efficiency, which is the talent of limiting required business investment as a means of lowering equity requirements. Operating efficiency seeks to increase profits, while asset efficiency aims to lower equity requirements, both of which can raise equity returns and shareholder wealth.
There is a third often neglected efficiency. That is capital efficiency, which is the art of assembling a capital stack designed to minimize the costs of borrowings, leases and equity (often finance people simply refer to this aggregate mix as “capital”). The reasons for this oversight vary. Commonly, business leaders suffer from cognitive bias, assume that capital stacks are a simple matter and believe they know all they need to about the options available. For certain, assuming all business participants are possessed of the same capital stack knowledge, the first two efficiencies are most important. That fact is evident by the modest movements in shareholder returns when moving lease or borrowing rates by a percent or two.
Here is another potential reason for capital stack cognitive bias. In 1958, economists Franco Modigliani and Merton Miller developed what is often called the “Capital Structure Irrelevance Principle,” which essentially stated that varying capital stack mixes would have no impact on corporate valuations. They were eventually awarded Nobel Prizes for their work. However, their findings were subject to important tax and transaction cost omissions, assuming also that individuals and corporations borrow at similar rates. Of course, tax considerations and transaction costs do matter and people and companies do not borrow at the same rates. The degree of sophisticated financing options developed since 1958 only adds to the ability of capital stack selections to be additive to value.
Capital stacks contribute to more than simply equity returns. They can be central to corporate operating flexibility. Opportunity costs begin life as potential drags on shareholder wealth, ending their lives as real and impactful costs. Most often, they are caused by poor capital stack decisions. Leaders can be tempted to sacrifice interest or lease rates for costly restrictions, including prepayment or assignability limitations, austere financial covenant packages and much more. I have many times witnessed the destruction of shareholder wealth at the hands of poor capital stack decisions.
Capital Stack Assembly
There is an order of operations when it comes to capital stack assembly. The first step is to focus on long-term capital, which can include real estate mortgages, real estate and equipment leasing options, subordinate seller financing and asset-based lines of credit, just to name a few of the more material options. The last of these tends to be classified by accountants as short-term in nature, but finance professionals tend to view this differently, since such facilities tend to be formula-driven, involving advance rates against accounts receivable and inventory, and tend to be readily renewable. The simple aim is to maximize long-term capital proceeds, while looking to minimize the payment on those proceeds.
The second capital stack assembly step entails borrowings having limited collateral that are repayable from free corporate cash flows. Such loans will tend to amortize more quickly and represent a more volatile form of borrowings because they are less universally available. Economic cycles come and go, lender risk tolerance rises and falls, and corporate cash flow loans are the most vulnerable to such changing environments.
With long and short-term borrowing and lease proceeds decided, your final step is to solve for equity.
It is important to know the art of the possible when it comes to capital stack assembly. You may not want to maximize borrowing and lease proceeds as a means of improving your margin for error. However, it bears note that no company ever went out of business simply because it lost money. Businesses fail when they run out of cash. In this light, liquidity access becomes an overriding essential ingredient to a solid capital stack.
This essential notion of the importance of capital availability is effectively a North Star for business leaders. Over 25 years of working with three successful public companies, we have adhered to this path. Our businesses have raised capital, even when it was expensive, so long as we were able to deploy the capital in a manner that was additive to shareholder wealth. We have likewise sough to maintain high levels of liquidity as a way to provide our companies greater margins for error while raising our chances to seize opportunities that came our way.
Understanding capital stacks and capital efficiency is essential for any business leader. On a daily basis, Operating and asset efficiency may command more attention. But overlooking capital efficiency can become suddenly perilous. Poor capital stack decisions can elevate opportunity costs. Poor capital stack decisions can impair liquidity. And a poor knowledge of capital stacks can absolutely deprive you of the knowledge to understand the shareholder value you and your leadership team have worked so hard to create.
