Capital Structure – The Tail on the Dog

Too often we see companies that find themselves with a capital structure that prohibits critical business activities, unduly influences future business moves or complicates the attraction of new capital. How does this happen? In some cases, it’s the result of a reactionary approach to building the capital structure. Management may act on ideas from bankers, investors, lawyers, or board members and enter into various transactions over time that seemed appropriate – but are later found to have hidden risks or hidden opportunity costs. In other cases, rapid and dramatic changes to a market or industry can render a capital structure unfit for a company.

 
The notion that capital structure is the “tail on the dog” is grounded in the idea that a capital structure should facilitate, rather than impede or prohibit, a company’s strategic goals and operational imperatives. It promotes the concept that only after a detailed review of a company’s strategy, goals, timeline, opportunities and constraints should the capital structure be conceived. As we often say to our clients, “tell us where you want the business to go, and we’ll help you design a capital structure and funding strategy to get you there.”

 
Capital structures should be as unique as the businesses they support. Some businesses are capital intensive; others are people intensive. Some are global; others are local. Certain industries are more volatile; others are more stable, and yet others are seasonal. Some companies have growing capital expenditure forecasts, and others project flat spending. Some businesses require heavy working capital; others might have negative working capital. Certainly management teams across the country understand these aspects of their business, but they don’t always map them against the opportunities, limitations and structure of the capital markets, the various capital instruments available, and the financial players operating in the marketplace.

 
The process of developing an effective capital structure can be figuratively represented by the act of looking through two separate lenses – a business lens and a capital lens – and then overlapping them to reveal a structure that is both effective and achievable. The business lens focuses on things like the operations, industry, assets, long-term strategy, outlook and stakeholders of a company to ascertain key needs, risks, and opportunities. The capital lens, on the other hand, narrows in on capital markets, instruments, structures and partners that are not only the most suitable in facilitating a company’s strategy, but are also the most attainable given the profile of the company and the conditions in the markets.

 
For example, a stable, asset-heavy, low-growth industrial company with a long history may be best served with a heavier mix of debt than equity, asset-focused credit support, a longer-dated maturity structure and capital providers that prefer lower volatility industries and companies. Conversely, a tech-enabled healthcare services company in acquisition mode may call for an equity-heavy capital structure with minimal debt and an investor base with a high risk tolerance and ample dry powder to fuel the acquisition strategy. While these examples seem elementary, it’s surprising how often we encounter companies with a capital structure mismatched with its business and strategy.

 
Devising an effective capital structure is a deliberate planning exercise, just as any other strategic initiative. Importantly, this planning should not be one-time in nature, but rather conducted with a frequency so as to amply anticipate needed changes required to accommodate shifting industry, company and market dynamics.

 
The good news is that the accessibility and velocity of information and capital continues to rise, as does the formation of new capital providers, capital markets, and capital advisors. Resources to help management teams make effective decisions are growing in abundance, which should result in more instances where the dog wags the tail, and not the other way around.