Changing Capital Structure Adds No Value

You are hearing more and more from Wall Street and the financial press that companies aren’t employing an "optimal capital structure" because interest rates are low and debt is "cheap."   These articles often refer to companies with too much cash on the balance sheet or companies which generate substantial free cash flow but have little debt.  And often the research will conclude with the point that the company should "lever up" the balance sheet or pay a special dividend to return value to the shareholders. 

Which brings me to one of my investing pet peeves – the idea that changing a companies capital structure adds value.  It doesn’t.  It simply shifts wealth and risk from one party to another.  And in most cases, adding significant amounts of debt often hurts the company and shareholders. 

In this weeks "The Trader", Barron’s columnist Mark Santoli mentions the large number of leveraged buyouts (LBOs) in the works.  In the article, Santoli quotes one portfolio manager saying "This LBO wave is fundamentally different from the last time around. Back then, LBOs were fixing bad management with debt. Now, they’re fixing bad capital structures."

Santoli explains "By "bad" capital structures, Kantor means inefficient balance sheets with too much cash and not enough debt to deliver desirable returns to equity holders. Where once LBOs were an instrument to dismantle silly conglomerates or unearth "under-managed" business, they’re now increasingly aimed at harnessing low-interest debt to solid companies."

The idea of a "good" or "bad" capital structure implies that you can add value by changing how a company is financed.   This is akin to saying you can add value to a house by making grandma sell her paid-for abode to a young couple who have to take on debt to buy it.  The transaction simply shifts wealth around.  Unless the young couple does something with the asset – i.e. fix it up – no actual value has been created. 

Finding the ideal capital structure comes from the concept of the weighted average cost of capital, or WACC (in business school lingo).  The WACC refers to the cost and amount of debt and equity a company uses to fund its operations.  Typically, debt carries a lower cost because 1) equity holders do not have their ownership diluted, 2) equity holders typically demand a higher rate of return because they can lose their entire investment if the company fails and 3) the interest paid on debt is tax deductible as a business expense.  Theoretically, debt should always be used to finance a business mainly because of point #3 – it is cheaper because Uncle Sam allows interest as a business expense deduction on taxes while it doesn’t allow cost of equity as a deduction. 

These points are generally correct.  However, there are hidden costs of debt that often go overlooked.  The first overlooked risk is the idea of increased financial risk – i.e. debt increases the risk of failure.   In calculating the WACC, one has to make an assumption as to the required return equity holders will expect.  This in itself is a difficult task that I won’t go into, aside from explaining that one of the variables in determining the appropriate returns on equity is Beta – or the riskiness of an asset.  Beta is often defined as the volatility of an asset relative to an underlying security or index.  For instance, the beta of INTC stock is 2.3 meaning that INTC, on a percent basis, moves more than twice as much as the S&P 500.   

But beta can also be used as a measure of company specific risk.  Under this definition, beta consists of two components – 1) the riskiness of a firms operations or business risk (called unlevered beta) and 2) the riskiness in a firms capital structure or financial risk (called leveraged beta).   The unlevered beta is simply an estimation of a firms business risks if it had zero debt.  A technology company would probably have a beta of 2.0 or more, while a dry cleaner would probably have a beta of 0.5 or less.  The leveraged beta reflects the firms actual capital structure (i.e. how much debt and equity the firm employs).  Therefore, as you increase the amount of debt in a company’s capital structure, the overall beta of the business increases.  In other words, you can make investing in a dry cleaning business as risky as investing in a tech company if you put enough debt on it.

The simple concept behind this complex explanation is that as you increase the amount of debt in a company’s capital structure, the financial risk increases.  This, in turn, increases the rate of return an equity investor expects.  Therefore, changing one variable (debt), doesn’t actually lower the overall costs of capital for a company that dramatically.  As a company increases the amount of debt, equity holders demand higher returns because of the increased financial risks. 

It is my contention that increasing debt dramatically actually increases the cost of capital because the financial risks go up exponentially.  Very few companies can actually withstand the pressure of "leveraging up" the balance sheet because their businesses are much less stable than most analysts estimate.   Financial risks are often underestimated because analysts think in a linear fashion – what happened in the past three years will happen in the next three years.  You only have to look back to 2000 to appreciate the folly of this kind of thinking.   Therefore, I believe investors actually destroy value by increasing debt dramatically, as is often the case in leveraged buyout situations or in cases where companies raise debt to buy back their own stock.  In these cases, the risks of using large amounts of debt far outweigh the tax benefits. 

The second cost of debt hardly ever gets mentioned but is just as important.  That is the cost and benefit of flexibility.  Having ready access to cash is worth more than most analysts appreciate.  Financial flexibility during difficult business environments is invaluable because it gives management time and options.  Inflexible capital structures during difficult business environments are the kiss of death for a company.  But even in good environments, a strong balance sheet can be used to increase the value of a company.  For instance, sales forces often use their company’s strong capital structure to win new business – "We’ll always be around" is a compelling selling point in the technology industry. 

Warren Buffett defends the fact that Berkshire Hathaway carries $40 billion in cash by mentioning flexibility.  Buffett believes (and his record bears him out) that he can deploy the cash effectively over time to increase shareholder returns – the past eight years have just not been the right time to aggressively deploy the cash.   And Buffett wants to remain flexible to take advantage of favorable prices and opportunities while maintaining a "safety net" for the highly volatile insurance business – something he can’t do if he pays the company’s capital back to shareholders.   

So as the noise surrounding LBOs and capital structures increases, remember that leveraging up a balance sheet doesn’t create value in and of itself.  While debt is cheap right now, investors need to understand the hidden costs.  Unless a change in capital structure accompanies a real business purposes such as financing an acquisition or raising capital to increase growth, adding debt only shifts wealth and risk from one party to another.  And oftentimes, adding too much debt increases the financial risks exponentially that any tax or ownership benefits are quickly negated.