Using Your Capital Structure As A Hedge Against Risk

March 2011

Companies are considering how their capital structures can protect against a broad range of catastrophic risks. But that's like a health plan that pays out only for the most costly, life-threatening diseases. Did BP envision a drilling accident that would shut off its access to short- and medium-term capital markets and result in worldwide condemnation? If it did, it certainly didn't prepare accordingly.

Those types of risks can be hard to identify and quantify and difficult to hedge. And certain events—financial-market meltdowns, product liability, and acts of God—are tough to insure against in traditional policies. In addition, there is typically a great deal of time and ambiguity surrounding the litigation that generally follows these events. Here's what to consider in building a financial hedge against the large risks that can crush a company:

  • Stress-test your structure. How will your capital structure stand up against "high-severity" scenarios (e.g., what happens if three major hurricanes hit your area in a single season? Could you survive?)? Brainstorming these "doomsday" scenarios may be difficult, but when the ramifications of any event are so bleak it might spell the destruction of your firm, that's the signal that you should put a task force on it.
  • What do you need? Analyze how large a capital-structure "shock absorber" you'll need in such situations. Think in terms of "the obligations you have and the risks you face, and then calculate the cushion you need to meet the obligations," notes Tim Koller, a principal in McKinsey & Co.'s New York office. You should also factor in volatility in cash flows, investment opportunities, expected dividends and buybacks, and the company's risk tolerance. "Once you've decided on a level of safety, you then translate that into target levels of debt and equity," he adds.
    In answer to the points above, Dennis Arriola, finance chief of SunPower, a maker of solar-power components and systems, works to ensure that, in any case, the company "has sufficient liquidity balanced by the cost of that liquidity." After projecting capital needs, he performs "what-if" analyses, including a scenario in which liquidity in the bank markets dries up. "We recognize that any projections the company puts together are wrong," he says. "The question is, how wrong can we afford to be? I try to look at the bookend of risks we can work with and how to manage around those extremes."

Meeting leverage needs
If the scenario applies, you can maintain debt ratios consistent with a target financial rating. By running less-leveraged, you gain flexibility and create what might be called a "crumple zone" for large negative events. It may help in the case of, say, missing an interest payment, but it can be economically costly. What's the right earnings-per-share hit needed to support a long-term, save-the-company strategy? What's the proper reduction in return on equity? The answer will differ for every company.

Another tactic might be to use less debt and go after longer maturities, less bank debt, or roomier covenants. Considering leverage versus other finance risks is another way to get comfortable with higher amounts of debt. Taking on debt offers substantial tax benefits, but you pay higher interest rates and reduce flexibility in terms of making investments.

If you do run with more leverage, you can protect yourself in other ways, such as by lowering operational risk. Regardless of the path you choose, you need to periodically update your assumptions and adjust to financial-market movements.

Sources: Capital Crumple Zones, CFO

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