Managing the right mix of debt and equity

1 JUNE 2023

The costly consequences of waiting too long to raise capital

By Sibonelo Mdluli

Coming out of the COVID-19 pandemic, many South African companies had relatively strong balance sheets and lower gearing levels thanks to disciplined cost control practices and strong cash generation in an accommodative fiscal environment. However, much has changed since then. We are increasingly having discussions with clients, for instance in the retail and manufacturing sectors, who are seeing margin pressure and risk to earnings because of low GDP growth, high interest rates, higher energy costs and down time as a result of loadshedding. All these factors are leading to an increase in gearing levels which, if left unchecked, would result in severe strain to these companies and value destruction for shareholders.

In light of the above, it is important that companies actively manage their capital structures to create an agile balance sheet with the right mix of debt and equity.

The ever-evolving macro environment and sector specific challenges require companies to engage in scenario planning that goes beyond the traditional financial budgeting process which is often based on a limited set of assumptions that fail to factor in unanticipated events.

The Importance of scenario planning

We often encourage boards of directors at clients to engage in scenario planning on a regular basis so they better understand the ability of the company to withstand macro and sector headwinds and to ascertain:

• whether there are operational levers to support the business – such as reducing operating expenditure, optimising working capital, eliminating or delaying non-essential capex and re-prioritising capital allocation;
• if additional liquidity support is available from funders such as working capital facilities, term debt funding, bridge facilities, ability to restructure term profiles etc.; and
• whether equity is required from shareholders and other investors.

Given the cost of equity and its permanent nature relative to other funding solutions, shareholders typically prefer management to explore solutions that rely on operational and funding levers, to the extent possible. Before the board and management approach shareholders to support an equity capital raise, the company must have critically evaluated its capital structure and must demonstrate the need for additional equity capital. 

Further, management must be able to demonstrate that all operational and funding levers have been considered before resorting to an equity issuance. The appropriate scenario planning will assist management to demonstrate that a pre-emptive equity capital raise is the most prudent course of action and that if not done in a timely manner the company may be forced into a situation where the balance sheet becomes over-geared and/or lenders force the company into raising equity (sometimes under sub-optimal market conditions).

Once a board and the executive has evaluated all available options for optimising the capital structure and it is clear that equity capital is required, it needs to carefully message the rationale for the equity capital raise. Shareholders need to understand the long-term investment thesis, strategy and growth drivers for the business and what the capital raise proceeds are intended to be used for. Investors have little appetite for supporting “blind pool” or “war chest” capital raises.

Delays can be detrimental

Once the board and executive have quantified the amount of equity capital to be raised in support of the investment thesis, it is important that the company moves decisively to raise that capital as any undue delays may result in further deterioration in the business, breaching of lending covenants and resultant declines in the share price which ultimately mean that (in absolute terms) when the company does raise the required equity, it will do so at a significantly lower price. Company boards would do well to prevent this type of avoidable value destruction.

Choosing the appropriate capital raise method

Another key decision for the board is the method to be used to raise equity capital and the treatment of the company’s shareholders. Does the company issue capital to existing shareholders on a pro rata basis or only to certain key investors? The answer to this, at least for public listed companies, will depend on a number of factors including: (i) the size of the capital raise; (ii) the shareholder approvals that a company already has in place; and (iii) the speed with which the equity capital needs to be raised. Undocumented deals such as accelerated bookbuild offerings (“ABOs”) require significantly shorter lead times than fully marketed offerings like rights offers.

Issuers looking to raise a smaller amount of capital relative to their market capitalisation can consider an ABO, whereas larger equity issuances can be implemented through a rights offer to existing shareholders. In certain instances, a combination of an ABO and issuance of a hybrid equity instrument such as a convertible bond could be considered if sufficient debt headroom exists.

The value of an experienced adviser

It is critical for a company’s board and executive management to seek the advice of an appropriately skilled and experienced corporate adviser early on in the process to assist in guiding them through some of the key judgement calls and decision points mentioned above and to provide ongoing support both during and after the completion of the capital raise. Boards and executive management teams often do not have sufficient time to adequately assess the requirement to raise equity, and because of their proximity to the business and their involvement in its operations, may come with a biased belief that the company can trade its way out of a difficult debt position.

By engaging independent and skilled advisers earlier on in the process ensures that a balanced view is brought to bear. The costs of such advisers is often off-set by the value preservation that is achieved through a well-managed capital raise process. Importantly, such advisers are often paid on a success fee basis, meaning that the company only incurs these costs if the capital raise is successfully concluded.  

When done right, an equity capital raise can position a company for growth and unlock value for all stakeholders. However, if not appropriately managed and/or there are unnecessary delays, capital raise efforts can result in significant value destruction and put a company’s board on a collision course with its shareholders and funders.

Mdluli is Equity Capital Markets Transactor, Corporate Finance at RMB