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Have recent market conditions changed attitudes to riskand capital structure? Over the course of the last fewmonths the world’s credit markets have experiencedsignificant problems. Problems that began in the US sub-

prime mortgage market and fed through to the broader market asparticipants began questioning how structured credit as a whole isanalysed and priced, culminating in a liquidity crunch with, for awhile, uncertainty over who the credible counterparties were. Thisdeterioration has manifested itself across the international financialsystem, including:

n losses at funds such as at Bear Stearns High-Grade StructuredCredit Strategies Enhanced Leveraged Funds, which led to theFunds filing for Chapter 15 protection in August 2007;

n the need for KfW, a German State owned bank, to rescue IKBwhich faced losses and a significant liquidity drain as a result oflosses in its Rhineland Funding Conduit which had invested in theUS sub-prime market;

n the dislocation of the short term bank market whereby Liborsettings exceeded the relevant fed funds or base rate by upwardsof 150 basis points;

n the first big run on a UK bank (Northern Rock) since the Victorianera and the need for the UK government to guarantee deposits atNorthern Rock after the liquidity crunch resulted in the bank beingunable to refinance upcoming maturities;

n the Fed’s “double” 50bps emergency rate cut on September 18th.

From a financing perspective, the credit deterioration has resulted ina re-pricing of risk and increased difficulty in accessing liquidity. Thisis particularly true for leveraged deals such as the banks failure toraise finance for Blackstone’s acquisition of PHH with GE, as well asthe failure of Freedom Communications to buy out private equity(PE) interests.

The early signs of recovery in the leveraged market in October-

November last year (e.g. the initial successful placement of $9.4bnof the total $15bn First Data financing) have proved to be somewhatshort lived and it now looks increasingly likely that PE houses willhave to live with tighter lending standards for some time to come.

At the same time, there is a considerable backlog of issuance inthe high grade market meaning that a large number of corporatesmay have to issue bonds in the first half of 2008 and thereby acceptthe new pricing environment.

Against this background of recent credit market turmoil and theresulting changed markets it is useful to understand how and whyfinancing and risk management techniques are evolving and highlightwhat might be some of the issues affecting corporate capitalstructures in 2008, including:

n Regulatory: The introduction of Basel II means that it may bebetter for banks to lend to high-grade corporates than it will toprivate equity houses. As a result, we may see a change in exitstrategies for private equity deals, where the exit becomes a tradesale to a high-grade corporate buyer rather than to anotherprivate equity/highly leveraged deal.

n IPOs: As an alternative to a trade sale, leverage deals may come tomarket via Initial Public Offerings (IPOs) as the preferred way ofgetting them off the private equity balance sheet. This raises thequestion of what should a balance sheet look like post-IPO to giveshareholders maximum return?

n Strategic risk management: In order to increase financialflexibility to achieve business objectives, acquisitions etc,treasurers and chief financial officers (CFOs) are increasinglylooking to use risk management in a strategic manner.

n Pensions deficits: So far equity markets have been nervous buthaven’t shown significant falls from the highs in mid-2007.Nevertheless, treasurers and CFOs need to be mindful of what

In the first of a short series ofarticles RBS’ Financing and RiskSolutions team reviews themes andtrends in financing and corporate

capital structure and suggests some considerations for treasurersand chief financial officers (CFOs) contemplating their effects onshareholder value.

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ANDREW WALKER, SANJEEVKUMAR AND SASHA RYAZANTSEVLOOK AT MAXIMISING SHAREHOLDERVALUE BY ACTIVELY MANAGING THECAPITAL STRUCTURE.

might happen to pension deficits in the event of significant equitymarket weakness, falling long-term interest rates, and anotherround of longevity adjustments.

THE EVOLUTION OF THE CAPITAL STRUCTURECorporate financing strategies continue to evolve, driven by therealisation that the financing strategy can create significantshareholder value, and that the view that debt is only a financing toolwith tax advantages is outdated.

Traditional funding structures have been based on a large amountof equity, with debt represented predominantly by bank debt and acomplementary mixture of public bonds or private placements fordiversification and maturity purposes.

As financial markets have matured some classes of debt haveassumed equity-like characteristics, and have increasingly been ableto underwrite what were once risks that needed to be underwrittenby equity.

As a result, a number of corporates have moved towards financingstructures that involve more granular tranching within the debt-equity spectrum and more transparent identification of key risks. Forexample:

n the use of subordinated debt/hybrid capital by well ratedcorporates e.g. Siemens, Henkel and less well rated or unratedcorporates e.g. TUI and Voestalpine;

n the issuance of index-linked and covered bonds (e.g. VeoliaEnvironnement);

n realignment of corporate risk layers (e.g. changing the pensionseniority by Pernod Ricard); and

n the tailoring of risk transfer so it more exactly meets thecorporate’s specific requirements rather than purely market norms(e.g. Tesco property sale & leaseback).

More recently corporates have begun to review whether even thistranched balance sheet represents the most efficient financingstructure, or whether further shareholder value gains might bederived from financing individual assets or individual businessesseparately – the ”Multiple Corporate Financing Approach” – driven bythe following types of consideration:

n Could the assets be ”sweated” more if they were financedseparately, even on a non-recourse basis, rather than on acombined basis in order to boost return on equity (RoE) orincrease debt capacity for (further) strategic moves?

n Would separate financing allow greater visibility to the market ofthe value of assets and hence encourage a re-rating of value by themarket?

n Could separate financing of certain assets or businesses also act asa “defence mechanism” against corporate raiders or activistshareholders by removing this avenue of re-structuring from theirarsenal?

This quest for increased financial flexibility now uses techniquesoriginally developed and used in particular sections of the financingworld including, such as, non-recourse project finance, infrastructurefinance, removing explicit market risks from property finance, andstrategic risk management to reduce cashflow uncertainties inleveraged situations.

MOTIVATIONS TO OPTIMISE THE CAPITAL STRUCTUREThere has been increased pressure from shareholders and boards ontreasurers and CFOs to determine whether their company’s capitalstructure has been optimised for a number of reasons including:

n they may become a bid target where PE firms or competitors reap“super-normal” rewards by optimising the balance sheet structure“after the event”;

n they may find their own ability to complete strategic corporateactions thwarted by competitors or PE firms who are using balancesheet structures more aggressively and are thus able to improvetheir bid prices; and

n the share price may not be maximised due to factors such as lowerRoE growth and an inaccurate perception of the value of certainassets/businesses (which could be corrected via financing).

There are increasing signs that the question of ”the amount of debt”is better understood, with corporates increasingly moving away fromthe AA/A type leverage profiles (e.g. Schneider Electric, HealthMedical Associates, and, to an extent, Nestle).

More aggressive corporates are already moving further in thisdirection to review the gains that cannot only be made fromtranching within the capital structure (e.g. hybrid debt) but also byusing the Multiple Corporate Financing Approach. Importantly, this ishappening across a range of sectors.

The Multiple Corporate Financing Approach is being consideredand used by companies with assets such as property, vehicles, andintangible assets too.

Those companies that either avoid the capital structure questionaltogether or that limit the discussion to the amount of debt, mayfind themselves under increasing pressure from shareholders,corporate raiders or private equity interests. They may also find thatthey fall behind their competitors and the wider market in terms ofdelivering increases in shareholder value.

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capital markets MAXIMISING SHAREHOLDER VALUE

IMPROVING RETURNS ON EQUITY RoE can be improved by increasing operating margins, asset turnover,or leverage according to the DuPont equation. RoE has been a keychief executive officer (CEO) focus over the last five years. Arguably,the improvement in RoE that we have so far witnessed has beenprimarily driven by the first two parts of the equation as highlightedby the 22 consecutive quarters of margin expansion in the US(achieved on the back of an extraordinary period of cost control) andthe low capex/GDP ratios in US and Europe over the last few years.

Leverage has increased but it still remains the case that mostcorporates are over-capitalised – as evidenced by default rates stillbeing close to all-time lows.

A number of companies have already begun to realise the RoEgains that can be derived from reduced asset investment or assetdivestment and cost control.

Intercontinental Hotels Group, for instance, is potentially movinginto the final straight on asset efficiency, with its announcement in2003 about selling hotels and focusing on managing and franchisingversus owning – an asset-light strategy which has been executed instages with proceeds returned to shareholders.

A further example is United Utilities disposing of electricitydistribution assets to North West Electricity but retaining anoperating contract.

Corporates are looking at using leverage to continue the RoEimprovement and also investigating whether alternative financingstructures can further boost RoE. It is via this holistic view of howfinancing affects RoE that the Multiple Corporate Financing Approachmay be able to provide benefits beyond traditional approaches. Forinstance:

n the multiple approach increases the scrutiny and visibility onreturns for each business thereby potentially improvinginvestment decisions and hence RoE. Many companies, such asSiemens, look at performance metrics such as Weighted AverageCost of Capital (WACC) or Economic Value Added (EVA) perbusiness. However, often the individual business WACC is

calculated by adjusting the group-wide WACC by a risk factorassociated with the business. The Multiple Corporate FinancingApproach should provide a clearer ability to calculate thesemetrics on a business by business basis, thereby leading toimproved investment decisions and RoE. In fact, it is often becausethere are businesses that are less visible or where a group-wideapproach misses the intrinsic value, that frequently privateequity/corporate raiders are able to extract value (a MultipleCorporate Financing Approach should alleviate this problem);

n In certain circumstances, the Multiple Corporate FinancingApproach can enable the investment to stay “off-balance sheet”hence further boosting RoE;

n Rating agencies do not always follow the accounting treatmentand may bring the assets financed on this basis on to the balancesheet;

n The approach can also potentially increase debt capacity and/orreduce cost of debt.

There are other emerging corporate financing strategies thatcorporate issuers have developed to achieve their strategic objectivesin the new market environment. These strategies include methods to:

n Benefit from asset price correction and explore partnershipswith PE: Many corporates want to acquire assets now and exploitthe difficulty facing PE to enter deals on the favourable terms thatmarkets were providing before the market turmoil. In addition, insome situations, corporates want to acquire assets in partnershipwith PE for a variety of reasons including (a) they don’t want tobuy the whole asset but don’t want to sell non-core assets to theirstrategic competition, and (b) the corporate has finite debtcapacity and doesn’t want to or cannot issue equity. As a result,corporates are also developing financing strategies that allow PEto enter deals and achieve the required internal rate of returns byusing the corporate’s involvement to either reduce cost of fundingfor PE or to facilitate the finance-ability of the overall structure byusing the corporate’s own liquidity.

n Access alternative sources of liquidity: There are still investors,notably quasi-government entities in the Middle East and Asia,which do not have liquidity constraints and see current markets asan opportunity to acquire international assets. Corporates shouldconsider the potential for this liquidity to create momentum intheir share price by encouraging these investors to take strategicstakes in their company (e.g. the Temasek and China DevelopmentBank investment in Barclays), or by tapping this liquidity andinvestment appetite in order to act on strategic moves (e.g.Nasdaq/ Borse Dubai and OMX).

n Minimise dependence on the market provision of liquidity byaltering their maturity profile: Corporates have always tried tofind the optimal maturity profile that would provide the rightbalance between risk, cost and flexibility. Given the reasonablylong period of benign credit environment over the last few years,some corporates (and financial institutions!) have developed amismatch between their assets and short-term liabilities. This washighlighted by the over-reliance by some on commercial paper(CP) and other short-term sources which provide the lowest costin exchange for the highest refinancing risk. When the CP marketexperienced difficulties corporates active in this market had toreview their strategy and term out to longer maturities (e.g.Safeway Inc’s $500m bond issue to term out CP on last year).

n Improve overall balance sheet efficiency: Although the threat ofbeing taken over by PE may have receded, many corporates stillfeel that sub-optimal capital structures will be targeted by

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shareholder activists such as Knight Vinke, or by other sponsorssuch as the previously mentioned Middle East and Asian wealthfunds. As a result, a number of companies announced significantshare buyback programmes in Q3 last year, though notably, thesewere mainly overcapitalised and cash-rich corporations. Others,whose balance sheets are not as inefficient, now seem to beadopting a “wait and see” approach to understand how the marketdownturn will develop and what liquidity position (and, perhaps,acquisition opportunities) they will have going forward beforecommitting further funds to share buybacks.

CONSIDERATIONS WHEN OPTIMISING THE CAPITALSTRUCTUREThere are a number of issues for treasurers and CFOs involved indetermining the optimal capital structure. These will have to betailored to the specific situation, and aligned to the strategicobjectives of the corporate and market conditions at the time. Herewe take a look at some of the key ones:

n Credit/ratings. It is important to ensure that ratings are optimisedbefore deciding to go ahead with a transaction. For example, therehave been inconsistencies in the way rating agencies have treatedsubsidiary investment and debt. Typically, the rating impact woulddepend on the value of the subsidiary in the context of the group,its strategic importance, name relationship and the likelihood thatthe corporate would support the subsidiary in the event of default.Should the corporate guarantee some of the debt of thesubsidiary/associate, this debt could be fully/partly consolidatedfor rating agency purposes. Is a formal rating advantageous orwould it be better to be un-rated?

n Accounting impact. The choice of financing structure cansignificantly alter the balance sheet impact for the corporate. Thespecific situations (and jurisdictions) will drive the structure thatproduces the most advantageous accounting treatment.

n Impact on other stakeholders. Interaction between corporateand financial sponsor. The corporate will have to understand itsown and the sponsor’s exit strategy for the asset and may enterinto call and put arrangements to allow for that. This would haveimplications for both accounting and ratings but also maypotentially create conflicts of interest between the partners.

n Shareholder activists. Whilst the markets may be more difficultnow and may force corporates to delay shareholder-friendlyactions they will have to balance this against potential pressurefrom shareholders.

n Treatment of existing debt holders. The consequence of leverageexisting closer to an operating company/asset is that it may leadto subordination of existing debt holders. If this is not handledappropriately, it may jeopardise the distribution process/liquidityof the debt of the new business/asset, as well as negativelyimpacting future debt issuance when the old “now subordinateddebt” is due to be replaced. Similarly, equal attention will need tobe given if covenants such as negative pledges are in thedocumentation.

n Pension funds. The effect of securing debt against some assets isin effect to make the defined benefit pension scheme now have alayer of claim above it. This may therefore require some degree ofquid pro quo with the pension trustees and/or the regulators.

WHAT DOES THIS MEAN FOR TREASURERS AND CFOS?The corporate finance world has become much more pro-active withcorporates regularly leveraging, acquiring, disposing, and re-

engineering their balance sheet in efforts to maximise shareholdervalue. The range of financing structures available is increasingly wideand sophisticated. Consideration of how some of these financingtechniques can be combined has sometimes lagged behind the waysin which the more aggressive users have adopted and are developingthe ideas.

PE and shareholder activists are an established reality and fewcorporates are immune from takeover. Accordingly, treasurers andCFOs should follow carefully not only what their competitors acrossthe globe are doing but how. In particular, they should be looking atthe sort of deals that their competitors are doing and the financingtechniques and risk management tools that they are using which aremaking them, or have the potential to make them, more of acompetitive threat.

Treasurers and CFOs need to ensure that they fully understand theoptions available to them to improve shareholder value through thecapital structure e.g. for strategic acquisitions or in the case of anunsought for approaches. Banks have particular expertise in thefinancing and risk management areas which can and should play avaluable part in the overall strategic corporate financing approach.Those banks that can combine their particular expertise in thefinancing and risk management spaces as an integrated whole canhelp the treasurer or CFO make sense of the options available todeliver that shareholder value. While it is understandable thatcorporates are often reluctant to discuss such questions neverthelessthey do need to be addressed, and more importantly the treasurerand CFO can make a significant contribution to determining theanswers by having sound advice and a coherent view on how thesefinancing structures may fit into their overall financing strategy.

We will have to wait to see the actual developments in 2008 but,while the market conditions may change, the fundamental questionsthat treasurers and CFOs should be discussing with their banks willremain the same.

Andrew Walker, Sanjeev Kumar, and Sasha Ryazantsev are inthe Financing & Risk Solutions team in Sector CorporateFinance, RBS Global Banking & Markets.

Andrew.Walker@rbs.comSanjeev.Kumar@rbs.comSasha.Ryazantsev@rbs.comwww.rbs.com/gbm

WHILST THE MARKET CONDITIONSMAY CHANGE THE FUNDAMENTALQUESTIONS THAT TREASURERS ANDCFOS SHOULD BE DISCUSSING WITHTHEIR BANKS WILL REMAIN THESAME.