Monday, March 29, 2010

Non-Leveraged Accretive Mezzanine Financing

I was looking over my CFA Level II materials for corporate finance this weekend when I looked at the CFA's definition of different types of risk. For instance:

Sales (Business / Industry risk)
- Operating Expenses (Operating Leverage)
- Interest Expense (Financial Leverage)
Cash flow

The definition of any type of leverage (operational or financial) is increasing your fixed cost component but reducing your variable component.

It got me thinking, is it possible to have an instrument which doesn't increase leverage and solvency ratios, but also provides accretion for common equity holders? For instance, if you want to deleverage, the general strategy is to purchase debt with equity (which results in dilution because cost of equity is higher than cost of debt due to risk concerns etc). I don't know if this is possible, but I asked myself about a preferred share with very particular characteristics.

Fixed income instruments (coupon paying bonds, dividend paying preferred shares) increase the fixed payments required which technically increase leverage.

Is it possible to have a preferred share that, rather than paying a fixed predetermined dividend (similar to dividend yield based on price), that pays a percentage of net income (similar to a stated dividend payout ratio). Because it is more senior than common equity, the cost of this capital would be less than the cost of equity (accretive if used in a refinancing / capital restructuring).

No Leverage
But the payout would also be variable based on NI meaning that it isn't technically leverage according to the CFA definition (plus it would be classed as equity rather than debt on the books). If earnings are low, the payout is low. If the earnings are high, payout is high. It rises and falls as a variable component rather than a stated fixed component.

The problem with this model of an instrument is that I don't think you could get a "senior" level instrument to payout variable to net income with a cost of capital less than common equity because they technically face the same level of risk (percent of NI).

Also, because earnings can be manipulated, perhaps the payout would work if it was stated as a percentage of EBT or some other higher quality form of earnings? At first I thought EBITDA, but then I realized that doesn't make sense. It would have to be paidout after EBIT (because interest should be a more senior form of financing and paid first). However, EBT is often modeled with a fixed tax rate to go to NI (so a % of EBT is really a % of NI since tax rate is usually constant).

Perhaps it could be payed out as a % of EBITDA which is paid out after interest?

This would justify the instrument being more senior and paying a lower cost of capital.


Jeff "meatball" Yang said...

Hi, I'm also studying for the CFA Level II in June. I thought this was an interesting post.

Because EBITDA is essentially sales - operating costs +/- current account adjustments, I was thinking of practical ways to get financing from those components. Do you think selling your receivables (assuming they are substantial enough) would qualify as a form of non-leveraged financing? What if this transaction were securitized? Actually, I think I've heard of this happening in the credit-card industry.

What do you think? It's the only thing I could think of that wouldn't be more senior to debt and taxes (since you can't just outright give cash flows to someone else before your debtors and the govt), yet would still be based on variable components.

Joshua Wong said...

Huh. Clever. I had never really thought about that (from a non-leveraged point of view). I've obviously heard of credit sales before, but didn't realize the effect with respect to leverage. Based on the CFA definition, I think that might actually work.

But ever since Enron, I think people seem to be a little more cautious about financing through sales. Selling receivables is one thing... "Selling" assets though an SPE is another (when really it's collateral for a financing deal).