Introduction to Funding
In the previous section, we have considered several tools to optimize working capital and improve cash management through cash pooling structures.
If corporates require funds for the long-term for large projects or investments, treasurers might need to explore various sources of funding from debt or equity markets, and decide on an optimal capital structure decision for the company.
In this article, we will explore the different types of funding tools available for treasurers and CFOs.
It is important for the treasurer to understand the different possible sources of funding and help the company diversify funding sources to optimize the company’s cost of capital. Thus, treasurers often need to maintain and improve relations with a wide spectrum of market participants.
Funding #1: Credit Facilities
A credit facility is an arrangement between the company and bank to allow the company to borrow a specified amount of money for a period of time.
The benefit of having some credit facilities is that the company can tap on the credit facility, and is not required to reapply for a new loan each time it needs funding.
There are different types of credit facilities like revolving credit, term loans, secured loans, unsecured loans, etc.
Companies should maintain some funding facilities from relationship banks to provide some comfort for funding needs, should a liquidity crisis arises.
Funding #2: Project Financing
Companies involved in large, complex and expensive industrial projects like building of infrastructure will require project financing to fund these projects.
In a typical project financing structure, companies will create a special purpose vehicle (SPV) to solely manage the project operations.
Financing of the infrastructure projects will be based on the projected cash flows of the project, rather than the balance sheet of sponsors, and are secured by assets of the project.
(In project financing, sponsors are basically investors who are willing to provide funding for the project, and secured by assets of the project.)
Project Financing is a form of off balance sheet funding.
All costs, revenue streams, project assets and liabilities will be attributed to the SPV, which will remain off balance sheet for the sponsors.
This helps to shield other assets owned by the project sponsor in the event of failure of project, and reduces the impact of the project on the shareholders’ debt capacity and cost of debt.
We have to be careful that while project debt is kept off balance sheet, it should not be construed as a reduction of the shareholders’ actual debt liabilities, as it merely masks the level of overall debt of the shareholders.
During the construction phase, there is usually no revenue streams, so relevant parties will take significant risk. Debt servicing will only be possible when the project is in operations phase.
Project Financing is typically limited or non-Recourse Funding for Lenders.
In the event that the SPV defaults, i.e. the SPV or project fails to make the required loan repayments to lenders, the lenders’ recourse typically is limited to the project assets, and not the shareholders’ assets.
Lenders might however have some recourse, if there is a deliberate breach on the part of the shareholders.
It will be necessary to consult applicable laws and seek legal advice to determine the amount of recourse available to lenders, should there be a default by the project company.
Funding #3: Capital Markets
Once a decision has been made to raise capital, companies can either turn to debt or equity capital markets for long-term funding.
They will need to decide on the optimal capital structure (debt-equity mix) and consider the cost of funding in deciding whether debt or equity is optimal.
Debt Capital Markets
The more common options for debt capital markets are:
a) Syndicated loan is a loan offered by a group of lenders that work together to provide funds for a single borrower. Companies typically rely on syndicated loans for projects that are too large for a single lender to handle. Syndicated loans help to spread the project risk among different lenders like banks, institutional investors and hedge funds. For a syndicated loan, there will a lead bank or underwriter, which will normally offer a bigger share of the total loan. Syndicated loans can either be underwritten, i.e. amount of capital raised is guaranteed, or done on a best efforts basis, i.e. if not enough investors can be found, the amount the borrower gets will be less than what is originally planned.
b) Bonds are fixed income securities that can be issued by companies to raise cash for a fixed period of time at a variable or fixed interest rate. Bonds are marketable securities that can be sold by one bondholder to another at the prevailing market rate that depends on the credit-worthiness of the lender and the prevailing interest rate.
c) Medium term notes (MTN) is a debt note offered by a company that usually matures in five to ten years on a fixed or floating rate.
d) Structured debt refers to complex debt instruments created from financial engineering to provide customized financing solutions for companies. Examples of structured debt are asset-based securities (ABS), i.e. financing that is backed by a pool of underlying assets, and collateralised debt obligations (CDOs). Structured debt has potential to decrease risk, increase liquidity but charges higher fees due to its complexity.
e) Mezzanine debt refers to debt that is subordinated to another debt issue (senior debt) by the same issuer. In other words, mezzanine is below senior debt, but above equity in the capital structure pecking order, i.e. in the event of a bankruptcy, senior debt holders are paid before mezzanine debt holders. Therefore, mezzanine debt has higher risk and is more expensive than senior debt. Mezzanine debt structures are most common in leveraged buyouts by private equity firms.
Equity Capital Markets
The company can consider either public or private issuances, if it decides to issue equity to raise funds.
a) Going public through Initial Public Offering (IPO). If the company decides to go public, it could do an initial public offering with the assistance of an investment bank acting in the capacity of an underwriter for the IPO. The role of the underwriter is to determine the offering price of the securities, buy the shares from the issuer and subsequently sell them to its distribution network which could include mutual funds, insurance companies, etc.
The direct cost of issuing equity for the company is the underwriting fees paid to investment bankers, lawyers, etc. The indirect cost, which often is more significant than the direct cost, is the cost of under-pricing of an IPO, due to information asymmetry between management and potential equity investors.
b) Issuing rights to existing shareholders. Companies in need of cash may also issue rights to existing shareholders to raise money. A rights offering entitles the shareholders to buy additional shares at a discount directly from the company in proportion to their existing holdings within a fixed time period. For the company, a rights offering enables the company to bypass underwriting fees, but it can also send a negative signal to the market that the company is struggling. Existing shareholders may be unhappy with the rights offering, as it implies that their existing shares will be diluted. The CFO will need to weigh various factors, and consider prevailing market conditions to decide whether doing a rights issuance is the best option for raising cash.
c) Raise capital through private placements. If companies do not want to go public, another option is to consider private placements, i.e. selling shares to a small number of selected investors to raise capital. Investors who would be interested in private placements are usually large banks, mutual funds, pension funds, etc. Private placements are usually faster than going public, and they usually involve awarding a significant amount of ownership in the company to a private placement investor.
Considerations between Debt and Equity Funding
The corporate treasurer should weigh the cost between raising funds through debt or equity.
Based on corporate finance theory, the cost of debt is cheaper than cost of equity, and the company can enjoy tax shield benefits from the interest deductions of debt, as compared to equity issuances.
However, taking excessive leverage can increase the bankruptcy risk of the company, and hamper the company’s ability to raise even more funds in the future.
Another consideration for the CFO or treasurer is that of regulations that may place limits on the debt-equity structure of the company.
The CFO and treasurer will therefore need to weigh many different factors and find a balance to find an optimal capital structure mix for the company.
Hope this short summary has provided a clear overview of the different options for funding for a CFO or corporate treasurer, and the various considerations in choosing one over another.
Next, let us consider the tricky issue of how treasurers should mange banking relationships with different banking partners.