Every company (public or privately held) funds itself with capital obtained through equity and debt. While equity refers to common stock and preferred stock, debt includes long-term borrowing via commercial papers, bonds, debentures, etc. The equation of the company’s capital formation (including equity and debt) is called the capital structure.
Suppose a privately held company has total capital of $3 million. It has $2 million coming from equity and $1 million coming from debt. Its capital structure calculates to 67 percent equity and 33 percent debt.
The term “recapitalization” is well-known and frequently discussed. Companies choose recapitalization as it offers many benefits. Let’s start by understanding what recapitalization is.
Recapitalization helps companies stabilize their capital structure by restructuring their capital (debt and equity ratio). The company restructures the ratio of different forms of capital, such as equity shares, preferred shares, bonds, debentures, etc., depending on its unique requirements. The process includes issuing one form of capital to buy back another form or adding additional capital.
For example, a company can issue debentures to exchange preferred shares to benefit from a favorable interest rate.
Dell, a publicly-traded company since 1988, went private in 2013 because its founder, Michael Dell, wanted to focus on long-term goals and get more control over strategic decisions. Dell partnered with private equity firm Silver Lake Partners to complete the privatization deal valued at around $25 billion.
Benefits of Recapitalization
Reduce tax obligations. As companies get tax deductions for paying interest on debt, a business looking to lower taxes can opt to increase debt in its capital structure. The cost of equity is higher than the interest cost of an all-equity business; however, a company confident of paying interest regularly even without earning enough profit should go for this recapitalization option.
Reduce interest burden. When a company does not want to incur losses paying interest, it may opt for equity recapitalization. The company can reduce its interest burden by exchanging equity for debt. By increasing equity capital, the company can retain its profits and not share them with stockholders as dividend payouts. The company may reinvest its profits to grow.
Boost public sector units. Sometimes the government takes the nationalization route and increases its stake to prevent companies from going bankrupt. It infuses capital into sick PSUs to boost them. For example, the government recapitalizes banks having a high level of non-performing assets and helps them increase their lending activity.
Refinance. When interest rates are favorable, companies recall old debt with high-interest rates and replace them with new, low-interest debt. Such refinancing helps them lower the cost of debt.
Prevent a hostile takeover. A company may use different defense mechanisms to prevent a takeover, leading to recapitalization. The company may buy back its stock from the market so that the acquiring company cannot get it. Or it could buy shares from minority holders and distribute them among friendly stakeholders. The company could issue rights shares at a discount and increase the number of shares available in the market to make acquiring a majority share difficult for the acquiring company. It may also issue debt in exchange for stock. All kinds of defense mechanisms lead to a restructuring of capital.
Avoid bankruptcy. Companies take extreme measures to avoid bankruptcy, such as merging with other companies, pledging the equity to raise debt, etc. All such measures lead to recapitalization.
Raise capital for growth. Capital constraints halt the growth of companies. The company may want to increase its market share by entering new markets. Businesses resort to infusing more capital when the cash flow cannot support functions like hiring additional staff or increasing production capacity. They could approach angel investors or private equity firms to raise funds via equity or debt or bring in new strategic partners to advise on new routes and better management practices. Such changes within the organization lead to recapitalization.
Stabilize share price. When the share prices of a company fall, it can use recapitalization to reduce the number of outstanding equity shares in the market and stabilize share prices.
Facilitate the exit of venture capitalists. Venture capitalists may want to exit a company to pursue other growth opportunities or reduce their burden. This leads to restructuring the company’s capital. New stakeholders then enter the company, or the shares of existing stakeholders increase. Sometimes, the company exchanges debt for equity to allow the venture capitalists to exit. All such scenarios lead to recapitalization.
Divestiture. Divestiture is the opposite of nationalization. Here the government aims to benefit PSUs by privatizing them. It withdraws its stake from companies and sells them to private parties. This form of recapitalization helps the government reduce expenditure.
Control desire. High debt in the capital structure restricts companies by requiring them to pay interest regularly. It does not allow business owners to make risky growth decisions or chase high-risk growth opportunities. Therefore, companies resort to recapitalization and reducing debt to increase their decision-making control in the business.
Reduce administrative costs. A publicly listed company bears costs concerning disclosures and regulatory requirements. When such costs become unbearable, a company may take the privatization route to reduce them. It ultimately leads to recapitalization.
Management buyout/leveraged buyout. A management buyout occurs when executives or managers of a company purchase controlling shares (assets and operations) in the company. It requires substantial financing via both equity and debt and leads to changes in capital structure. Similarly, a leveraged buyout occurs when a company acquires another company and raises debt (loans or bonds) to pay for the acquisition. This process changes the capital structure of the acquired company, leading to recapitalization.
The exit of the business owner(s). Business owners planning their exit can improve their company’s position for long-term success via recapitalization. They may pursue multiple recapitalization strategies at once for different partners. Seek guidance from professional advisors to identify the correct type of transaction and determine the feasibility of recapitalization.
Utilize Recapitalization to Your Benefit
Proactive and decisive recapitalization decisions may stabilize your company in the short term and gear up your business for long-term shifts in customer expectations, technology, trading arrangements, supply chain, regulations, etc. Recapitalization helps companies grab high-risk growth opportunities and scale.
Focus on financial restructuring, liquidity and cash, cost competitiveness, and stakeholder management (including financial stakeholders, customers, suppliers, and employees) to navigate complex challenges in business.
Seek guidance from professional advisors to utilize recapitalization to your benefit. Get in touch to see how Value Scout can help you.