This issue’s question
“How can treasury best define the company’s optimal capital structure and what steps can it take to achieve this?”
Suzanne Perry, Assistant Group Treasurer, RELX Group:
Treasury teams operate for the long-term, balancing risk and reward, and thus are ideally placed to define the company’s optimal capital structure. It is vital that the capital structure is tailored to a company’s profile and specific objectives and is resilient enough to operate both in current market conditions and under stress. Having said this, resilience cannot come at any cost and treasury needs to ensure that the company is run efficiently with a mix of short and long-term debt as well as more expensive equity financing.
At RELX Group the capital structure is managed to support our objective of maximising long-term shareholder value through appropriate security of funding, ready access to debt and capital markets, cost-effective borrowing and flexibility to fund business and acquisition opportunities while maintaining appropriate leverage to ensure an efficient capital structure. RELX Group has a diversified and relatively low risk business model and seeks to maintain credit rating agency metrics that are consistent with a solid investment grade credit rating (RELX Group’s current ratings are BBB+/Baa1/BBB+ with S&P, Moody’s and Fitch respectively). RELX Group targets cash flow conversion of over 90% and over the longer-term this cash is used with an eye to balancing dividend policy, selective acquisitions and share repurchases, and retaining balance sheet strength so as to maintain access to cost-effective sources of borrowing.
RELX Group customers appreciate the low level of financial risk associated with the company. RELX Group is a global provider of information and analytics for professional and business customers across industries. Customers include governments, universities and other institutions seeking long-term strategic partnerships. A solid investment grade credit rating is consistent with the message that RELX Group is a company that will be around for the duration.
In recent years RELX Group has spent less on acquisitions and focussed on organic growth. In order to maintain an efficient capital structure and prevent an increase in WACC, RELX Group has undertaken share buy-back programmes to maintain leverage in a range consistent with a BBB+/Baa1 rating. Treasury maintains RELX Group’s cash flow forecasts and related leverage metrics and hence can advise the board as to how share buy backs fit into the company’s overall credit rating profile. RELX Group operates several commercial paper programmes to ensure short-term liquidity and to avoid inefficient balance sheet grossing as the significant amounts of cash collected in the final quarter of each calendar year can be used to pay down commercial paper rather than sit as cash on the balance sheet at year end.
RELX Group Treasury continues to monitor the requirements of the rating agencies, the liquidity and cost of debt capital markets and takes instruction from the board on risk appetite. Any significant change in any of these elements would necessitate a review of the capital structure to ensure it is still fit for purpose.
Shoaib Yaqub, Head of Financing Solutions & Advisory, Standard Chartered:
Treasurers today are operating in a very dynamic environment, where ongoing challenges and complexities make it difficult to predict the future and streamline their organisations. External influences from macro-economic impacts to innovative trends in new technology and new competitors, mean treasurers need to equip their organisations to be agile and responsive to seize opportunities but also stay resilient and efficient in the face of change and potential shocks.
This balance requires careful, detailed and regular review of the capital requirements and financial policies.
Determining the likely funding needs based on business outlook will be the main driver of this review and is clearly a complex task. This analysis should include detailed, informed assumptions around revenues, changes in working capital, acquisitions and disposals, dividend policy, cost of debt, and new debt issuance, amongst others. Through understanding of key aspects of the business, like liquidity, projected return on investment in R&D and geographical or product expansion, and the potential impact of the economic, societal and regulatory environment in which it operates, a treasurer can ascertain critical future needs.
For instance, liquidity headroom for a corporate looking to increase its R&D investment over the next few years will be very different to those of a mature corporate looking to maintain strong shareholder returns.
The next step is around making your balance sheet shock proof and getting the right mix of debt and equity. Treasurers need to dissect various components of the capital structure and reassess whether the corporate’s financial policies are still fit for purpose. Is the current rating (or financial leverage) appropriate for the business and its outlook? Are the committed facilities enough to cover upcoming requirements or are they unnecessarily high?
One aspect that normally gets ignored in this analysis is country risk, which is an important consideration for global corporates given exposure to any volatile geographies.
Combining this information with the original understanding of the business profile will help outline a truly optimal capital structure. In many cases, this exercise may highlight actionable insights on how to achieve this; such as aligning with medium and long-term targets and considering appropriate liquidity buffers, whilst also incorporating issues that are specific to the business, such as forthcoming acquisitions.
Finally, it never hurts to do a competitor analysis. Many corporates like to benchmark against their direct competitors but, in some cases, it is useful to compare more broadly. Best practice for one organisation may not be appropriate for another. So, it’s important to consider the variables of each organisation in terms of capital structure, end market exposure and shareholder objectives.
The results of any exercise to evaluate capital structure should be regularly reviewed. Treasurers should also incorporate stress testing and scenario planning in the process, as this exercise can help identify, and sometimes even quantify, black swan events.
With access to the right data, analytics and knowledge, treasurers can formulate a capital structure that will help deliver the business’ strategy, increase resilience in the face of unknown challenges and equip the business to position itself for the opportunities ahead.
Giles Newell, Head of Advisory for GTS EMEA, Bank of America Merrill Lynch:
Whilst an optimal capital structure is synonymous with Weighted Average Cost of Capital (WACC) theory; in practice, treasury functions focus very much on the debt side of the equation. As a result, it is useful to consider treasury’s role and some of the practical steps it can undertake to optimise debt levels.
Corporates tend to seek a level of debt which is commensurate with their scale, industry sector and risk appetite. This should also reflect a desire to retain a debt buffer to cater for unexpected events such as M&A activity, cyclical results or a downturn in trading.
Since banks and rating agencies have similar methodologies in assessing corporate risk whether a corporate is rated or not, treasury functions may wish to consider focussing on the following three risk elements:
Business risk – analysis of the stability and predictability of a business (country and industry risk as well as competitive position within industry).
Financial risk – assessment of the capacity of a company to meet its financial obligations (cash flow and leverage).
Operational risk – being the specific strategic objectives and policies a company adopts. This includes factors such as approach to risk management, corporate actions, target debt levels and dividend policy.
Whilst business risk can often only be influenced over the medium to long-term, a company has a far greater ability to directly manage its financial and operating risk.
Treasury plays a significant role in managing a company’s financial risk by diversifying sources of debt, repaying or extending debt maturities, holding appropriate levels of committed backup liquidity, and efficiently managing working capital. Similarly, in relation to operational risk, treasury will advise on an appropriate risk management approach and dividend policy, which is documented within the company’s treasury policies.
Some further practical points that treasury may consider include:
Establishing a supportive banking group who will provide credit through the business cycle. This takes active management by considering the core banks strengths and weaknesses, total level of ancillary fees and how these are allocated.
Provision of company data including forecasts. It is important that these forecasts are credible over time – so treasury may have to apply haircuts to over optimistic corporate finance forecasts. Banks and rating agencies have long memories and consistently demonstrating an ability to meet forecasts will enhance a relationship of trust.
Regular meetings with banks and rating agencies. This allows the CFO/Group Treasurer/Investor Relations the opportunity to provide context and explanations to financial results and forecasts. Rating agencies should be invited to any debt or equity analysts’ presentations.
A formal annual review of treasury policies, signed off by the board. In doing so the company’s risk management approach is front of mind to the board. Regular reporting of adherence further supports this activity.
Monitoring credit metrics and estimating debt capacity, by working alongside corporate finance. Treasury can add value into any M&A funding decisions and use the output to further develop banking group relationships.
The aforementioned points demonstrate the multi-faceted nature of bank relationships and ratings agencies. Financial ratios are one facet, but equally perception and communication are critical. Where permitted, sharing confidential forecasts and board objectives on financial and operating risk appetite will further these relationships. Treasury resource is required to support this high level financial discipline as a loss of confidence takes a long time to repair.
“The latest AFP Fraud Payment Survey found that 80% of companies had at least one instance of payment fraud occur in 2017. What can treasury do to stop this?”
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