In recent times, especially as we enter the 21st century, the term “recapitalization” has gained extreme popularity. In this article, we will attempt to understand recapitalization. However, it is important to first understand the term “capital structure” to understand recapitalization.
Understanding the Capital Structure
It is common knowledge that a majority of the public or privately held companies in the world are funded by capital provided through equity and debt. Equity includes common stock and preferred stock, whereas debt includes long-term borrowing through bonds, debentures, commercial papers, etc. This whole equation of capital formation is termed the capital structure of the company. For example, if a company has a capital of USD 200,000.00, out of which USD 150,000.00 is funded through the common stock and USD 50,000.00 is funded through long-term money market bonds, then the company’s capital structure is 75% equity & 25% debt.
- Understanding the Capital Structure
- Recapitalization – Meaning
- Types of Recapitalization
- Reasons for Recapitalization
Recapitalization – Meaning
In simple terms, recapitalization means changing the capital structure of a company, i.e., changing the ratio of equity and debt mix in the total capital. This is fundamentally done by exchanging one type of capital for another or introducing new capital. For example, a company may replace the common stock in exchange for preferred stock. It is nothing different but a type of corporate restructuring.
There are mainly four types of recapitalization as follows:
Types of Recapitalization
In a leveraged recapitalization, a company replaces part of its equity with debt. So the deal may look like this – XYZ Ltd. offers two units of debenture against one common stock. This will change the company’s capital structure, i.e., now the percentage of the debt will increase whereas the percentage of equity will reduce. Companies resort to leverage recapitalization when their share price is declining. It is a method of controlling the fall in share price by reducing the number of outstanding shares in the market. Market views leveraged recapitalization in a negative light. Therefore, it is not good for the reputation of the company.
A leveraged buyout is a term used for the acquisition of a company or a part of another company financed with a substantial portion of borrowed funds. Acquiring company uses assets of the target company are mortgaged to borrow funds used to acquire the target company. Recapitalization is not the main motive but an outcome of a leveraged buyout. In other words, the acquiring company does not necessarily have an intention to change the capital structure of the acquired company. However, due to such substantial borrowings, the debt obligation of the acquired company increases, and the capital structure automatically changes, thus giving birth to recapitalization.
Equity recapitalization is one of the most common forms of recapitalization. In this, the company raises new funds by issuing a part of the authorized common stock. This new fund is used to buy back the company’s debt instruments. Reducing debt and increasing equity in the capital structure of the company is a positive sign. This is because the holder of the debt instrument has to be paid regular interests, which, in turn, reduces the company’s profitability. Lower debt improves cash flows, and higher equity means less mandatory obligations and less liability.
Nationalization/ Capital Infusion
Nationalization/capital infusion is usually done when a big conglomerate affecting a nation’s economy is facing bankruptcy. In this method, the government infuses capital into private companies by buying a substantial chunk of the company’s equity. The classic example of nationalization is the TARP program introduced by the government of the United States to float the country’s banks in the troubled time of the depression of 2008. Again this method is not done with the purpose of changing the capital structure. Recapitalization is a result of nationalization.
Sometimes the government also uses nationalization as a tool to acquire highly profitable companies.
This takes us to our next question, why recapitalize at all? Why change the capital structure of the company? The reasons can be many, some of which are as follows:
Reasons for Recapitalization
Reduce Debt Obligation
When companies take debt, it becomes quite a burdensome liability most of the time. Debt obligation comes with stringent and regular repayment schedules that a company must adhere to. Failure to comply leads to a lower credit rating. Maintaining debt is a balancing act, and if given a chance, the companies want to get rid of the debt. Recapitalization is a straightforward method to achieve this.
Stabilize Share Price
As mentioned in the previous part of this article, sometimes companies recapitalize to stabilize their share prices. Especially when its share price is falling, the company reduces its number of outstanding equity shares in the market through recapitalization.
As a Tool to Avoid Bankruptcy
When they are on the brink of bankruptcy, they take extreme measures to avoid it. These companies may consider merging with other companies or may even ask for help from the government. In the process, they have to pledge their equity or raise additional debt. This inevitably results in the recapitalization.
To Raise Capital For Growth
Many times fast-growing companies can face capital constraints. Despite a healthy positive cash flow, they may not have money for functions such as increasing production capacity or hiring additional sales staff, etc. In such cases, a capital infusion is a great option. These companies might go to a venture capitalist or an angel investor to raise funds through equity or debt and, in turn, recapitalize the capital structure.
Interest Reduction and Tax Planning
There are instances when some company has very old outstanding debt instrument floating in the market that pays a much higher interest rate than the current interest rate. In such a scenario, the company may consider replacing its high-interest debt instrument with a lower one or maybe even with equity. For example, many companies issue callable bonds that they can call back if the interest rates become unfavorable.
Also, sometimes a company may want to introduce new debt to reduce its taxes. Though this can’t be the only reason to recapitalize, however, this is a pretty good side benefit of it.
Management Buyout/ Leveraged Buyout
Management buyouts (MBO) are one of the formidable reasons due to why recapitalizations occur. The financing required for an MBO is quite substantial, both debt & equity. This inevitably results in changes in the capital structure. For example, the management of a company might try to pay for the company with ESOP, thereby may reduce equity capital.
Similarly, a leveraged buyout (LBO) produces a lot of debt, thereby changing the capital mix.