Wednesday, October 27, 2010

Capital Structure

Before continuing on the ACAS company dive, I wanted to have a quick post that discusses some of the key terms used when describing a BDC's portfolio companies. A hyper-link on the term means I am sending you to a site with a good definition that expands on the item.

Capital Structure 
This term refers to how a company finances its assets and business through various combinations of Debt and Equity. There are many different variations of Debt and Equity and each one represents a trade-off between security and agency within the company.

Debt Financing
There are two main types of financing extended to a Company - Asset-Backed and Cash Flow. Asset-backed loans for everyday people would be equivalent to a mortgage or car loan. There is some form of collateral that is backing the loan. If the borrower defaults on the loan, the lender can take possession of the physical (or in some industries - take the Intellectual Property (IP)/patents) asset. A Cash Flow loan is equivalent to a Credit Card. These loans are based on the company's earning power and ability to pay back the loan with its Earnings.

Asset-Backed Loan
In terms of corporate finance, a typical asset-backed loan is a fixed term loan of about 3-5 years (as opposed to a 30 year mortgage). The main reason a company looks for an ABL is to fund an expansion of the firm (leveraged buyouts will be discussed later). These loans have many flavors and names such as "Term Loan", "Senior", "Subordinated", "Jr.," "Mezzanine" and "Tranche". The name is very important in an ABL, it tells you the claim priority of the loan (who gets paid first in case of bankruptcy) as well as what guarantees are attached to the loan. The amount a company can receive in an ABL is tied to the company's assets.

Term Loan A, B, C
It is very common for a BDC to hold a Term Loan B or C on its Balance Sheet. Most ABLs are extended by a primary lender (bank) that will hold the most senior tranche of the loan (Term Loan A - TLA). The bank will typically hold this loan on its balance sheet until maturity. Sometimes if the desired amount of credit the company desires is more than what the primary lender wants to extend, the loan is offered by the lender to other institutions. This is known as syndicating a loan and these investors typically invest in a slightly different tranche called the Term Loan B or C. TLAs typically have a fixed amortization schedule and the lowest pricing for a loan. A Term Loan B/C is different than the TLA. These loans have the same seniority "pari passu" as the TLA, but their amortization is usually a token amount followed by a balloon payment at maturity (think ARMs). TLB/C may have a longer maturity date than the TLA and will have a higher price than a TLA (L+500 versus L+300). For a lender to extend loans to a company, they typically attach a number of covenants to the loan. These covenants help ensure that the borrowers stays in a position that will allow them to pay for the interest and amortization over the course of the loan.

Cash Flow Loan
A CFL is called a Revolver in the corporate world. A revolver is typical for many companies that have seasonal cash flows (think retailers/construction) that need to fund their need for working capital during these times. A Revolver is a special type of loan in that it is a Line of Credit extended to a company (like a credit card) but it carries a maturity date and two interest rates. The first interest rate is the funded rate - this is like your APR on your credit card. The second rate is for the unfunded/unused portion of the Revolver. This rate is typically very small (25-75 bps) but when you have a $100m Revolver, the interest expense does add up!

Basis Points (BPS) "bips"
A basis point is equal to 1% of 1% as a rate. So, 100 basis points = 1% interest.  It may take awhile to get used to this, but after reading enough documents or talking with enough people about finance, it will become second nature.

A loan's "price" often refers to the interest rate on the loan. This is different from Bonds, since most bonds are quoted on their yield to maturity (a 5% coupon yielding 5% is priced at par, where as a 4% YTM means the bond is above par). Since most loans in corporate finance are floating rate (they have an underlying index such as LIBOR, PRIME or EURIBOR), it is very common to hear of a loan priced as "Libor plus 500".

This is the loan's remaining years until maturity, although it will sometimes be quoted in months. For example, a 5 year loan that was originated in 2008 has a tenor in 2010 of 3.

Loan Seniority List / Hierarchy of Creditors
When you hear about a company going bankrupt / loan pricing, the order of seniority and pricing generally have an inverse relationship (more senior you are, the lower the price). Here is the order of seniority in a firm's capital structure.
Revolver - Secured, little influence on management
Term Loan A - Secured
Term Loan B - Secured
Term Loan C - Secured
Mezzanine Loan - Unsecured
Bond Holders - May be secured, mostly unsecured
Preferred Equity - No security, but have influence on management
Common Equity - No security, but have influence on management

There you go, now when you read a firm's 10-K and you see they have "Senior Secured" notes, you know they most likely have a TLA/B/C.

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