Optimal Capital Structure, Part 26.
The two things (in finance) that interest me most are market structure and capital structure. To date, the discussion on the Park Paradigm has centred far far more around the former. I’ve been meaning for some time now to redress that balance but two (well three if you count procrastination) things have got in the way. Firstly I’m still not sure at exactly what assumed level of knowledge I should pitch the discussion; discussion of capital structure can be somewhat daunting for non-specialists. Not so much because it is intrinsically difficult to grasp but more just in terms of knowing the jargon and having spent the time to learn some basics in terms of the building blocks of finance and what makes up a balance sheet. Secondly because as an “approved person”, regulated by the FSA and working for a large financial institution, I need to be cautious about providing anything that might vaguely be perceived as “investment advice” even though this blog is clearly written in a personal capacity and does not reflect the views or opinions of the firm I work for and nothing I write should be construed as investment advice and these are just my personal opinions and ask your mom before doing anything anyways and I didn’t want to have to append a 3 page disclaimer to every post. Phew…
So to tackle the first issue, I’m going to assume a basic introductory university level knowledge of finance and perhaps lean on wikipedia a bit more than usual to link to definitions, so as not to turn this into a tutorial on basic finance. As for the second point I will emphasize that any reference I might make to specific companies or industries should not be regarded as anything other than personal opinion and that no one should infer any explicit or implicit advice is contained therein.
So disclaimers aside, what was the spark that got me (finally) to have a go? Microsoft. As you all know a company that has been – even more than usually – in the news recently. Specifically I’ll draw your attention to two items: their announced share buyback and an editorial by David Kirkpatrick on Microsoft’s new approach to competition and openess.
David opens with:
In the early years of the U.S. Justice Department’s antitrust assault on Microsoft in the 1990s, I occasionally opined that, for better or worse, Microsoft (Charts) was likely to end up as some sort of regulated utility. I saw Microsoft’s Windows as central to modern life, and believed that something so critical would inevitably come under governmental oversight.
Rob Cox of breakingviews.com sums up the logic behind the buyback thus:
Microsoft has shocked the market with its plans to buy back $20bn worth of its stock in a tender offer next month. The software giant has already returned $23bn to shareholders through dividends and stock buybacks over the past 12 months. And one can’t forget its $32bn special dividend two years ago. It’s pretty clear even the group itself now realises it is ex-growth.
I first started writing this post in July (!) , in the mean time John Plender actually wrote in the FT (with a different spin – ie private equity – but similar underlying logic imo) something similar to what I was going to write (apologies, stupid FT behind a firewall stuff):
Private equity folk could do wonders with Microsoft
By John Plender
Published: August 17 2006 18:54 | Last updated: August 17 2006 18:54
As leveraged buy-outs go, the recently announced $33bn deal to buy HCA, the US hospitals group, is rated the biggest ever. Now, NTL, the heavily indebted European cable group, looks set to go the same way for an eye-popping $20bn. With private equity investors gobbling up bigger and bigger chunks of the corporate world, fuddy-duddies worry that quoted equity will shortly become extinct. The usual party-poopers see a bubble and warn that hubris will soon lead to nemesis. For them, over-ambitious private equity folk deserve their status, shared with hedge funds, as the new bogeymen of the western world.
Anyhow… where was I? What these various commentators are getting at is the following: Microsoft’s capital structure is completely innappropriate for it’s underlying business. It still has the balance sheet (ok slightly less with the buybacks and dividend but still…) of a risky fast growing knowledge-based services company: ie large (enormous) cash balances and equity-only financing. Against this however is a mature and robust (granular and stochastic) business throwing off gigantic and regular cashflows. Corporate finance 101 question: ‘How should such a company be financed?’ Answer: With debt! Now whether that is via on balance sheet leverage (a la Plender’s private equity LBO) or off-balance sheet (securitised – a la bank securitizing the regular cashflows of mortgage or credit card repayments) is a second order question.
Indeed this is the case for any ‘utility’-like business. The problem is I think that there seems to be an irrational aversion to being labelled as a utility…mature. It’s as if the business establishment only values growth companies (and their management.) Obviously this is changing and is (part of) the giant opportunity that folks like KKR and Blackstone and the other giants of private equity discovered and have been feasting on for the past 20 years to the benefit of their investors and the economy alike. But the importance of getting this right goes beyond – in some industries – just having the optimal and most efficient (thus profitable) capital structure. It can fundamentally alter the competitive behavior, for better or worse, of companies.
Indeed I was prodded into finishing this post by reading Gordon’s post on the behavior of US telcos. Here is an example of an industry who’s capital structure is driving nonsensical (at an economy-wide level) behavior. As network providers, even better – regulated – network providers, they should be funded by debt. Indeed, the core infrastructure should be securitized and spun out of the vertically integrated groups. As Gordon points out their rabidly defensive and rent-seeking behavior is a natural if cynical reponse to their business environment and – I would add – their capital structure. With all that equity sloshing around on their balance sheets needing to be fed, they have to extract monopoly type rents via rationing. There is no way to isolate the true cost of the infrastructure from the rest of the balance sheet. The optimal solution is to have a separate network company funded by debt with open-access and – where natural monopolies exist – a regulator to set prices (based on ensuring a decent economic return and continuing investment and innovation.) If that sounds complicated, the UK has been quite successful in implementing this kind of model, for instance in water services. So the question is, when is Guy Hands going to bid for at&t and break it up? 
(Comments and criticism welcome, but can I just say up front that I acknowledge my analysis – as presented in this short blog post – is oversimplified and incomplete; basically I ask you to indulge the somewhat shoddy exposition and attack (or endorse) the fundamental idea, for which in contrast I have complete confidence and stand behind fully.)
