Vince Bellino ‘15 and Paul Buckley ’17
The capital structure tells a story about how a company finances its operations and growth initiatives through the use of different sources of funds. As an investor, this provides for a lot of opportunity, while taking into account one’s goals and appetite for risk.
A company’s balance sheet is a financial statement that summarizes its assets (economic resources with an expected future benefit), liabilities (legal obligation to repay creditors), and equity (shareholder ownership in the company). So, when isolating the capital structure we are looking at the company’s liabilities and shareholder equity. Depending on the individual enterprise, there may be multiple levels of both debt and equity. The typical debt structure is as follows: senior debt, mezzanine, and high yield or subordinated debt. A term loan is an example of senior debt. Due to the fact that it ranks highest within the debt structure, investors will receive the lowest annual coupon payments. This is because it is the first priority to be repaid in the event of a bankruptcy. The loan is oftentimes secured or collateralized against the company’s assets, therefore reducing the risk profile. The next tranche is mezzanine debt. Investors are taking on more risk, in exchange for higher interest payments. Depending upon its structure, mezzanine debt may be secured or unsecured. If it is secured, there is less risk and a lower interest payment. On the other hand, unsecured debt has no collateral so it will derive a higher coupon rate. Lastly, high yield debt or “junk bonds” are the riskiest debt investments. Investors are last to be repaid in the event of bankruptcy, however, they receive the highest coupon payments amongst the debt tranches.
Hedge funds, pension funds, or asset managers typically invest in these various debt instruments. Retirement portfolios may have investments in different level of tranches depending on their investor’s appetite for risk.
Shareholder’s equity can be disaggregated in two main parts: preferred and common stock. Preferred stock is a hybrid of a bond and common equity because the investor receives constant dividends (like coupon payments) and the principal value has the potential to appreciate (like stocks). Preferred investors typically do not have any voting rights and are subordinated to any outstanding debt. Lastly, there is common stock. It is the equity instruments that are traded on the stock exchanges i.e. NYSE. Common stock investors have voting rights and are essentially the “owners” of the company. However, common stock is the lowest in the capital structure and has the fewest rights in the event of bankruptcy.
As a prudent investor, it is important to understand the risks associated with a given investment and how they are affected given adverse economic conditions.