Alternative Ways To Raise Capital In This Economic Downturn

The year 2009 has brought with it a tremendous amount of uncertainty in all aspects of economic (and some would argue non-economic) sphere of life. However, one thing that almost all people are agreed on is that we are currently passing through one of the worst economic crises since the Great Depression of the 1930s. The pre-crisis days when companies could raise capital through a variety of traditional means are a distant memory and there is little visibility on when things will go back to “normal”. Some of the traditional sources of funding for a company during a normal economic environment included:

• Working capital lines (fund / non fund based)

• Term loans from banks / financial institutions

• Bond issues (if the quantum of fund raising was significant)

• Rights issues of equity / equity linked instruments

• Issue of new equity shares for placement to select Investors

Prudent companies also ensured that they matched capital use and source appropriately along the parameters of risk and timelines. Thus long term sources were used for long term purposes such as expansion of facilities, setting up new plants or acquisitions, while short term sources were used for short term purposes such as working capital and trade financing.

The current economic downturn was preceded by a period of unprecedented economic growth and credit expansion with a strong theme of underlying optimism. Companies and other investors were sometimes tempted to use short term capital for long term uses such as expansions and acquisitions.

While credit markets showed signs of shakiness since mid to late 2007, the sudden pace and the extent of deterioration in credit markets and in the global economic situation after the collapse of Lehman Brothers in September 2008 caught most people by surprise. As a result many companies are in a situation where they are facing refinancing risks for their short-term loans in an environment of severe capital scarcity. Examples include some companies and investors that used short term bridge loans for acquisition financing without an assured “take-out”, or companies that used their working capital facilities to invest in development of new projects which have now been hit by the downturn.

The crisis also put a strain on traditional bank financing including trade and working capital finance with banks cutting credit lines and withdrawing facilities even from some long standing clients.

The situation has subsequently improved since the bleak days of September/October 2008 with strong support from all key Governments to shore up the banking system and with equity investors now willing to consider investments in companies as borne out by the recent spate of rights issues and the surge in stock prices (though it remains to be seen if this is sustainable). However, even after these improvements, the situation has not resumed to “normal” and capital raising for day to day business operations and for projects is not an easy proposition for most companies.

In the current situation, companies need to think “out of the box” when considering options to raise capital. We have outlined below a few examples of the methods companies are actually using to raise capital in the current environment.

In general terms we could classify these sources of capital that companies are utilizing in the current climate as:

• External sources

• Internal sources

Raising Capital from External Sources

In the current environment, the traditional sources of external capital viz banks, bond investors, and shareholders (including institutions and retail) have been affected by the general environment of risk aversion.

In this situation, companies that are backed by cash rich shareholders, could consider rights issues underwritten by controlling shareholders. While the regulatory aspects could take some time, this could be a dependable method of raising capital for some companies.

Debt financing, while difficult, is also not completely ruled out as an option. In certain cases, companies are able to raise finance from banks or finance companies especially for working capital purposes or where the finance is against specific income generating assets. Chances of success are usually better where customers have existing relationships with the banks or financial institutions in question. Examples include certain financial institutions offering asset backed financing for specific working capital / trade financing requirements, financing of select oil & gas assets with specific long term contracts with credit worthy customers etc. In cases where the above is not possible, given the uncertain economic situation, companies are raising capital through mechanisms that provide capital providers with the ability to benefit from the upturn, but at the same time providing for some downside protection. These methods include:

• placement of shares at a discount to market

• issue of convertible instruments

Placement of shares at a discount:

In this case equity shares are issued on a preferential basis to investors with appetite for significant blocks of shares in the company. The investors could range from distressed situation hedge funds to individual high networth investors. The shares are typically placed at a discount to the market price to generate interest and to provide some measure of downside protection to the investors.

The potential advantage from the company’s perspective is the speed at which this exercise could be carried out. However the key issue is that the discount to market price results in a higher dilution in addition to potentially sending a price signal to the market. The possibility also exists of investors trying to lock in a gain by selling the shares in advance of the issue of the placement shares, thus putting some downward pressure on the market price.

Investors could find this attractive based on the recent pricing trend and the discount offered. Key challenges remain the absence of downside protection beyond that offered by the price discount.

The key issues to consider include:

• pricing - discount that is acceptable

• suitability of the type of investors from the company’s perspective

• immediate extent of dilution and impact on controlling shareholder dynamics
• approvals

• degree of discount permissible under applicable regulations

Issue of convertible instruments:

These instruments are typically structured as either convertible preference shares, notes or convertible bonds. They could also be issued as a bond with attached warrants. Companies could find this an attractive mode of raising long term capital as the instrument is either converted into equity shares or redemption (if any) is typically after 3-5 years. Further conversion pricing is typically at a premium to recent stock market prices thus being potentially less dilutive than issuing shares at a discount. The coupon (or dividend) on the instrument is also likely to be lower than the borrowing rate for the company in the current environment, bringing cashflow benefits. Further, the typical investors such as private equity funds could potentially contribute further value by providing the company with access to their expertise and networks.

On the other hand, we believe that certain private equity investors could find these instruments interesting due to a combination of factors. These include the strike price being attractive from the perspective of historical stock market valuations, the conversion feature providing the ability to benefit from the upside, and the redemption features providing downside protection which is valuable in the current environment. In many cases, the investor could also have a board seat and certain minority protection features.

Key issues to consider include regulatory, accounting and other issues such as:

• overall economic package – conversion price, coupon, conversion timeline, etc.

• suitability of the investor from the company’s perspective

• requirements for shareholder approval, depending on the extent of dilution, features of the instrument and existence of a general mandate from shareholders

• constraints on the features of the instrument especially in the case of listed companies

• accounting aspects of the instrument – certain ways of structuring the instrument could make a difference in terms of it being classified as debt or equity with attendant impacts on the financial statements

Raising Capital from Internal Sources

A source that companies usually do not consider in normal circumstances is the release of capital from their own balance sheet and operations. The measures to release internal capital cover a range of timelines, with some providing capital in the short term, while others taking longer to implement but being more permanent in nature.

Some of the measures being taken by companies to generate capital from their internal resources include:

• Reduction of working capital required in the business

• Rationalization of business locations

• Divestment of non-core operations

Review of working capital from a bottom up approach can assist in identifying items of working capital that do not have a high rotation in the business, which can then be used to release capital for the business. Examples include some retailers, where slow moving stock is being cashed out via large discounts to recover capital. Unless the improvements in working capital are permanent, as the business starts picking up, reinvestment in working capital will be required. We believe that with the credit situation improving over time, working capital financing should be possible and therefore this measure could at least provide a temporary source of funding for the company.

Some companies with operations across multiple locations are reviewing all their plants and operations in light of the reduced production levels with an aim to consolidate manufacturing in a few large locations and shut down the smaller locations to reduce overheads and to make production more efficient. This also creates a surplus of certain assets with a potential to dispose them for cash (though a “book” loss may be incurred).

Finally certain companies are undertaking a strategic review of their businesses to determine core and noncore elements. The non-core elements could potentially be more valuable to other companies which could therefore offer a reasonable value for these operations. In addition, private equity funds are also now reviewing opportunities to acquire such non-core operations which could be grown faster with sufficient injection of capital and other resources. Examples of this approach include situations where companies could spin-off their non-core businesses into a joint venture with a financial investor to release capital for the parent company. The financial investor’s interest would be to work with the management team of the joint venture to create value through growth and other means with the objective of eventually exiting via an initial public offer or a sale to a strategic investor. The deal structure could provide for a situation where, if it so desires, at this stage, the parent company could possibly buyout the financial investor.

In conclusion, while the environment is certainly tough, fundamentally sound companies will have options to raise capital to tide them over the current financial crises. The key is to think “out of the box” and to tap capital sources that have not traditionally been large providers of capital in a corporate context. Of course, the actual solution adopted in a particular situation would eventually be determined by the board of directors based on a balanced consideration of risk, return and availability of capital.

The author is an Executive Director with PricewaterhouseCoopers

Corporate Finance Pte Ltd (“PwC”). The views expressed here are his own. While this article is written in good faith to inform readers at a general level, it is not and should not be construed as being, a substitute for exercise of judgment by the reader prior to taking or refraining from any action. Readers should take suitable professional advice prior to taking or refraining from any actions based on the contents of the article.