In a previous entry, we stated that debt functions as a lever to boost opportunities. But brace for more good news! There are a couple more benefits to debt, and we will explore one of them for the time being. For that purpose, here is one seemingly out of context question: do you recall the benefits of being first in line for anything?

Collaboration: Finding the Best Solution Among Teams

The first concert I ever attended was David Guetta’s at Estadio Azteca in 2011. The announcement had such an impact that one month after announcing the date, the organization moved the location from the parking lot of the stadium to its inside. When my brother and I heard this, we got worried: how would we ever get tickets if 100,000+ people were interested in going?

When the tickets were announced, there was a special pre-sale that required buyers to pay an extra fee of $25 to get ahead of the general sale. We had been waiting for 3 years for David Guetta to come to Mexico, and we faced two options: (i) pay the extra $25 and secure a ticket or (ii) not pay the $25, save some money, but bear the risk of not getting the tickets later. Were there 100,000+ people interested in going to the event or was it just a PR stunt to hype the concert? Was removing the certainty of going to the concert worth $25?

Paying the extra $25 meant you were first in line for ticket purchase or, as it is known in the financial world, you had seniority over other willing buyers. For instance, let’s say some of the seats were closed down due to renovation works on the stadium. The “senior” buyers (those who paid $25) would have access to the remaining seats before the rest of the buyers. After all senior buyers made their purchases, the remaining tickets would be sold to “subordinated” buyers (those not paying the extra fee, just the ticket). And, for the sake of the example, let’s assume that if all seats were not sold, a very low fee would be charged for anyone else interested in attending the concert. We would deem the ones paying the extra fee as “conservative”, the ones that just bought the tickets as “moderate”, and the ones waiting for empty seats as “aggressive”.

Turning to the financial world, we can connect this example with the capital structure of any company. The capital structure (or capital stack) is simply the set of resources (money) needed to finance the company’s operation. Capital can take on different forms, being the two most common debt and equity. Among other distinctions, the one in focus here is that debt capital providers stand senior to subordinated debt capital providers and to equity capital providers. In case of bankruptcy, senior lenders are paid off first, like the ones who paid the $25 extra fee. Subordinated lenders are paid off next, like the ones that did not pay the extra fee, but paid their ticket. Whatever remains, if anything, is left to be allocated to equity capital providers. We can see how different capital providers bear distinct risks, and thus will charge varying costs for providing their capital; senior debt thus is cheaper than subordinated debt and equity capital, because it is the most conservative, less risky investment.

In some cases, there is a further level of security when providing debt capital to a company, which is a guarantee or collateral. This may be real or financial assets or pledged cash flows that flow first to the secured lender, which stands senior even to senior lenders. The latter hold a first in line claim to all the company assets except for those pledged as collateral to the secured lenders. Secured lenders in the concert example would be like the people that besides paying the pre-sale extra fee, also bought VIP tickets with specific seats allocated to them that can’t be bought by anyone else. Returning back to the financial world, sometimes secured debt facilities are the only way to get debt capital, or at least the required amount of capital if it is big enough.

As in the concert example, we can find people all along the risk tolerance spectrum: conservative lenders that provide secured debt facilities on one side of the spectrum, and venture capital and equity investors on the other side of the spectrum. In between, we can find banks and debt funds willing to provide debt capital in varying forms, such as senior facilities for the most conservative, and mezzanine facilities for the most subordinated, riskier type of debt capital. Every one of them has distinct capabilities and objectives, which results in different requirements and debt structures and in varying levels of compensation that will be demanded for the risk being taken.

One last question remains, though, and it is why a company should resort to more expensive (subordinated) lenders. As each company only has a limited number of assets that can be pledged as collateral, additional funding is thus necessary if more money is needed to fuel growth. As risk goes up, so does the cost of those funds. But, if the returns still exceed the increased blended (secured + senior + subordinated) cost of funds, it is worth the shot!

For the time being, we can conclude that many times, companies should look for debt capital to lower blended cost of capital and to expand growth opportunities without giving up any ownership stake (i.e. levering up). And within the domain of debt capital there are various opportunities to explore and find debt solutions suitable to the company’s growth profile, its pledgeable assets, and its life stage.

P.S.: if you were left wondering about the David Guetta concert… yes, me and my brother paid the $25 extra dollars, it was totally worth it.

By: Fernando Muleiro

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