The D Word: Is it Wise to Mess with Capital Structure?!

 

January, 2015 saw private equity house KKR receive the final instalment of their sale to Walgreen Co. which saw them triple their initial investment back in 2007. In this week’s blog I am going to examine how KKR maximised the benefit of capital structuring and reaped the rewards

Back in the 2007 debt fuelled buyout wave before the financial crisis, KKR bought Boots Alliances for $22billion: $19.55bn of that being paid for with debt with the remainder being cash (Carey, 2015). They brought the company out of the public domain by taking advantage of the extremely low interest rates at that time. By doing so this lowered their WACC. As KKRs return on invested capital is significantly higher than the WACC, they managed to make positive excess returns. The lower the WACC is, the higher the NPV of a project will be, meaning more returns will be generated. This principle disproves Modigliani and Miller’s “capital structure irrelevance theory” which argues that a company’s capital structure has no impact on the WACC. The main problem with M&M’s theory is that it doesn’t account for taxation: debt is advantageous over equity as debt has a tax advantage. It also assumes there are perfect capital markets, with perfect information available to all economic agents and no transaction costs. It also assumes there are no costs of financial distress and liquidation (Arnold, 2013).

As of today, KKR & Co LP's weighted average cost of capital is 6.12%. KKR & Co LP's return on invested capital is 30.14% (Bloomberg, 2015). KKR & Co LP generates higher returns on investment than it costs the company to raise the capital needed for that investment. It is earning excess returns. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases

The basic principle here is as follows: load with debt; make a lot of net profit, then float again on stock market.  However, there’s a catch. This is all based upon the assumption that the cost of debt will remain the same. Warren Buffett, Berkshire Hathaway CEO warns against this kind of financing, suggesting you should not borrow to invest. Alternatively, private equity firms could use a float instead to fund their acquisitions. This would reduce the impact of any financial disasters as they wouldn’t be tied into any long term debt obligations and be forced into bankruptcy.

Personally, my views are consistent with the trade-off model (Kraus & Litzenberger, 1973) which suggests there is an optimum capital structure which could lower the WACC, up to a certain point. I think the benefits of debt finance outweigh the risks up to a certain point, after said point shareholders will become very cautious and this will have a negative impact on the share price of the firm. Debt finance is advantageous over equity as debt has a tax advantage.    

 

Arnold, G. (2013). Corporate financial management. London: Financial Times.

Carey, D. (2015). KKR Tripling Its Investment With Alliance-Walgreen Merger. Bloomberg.com. Retrieved 1 March 2016, from http://www.bloomberg.com/news/articles/2015-01-02/kkr-tripling-its-investment-with-alliance-walgreen-merger