I thought about writing a three-part post; credit investors’ perspective, shareholders’ perspective and the process behind putting a new debt facility in place. I reconsidered and what follows is the result. I’ll revisit the process in my next post.
Debating cost of debt features in every negotiation leading up to (or not) executing a credit deal. Margin is the uncontested champion in the contest of being the reference of cost in those debates. Settling on margin as the indication of the cost of credit has the effect of establishing potentially opposing sides. We find ourselves reverting to a soldier mindset and forgetting how to think like a scout (“The Scout Mindset”, Julia Galef). That’s to say we view outcomes as wins or losses rather than good or optimal while we are in the throes of discussing terms.
Focusing on opportunity cost can position both shareholders and credit investors on the same side of the negotiating table. I’ve outlined a scenario which is common in most markets; shareholders in a producing asset are faced with the decision of taking capital out, continuing development or an opportunity to do both.
I’ve left out the details of the model to avoid any sense of false precision. All of the numbers are based on a three-statement financial model I built and calibrated on the last 4 years of audited results. Suffice it to say that the following points are the most important to keep in mind:
Existing debt – there is long term debt on the balance sheet which is either repaid by 2024 (Scenario 1 and 2) or refinanced with a new loan on day 1 (3 and 4).
New debt – as noted above, scenarios 3 & 4 assume a new long term debt facility goes onto the balance sheet. Scenario 3 has a simple amortizing term loan. Scenario 4 has additional features which increase the cost and shorten duration.
Recapitalization – shareholders benefit from a dividend of cash available at the end of each year (1 and 2) or from a special dividend day 1 in addition to the same annual dividends as 1 and 2 (3 and 4).
Development – two scenarios assume no new development (1 and 3) and the other two assume the same investment program in terms of amount and timing (2 and 4). Timing is fixed and there is no benefit of accelerating the program.
Eventual sale – shareholders are assumed to sell the entire asset in 2025 for an amount equal to NPV10 of the remaining cash flows less any existing debt.
Returns – basis for calculating returns the original investment amount and the point in time when the asset was purchased; 2017.
Cash disbursements – basis for determining the nominal amount of cash disbursed to shareholders and credit investors is the point in time when shareholders are going to make a decision to do nothing or pivot; 2022.
Scenarios 3 & 4 are a great example of Howard Marks’ idea that You can’t eat IRR. Incrementally developing the asset within cash flows generated by the asset gives shareholders the same return as not developing the asset, refinancing the existing loan and making a special distribution on day 1. Shareholders get more cash by gradually repaying the existing loan by 2024, reinvesting a portion of the cash flows into the development and collecting a dividend annually.
A few things are happening which impact both return and cash disbursed. Higher margins increase the effect of the tax shield and partially offsets the cost of increased interest rate. Size and timing of cash disbursements to the shareholders impacts the two shareholder outcome metrics.
Remaining value of the asset in 2025 accounts for 48 – 83% of the cash disbursements to shareholders. Exit risk or the potential cost of sale in 2025 deviating from expectations is concentrated in the first two scenarios; 73% and 83% of the cash disbursed to shareholders is derived from the sale of the asset. Exit risk is reduced to 46% - 75% in scenarios 3 and 4 respectively.
Enter opportunity cost. Development boosts returns and cash distributions. Foregoing the development is effectively leaving cash on the table. Shareholders opt out of $33m - $37m of cash distributions by not pursuing the development in the cases above. Said another way, the opportunity cost of scenario 3 is $33m net of the incremental costs of the debt. Yes, you read that correctly, the $33m of disbursements sacrificed by nominating scenario 3 are based on the cash available after the payments made to the creditors.
One argument against the expensive loan in scenario 4 is that return and cash distributions from organic development approach the same level. Credit investors reduce shareholders’ exit risk on day 1 by bringing new capital to recapitalize shareholders with a special dividend. Recapitalizing the shareholders on day 1 is the same as brining a portion of the 2025 sales price forward and paying it out in 2022.
Shareholders might be tempted to seize scenario 4 and then reverting to their soldier-selves and fight to win a lower amount paid away to credit investors. Reducing the effective margin from 15.525% to 10.565% boosts their returns 0.9% and brings in another $9m in cash disbursements. Day 1 disbursement could also be increased which would further reduce shareholder exit risk.
Cost of the shareholder pursuing that opportunity is the potential loss of a credit investor. Prioritizing a recapitalization implies that the cost of that option could be $44m. Shareholders faced with an opportunity cost of $44m would not rationally refuse to pay a higher margin on the option which enables them to avoid that cost.
A final thought: capital providers can be very creative and equally constructive. Setting on the same side of the table with them can and focusing on opportunity costs can lead to outcomes which provide shareholders with better returns and cash distributions. Invest the time to consider what “expensive” credit from an alternative provider affords your company in terms of opportunities when comparing it to conventional bank credit.
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