What’s capital structure and why do investors need to know about it?

When a business decides to raise money to fund its operations, it has two main options to choose from: equity or debt. Many businesses use a combination of both, and that combination is what we refer to as the capital structure of a business. Or, in more simple terms, you can think of it as how the business is financed. 

Investing through Equity capital or Debt capital

Let’s look at equity capital first.

When most people think of investing in a business, they think of equity capital, which is a fancy way of saying ‘buying shares in a company’. Often, this is simply due to convenience or not understanding that there’s another option available (in the form of debt capital).

However, equity capital comes with a few things to watch out for.

Firstly, when you buy shares in a company, the returns you’re hoping for are tied to the company’s future performance. And, as we all know, previous returns or performance are never a predictor of the future. In essence, you have to ask yourself what happens if the company under-performs, or even fails.

Secondly, there’s the issue of capital dilution. If the business that you’re invested in decides to sell more shares, it creates more shareholders to then split any profits with.

Now, let’s take a look at debt capital.

Debt capital is a way of investing in a company without taking any ownership or shares in it. Instead, you lend money to the company through loans or bonds.

For an investor, there can be plenty to like about this. Indeed, by its very definition, a ‘loan’ makes it clear that you’re expecting your money back (which isn’t necessarily the case if you buy shares). In this way, it can offer more surety.

And, if you’re a fan of surety, you’ll also like these points:

- Frequent payments. With a private debt loan, an investor receives monthly repayments as the business makes repayments. This differs from owning shares, where shareholders may receive dividends less frequently, or sometimes not at all.

- Amortisation. Rather than hoping for a big pay day in the future, both the principal and interest of a private debt loan is paid off over time, giving the investor more consistency on their returns.

- Shorter maturities. A private debt loan is usually over a shorter time period than a bond, often meaning that the investor gets all their money back, plus interest, in just 2 to 5 years.

Given some of the points above, providing debt capital to businesses can be an attractive investment choice. It can offer attractive returns, while also preserving your initial investment. And, what’s more, debt capital is a ‘senior debt’.

Senior debt? Junior debt? What’s the difference?

Put simply, there’s a hierarchy amongst different types of debt. Or, to put it another way, when it comes to repaying investors, there’s a pecking order regarding who gets paid first.

If a company goes out of business, Australian corporate insolvency laws give priority to certain types of finance. This means that should a company go bankrupt, the issuers of senior debt are paid first, followed by junior or subordinated debt holders, then preferred shareholders, and then common shareholders.

So, it pays (quite literally) to be high on that list. And that’s one of the powers of debt capital as an investment choice.

Senior status, lower risk

Apart from having the highest priority for repayment in the event of bankruptcy, a senior debt loan is often secured by a lien against a company’s collateral.

For example, a lender may place liens against equipment, vehicles, or property when issuing a loan. Then, if the loan goes into default, the asset may be sold to repay senior debt holders.

It pays to have a good manager

Evaluating a company’s capital structure is an important consideration when investing. The capital structure of an organisation can vary due to a number of factors, including the business category, what stage the company is at, and monetary regulations.

For debt capital, having a good private debt manager is imperative, as they’ll conduct thorough due diligence and identify any risks.

With their experience, they understand the landscape, and have the skills to negotiate with the borrower to help mitigate any risks and provide favourable terms for the investor.

These terms might include reporting obligations, covenants, and security, as well as careful monitoring and more.

If you’d like to know how debt capital can work for you as an investment option, visit fccapital.com.au