Raising Capital

Death Spirals

The term “death spiral” is applied to a number of alternative finance methods offered by certain investment funds to smaller quoted companies. They include equity credit lines, equity swaps and variable conversion rate convertible loans. The question is are such death spirals always fatal?

Let me start with an analogy – is climbing Mount Everest always fatal?  The answer is not anymore with modern equipment, thorough training and good guides. However, if you have never climbed anything more demanding than a flight of stairs, smoke 60 cigarettes a day and are morbidly obese, then climbing Everest is probably not very sensible.

This is the problem with most death spiral arrangements – they are taken up by the corporate equivalent of our unhealthy wannabe climber.

The various death spirals, sorry, I mean alternative equity finance arrangements, fall into the broader category of mezzanine funding, i.e. higher risk and higher return (for the investor) than conventional secured or unsecured debt, but lower risk and lower return than ordinary equity. This is reflected in the underlying funds who are typically seeking an annual return in the 12-20% range.

So an example of a sensible use of such finance would be a profitable, cash generating company seeking to finance expansion (adding a second production for example) where the bank will provide 70% of the required capital by way of a loan and they want to raise the balance at a lower cost of capital than issuing shares.  Never forget that (in theory at least) ordinary equity is the most expensive source of capital, with institutional small cap investors seeking average return rates of circa 30% per annum. So that company will have borrowed 70% of the funding at say an 8% cost and the remaining 30% at say a 16% cost, compared with a 30% cost for equity.

However, probably only 5-10% of the transactions done for alternative equity finance arrangements are done by such companies.  The rest are done by companies for whom they are really not suitable, but who desperately need fresh capital and all other sources have been exhausted (at least without conditions such as substantial management changes).  So companies with no cash flow, such as mineral exploration companies and cash shells enter into death spirals in order to pay salaries and adviser fees. This is the corporate equivalent of borrowing money on your credit card when you are unemployed in order to go to the race course and bet on the horses; there is always a chance that your bets pay off, but the odds are generally against you.  When those bets do not pay, the day of reckoning comes up at the end of the month. This means more and more shares or ever larger amounts of money have to be returned to the funder.

So, if a company in your portfolio takes out such an arrangement, look to the fundamentals.    Does the business (not the share price) generate a return on capital of well in excess of 20% per annum.  If it does, then it is probably a sensible source of finance, especially if blended with lower cost bank debt, invoice discounting or similar.  If that is not the case, then be very careful.

The Secret Nomad

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2 replies »

    • The problem is that the Prospectus Rules have made rights issue too costly and slow for smaller companies. An effort at investor protection has resulted in shareholders suffering.

      Like

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