CONTINGENT CAPITAL: INTEGRATING CORPORATE FINANCING AND RISK MANAGEMENT DECISIONS

Financial executives of companies that face a sharp increase in business or financial risks have two basic ways of protecting the solvency and strategic viability of their organizations: they can transfer those risks using insurance or derivatives; or they can raise additional capital, typically by issuing equity, to cushion the firm against the higher expected volatility. But CFOs now also have a third means of managing risk, known as "contingent capital," that effectively combines capital raising and risk management.
A contingent capital facility gives a company the right to raise capital after the realization of a loss arising from one or more specified risks, thus ensuring access to capital in potentially difficult times. For example, Swiss Re recently granted Michelin a five-year right to issue ten-year subordinated debt at a fixed spread over LIBOR, though only under conditions in which the tire maker expects its own earnings to be down. To the extent that it eliminates the need to keep more capital on the balance sheet, the use of such contingent capital has the potential to increase shareholder value by reducing a company's overall cost of capital. This article provides an introduction to some recent innovations in contingent capital, along with discussion of their role in integrating corporate finance and risk management.     

THE REVOLUTION IN CORPORATE RISK MANAGEMENT: A DECADE OF INNOVATIONS IN PROCESS AND PRODUCTS

The explosion of corporate risk management programs in the early 1990s was a hasty and ill‐conceived reaction by U.S. corporations to the great “derivatives disasters” of that period. Anxious to avoid the fate of Barings and Procter & Gamble, most top executives were more concerned about crisis management than risk management. Many companies quickly installed (often outrageously priced) value‐at‐risk (VaR) systems without paying much attention to how such systems fit their specific business requirements. Focused myopically on loss avoidance and technical risk measurement issues, the corporate risk management revolution of the '90s thus got underway in a disorganized, ad hoc fashion, producing a curious amalgam of policies and procedures with no clear link to the corporate mission of maximizing value. But as the risk management revolution unfolded over the last decade, the result has been the “convergence” of different risk management perspectives, processes, and products. The most visible sign of such convergence is a fairly recent development called “alternative risk transfer,” or ART. ART forms consist of the large and growing collection of new risk transfer and financing products now being offered by insurance and reinsurance companies. As just one example, a new class of security known as “contingent capital” gives a company the option over a specified period—say, the next five years—to issue new equity or debt at a pre‐negotiated price. And to hold down their cost, such “pre‐loss” financing options are typically designed to be “triggered” only when the firm is most likely to need an infusion of new capital to avoid underinvestment or financial distress. But underlying—and to a large extent driving—this convergence of insurance and capital markets is a more fundamental kind of convergence: the integration of risk management with corporate financing decisions. As first corporate finance theorists and now practitioners have come to realize, decisions about a company's optimal capital structure and the design of its securities cannot be made without first taking account of the firm's risks and its opportunities for managing them. Indeed, this article argues that a comprehensive, value‐maximizing approach to corporate finance must begin with a risk management strategy that incorporates the full range of available risk management products, including the new risk finance products as well as established risk transfer instruments like interest rate and currency derivatives. The challenge confronting today's CFO is to maximize firm value by choosing the mixture of securities and risk management products and solutions that gives the company access to capital at the lowest possible cost.     

Debt valuation, renegotiation, and optimal dividend policy

The valuation of debt and equity, reorganization boundaries,and firm's optimal dividend policies are studied in a frameworkwhere we model strategic interactions between debt holders andequity holders in a game-theoretic setting which can accommodatevarying bargaining powers to the two claimants. Two formulationsof reorganization are presented: debt-equity swaps and strategicdebt service resulting from negotiated debt service reductions.We study the effects of bond covenants on payout policies anddistinguish liquidity-induced defaults from strategic defaults.We derive optimal equity issuance and payout policies. The debtcapacity of the firm and the optimal capital structure are characterized.     

RETHINKING RISK MANAGEMENT

This paper presents a theory of corporate risk management that attempts to go beyond the "variance-minimization" model that dominates most academic discussions of the subject. It argues that the primary goal of risk management is not to dampen swings in corporate cash flows or value, but rather to provide protection against the possibility of costly lower-tail outcomes –situations that would cause financial distress or make a company unable to carry out its investment strategy. (In the jargon of finance specialists, risk management can be viewed as the purchase of well-out-of-the-money put options designed to limit downside risk.)
By eliminating downside risk and reducing the expected costs of financial trouble, risk management can also help a company to achieve both its optimal capital structure and its optimal ownership structure. For, besides increasing corporate debt capacity, the reduction of downside risk also encourages larger equity stakes for managers by shielding their investments from "uncontrollables."
The paper also departs from standard finance theory in suggesting that some companies may have a comparative advantage in bearing certain financial market risks–an advantage that derives from information acquired through their normal business activities. Although such specialized information may lead some companies to take speculative positions in commodities or currencies, it is more likely to encourage "selective" hedging, a practice in which the risk manager's "view" of future price movements influences the percentage of the exposure that is hedged.
But, to the extent that such view-taking becomes an accepted part of a company's risk management program, it is important to evaluate managers' bets on a risk-adjusted basis and relative to the market. If risk managers want to behave like money managers, they should be evaluated like money managers.     

A Framework for Corporate Treasury Performance Measurement

Corporations generally do not have a formal process for evaluating the effectiveness of their treasury departments in managing debt. To the extent that corporate borrowing decisions are predicated on "market timing" rather than matching the interest rate sensitivity of the firm's liabilities to that of its assets, the firm is effectively making bets on interest rates that should be monitored and evaluated.
The author has developed an approach that allows for periodic reporting of treasury's performance to investors and that also provides a framework for treasury to compare and choose among alternatives in the capital markets. The basic idea is to calculate a company's liability return and then establish a benchmark portfolio that allows measurement of relative performance. For a nonfinancial corporation, a useful benchmark can be constructed using the collective debt obligations of the company's industry peers. The assumption underlying this benchmark is that the financing of the industry as a whole is designed to produce an "optimal" asset-liability configuration and net exposure to interest rates.     

Debt maturity structure of Chinese companies

Numerous studies have focused on the theoretical and empirical aspects of corporate capital structure since the 1960s. As a new branch of capital structure, however, debt maturity structure has not yet received as much attention as the debt-equity choice. We use the existing theories of corporate debt maturity to investigate the potential determinants of debt maturity of the Chinese listed firms. In addition to the traditional estimation methods, the system-GMM technique is used to explicitly control for the endogeneity problem. We find that the size of the firm, asset maturity and liquidity have significant effects in extending the maturity of debt employed by Chinese companies. The amount of collateralized assets and growth opportunities also tend to be important. However, proxies for a firm's quality and effective tax rate apparently report mixed or unexpected results. Debt market and equity market conditions are also examined in relation to corporate loan maturity. The system-GMM results show that market factors seem to influence debt maturity decisions. Finally, corporate equity ownership structure has also been found to have some impact on debt maturity mix.     

Optimization of a firm's capital structure: A quantitative approach based on a probabilistic prognosis of risk and time of bankruptcy

This article develops a new probabilistic approach to the problem of optimization of a firm's capital structure. The main idea of the approach is straightforward. As a possible firm's bankruptcy is the principal factor restricting the amount of borrowed capital, we assess the probabilities of bankruptcy at various time horizons in the future dependent on the proportion of debt capital and other indices of a firm's current financial position and then calculate how these probabilities influence the firm's value.We identify a set of factors determining conditions of existence and the value of the optimal debt/equity ratio. These include the characteristics of a firm's debt (proportion of short-term component of the debt, cost of service, and maturity horizons of long-term component), characteristics of a firm's ability to pay the debt, and some macroeconomic factors.We represent dependencies of optimal debt/equity ratio and gains in a firm's value on the main influencing factors.The approach is based on real data of real firms and does not use superfluously formalized models. We believe it can be used in practical capital structure decisions although specific calculations must be fulfilled for each firm that needs such decision.     

Bloomberg Intelligence Roundtable on The Theory and Practice of Capital Structure Management

Since the formulation of the M&M propositions almost 60 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial “pecking order” in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In this roundtable, a leading finance professor is joined by six practitioners in discussing whether and how capital structure decisions and payout policies can create value, with special attention to the healthcare industry. The consensus is that for those parts of the pharma industry with large growth opportunities, equity financing should be the main source of capital. But for those parts of the industry with shrinking prospects, increasing levels of debt and raising dividends are recommended.     

SOME NEW EVIDENCE ON WHY COMPANIES USE CONVERTIBLE BONDS

The popular argument for convertibles holds that they provide issuers with "cheap" debt and allow them to sell equity at a premium over current value. Objecting to the "free lunch" implied by such an argument, financial economists have offered other explanations that show how the combination of debt and equity built into convertibles can serve to reduce information and agency costs faced by companies and their investors.
In this article, the authors use the results of their recent study to reconcile the two positions. Following Jeremy Stein's view of convertibles as "backdoor equity," the authors argue that convertible bond financing is an attractive alternative for companies that have large growth potential but find both conventional debt and equity financing very costly. Such companies are often deterred from funding their capital investments with straight public bonds by their high risk, relatively short track records, and high expected costs of financial distress. At the same time, the information "asymmetry" between management and outside investors can make equity very expensive in such cases. In layman's terms, management may feel that the company's share price does not accurately reflect its growth prospects, or be concerned that the mere announcement of a new equity offering will cause the share price to fall sharply.
To the extent the stock market is persuaded that management's choice of convertibles is based on this combination of promising growth prospects with limited financing options, it is likely to respond more favorably to the announcement of a new convertible offering. The authors furnish evidence in support of this argument by reporting that the market reacts less negatively to those convertible issuers with higher post-issue capital expenditures and higher market-to-book ratios, but with lower credit ratings and higher (post-offering) debt-equity ratios.     

TOWARD A MORE COMPLETE MODEL OF OPTIMAL CAPITAL STRUCTURE

Most corporate finance practitioners understand the trade-off involved in making effective use of debt capacity while safeguarding the firm's ability to execute its business strategy without disruption. But quantifying that trade-off to arrive at an optimal level of debt can be a complicated and challenging task. This paper develops a simulation model of capital structure that starts by generating multiple estimates of market rates (LIBOR, currency rates) and corresponding company operating cash flows. To arrive at an optimal capital structure, the model then incorporates the shareholder value effects of alternative financing decisions by directly measuring the costs of financial distress, including the costs of missed investment opportunities and higher working capital requirements.
The model generates both a target credit rating and a lower fallback rating that permits a higher level of debt to maintain investments and dividends when operating cash flows are weak. As the model shows, companies with volatile cash flows and significant investment opportunities can add substantial shareholder value by establishing a fallback credit rating that is one or two notches below the target rating. The model also optimizes the mix of fixed versus floating debt, the maturity structure, and the currency composition. Another distinctive feature of the model is its ability to estimate the expected cost of alternative liability structures that can provide the liquidity insurance necessary to sustain the firm through periods of severe stress. This cost turns out to be quite small relative to the total market capitalization of the average firm.     

A COMPARABLES APPROACH TO MEASURING CASHFLOW-AT-RISK FOR NON-FINANCIAL FIRMS

Cashflow-at-Risk (C-FaR) is an attempt to create an analogue to Value at Risk (VaR) that can be used by non-financial firms to quantify various kinds of risk exposures, including interest rate, exchange rate, and commodity price risks. There are two basic ways to attack this problem. One is from the "bottom up," which involves building a detailed model of all of a company's specific exposures. The C-Far approach presented here is a "top-down" method of comparables that looks directly at the ultimate item of interest—the companies' cashflows. The fundamental challenge facing the top-down strategy is that, for any one company, there is not enough data on its own cashflows to make precise statements about the likelihood of rare events. To get around this problem, the authors match a target company with a large set of comparable companies that are expected to have similar cashflow volatility. The comparables are chosen to be close to the target company on four dimensions: (1) market cap; (2) profitability; (3) industry risk; and (4) stock price volatility.
C-FaR can be useful to managers addressing a variety of corporate finance decisions. For example, by providing estimates of the probability of financial distress, the C-FaR method can be used in conjunction with capital structure data to help formulate debt-equity tradeoffs in a more precise, quantifiable fashion. It can also be used to evaluate a firm's overall risk management strategy, including the expected benefits of using derivatives to hedge commodity-price exposures or the purchase of insurance policies. Moreover, C-FaR may even have a use in investor relations: by disclosing the results of a comparables-based C-FaR analysis ahead of time, a company may be able to cushion earnings shocks by furnishing investors or analysts with credible, objective estimates of what is likely to happen to their cash flows under different economic scenarios.     

A SENIOR MANAGER'S GUIDE TO INTEGRATED RISK MANAGEMENT

This paper provides an overview of corporate risk management for senior managers. The author discusses the integrated risk management framework, emphasizing that a company can implement its risk management objectives in three fundamental ways: modifying its operations, using targeted financial instruments, or adjusting its capital structure. "Integration" refers both to the aggregation of all risks faced by the firm into a net exposure and to the coordinated use of these three risk management techniques. The author provides a functional analysis of integrated risk management using a wide-ranging set of case illustrations to show how the risk management process influences, and is influenced by, a company's overall strategy and business activities. Based on such analysis, the article concludes by sketching a framework intended to help managers design a value-maximizing, enterprise-wide corporate risk management system.     

ENTERPRISE RISK MANAGEMENT: THE CASE OF UNITED GRAIN GROWERS

Enterprise risk management (ERM) refers to the identification, quantification, and management of all of a company's risks within a unified framework. This approach is much more comprehensive than traditional risk management practice, where different types of risk are managed by different people using different tools. The authors evaluate the advantages and disadvantages of ERM and then describe how United Grain Growers (UGG), a major farm service provider in Western Canada, established such an approach.
Extensive risk identification and measurement indicated that the volatility of UGG's earnings was driven to a large extent by changes in the volume of its grain shipments, which in turn were principally due to variation in weather. After first considering the use of weather derivatives to hedge the risk, the company ended up purchasing an insurance contract, bundled with its traditional insurance coverage, that pays UGG if its grain volume is unexpectedly low. The potential for moral hazard that can make insurance an expensive proposition was limited by basing payoffs on industry grain shipments rather than the company's shipments. The bundled approach served to expand and integrate UGG's insurance coverage, while eliminating redundant coverage.
Besides economizing on insurance costs, another valuable aspect of enterprise risk management is as a source of information about the operations of the firm. By providing managers with a better understanding of their business and events that can undermine the firm's strategic objectives, ERM can lead to better operating decisions as well as a more efficient approach to risk retention and risk transfer.     

Capital Structure, Information Acquisition and Investment Decisions in an Industry Framework

This paper analyzes the relationship between a firm's capital structure and its information acquisition prior to capital budgeting decisions. It is found that low-growth industries can sustain a large number of levered firms. In these industries, leverage is negatively related to a firm's incentive to acquire information during the capital budgeting process. In contrast, high-growth industries only sustain a small number of levered firms. In these industries, levered firms acquire more information than all-equity financed firms. The model yields empirical predictions regarding the effects of leverage on the expected amount and the volatility of corporate investment. While leverage does not affect firm value, highly levered firms generate a more volatile cash flow than firms with low debt levels.     

Local Taxes and Capital Structure Choice

This paper investigates the question of taxation and capital structure choice in Germany. Germany represents an excellent case study for investigating the question of whether and to what extent taxes influence the debt-equity decision of firms, because the relative tax burdens on debt and equity vary greatly across communities. German communities levy local taxes on profits and long-term debt payments in addition to personal and corporate taxes on the federal level. A stylized model is presented incorporating these taxes. The model shows that local taxes create substantial incentives for firms to use debt financing. Furthermore, the paper empirically investigates the effect of local business taxes on the share of debt used to finance incremental investments by German firms. I find that local taxes significantly influence the capital structure choice of firms, controlling for a large number of other factors. In an extensive sensitivity analysis the tax effect are found to be robust across several different specifications.     

UNIVERSITY OF GEORGIA ROUNDTABLE ON ENTERPRISE-WIDE RISK MANAGEMENT

For many years, MBA. students were taught that there was no good reason for a company that hedged a large currency exposure to trade at a higher P/E than an otherwise identical company that chose not to hedge. Corporate stockholders, simply by holding well‐diversified portfolios, were said to neutralize any effects of interest rate and currency risk on corporate values. And thus corporate efforts to manage risk were thought to be “redundant,” a waste of corporate resources on a function that was already accomplished by investors at far lower cost. But the theory underlying this “perfect markets” framework has changed in recent years to focus on ways that corporate risk management can add value. The academics and practitioners who participated in this roundtable began by discussing in general terms how risk management can be used to support a company's strategic plan and investment policy. At Merck, for example, where R&D spending was determined as a percentage of earnings, a policy of hedging foreign currency exposure to reduce earnings volatility was viewed as adding value by “protecting” the firm's R&D. The panelists also agreed that a well executed risk management policy can increase corporate debt capacity and, in so doing, reduce the cost of capital by lowering the likelihood of financial distress. For example, companies with debt covenants might undertake a risk management program to lower earnings volatility and ensure a minimum level of earnings for debt compliance purposes. But one of the clear messages of the roundtable is that risk management and earnings management are not the same thing, and that companies that view risk management as primarily a tool for smoothing reported earnings have lost sight of its real economic functions. Moreover, in making decisions to retain or transfer risks, companies should generally be guided by the principle of comparative advantage. That is, if there is an outside firm or investor willing to bear a particular risk at a lower price than the cost to the firm of managing that risk internally, then it makes sense to lay off that risk. In addition to the cost savings and higher return on capital promised by such an approach, a number of the panelists also pointed to a less tangible benefit of an enterprise‐wide risk management program—namely, a marked improvement of the internal corporate dialogue, leading to a better understanding of all the firm's risks and how they are affected by the interactions among the firm's business units.     

金融资产配置与违约风险:蓄水池效应,还是逐利效应？

本文以2007—2016年中国A股上市公司为研究对象,检验了企业金融资产配置对违约风险的影响。实证研究发现:金融资产持有量越多,企业的违约风险越低,金融资产配置的“蓄水池效应”显著;在货币政策宽松时期,金融资产配置导致的代理冲突显现,宽松的货币政策会抑制金融资产投资对违约风险的降低作用。政府规制也会有一定的公司治理作用,将产业政策纳入讨论发现:对于产业政策支持的行业来说,企业金融资产配置能够降低违约风险,但是宽松的货币政策会刺激管理层的短视投资行为,抑制政府规制的公司治理作用。进一步地,本文提出会计稳健性的提升是企业金融资产配置降低违约风险的重要路径。本文的研究结论丰富了企业金融资产配置动机和违约风险影响因素的讨论,能够为政府部门防范经济运行中的内在风险提供有益借鉴。     

BETAS AND DEBT MANAGEMENT WITHIN THE UK TAX ENVIRONMENT

Tax complexities relating to corporate tax losses, induced by debt finance, and to the differential tax treatment of equity and sterling debt, are introduced into corporate valuation. The after personal tax value of the geared firm can be less than that of the equivalent ungeared firm. Also, debt-induced tax losses can create negative betas. These fiscal effects are incorporated into degearing formulae under active and passive debt management policies.     

DESIGNING CAPITAL STRUCTURE TO CREATE SHAREHOLDER VALUE

In the past decade, many U.S. companies have launched aggressive share repurchase programs with the expectation that value can be created by returning excess capital to shareholders and moving the firm closer to its optimal capital structure. But how much capital does a company really need to support its business activities? This article presents an economic framework or “model” that can be used to simulate the effect of various capital structure choices on shareholder value. The fundamental insight underlying the model is that judicious use of debt can add value by reducing corporate taxes and strengthening management incentives to increase efficiency, but that too much debt can result in a loss of business and perhaps a costly reorganization. Indeed, one of the key findings of the authors' recent research is that companies with highly leveraged balance sheets suffer disproportionately large losses in market share and value during industry downturns. As illustrated in a case study of a hypothetical general merchandiser, the model makes it possible to identify an optimal debt-equity ratio (and percentage of fixed- versus floating-rate debt)—one that balances the value of the tax shield from debt against the increased risk of financial distress.