April 2013 | 

Wharton on Raising Capital to Fund Growth


Financial distress isn’t something most financial professionals like to think about, let alone plan for. But if your organization needs to raise capital, it’s something you need to consider. “If you haven’t been able to keep up with changes in the finance industry, including new practices in debt contracting and how financial distress plays out, you can be at a disadvantage,” notes Wharton finance professor David Musto. “There are new players, including distressed debt investors, who may be eager to capitalize on someone else’s misstep.”

Before you go to capital markets, says Musto, understand how you can position yourself through the debt contract. “Some commitments may keep you from taking certain actions in the future. It might make the bond easier to sell, but you have to bear in mind the tradeoff — you get a better deal by constraining your latitude. This is an important issue to consider when you go to capital markets. Understand what you are promising when you sell a bond, and the kinds of risk you are exposing yourself to.”

Musto serves as co-faculty director for a new Wharton Executive Education program, Raising Capital to Fund Growth to Fund Growth. “Financial professionals need to keep their knowledge and skills sharp. There are considerable risks involved in raising capital, but you can reduce them by the way you go to the capital markets in the first place. The bond example is a good one: to make covenants that will protect you if your firm gets into trouble, you need an understanding of those covenants so one unsteady period doesn’t make you vulnerable to dire consequences.”

Finance professor Bilge Yilmaz, co-faculty director of the program, notes, “If you’re the head of a group that’s supposed to issue a security, you must know why certain covenants are included, what they cost, and what they can mean for your firm in all of the future situations you may find yourself in. Ten years ago if you took David’s class on Capital Markets [which the new program is based on], you were exposed to the bond-contracting practices of the time, which were quite different. As markets adapt to new realities, and bondholders sharpen the use of their rights, covenants and related negotiating points have to keep up. It is similar with technical glitches of pricing securities, control contingencies, and security design. Keeping up with changes is challenging but vital.”

Wharton accounting professor Jennifer Blouin agrees, “Taxes, and specifically changing tax rates, affect every decision, especially when they involve debt. The United States is currently talking about reducing the corporate tax rate [currently at 35 percent], but they want it to be revenue neutral. That means while you will pay less in taxes, you’re going to have to give something up. Interest deductions, for example, might be limited. This can affect the dynamics of your company if you are a cross-border or multinational.

“Tax rules are out of your control,” Blouin continues. “Legislation is shifting and unpredictable. What’s important to be aware of is that debt is mobile — you can borrow from many places. Because of the U.S.’s relatively high tax rate, you are incentivized to park that debt in the United States. But you can’t have 90 percent of your profits overseas and most of your interest here. When you think about efficiently allocating debt abroad, you must be aware that the European Union is challenging these tax minimization strategies. As governments compete for corporate tax dollars, there is a global race to the bottom. Financial professionals need to understand this landscape as they make decisions about where to borrow from.”