The Art and Science of Capital Structure

Capital Structure Fundamentals and Context

• Merton Miller's Nobel-winning theory posits capital structure is irrelevant in valuations only in frictionless environments (e.g., a moon of Jupiter without atmosphere), but on Earth, it is critical.
• Key factors influencing capital structure decisions include company management quality, industry volatility (e.g., high volatility tech requires less debt), capital market timing, economic conditions, regulation, and societal perception.
• Steve Ross's tenure at Warner allowed for complex capital structures, while his death necessitated simplification.
• Society's perception of an industry directly influences regulatory risk; for example, the public views banks negatively, leading to increased scrutiny.

Evolution of Banking Capital Structures and Regulation

• Pre-1980s bank capital structures were simple (deposits and equity); the 1980s introduced regulatory changes allowing various debt forms (e.g., non-cumulative preferred) to count as equity.
• Pre-2008, some US banks held equity capital as low as 1% of assets due to these regulatory accounting shifts.
• Post-2008, bank capital structures are strictly controlled by regulators, effectively transforming banks into public utilities subject to rigid capital and lending requirements.
• European banks face a 3:1 asset-to-GDP ratio compared to the US (1:1) and hold only 4.5% capital versus the US 8.5%, while being funded 50% by deposits compared to the US 85%.
• New US regulations (effective May) allow small banks (under $1B assets) to issue sub-debt counted as equity at a 3:1 ratio, expected to drive massive consolidation among the 5,800 small US banks.

Shadow Banking and Market Dynamics

• Regulatory constraints (Basel, Dodd-Frank) have forced money-center banks to contract, creating opportunities for the "shadow banking system" (hedge funds, private credit) to fill gaps in leveraged loans, high-yield bonds, and preferred convertibles.
• Shadow banking assets in the alternative financing space have reached over $75 trillion globally.
• Mitch's firm (Canyon) and other alternative asset managers focus on "anticipate, precipitate, participate" strategies regarding balance sheet changes in both micro and macro environments.
• The US market has a "desert" of operating finance companies, whereas Europe has a vacuum where operating finance companies are virtually non-existent, creating a prime investment opportunity.

Investment Strategies and Specific Market Opportunities

• Crescent Capital: Manages $18 billion (50% private); has invested over $10 billion in mezzanine finance (senior debt to equity) over 25 years.
  • Lends to companies requiring rates of 7-15% in a 5% public market environment.
  • Targeting talent "refugees" from exiting financial divisions (e.g., GE Finance) and social-impact sectors (e.g., UK nursing services).
  • Currently lending senior to US/EU companies at under 4x cash flow at ~10% interest rates.
• Leonard Green: Operates a $6.25 billion fund with flexibility to invest in equity, PIPEs (Private Investments in Public Equity), and public debt.
  • Utilizes PIPEs for downside protection (e.g., 8% preferred return in 2008 Whole Foods deal).
  • Actively engages in OpCo/PropCo arbitrage (e.g., buying public companies with high real estate value, selling real estate at 6% cap rates, and retaining the operating company at 10x EBITDA).
  • Shifted from fear of covenants to a "feed frenzy" environment where 33% of deals involve diverse securities beyond traditional LBOs.
• Canyon (Mitch): Focuses on balance sheet restructuring, including "buying losers" to liquidate into winners (e.g., UK consumer finance) and investing in undervalued banks (COCOs, equity).
  • Invested heavily in alternative energy (SunEdison, SolarCity) benefiting from regulatory subsidies and low interest rates via OpCo/PropCo structures.
  • Identified capital structure arbitrage in the gaming sector (Caesars bankruptcy) using OpCo/PropCo splits.

Operational Discipline and Labor Trends

• The 2008-2011 crisis forced lasting discipline on US corporates, resulting in higher cash generation, improved cost control, and more realistic management assessments of core competencies.
• Profit margins are at all-time highs due to operational efficiency rather than just favorable economic conditions.
• Rising labor costs (minimum wage debates, Affordable Care Act) are driving a shift toward automation, reduced hours, and increased employee deductibles/co-pays.
• Companies are moving from "command and control" to collaborative environments to solve cost issues, though labor cost remains a primary regulatory/regulatory headache.

Forward-Looking Statements and Firm Strategies

• Europe: Expected to experience a "supertanker" turnaround in job creation as new finance companies replace contracting banks, though this will take 5-10 years.
• Capital Market Volatility: Expect continued acceleration of balance sheet changes and restructurings despite being late in the economic cycle.
• Firm Evolution:
  • Leonard Green: Core business remains PE, but open to diversification into related areas due to capital abundance; will not become a "global supermarket."
  • Canyon: Plans to extend skill sets into structured finance (CLOs, RMBs) and invest in alternative asset managers (e.g., Blackstone) without becoming a regulated bank.
  • Crescent: Aims to scale to compete with larger firms like Blackstone, potentially entering real estate lending (but not equity) to capitalize on market arbitrage.
  • All panelists agree on the prohibition of owning regulated banks due to regulatory risk and personal liability, preferring to act as "shadow banks."