"Terra
Firma, one of Europe's biggest private equity firms, has been fighting to win
back investor support after losing £1.75 billion ($2.72 billion) in equity from
a £4.5-billion buyout of music label EMI Group in 2007. It said recently it
would change its approach to investing and spend 1 billion euros ($1.14
billion) of its own capital on future deals."
(Ranasinghe,
2015)
Recent capital structure decisions by Terra Firma suggest the firm are still trying to lower financial distress costs caused by their unsuccessful takeover of EMI in 2007. I believe that the unsuccessful takeover still remains the primary cause of these financial stress costs, where despite the firm managing to avoid liquidation, its relationship with creditors have remained seriously damaged, mentioned as Arnold (2013) as a cause of financial distress; with it being reported in 2011 that Terra Firma was forced to hand over EMI to Citigroup after being unable to keep up interest payments on loan (BBC News, 2011). Since then I believe the failed takeover has followed Terra Firma, with investors questioning the firm’s ability to deliver on future promises.
The recent decision from Terra Firma to invest its own
equity in future investments seriously suggest this is the case, with potential
investors currently requiring a higher rate of return. Cheap debt is
currently unobtainable - as depicted by my position of
TerraFirma within Figure 1 - with shareholders and lenders increasing
their demand of return due to associated risk (Myers,
1984) (Arnold, 2013). I believe the return for investment requested
by investors is currently so high they outweigh the tax advantages achieved
through gaining capital through debt.
Source:
Self-Elaboration for Blog
Thus I believe the recent capital
structure decision could be seen as a 'signalling' attempt primarily
aiming to increase investors’ confidence in the firm. Signalling is described
by Arnold as 'financial decisions taken to be signals from the manager to the
financial market' (2013). I believe the recent announcement by Terra Firma
is a signal to the market that the firm can invest its own equity due to an
ability to produce profits from other investments. Terra Firma's
management hope this will decrease the doubt potential investors have in the
firm, and thus their required rate of return back towards the optimal gearing
level.
Furthermore with questions over Terra
Firma's ability to return investments, the decision will decrease their gearing
ratio. Despite the 'handing over' of EMI to Citigroup perhaps decreasing some
debts, it must be noted there was a large loss 1.75 billion equity, which could
have increased the debt to equity and thus gearing ratio greatly. It is noted
in academic theories that higher levels of gearing are accompanied by higher
financial uncertainty and thus higher financial stress (Myers, 1983) (Arnold,
2014). Thus in theory decreasing their gearing ratio therefore should lead
to confidence over the firm’s ability to repay debts and thus lower the
financial stress, further leading to a movement of Terra Firma's current cost
of capital back towards the optimal gearing level depicted in figure 1.
In conclusion I believe Terra
Firma's recent announcement to use equity in future investments can hardly be
seen as surprising but again highlights financial distress in the company. Past
investment decisions have led to concern among its investors .Personally I am
not surprised by the large impact poor prior investment decisions
have on a firms ability to gain 'cheap debt', however it
brings into light how capital structure decisions can be majorly
impacted by financial distress.
References
BBC News. (2011). Citigroup takes ownership of EMI.
Retrieved 28 February 2015, from http://www.bbc.co.uk/news/business-12339299
Myers, S. (1984). The Capital
Structure Puzzle. The Journal
of Finance, 39(3), pp.574-592
Ranasinghe, D. (2015). Deal pipeline is huge: Terra
Firma's Guy Hands. CNBC.
Retrieved 28 February 2015, from http://www.cnbc.com/id/102453672
