You may have heard people in the financial sector, including our Hon Minister of Finance, speak about assets along the capital structure. But what in the world does that mean? And, more importantly, what does it have to do with me? Well, let's level up your financial arsenal.
At the basic level capital structure refers to the different sources used to finance a business, ie specific forms of equity and debt. It can take the form of stocks: common or preferred and retained earnings; as well as debt such as bonds, notes and loans which can have a tenure of short and long term. Having the appropriate asset mix impacts how well-funded and operated a company will be, and therefore how profitable it will become. Hence, when assessing a company, the debt-to-equity ratio is always a key metric; it will give an indication of risk.
In previous articles we discussed at length the relationship between risk and return; where an asset falls along the capital structure tends to be an indication of the risk one is taking on. Therefore, in the event of a winding up it would indicate the sequence in which investors would be paid, enabling them to recover their initial investment. So holders of debt instruments are paid out first then preferred and lastly common shareholders. Think of each layer like a stack of bricks, the higher up the capital structure the lower the risk and therefore lower risk tends to lean towards a lower return.
WHY IS IT IMPORTANT TO ME?
Investing along the capital structure is where the real money is made. One must take a calculated risk in order to gain alpha type returns. Hence, examine the entities you are thinking about investing in to ensure they have a healthy debt to equity ratio in line with their industry.
But what are alpha type returns and why do you need them? Alpha represents the above-the-benchmark returns in your portfolio. You do not just want to hedge against devaluation and inflation, you need returns above and beyond both, in order for you to truly say you are making gains on your portfolio. Otherwise, you are only securing the purchasing power of your money.
You may have heard billionaire Michael Lee-Chin speak about the liquidity discount: this is one vehicle to attaining alpha type returns. Family offices and other financially savvy investors are looking to private equity in order to take advantage of the illiquidity discount. Let's put it into context. Have you ever looked at the financials of a company that was about to list? Quite often you will see a large capital injection in the preceding years before the IPO. This capital injection allows the entity to fuel its growth and garner a greater valuation at the IPO stage. Once listed, the company has already been positioned for further growth and is seeking another capital injection to take it to the next level. Now imagine being the private equity investor that provided the pre-IPO capital â€” cha-ching-ching! As happy as the IPO investors are, it is this early investor that is ecstatic as returns grow exponentially.
The point of all of this is to say: do not just invest in one or two types of securities. Jamaica has the most vibrant and developed capital markets in the region; take advantage of them. A truly balanced portfolio will require a blend of assets that include debt and equity along the capital structure with varying tenures. Consider a private equity fund if you do not have the opportunity to invest directly into a potentially lucrative opportunity entity. Typically, direct investments are limited to accredited investors or personal relationships, so a fund will not only be the most accessible, but it will also allow for you to diversify your risk across several entities.
"Nothing is more expensive than a missed opportunity." H Jackson Brown Jr.