“Too few people understand a really good sandwich” -James Beard
In our recent six-part series, “A Historic Blogpost,” we covered a number of strategies across the spectrum of private equity, debt, and other holdings. While some aspects of risk/reward were alluded to throughout that series, I think it’s worth examining the risk/reward continuum of the capital structure for additional context. Much of this topic isn’t only applicable to alternative investments. Still, it’s an important one for understanding many alts strategies – and it may even provide insights for the traditional part of your portfolio. With that, let’s build ourselves a capital sandwich.
It Starts with the Bread
Just as two slices of bread serve as the basis to make a sandwich, a given company capital structure will likely have common equity and senior debt as basic building blocks. The equity – or bottom slice of bread – is the riskiest part of the structure, as everything else sits on top. That bottom slice can get smashed or compromised by the ingredients above it, and it can be ruined by running juices of other food on your plate. Similarly, if something goes wrong with a company, the equity is the first to take the hit, thus helping to protect the investments above it. To compensate them for their risk, equity holders also directly participate in the company’s growth, which means more upside potential.
Senior debt (our top slice of bread), on the other hand, sits high and dry on top of the other components. The juice from your fruit salad may ruin the bottom of the sandwich, but there’s not a chance it will go through all of the layers of protection and pose a threat to that well-insulated top slice. Even in the event of bankruptcy – backed by the remaining assets of the company – senior debtholders may be made whole while equity owners walk away empty-handed.
Rye or Wheat?
As with bread, there are many examples of common equity. On the traditional side, this includes common stock of publicly traded companies (if you’re a client of The Bahnsen Group, your Dividend Growth stocks fall into this category). In the Alts realm, it’s similar to what you may find in private equity investments, such as ownership of private companies and real estate. In both situations, there can be a very rewarding upside but also a catastrophic downside (i.e., total loss).
Recently, I wrote about several funds that involve private ownership and that there are two main ways to help mitigate equity risk (this is conceptually similar to public equities, though there is arguably much greater control in private markets):
- Underwriting: what we pay for a given business or property, considering how we believe that asset will perform in the future and accounting for worst-case scenarios.
- Diversification: we cannot imagine or plan for all detrimental outcomes, so owning smaller stakes in more businesses or properties lowers the chance that any single factor will “blow up” one’s portfolio.
Turning our attention to debt, there can be varying degrees of seniority, but the most senior type is typically senior-secured loans or bonds. These arrangements are “senior to” (i.e., ranked higher than) other debt of the company and secured (i.e., backed) by some form of collateral, like the assets of the business. The increased protection inherent to senior debt also means that it should pay a lower yield than riskier bonds below it (which we’ll get into shortly). It also has the best chance of maintaining its value through worst-case scenarios for the company.
Meats and Cheeses
Between our (most-risky) common-equity bottom and our (least-risky) senior-secured-debt top, there are other forms of debt and equity that a company can use to raise capital and/or distribute ownership.
Preferred Stock: preferred stock sits just ahead of common stock with regard to claims on the company (but still below bonds), and that’s true for either distributions (e.g., dividends) or liquidation events (bankruptcy). However, it also typically lacks the voting rights afforded common shares. Preferred stock is considered a hybrid security between stocks and bonds. It pays a fixed dividend (“bond-like”) but also represents ownership (“stock-like”) and may even be convertible to common shares in some instances (known as convertible preferred stock).
Mezzanine Debt: Continuing to build our capital sandwich from bottom to top (bun), mezzanine debt is our next potential ingredient. Like the preferred stock below it, “mezz debt” is a hybrid of equity and fixed income, but it’s even more bond-like. For reference, we covered an example of mezz debt in our small business loan fund in the last alt.Blend (A Historic Blogpost – Part 6).
While mezzanine loans are very clearly fixed-income arrangements at their core – consisting of obligations that require interest payments and ultimately full repayment – they also include ways to participate in the company’s growth (like call options, rights, or warrants, which we will not go into here). Mezz debt is subordinate to (i.e., below) other debt securities of the company and serves as a bridge between equity and debt financing.
Convertible Bonds: Yet another hybrid security, convertible bonds are debt securities that include a provision for converting to shares of common stock. And – as we can tell by where they fall in the sandwich – they are far more senior (i.e., less risky and more likely to have recovery) in the capital structure than preferred stocks. The company can pay a lower coupon on these bonds vs. regular bonds because of the conversion privilege.
Other Bonds/Debt: There can be many other bond/debt issues, ranging from junior (more risky, more yield) to more senior (less risky, less yield) until you get to senior-secured bonds we discussed earlier.
Deli-Wrapping It All Up…
We’ve touched on only a select number of equity/debt options that companies have, but the above should help give you a taste of arrangements that may exist within a capital structure. By navigating this spectrum, investors and businesses can select from many combinations that vary risk, ownership, yield, protection, and optionality to find the balance they desire. Many of these, such as common/preferred/convertible stocks and bonds, are found within public markets. On the other hand, Mezzanine debt is found almost exclusively in private transactions, in my experience (I cannot offer you a publicly traded example, but feel free to call me out on this).
Most notably for the purposes of alt.Blend, all of these pieces can be found within alternative investments. Various equity/stock and debt/bond arrangements are essential components of venture capital, real estate, merger arbitrage, long/short, distressed, private debt, and almost any Alt one may encounter. Having a grasp on fundamental equity and debt arrangements can help you quickly make sense of a given strategy, ask relevant questions, consider practical alternatives, and – perhaps most importantly – know what you own.
A Taste of Pittsburgh: Merrill Hoagie
While we’re on the topic of sandwiches…if there’s one reason Pittsburgh will always hold a special place in my heart (aside from growing up just north of the city, having an extensive network of friends and family there, being a lifelong Penguins and Steelers fan, etc.), it’s that when you get an Italian hoagie from any pizza shop around Pittsburgh, it’s served hot. Not “toasted.” Hot. It’s magical. You order an Italian hoagie, and it’s served the way Italian hoagies are supposed to be served: baked with the lunch meat heated all the way through, melted cheese, toasty Mancini’s bread – the final touches of shredded lettuce, tomatoes, onions, and Italian dressing added after it’s out of the oven. Outside of The ‘Burgh, trying to get a decent Italian hoagie requires a paragraph of special instructions for a subpar imposter version.
And, finally, if you’ve ever seen a Pittsburgh Steelers game, then you’ve surely also noticed a sea of yellow Terrible Towels spinning in the hands of Steelers fans. What you may not know, however, is that the creation of the Terrible Towel (which has its own Wikipedia page) is attributed to the late Myron Cope – the long-time Pittsburgh local play-by-play announcer with an unforgettably distinct, animated delivery and known affectionately as “the voice of the Steelers” (here’s a link to some of his notable vocal escapades).
After the 1987 draft, Merrill Hoge joined the Steelers as a running back, and – as far as I remember – Myron Cope always mispronounced his name. “Hoge” is supposed to rhyme with “Dodge,” but, instead, Myron pronounced it as “hoagie.” Merrill Hoagie! Who knows why, but calls like, “Hoagie, diving into the endzone for the touchdown!” was hilarious to us kids. A Pittsburgh Italian hoagie, on the other hand, is no joke. Go get yourself one and enjoy a small taste of heaven.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
