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CAPITAL STRUCTURE BY PRIORITY RANKING: WHO GETS PAID FIRST?

FIRST

Senior Secured Debt aka secured bonds.

Senior refers to its priority in the capital structure not to the age of the debt. Bonds are
backed by collateral.

SECOND

Senior Subordinated Debt.

These are Unsecured bonds and are backed only by the promise & good credit of the
bond's issuer.

THIRD

Subordinated aka Junior debt.

This debt gets paid ONLY after higher ranking debt is paid.

The more junior bonds issued are usually called subordinated debt because a junior
bondholder's claim for repayment of the principal is subordinated to the claims of
bondholders with the issuer's more senior debt.

Mezzanine Debt is subordinated debt that usually blends equity & debt features.

FOURTH

Hybrid Financing. This is a segment of the capital structure that also blends equity & debt
characteristics.

Convertible Bonds are the most common type of hybrid financing. They have a rate of
interest and give the owner the right to exchange the bonds at some stage in the future
into ordinary shares according to a prearranged formula. They are sometimes called
Convertible Loan Stock.

What is the conversion value? The value of a Convertible Bond if it were converted into
ordinary shares at the current share price.

FIFTH

Preference Shares.
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These are like debt because holders are usually entitled to a fixed rate of
dividend/predetermined repayment. But this not guaranteed; the firm is not obliged to pay
back this specified amount and non-repayment does not, therefore, trigger default.

Holders of preference shares precede the holders of ordinary shares but follow bond
holders & other lenders, in the payment of dividends & return of principal.

Preference shareholders do not always have voting rights.

There are 4 types of preference shares:

1. Participating gives the holder a share in residual profits.

2. Cumulative - carries forward the right to preferential dividends.
3. Redeemable - a pref share with a finite life.
4. Convertible - may be converted into ordinary shares.

There are 3 Main Reasons to issue preference shares.

First it is cheaper than issuing ordinary shares & avoids common shares ownership dilution.

Second pref shares can be used in balance sheet management; some investors prefer low
debt-to-equity ratios and issuing prefs can better lower the D to E ratio than issuing debt; a
firm may need this financing to avoid a technical default on an existing bond - the latter
could trigger an immediate call on previously issued bonds or an increase in interest rates
on those bonds.

Thirdly, prefs give firms flexibility in making dividend payments. If a firm is running into cash
issues, it can suspend preference share dividend payments without risk of default.

LAST IN THE CAPITAL STRUCTURE PRIORITY

EQUITY. Ordinary aka Common shares.

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TYPES OF EQUITY

Founders Shares

Held by the founders of the company.

May have characteristics that distinguish them from Ordinary shares e.g. dividends are paid
only after all other categories of equity shares have received fixed rates of dividend.

Usually carry special voting rights over certain company matters.

BUT sometimes they are simply Ordinary shares held by the founders.

Ordinary/Common Shares

These are the equity capital of the firm. They are entitled to control the direction of the firm
via the power of their votes, one share one vote.

Holders are the owners of the company and entitled to all distributed profits AFTER the
holders of pref shares, and other debt holders have had their claims met.

Owners have rights to dividends, vote at shareholder meetings, there is zero contract
between the company & shareholder that the shareholder will get back the original
capital invested.

Preference Share/Preferred Stock

As has been noted in the Priority of the Capital Structure, preference shares are like debt
because holders are usually entitled to a fixed rate of dividend/predetermined repayment.
But this not guaranteed; the firm is not obliged to pay back this specified amount and non
repayment does not therefor trigger default.

Holders of prefs precede the holders of ordinary shares but follow bond holders & other
lenders, in payment of dividends & return of principal. Pref shareholders do not always have
voting rights.

To reiterate, there are 4 types of pref shares: Participating gives the holder a share in
residual profits. Cumulative - carries forward the right to preferential dividends. Redeemable
- a pref share with a finite life. Convertible - may be converted into ordinary shares.

Convertible Equity

A hybrid type of finance. Usually takes the form of convertible preferred shares i.e.
preferred equity that can be converted into ordinary equity at the holder's discretion.
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It usually has a stated preference amount in the event of liquidation, and it sometimes has
a set dividend rate that acts similarly to a coupon rate for a bond.

Equity Warrants

A security issued by a company that gives the owner of the security the right, but not the
obligation, to buy shares in the company from the company at a fixed price during or at
the end of specified time period.

WARRANTS RARELY HAVE ANY INTRINSIC VALUE ON THEIR OWN. The only value the warrant
has comes from its conversion feature. Warrants are like options but tend to have longer
lifespans with expiration dates as much as 10 years ahead. Like options, if they expire
unexercised, they are worthless.
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SOURCES OF EQUITY FINANCE

INITIAL PUBLIC OFFERING (IPO)

An IPO is also known as a New Issue. The offering of shares in the equity of a company to
the public for the first time. Result, stock market listing.

RIGHTS ISSUE

An invitation to existing shareholders to purchase additional shares in the company in

proportion to their extant holdings.

PRIVATE EQUITY

It's in the name. PE investors invest only in private i.e. non public/ non listed companies. PE
is an umbrella label that includes: business angels, VC, MBOs, LBOs, inter alia. Classic PE
firms like Blackstone, Apollo, KKR take controlling stakes when they invest.

VENTURE CAPITAL

Venture Capital specialists rarely want a controlling stake in the company and the
entrepreneurs do not want to sell a controlling stake at this stage. VCs often buy 20-30% of
the company. VC is a form of Private Equity.

CROWD FUNDING

Crowdfunding is the process of raising small amounts of money for a project or venture by
a large number people. It is usually achieved via an online platform. Reward and equity
crowdfunding are the most common types of crowd funding.

Reward funding provides something in return for the money, but not equity. Could be the
first version of XYZ, exclusive ltd editions etc.

Equity funding is just that - shares for money. BUT debt crowdfunding is growing - see
P2P/Marketplace lending.
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WORKING CAPITAL, CASH, FINANCING

WORKING CAPITAL

Working capital is the operating liquidity available to a company. It is current assets minus
current liabilities.

Net working capital is working capital minus cash (which is a current asset) and minus
interest bearing liabilities (debt).

You can have assets and profits but if you don't have working capital, i.e. cash or assets
that can be converted into cash, the firm may not be able to continue operations, pay its
bills etc.

What does the management of Working Capital involve? The management of inventories,
accounts receivable and payable and cash.

WORKING CAPITAL & COMPANY VALUATON

A reduction in working capital requirements will generate a positive free cash flow, all else
being equal, that the company can distribute to shareholders.

RECEIVABLES AKA DEBTORS

How long will they take to pay? Trade debtors divided by sales multiplied by 365 gives you
an indication of the average number of days.

PAYABLES AKA CREDITORS

How soon should you pay your creditors? Taking your time improves cash flow BUT may
hurt your reputation as a signal of financial weakness.

FACTORING

Companies facing a cash flow squeeze & slow paying customers often sell their invoices or
accounts receivable to specialised firms called factors.

The factor gives the company 70-90% of the invoice amount AFTER doing a credit check on
the customer who is late in paying. When the bill is paid, the factor remits the balance to
the company, minus a transaction / factoring fee which can be several hundred basis
points more than a "normal" lender.
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BANK FINANCING

Overdrafts. Loans, single and end of period, can't be paid off early Libor plus. Bridge Loan.
Line of Credit.

There is no penalty for early repayment of the overdraft, but it is repayable on demand.

Loans will have terms and likely require collateral. EXAMPLES OF COLLATERAL THAT CAN BE
USED? Inventory, property, etc.

Lines of Credit can be revolving ie you pay a commitment fee and use funds as needed;
they can also be evergreen meaning the principal does not need to be repaid by a
specific date.

BRIDGE LOAN .. continued next page

Bridge loans are for individuals or companies that need short term financing often when
selling & buying property with mismatched completion dates. Terms of a few days to 6
months, but can be up to 12 months.

These loans are also used by start-up companies that are loss making and will run out of
cash before they can conclude a round of financing or other transaction.

Bridge loans to companies are usually made by existing investors. Other investors will see
such a loan as a red flag.

BONDS

A debt instrument that requires the issuer aka borrower to repay the lender aka investor the
amount borrowed (the principal) plus interest over a specified time period. The date on
which the principal must be repaid is called the maturity date. Usually bonds with a
maturity of 1 to 5 years are considered short term; 5 to 12 years are intermediate; and
bonds with a maturity of more than 12 years are long term (Fabozzi, 2000).

INVESTMENT GRADE OR NON-INVESTMENT GRADE aka HIGH YIELD BONDS

The coupon/interest payment is always determined at origination.

Fixed rate or floating rate. Fixed rate coupons are usually paid semi annually. Most of these
bonds trade in the OTC market. This is decentralised with bond dealers & brokers trading
nationally & globally.

CREDIT RATING
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The rating depends on the likelihood of default i.e. the non-payment of interest and / or
capital.

At what level does an investment grade bond become a non-investment grade bond?

Fitch, a rating agency, has the following: Investment Grade are ratings AAA to BBB; and
Non-Investment Grade are ratings BB to D.

ZERO COUPON BONDS

This is the only bond that does NOT pay a coupon. It is sold at a discount to par value with
a specified duration and redeemable at par.

The investment is all about capital gain. See Arnold p431.

DISTRESSED DEBT

The debt of financially distressed companies whose bonds may at some point been
investment grade. Distressed securities are bonds with an interest rate of more than 1,000
basis points above the yield of equivalent maturity US Govt debt (FT.com, 5 June 2016,
4.43pm).

DEBTOR-IN-POSSESSION FINANCING (DIP)

Financing obtained by an insolvent debtor while said debtor is restructuring its business.
The term originated from the US practice in Chapter 11 proceedings under the US
Bankruptcy Code. During a chapter 11 process, the debtor is referred to as a DIP since the
debtor is continuing "in possession" of the business while the company is being restructured.
(The Canadian Business Journal, Sept 2013).

COMMERCIAL PAPER (CP)

CP is a short term debt instrument issued by large companies. It is usually issued at a

discount to a predetermined face value, this means investors acquire CP at a price below
the face value and receive the face value at maturity.

The difference between the purchase price & the face value is the discount i.e. the interest
received on CP. In practice, the interest rate on CP is a bit higher than the rate on Treasury
bills of the same maturity and a bit lower than the interest rate on loans of the same
maturity. LIBOR is the benchmark interest rate paid on short term lending among large
banks.
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CP is rated by the rating agencies e.g. S&P, Moody, Fitch. It usually has a very high short
term rating. Most investors purchase at issuance and hold until maturity; there is little trading
of CP in the secondary market.

MEDIUM TERM NOTE (MTN)

This is a corporate debt instrument. It has a unique feature: notes are offered continuously
to investors by an agent of the issuer. Investors can select from maturities ranging from 9
months to 30 years.

The MTN name is misleading; traditionally it referred to debt issues with maturity greater
than 1 year but less than 15 yrs.

The purpose for many issuers is to fill a funding gap between CP and long term bonds. MTNs
are registered with the SEC, Rule 415.

RISKS OF BONDS TO INVESTORS/LENDERS

Liquidity - how easy is the bond to sell if you need to? Interest rates - if they rise the value of
a corporate bond in the secondary market will likely fall. Event - Mergers, acquisitions etc
can have a negative impact on a bond issuer's ability to pay its creditors. FX risk if a
merger or acquisition is between firms with different reference currencies.

TECHNICAL DEFAULT

This may occur when the debt to equity ratio breaches a limit set in a currently issued bond
covenant.
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ABS, MBS, CDO, CLO, SECURITISATION, SYNDICATION, REPOS

ASSET BACK SECURITY (ABS)

An ABS is a pool of financial assets that have cash flow E.G. loans, mortgages, credit cards,
accounts receivable etc. Before the investment banks get hold of them, these assets are
not tradeable. Investment banks repackage these assets into other securities e.g. bonds,
and sell them to investors (i.e. securitise them).

MORTGAGE BACKED SECURITY (MBS)

These are mortgage loans that have been pooled and repackaged by investment banks to
create investable securities. A form of asset backed security.

COLLATERALISED DEBT OBLIGATION (CDO)

A CDO is a type of ABS wrapper i.e. a structured asset backed security. It is a security that
pools together different types of bonds, loans, mortgage backed securities & other cash
flow generating assets and slices/repackages them into different tranches each with a
different risk profile & related rating that are sold to investors. The seniority of the tranche
determines the payment priority of investors.

COLLATERALISED LOAN OBLIGATION (CLO)

A CLO is a structured debt security containing a pool of commercial loans that are
repackaged into tranches with different risk profiles & related rating and then sold to
investors. As with CDOs, the seniority of the tranche determines the payment priority of
investors.

SECURITISATION OF LOANS

Loans that are put into investment products and divided into pieces aka tranches. The
tranches are like the priority ranking of the capital structure.

SYNDICATED LOAN

One lending may not want to lend the whole amount. Therefore, institutional investors,
banks etc get together and agree to each take a portion of the loan.
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REPURCHASE AGREEMENTS (REPOS)

The sale of securities for cash with a commitment to repurchase them at a specified price
at a future date. Practically, the Repo is simply a collateralised loan (Carpenter).

The term is 1 day (overnight repo) to 1 year. Most repos have maturities of up to 3 months.

The transaction is called a Repo Agreement because it requires the sale of the security and
its repurchase at a future date. Both sale & purchase price are specified in the agreement.

There is a lot of jargon describing Repo transactions. Remember, one party is lending
money & accepting a security as collateral for the loan AND the other party is borrowing
money & providing collateral to borrow the money.
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SWAPS & OPTIONS

And a few other useful labels & definitions

CREDIT DEFAULT SWAP (CDS)

CDSs are a form of credit insurance. A CDS is a contract in which one party (protection
buyer) pays a periodic fee to another party (protection seller) in return for compensation
for default (or similar credit event) by a reference entity or basket of entities or an index of
entities.

The reference entity is not a party to the CDS. CDS contracts can be used to buy or sell
credit protection on individual securities or indices.

INTEREST RATE SWAP

Interest rate swaps involve the exchange by one party with another party of their
respective commitments to make or receive interest payments (e.g. an exchange of fixed
rate payments for floating rate payments). On each payment date under an interest rate
swap, the net payment owed by each party (and only the net amount) is paid by one
party to the other.

CURRENCY SWAP

Currency rate swaps are agreements between 2 parties to exchange future payments in
one currency for payments in another currency. These agreements transform the currency
denomination of assets & liabilities. Unlike interest rate swaps, currency rate swaps generally
include an exchange of principal at maturity.

OPTION

An option is a contract giving one party the right, but not the obligation, to buy or sell a
financial instrument, commodity etc at a pre-agreed price on or before an agreed date.
In exchange for this right, the option buyer pays the seller a premium. The premium
depends on (WHAT??) three things: 1) the strike price; 2) the volatility of the underlying
asset; and 3) the length of time to expiration.

The strike price is the price at which the underlying asset is bought or sold when the option
is exercised.

LEVERAGE

Leverage is borrowing. It is created with a debt component in the capital structure. The
higher the debt the higher the leverage because the company must has more interest to
pay. Leverage can be great if the company generates a higher ROI (return on investment)
than the cost of the interest and this will have a positive effect on shareholder return. BUT
the flip side of this coin is possible bankruptcy.
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BONDS & TAX & EQUITY

The interest paid on bonds is tax deductible. This tax shield enhances the value of the firm
e.g. lowers the cost of debt. As the priority capital structure ranking shows, creditors have a
claim to income and assets that has preference over equity. It is possible, therefore, that as
the company uses more debt in its capital structure the cost of equity increases because of
the seniority of the debt.

PUBLIC PRIVATE PARTNERSHIP (PPP)

There is no single widely accepted definition of PPPs. However, consensus pretty much
agrees the PPP Knowledge Lab definition: a long term contract between a private party
and a government entity, for providing a public asset or service, in which the private party
bears significant risk and management responsibility, and remuneration is linked to
performance.

PPPs usually do not include either service contracts or turnkey construction contracts, which
are categorised as public procurement projects, or the privatisation of utilities where there
is limited ongoing role for the public sector. Source: ppp.worldbank.org

P2P aka MARKETPLACE LENDING aka DIRECT LENDING

Matching borrowers and lenders via on line platforms / marketplaces. Direct lending by
investors to consumers and SMEs. It is a disintermediation of the banking sector that either
cant or wont lend (changes in reg capital requirements and other reasons).

The main P2Ps were founded within the last 15 years. Direct lending is primarily floating rate
and fixed rate loans. Not bonds.