If you’re only looking at the income statement when figuring out which shares to buy, you are suffering from a huge blind spot in your investment analysis. Not sure why? Have a look in a dark, sad corner for a shareholder in Steinhoff, Nampak or Tongaat. In a pool of tears, you’ll find some of the answers.
The income statement tells you a lot about how the company makes money and very little about where that money goes. You can have the most profitable business in the world, but if the keys are held by the bank and the preference shareholders, it hardly matters. As an ordinary shareholder, you can be stuck outside the window in the snow, watching everyone else eat the Christmas gammon.
The balance sheet is where you will find details on the capital stack — the term used by private equity and similar investors to describe the layers of the funding cake. These layers can include senior debt, subordinated debt, mezzanine finance instruments and all kinds of exotic structures. The only certainty is that there must be some ordinary equity, as a company cannot be a company unless it has shareholders.
Festive cake analogy aside, another useful way to imagine the balance sheet is a spectrum with pure debt on one end (senior debt) and ordinary equity on the other. These are collectively known as “securities” and as you move from debt to equity, the level of risk for the securityholder increases. In line with the most fundamental rule of all in finance, this means that the expected return must increase as well.
Every securityholder on that spectrum is an “investor” — it’s just the mandate and style of investment that varies. For example, PBT Group recently offloaded the preference shares that have been funding its BBBEE shareholder to Sanlam Investment Management (SIM). This makes perfect sense, as PBT Group is an operating entity that needs to generate a high return on equity, whereas SIM is a long-term institutional investor looking for products that offer the right mix of yield and risk. As the preference shares are mezzanine instruments, they cannot possibly generate the returns needed by PBT Group shareholders. They were a necessary step to achieve empowerment rather than a pure investment decision. For SIM, the instrument is perfect for its investment mandate.
This doesn’t affect the empowerment structure. It just means that the owner of the preference shares has changed, probably because PBT Group has developed to the point where SIM feels comfortable holding the exposure. This is an impressive step for the company.
As Steinhoff punters have now learnt, understanding the capital stack is critical in deciding whether to invest in these shares
As you can now see, the art of capital allocation lies in understanding how this medley of financial instruments works together to create the pool of funding that finds its way into the economy. This includes asset classes like alternative investments, which may include mandates such as debt-led strategies that aim to achieve yield and capital protection with an equity kicker as well.
The devil is well and truly in the details in mezzanine structures. They are frequently used in early-stage entities (including junior mining houses) and higher-risk applications like turnaround strategies. When companies are desperate for capital, they find themselves holding the begging bowl at the offices of hard-core investors who specialise in finding ways to squeeze ordinary shareholders out of the company.
It might sound unfair to you, but there’s a simple way to avoid being in this situation: don’t run a company on a knife’s edge when it comes to debt. For investors, be careful of management teams who are juicing up returns with regular corporate actions funded by debt.
Once the pain has become clear and you are in the throes of a turnaround story, you need to think like a trader initially and then like an investor. In many of these stories, the best returns are made soon after the initial crisis, as the market gets a glimmer of hope from the management team about efforts to restructure the balance sheet. The exuberance can drive huge returns in the share price, as people climb in with the hope of a 10 times return.
Sadly, there is often a 0.5 times return (or worse) on offer once the dust settles. As Steinhoff punters have now learnt, understanding the capital stack is critical in deciding whether to invest in these shares. Before you know it, you could be facing a choice of owning nothing or owning almost worthless unlisted shares. When the capital stack attacks, it’s ugly.
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