When Leverage Just Becomes Too Much
by Willem Reitsma, Imperial Holdings, and Barry Martin, Debt Capital Markets team, Rand Merchant Bank
Following a strategic decision taken by the Imperial Board during 2007, the integrated leasing and capital equipment division, (subsequently rebranded as ‘Eqstra’), was unbundled from Imperial and listed on the JSE during May 2008. As is typical for many of Imperial’s divisions, Eqstra operated as an autonomous division within the Imperial Group.
Eqstra’s businesses include leasing, distribution and value-added services, with the following main asset classes:
- Passenger and Commercial Vehicles;
- Industrial Equipment; and
- Construction and Mining.
Why was the unbundling considered?
Leasing businesses generally have long-term contracts with customers, which are backed up with assets and which lend themselves to higher levels of gearing. The gearing or high debt levels can be justified based on the certainty of future cash flows and the low volatility of earnings. As a leasing business needs a ‘funding component’ for the business to be viable, it therefore needs to operate as a quasi bank and must reduce its weighted average cost of capital through increasing its debt levels relative to equity. International leasing businesses have debt-to-equity ratios of anywhere between 4x to 6x.
Imperial Holdings’ debt-to-equity ratio, however, as a diversified industrial business, required a ratio of around 1x. With the leasing business having a gearing ratio of around 3x (on the conservative side of international standards) and this business is increasing significantly in size due to the commodity and infrastructure boom taking place in South Africa, the Group’s gearing ratio increased. On a sum-of-the-parts basis, the gearing levels in each business could be justified but at a Group level the ‘debt’ was perceived as being too high.
A simple illustration of this is shown in Figure 1.