To hear the media expound on the subject, the main source of trouble for many companies of late has been their so-called asset-light business model. Surprised by the rapid unravelling of the recent economic boom, pundits have taken the axe to any strategy developed by the 1990s whiz kids whom they once lauded and now apparently disdain.

In the case of capital-light—or capital-efficient—models, their critique may be too hasty. It is certainly too sweeping. Acting in the best interests of investors includes structuring and restructuring the balance sheet to squeeze all possible earnings from every dollar of investor capital—and it always has. Focusing the investment of capital on those assets where a company's expertise lets it earn the best return for investors is simply to be capital efficient. While this strategy carries its own risks and limitations, as does any innovative business approach, for many companies it also creates real value and may be the only alternative to stagnation.

We researched more than a dozen top-performing companies from a wide variety of asset-intensive industries¹ to see how they raise and deploy capital for growth in capital-constrained conditions. We found that many of these purposefully reshape their asset portfolio to support their growth aspirations, refinancing assets as their role in the company's business changes.

Tried-and-true strategies

Companies that look to their balance sheets for the capital to pursue growth and improve returns are using strategies that are neither particularly new nor surprising.

First, the companies we analyzed focus carefully on the parts of each business where they create the most value, divesting noncore risks, assets, and cash flows to others that can better manage them. The capital so generated can then be reinvested back into the core business and grown organically or through acquisitions.

Consider as illustration the familiar project finance case of Tampa Bay Water Authority. Instead of undertaking the risk of constructing a new water treatment facility, Tampa Bay awarded a turnkey construction contract to a best-in-class construction company. In addition, instead of managing and operating the facility, the authority awarded a 30-year, $600 million performance-based contract to water systems operator Poseidon. As a result, the cities of Tampa Bay and St. Petersburg were able to develop their new water treatment facility without levying new taxes and actually lowered the cost of water, returning nearly $300 million to consumers over the life of the agreement.

Second, we found that capital-efficient companies adopt tax-advantaged corporate forms like limited partnerships and sale leasebacks to capture cost-of-capital savings and to match investors with tailored risk/return offers. Such tools for transferring risks, assets, and cash flows are much more efficient than traditional leasing contracts and limit the amount of value lost either to taxation or to financial intermediaries.

Finally, they employ tools like contingent capital or hybrid securities to match the form of financing to the specific economic characteristics of the business. Full disclosure of residual liabilities, of course, is critical to protect the interests of all investors.

Although capital-efficient business models do utilize sophisticated financing tools, they are not a form of financial engineering.

We also found that although capital-efficient business models do utilize sophisticated financing tools, they are not a form of financial engineering. Unlike financial engineering, capital efficiency creates real value through improved operations, increasing margins by linking strategy with the optimal asset/risk position, supporting that position with the most efficient capital structure, and using liberated capital to build the core business. This can be done—and is routinely done by many successful companies—transparently and in the best interest of investors.

Case example: Rogers Sugar

In 1997, Canadian buyout firm Onex and a private investor jointly acquired BC Sugar for Cdn$407 million. With more than 60 percent market share, BC Sugar was the country's largest refiner of sugar in a protected industry with steady and predictable economic characteristics and a good operating track record.

The new owners quickly made a number of management and board changes, followed by a $40 million capital investment into one business unit, Rogers Sugar, to expand its capacity and reduce operating costs. Onex then effectively divested itself of Rogers Sugar by transferring it to Rogers Sugar Income Fund (RSIF), a special-purpose entity with similar income tax advantages to a REIT.² It then sold RSIF to investors for Cdn$382 million. Exhibit 1 outlines the new ownership structure.

Onex retained ownership of what was left of the original BC Sugar business, Lantic Sugar, along with strategic management control of Rogers Sugar, for which it receives an annual fee of $300,000. It also earns incentive payments tied to cash distributions to RSIF unit holders and holds, through Lantic, a long-term outsourcing agreement with Rogers Sugar for marketing and financial services, earning an annual fee of about $4 million. At the same time, RSIF unit holders enjoyed a first-year yield on their units of more than 15 percent.

As a result, with a small capital investment and a number of operating improvements, Onex expanded its capacity, improved its operating margins (reducing production costs by 8 percent), lowered its tax liability, and nearly recovered its original investment. By retaining management control of RSIF, Onex also reassured its own investors of the ongoing profitability of the business. RSIF unit holders, in turn, were able to earn a steady and attractive return on their investment.

As this example illustrates, disaggregating assets, cash flows, and risks and transferring them to their natural owners is not a zero-sum game. Instead, while it increases the returns on individual parts of a company's business, it also improves the overall economics for other participants in the transaction by creating powerful incentives for each to maximize returns, leverage unique skills and relationships, and encourage the transparency necessary for investors to fully appreciate the value created.

Creating real value

Clearly, the key to successfully moving to a capital-efficient business model is identifying assets, risks, and cash flows by their distinct risk characteristics and then retaining only those that are central to how a company creates value.

An example of this is railcar owner GATX. The company realized in 1996 that it created more value through activities related to railcars such as dispatching, design, and procurement, than it did through actually owning them. So GATX aggressively divested its underperforming assets—including both liquids storage terminals and certain railcar assets—and financed new assets through nonrecourse structures like debt, sale leasebacks, and limited liability partnerships. Focusing on its expertise in fleet management, the company launched a series of web-enabled logistics services that provide real-time reporting of schedules, the calculation of regulatory compliance, remote monitoring of cars, and sourcing of raw materials. The combined impact of this effort was to increase GATX earnings by 13 percent per year over the past five years and generate 21 percent returns to shareholders (annualized)—relatively attractive numbers for an asset-heavy company with limited growth options.

Like GATX, companies that disaggregate assets, risks, and cash flows can create value in a number of ways:

Improving operating margins. When a company narrows the number of assets and risks in its portfolio to the handful where it really creates value, its management team is able to focus its energies and develop deep insight into and expertise in managing core risks. As a result, the team can extract more value from those risks and the economic gain created is significantly greater. For instance, after transferring the ownership of its physical properties to private investors, Four Seasons Management has been able to focus on the critical value drivers for the business, including yield management and the quality of the customer experience. Clearly, Four Seasons also faces certain limitations. Fifty-year contracts with facilities owners restrict its ability to reshape its portfolio of properties over a short period of time. But this may be easily outweighed by the fact that the company, undistracted by many of the ownership issues and problems of traditional hotel chains, is able to earn $100 more per room than its closest competitor (Exhibit 2).

Capturing tax advantages. Most countries have tax-advantaged corporate forms like income trusts or limited liability partnerships that enable companies to transfer risk to its natural owners. These corporate forms typically allow companies to remunerate investors and finance capital investments using before-tax revenues, ultimately lowering a company's taxable income and increasing the pool from which investments are made and investors paid. For example, Marriott restructured its business portfolio in 1993 by transferring its properties into a REIT, putting physical property into a trust while retaining the hotel management and operations services. The announcement resulted in a 20 percent appreciation of Marriott's share price.

Reducing cost of capital. When companies transfer risks to more natural owners, their cash flows can become significantly less volatile. Less volatility combined with an optimal capital structure can reduce the cost of financing highly capital-intensive assets. For example, overall investment risk associated with power plant development has been significantly reduced by securing long-term fuel contracts and power purchase agreements. Using this approach, power plant developer Calpine used forward contracting of its production to reduce market volatility and has been able to raise a $1 billion revolving credit facility at rates comparable to its balance sheet debt in order to finance additional power projects. Typical project financing costs are 200 to 350 basis points above balance sheet debt.

Realizing fuller asset valuations. Credit and equity analysts have long argued that conglomerates are discounted by 20 to 30 percent relative to net asset value because investors are unable to truly identify the sources of value creation and because investors can assemble a more diversified and efficient portfolio at a lower cost than the management team of a conglomerate can. The reverse is also true. Disaggregating assets and risks into unique packages increases visibility into the true sources of value and risk and allows companies to enjoy a fuller equity valuation.

Today, capital constraints and inadequate management resources limit the growth of many companies. Capital that is liberated from the balance sheet can be used to pursue new opportunities without repeatedly turning to the capital markets for funds. This not only enhances the company's credibility with investors but also allows the company to reduce transaction costs and to move more quickly to capture opportunities. Reducing the complexity and scope of the business also frees up management resources to look for new opportunities that might not be pursued under a more traditional management approach.

Companies must often adopt a new mind-set to make capital efficiency a key part of their business model. Capital-efficient companies typically involve a narrower portfolio of assets and risks that is better aligned with their distinctive capabilities, value creation approach, and strategy. They tend to shape carefully the role that they play relative to the assets that they choose to hold and focus their functional capabilities on narrowly-defined risks where they excel at value creation. That typically means owning (raising capital and shaping portfolios of investments), managing (deploying assets optimally into the marketplace), or operating physical assets—not all three, as is the case in most vertically integrated companies.

This model naturally involves some complications, chief among them the need to manage multiple partnerships with the natural owners to which assets and risks have been transferred. That often includes ongoing negotiations and the uncertainty around what to do when a contract or partnership expires. But, when the strategy is pursued intelligently and competently, the advantages of stronger margins, enhanced brand equity, and privileged access to low cost capital far outweigh such difficulties.