Growth at speeds of capital

October 1, 2008 By and    

The retail propane industry is considered “capital intensive” because, in order to gain a customer, we purchase and install an asset that we continue to own yet stays in place as long as we have that customer. That asset, the tank, is expensive (twice its cost of a few years ago) but one that has a long practical life – in decades.

Carl Hughes
Carl Hughes

The relationship between growth and our capital needs is linear, in that every new customer requires a new asset, which requires additional capital. To grow, we need access to capital.

Sources of capital

There are two primary forms of capital: equity and debt. Equity capital has the primary characteristic of ownership rights. Equity capital is “at-risk” capital, meaning that if the business fails, the equity invested becomes worthless. Types of equity capital include the original seed money (founders’ equity) used to start the retail propane business, as well as private equity, public equity and retained earnings.

Private equity is a broad term applied to any new equity investment in a company, with varying expectations for expected returns and exit dates. Since 1994, larger retail propane companies have accessed the public markets under the master limited partnership (MLP) structure to meet equity capital needs.

Debt capital requires the repayment of the amount lent over some specified period and includes a contracted interest rate. Traditional commercial lending is the primary source of debt capital used in the propane industry. This lending is generally asset-based, meaning a bank will lend money to a borrower based on a percentage of the residual or liquidation value of the asset being acquired. The bank will take a lien on the acquired asset and use it as collateral in the event of default on the loan. Lenders require a certain proportion of equity to be in place in order to make the loan, with the equity being subordinate or secondary to the debt in the event of default.

Typically, startup propane companies are “seeded” with equity capital from founding shareholders. This initial risk capital is then matched with a lending arrangement from a commercial bank. This combined equity/debt capital base is used to acquire the initial assets to start the company. For young propane companies, the equity is typically held constant and the commercial lending is used for growth.

As the business grows, the founders’ equity/debt relationship is maximized because at some point lenders will require more equity before they add more debt. Without additional equity injected into the company, growth is restricted to available debt financing that can be incrementally added with retained profits. At this point – without additional equity – growth slows or comes to a stop.

Investors have expectations

The key point of this discussion on the types of capital used to build a propane business is that all investors or managers of capital lend, commit equity or invest with a clear set of expectations. Lenders not only expect their capital back along with interest payments, they also want low risk.

A lender who perceives higher risk can do one of three things: charge higher interest costs; require more equity to be placed ahead of the debt; or choose not to lend at all. Equity investors clearly understand their capital is at risk, and they expect a higher return for a higher perceived risk.

Performance attracts capital

Managers of all types of capital see financial performance as the top priority. Individually, we conduct a similar evaluation with our own personal investments. We want the highest possible return, but we also want safety. Those managing capital, debt or equity have the same basic needs, with a bias of one sort or another.

Further, investors of all types study, measure and rank the financial performance of their investments, whether debt or equity. It is a fundamental of the financial markets that the investor community seeks out and desires returns at or above expectations, driven by financial results that are consistent and perform above the average.

It is therefore first and foremost a requirement for retail propane companies to demonstrate financial performance if they desire to grow. Building an asset base that does not produce financial results will not attract future investors. On the other hand, delivering consistent, above-average financial results will attract more capital.

Carl Hughes is senior vice president of business development for Inergy LP. He can be reached at
or 816-842-8181.

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