Regional President Speech

Silas Keehn Remarks Vanderbjlt University, 1989 Draft 3 (4/6/89) The Debt-Defying Feats of U.S. Corporations I am very happy to be here today. Speaking to a group of Vanderbilt MBAs has become a tradition for me, and I look forward to it every spring. {INSERT STATEMENT ABOUT D. DAANE RETIREMENT) Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 2 I usually speak to this group on topics that are particularly important to the financial services industry, and this year will be no different. Last year I spoke about the restructuring of the financial services industry. My topic this year, the restructuring of the U.S. corporate sector, may be somewhat more ambitious. J feats The Debt-defying· of U.S. Corporations • .:; · ~ • SHas Keehn' President ·••h-•;;i '.:-.; . '·l·fI· )~•, ~:.: Federal Res I e rve Bank of Chicago • • :: • Ir-~: April121989 .'1'•!, 1·,· 1·:.j.1r:-1. ..• ) _--.: .·.• I ; .•: • :: ~ •· . :·~ • •• •·. ·!. I I I I • -~ f .. •---.. ..., Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 3 Today, I plan to give an overview of recent trends in corporate restructuring: look at why a firm would want to restructure: discuss the impact of restructuring on various parties such as shareholders, debtholders, taxpayers, and financial intermediaries; and finally, comment on what, if anything, should be done to reduce leverage in the U.S. corporate sector. ~ ~ ~_s p/c~.S. - ~c,,JJla~. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 4 Before I begin, though, I would like to share with you some / news I recently received about what appears to be, the ultimate I leveraged buyout. According to an article in Pensions and Investment A1e, Kohlberg, Kravis, Roberts & •C o., the firm that / just bought RJR Nabisco, has offered 11.25 trillion for the ./' federal government, all but 120 million. of which will come from the issuance of debt. Much of this debt is expected to be paid down with the proceeds from the s·ale of government assets. / According to the article, Gene~al Electric, United Technologies, and General Dynamics are lik~ly purchasers of the Department of ,./ Defense minus the Petagon building, which will probably go to ' JMB Real~y. Exxon and Mobil are expected to bid for the . ' Department of Energy. Citicorp is supposedly interested in / acquiring the Federal Home Loan Bank Board. The real plum, however, is the. Fed, which is expected to be sold to a consortium of Japanese and U.S. institutions. Analysts are ; quite wary, of this deal. They have pointed out that the federal government is already highly leveraged; some say that the 5:J:1 gove. rri~ent has increased its leverage over th01a deeade iA aa ( n , ... , / F,' r.s. ~c:> ~ attempt to fend off such a takeover attempt. . 'T J¼-1.r~ ~ ~~ dlli--f -- A-- ~ ~ b /U-VW~ -4-p~ t .. ~ ~ ~ ~ I ~{l.A-.,fl ~ 1~~ C!.»¥~- ;2., :J ~~0--,, .. . ~~~~ 7i.r oJ tv-, ~~ ~ ~ PCJCu-? °'1---' 4-N • r I. ~~'~ Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 5 While my news flash is obviously fiction, recent events in the corporate sector indicate that fact and fiction are not all that far apart. Overview The market for corporate control--firms competing for the right to manage corporate resources--has become an increasingly important element of the corporate landscape. The Institutional Investor has reported that a "remarkably liquid market ... like the market for real estate" has developed and now "a large cross section of corporate America has become a collection of properties to be bought and sold." ~,_ ~'' ,,I .S (' Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 6 Indeed, the number of mergers and acquisitions in each of the last five years is more than double that of any year during the merger wave of the late 1960s. Number of M & As growing ... 5,000 2,500 0 1..-1~_,1,.-L...J-...I..-JL.-1,__.___.__._~.____._~--..__.__.. .... 1967 '73 '78 79 '82 '85 '88 I I l - . ' Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 7 An Increasing percentage of the value of these deals are highly leveraged transactions. '~ '~ ,.• .J ' ~~.,~·/ / ~I /~,.~?. !-,,; ... increasing percentage of M & A involves "'J VJ<,~) highly leveraged transactions (JY1_1 'rJ 15% 0 ________. ..__ ____. .&..._---'---'-----' l 1981 '82 '83 '84 '85 '86 '88 I ---- l Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 8 Furthermore, many companies that are not involved in a merger or acquisition have substantially increased their leverage through "recapitalizations." More firms undergoing highly leveraged transactions ... 20% b>O" % of firms witttdebt-to-assets greater than S0°.4 ... ... and that more than doubled their ratio from the previous year. O'-----L---.J---_.__ __ _._ ______ 1981 '82 '83 '84 '85 '86 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis g The use of leverage in M&A is not at all new. In 1901, J.P. Morgan issued S570 million in bonds and an equal amount of preferred and common stock to buy Andrew Carnegie's steel interests and create U.S. Steel. The deal today would have been valued at S23 billion, almost as much the price tag on RJR Nabisco. The 1901 deal has many parallels with today's LBOs--the terms of the deal, including the issuance of "junk bonds": complaints from Washington that such leveraged transactions were not in the public interest; and jitters on Wall Street. There is, however, one major difference between J.P. Morgan's deal and the LBOs of today: Morgan's deal involved the merging of eight companies into one,~hile a typical LBO today involves sell-offs, spin-offs, nd asset sales. I - ----; • { ~ f~.PfL- ... ~ ~ \ ·- l • -~:-:.'?~---_:_~,~-:~_:.-.~-~'.::~:-~:?~~-·:~tf:.~ ~-... :_~,: -~:~:~_-:-.. ~.:::. ..· .. . :.~.::~:~>~~~-~-> '. ·-: .• ,? :_ ••1 . ; ' •. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 10 Supposedly, a firm will not acquire another unless the acquirer believes that there are gains from doing so. Indeed, acquisition premiums are a reflection of those anticipated gains, which are usually expected to result from diversification, the elimination of duplicate operations, economies of scale and scope, and overall improved efficiency. -\I ~ _. ?~ . _-_. ~ . ' . : . . , : : •.. · . : . . . . . . _ . · ; . , · .:. . . · . - ..- ~ . ... . .. - · . · . · ' · .•· . .. ' . - . . . . • . - - - . .... 'I ·.. _:)i)'. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ~~ 11 During the late sixties and early seventies, most of the gains from acquisitions were expected to come from J diversification. At the time, it was widely believed that "two plus two equals five." For example, Textron, a textile ~ manufacturer, diversified into various machinery and electronics + businesses; Gulf Western, a publishing and information ~ ~ services firms, diversified into entertainment and financial services: and General Mills, a food producer, bought, among other things, restaurants, clothing manufacturers, and a toy company. ~ ~ ~•ML~ - ~ ~ w d ; f) ~ ttJ, /2.. ~ ~A.I e,._ :__..i._· Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 12 From 1948-63, less than 16 percent of all mergers were pure # . conglomerate mergers. In contrast, from 1963-72, 33 percent of all mergers were conglomerations. During that time, Gulf+ Western acquired Paramount Pictures, and Textron acquired Erie Tool Works and the Sheaffer Pen Company. From 1973 to 77, 49 percent of all combinations were conglomerations. Gulf+ Western continued its shopping spree, buying wltat ia-t1et Associates NatieAal Banlf..and Providence Capitol Insurance. General Mills acquired Ship 'n Shore and a British toy company. r i ----. -------------- Pure conglomerations as % of assets acquired ! . 50% .. l I I I l f 25% • .. .. --- --- -- -- ---- I I I 1948-53 1954-63 1963-72 1973-77 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 13 But the "new math" did not work out so well. Not only did two plus two not equal five, but two plus two often equalled three. Studies of the mergers of the 60s and 70s show that seven out of ten acquisitions failed for one reason or another. The acquiring firms' stock usually dropped once a deal was announced, and shortly thereafter, the combined value of the acquirer and target dropped below what they would have been worth separately. In addition, several years after consummation of the deal, the targets would lose market share, and their profits would fall. t- Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 14 Much of the corporate restructuring of the eighties is reversing the merger trends of the 60s and 70s. Diversification is "out." Now the thinking is that five minus one equals five or maybe even six. Gulf+ Western, in 1983, began a major divestiture program that included a one-time charge to earnings of $470 million, which resulted in a $200 million loss that ~~~ year. In 1986, Dart and Kraft divorced each other after a six-year marriage, and in 1987, United Airlines announced plans ' to sell off its non-airline operations--Hertz, Westin Hotels, Cm,t1~,·cJi"~ I 'Pcv-'"'-.A--v-C r,,Lf'{, Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 15 Between 1983 and the first half of 1988, nearly 70 percent of all LBOs Involved divestitures. Also, firms are being acquired, many through LBOs, with the intention of the acquirer to liquidate parts of the target firm . .Dr · u ~~ ~ \1--o tu- L-. g r9 ~- LBOs that resulted from divestitures 100% % of total number of lBOa % of total value of lBOa 0 ...__ __________. ___ ______ __. ____ ·as 1983 '84 '86 '87 '88 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 16 Corporate restructurin1 Leveraged buyouts are Just one component of a larger phenomenon--namely, corporate restructuring. Corporate restructuring is, in the broadest sense, an alteration of the ownership structure of a firm, that is, an alteration of its mix of debt and equity. Since 1978, the retirement of equity has outpaced new issues by nearly $400 billion, while net issuance of corporate debt more than doubled, bringing the total outstanding to nearly 12 trillion. 6 ~ ~ ~ ~ ~ Equity has been retired while new debt has been issued blntondollars 200 150 ·net new debt 100 j '-150 _ __._ _____ _._ _____________ I 1 1978 79 '80 '81 '82 '83 '84 '85 '88 '87 '88 • I -I Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 17 Consequently, in the last ten years, the combined debt-to-equity ratio of all nonfinancial corporations in the U.S. Increased from about 68 percent in 1978 to ~percent today. Debt servicing now accounts for neaf3 0 percent of corporate cash Rows, compared to an eszted 18.5 percent ten years ago. ~ -~1Jv-d,U,~ ~ vr-,../'-<.~p.;cv-~, J _ . r ~ --~~t-u/oo~-o/ ~ ~ ~ .J ~'c--,'A,;~ , Debt to equity ratios increasing and interest expense consumes more cash flow 90% debt/equity 45% Interest expensafcash trow 15% ----------------------------- w 19n ~ ~ ~ ~ ~ ~ ~ • Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 18 The move to higher debt ratios ( on a book value basis) and increased debt servicing has been accomplished through leveraged buyouts, leveraged share repurchases, leveraged cash outs, as well as other means. Leveraged share repurchases and leveraged cash outs, in effect, replace equity with debt without changing the ownership of the firm. Leveraged buyouts have the same effect on a firm's capital structure as leveraged share repurchases and leveraged cash outs, but LBOs do change the firm's ownership. I 1, .. ,• I. j I j Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 19 LB Os are perhaps the most controversial form of restructuring. An LBO invloves the use of a target company's assets as collateral to borrow funds to take the firm private. The borrowed funds are usually obtained through a bank loan and/or the capital markets by issuing high-yield, high-risk bonds, more commonly known as junk bonds. The acquirer is often an individual; small group of investors, which includes LBO firms, pension funds, and insurance companies; or management aided by investment banks . ... .. _ : ' I•. •'• :;-~- ,. .... \ . ;· i ~\ _ ____ T"_ . •. ' Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 20 While there is no universal criteria for an acquisition to qualify as an LBO, much of the controversy surrounding these ~ deals stems from the significant debt burden incurred by the target firm. A typical LBO consists of between 40 and 70 percent senior debt, between 15 and 35 percent junior debt, and between 5 and 15 percent equity. That is, it is not at all uncommon for a firm's debt to climb from 51 percent of assets to more than 80 percent. For Mary Kay, an extreme example, total debt increased over 900 times, and went from 25 percent of assets to 82 percent in one quarter. tfai~_clebt~to:.ass_ets ~atio .of CECO Industries jumped from 46 percent to 95 percent, and fell only 2.5 percentage points two years after the_ LBQ.; -L -- 1 I "Typical" debt burden of an LBO target 100% ,------- CECO Mary Kay 50% 0 ......, ________ _,_ _____. ...._. ________ , 1 q1r pre-LBO LBO q1r 8 qll'S post-LBO Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 21 Also contributing to the controversy surrounding LBOs is the explosive growth in the number and size of these highly leveraged deals. In 1981, there were 99 LBOs: in 1988, there were over 300 LBOs. As a percent of total mergers and acquisitions, LBOs have increased from just over 4 percent in 1981 to 9 percent in 1988. j ),.,'1 \7,'( I eJowd ~ r{ _/ - (L /\- -A/ c.,{r, ~..> I< '"'J- J2-J2,f> ~I Growth_ in number of LBOs 400 15% 10% 5% O'--.....L----'--.....1.--_,__ ________ 0% 1981 '82 '83 '85 '86 •17 '88e ... J Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 22 Growth In the value of all LBOs has been even more dramatic. The total value of LBOa In 1981 was 13.1 blllion--less than, percent of the value of all takeovers that year. In 1988, the value of LBOs was 143 billion--19 percent of the value of all takeovers. Even after adjusting for inflation, that's over a tenfold increase. Growth in value of LBOs $50 $40 $30 , ......... ..... __ , $20 ~ , ---- 20% -- $10 "',. ---- , percent ~------------------------0% 1981 '82 '83 '84 '85 '88 '88 .. .. -·-·---·---·-··----------- -· Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 23 Not only are we seeing more LBOs, but we're seeing bigger ones. The average LBO in 1988 was 1135 million, compared to 131 million seven years earlier. We're seeing bigger LBOs mffllon dollars 150 0 -------------------------- 1981 '82 '84 '85 '88 '87 '88 \ __ ' -- _____ _) - ·--··---·•------ ---------------- Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 24 Why restructure? Before discussing the implications of increased leverage, let•s take a step back and explore why a company would want to increase its debt. Finance theory tells us that, in a "perfect world," a firm's mix of debt and equity shouldn't matter. That is, in a world with no taxation and perfect information, any combination of debt and equity should be as good as any other. But the world is not perfect. A firm's mix of debt and equity do matter. -------·· Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 25 Two explanations for the recent trends in corporate restructuring have become very popular. The first, the "cash flow" theory, is often discussed in very favorable light. The second, federal tax policy, Is, almost without fan, presented as the dark side of highly leveraged transactions. The cash flow theory There are two basic aspects of the cash flow theory. The first is concerned with how imperfect information affects the relationship between managers and shareholders. The second aspect concerns the efficient allocation of capital. Taken together, they suggest that current trends in corporate restructuring will lead to a leaner, more efficient economy. r:=::,~~~.-~~-"":;.,-~;t,;1;~;') --.. ; • >< , ••••••• >~ • -1-- l -----r··•- - · ~ - - I Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 26 Aspect No. 1: The power of levera1e Corporations, especially large ones, are owned by numerous and diverse shareholders but usually controlled by managers whose objectives are often at odds with those of shareholders. For example, if management's power base is defined by the asset size of the firm or the number of subsidiaries under its control, or if their bonuses are defined by such things as sales volume, then management may take on projects or buy companies that support their agendas but do not necessarily maximize shareholder wealth. .·.·. ~ i\-:.· f!~ •. ,,. ... ·. f)· .... Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -~~ ~ 27 One way to reduce the ability of managers to take actions that are not In shareholders' best interests and, at the same time, give management strong incentives to take steps that benefit shareholders is to use the "power of leverage." That is, saddle the firm with debt and give management an equity stake in the A~~ firm. tv~ -rt., l:,~u ~ - ~~ ~--r -- --• The rationale for this strategy may not be intuitively obvious, so let me explain. Managers must decide in which projects to invest. Now, you are all MBAs, so by now you are probably saying to yourselves "Easy. Positive net present value project." But it's- not that easy because managers often have incentives to invest in projects that are not in the best interest of shareholders. As I mentioned, management's top priorities may be to increase the assets under their control, secure or advance their employment, increase sales in ways that fly in the face of sound business judgement, and_ so on. l --- .\. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 28 There are several contractual arrangements, such as stock option plans, that help to align management's goals with those of shareholders. But how can debt help to align their objectives? Managers fund new ventures with debt, equity, or internally generated funds. While it is true that the sources of funds should not affect the profitability of various projects, the sources of funds do affect management's willingness to evaluate projects solely on a net present value basis. If debt or equity is the source of financing, managers must undergo the scrutiny of the capital markets, and an efficient market would exact a very high price for funds for negative NPV projects. If a firm is fairly profitable and expects to have a steady stream of excess cash flows, however, internal funding is a readily available source of financing that avoids immediate market scrutiny. Therefore, to ensure that ·management does not invest the excess cash flows unwisely, a firm can alter its capital structure, by repurchasing shares with new issues of debt. Shareholders receive expected future excess cash flows in the present, while managers have to use the c~sh_flows as they accrue to service the additional debt. . ' ~f':. ; ~ ·./.:.: " : · ··•· Digitized for FRASER 1: ~~ I ._, .. _,:.:;·~••;.c&.;...:~£,- • .~;;4 ,; _ https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 29 Even if managers did not use excess cash flows for negative NPV projects but paid them out as dividends to shareholders with the promise to do so in the future, restructurin1 may still be preferable. Promises to continue to pay dividends are unenforceable, and the stock market punishes dividend cuts with large price reductions. Substituting debt for equity.in effect, seals management's promise to pay out future profits. ' I I .. ..:... I I I I -,- -- - ·- ------- -- ·· 1· ... - __ I JI ),.-·-· . , L. -- •. __ Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 30 What about companies that do not expect a steady stream of excess cash flows? How will they be able to handle the extra Interest expense? Those firms that are already efficiently run may not be able to handle Increased debt. However, for those firms that are inefficiently run because of management malaise or because they are at a point in their development where new professional management is essential, Increased debt ratios and the concomitant increase in debt servicing encourages management ( often new management) to cut costs, to sell off unprofitable operations, to focus remaining operations, and to become overall more efficient. The need to repay debt is a powerful motivator. ;:·: ... ~ ' ~:...": ·¥·-, ;9 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 31 I mentioned earlier that giving new management an equity stake in the firm after an LBO or a recapitalization is very common. This equity stake can be of a relatively mild form such as profit sharing or of a stronger form such as employee stock ownership plans and complete management ownership. In varying degrees these give management an incentive to maximize shareholder wealth by more closely aligning the goals of management and shareholders. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 32 In addition to the alignment of objectives, highly leveraged . transactions also make monitoring management easier. Leveraged transactions frequently result in the concentration of equity in the hands of a few shareholders. Even if management is not Included among a highly leveraged firm's shareholders, usually Included are LBO boutiques and their team of institutional investors or Wall Street firms. Such concentrations of equity improve the monitoring of management. Therefore, should the actions of management stray from the goals of shareholders, they will not go far. t .. ! .:. l ,: ••. . I .. .. ~ \,. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis r , 3 ~ Aspect No. 2: Cash rich/star poor These corporate restructurings also improve the allocation of capital among firms. In the Jargon of the Boston Consulting Group, the present value of the excess cash flows form the cows is paid out to existing shareholders with the proceeds from new debt. They, in tum, reinvest the funds in someone else's rising stars. The recapitalized firm then liquidates dogs and questionable operations to pay down some of its debt with the proceeds from the sales. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 34 The end result is that funds that were subsidizing dogs are now financing rising stars, and question marks that were making excessive demands on existing management are (hopefully) in more competent hands. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 35 As I just said, the classic LBO candidate is a firm with excess cash flow but no investment opportunities within its own line of business. In most cases such firms would not be high-growth companies, but rather firms in their golden years. Consider the following examples: Safeway Stores, the nation's larest supermarket chain: Dan River, a textile manufacturer: and RJR Nabisco, the product of two firms in mature industries, tobacco and food products. cu.:-w ~ ~'l,(, d,'IJ9.. . A/l-'J~ 11\/~tu~, Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 36 Taxation A second popular explanation for corporate restructurings Is, of course, taxation. Tax policy certainly can influence a firm's capital structure. Clearly, If tax policies afford more favorable treatment to one form of financing than another, the favored form will dominate. This is exactly the case today. Debt is given more favorable tax treatment than equity. Returns to debtholders--interest--is tax deductible, wherease returns to equity holders--dividends and capital gains--are not. V . ,. '' . r l •. ----·---· ,. .. •· Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 37 But interest has been tax deductible for quite some time, so why the increase in debt relative to equity now? To answer this question, we need to look at federal tax policy prior to and after the Tax Reform Act of 1986. Despite the reduction in the top marginal corporate tax rate from 46 percent to 34 percent, the 1986 Act actually increased the effective corporate tax rate for many corporations by lengthening depreciation allowances, eliminating the investment tax credit, and raising the alternative minimum tax Therefore, in 1987, when the Tax - Reform Act of 1986 took effect, St of interest expense increased in value for the average firm in all but two industry categories. On average, it increased in value by 3 cents. In one industry, transportation, it increased by 14 cents. I I I I i' Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis--- -(~ /ff tJ'> ~ 38 '\j ~~ The Tax Reform Act also made !~st Income more palatable / to individual investors--1.e., ensured that creditors would not ,r{lf' - require a higher return and therefore counteract the tax-Incentive to use debt financing--by reducing the maximum marginal tax rate on ordinary income, which Includes interest income, from 70 percent in 1980 to 28 percent. In addition to making debt financing more attractive for corporations, the 1986 Act also made equity financing less attractive for individual investors than it had been in prior years. This was accomplished by eliminating the dividend exclusion and the favorable treatment of long-term capital gains. Since January 1987, dividends and capital gains have been treated the same as interest income by the Internal Revenue Service. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 39 To summarize, the Tax Reform Act encouraged the increase in debt relative to equity in the U.S. corporate sector by doing three things. First, it increased the value of interest expenses at the corporate level. Second, it increased the value of interest income at the individual investor level. Third, it decreased the value of income from equity investments for individual investors. . , •.. ---:11 I------------ Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 40 Takeover defense Before going on, let me just briefly mention one other reason that a company might want to increase its leverage--•• a takeover defense. It is often said that the best defense Is a strong offense. In the case of corporate takeovers, a firm's best defense is the maximization of shareholder wealth. If that is to be accomplished by altering a firm's capital structure in favor of debt--for whatever reasons--then whether an acquire, takes these steps or whether existing management and ownerwhip do so Is irrelevant. New management without prior ties to employees or the community, however, may be more objective and better able to adapt the firm's productive assets to its changing environment, but sometimes the threat of becoming a takeover target achieves the same ends as actually being taken over would. ii}~ r~.j: . r ~ '•..• '. ' L. •... ~L~i~;;;~;:~);;fJ..:~~Ji:±.~ii.:i.;.>i3tJi~i~jJtit:~~ithzJ~~~~:~~k:~:-i;::· J Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 41 Implications Increased leverage in the U.S. economy--for whatever reasons--has implications for shareholders, bondholders, taxpayers, financial intermediaries, and policymakers. I • I ' Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 42 Shareholders Shareholders, on the whole, will not sell out for less than the market price. Acquirers, therefore, must pay premiums over current market prices for their target firms. Such premiums have averaged nearly 40 percent In recent years. Research clearly indicates that stockholders of acquired firms, including those acquired through LBOs, gain. They benefit by receiving returns above those that would have occurred had the stock followed overall market movements. One researcher conservatively estimates the gain to target shareholders from takeovers of publicly traded companies between 1981 and 19_86 to be nearly 50 percent, or an estimated 8134 billion. Target shareholder cl~arly gain ... 55% 45% sc.a.\e) • (. f c: ·---------- ··---·---------- ----------------------------- Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 43 The same studies find that bidder firm shareholders have equal probabilities of gaining or losing and at best receive modest gains. Some sellers consistently win, and buyers, on average, break even. The average successful tender offer results In a statisticlly significant positive revaluation of the combined firm. Thus, on balance, takeovers, including LBOs, enhance shareholder wealth. I' I I I I i I I ! i .· ·1·· .. _____ _J\ •• • --------~-----·- Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis •• Although easily measured, shareholder 1ains do not provide an accurate measure of welfare gains. If, for example, gains are a result of wealth transfers, then the increase in share prices overstates the efficiency gains of takeovers. This is because shareholder gains must be weighed against the losses of othen. Opponents of LBOs argue that gains from such transactions result primarily from wealth redistributions: the target sharholders• gains are at the expense of someone else•• loss--such as the target companies employees or taxpayers or the target•s bondholders. /,. . ":.' > ·. . ~.f· Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Bondholders Corporate bondholders purchase bonds based on, among other factors, the bond's rating, which reflects an assessment of the likelihood that the company will make timely interest and principal payments. Purchasers of high grade bonds assume vary little, if any risk of corporate default. That is, they do so in a world without LBOs, leverage repurchases, and other forms of restructuring that result in substantial increases in leverage. If the additional debt increases the probability or cost of future default, then the value of the target's bonds will decline. .•. .. . . :; f: •~ --· Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 46 However, It is possible for bondholders to gain, or at least not lose, from highly leveraged transactions. . Bonds may contain covenants that prohibit the Issuance of debt that Is of equal or higher seniority, or that require repayment prior to taking on new debt. Unfortunately, more than half of all debt contracts contains no such restrictions. Many debt contracts outstanding today were entered into when LBOs were certainly not the norm. I would expect contracts entered into today to have much stricter convenants. But there are other reasons that bondholders may not fare so poorly after a highly leveraged transaction. For example, the power of leverage that I spoke of earlier is expected to increase a firm's efficiency and therefore its total operating cash flows. In addition, other claims on a firm may go down as the result of an LBO. New owners may terminate the target firm's pension plan or cut back on staffing. ·-~.,-r:· ~ , • . :{('.~. •· • . ; ••- ~•:~~,r.. ' . :. ;. ---------------·- Digitized for FRASER ··--·-··--··•·· - --··-·•· https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 47 compared the returns on bonds of takeover aW"IC!---..•rrn-,er to bonds with similar characteristics of corporations not subject to takeover, or to changes in• selected bond index. These studies found that, on average, target company bondholders neither gain nor lose by a significant amount in takeovers. Furthermore, there were no noticeable wealth transfers between bondholders and stockholders. , .. ; j .. _;... -· ' ·.9 •.• : ~-;. -.':,-·. ·" -~·. ,-.--.- -'"-. ". • . . -·- ... r l I .. 1 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 48 Research conducted by my staff found that bondholders of LBOs occuring prior to the tax law changes received si1nificant gains averaging over 7 percent, whDe bondholders of LBOs effective after January 1987 received significant losses averaging just over 5 percent. This significant difference coincides with the dramatic increase In the size of LBOs and suggests that tax incentives may have changed the nature of some LBOs. That Is, tax incentives may have pushed some marginal deals over the edge to completion. But even in the worst case, the losses to bondholders are dwarfed by shareholder gains. l:)edl Bondholders havllosing since 1987. .. - 10% .. 5% I I -5% • ~ I I I I pre-1987 post-1987 ... -----,. ' Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 49 Tax effects What then is the source of the gains? If I were to take an Informal poll right now, I would probably get, at least,• majority to say "the U.S. taxpayers.• Contrary to what you probably have seen in the popular trade press, however, taxpayers may not lose either. To get an understanding of the tax gains and losses, you should consider a few basic points: 1. Someone's interest expense is someone else's interest Income, which may or may not be taxed at the same rate. 2. Leveraged buyouts almost always give rise to huge capital gains, which are subject to taxation. 3. Leveraged buyouts often result in sell-offs of target assets. 4. leveraged buyouts generate taxable fee income for commercial bankers and investment bankers . .. . -· ,~,. :es. . ~~..;:~_:_~~ •• Digitized for FRASER J 4 •• ~-• ....... • ...... ..:. •••• ~.""-.... • • • ......... -~ •• • , https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 50 Before generalizing about the tax implications of LBOs, let•s concoct an extreme example and analyze its tax effects. Consider a $10-billion firm that is all equity financed (i.e., = assets equity= $10 billion). The firm•s shareholders consist of 65 percent individuals and 35 percent tax-exempt entities such as pension funds. The firm is expected to earn $1.45 billion before taxes in each of the next five years, and will pay out arr of its $960 million in after-tax profits as , / dividends to its shareholders. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 51 Roy Raider, Inc. (RRI) engineers a LBO, offering to pay $14 billion for the firm (a 40 percent premium). RRI pays for the firm with $2.8 billion in cash and $11.2 billion from the proceeds of a 5-year, 13-percent bank loan that is collateralized by the firm's assets. ) I i I I_ l -- J Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ,\ r ) Li\ 1 ( / (\ 52 '. let's examine the tax consequences. First, the tax vi. \ situation without the leveraged buyout would look like this. The firm would earn Sl.45 billion in each of the next five years and would pay $495 million in corporate income tax. The $960 million after-tax profits would be dispersed as dividends, but because only 65 percent of the stockholders are required to pay tax on dividends, only $624 million are taxable. The taxable dividends are taxed as ordinary income at the individual level . l of 28 percent, yielding tax revenue of $175 million. The total \ value of this stream of tax revenue today, discounted at 13 percent over five years (the rate on the LBO loans), is about S2.35 billion. -----· J q' I fI - Digitized for FRASER I https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 53 Now, the tax situation after the leveraged buyout would look like this. First, the LBO would give rise to a 40-percent capital gain for shareholders. With 65 percent of the equity held by individuals, the capital gain would yield $728 million In tax revenue. Second, the yearly Interest expense on the LBO loans will amount to $1.45 billion, so the firm will have no taxable income in each of the next five years. Third, the $1.45 billion in interest expense will be interest income for the holders of the LBO loans. Let's assume that all the debt is held by commercial banks and that they fund the loans entirely with deposits at the risk-free rate of, say, 9 percent. (Banks actually fund loans with at least 6 percent of equity, but the no-equity assumptions will not alter the analysis materially.) The effective federal tax rate for most commercial banks is about 10 percent, so the LBO loan will generate tax revenue of S44.2 million over each of the next five years at the bank level and $280 million (28 percent of $1 billion in interest income) at the individual level. The total value of this stream of tax revenue today, discounted at 13 percent over five years, is about S1.8 billion. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ,, ,·( I ..,;--- - - ( .r,,. j Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 54 The LBO results in a net loss of $550 million for the U.S. Treasury. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 55 ~ But remember that this is an extreme case. So let's inject ~ some reality. Suppose RRI cuts the firm's debt by 30 percent at _/ the end of the first year by selling off assets for a 20 percent U v- capital gain. Similarly, the firm cuts its debt by 15 percent, or 11.1 billion, at the end of the second year by selling off assets at a 20 percent premium. Tax revenues in the first year •• -.- would be the same as they would had no sell-off~~ occurred. In the second year, however, the firm shows a $991 million profit, which includes the capital gain. The corporation now has to pay corporate tax of $336.9 million in the second year. Similarly, the firms earns a profit in the third year, on which it must pay $265.3 million to the Treasury. In the fourth and fifth years, the firm pays St 98.5 million in federal income tax on $722 million of profits. .. ---·-·------------ -·-· I -.<. ---~--~-~·.·:-:_ .. I I I •. .• • _:·,. 7:--=-.... ---::_-_ . ~·t-t:o-.,~~- ..• . . - I I Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 56 Because debt was cut, the interest income of creditors was also cut and, consequently, so were their tax bills. j . i I I Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 57 The current value of the stream of tax revenues that will result from this new situation is nearly S2.4 billion, slightly higher than had there not been an LBO at all. Furthermore, we have not even taken into account that the LBO will generate fee income for investment bankers and commercial bankers of at least $100 million and tax revenue of $34 million. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 58 From this simple analysis, we can generalize about the effects of highly leveraged transactions on the Treasury. But first I would like to point out that there really is no .. typical" LBO or highly leveraged transaction. Some firms pay down their debt vary rapidly after increasing it so dramatically. Some do so only to increase their debt again within a few years. Other firms pay down their additional debt very slowly after a highly leveraged transaction. ,, - ••• 11 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 59 In general, though, we can say a few things about how highly leveraged transactions affect the U.S. Treasury. First, the faster firms pay down their debt after a highly leveraged transaction, the less adverse the consequences for the Treasury. Second, the more asset sales that result from a deal, the better off the Treasury will be. Also, remember that asset sales and accelerated repayment of debt often go hand and hand. Third, the higher the acquisition premium or premium on equity buybacks, the more tax revenue that results. Fourth, the more effective the highly leveraged transaction in improving efficiency and performance of the target firms, the more taxable corporate in~ome. __ J j Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 60 F1 • nanc1 • a I • a n t erme d . 1 ar1 • es Proponents of leveraged buyouts argue that much of the current restructuring is at the urging of financial Intermediaries whose shortsightedness is focussed on their fees and not on the long-term health of their clients or the U.S. economy. Indeed, along with shareholders, financial intermediaries--commercial and investment banks--stand to gain the most from leveraged transactions. Unlike target sharholders, however, financial Intermediaries stand to lose a lot if the gains from the leveraged transaction turn out to be less than expected. ' I ! I ! I I' ·- . . . . . - . • ' Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 61 Commercial bank Involvement Since restructurings require huge amounts of debt, It should come as no surprise that commercial banks are heavily Involved In M&A financing. Given the nature and size of many deals, It also should not surprise anyone that it Is the largest banks that are most actively involved. Margins on loans to investment-grade customers have been cut paper-thin due to heavy pressure from the commercial paper market and fierce competition for middle-market customers. Therefore, the hefty fees and attractive rates on takeover-related loans, which yield returns that are often two and three times returns on comparable nontakeover-related commercial loans, seem like manna from heaven to the large banks . ., . , .> Digitized for FRASER ----.J ... ···- https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 62 Consider the proposed pricing of the RJR loans. The nearly 814 billion in permanent bank financing was priced at prime plus 1.5 points with fees ranging from 1.5 to 3.25 points (about 1333 million in fees alone). The bridge loan of 81.5 billion was priced at prime plus 2.25 for the first year and goes up thereafter. ; I - I ' I I I i I .. l I Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 63 Various surveys place takeover-related loans held by ten of the largest U .S.commercial banks at about S20 billion and estimate that they have originated about S100 billion of such loans last year, bringing the total outstanding to about $450 billion. That is enough to have financed nearly St trillion in highly leveraged takeover activity. Obviously, if commercial banks are originating five times more than they are holding of these five-to-eight-year loans, they must be selling big chunks to other investors. Indeed, the very attractive returns, even on the senior debt, has created an insatiable appetite for LBO loans among various institutional investors. Commercial banks are selling LBO loan participations to thrifts, regional banks, pension funds, and the most voracious, foreign banks. The Japanese, reportedly, are buying over 30 percent of our LBO loans. Overall, the proportion that stays within the U.S. banking system is about 15 to 20 percent. Sixty large U.S. banks reported that merger-related loans account for about 11.5 percent of their commercial loan portfolios_, down from 15.7 5 percent a year ago. ________ r i ~. ...., ._;,,.~ :-:-::-":.:·-'.•./,:,:~=-.'": :_.. ·t~~-•:";_': ---~-,:.-~···· ~.,_. -· ·-~-:"',"'.!"'~ ,,•:":""'''· .,-,~----.. ... ... ,.-.,·.Ii, .. Digitized for FRASER ·,.' https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 64 What is the exact nature of commercial bank lending for takeover purposes'? As I said earlier, LBOs and restructurings usually consist of senior debt, junior debt, and a small percentage of equity. While commercial banks are participating in all aspects, funding senior debt clearly dominates. Furthermore, according to the February 1989 Federal Reserve System Survey, over 40 percent of takeover-related loans provide for adjustments to the interest rate according to the borrower's creditworthiness. This protects banks by giving borrowers incentives to improve their balance sheets and pay down their loans quickly. loans are usually paid down well in advance of maturity (usually in two to three years). The funds to paydown the loans come predominantly form cash flows or the proceeds from asset sales. Consequently, banks reported, on average, the same or lower charge-off rates for takeover loans than nontakeover-related commercial loans of comparable seasoning. -.,;. • Sources of funds to paydown LBOs loans '/I 30% ..... cash asset bond& Digitized for FRASER flow commercfal https://fraser.stlouisfed.org paper Issuance Federal Reserve Bank of St. Louis 65 While this evidence may indicate that LBO lending Is the business to be in for commercial banks, such a statment may be exaggerated and not consider the substantial risks Involved. According to the Fed's survey, commercial banks seem to be less willing to make merger-related loans. Over 40 percent of the respondents indicated that they were less willing to make merger-related loans than they were a year ago, while only 3 percent were more willing. Consequently, the share of business loans accounted for by such loans is down from a year ago. Commercial banks' willingness to make merger related loans 25% .. 111.•------- I I :..-_ - _ ..._ -_ H I less wllllng unchanged morewlDlng Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 66 This reduced willingness to extend merger-related credit is probably due, at least in part, to signs that such loans are not performing as well as they had in the past. While the loss situation continues to be favorable relative to nonmerger-related credits, 40 percent of the respondents to our survey indicated that they had charged off merger-related loans, up from 25 percent in 1986 and in 1987. Proportion of banks that charged-off merger related loans .. 50% - 25% ·-·-, 0 I I I Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 67 The economic climate of the last six years has been relatively benign, and no one knows for sure how a portfolio of LBO loans will perform If a recession hits. Those with undiversified portfolios, with portfolios of junior debt and equity pieces, and even with senior loans based on overly optimistic cash flow projections will certainly be hurt. The returns on LBO Investments have been very high. So have the risks. They just have not been tested yet. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 68 The role of investment banks Like commercial banks, investment banks are also playing a very big role in recent corporate restructurings. They give advice on mergers and acquisitions and on recapitalizations, as do commercial banks. Investment banks also assist clients in financing by underwriting bond and equity issues--a function that commercial bank-affiliated firms had been barred from performing until very recently. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 69 With the trend toward debt issuance and equity retirement, investment banks are underwriting more debt issues than equity. One form of debt that Investment banks have been Increasingly offering are "Junk" bonds. Junk bonds are, very simply, high-yield, noninvestment-grade bonds. They are now used for, of course, LBOs and recaps, but also for general purpose financings and construction loans. In highly leveraged transactions, junk bonds would usually be included in the junior portion of total debt. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 70 This form of financing has grown from $20 billion in 1982 to nearly $200 billion today. Junk bonds have certainly outpaced other forms of debt. Junk bonds now account for over 25 percent of all corporate debt issued. • . ; <j~~j~,. ':'" .... ~ - Ll.~ttli~~- --- ~:. _J:: · >I,t]r,r; : •'.Y C~-ttf~ , ' '; Junk bonds are outpacing other fonns of debt... • as% ol lotal • -· • ~ : • . . -- = • . .. ~ , •J,·- • : • :,I ; .•. : • ' bond offerings ............. .... ; S30 ; ........ ., ~ ;""' S20 10'4 $10 .. :: . • ...:..·.:.:} "! ;..r, •. ..• •· ... ,. ·--..,J.• ---•••• ) , ) Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 71Q_ There are at least two reasons why this is so. The first has to do with supply and the second, with demand. The potential for junk bond issuance is huge and starting to be realized. Of the 24 bond ratings that S&P and Moody's assign, only 9 are "investment-grade" ratings, and only 23 percent of the roughly 2200 nonfinancial firms that file with the SEC carry such ratings. This implies that over three-quarters of these firms are rated below investment grade or not at all and, therefore, are issuers or potential issuers of "junk" bonds. In addition, it is estimated that an other 20,000 companies that are not required to report to the SEC are also potential junk bond issuers. These figures translate into a 40 to 1 ratio of junk bond to investment grade issuers. In dollar amounts, it is estimated that junk bonds could eventually be four times as large as investment-grade corporate debt. I "4 -t-f" I -c,' - ; , '1. . t,.:.-:- • -r(1.:. ,1 - .. 1 .,, - ! I:, C.~ .....; Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis J2 '1/b Obviously, the supply side has great potential, but what about demand? -D~ emand, which comes primarily form mutual funds and insurance companies, has been very strong because the risk-return trade-offs have been remarkably favorable--so favorable that it could make efficient market theorists shutter. I Junk bond ownership insurance cos. other thrifts Individuals pension funds Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -ia' 7/e- Last fall, junk bonds that were rated barely below ·investment , grade, such as those issued by Donald Trump to finance the Taj Mahal, carried interest rates of 13.75 to 14.50 percent, while long-term investment-grade corporates yielded about 10 to 10.5 percent--a 325 to 450 basis point differential. Earlier issues that were rated even lower, carried interest rates as high as 20 percent. So much for return, what about risk? One study shows that from 1977 to 1986, a portfolio of high-yield bonds would have produced higher return for less risk than AAA and AA bonds and government bonds. And while the S&P500 would have given an investor a slightly higher return, he would have had to bare nearly. 50 percent more risk. /;f,~& an~ /'/~f~rll~ c reo ) 19•i1 - I ~s·~ c::oe ) ""' I - ! ~i.5"'-~\d ' 11\ch-y \ AA!'\~ AA I bc1ieu Go .. +· ~ l - - .., '-' i---- Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis How can such a situation exist, and can it persist? Several , explanations have been offered as to why such· a risk-return relationship exists. For example, some say that prices in the high-yield market adjust more slowly than in other bond markets. Others say that a high degree of risk associated with junk bonds is firm-specific and can therefore be diversified away in an index. This may be true, but another explanation is that junk bonds contain huge risk premiums for risks that investors have so far been paid handsomely to bear but that have not materialized yet. So if the risks and returns are recalculated, say, through the 1990s, they will look much diferent. One thing is clear, junk bonds cannot continue to have higher yields but lower risk than other bonds for much longer, and while there is still a lot of room for the junk bond market to expand, I doubt that it will be four times as large as the market for investment-grade corporate debt any time soon . .../ J..J..,-1h - j ; ~ /d mu r .t::--e + oc& ~ =-1.::. s'faw/1 ✓ ;..J,,5 1, - ~p-r I ~l 'fl :.lt..--1 ;.:... " !'' Y cv e; / di .;er-:.i /: .,,J l'.,.' Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 72 While junk bonds may be a relatively recent phenomenon, the involvement of investment banks in M&A and underwriting certainly is not. Their roles in takeovers and restructurings, however, have changed. Some Wall Street firms are no longer only advising on mergers and acquisitions, underwriting securities, and investing in very small portions of corporate securities. Now they are gobbling up whole firms. By pooling their funds with those of other institutional investors, investment banks are becoming the outright owners of major corporations. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 73 Thus, the days of J.P. Morgan--remember the U.S. Steel deal--are re-emerging. Finance and commerce are coming together to reshape the corporate landscape. Ironically, or perhaps coincidentally, the Investment bank with the biggest coffer is Morgan Stanley, a direct decendant of J.P. Morgan. Investment banks, along with their backers, now have about $15 billion at their disposal for equity investments. That is enough to buy a half dozen RJR Nabiscos or a few hundred smaller firms. LBO-related business may seem like a gift from the gods to investment banks also, but the risks are always lurking in the background. Bridge loans must be refinanced with junk bonds and a downturn in the markets could leave investment banks holding more LBO debt than they want, or they could be left with a capital loss. Also, the effects of a recession will first be felt by equity investors, and as equityholders, some investment banks will more than likely take a hit. - f==':--~----~~t:,·_: :~--~---_->~~~-c-7X:~-~·,_.;,_, :~-,.j -~. ~:: ~:~-\i· ·/~_::-~=-::"7?r:'. --~-:>:_~-_::~:'::-~ '-::·'::~:_::x.:: ~ :j V ·: ,; !t·· .: ic-:-•~ . ... ., ,.: ~~IIWI-., •·•· .• ;•: F• I•'• Digitized for FRASER . _I https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 74 Policy implications If all the relevant parties involved in highly leveraged transactions either gain or, at least, do not lose, then why all the fuss about the increased debt in the corporate sector? Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis '\U\ pr ~ .,91 QUESTIONS FOR STUDENTS: 1. Is the default risk assessment accurate? {E.g., what if interest expenses rise as cash flows fall?) 2. Are there other public costs associated with LBOS (e.g., to emplo..Y.ees, managers, the community in which it operates}? 3. What are the implications for management (i.e., the way managers must manage}? 4. Are changes in tax policy OR merger policy needed? What would you suggest? 5. Are there implications for monetary policy? Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 75 Opponents of highly leveraged transactions argue that such transactions are merely costly restructurings of corporations that provide no social benefits and may very likely entail considerable social costs. Preventing such buyouts would, it is argued, improve economic welfare. On the other hand, proponents argue that LBOs provide net gains to society by reducing the conflicts of interest between management and shareholders. This, in turn, improves resource allocation and efficiency, and encourages value-maximizing behavior. Thus, attempts to prevent such transactions would have negative effects. Both views are valid, but both are also biased. You need to take the costs and the benefits into consideration. If the costs exceed the benefits, then measures that reduce leverage should if'!1prove economic welfare. If, however, the benefits exceed the costs, then such measures would reduce it. r· :(:;._,.. .. . . , .. i~.- . i· • ;~ :: :._ k r· c}~: f: r . .... t•r: t:-:·_:. ·1 . •' . ~ ~ • ~, ki.tY:~~2';'~.i,.~.citr~"~;:,;;~~t'~>i.S'i:iS:iti? _- ; . \~ --- , t - ' --·. -------···•-·· .. -- -·· ··--· --· -----··- ·--- Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 76 If • number of highly leveraged firms go bankrupt, there could be considerable costs involved. These costs would, of course, entail such direct costs as lawyers' and accountants' fees and the value of time spent administering the bankruptcy, but there would also be indirect bankruptcy costs--that is, the lost opportunities. These are much harder to measure. While it may be possible to measure a firm's lost sales and lost profits, how do you measure such things as the inconvenience to consumers if no direct and immediate substitute for the bankrupt firm's product exists? .. ~---···· : .• I· •-· I I I i i I I l l I : .. _.1•· Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 77 One researcher has made an attempt to measure both direct and indirect bankruptcy costs. He estimated that the cost of bankruptcy, on average, Is about 16 percent of the value of• firm's assets just prior to bankruptcy. Six percentage points ~ are direct costs, and the other ten are' indirect costs. Both costs, of course, must be weighed against the gains from Improved efficiency of firms and in the allocation of resources. A recent study shows that after management lead buyouts, the operating income of target firms improves substantially. The return on the market value of assets is expected to be nearly 3 percentage points more than it would be without a buyout. This implies that the probability of bankruptcy for highly leveraged firms would have to be about 20 percent before the gains from leverage were exhausted. -I i •• F:. :,, .,. I •· •• • , I •. ~•-·· ••-., l;i '. ·• . ' • • . • . .L -~CL~; .: ,;LiLti~ L/,;;,.·,.;.;,i}:ti::?l'.;Li;;,J;i,;._;';;i;;i!~ih:f;,:if . Ei ------ ···--- -·---··· ··• ··-· - - 1 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 78 Is it likely that the bankruptcy rate would reach 20 percent even during a severe recession? The answer is "probably not." First, the ratio of debt to market value of equity, a measure of solvency, Is lower today than It was during the last half of the 1970s. Debt-to-market value of equity is lower today than in mid 70s ... percent 120% 100% 80% I 40% 1-1,....L.L..&...L...ll-l-J-IL..L...a....1. .............._ ,_. ......_ ._. ....._ _. ..._ _ ' I i 1963 '88 '70 74 '78 '82 '88 '88 \ I L Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 79 Second, even though interest expense as a percent of cash flows, a measure of liquidity, has been at all-time highs and may indicate trouble ahead, the ratio of Interest expense to current assets for nonfinancial corporations is not much higher today than it was ten years ago, and is slightly less than it was over the last five years. Therefore, should a firm have insufficient cash flow to service its debt, It it very likely that the firm could sell some off its liquid assets to fend off creditors . ... and firms are fairly liquid 30% 20% interest expense/ current assets 10% 0 L.,,__..___....___....___....___....__ _.__ _ _.__ _ _.__ 1978 '79 '80 '81 '82 '83 '84 '85 '88 •. ., Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 80 These figures, of course, are averages, and tells us nothing about the distribution." In other words, averages do not indicate whether or not more firms are nearing insolvency or illiquidity. So let's look at the distributions. A higher proportion of nonfinancial firms today have debt-to-asset ratios, on a market value basis, in the upper ranges than did ten years ago. But the proportion is not a lot higher. A greater proportion of firms are highly leveraged ... 20% 15% 1878 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 81 Also, the proportion of nonfinancial firms today that are very highly leveraged is nowhere near as high as it was in the mid 1970s. Therefore, it appears that a high percentage of firms are not approaching insolvency. • •• • -'?1 'rpr~r· ';- lr"'r.Jr."!""·-,c·:1"1~ The proportion of highly leveraged firms Is not as great In the mid-708 111'9' • = 1174 '' ' 11117 . "' °"' ..... ~--t1.1~111.......a.a...Kn1L-.1.&.J~W'la.··R=SZSl.......1l~--10-aae11t .I-A .1-.7 .7•A .1-A .1-1 (martcet value bMII) •r -~; . -"~dii-ti!~~! . .:. .J Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 82 What about liquidity? Well, the that's a different story. A much higher proportion of firms have interest expense-to-cash flow ratios in the upper ranges than did ten years ago. Distribution of firms seems to be shifting away from liquidity ... 8% 1978 4% 1987 2% .5-.8 .8-.7 .7-A .8-.9 .9-1 >1 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 83 The proportion in the upper ranges is even significantly higher than it was in 1982, the previous record year. In addition, over 7 percent of nonfinancial firms are now illiquid according to this measure. It appears, therefore, that liquidity, or rather illiquidity, is what we should be looking out for. It also implies that, when we enter an economic downturn, asset sales will become common practice for many firms. Distribution of firms seems to be shifting away from liquidity ... 8% 1982 4% 2% Interest expense/ Oo/. ..-..-...-,L.Mi;l--.-~-...--u..w. ....._ __.,u...A._--..a.lLIIII......,.--"' cash flow .5-.8 .8-.7 .7-.8 .8-.9 .9-1 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 84 Before I go on to estimate how these highly leveraged and relatively illiquid firms will do during a recession, let me point out a few more thing. The proportion of firms with debt-to-market value of assets ratios greater than 50 percent and/or have more than 50 percent of their cash flow consumed by interest expense is relatively high today but no higher than at some other periods over the last 15 years. However, the proportion of firms with both high leverage and low interest coverage is at its highest level since 1972. So, we are seeing more firms enter the "danger zone." Firms in the "danger zone" "• firms with market value of debt-to-assets greater than 50% and/or Interest expense-to-cash flow greater than 50% 40% % firm• with market value of d1bt-tc,.aa11ts great• 20% than 50% and Interest expens•to-cuh flow greater than 50% • 0% L..1-_1,_..:1.-.J-...J.__,lL-..L.-.eoL-..L--.82.L-_.__ _ ~84~~.~88=- 1972 74 '78 78 ,::1 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 85 Now, how is a recession likely to affect these firms? Will 20 percent or more of them fail and, therefore, wipe out all of the gains from leverage? To answer these questions, my staff simulated some economic shocks. First, they examined what would happen if the market value of equities fell dramatically, that is, by 30 percent. To put this 30 percent decline in perspective, consider that during the 1973-74 recession, the S&P 500 fell about 29 percent. The stock values of highly leveraged firms at that time did not fall as much. During October 1987, the S&P declined about 25 percent, and the stocks of highly leveraged firms at the time fell about 30 percent. So a 30-percent decline is a fairly good assumption. My staff found that such a decline would cause only 2 percent of today's highly leveraged and relatively illiquid firms to become insolvent. Even a 60-percent drop in the market would produce a failure rate of only 10 percent. As the figures we saw before suggested, so_lvency is not going to be the problem. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 86 The second jolt my staff gave to these firms involved reducing the cash available for interest payments. During the 1981-82 recession, cash flows, on average, for nonfinancial firms as well as for highly leveraged firms fell no more than 10 percent. Such a decline would result in about 10 percent of currently highly leveraged and illiquid firms to experience difficulty in meeting their interest payments. This type of shock would have a bigger impact than a market decline, but the impact is still not big enough to erase the benefits from leverage. Cash flows would have to fall by 20 percent to get a greater than 20 percent bankruptcy rate among highly leveraged firms. So, would anything be done to reduce leverage in the corporate sector? I would have to say, at this point, probably not a lot. While it serves no social or economic purpose to have the tax code encourage firms to use one form of fina.ncing over another, evidence indicates that the free-cash flow theory is well-grounded in reality. Therefore, I would expect that we would still have leveraged buyouts and recapitalizations even if debt and equity were treated equally by the IRS. I would expect, however, to see the degree of leverage fall below what we have been seeing lately and probably a more equitable tax code would weed out the "dumb deals" and provide a bigger cushion to cover the margin of error that is present in my analysis. Absent changes in the tax code, though, there are some Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 87 indications that the trend toward highly leveraged transactions is abating. Leveraged buyouts as a percent of the number of mergers and acquisitions in 1988 and as a percent of the dollar value of M&.A activity in 1988 are both off slightly from 1987. In addition, the dollar value of LBOs has been more or less flat since 1986. Also, as I mentioned earlier, commercial banks are becoming less willing to extend credit for these transactions. Also, the number of companies that are ripe for highly leveraged transactions is likely to fall, if it hasn't begun to already. The proportion of LBOs of conglomerates, prime LBO candidates of in the early years, has been falling. On the rise, have been leveraged buyouts of already private firms. These tend to be much smaller deals. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis

Silas Keehn (1989, April 5). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19890406_silas_keehn

@misc{wtfs_regional_speeche_19890406_silas_keehn,
  author = {Silas Keehn},
  title = {Regional President Speech},
  year = {1989},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19890406_silas_keehn},
  note = {Retrieved via When the Fed Speaks corpus}
}