Full text of Chicago Fed Letter : Buyouts and Bondholders, No. 17
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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO JANUARY 1989 NUMBER 17 Chicago Fed Letter B uyouts and bondholders Leveraged buyouts (LBOs) are still only 7 to 8% of all merger and acqui sition (M&A) deals done in the U.S. Yet, by dollar value they now consti tute more than 20% of all M&A ac tivity (see Figure 1). The absolute and relative dollar values of LBOs increased significantly in 1986 and have contin ued at a high pace. Indeed, the recent RJR Nabisco LBO, at nearly $25 billion, exceeds the annual value of all LBOs for 1984 and 1985 (see Figure 2). The large and sometimes astonishing gains associated with these deals have put them in the spotlight, making LBO a newsworthy, market-moving acro nym. Substantial profits accrue to shareholders, investment bankers, fi nancial advisors, and attorneys. But has the lustre of these gains obscured a darker side of LBOs? Are these pro ceeds derived from the creation of wealth or are they obtained at the ex- pense of others? Is someone taking a hit? This issue of Chicago Fed Letter focuses on the wealth transfer from target company bondholders to target company shareholders. What is an LBO? In an LBO, an individual or small group of investors, often company management in conjunction with an investment banking firm, uses the company’s assets as collateral to borrow funds to take the company private by purchasing all of its outstanding stock at a premium. It is common to sell high-yield, highrisk securities (junk bonds) to accumu late the cash necessary for an LBO. The resulting company is highly lever aged, with a significant debt burden. For 58 LBOs from 1980 to 1984, aver age long-term debt increased by 262% and the average debt-to-equity ratio jumped to more than 5 to 1. This was an average increase of more than 1, 000%. Why LBOs? Taking a company private may protect it from hostile suitors. LBOs are often proposed to shareholders by manage ment in an effort to save their company from a hostile takeover. SOURCE: M e r g e r s of selected years. a n d A q u i s i t i o n s , Almanacs But even in the absence of a hostile takeover threat, there are several in centives for LBOs. Although the com pany is burdened with significant debt subsequent to the LBO, it is the debt that generates much of the cost savings and increased efficiency associated with the LBO. The debt results in tax savings in the form of interest de ductions. LBOs can also increase wealth by reducing conflicts of interest created by the separation of manage ment and ownership. W ho gains? If an LBO is successful, there are gains to be made. Shareholders, on the whole, will not sell out for less than the market price. Thus, by the nature of an LBO, the buyout of shares must be at a premium over the market price. Research clearly indicates that stock holders of firms acquired in M&As (in cluding LBOs) gain. They benefit by receiving returns above those that would have occurred had the stock fol lowed overall market movements. One researcher conservatively estimates the gain to target shareholders from take overs of publicly traded companies be tween 1981 and 1986 to be 47.8%, or an estimated $134.4 billion. The same studies find that bidder firm shareholders have equal probabilities of gaining or losing and at best receive modest gains. Yet, recent research concludes that the average successful tender offer results in a statistically sig nificant positive revaluation of the 2. . . . and more bucks billions of dollars 50 ----------------------------- Value of LBOs 1984 1985 1986 1987 1988* *First half of 1988 plus the R JR Nabisco deal. S O U R C E : M e r g e r s a n d A q u i s i t i o n s , Almanacs of selected years. combined firm. Thus, on balance, takeovers, including LBOs, enhance shareholder wealth.1 Sources of gain But, while M&As do enhance wealth, such wealth may not be derived en tirely, or at all, from increased effi ciency (e.g., resource reallocation, removal of inefficient management, or economies of scale or scope). The cre ation of value and gains from efficiency are even more suspect in LBOs which, by their nature, lack the usual synergistic gains of M&As. Although easily measured, shareholder gains do not provide an accurate measure of welfare gains. If, for ex ample, takeover and LBO gains are a result of wealth transfers, then the in crease in share prices overstates the ef ficiency gains of takeovers and LBOs. This is because shareholder gains must be weighed against the losses of others. Opponents of LBOs argue that gains from such transactions result primarily from wealth redistributions: one stakeholder’s gain—the target shareholder’s—is at the expense of another’s economic loss—such as the target company’s employees or its bondholders or the U.S. Treasury. In the extreme, such transactions are merely costly restructurings of corpo rations that provide no social benefits. 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 be tween management and shareholders. This, in turn, improves resource allo cation and efficiency and encourages value-maximizing behavior. Thus, at tempts to prevent such transactions would have negative effects. Research has been unclear concerning the sources of takeover gains. They may result from redistribution and in creased efficiency. But the sources of gain vary from deal to deal, from in dustry to industry, and from year to year. Studies have addressed the wealth transfers to target shareholders from: government (and, thus, taxpayers) in the form of tax savings; target labor in the form of lower wages and higher unemployment; and target bondholders in the form of reduced bond values. Do target bondholders lose? Corporate bondholders purchase bonds based on, among other factors, the bond’s rating, which reflects an assess ment of the likelihood that the com pany will make timely interest and principal payments. Purchasers of high grade bonds assume very little, if any, risk of corporate default. That is, they do so in a world without LBOs. LBOs result in increases in the firm’s debt burden. If the additional debt increases the probability or cost of fu ture default, then the value of the target’s bonds will decline. Among several recent examples of fall ing bond values associated with LBOs, the most notable is RJR Nabisco (see Figure 3). Indeed, some RJR bondholders have filed suit against RJR. They argue that RJR manage ment has failed in its duty to bondholders and that the LBO benefits others, including management, at the direct expense of the bondholders. These highly publicized examples may be isolated instances of extremely risky ventures or of poorly written bond covenants that fail to adequately pro tect the bondholder. Or, they may in dicate that bondholder losses are sometimes the price paid for shareholders’ and others’ gains in LBOs— more respectably, the price or to be paid to obtain efficient manage ment and allocation of resources. Additional evidence Prior studies have compared the re turns on bonds of takeover targets ei ther to bonds with similar characteristics of corporations not sub ject to takeover, or to changes in a se lected bond index. These studies found that, on average, target company bondholders neither gain nor lose by a (statistically) significant amount in takeovers. Furthermore, there were no noticeable wealth transfers between bondholders and stockholders.2 The following analysis is specific to LBOs and looks solely at the change in bond value attributable to the an nouncement of the LBO. It does so by controlling for changes in the bond price caused by changes in interest rates on government securities of com parable duration. Our study covered 20 LBOs, including some of the largest ones, from mid-year 1984 to mid-year 1988. All the organ izations had corporate bonds outstand ing at the time of the announcement of the LBO.3 Results for the entire sample are con sistent with previous research using both monthly and daily bond data. Overall, the probabilities of a gain or a loss in bond values upon an LBO announcement are about equal. Moreover, on average the increases or decreases in bond values of LBO targets are not statistically significant. This is true across all bond grades. So overall, stockholders are not gaining at the ex pense of bondholders in LBOs. However, this is not very consoling to the holders of approximately 50 per cent of those issues that do lose value. Although the average change in bond prices across all issues in the sample is a statistically insignificant 0.50%, the difference between the minimum ( —1.84%) and maximum ( —15.39%) loss is great. L B O t a r g e t b o n c is turreth n d s : U g a m s a n d lo s s e s ( % o f b o n d ’ s fa c e v a lu e ) All bonds (n = 2 0 ) Average - 0 .5 0 Range -1 5 .3 9 -1 7 .0 8 Gainers ( n = 1 2) Losers (n = 8 ) 5.87 -0 .5 8 -1 7 .0 8 - 7 .5 4 - 1 5 . 3 9 - - 1 .84 The reconciliation of these and previ ous results with the highly publicized negative returns (and less publicized gains) to bondholders of certain LBO targets is the recognition of the differ ence between individual and average results. Interestingly, the average data in this analysis hides the fact that the two highest-rated bonds (A + ) each had losses greater than the two lowest rated bonds (B + ) upon the announce ment of their respective LBOs. The aggregation of data also masks a major tax-related incentive of LBOs. The Tax Reform Act of 1986 elimi nated the preferential tax treatment of capital gains. This has increased the incentives to issue debt. (Interest pay ments on debt are deductions from taxable income, but dividend payments are taxed at the corporate or personal tax rate.) Capital restructuring in the form of an LBO increases the value of the firm by reducing its tax burden. A split of our LBO sample into those effective prior to and after January 1987 provides a suggestive, but not conclusive, bit of information. Bondholders of LBOs occurring prior to the tax law changes effective in 1987 received significant gains averaging 7.36%, while bondholders of LBOs ef fective in 1987 and later received sig nificant losses averaging 5.10%. The statistically significant different experi ences of the two groups coincides with the dramatic increase in size of LBOs and suggests that tax incentives have changed the nature of LBOs. The guiding principle for the bondholder may be to judge each case individually, taking into account a firm’s exposure to an LBO. While changes in bond prices are certainly important to those buying and selling bonds, it may be argued that bonds are usually bought as a long-term invest ment to be held to maturity with rela tively guaranteed interest payments. However, the price of a bond today is affected by the probability and cost of default in the future. Right or wrong, a change in bond values today reflects the market’s best guess about the LBO’s long-term impact on default risk. Assessment Falling bond values for certain LBO targets represent the market’s down grading of the bond quality prior to or in absence of an official downgrade. Several factors may play a role in the downgrading of individual bonds. For current and prospective bondholders relevant factors to con sider are: the size of the deal; the level of existing debt and the relative in crease in leverage; expectations of the corporation’s future credit needs; whether the LBO group includes cur rent management; the protective covenants of the bond agreement; the firm’s level of free cash flow; the degree of increase in stock values; the terms of the deal including plans to pay down the debt; the firm’s tax liabilities and the tax consequences of the deal; and the corporation’s bond rating history. 1988 (N ew Y ork: S ta n d asrd & P o o r’s C o rp o ratio n ). I f m ore th a n one issue of lon g -term d e b t was o u tstan d in g , the one used was the m ost highly rated issue w ith the longest term to m a tu rity . S T R IP d a ta (T re a su ry 0% C A T S p rio r to F eb ru ary 1985) are from S alom on B rothers Inc. Bond Market Roundup J u ly 1984-N ovem ber 1988. 3 P au l A squith a n d E. H a n K im , “T he Im p a c t o f M e rg e r Bids on the P a rtic ip a t ing F irm s’ S ecurity H o ld ers,” Journal o f Finance, V ol. 37, No. 5, (D ecem ber 1982), pp. 1209-1228 covers 50 conglom erate m ergers from 1960-1978.; D eb ra K. D ennis a n d J o h n J . M cC onnell, “ C o rp o rate M ergers a n d S ecurity R e tu rn s ,” Jour nal o f Financial Economics, Vol. 16, No. 2 (June 1986), pp. 143-187 covers 132 m ergers from 1962-1980.; an d K en n eth L ehn a n d A n n ette Poulsen, “ L everaged Buyouts: W ealth C re a te d or W ealth R e d istrib u te d ? ,” in Public Policy Toward Cor porate Takeovers, (N ew B runsw ick, N J: T ra n sa c tio n Books, 1988) covers 13 bonds o f firms subject to LBOs. In short, with LBOs an increasing pos sibility, the bondholder needs to think more like a stockholder. — Diana L. Fortier1 2 1 F o r a review o f the lite ra tu re on gains a n d sources o f gain in takeovers, see D ian a L. F o rtier, “ H ostile T akeovers a n d the M a rk e t for C o rp o ra te C o n tro l,” Economic Perspectives, F ed eral R eserve Bank o f C hicago, J a n ./F e b . 1989. F o r evidence on the gains to shareholders from LBOs see K h alil M . T o ra b z a d e h a n d W illiam J . B ertin, “ L everaged Buyouts a n d S h a re ho ld er R e tu rn s ,” The Journal o f Financial Research, Vol. 10, No. 4, (W in ter 1987), pp. 313-319. 2 LBOs used w ere listed in Mergerstat Review 1984-1987 (C hicago: W . T . G rim m & Co.) o r in the q u a rte rly R osters o f Mergers & Acquisitions 1 9 8 5 Q L 1 9 8 8 Q 2 . LBOs o f subsidiaries o r units o f an o rg an izatio n w ere excluded. Also excluded w ere lBOs an n o u n ced aro u n d the tim e o f the O c to b e r 1987 crash. C o rp o ra te bon d d a ta are from S & P ’s Bond Guide J a n u a r y 1984-N ovem ber K arl A. Scheld, Senior Vice President and D irector of R esearch; D avid R. A llardice, Vice P resident and Assistant D irector of Research; E dw ard G. N ash, E ditor. C hicago Fed L etter is published m onthly by the R esearch D ep artm en t of the F ederal Reserve Bank of C hicago. T h e views expressed are the au th o rs’ and are not necessarily those o f the F ederal Reserve Bank o f C hicago or the Federal Reserve System. Articles m ay be rep rin ted if the source is credited and the R esearch D ep artm en t is provided w ith copies of the reprints. C hicago Fed L etter is available w ith o u t charge from the Public Inform ation C enter, F ederal Reserve Bank o f C hicago, P.O . Box 834, Chicago, Illinois 60690, or telephone (312) 322-5111. ISSN 0895-0164 Hopes of a continuation of August’s slowdown in U.S. industrial production that would ease inflationary pressures were further dampened by solid growth in Oc tober. Manufacturing activity in the nation rose 0.5 percent in October, up from 0.4 percent in September. Durable goods, led by business equipment and auto motive products, provided the bulk of the growth. Midwest manufacturing activity was unchanged from its September level, re flecting spot weaknesses in business equipment-related industries. While nonelec trical equipment continued to expand activity, instruments edged downward and electrical equipment declined after two strong months of expansion. Also, trans portation equipment continued its downward trend as plants closed in Michigan. Chicago Fed Letter F E D E R A L R E S E R V E BAN K O F C H IC A G O P u b lic In fo rm a tio n C en ter P .O . Box 834 C h ica g o , Illin o is 60690 (312) 322-5111 N O T E : T h e M M I is a com posite index o f 17 m an u factu rin g industries and is constructed from a weighted com bination o f m onthly hours worked and kilow att hours d a ta . See “ M idw est M a n u facturing Index: T h e C hicago F ed ’s new regional econom ic in d icato r,” Economic Perspectives, F ederal Reserve Bank of Chicago, Vol. X I, No. 5, S eptem ber/O ctober, 1987. T h e U n ited States represents the F ederal Reserve B o ard ’s In d ex o f In d u strial P roduction, M anufacturin g .