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For release on delivery
June 26, 1989
9:00 a.m. E.D.T.

Economic Competitiveness, Management Accountability
and Corporate Leverage

Address by Manuel H. Johnson
Vice Chairman

Board of Governors of the
Federal Reserve System


Conference Sponsored by
United Shareholders Association

Washington, D .C .
June 26, 1989

I'm very pleased to be here and to address this
distinguished group of corporate leaders and public

As the United Shareholders Association clearly

recognizes, corporate shareholders will play a critical role
in determining whether the United States can compete
successfully in an increasingly integrated global economy.
For the United States to maintain and strengthen its
competitive position internationally, we must ensure that
our enterprises are highly innovative and our resources are
allocated efficiently.

I strongly believe that our

capitalistic system of private ownership, profit
maximization, and fully competitive markets is the best way
to achieve this goal.

But this system will be innovative

and yield an efficient allocation of resources only if
corporate managers have incentives to act in the interests
of shareholders.




The formation and growth of the United Shareholders
Association reflects a growing concern that conflicts of
interest between shareholders and managers, compounded by
biases in our tax system, have been eroding the productivity
and competitiveness of American corporations.

The recent

wave of leveraged buyouts and some other forms of corporate
financial restructuring can be viewed as the logical
response of a vibrant capitalistic system to poor management
and tax distortions.

Higher leverage has forced management

to enhance productivity by trimming unnecessary operating
expenses and by curtailing wasteful investments, including
the ill-conceived attempts at diversification that were so
prominent in the 1960s and 1970s.

Furthermore, by reducing

the share of income from corporate assets that is subject to
double taxation, higher leverage tends to counteract the tax
system's bias against the payout of earnings to




From my perspective as a central banker, however, I
am concerned that these efficiency gains from higher
leverage could pose some problems for macroeconomic and
financial stability.

Although I think that such adverse

side effects can be avoided, provided that lenders to highly
leveraged firms carefully assess a company's ability to
service its obligations in both good times and bad times.
Sources of Efficiency Gains from Higher Leverage
The theory most often cited in support of the view
that higher leverage induces more efficient utilization of
corporate resources is
corporate restructuring.

called the free-cash flow theory of
This theory posits that many

corporations produce more cash flow than needed to maintain
themselves as profitable going concerns.

But professional

managers who typically control these corporations frequently
resist paying out such excess corporate resources--the freecash flow— to shareholders, who can be depended upon to




deploy such funds to their most profitable and, presumably,
most efficient alternative uses.

In part, the failure of

corporate managers to release free-cash flow can be
attributed to the bias in our tax code against the payment
of dividends.

But a more basic reason is the absence of

incentives for managers to act in the interest of

In the absence of effective oversight by

boards of directors, shareholders' rights are often
compromised and the productivity of the overall economy is
harmed as managers direct free-cash flow toward wasteful
projects, excessive perquisites, and uneconomic
The existence of free-cash flow creates
opportunities for what have come to be called "unaffiliated
corporate restructurers."

They are also called "corporate

raiders" by professional managers and "corporate saviors" by

According to the theory, the restructurer

identifies mismanaged companies and promises to direct freecash flow away from wasteful projects once control of the
corporation is achieved.
be worthless.

Words and promises, of course, can

The uniqueness and value of a restructurer's

promise, however, is based on the willingness to pay a
significant premium to current shareholders for the
opportunity to make the promise good.

In the vast majority

of cases, of course, it is impossible to finance the
purchase of a multibillion dollar corporation entirely out
of internal resources.

Rather, most of the funds necessary

for a restructuring must be borrowed.

Lenders must be

convinced that a heavy debt burden can be carried by
diverting the acquired corporation's future free-cash flow
away from wasteful projects and towards servicing debt.
the restructurer's assessment of the potential of the
corporation is correct and the necessary funds are





forthcoming, a more efficient allocation of resources
More generally, the validity of the free-cash flow
theory as an explanation for the recent wave of corporate
restructuring in the American economy depends on the truth
of three key assertions:

(1) many corporations are, in

fact, managed inefficiently;

(2) the stock market recognizes

inefficient management and, as a result, share prices trade
at significant discounts; and (3) lenders correctly judge
that the free-cash flow will comfortably support the
increased debt burden incurred to finance the upfront
payment to shareholders of the acquired corporation.
The history of the oil industry in the early 1980s
provides the clearest evidence for the free-cash flow theory
and is, no doubt, familiar to many in the audience here

As oil prices increased tenfold in the 1970s, fuel

economization efforts by the public left the industry with

substantial excess capacity.

Earnings and cash flow were

high, but the marginal productivity of resources in the oil
industry was low.

Conditions in the industry suggested

appropriate action would involve cutbacks in exploration and
development and a reduction in size.

Yet managers continued

to fund exploration and development and to maintain the size
of the industry.

Takeover specialists recognized that value

could be created by curbing investment in these less
productive areas and returning funds to shareholders.
Through takeovers or the threat of takeovers the necessary
changes in corporate strategy were implemented.

And once

takeovers or defensive actions were announced, share values
rose substantially.
Indeed, in the oil industry and in other industries
such as food products and communications, returns to
shareholders of acquired corporations generally have proven
quite substantial.

Depending on the time period analyzed




and the type of transaction, studies find that shareholders
earn from 20 to 40 percent in a restructuring.

Of course,

not all of these gains can be attributed to improvements in

As I noted earlier, financial restructuring is

attractive in part because it allows corporations to
transfer excess resources to stockholders in ways that avoid

In addition, a portion of the gains to

shareholders have come at the expense of bondholders.
Indeed, bondholders now routinely protect themselves against
"event risk", that is, the risk of restructuring-related
losses, by requiring that "poison puts" be included in bond
Critics of corporate restructuring have gone so far
as to assert that all of the gains to shareholders represent
transfers of wealth from other parties with claims on
corporate assets, rather than real improvements in

Available empirical evidence, however, does

not support this criticism.

Several recent studies have

carefully examined the pre- and post-leveraged buyout
performance of public companies that were taken private in
the early and mid-1980s.

Evidence from the studies

confirmed that the operating income of these companies
increased following the buyouts, both absolutely, and, more
impressively, relative to other firms in the same industry.
The improvements in operating income were accompanied by
declines in expenditure on new capital and some employment

Although these studies cannot be considered

definitive because of data limitations, I am confident that
as more data become available, they will demonstrate
efficiency gains.
Effects of Higher Leverage on Macroeconomic Stability
While it seems fairly clear that the leveraging of
corporate balance sheets has improved the productivity and
competitiveness of many firms, the greater use of debt also

makes them more vulnerable to adverse unanticipated economic
events, such as an economic downturn or a rise in interest

For the corporate nonfinancial sector as a whole,

standard measures of debt service burdens have risen sharply
in recent years.

For example,

the ratio of gross interest

payments to corporate cash flow before interest provision is
currently about 35 percent, close to the 1982 peak when
interest rates were much higher and profits were weak owing
to the recession.

Moreover, these increased debt service

burdens have been highly concentrated, largely among those
firms that have actively sought the benefits of higher

Indeed, in the

past several years, the group of

large, publicly-owned firms with highly leveraged balance
sheets reported interest expenses increasingly in excess of
their pre-tax operating income.

They have no cushion of




By cutting into earnings, an economic downturn
would place further pressure on these firms by reducing
their cash flow, while higher interest rates would add to
debt service burdens at those firms that finance themselves
with short-term or variable-rate obligations.


companies are obviously relying on asset sales to meet their
debt obligations, and adverse macroeconomic events would
further increase pressures to liquidate assets. What
concerns me most about this strategy is that the liquidity
of the markets for corporate subsidiaries or other assets
could shrink considerably during such periods.
More generally, I am somewhat concerned that the
positive incentive effects of debt, such as assuring that
management will not waste cash flow on low-productivity
projects, tend to operate better in an environment where the
risk of bankruptcy is low.

If bankruptcy is likely,

however, managers often are tempted to take excessive risks




to avoid bankruptcy and the loss of their jobs.
Furthermore, companies near bankruptcy may find it difficult
to persuade potential workers, suppliers, and customers to
enter into long-term relationships.

While bankruptcy can in

principle be avoided by renegotiation of debt terms, for
example, in reality bankruptcies will occur.


are sometimes blocked by the need of creditors to maintain a
reputation for toughness or by the difficulty of getting
various classes of creditors to compromise their divergent
claims and interests.
In addition to the risks incurred by individual
firms, high debt levels have the potential, however remote,
to contribute to macroeconomic instability.

If there were a

significant negative shock to the economy, high debt levels
could lead to a succession of bankruptcies, causing, in
turn, a crisis of confidence.

Like banks, nonfinancial

corporations often have assets which are relatively illiquid



compared to their liabilities.


These corporations count on

being able to roll over liabilities as they come due.


there were a crisis of confidence, creditors might stop
lending to highly leveraged corporations.

Fortunately, most

of the restructured firms thus far appear to be in mature,
stable, noncyclical industries.

For such businesses, a

substantial increase in debt may raise the probability of
insolvency but only to a relatively small level.
Nonetheless, roughly two-fifths of merger and acquisition
activity, as well as LBOs, have' involved companies in
cyclically sensitive industries that are more likely to run
into trouble in the event of a severe economic downturn.


is these companies that have the potential to cause systemic

The Federal Reserve, of course, is sensitive to

possible systemic liquidity problems like the stock market
break on October 19, 1987 and would incorporate such events
into monetary policy decisions.




Highly Leveraged Financings by Banks
At the Federal Reserve, we have been particularly
concerned about risks to U.S. banking organizations from
their participation in highly leveraged financings.

As I'm

sure you are aware, many of the largest U.S. banking
organizations have been very actively involved in financing
the restructuring of corporate America.

Because these large

banking organizations play a central role in our credit and
payments systems, widespread losses on restructuring credits
could weaken our country's macroeconomic and financial
Accordingly, the potential risks to the banking
system from highly leveraged credits have received our close
attention for some time.

The Federal Reserve first issued

supervisory guidelines for assessing LBO-related loans in
1984, and following an intensive review, we updated our
guidelines earlier this year.

In issuing these guidelines,




we have not in any way attempted to arbitrarily restrict
bank financing of corporate restructuring.

However, because

high leverage increases the vulnerability of borrowers to
adverse economic and financial developments, we have
actively urged bank managements to exercise caution and
apply especially rigorous lending standards to
participations in LBOs and other highly leveraged
transactions. In this regard, we simply have underscored
and supplemented our existing loan review procedures.
The new guidelines place special emphasis on the
importance of evaluating the adequacy and stability of the
corporate borrower's current and prospective cash flow under
varying financial and economic conditions, including the
possibility of higher interest rates or recession.

As I

noted earlier, I am especially concerned about loans whose
repayment depends on the sale of assets or subsidiaries.
The guidelines note that our examiners will not only




scrutinize carefully the methods used to determine asset
valuations and projected sale proceeds but also carefully
assess the extent to which highly leveraged borrowers are
protected against interest rate increases.

Most large

banking organizations, I am happy to report, now require
highly leveraged borrowers to purchase interest rate caps or
enter into swaps to limit their interest rate exposure.
In conclusion, I am confident that with the
appropriate lending policies and procedures in place at U.S.
banks and other major lenders to leveraged enterprises, we
can avoid the potential adverse macroeconomic consequences
of corporate leverage, while we enjoy the associated gains
in productivity and competitiveness.

And with


assets deployed efficiently, I am confident that we can
continue to improve our competitive position
internationally, as we must if the United States is to
maintain its leadership position.