Financing patterns of European Buy-Outs 9783836625654, 9783836675659
As Buy-Outs became larger and more levered in the mid 2000's the European Leveraged Finance market experienced a wa
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Sascha Kaumann
Copyright © 2009. Diplomica Verlag. All rights reserved.
Financing patterns of European Buy-Outs
Diplomica Verlag
Sascha Kaumann Financing patterns of European Buy-Outs ISBN: 978-3-8366-2565-4 Herstellung: Diplomica® Verlag GmbH, Hamburg, 2009
Copyright © 2009. Diplomica Verlag. All rights reserved.
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Table of contents TABLE OF CONTENTS.......................................................................................................................................I LIST OF ACRONYMS ......................................................................................................................................III LIST OF OBJECTS............................................................................................................................................ VI 1.
2.
INTRODUCTION ....................................................................................................................................... 1 1.1.
DEFINITION OF BUY-OUTS .................................................................................................................... 2
1.2.
RELEVANCE OF BUY-OUTS ................................................................................................................... 4
1.3.
RESEARCH FOCUS ................................................................................................................................. 6
1.4.
METHODOLOGY & STRUCTURE ............................................................................................................. 7
THE QUEST FOR A THEORY ON OPTIMAL CAPITAL STRUCTURE ......................................... 9 2.1.
TRADITIONALISTS ................................................................................................................................. 9
2.1.1.
Assumptions made by traditionalists............................................................................................. 10
2.1.2.
Irrelevance hypothesis................................................................................................................... 11
2.2.
MODERNISTS ...................................................................................................................................... 13
2.2.1.
2.2.1.1.
Corporate taxes.................................................................................................................................... 14
2.2.1.2.
Corporate and personal taxes............................................................................................................... 14
2.2.2.
Risky debt hypothesis .................................................................................................................... 17
2.2.3.
Costly contracting hypothesis ....................................................................................................... 19
2.2.3.1.
Assumptions made in Agency Theory................................................................................................. 19
2.2.3.2.
Definition of contracting parties.......................................................................................................... 22
2.2.3.3.
Agency conflicts and costs .................................................................................................................. 23
2.2.3.4.
Implications for shareholders and empirical evidence from leveraged Buy-Outs ............................... 30
2.3.
3.
AN INTEGRATED MODEL OF CAPITAL STRUCTURE ............................................................................... 32
2.3.1.
The case of pure debt and equity................................................................................................... 33
2.3.2.
The case of hybrid financing instruments...................................................................................... 35
FINANCING PATTERNS OF EUROPEAN BUY-OUTS .................................................................... 39 3.1.
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Tax hypothesis............................................................................................................................... 13
DETERMINANTS OF CAPITAL STRUCTURE CHOICE ............................................................................... 39
3.1.1.
Asset characteristics...................................................................................................................... 40
3.1.2.
Liability characteristics................................................................................................................. 41
3.1.2.1.
Senior debt .......................................................................................................................................... 42
3.1.2.2.
Mezzanine ........................................................................................................................................... 47
3.1.2.3.
High Yield........................................................................................................................................... 49
3.1.2.4.
Preferred equity ................................................................................................................................... 51
3.1.2.5.
Ordinary equity ................................................................................................................................... 52
3.1.2.6.
Summary ............................................................................................................................................. 53
3.1.3.
Availability of funds ...................................................................................................................... 54
3.1.4.
Summary........................................................................................................................................ 56
3.2.
EVIDENCE FROM EUROPEAN BUY-OUT CAPITALISATION .................................................................... 56
I
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4.
THE CAPITALISATION PROCESS AND OTHER SOURCES OF VALUE.................................... 61
5.
SUMMARY AND OUTLOOK................................................................................................................. 65
6.
REFERENCES .......................................................................................................................................... 67
7.
APPENDIX ................................................................................................................................................ 81
II
7.1.
ADDITIONAL SOURCES OF INFORMATION ............................................................................................ 81
7.2.
LEVERAGE EFFECT .............................................................................................................................. 81
7.3.
DERIVATION OF THE MILLER MODEL ................................................................................................. 82
7.4.
FINANCIAL MODEL FOR CAPITALISATION ANALYSIS ........................................................................... 83
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List of Acronyms &
And
%
Percent
€
Euro
$
US Dollar
App.
Approximately
B
Value of the bonds of a levered company
bn
Billion
bps
Basis points (one 100th of a percent)
BVK
Bundesverband deutscher Kapitalbeteiligungsgesellschaften e.V.
CAPM
Capital Asset Pricing Model
CEPRES
Centre for Private Equity Studies (Frankfurt, Germany)
CMBOR
Centre for Management Buy-Out Research (Nottingham, UK)
Cp.
Compare
DCF
Discounted Cash Flow
DDM
Dividend Discount Model
DWS
DWS Investment GmbH
EBIT
Earnings before interest and taxes
EBITDA
Earnings before interest, taxes, depreciation and amortisation
EBO
Employee Buy-Out
ed.
Edited
e.g.
Exempli gratia (For example)
Et
Equity value of the company in period t
et al.
Et alii (And others)
etc.
Et cetera
et seq.
Et sequens (And the following page)
et sqq.
Et sequentia (And the following pages)
EVCA
European Private Equity & Venture Capital Association
E [x~]
Expected earnings
F
Face value of bonds outstanding
FBO
Family Buy-Out
GS
Goldman Sachs
I
Cost of investment III
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IBO
Institutional Buy-Out
i.c.w.
In conjunction with
i.e.
Id est (That is)
IRR
Internal rate of return
kA
Return on assets of the company
KKR
Kohlberg, Kravis and Roberts
k LS
Equity cost of capital of the levered company (Return on equity)
k US
Equity cost of capital of the unlevered company (Return on equity)
kWACC
Weighted average cost of capital1
L
London Interbank Offer Rate
LBO
Leveraged Buy-Out
LIBOR
London Interbank Offer Rate
LTM
Last twelve months
m
Million
M&A
Mergers and Acquisitions
MBI
Management Buy-In
MBO
Management Buy-Out
M&M
Modigliani and Miller
MSCI
Morgan Stanley Capital Investments
MTU
Motoren und Turbinen Union GmbH
na
Not applicable / Not available
NPV
Net Present Value
P
Promised payments to debtholders
p.
Page
pp.
Pages
PV
Present value
PWC
Price Waterhouse Coopers
q.e.d.
Quod errat demonstrandum
q.v.
Quod vide (See as well)
R&D
Research and development
1
“The average cost of capital on the firm’s existing projects and activities. It is obtained by weighing the cost of
each source of funds by its proportion of the total market value of the firm.” [Roos/Westerfield/Jaffe (1996), p.885].
IV
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Rf
Cost of risk-free debt
s
Future states of the world
sA
Breakeven state for the all-equity company
sB
Breakeven state for the levered company
SL
Value of the stocks of a levered company
SU
Value of the stocks of an unlevered company
tB
Personal tax rate on interest
tC
Corporate tax rate
TEV
Total enterprise value
TMT
Telecommunication, media and technology
trn
Trillion
tS
Personal tax rate on dividends and other equity distributions
u.a.
Unnamed author
UK
United Kingdom
US
United States of America
USA
United States of America
V
Value of the company
VL
Value of the levered company
VS
Value of newly acquired assets
vs.
Versus
Vt
Value of the company in period t
VU
Value of the unlevered company
yoy
Year on year
ZfbF
Zeitschrift für betriebswirtschaftliche Forschung
V
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List of Objects Figure 1
European fund in and out-flow of selected asset classes ....................................... 5
Figure 2
Five year trend in European private equity investments ........................................ 5
Figure 3
Stage model of the Buy-Out process...................................................................... 6
Figure 4
Graphical representation of the Miller model ...................................................... 15
Figure 5
Impact of costs of financial distress on firm value............................................... 18
Figure 6
Illustration of the underinvestment problem ........................................................ 28
Figure 7
Agency costs’ effect on firm value ...................................................................... 32
Figure 8
Illustration of the trade-off theory........................................................................ 33
Figure 9
Determinants of Buy-Out capital structure .......................................................... 39
Figure 10
Sources and uses of funds in the European Buy-Out market............................... 57
Figure 11
European senior debt issuance ............................................................................. 58
Figure 12
European issuances of hybrid products................................................................ 59
Figure 13
Funding vs. investment in European equity products .......................................... 60
Figure 14
Components of realised returns............................................................................ 63
Figure 15
Graphical representation of Modigliani and Miller’s proposition II.................... 82
Table 1
Overview of different Buy-out models ................................................................. 3
Table 2
Comparison of cash flows from investment in the levered vs. unlevered firm... 12
Table 3
Direct and indirect costs of financial distress...................................................... 17
Table 4
Classification of Agency problems ..................................................................... 21
Table 5
Stereotypes of contractual parties ....................................................................... 23
Table 6
Array of Agency problems analysed................................................................... 24
Table 7
Agency costs revisited......................................................................................... 31
Table 8
Selection of empirical studies on optimal capital structure................................. 34
Table 9
Selection of theoretical research on optimal capital structure............................. 36
Table 10
Selection of empirical studies on optimal capital structure................................. 37
Table 11
Overview of individual financing instruments’ characteristics........................... 42
Table 12
Popular covenant types........................................................................................ 46
Table 13
Qualitative evidence from contractual specifications ......................................... 54
Table 14
Large cap financial sponsors ............................................................................... 55
Table 15
Levers for value generation in Buy-Outs ............................................................ 62
Table 16
Interview partners from the investment community ........................................... 81
Table 17
Interview partners from academia....................................................................... 81
VI
1. Introduction The 1980’s saw the creation of a new form of corporate takeover: Leveraged Buy-Outs.2 Extensively discussed, they led to a widespread public debate on corporate governance in the US that culminated in a 1989 congressional hearing on the possible implications of leveraged Buy-Outs for the economy.3 The public picture was clear: The “Barbarians at the Gate“4 travelled in pin-striped suits knocking on executives’ doors while asking for their seat in the corporate boardroom. Actions such as, paying for acquisitions with borrowed money, cutting jobs, stealing tax money from the state through increased leverage and selling the firms after a couple of years for a huge profit, all contributed to the image of LBO financiers as corporate raiders. Not only within the public spectre, but moreover, economic literature seriously criticised the one-off gains and zero-sum sources of value5 associated with leveraged Buy-Outs. Summers labels the private benefit of LBO shareholders as being achieved at the expense of other stakeholder groups, misevaluations and future growth opportunities.6 Despite this, advocates of this new form of organisation were to be found. Not only did investors searching for higher returns in a low interest environment, welcome the advent of the LBO asset class, but moreover literature began to develop awareness of the benefits of those transactions. The solution to acute incentive problems found in public corporations, which this new form of takeover was able to offer led Jensen to remark: ”The last share of publicly traded common stock will be sold in 2003”7. Knowledge of this new acquisition technique quickly began to reach Europe and by 1989 the total value of Buy-Out transactions undertaken reached €bn 6.5 in the old continent, a 70% year on year increase from 1981.8 After a fall in Buy-Out activity in the late 1990’s transactions have recently increased with prominent examples in 2003 including the €bn 1.05
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takeover of BertelsmannSpringer, the science and business media publishing unit of
2
However, Hoffmann and Ramke find traces of Buy-Out behaviour in the Bible and the Middle Ages [cp.
Hoffmann/Ramke (1992), p.31] it were the 1980’s that made this new technique popular. 3
US Senate (1989), p.1.
4
Title of a book on the LBO of RJR Nabisco that received strong media attention [cp. Burrough/Helyar (1990)].
5
Cp. Rappaport (1990), and comment by Summers in DeAngelo (1990), p.415 et seq.
6
Cp. DeAngelo (1990), p.416.
7
Jensen (1989), p.120.
8
Cp. CMBOR (2004), p.38.
1
Bertelsmann, by UK financial sponsors Cinven and Candover9 and the €bn 5.7 takeover of Seat PagineGialle by a consortium of BC Partners, CVC Capital Partners, Investitori Associati, and Permira10, Europe’s biggest Buy-Out in 2003. Of particular interest to both the academic and financial communities, is the aspect of their financing structure. Why are LBOs financed with so much debt? How are the complicated financing structures justified? In the end, what value will be created for the equity investor? These are just some questions that will be touched upon within this research. The first chapter should give us a first glance of the Buy-Out landscape and the structure of this document by providing: A definition of Buy-Outs in general and our research subject in detail. A justification of the relevance of the Buy-Out sector to an equity investor. Guidance on the focus of our research within the Buy-Out process. An introduction to the methodology and structure employed in this research.
1.1.
Definition of Buy-Outs
Buy-Out transactions are a sub-segment of the private equity market performed in the latter stages of a company’s life cycle.11 “Simply stated, a Buy-Out involves the transfer of ownership of an entity from its current owners to a new set of shareholders […]”12, thereby relying on specialised finance companies13. Another characteristic of Buy-Out transactions is the take private of the target company through the buying-up of shares that are consequently removed, at least partially, from publicly traded securities markets.14 In practice different
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kinds of Buy-Outs are distinguished.15
9
Cp. Meehan/Brewis (2003), p.1.
10
Cp. Portanger/Galloni (2003), p.C.5.
11
Cp. EVCA (2004c), p.18.
12
Wright et al. (1990), p.62 cited in Schabert (2000), p.7.
13
Specialised finance companies can be either debt (banks, institutions) or equity providers (financial sponsors).
14
Cp. Fox/Marcus (1992), p.63.
15
Q.v. Table 1, p.3.
2
Table 1
Overview of different Buy-out models
IBO
MBO
MBI
Spin-
EBO
FBO
off/out Main player
Financial sponsor16
Predominant goals of main player‡ Ownership structure after Buy-Out Pre-transaction information asymmetry Legal entity Financing Notes:
Outside manageme nt Strategic, Personal
Existing employees†
Financial, Strategic
Existing manageme nt Strategic, Personal
Concentrat ed
Concentrat ed
Concentrat ed
Concentrat ed
Diverse
High/Low
Low
High
Low
Low
Diverse/ Concentrat ed Low
Existing Leverage financing
Existing Leverage financing
Existing Leverage financing
New Leverage financing
Existing Leverage financing
Existing Leverage financing
Strategic, Personal
Existing Company employee heirs s† Strategic, Personal Personal
†
Broader basis then existing management, includes employees from different levels. Financial goals include return on investment, private wealth, etc.; Personal goals include job security, status, etc.; Strategic goals include growth prospectuses for company, platform strategy, etc.. Source: Own analysis i.c.w. Schabert (2000), pp.7-11, BVK (2003), p.36. ‡
A common factor among all types of Buy-Outs is their leveraged financing. This technique requires the target company to support a heavy debt burden. A long standing argument was that, due to the leverage effect17 this increase in debt yields higher equity returns and thus benefits equity investors. We will see that additional advantages of increased debt use are tax and incentive benefits.18 Important differences between Buy-Out models exist as well, mostly due to differing information and incentive structures. This research will largely focus on IBOs due to their pronounced economic importance and increased deal size, allowing for the full array of financing instruments to be analysed.19 The long standing mantra of Buy-Outs being limited to stable cash-flow, no growth target
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companies seems to have been weakened by the advent of the new form of entrepreneurial
16
We introduce this term widely used in the business world to denominate the general partner in a Buy-Out
fund. Literature knows several other denominations, e.g. LBO association [cp. Jensen (1989), p.130] or Buy-Out specialist [cp. Cotter/Peck (2001), p.103]. 17
Q.v. 7.2 Leverage effect, p.81.
18
Q.v. 2. The quest for a theory on optimal capital structure, p.9.
19
Q.v. 1.3 Research focus, p.6.
3
Buy-Outs undertaken in very dynamic industries.20 For the purpose of this research, however, we shall stick to the stereotype of a stable company with a well proven business model to analyze financing behaviour ceteris paribus. 1.2.
Relevance of Buy-Outs
Today more than ever, wealth is amassed in private portfolios.21 However, in a time of saturated markets with fierce competition and dwindling interest rates, investors are forced to look beyond traditional investment means, such as stocks or bonds, to increase the return of their portfolios.22 Whereas other asset classes, like traditional equity or bonds, have seen divestment activity in the past five years private equity has attracted a steady inflow of investments23 from asset managers.24 This is mainly due to its attractive return25, reasonable volatility and portfolio diversification effect.26
20
For a discussion of this new form of Buy-Out please refer to Wright/Hoskissen/Busenitz (2001) and
Wright/Hoskisson/Busenitz/Dial (2001). 21
The leading wealth management consultancy Scorpio Partnership estimates assets under management of the
global private banking industry to have reached $trn 4.6 with growth rates of 15% yoy [cp. Scorpio Partnership (2004), p.1]. 22
Within this research we shall take an equity investor’s perspective, however the Buy-Out topic seems relevant
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for a broader audience of stakeholder groups, e.g. 60% of companies report an increase in employees post BuyOut [cp. EVCA (2001), p.14]. 23
Goldman Sachs estimates that in 2003 4.0% of total European fund assets have been allocated to the private
equity asset class compared with just 2.5% in 1999 [cp. Goldman Sachs (2004), p.28.]. 24
Q.v. Figure 1, p.5.
25
Supported by gross performance studies [cp. EVCA (2004b), p.5, Goldman Sachs (2004), p.32], however
Kaplan and Schoar find that private equity fund returns are not greater than equity returns net of fees [cp. Kaplan/Schoar (2003), p.2]. 26
4
Cp. Merrill Lynch (2004b), p.19 and EVCA (2004c), p.5 as well as Herman, M. (2004), p.1.
Figure 1
European fund in and out-flow of selected asset classes 7.7% 0.21
€bn 300,0 250,0
7.4% 0.05
200,0 150,0 100,0
2002
50,0
2003
14% 0.32
0,0 (50,0)
1999
2000
2001
2002
2003
(100,0) Bonds
Equities
Private Equity
Note:
Average annual return in % and standard deviation of asset class shown in circle; Period 1994-2003 was used; Indices include JP Morgan European Government Index (Bond), MSCI Europe (Equity), Merrill Lynch Private Equity Index (Private equity);. Source: EVCA (2004b), p. 24; Merrill Lynch (2004b), p.12; DWS (2004), p.10.
Zooming into the private equity market, a trend towards Buy-Out investments seems to emerge.27 Survey results by Goldman Sachs show an increasing optimism for Buy-Out investments in years to come.28 Figure 2
Five year trend in European private equity investments 25.1 €bn
35.0 €bn
24.3 €bn
41%
45%
27.6 €bn
29.1 €bn
61%
63%
2002
2003
100%
80% 53% 60%
40%
20%
0% 1999
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Seed
2000 Start-Up
2001 Expansion
Replacement Capital
Buyout
Note: Total capital invested shown in circles. Source: EVCA (2004a), p.13.
27
Q.v. Figure 2, p.5.
28
The number of respondents rating Buy-Outs as the most attractive private equity investment class over the
next three years rose from 28% in 2001 to 61% in 2003 [cp. Goldman Sachs (2004), p.32].
5
The increase of Buy-Out funds raised can be attributed to investors reducing their exposure to highly volatile early stage investments which had to be written off after the burst of the New Economy bubble in the year 2000.29 The following trends can be observed in the European Buy-Out market30: The Buy-Out market breaks records in both investments and deal flow. In 2003 €bn
18.4 have been invested in 536 deals. High value deals (above €m 250) are on the increase. Germany is the number one market after France, measured by deal value. Local divestment remains the most common source of Buy-Outs. General manufacturing is the most active sector.
To summarise this chapter we can conclude that the private equity asset class, and specifically the Buy-Out sector, are of great importance to the global investor. 1.3.
Research focus
After having defined our research subject and justified its importance we come to the question of what specifically will be covered within this paper. The full Buy-Out cycle includes three different phases: the acquisition, holding and divestment phase.31 Within every phase we can distinguish between various tasks that have to be performed by the equity investor to guarantee the success of the transaction.32 Figure 3
Stage model of the Buy-Out process
Key tasks of the acquirer
Acquisition phase
Holding period
Divestment phase
Target selection
Debt paydown
Valuation
Valuation
Equity story
Capitalisation
Operational efficiencies
Negotiation
Growth
Negotiation
Research focus
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Source: Own analysis i.c.w. Berg/Gottschalg (2003), p.5 et seq..
29
Source: Interview with Jean-Philippe Maltais (14. June 2004).
30
Cp. CMBOR (2004), pp.3-44.
31
Cp. Berg/Gottschalg (2003), p.5 et seq.
32
Q.v. Figure 3, p.6.
6
We will concentrate our research efforts on the description of the capitalisation task. In particular we will analyse the value creation potential of adequate leveraged Buy-Out capitalisations in Europe, taking the perspective of an equity investor. This will include both a practical and a theoretical view on the subject. 1.4.
Methodology & structure
As stated above our declared goal is the explanation of European LBO capitalisation. To achieve this, we will keep an equity investor’s perspective and ask the question of how value is created for the investor by capital structure alternations. In the tradition of Decision Theory’s prediction, that “better answers to normative questions are likely to occur when decision makers have a richer set of positive theories”33, we will choose a positive research focus, i.e. we will primarily concentrate on explaining capitalisation structures found in the market rather than constructing a normative model on LBO capitalisation.34 Historically, corporate finance theory has rather focused on normative questions while neglecting positive theories.35 This behaviour bears the risk of drawing conclusions based on a misconception of reality.36 We will look beyond the traditional financing instruments of pure debt and ordinary equity. Present day leveraged transactions are capitalised by employing a wide array of different financing instruments transmitting various effects on firm value. Specifically we will observe the use of senior debt, high yield bonds, mezzanine loans, preferred and ordinary equity in the market. The evidence provided from this observation is primarily of a qualitative nature. Although this evidence is not able to deliver answers on the absolute strengths of underlying forces, it is able to generate valuable insights on the direction and foundations of these forces. In the
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social sciences qualitative evidence has been employed frequently and is particularly popular
33
Smith (1989), p.3.
34
Positivism [cp. Schweitzer (1978), p.3] and normative theory [cp. Bea/Dichtl/Schweitzer (2000), p.100] are
two specific goals of economic research. 35 36
Cp. Smith (1989), p.3. Chmielewicz points out that economic theory and practice are so dynamic that universal validity in the
dimensions time, space and object is nearly impossible to achieve. Positive theories can help to understand the interactions of variables that create dynamism [cp. Chmielewicz (1994), p.130 et seq.].
7
with the Property Rights and Economic Analysis of Law literature.37 It even helped shape entire branches of scientific research.38 This research is structured accordingly: In chapter 2 we will introduce traditionalist and modernist views on optimal capital structure. For the traditionalist view, we identified the irrelevance hypothesis of capital structure for firm value. For the modernist view we will derive and provide empirical evidence for the tax, risky debt and costly contracting hypothesis. On the basis of these hypotheses we will derive a model of optimal capital structure for the case of pure debt and equity. For the case of hybrid financing instruments we will provide a thorough review of state-of-the-art research. Chapter 3 will introduce the determinants of Buy-Out capitalisation structures. Mainly asset characteristics, liability characteristics and availability of funds are found to have an impact on the final capitalisation of a Buy-Out. Furthermore we will observe financing patterns of European Buy-Outs in the light of those determinants. Chapter 4 will embed the capitalisation process in a framework for value levers in Buy-Out transactions. Chapter 5 will summarise our findings and provide the reader with an outlook on further
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research.
37
Cp. Coase (1960), Demsetz (1967), Manne (1967), Alchian/Demsetz (1972), Posner (1972), Cheung (1973).
38
Qualitative evidence seems to be instrumental in the development of Natural Sciences [e.g. Darwin (1859)].
8
2. The quest for a theory on optimal capital structure In the following chapter, we will undertake a journey initiated in the late 1930’s, namely the quest for a theory on optimal capital structure. Researchers have long been asking the question whether differences in a firm’s capital structure have an impact on the value of the firm39, thereby using two rival views: Traditionalists40 argue that markets are efficient, leading to the result of capital structure’s irrelevance for firm value. Moreover, Modernist research suggests that market frictions are existent,41 thus obtaining an optimal capital structure. We will discuss both views and their implications for the existence of an optimal capital structure by: Presenting the basic assumptions made in the two competing theoretical concepts. Deriving the main hypotheses as developed by traditionalists and modernists.
2.1.
Traditionalists
Prior to the 1950’s, finance literature largely consisted of ad hoc theories containing little systematic analysis.42 Its major concerns were optimal investment and dividend policies, but little consideration was given to the effects of financing decisions and the nature of equilibrium in financial markets. Theories were mostly of a normative nature with little attention to positive questions. In the 1950’s fundamental changes in finance began to occur. Hand in hand with the introduction of traditional analytical methods and techniques to finance problems, came a shift in research focus from normative to positive theories. Being in the tradition of Neoclassic Economic Theory,43 early researchers in the field of corporate finance assumed that markets are perfect. Those traditionalists therefore came to the conclusion that a firm’s financing choice does not have an impact on its market value. This chapter will: First take a closer look at the assumptions made on perfect markets. Secondly build on those assumptions to derive the irrelevance hypothesis of financing
choices for firm value as proposed by Modigliani & Miller.
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39
In fact, Williams was the first to argue that a firm’s financing choice does not affect its market value. He calls
it the “Law of the conservation of investment value” [cp. Williams (1938), p.73]. Later, Morton derived the same argument [cp. Morton (1954)]. However, none of these works included a proof as sophisticated as Modigliani and Miller’s arbitrage mechanism [cp. Modigliani/Miller (1958), p.269]. 40
Denomination in analogy to Brealey and Myers [cp. Brealey/Myers (2000), p.484].
41
Namely frictions as far as taxes, costs of financial distress and Agency costs are concerned.
42
Cp. Smith (1989), p.3.
43
For the pros and cons of Neoclassic Economic Theory, please refer to Williamson [cp. Williamson (1988),
p.159].
9
2.1.1.
Assumptions made by traditionalists
Traditionalists regarded markets as being perfect, thereby making the following primary assumptions: 44
Absence of corporate and personal taxes
A world without frictions does not include any government intervention, i.e. no taxes are being paid on corporate or personal earnings. Debt is risk free
45
Debt is always provided to the firm at a constant cost regardless of leverage, i.e. costs of financial distress are not considered. Symmetrical information
Asymmetrical information and conflicts of interest between managers and investors are not being recognised46, i.e. no Agency costs are imposed on shareholders. Additionally, the following assumptions have been made: All firms are supposed to be in the same risk class
47
When formulating their original theory, Modigliani and Miller did not have a tool to allocate a risk profile to a firm. Later, the capital asset pricing model was introduced by Sharpe48, Lintner49 and Mossin50, thus providing a framework for adequate risk evaluation. Integrating the CAPM and capital structure theory, Benninga and Sarig derive the invariance of firm value to leverage.51 Hence we can relax this assumption without changing the fundamental insights of Modigliani & Miller. 52
The corporate investment plan is determined solely on NPV criteria
This assumption excludes the fact that the corporate investment plan is determined through financing choices, i.e. the capital structure does not affect cash flows. We will indirectly relax this assumption when discussing market frictions implied by taxes, costs of financial distress and Agency costs. However, three areas of additional research have
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been identified covering the interdependence of a firm’s financial and product market 44
Cp. Modigliani/Miller (1958), p.273.
45
Cp. Modigliani/Miller (1958), p.262.
46
Cp. Jensen/Meckling (1976), p.308.
47
Cp. Modigliani/Miller (1958), p.266.
48
Cp. Sharpe (1961, 1964).
49
Cp. Lintner (1965).
50
Cp. Mossin (1966).
51
Cp. Benninga/Sarig (1998), p.30.
52
Idea was originally introduced by Fisher [cp. Fisher (1930)].
10
decisions in the areas of strategy53, industry structure54 and relationships along the value chain55. As those areas constitute a very new research focus that has neither developed coherent theories nor sufficient empirical tests, we will refrain from covering it in here. 2.1.2.
Irrelevance hypothesis
With their ground breaking paper, Modigliani and Miller derived the irrelevance of capital structure for firm value.56 To arrive at that conclusion, they were one of the first to use an arbitrage57 argumentation. Their line of reasoning rests on two investment strategies: strategy I involves investing in an unlevered company, and strategy II in a levered company. To buy an unlevered company, the investor has to buy its stocks for the value SU 58 and can claim its expected earnings E [x~] .59 The alternative, strategy II, is to invest in the levered company, however, the stock investor has to bear the cost of debt financing and consequently receives only (E [x~] − Rf F ) in earnings for its cash layout of SL in period 0.60 The total value of the levered company is the sum of the value of stocks plus the value of bonds.61 Formula 2-1
53
VL = SL + B
Pioneering research on the interdependency of product market strategy and capital structure, Brander and
Lewis protagonised two effects a firm’s financial structure can have on its strategy: The limited liability and the strategic bankruptcy effect [cp. Brander/Lewis (1986), p.956 et sqq.]. 54
Maksimovic took the interdependency argument of Brander and Lewis further by endogenizing capital
structure decisions. He postulated an optimal capital structure depending on the number of firms in an industry and the elasticity of demand [cp. Maksimovic (1988), p.395]. Copyright © 2009. Diplomica Verlag. All rights reserved.
55
Includes relationships with a firm’s input suppliers [cp. Sarig (1996)], its workers [cp. Perotti/Spier (1993)] as
well as its customers [cp. Titman (1984)]. 56
Cp. Modigliani/Miller (1958), p.268.
57
Arbitrage is defined as a “purchase of one security and the simultaneous sale of another to give a risk-free
profit” at no cost [Brealey/Myers (2000), p.1061]. 58
For acronyms, please refer to the List of Acronyms, p.III.
59
Q.v. Table 2 - line (1), p.12.
60
Q.v. Table 2 - line (2), p.12.
61
Q.v. Table 2 - line (4), p.12.
11
Table 2
Comparison of cash flows from investment in the levered vs. unlevered firm
Time
0
1
2
…
∞
(1)
= VU (Strategy I)
− SU
+ E [x~]
+ E [x~]
+ E [x~]
(2)
+ Stock investment
− SL
+ (E [x~] − Rf F )
+ (E [x~] − Rf F )
+ (E [x~] − Rf F )
(3)
+ Bond investment
−B
+ Rf F
+ Rf F
+ Rf F
(4)
= VL (Strategy II)
− SU
+ E [x~]
+ E [x~]
+ E [x~]
Note:
B = Value of the bonds of a levered company, E[x] = Expected earnings, F = Face value of bonds outstanding, Rf = Cost of risk-free debt, SL = Value of the stocks of a levered company, SU = Value of the stocks of an unlevered company, VL = Value of the levered company, VU = Value of the unlevered company. Source: Own analysis i.c.w. Ross/Westerfield/Jaffe (1996), p.386 et sqq..
As the stream of earnings of the levered company replicates the stream of earnings of the unlevered company the two initial investments must be equal: Formula 2-2
SU = SL + B
or62
Formula 2-3
VU = VL
(M&M Proposition I)
Here the arbitrage argument holds. Would the value of the levered company be greater than the value of the unlevered company, i.e. VL > VU , an arbitrageur would benefit by borrowing money on his own account and investing in the unlevered company thus replicating the cash flows of the levered company, but having bought in cheaper.63 If it holds that VL < VU , then an arbitrageur would have to short strategy I and long strategy II to benefit. Acting as an arbitrageur influences prices and thus the arbitrage opportunity vanishes.64 It seems that in equilibrium Formula 2-3 holds true. This model has been labelled as the pie model of capital structure,65 due to the fact that the pie, i.e. firm value, stays the same regardless of leverage. Hence, capital structure decisions can be seen to be a mere means of distributing this fixed value to the claimholders, i.e. Copyright © 2009. Diplomica Verlag. All rights reserved.
shareholders and bondholders.
62
With Formula 2-1.
63
Cp. Ross/Westerfield/Jaffe (1996), p.388.
64
Cp. Modigliani/Miller (1958), p.269.
65
Cp. Ross/Westerfield/Jaffe (1996), p.384.
12
The simplicity of this insight is palpable, however, it is not able to explain capital structure decisions in reality.66 Why should shareholders take on debt if they cannot positively affect firm value? Literature soon criticised the restrictive assumptions made by Modigliani & Miller. In the following chapter, we will try to relax those assumptions in order to better align the model to actuality. 2.2.
Modernists
As shown in the previous chapter a traditionalist approach towards capital structure research will ultimately lead to the irrelevance hypothesis. Literature soon began to criticise the restrictive assumption of perfect markets made by this approach.67 Market inefficiencies began to appear on the radar screen of economic researchers. In particular taxes, costs of financial distress and informational asymmetries made researchers think about how to incorporate those frictions into their capital structure models. Within this chapter we will present theoretical concepts developed in response to the identified market frictions in a ceteris paribus analysis, i.e. other variables constant, the effect on firm value will be analysed for the following variables: Corporate and personal taxes (tax hypothesis) Costs of financial distress (risky debt hypothesis) Agency costs (costly contracting hypothesis)
2.2.1.
Tax hypothesis
Soon after the original paper of Modigliani & Miller, researchers began to realise that a company’s capital structure and its operating environment are not independent68, moreover balance sheet and income statement are linked. Suppose, taxes are being introduced and interest payments are tax deductible. As taxes are nothing else than a cost to the firm, firm value should be maximised by minimising those costs. In this way, higher leverage reduces tax costs and maximises firm value.69 The following chapter will derive the value generation
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potential of corporate and personal taxes by presenting the models of Modigliani and Miller (1963) and Miller (1977).
66
Cp. Smith (1989), p.9.
67
Cp. Rubinstein (2003), p.3.
68
Cp. Ross/Westerfield/Jaffe (1996), p.400.
69
Cp. Ross/Westerfield/Jaffe (1996), p.402.
13
2.2.1.1.
Corporate taxes
In a correction to their original paper, Modigliani & Miller react to the critics and derive the value generation potential of corporate tax shields.70 They acknowledge that the “deduction of interest in computing taxable profits will prevent the arbitrage process from making the value of all firms in a given asset class proportional to the expected returns generated by their physical assets”71. That means that their Proposition I72 has to be restated as: Formula 2-4
VL = VU + t C ⋅ B
The value of the levered company consequently equals the value of the levered company plus the value of corporate tax shields. The problem with this analysis, however, is that it overstates the tax advantage of debt by considering only the corporate profits tax. As investors in a company care about their after-tax returns73, we have to incorporate personal taxes in our discussion. 2.2.1.2.
Corporate and personal taxes
Enhancing the results derived by him and his colleague Modigliani, Miller came up with his own model of capital structure, which incorporated both personal and corporate taxes.74 If corporate taxes are paid on corporate earnings less interest payments and personal taxes are paid on dividend and interest income received by shareholders, it can be shown that75: Formula 2-5
⎡ (1 − t c ) ⋅ (1 − t s ) ⎤ VL = VU + ⎢1 − ⋅B (1 − t B ) ⎥⎦ ⎣
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Figure 4 illustrates this formula.
70
Cp. Modigliani/Miller (1963), p.436.
71
Cp. Modigliani/Miller (1963), p.433.
72
Q.v. Formula 2-3, p.12.
73
Cp. Barclay/Smith (1999), p.10.
74
Cp. Miller (1977).
75
Cp. Miller (1977), p.267. For a detailed derivation of the formula, please refer to 7.3 Derivation of the Miller
Model, p.82.
14
Figure 4
Graphical representation of the Miller model 76
Value of tax shield
VL
A
VL = VU + t C ⋅ B if t B = t S
Irrelevance of personal taxation
B tS > tB
VU
VL = VU if (1 − t B ) = (1 − t C ) ⋅ (1 − t S )
1 − t B > (1 − t C ) ⋅ (1 − t S )
Irrelevance of taxation tS < tB
1 − t B < (1 − t C ) ⋅ (1 − t S )
C B
Note:
B = Value of the bonds of a levered company, tB = Personal tax rate on interest, tC = Corporate tax rate, tS = Personal tax rate on dividends and other equity distributions, VL = Value of the levered company, VU = Value of the unlevered company. Source: Ross/Westerfield/Jaffe (1996), p.436; Keiber (2003), p.8.
If gains on interest income are taxed identical to equity distributions on the personal level, the value of the levered company is equal to the value of the unlevered company plus the tax shield generated through the tax deductibility of interest expenses.76 Formula 2-6
VL = VU + t C ⋅ B
Another insight is that in the case of the after-tax dollars to shareholders being equal to the after-tax dollar to bondholders, i.e. (1 − t B ) = (1 − t C ) ⋅ (1 − t S ) , the value of the levered and the unlevered company are equal. Consequently, firm value creation potential depends on the relationship of corporate and personal taxes and can be: Higher than all-equity firm value plus tax shield (area A) Between all-equity firm value and all-equity firm value plus tax shield (area B) Lower than all-equity firm value (area C)
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In reality, we will find that the average tax rate of shareholders is lower than those of bondholders77, for the reason that equity investors receive most of their income through capital gains that are taxed at a lower rate, i.e. t S < t B . Additionally, shareholders can postpone taxes by choosing not to realise capital gains, thus earning the time value of
76
Originally derived by Modigliani/Miller (1963), p.436.
77
Cp. Barclay/Smith/Watts (1995), p.7.
15
money.78 However, shareholders are in fact double taxed: once through corporate taxes and again through personal taxes. As a result the after-tax dollars to shareholders should be less than the after-tax dollars to bondholders79, i.e. (1 − t B ) > (1 − t C ) ⋅ (1 − t S ) . Summarizing our insights on corporate and personal taxation, we can derive a value generation potential of total taxes that is positive, but less than proposed by Modigliani and Miller (1963), i.e. somewhere in area B80. Altogether, shareholder value81 will increase modestly.82 Empirical evidence on the tax hypothesis of debt financing has been mixed. Theory predicts that firms with more taxable income or lower non-debt tax shields83 should have higher leverage ratios. By regressing non-debt tax shields against companies leverage ratios, early researchers actually found the inverse relation, i.e. more non-debt tax shields meant less debt.84 This early research was flawed in two ways. First, the used tax variables were crude proxies for a company’s effective tax rate, and secondly they neglected correlations between variables. For example, companies with high levels of depreciation and other non-debt tax shields tend to have mainly tangible fixed assets. Since fixed assets provide good collateral, high non-debt tax shields may in fact be a proxy not for limited tax benefits, but for low contracting costs associated with debt financing.85 More recent research found positive evidence for the tax hypothesis while eliminating shortcomings of early studies by concentrating on incremental financing choices86 or by constructing a firm specific tax
78
Cp. Graham (2003), p.1120.
79
Cp. Graham (2003), p.1101.
80
Graham estimates the capitalized tax benefit of debt to equal 9.7 percent of firm value [cp. Graham (2000),
p.1901 and q.v. Figure 4, p.15]. 81
Namely the after-tax equity cash flows discounted at the equity cost of capital, less the tax deductible interest
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payments discounted at the after-tax cost of debt, i.e. 82
EBIT ⋅ (1 − t C ) ⋅ (1 − t S ) k US
−
k f ⋅ (1 − t C ) ⋅ (1 − t S ) . R f ⋅ (1 − t B )
Graham estimates shareholder value, created after personal taxes, to be around 4 percent [cp. Graham (2000),
p.1901]. 83
Cordes and Sheffrin suggest that non-debt tax shields, i.e. loss carry forwards, accelerated depreciation, etc.,
can be quite substantial and may eliminate the need for debt generated tax shields [cp. Cordes/Sheffrin (1983), p.105]. 84
Cp. Bradley/Jarrel/Kim (1984) and Titman/Wessels (1988).
85
Cp. Barclay/Smith (1999), p.18.
86
Cp. Mackie-Mason (1990) and Cordes/Sheffrin (1983).
16
function87. We conclude that the empirical literature has sufficiently verified the existence of value creation potential in debt implied tax shields. 2.2.2.
Risky debt hypothesis
After having introduced taxes to the world of Neoclassic Economic Theory, we will relax another assumption, namely the provision of risk-less debt.88 Modigliani & Miller assume in their original paper that debt is provided at a fixed cost regardless of a firm’s leverage.89 However, in reality, financial institutions will price bonds according to the expected costs of financial distress, that are calculated by multiplying the discounted costs of financial distress, with the probability of a distressed state being realised.90 Let’s take a closer look at the two components of the equation. Costs of financial distress occur in the case of a levered company not being able to meet its obligation to repay debt or pay interest. We can distinguish between direct and indirect costs of financial distress.91 Table 3
Direct and indirect costs of financial distress
Direct costs of financial distress
Indirect costs of financial distress92
Lawyers Administrative and accounting fees Expert reports
Management time Decreased productivity Lost sales due to negative impact on reputation Forced liquidation of a viable business
Management time
Source: Ross/Westerfield/Jaffe (1996), p.419 et sqq., Brealey/Myers (2000), p.514 et seq., Kaiser (2002), p.19.
Direct costs are out-of-pocket expenses for the administration of the bankruptcy process.
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They are of minor importance while accounting for app. 493 to 594 percent of a company’s
87
Cp. Graham (1996, 2000).
88
Q.v. 2.1.1 Assumptions made by traditionalists, p.10.
89
Cp. Modigliani/Miller (1958), p.262.
90
Cp. Myers (1984a), p.580.
91
Q.v. Table 3, p.17.
92
Some authors count the Agency costs of the underinvestment and asset substitution problem to the indirect
costs of financial distress [cp. Jensen/Meckling (1976), p.339, Barclay/Smith/Watts (1995), p.8], however, we will follow Brealey and Myers in their distinction between pure financial distress costs and costs imposed by Agency conflicts [cp. Brealey/Myers (2000), p.511 et sqq.] to better illustrate the gradual relaxation of restrictive assumptions made in classic economic theory. 93
Cp. Altman (1984), p.1077.
94
Cp. Warner (1977), p.77.
17
pre-bankruptcy market value. Of greater importance are indirect costs of financial distress, while accounting for an estimated 20 percent of a company’s pre-bankruptcy market value.95 They are induced by the impaired ability to conduct business in a bankruptcy situation, e.g. loss of sales and profits due to lack of confidence in the company96. The probability of a company reaching a bankrupt state rises linearly with leverage.97 With this information, positive discounted costs and linearly rising probability of financial distress, we can derive the following figure. Figure 5
Impact of costs of financial distress on firm value
VL
PV (Direct and indirect costs of financial distress)
B Note: B = Value of the bonds of a levered company, VL = Value of the levered company. Source: Keiber (2003), p.9.
Hence, firm value is reduced by introducing costs of financial distress. As bondholders rationally assess the present value of the costs of financial distress, they will impose a premium on additional debt financing. This harms shareholders directly and decreases the value of their stocks by the present value of the costs of financial distress.98 Empirical literature proving the risky debt hypothesis is vast and affirmative. A wide array of papers finds evidence on large public corporations99 and highly levered transactions100.
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Consequently, we conclude that the risky debt hypothesis is sufficiently proven.
95
Cp. Altman (1984), p.1080 and later Lang/Stulz (1992), p.51.
96
Cp. Warner (1977), p.72.
97
Cp. Keiber (2003), p.9.
98
Cp. Ross/Westerfield/Jaffe (1996), p.427.
99
Cp. LoPucki/Whitford (1993), Ofek (1993), Opler/Titman (1994), Hotchkiss (1995), and Gilson (1997).
100
18
Cp. Opler/Titman (1993), Asquith/Gertner/Scharfstein (1994), and Andrade/Kaplan (1998).
2.2.3.
Costly contracting hypothesis
Within the following section we shall unravel another assumption made by traditionalists: the non-existence of information asymmetries and individual opportunistic behaviour. We will do so by introducing a competing theoretical stream called Agency Theory in the following steps: Summarizing the main assumptions made in Agency Theory. Characterising the main players of interest in a company’s Agency relationships. Discussing Agency problems associated with debt and equity. Deriving the implications for shareholders and providing empirical evidence.
2.2.3.1.
Assumptions made in Agency Theory
Neoclassic Economic Theory has long seen the firm as a black box101 delivering production results, but not allowing for relationships between the acting individuals. Agency Theory tries to overcome those deficiencies while looking at the firm as a “legal fiction which serves as a nexus for a set of contracting relationships among individuals”102. It is important to note that this individualisation of the firm shifts the focus from collectives to individuals and their motivations.103 The beginnings of Agency Theory can be traced back to the early 1970’s with papers by Spence and Zeckhauser104 and Ross105 and led Stiglitz to proclaim a paradigm shift in economic analysis106. Two types of literature can be distinguished that address, “the contracting problem between self-interested maximising parties”107. The Economic Theory of Agency108 is a normative, mathematically formalised and less empirically orientated theory. It has traditionally concentrated on the characteristics of
101
Cp. Jensen (1983), p.328.
102
This methodological individualism was first mentioned by Schumpeter [cp. Schumpeter (1908), p.90] and
later made popular in finance literature by Jensen and Meckling [cp. Jensen/Meckling (1976), p.310]. 103
Initial research on contractual relationships between and inside firms has been done by Coase
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[cp. Coase (1937)] and Alchian and Demsetz [cp. Alchian/Demsetz (1972)]. 104
Their work concentrated on the analysis of moral hazard in insurance contracts [cp. Spence/Zeckhauser
(1971)]. 105
Ross was the first to coin the term “Principal-Agent-Problem” with one of the first overviews on Agency
theory [cp. Ross (1973), p.134]. 106
Cp. Stiglitz (2003), p.466 et sqq.
107
Jensen (1983), p.334.
108
Denomination follows Barnea, Haugen and Senbet [cp. Barnea/Haugen/Senbet (1985)], whereas Jensen
distinguishes between principal-agent literature and positive Agency literature [cp. Jensen (1983), p.334].
19
contracts between individuals, i.e. preference and informational structure. Analysis is designed towards implications on risk sharing, optimal contract and welfare issues. In contrast the Financial Theory of Agency focuses on additional aspects of the contracting environment. Monitoring and bonding activities are explained by linking them to factors like capital intensity, degree of specialisation of assets, information costs, etc..109 The following paragraph will provide an insight into the fundamentals of both theories. At the heart of Agency Theory is the Agency relationship between principal and agent. Jensen and Meckling define this relationship as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”110. We can clearly see that this relationship involves direction. Typically the first move, e.g. offering an employment contract, is made by the principal.111 The agent can then choose to accept it. The second assumption made in Agency Theory is that information asymmetries exist between principal and agent. The sources of informational asymmetries can be hidden characteristics, that is to say, the information about personal goals and one’s personality, hidden action, in other words, the inability to monitor the counterparty’s actions, and hidden information, specifically, possession of information that the other counterparty lacks.112 Informational asymmetries do not imply bound rationality.113 Rather the two contractual parties together would have sufficient information to account for all eventualities that might arise in the contractual relationship. This total information is just distributed unevenly.114 As information transfer implies costs we will not observe complete contracts.115 Hence the agent’s conduct is not fully discernible by the principal, implying the existence of a discretionary freedom of action. Linking this discretionary freedom of action to an assumption on human behaviour we can predict possible actions by the principal and agent. Therefore a third assumption in Agency
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Theory is made on the individual incentive structures. Traditional Agency Theory does not 109
Cp. Jensen (1983), p.335.
110
Jensen/Meckling (1976), p.308.
111
Cp. Richter/Furubotn (2003), p.285.
112
Cp. Jost (2000), p.475 et seq.
113
Cp. Richter/Furubotn (2003), p.238.
114
To argue with mathematics: Each individual holds a set of information A respectively B. As A≠B,
information asymmetries exist. Full information could be reached through information exchange (A ∪ B). 115
20
Cp. Jost (2000), p.477.
break with the classic model of the homo oeconomicus, i.e. utility maximising human behaviour.116 However more recent literature incorporates more complex features in human behaviour.117 “The behaviour of the organization is the equilibrium behaviour of a complex contractual system made up of maximizing agents with diverse and conflicting objectives”118. Now it becomes clear that opportunistic behaviour by the contractual parties is possible when using their discretionary freedom of action.119 For the existence of Agency problems a divergence in individual goals has to be present and the discretionary freedom of action has to be exploited to the detriment of the counterparty. Agency problems can be either of ex-ante or ex-post nature with individual or collective organisational reference. Literature has developed a system of classifying the relevant Agency problems.120 We will later discuss capital structure specific Agency problems.121 Table 4
Classification of Agency problems
Adverse selection Moral hazard
Free rider
Ratchet effect
problem Cause of problem
Private Information
Nonobservability of conduct Asymmetric
Lack of bonding capacity
Asymmetric
Nonobservability of conduct Asymmetric
Information structure Time horizon
Ex-ante
Ex-post
Ex-post
Ex-post
Organizational reference
Individual
Individual
Collective
Collective
Asymmetric
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Source: Jost (2000), p.500.
116
Cp. Richter/Furubotn (2003), p.288.
117
The model of the complex man assumes that humans have a hierarchical set of needs which are situation and
time dependent as well as humans being versatile and capable of change [cp. Schein (1988), p.93 et sqq.]. For a discussion of alternative models of man please refer to Meckling [cp. Meckling (1976)]. 118
Jensen (1983), p.327.
119
Cp. Jost (2000), p.482.
120
Q.v. Table 4, p.21. For a review of traditional Agency problems please refer to Jost (2000), p.492 et sqq.
121
Q.v. 2.2.3.3 Agency conflicts and costs, p.23.
21
Agency problems result in costs for the firm by having to bear their detrimental effects or by engaging in activities to mitigate them.122 Jensen and Meckling distil three categories of Agency costs123: Monitoring expenditures by the principal
Expenditures incurred by the principal to design appropriate incentives and monitor the agent. Bonding expenditures by the agent
Costs incurred by the agent to make sure “that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions”124. Residual loss
The additional loss through the divergence of the agent’s decision from the principal’s wealth maximizing decision, is not explainable by monitoring and bonding costs. We will later specify those costs more precisely. Summarising this section we have made the following assumptions: Nature of the firm: The firm is a nexus of directional contractual relationships between
principal and agent. Informational distribution: Full rational behaviour of individuals, but asymmetric
information inhibits complete contracts. Individual behaviour: Individuals are utility maximisers.
Out of those assumptions on human behaviour Agency problems result that impose costs on the contracting parties. 2.2.3.2.
Definition of contracting parties
We have talked about individuals and contracting parties in the last chapter, but haven’t answered the question of what’s behind those subjects. We will make two simplifications in
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this chapter.
122
“Agency costs are defined as the sum of the costs of structuring, bonding, and monitoring contracts between
agents. Agency costs also include the costs stemming from the fact that it doesn't pay to enforce all contracts perfectly.” [cp. Jensen (1983), p.331]. 123
Cp. Jensen/Meckling (1976), p.308.
124
Jensen/ Meckling (1976), p.308.
22
We know that every individual is unique in its goals and behaviour, but for the purpose of this research it is useful to condense the sum of individuals into groups with relatively homogenous goals. For example shareholders of a company can be school children experimenting with the world of finance or strategic investors that hold a great amount of outstanding shares. However a combining factor of all shareholders is their willingness to maximise the value of their stocks. Hence they will act accordingly and thus can be grouped in the shareholder class of contracting parties.125 Another simplification is made towards the array of groups covered in this research. Jensen identifies the following stakeholder groups: suppliers of labour, capital, raw materials, risk bearing services, and customers.126 However constituting a tempting research goal the scope of this paper will not be sufficient to analyse Agency relationships between all of those groups. Hence we will limit ourselves to an analysis of the contractual relationships between shareholders, managers and bondholders. Contracting party stereotypes are shown in Table 5. Table 5
Stereotypes of contractual parties
Shareholder Information available Only limited information about the internal situation of the company Individual goals Maximisation of shareholder value Control rights
Voting rights
Ownership rights Claims
Ownership of equity Residual claim on cash flow and assets
Manager
Bondholder
Full array of information of company situation
Only limited information about the internal situation of the company Maximisation of Securing principal personal wealth and interest payments Operational decisions Right to limit activities specified in covenants No ownership Ownership of bonds Salary as a senior Senior and junior claim on cash flow; claims on cash flow no claim on assets and assets
Source: Own analysis i.c.w. Barclay/Smith (1995b), p.900.
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2.2.3.3.
Agency conflicts and costs
Provided with the basics of Agency Theory and a characterisation of relevant players we will now turn towards identifying the underlying Agency problems. Table 6 shows the identified
125
Intra-group Agency conflicts are not covered in this research. A popular example of principal-principal
Agency conflicts is the free-rider problem of small shareholders [cp. Shleifer/Vishny (1986) and more recently Dharwadkar (2000), Marchica (2001), Burkart/Panunzi (2003)]. 126
Cp. Jensen (1983), p.326.
23
Agency problems of outside equity respectively debt as they result in the relationship between managers and shareholders respectively bondholders and shareholders. Table 6
Intra-Group problems
Managers
Array of Agency problems analysed
Agency costs of equity
Shareholders
Agency costs of debt
Free cash flow problem
Asset substitution problem
Underleverage problem
Underinvestment problem
Milking the property
Claim dilution problem
Bondholders
Source: Own analysis.
Agency costs of equity
Historically companies were run by their founders leaving management and ownership in the same hands. However with the beginning of industrialisation required investments rose beyond sums that could be provided on a bank loan basis. Entrepreneurs turned to the developing capital markets to obtain equity thus giving up part of their ownership. The model of the listed corporation was borne where capital owners (Principal) hired managers (Agent) to conduct the company’s day to day business.127 This separation of control and ownership brought two basic problems with it: the problem of excess free cash flow and the underleverage problem. Excess free cash flow can be defined as “cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of
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capital”128. Generation of excess free cash flow can be observed predominantly in mature industries where firms generate substantial cash flows, yet spawn few attractive investment opportunities, as well as industries characterised by economic rents or quasi rents129. A
127
Cp. Berle/Means (1932) and Williamson (1964) for a discussion of the separation between ownership and
control. 128
Jensen (1986), p.323.
129
Rents are returns in excess of the opportunity cost of resources to the activity. Quasi rents are returns in
excess of the short-run opportunity cost of the resources to the activity. [cp. Jensen (1986), p.323].
24
popular example of a company that enjoys significant monopoly rents and amasses enormous piles of cash is Microsoft.130 The problem with excessive cash is that conflicts of interests between shareholders and managers occur. Whereas shareholders would want the management to pay out the cash so that they can invest it in higher return projects, management has an incentive to keep it in the company. The reluctance of management to pay out the cash is based on the incentive to spend the company’s cash on: Perquisites whose value accrues only to them. Examples include company jets, inflated
expense accounts, etc.. 131
Growth strategies that grow the firm beyond its optimal size.
This is due to the
linkage of sales to managers’ compensation132 and promotion through the internal reward system133. Consequently shareholders incur costs through direct value appropriation by managers (perk consumption) as well as through inefficient investments (excessive growth). A means to curb those Agency costs are monitoring and bonding activities. Monitoring activities include “auditing, formal control systems, budget restrictions, and the establishment of incentive compensation systems which serve to more closely identify the manager’s interest with those of the outside equity holders”134. Bonding activities include “contractual guarantees to have the financial accounts audited by a public account, explicit bonding against malfeasance on the part of the manager, and contractual limitations on the manager’s decision-making power”135. Jensen and Meckling show it actually makes no difference who bears the costs of monitoring/bonding, the wealth reduction is always borne by the shareholder.136 The shareholder will only be interested in engaging in monitoring/bonding activities if the marginal benefits outweigh the marginal costs.137 Thus he is interested in
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efficiently modelling the monitoring/bonding system. An efficient means to discipline
130
Cp. u.a. (2004), p.66.
131
Donaldson found in his study of 12 large Fortune 500 firms that management was driven by the maximisation
of aggregate purchasing power available to management, i.e. cash, credit, etc., rather than maximisation of firm value [cp. Donaldson (1984), p.3]. 132
Cp. Murphy (1985), p.11.
133
Cp. Baker (1986), p.1.
134
Jensen/Meckling (1976), p.323.
135
Jensen/Meckling (1976), p.325.
136
Cp. Jensen/Meckling (1976), p.325.
137
Cp. Jensen/Meckling (1976), p.323 et seq.
25
management is the use of debt.138 Other disciplinary forces include the managerial labour market139, market for corporate control140, etc.. Another less noted category of Agency problems arises from the different risk exposure of shareholders and managers. Whereas shareholders may only care about the systematic risk of a company’s stock, because they hold a well diversified portfolio of securities, managers tend to care more about the total risk of a firm.141 Managers have typically invested a substantial fraction of their wealth in firm-specific human capital that is destroyed in the case of bankruptcy142 and they may reduce their future earnings capacity by way of a damaged professional reputation in the case of bankruptcy143. Managers react to their comparatively higher risk exposure in two ways. First they will demand higher compensation ex-ante to bear the non-diversifiable risk of their claim144 and second they will under-leverage the firm to reduce that risk145. Costs are imposed to shareholders due to the higher compensation schemes as well as through the foregone tax advantage of debt.146 The problem can be fought against by aligning stockholder and manager’s incentives, e.g. issue executive incentive plans, encourage equity ownership by managers, or by increased monitoring, e.g. place investment bankers on the board, concentrate equity ownership.147 Agency costs of debt
Both shareholders and bondholders are essentially providers of financial resources to the company, however important differences exist. Whereas bondholders receive a predefined claim on a company’s cash flow that consists of periodic interest and principal payments,
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shareholders are residual claimants that receive irregular dividends and the residual firm value 138
Cp. Jensen (1986), p.324.
139
Cp. Fama (1980), p.292 et sqq.
140
Cp. Jensen (1986), p.328.
141
Cp. Mehran (1992), 541.
142
Cp. Fama (1980), p.291 et seq.
143
Gilson provides evidence that a high probability of top executives loosing their job in financially distressed
firms exists. The situation is aggravated as none of the departing managers in his sample is placed in top positions at other publicly traded firms within three years [cp. Gilson (1989), p.241]. 144
Cp. Mehran (1992), p.542.
145
Cp. Donaldson (1961), p.35 and Ellsworth (1983), p.174.
146
Q.v. 2.2.1 Tax hypothesis, p.13.
147
Cp. Mehran (1992), p.542 et seq.
26
after deducting all more senior claims. Shareholders (Agent) and bondholders (Principal) are in an Agency relationship which provides incentives for the shareholders to expropriate firm value. To be able to analyse this issue without interference of other Agency problems (ceteris paribus) we will make the assumption that managers maximise equity value and can consequently be neglected in the analysis.148 Four major Agency problems arise: The asset substitution, underinvestment, “milking the property”, and claim dilution problem. The asset substitution problem originates in the shareholder-manager’s incentive to invest in highly risky projects due to the limited downside potential he faces in the case of a highly levered company.149 Risky investment projects are characterised by a very high payoff with very low probability and a loss with a high probability, i.e. even negative NPVs might be expected. In the probable case of a project failure the company declares bankruptcy and any losses greater than paid in equity are borne by bondholders. In the case of a project success bankruptcy is adverted and additional value after debt servicing accrues fully to shareholders.150 Expected payoff for shareholders is positive and thus very risky projects are undertaken.151 However this strategy might seem to benefit shareholders it will not do so when bondholders accurately perceive the motivation of the shareholder-manager to undertake risky projects and price this residual loss in their debt provision contracts.152 To mitigate those Agency costs a transfer of information is necessary. The bondholder can include covenants to limit managerial leeway into the indenture153 provisions; however he will incur the costs of writing and monitoring those contracts. As the shareholder-manager is ultimately bearing those costs he has a strong incentive to provide information at the lowest
148
Jensen and Meckling suggest that this alignment of incentives can happen through the manager becoming the
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sole equity holder by purchasing all of the outside equity [cp. Jensen/Meckling (1976), p.333]. 149
Cp. Jensen/Meckling (1976), p.334.
150
The equity value actually behaves like a European call option on the firm value with strike price of the value
of debt outstanding [cp. Brealey/Myers (2000), p.512]. 151
For examples please refer to Ross/Westerfield/Jaffe (1996), p.421 et seq. or earlier Jensen/Meckling (1976),
p.334 et sqq. 152
Cp. Jensen/Meckling (1976), p.337.
153
The written agreement describing the details of the debt issue is called indenture [cp. Ross/Westerfield/Jaffe
(1996), p.567].
27
cost possible.154 He can voluntarily agree to provide detailed reports of current activity; nonetheless he will incur the attached bonding costs. Another problem that occurs in the Agency relationship between shareholder and bondholder is the underinvestment problem.155 Stockholder-managers might forgo positive NPV projects when they feel that the additional value created falls entirely in the hands of bondholders. To illustrate this Myers separates the firm value in the intrinsic value of assets in place and the option value of future growth opportunities.156 He then constructs a state dependent model of firm value to compare an all equity financed with a debt financed firm.157 Debt is assumed to be risky and matures before the investment decision is made, but after the true state of nature is revealed.158 In either case, the all-equity financed and the levered company, a breakeven state exists from which onwards it makes sense to invest in future growth opportunities as the value of the newly acquired assets is greater than the cost of the investment. Figure 6
Illustration of the underinvestment problem
Dollar value per state
Foregone investment projects
VS
I+P I sA
sB
s
Note:
VS = Value of newly acquired assets, I = Cost of investment, P = Promised payment to debtholders, s = future states of the world, sA = Breakeven state for all equity firm, sB = Breakeven state for levered firm. Source: Myers (1977), p.144.
Figure 6 shows that the breakeven state is higher in the case of a levered company as the Copyright © 2009. Diplomica Verlag. All rights reserved.
value of the acquired assets has to support both, the investment cost and the promised payment to debtholders. Consequently not all investments in future growth opportunities are
154
Cp. Jensen/Meckling (1976), p.338.
155
The underinvestment problem was first discovered by Myers (1977).
156
Cp. Myers (1977), p.141.
157
Q.v. Figure 6, p.28.
158
Cp. Myers (1977), p.143.
28
realised, specifically, shareholders are reluctant to realise those projects whose fruits are only reaped by bondholders. This suboptimal investment policy reduces firm value and consequently shareholders’ wealth.159 The underinvestment problem can be fought against by rewriting the debt contract to require shareholders to undertake all future investments with positive NPVs, shortening debt maturity160, restricting dividends161, monitoring and voluntary forbearance162. However all means will ultimately come at a positive cost. A very similar problem to the underinvestment problem is the strategy of shareholders to expropriate firm value by paying out dividends or other distributions to equityholders.163 Whereas the shareholders in the underinvestment problem choose not to raise new equity, they actually withdraw equity in the so called “milking the property” strategy.164 If bondholders correctly anticipate the stockholder-manager’s incentive to pay out cash dividends they will impose the costs on the shareholder ex-ante. Costs can be mitigated through information transfers leading to monitoring or bonding costs.165 If bonds are priced under the assumption that no additional debt will be issued, the value of the bondholders’ claims is reduced by issuing additional debt of the same or higher priority.166
159
Cp. Myers (1977), p.147.
160
Debt that matures before an investment option is to be exercised does not induce suboptimal investment
decisions [cp. Myers (1977), p.149]. 161
Restrictions on dividends provide the firm with enough funds to finance future investment projects thus
decreasing the dependence on debt while alleviating the underinvestment problem [cp. Myers (1977), p.151]. 162
As a matter of fact shareholders cause the underinvestment problem and are ultimately the ones that have to
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bear the costs. Society should be able to work out contractual, legal and institutional arrangements which minimize the overall cost of the game [cp. Myers (1977), p.152]. 163
Formally:
∂E t dVt − dVt > 0 , hence the change in equity value plus dividends received is positive ∂Vt
[cp. Keiber (2003)]. 164
Cp. Ross/Westerfield/Jaffe (1996), p.423.
165
Q.v. Asset substitution problem, p.27.
166
Cp. Smith/Warner (1979), p.118. Bebchuk (2002) shows that ex-post deviations from absolute priority in
bankruptcy do always imply negative effects ex-ante.
29
Increased leverage means increased bankruptcy risk which is not compensated by the interest rate of the old bonds, thus leaving old bondholders with significant wealth losses.167 Costs to shareholders arise through old bondholders’ pricing those wealth losses into original bond contracts. Shareholders are hence interested in effectively signalling their compliance with bondholder interests. This can be done via covenants restricting shareholders’ freedom to issue new bonds. 2.2.3.4.
Implications for shareholders and empirical evidence from
leveraged Buy-Outs
Having discussed the basic Agency complications arising in capital structure choice we can now determine the effect of increased leverage on Agency costs of debt and outside equity. As far as Agency costs of equity are concerned Stulz shows that debt is an efficient means to reduce free cash flow available on managers’ discretion.168 In the case of the underleverage problem increasing leverage reduces the costs to shareholders from the foregone tax advantage of debt, however costs of manager compensation are likely to increase. The combined effect of leverage on firm value should be positive due to the relatively small costs of additional manager compensation and the substantial benefits from tax deductibility of interest payments.169 Hence we can state that firm value and therefore equity value are increased with rising leverage in the case of Agency costs of equity.170 Agency costs of debt will increase with rising leverage and thus decrease shareholder value. Reasoning is very similar for the sub-problems, asset substitution, underinvestment, milking the property, and claim dilution. As bondholders will get hurt by opportunistic shareholder moves they will anticipate the costs of this wealth appropriation ex-ante and will demand higher interest payments for additional debt. Higher interest payments are nothing else then a
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wealth transfer from stockholders to bondholders and consequently equity value is reduced.171
167
Cook and Esterwood find evidence for old bondholders’ loosing approximately 3% of the market value of
their outstanding bonds after MBO announcements, i.e. significant increase of firm leverage [cp. Cook/Esterwood (1992), p.102]. Asquith and Wizman find negative abnormal returns for non covenant protected bonds of -5.2% throughout their sample period [cp. Asquith/Wizman (1990), p.202]. 168
Cp. Stulz (1990), p.3.
169
Deferred from Graham (2000), p.1901.
170
Cp. Jensen (1986), p.324.
171
Cp. Smith/Warner (1979), p.119.
30
Table 7 provides with a wrap-up of leverage’s effect on Agency costs. Table 7
Agency costs revisited
Agency problem
Costs incurred shareholders
Free cash flow
Perk consumption Excessive growth Higher manager
Underleverage
by Effect of increased … consequently leverage on Agency firm value will … costs … Reduction Increase
compensation Foregone tax advantage of debt Asset substitution Higher ex-ante bond issuance price Underinvestment Forgone positive NPV investments Milking the Higher ex-ante bond property issuance price Claim dilution Higher ex-ante bond issuance price
Reduction
Increase
Increase
Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease
Source: Own analysis.
Combining all effects mentioned above we obtain a U-shaped function by equating the marginal Agency cost of debt and the marginal Agency cost of equity as depicted in
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Figure 7.172
172
For a derivation of the optimal point please refer to Jensen/Meckling (1976), p.344 et sqq. , Myers (1984a),
p.577, and Green/Talmor (1986). Literature consequently assumes a non-linear impact of Agency costs on firm value. A potential interaction of the risk shift and underinvestment problem has been identified in literature [cp. Myers (1977), p.167], but research is ambiguous about its effects [cp. Gavish/Kalay (1983), Bradley/Jarrell/Kim (1984), Long/Malitz (1985), Titman/Wessels (1988), Mao (2003)].
31
Figure 7
Agency costs’ effect on firm value
VL
VL VU
Optimum
B SL
Note:
B = Value of the bonds of a levered company, SL = Value of the stocks of a levered company, VL = Value of the levered company, VU = Value of the unlevered company. Source: Own analysis.
Empirically this theory has been widely tested. Since the early 1980’s Agency Theory has been employed to explain the performance outcomes of leveraged Buy-Outs. Of particular interest have been the more closely aligned incentives between managers and shareholders and the controlling function of debt.173 Empirical evidence seems to have sufficiently tested Agency theoretical predictions in real world scenarios.174 2.3.
An integrated model of capital structure
In the last two chapters we placed traditional theory side by side with modernist approaches to capital structure. The empirical evidence is in overwhelming support for the modernist view on the world. Seemingly, markets appear to contain frictions that impose costs and benefits on shareholders. However, evidence seems clear cut, corporate financial theory seemed to progress slowly on their way of developing a combined theory of capital structure choice. Copyright © 2009. Diplomica Verlag. All rights reserved.
This was mainly due to corporate finance’s underdeveloped empirical methods and its less precise theories.175 Theories are not mutually exclusive and rely on hard to measure variables. This chapter will provide the reader with the following:
173
Cp. Kaplan (1989b), Green (1992), Mehran (1992), and a meta study by Denis/McConnell (2003).
174
Cp. Bruton/Keels/Scifres (2002), p.709.
175
Barclay/Smith (1999), p.9 point out that capital market theory achieved superior advancements because its
theories were easily reducible to precise mathematical formulas.
32
Derivation of an integrated model of capital structure choice as proposed by Myers for
the case of pure debt and equity. Review of state-of-the art research on optimal capital structure for the case of hybrid
financing instruments. 2.3.1.
The case of pure debt and equity
A first attempt to integrate all three hypothesis of modernism, i.e. tax, risky debt and costly contracting hypothesis, was the trade-off theory developed by Myers.176 It assumed that an investor traded off the benefits of increased debt use, i.e. tax shields and Agency cost reductions, against its costs, i.e. increased costs of financial distress and Agency costs of debt.177 Mathematically the following equation holds178: Formula 2-7
Value of = Value if all - equity + PV (tax shield) - PV (costs of - PV (Agency costs) the firm financed financial distress)
Consequently a U-shaped curve is obtained.179 Figure 8
Illustration of the trade-off theory180
V
VU
Optimum
B SL
B = Value of the bonds of a levered company, SL = Value of the stocks of a levered company, tC = Corporate tax rate, V = Value of the company, VL = Value of the levered company, VU = Value of the unlevered company. Source: Own analysis i.c.w. Myers (1984a), p.577 and Ross/Westerfield/Jaffe (1996), p.426.
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Note:
176
Cp. Myers (1984a).
177
Theory has long embraced the trade-off theory and provides a vast array of theoretical proofs [e.g. Kim
(1982), Stulz (1990)]. 178
Cp. Brealey/Myers (2000), p.510.
179
Q.v. Figure 8. This is achieved by integrating Figure 4, p.15 and Figure 5, p.18 and Figure 7, p.32. Please
note that integrating Figure 4 and Figure 5 would not necessarily lead to an optimal leverage ratio, however the non-linear nature of Agency costs, as depicted in Figure 7, is able to accomplish that. 180
In contrast to the original representation Agency costs of equity are represented by the curved line
intersecting the vertical axis at a lower intercept [cp. Keiber (2003), p.10].
33
The implication of the trade-off theory is that an optimal target debt to equity ratio exists and firms should strive to reach it. However the determination of the optimal point that maximises shareholder value is highly arbitrary. We can’t provide an exact figure, e.g. 80% debt with 20% equity, as it depends heavily on the strength of the various tax, financial distress, and Agency effects. Empirical studies of the combined tax, financial distress and Agency effects seem to prove the theory of an optimal capital structure.181 Table 8
Selection of empirical studies on optimal capital structure
Author (Year)
Find support for…
Sampl
Method
Comments
e optima l capital structu re
tax hypo thesi s
risky debt hypo thesi s
costly contracti ng hypothesis
Castanias (1983)
9
9
9
9
Bradley/Jarrell/ Kim (1984)
9
9†
9
9
Mao (2003)
9
8
8
9
Note: † Only weak support is found. Source: Own analysis.
18,714 Macro data firms crosssectional analysis 851 Firm firms specific crosssectional analysis 3,452 Firm firms specific crosssectional analysis
Good discussion of statistical problems occurred with prior studies. Missing to capture the impact of the asset substitution problem.182 Unifies the analysis of debt Agency problems by developing a coherent model.
A combining problem of all these studies, however, is that they treat debt and equity as being Copyright © 2009. Diplomica Verlag. All rights reserved.
homogeneous. Consequently their study design is not able to capture the full range of liability characteristics183. The following chapter tries to make this distinction and will summarise
181
For a selection q.v. Table 8, p.34.
182
Mikkelson (1984), p.879.
183
Barclay and Smith identify the following liability characteristics: maturity, covenant restrictions,
convertibility, call provisions, security and public or private placement [cp. Barclay/Smith (1996), p.210].
34
state-of-the-art research on the optimal capital structure in the case of hybrid financing instruments that combine various liability characteristics. 2.3.2.
The case of hybrid financing instruments
As we have found, liabilities can be distinguished by a number of variables.183 This implies that our decision variables have been multiplied as well. Whereas the focus in the last chapter was to see firm value’s reaction to alterations in leverage only, we would now additionally have to analyse its reaction to maturity, covenant restrictions, convertibility, call provisions, security and public or private placement. This leads to two areas of research in economic theory: First, what specifications of those liability characteristics should securities have to reach maximum benefit for its issuers? For a discussion the reader should refer to the standard paper on this topic written by Allen and Gale184 or a more recent review from Robe185. Secondly, how should the securities available in the market be combined to reach maximum value creation for a company? Although no combined model of capital structure decisions has been developed so far, literature was able to progress on several fronts. In the following we will describe recent progress made, by giving a short review of relevant literature, both theoretical and empirical. Early theoretical research models seem to follow no clear structure. Models have different foci as to what explaining theories they support and typically cover only a small array of liability characteristics. Recently, efforts are made to integrate proven theories and widen the
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liability characteristics covered.186
184
Cp. Allen/Gale (1988).
185
Cp. Robe (1990).
186
Q.v. Table 9, p.36.
35
Table 9
Selection of theoretical research on optimal capital structure
Author (Year)
Evidence for optimal capital structure No
Barnea/ Haugen/ Senbet (1980)
Arzac (1990)
Yes
Barclay/ Marx/ Smith (2003)
Yes
Liability Explaining characteristi theories cs Call provision, maturity
Comments
Costly contracting hypothesis
Focus is rather to explain complex financial instruments than to give advice on their application. Agency problems associated with informational asymmetry, managerial risk incentives, and foregone growth opportunities are covered. Convertibili Signalling Develops a model to explain ty hypothesis187 capital structure decisions for the case of pure debt and equity. It is extended to explain arrangements such as strip financing and equity kickers. Leverage, Costly First model to capture joint maturity contracting determination of two liability (simultaneous) hypothesis, tax characteristics (leverage and hypothesis, risky maturity). debt hypothesis
Source: Own analysis.
Of particular interest is the study of Barclay, Marx and Smith (2003). It tries to construct a model by integrating existing theories and by deriving prerequisites for an optimal capital structure to exist. Due to its reduced scope of liability characteristics, i.e. only leverage and maturity are covered, and its complexity the author choose not to cover it in this paper.
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Empirical testing of models for hybrid financing instruments has developed slowly.188
187
The signalling hypothesis was originally derived by Ross (1977) and Leland/Pyle (1977).
188
Q.v. Table 9, p.36.
36
Table 10 Author (Year) Titman/ Wessels (1988)
Selection of empirical studies on optimal capital structure Evidence for optimal capital structure No
Barclay/ Smith (1995a)
Yes
Barclay/ Smith (1995b)
Yes
Barclay/ Marx/ Smith (2003)
Yes
Asset characteristics
Liability characteristics
Explaining theories
Sample
Method
Comments
Collateral value of assets, non-debt tax shields, growth, uniqueness of products189, industry, firm size, volatility of earnings, profitability Growth193, regulation, abnormal returns195, tax bracket, firm size Growth193, regulation, abnormal returns195, tax bracket, firm size Growth193, regulation194, abnormal returns195, tax bracket, firm size
Maturity, convertibility
Costly contracting hypothesis, tax hypothesis, risky debt hypothesis, industry structure arguments190
469 firms
Firm specific linear structural modelling191
Rather documentation of empirical regularities that are consistent with existing theory then conclusive interpretation.192
Maturity
Costly contracting hypothesis, tax hypothesis, risky debt hypothesis Costly contracting hypothesis, tax hypothesis, risky debt hypothesis Costly contracting hypothesis, tax hypothesis, risky debt hypothesis
39,949 firm year observa tions 36,845 firm year observa tions 6,000 firms
Firm specific crosssectional analysis Firm specific crosssectional analysis Firm specific multiregression analysis
Primary significance of growth, regulation and size coefficients.
Priority
Leverage, maturity
Initial empirical investigation on priority structure. Strong support that a firm’s financial architecture is primarily determined by its investment opportunities.
Source: Own analysis.
This is mainly due to the less precise theoretical models developed and the difficulty to measure variables affecting capital structure choices.196 Most empirical works, however, find sufficient evidence for the theoretical concepts introduced in chapter 2.2 to apply to capital structure decisions in the case of hybrid financing instruments. The strength of effects induced by those theoretical moderators is found to depend on a firm’s asset characteristics197, e.g. a firm that enjoys a lot of growth options in its asset portfolio might be especially interested in
189
As measured by R&D expenses over sales, selling expenses over sales, and quit rate of workforce [cp.
Titman/Wessels (1988), p.5]. 190
As outlined by Brander/Lewis (1986), Maksimovic (1988), Sarig (1996), Perotti/Spier (1993), and Titman
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(1984). Q.v. footnotes 53 to 55, p.11. 191
An introduction to this statistical technique is found in Bentler/Bonett (1980) and Fornell/Larcker (1981).
192
Cp. Titman/Wessels (1988), p.17.
193
Labelled investment opportunities in original research [cp. Barclay/Marx/Smith (2003), p.149].
194
Measured by a dummy variable [cp. Barclay/Marx/Smith (2003), p.165].
195
To express overall firm quality.
196
Cp. Barclay/Smith (1999), p.9.
197
Asset characteristics include both tangible and intangible means to conduct business, i.e. factors like the
quality of the management team are included in this definition as well.
37
shortening its debt maturity to fight the underinvestment problem, whereas this might not be that important for a firm with less growth options.198 To summarise the key insights from this literature review on the existence of an optimal capital structure for the case of hybrid financing instruments we can state: An optimal capital structure for the case of hybrid financing instruments seems to exist. Introduced theoretical concepts are valid. Potential of liability instruments to affect firm value depends on a firm’s asset
characteristics. Armed with this knowledge we will enter the practical stage and analyse the financing
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instruments found in today’s Buy-Out practice.
198
38
Q.v. Underinvestment problem, p.28.
3. Financing patterns of European Buy-Outs The last chapter provided us with the necessary theoretical basis to analyse capitalisation structures. This chapter introduces us to the European Buy-Out market by: Providing an overview of the determinants of capital structure choice in European Buy-
Outs. Reviewing observed financing patterns of European Buy-Outs in the light of those
determinants. 3.1.
Determinants of capital structure choice
Chapter 2.3.2 showed us that liability instruments can affect firm value. However, their potential to create firm value depends on asset characteristics. Consequently, firm value is a function of both asset and liability instruments, i.e. assets have to be financed with the right liabilities. In the Buy-Out practice another element is of material relevance: The availability of funds.199 Full value creation can only be achieved if the necessary liability instruments are available. Figure 9
Determinants of Buy-Out capital structure 3.1.2
3.1.1
3.2
Capital structure
ty bili Lia stics i ter rac a h c
Availibility of funds
As s cha et rac ter isti cs
3.1.3
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Note: Relevant chapters are shown in circles. Source: Own analysis.
In the following we shall analyse all three determinants of a Buy-Out’s capital structure. Chapter 3.1.1 will show us the asset characteristics of a typical Buy-Out target and the problems associated with those characteristics. Chapter 3.1.2 will cover the potential of financing instruments to mitigate those problems and create firm value. 199
Cp. De Ridder (1990), p.59.
39
In chapter 3.1.3 we will discuss the availability of the necessary liability instruments to achieve maximum firm value creation. Chapter 3.2 will then project our findings on the observed capitalisation of Buy-Outs in the European market. 3.1.1.
Asset characteristics
Although every target company is unique in its asset characteristics, some combining factors seem to evolve when looking at European Buy-Out targets. The following will assign important asset characteristics and its implications for firm value to the tax, risky debt and costly contracting hypotheses introduced in chapter 2. Tax hypothesis
Typical Buy-Out targets are to be found in the chemical and manufacturing industry.200 As those industries require significant capital investments, non-debt tax shields seem to be important. However, pre-Buy-Out companies typically use less leverage than comparable companies in the sector.201 When accounting for all of those effects, Kaplan finds that pre-Buy-Out effective tax rates are high and that a considerable advantage of debt finance exists.202 Risky debt hypothesis
Due to the low leverage of pre-Buy-Out companies that translates into high interest coverage ratios203, the probability of default is relatively low. The nominal costs of financial distress should not be materially different from other companies. We can infer that expected costs of financial distress seem to be quite low in pre-Buy-Out companies. Costly contracting hypothesis
Agency costs of debt should be relatively low due to the low leverage. Furthermore, pre-Buy-
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Out companies are often found to be operating in industries subject to tight regulation, e.g.
200
Cp. EVCA (2001), p.7.
201
Cp. Matzen/Krenz (1989), p.465. Kaplan finds median pre-Buy-Out book value of debt to capital to equal
18.8% [cp. Kaplan (1989a), p.630]. 202
Cp. Kaplan (1989a), p.630.
203
Interest coverage ratio is defined as EBITDA divided through total gross interest expense [cp. Barclays
Capital (2004), p.18].
40
defence or utilities. This adds towards the reduction of Agency costs of debt by transferring much of management's discretion over investment decisions to regulatory authorities.204 Buy-Outs have occurred mostly in mature industries with low growth expectations and high potential to generate free cash flows.205 These excess free cash flows aggravate Agency costs of equity. Neither efficient monitoring systems seem to be present with targets being diversely held pre-Buy-Out206, nor do managers have strong incentives to improve performance as their compensation is only loosely tied to firm performance207 and they typically own only a small fraction of the company’s equity.208 Consequently, we find strong support for high Agency costs of equity. We conclude that pre-Buy-Out companies make inefficient use of the tax benefits of debt, experience low expected costs of financial distress, low Agency costs of debt and high Agency costs of equity. 3.1.2.
Liability characteristics
Having outlined the specific problems that exist in typical Buy-Out target asset portfolios, we will now shift the discussion towards liability instruments’ power to solve those problems and generate firm value. We will cover liability instruments typically used in European Buy-Out transactions, i.e. senior debt, mezzanine, high yield, preferred and ordinary equity. Within this chapter we will: Present the instruments’ main contractual features, as observed in the market. Derive each instrument’s value generation potential for the equity investor by relating
contractual specifications to the tax, risky debt and costly contracting hypothesis. Due to the lack of powerful statistical methods that allow for an isolated analysis of effects209, the evidence will be of a qualitative nature. Hence, the effects and their direction will be documented, but not their strengths.
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Table 11 provides the reader with a first overview of the characteristics of individual financing instruments that will be the basis for further analysis in this chapter.210 204
Cp. Barclay/Smith/Watts (1995), p.15.
205
Cp. Jensen (1986), p.325.
206
Cp. Cotter/Peck (2001), p.103.
207
Cp. Jensen/Murphy (1990), p.225.
208
Cp. Denis (1994), p.200.
209
Cp. Barclay/Smith (1999), p.9.
41
Table 11
Overview of individual financing instruments’ characteristics Instrument
General terms
Senior debt A [B&C] loans L + 225 bps [275, 325 bps] No
Mezzanine facilities L + 400 bps
High Yield notes
Preferred equity
Equity
9-11%
300 – 400 bps
No
Preferred dividends Cumulative
Ordinary dividends No
Bullet
Bullet
No
No
10 years
10 years
Infinite
Infinite
Call premium
Amortising [Bullet] 7 years [8-9 years] No
Yes
Yes
No
No
Placement costs
Low
Low
High
Low
Low
Placement agents
Banks / Institutions
Bank / Institutions
Institutions / Individuals
Financial sponsors
Interest payments
Yes
Yes
Yes
Asset depreciation
Yes
Yes
Yes
Dividend payments are not tax deductible Yes
Financial sponsors / Management Dividend payments are not tax deductible Yes
Placement cost amortisation Security
Yes
Yes
Yes
No
No
Assets [Cash flow] 80%
2nd ranking on cash flow 40%
3rd ranking on cash flow 20%
4th ranking on cash flow na
Residual
Syndication
Yes
Yes
No
No
Yes
Counterparty structure Legal documentation
Concentrated
Concentrated
Dispersed
Concentrated
Concentrated
Credit facility agreement (private)
High Yield indenture (public)
Partnership agreement (private)
Partnership agreement (private)
High Yield prospectus (public) No
Business plan (private)
Business plan (private)
Board seat
Information memorandum (private) No
Mezzanine facility agreement (private) Information memorandum (private) No
Seldom
Yes
Cash interest Non-cash interest Repayment
Tax hypothesis
Deductibility f
Maturity
Risky debt hypothesis
Incentive structure
Costly contracting hypothesis
Informational aspect
Recovery rates
Marketing documentation
na
Warrants
No
Yes
No
No
No
Covenant protection
Strong
Strong
Medium
No
No
Control rights
Specified in covenants
Specified in covenants
Specified in covenants
Conditional voting rights
Full voting rights
Note: Senior B&C loan term shown in brackets [] when different; L = LIBOR. Source: Own analysis i.c.w. Merrill Lynch (2003a), p.5 and Suni (2003), p.25 et sqq., JP Morgan (1997), p.2., Barclay/Smith (1996), p.212, Ross/Westerfield/Jaffe (1996), p.374, Fitch Ratings (2003), p.2, Interview with Jeremy Selway (21. June 2004).
3.1.2.1.
Senior debt
The most debt like element in an LBO capitalisation is senior debt. It is provided by banks
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and financial institutions in the form of term loans. To cover a wide spectrum of risk and return trade-offs, senior loans are available in three different tranches. Tranche A is the most secured tranche with B&C senior loans ranking lower in a company’s capital structure.
210
42
Q.v. Table 11, p.42.
The financial terms of the different tranches are distinguished by interest rate, repayment mode and maturity. Typically, senior debt is provided at a floating cash rate211 with a mark-up over LIBOR increasing in maturity and security. Repayment terms also vary with amortising212 repayment preferred by A loan investors and bullet213 repayment preferred by B&C loan investors. Maturity of senior debt is relatively short compared to hybrid instruments. Normally, no call premium214 is imposed on shareholders in the case of repayment before maturity. Senior debt loans are essentially privately placed bonds that enjoy the advantages of lower distribution cost215 and avoidance of public registration cost216. Banks and Financial institutions are the main players in senior debt provision. After this short wrap-up of general terms we will now see how senior debt can alter asset induced firm problems through its contractual feature. Tax hypothesis
The tax effect of senior debt is threefold: Interest payments are tax deductible, assets financed with senior debt are depreciable217, and placement costs can be amortised over the life of the issue.218 Therefore, contractual prerequisites exist to realise the full value creation potential of debt and non-debt tax shields. Latest empirical evidence seems to support these findings.219 Senior debt consequently is an efficient means to lower a company’s tax burden.
211
Cash interest is paid in cash whereas non-cash interest is paid by issuing additional bonds, i.e. by raising the
principal. 212
Constant annuity to pay back principal plus interest over the life of the loan.
213
Interest is paid annually with the principal being paid back at maturity.
214
A call provision enables a company to repurchase the entire bond issue at a predetermined price before
maturity.
The
difference
between
repurchase
price
and
face
value
is
the
call
premium
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[cp. Ross/Westerfield/Jaffe (1996), p.554]. 215
Cp. Ross/Westerfield/Jaffe (1996), p.566.
216
Cost of public registration can reach 3.5-4.5% of issuance volume with its components: underwriter costs
(commissions, non-accountable expense allowance), professional costs (legal fees, accounting, investment bankers and consultants), additional up-front costs (printing, registration fees) [source: Interview with Carlo Fontana (15. July 2004)]. 217
Note that this is a valuable insight as assets financed by capitalised leases are not depreciable, i.e. no non-debt
tax shields are realised [cp. Barclay/Smith (1996), p.212]. 218 219
Cp. Barclay/Smith (1996), p.212. For empirical evidence on corporate tax reductions in Buy-Outs please refer to Kaplan (1989a),
Schipper/Smith (1988). For general empirical evidence q.v. 2.2.1 Tax hypothesis, p.13.
43
Risky debt hypothesis
Interest charged is essentially a function of the loans’ security features. We can broadly distinguish between asset based and cash flow based lending. In an asset based lending scheme, the company’s assets will serve as collateral, whereas the company’s projected future cash flow will serve as collateral in a cash flow based lending scheme. Asset based lending schemes are less risky as lenders have direct access to the company’s assets whose value is less subject to volatility than a company’s cash flow. Senior A loans are provided through an asset based lending scheme220, whereas Senior B&C loans are provided through a cash flow lending scheme221. To further reduce their exposure to single transactions, senior debt investors can pass default risk on to other banks. This technique, known as syndication, is quite common with over 60% of senior Buy-Out related debt being syndicated.222 The global coordinator of the bond issue originates the transaction and then passes on part of the default risk to other banks for a fee.223 The limited number of counterparties in senior debt loans results in easier renegotiation in the case of default224 which can substantially decrease direct and indirect costs associated with financial distress.225 Another means of risk reduction can be found in the comparatively short maturity of senior debt loans. Merton and later Ho and Singer demonstrate that a reduction in the time to maturity of debt outstanding will reduce the elasticity of the value of the bonds with respect to the value of the firm, i.e. reduce the risk of these bonds.226
220
Production facilities can be lent against up to 80% of their liquidation value for 5-7 years, properties against
70-75% of their liquidation value for 10-15 years [cp. Michel/Shaked (1988), p.183] and receivables against 5080% of their nominal value according to their maturity [cp. Boemle (1986), p.228]. 221
Senior B&C loans are typically given out for up to two times annual gross cash flow
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[cp. Merrill Lynch (2003d)]. 222
Source: Interview Simon Steffen (1.July 2004).
223
Cp. Ernst & Young (2002), p.2.
224
Andrade and Kaplan find that costs of financial distress are negatively related to the debt owned by banks in
highly levered transactions [cp. Andrade/Kaplan (1998), p.1445]. 225
Those reduced renegotiation costs have to be weighted against losses imposed through the extraction of
monopoly rents by borrowers in the case of renegotiation [cp. Diamond (1991), p.722, Rajan (1992), p.1381 et seq.]. However in the typical case of syndicated loans the losses should be minimal [cp. Gilson/Warner (1997), p.7]. 226
44
Cp. Merton (1974), p.459 and Ho/Singer (1982), p.384.
The floating rate interest payments of senior loans are a major risk driver in Buy-Out transactions. Due to the high leverage, companies have huge exposure to interest rate shifts.227 However, instruments exist to limit that risk, e.g. swap contracts, 40% of Buy-Out debt in Europe remains un-hedged.228 We conclude that costs of financial distress do exist, but modern contractual specifications in senior debt loans allow for a significant reduction of those costs for banks. These lowered costs of financial distress should result in lower prices for senior loans and consequently benefit shareholders. Costly contracting hypothesis
Agency costs of debt are being imposed on shareholders due to the existence of a discretionary freedom of action, induced by asymmetric information, which could be exploited to the detriment of bondholders, in the case of misaligned incentives.229 We will now examine the conditions being present in senior debt contracts that foster Agency costs. As far as the informational aspect of senior debt is concerned, we find that documentation, both legal and marketing, are private documents. The private nature of these documents lowers the cost of information transfer, because managers can be sure that no sensitive information will be leaked to the market and information has to be provided on an informal basis.230 Banks seem to have a cost advantage in information production and transmittel.231 As with every good, lower price means higher consumption232, thus implying that private debt holders will be better informed than public ones.233 Another important source of information is board seat representation.234 This superior information lets banks perform monitoring efforts more efficiently and thus reduces Agency costs of debt. 227
Cp. De Ridder (1990), p.55.
228
Cp. Hickey (2003), p.2.
229
Q.v. 2.2.3 Costly contracting hypothesis, p.19.
230
Due to adverse selection effects management has incentives to transmit information for the financing of above
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average projects [cp. Leland/Pyle (1977), p.371]. 231
A vast literature has been developed to analyse the benefits of delegating informational tasks to an
intermediary [cp. Leland/Pyle (1977), Diamond (1984), Campbell/Kracaw (1980)]. 232
Whereas public debtholders receive quarterly accounts, private debtholders are informed every month about a
firm’s operating statistics [source: Interview with Jeremy Selway (21. June 2004)]. 233
Bank debt is effectively a form of inside debt [cp. Kane/Malkiel (1965) and later Fama (1985), Bernake
(1984)] and thus able to mitigate the underinvestment problem [cp. Myers/Majluf (1984)]. 234
Suni points out that the presence at board meetings provides important information to assess credit risk [cp.
Suni (2003), p.26].
45
On the incentive structure side we find a very debt focussed mindset. No warrants are being used in senior debt thus drawing a strict line between debt- and equityholders.235 To make up for the shortcomings of this divergence of incentives, covenants are used quite heavily.236 Table 12
Popular covenant types
Covenant type
Reason for covenant
Financial statement signals Asset 1. Working capital problem requirement 2. Interest coverage 3. Minimum net worth Restrictions on switching assets Asset problem Requirement of investments
Effect of covenant
substitution Signals a shift in investment policy to bondholders, i.e. works as a warning sign. substitution Directly imposes limits on undertaking risky projects.
Underinvestment problem Milking the property problem
Restrictions on asset disposition 1. Limit dividends 2. Limit sale of assets 3. Collateral and mortgages Dilution Claim dilution problem 1. Limit on leasing 2. Limit on further borrowing
Incentives for suboptimal investment policy are reduced. Directly limits wealth expropriation by shareholders.
Limits the ability of shareholders to dilute bondholders’ claims.
Source: Own analysis i.c.w. Ross/Westerfield/Jaffe (1996), p.425, Smith/Warner (1979), p.125 et sqq.
Strong covenant protection is important for bondholders, as they might otherwise be subject to wealth expropriation by corporate decisions.237 In an LBO situation, however, the specific shareholder structure implies disincentives for bondholder wealth appropriation. Being the main holders of ordinary share capital, financial sponsors are repeated players in the debt markets with their reputation as good borrowers at stake.238 Hence, they are rather interested
235
Warrants give the debtholder the right to purchase shares of a company for a specified strike price after the
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debt contract has matured [cp. Goldman Sachs (2001), p.6]. In turn interest payments for the debt contract are lowered. This aligns debtholder and equityholder incentives to maximise shareholder value. 236
A covenant is a contract stating various actions that the company can not/ has to take [cp.
Ross/Westerfield/Jaffe (1996), p.424]. Violation of a covenant agreement triggers repurchase or compensation duties by the company [cp. Asquith/Wizman (1990), p.199]. 237
While analysing wealth effects of Buy-Out transactions on existing bondholders, Asquith and Wizman find
positive abnormal returns for strong covenant protected bonds of +2.6% throughout their sample period and negative abnormal returns for non covenant protected bonds of -5.2% [cp. Asquith/Wizman (1990), p.202]. 238
46
Cp. Cotter/Peck (2001), p.112.
in doing good business with bondholders on a repeated basis then reaching one-off gains through bondholder wealth appropriation. We conclude that tight informational control fosters an active monitoring of shareholders by bondholders, thus lowering Agency costs of debt. The impact of incentive structures on Agency costs of debt is twofold: The traditional Agency problems of debt are existent, but are ameliorated through Buy-Out specific ownership and contractual structures. Agency costs of equity are being imposed on shareholders by managers that make inefficient use of free cash flow, either through over-investing or consuming of perquisites, or by underleveraging the firm. In this context, debt is an efficient means to fight the free cash flow problem, because interest payments reduce free cash flow available on manager’s discretion, thus curbing inefficient use of cash reserves.239 Additionally, debt gives shareholders the right to force the company into bankruptcy and thus pay out excess cash. As Glassman and Steward put it: “Equity is soft, debt hard. Equity is forgiving, debt insistent. Equity is a pillow, debt a sword”240. Monitoring activities, either through informal information exchange or contractual covenants, help to fight both, the free cash flow and the under-leverage problem.241 We conclude that senior debt is an efficient means to fight Agency costs of equity. 3.1.2.2.
Mezzanine
Mezzanine is a hybrid instrument that shares characteristics of both, debt and equity. Its subordination (equity like) is compensated by higher interest payments (debt like). Mezzanine facilities are usually provided for long-term financing (10 years), are repaid at maturity and charge both cash and non-cash interests. Floating cash interest is paid, as this allows banks to better match assets and liabilities in their balance sheet.242 Non-cash interest is a specific feature of mezzanine facilities. Interest is paid by issuing additional bonds, thus not straining a company’s cash flow. However, the interest and principal have to be paid all-
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in-once at maturity, the liquidity problem can be ameliorated by granting several mezzanine
239
Cp. Jensen (1986), p.324.
240
Stewart/Glassman (1988), p.10.
241
Cp. Berger/Ofek/Yermack (1997), p.1421.
242
Banks typically have periodic floating rate commitments to depositors. Hence they are interested in receiving
floating rate interest payments to make up for those commitments.
47
facilities with different maturity dates.243 If shareholders whish to pay back the principal amount of the mezzanine facility pre-maturely, they have to bear a call premium to make up for the foregone subsequent interest payments of bondholders. As placement agents are private institutions, the placement costs are comparatively low. Tax hypothesis
Mezzanine enjoys the same tax deductibility measures as senior debt and thus constitutes an instrument to reach the full value creation potential of corporate tax shields.244 Risky debt hypothesis
Mezzanine’s secondary ranking in the case of bankruptcy does impose higher costs of financial distress on the company with recovery rates far below those of senior debt.245 Mezzanine loans are facing mounted interest rate risk, as they are provided on a floating rate basis.246 Like in the case of senior debt, syndication and a concentrated counterparty structure are able to ameliorate the mounted costs of financial distress. Shareholders indirectly have to bear those costs of financial distress through higher interest payments. Costly contracting hypothesis
As for the Agency costs of debt, we see the same private character of information as experienced with senior debt loans. This should help reduce information asymmetries significantly. Mezzanine holders are interested in the securitisation of their interest and principal payments and might thus collide with shareholder interests.247 However, the nature of mezzanine instruments offers two contractual characteristics to align shareholder and bondholder interests. First, through the “stick” of strong covenant protection248, secondly, through the “carrot” of equity participation. Equity participation is typically achieved through the issuance
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of warrants giving the mezzanine-holder the right to purchase a company’s shares at maturity
243
Dual tranche mezzanine is a very new innovation in the financing market. It was staged in the Telediffusion
de France and Ontex transactions in 2003 [cp. u.a. (2003), p.3]. 244 245
Q.v. 3.1.2.1 Senior debt, p.42. Recovery rates of mezzanine are 40% compared with 80% in the case of senior debt
[cp. Fitch Ratings (2003), p.2]. 246
Q.v. 3.1.2.1 Senior debt, p.42.
247
Q.v. 2.2.3.3 Agency conflicts and costs, p.23.
248
Mezzanine instruments essentially hold the same covenants as senior loans [q.v. 3.1.2.1 Senior debt, p.42].
48
for a specified price.249 As this right is valuable, interest payments for the shareholders are reduced. With this technique, bondholders have strong incentives to maximise equity value yielding additional profits to them.250 We can conclude that Agency costs of debt seem to be minimised by powerful information exchange and incentive alignment. As far as Agency costs of equity are concerned, mezzanine facilities enjoy the same effects as senior debt loans by disciplining management through increased monitoring and pressure to meet interest payments. 3.1.2.3.
High Yield
Capital market risk and return characteristics of high yield bonds have been extensively analysed in literature251, with little attention given to corporate finance issues.252 We will try to add to this research with a short discussion of the effects of individual contractual features of this instrument. Providing long-term financing with a bullet principal repayment, high yield bonds are especially designed for the individual investor eager to receive a steady flow of income. However, the high fixed cash interest paid on those bonds is a relatively unattractive means of financing in the low interest environment found in today’s markets.253 A call premium is imposed on shareholders for paying back the bond prematurely. The wide circle of investors raises both marketing and distribution costs for this product. Tax hypothesis
High yield bonds enjoy the same tax deductibility measures as senior debt and thus constitute
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an instrument to reach the full value creation potential of corporate tax shields.254
249
Cp. Goldman Sachs (2001), p.6.
250
Arzac points out that attaching warrants to a bond basically yields to the same results as using strip financing,
i.e. distributing equity and debt claims evenly on claimants [Cp. Arzac (1992), p.21]. 251
Especially active have been the chairs of Altman [cp. initially Altman (1989) Asquith/Mullins/Wolff (1989)
and more recently Altman (1998), Altman/Hukkawala/Kishore (2000)] and Blume [cp. Blume/Keim (1987), Blume/Keim/Patel (1991)]. 252
Cp. Gilson/Warner (1997), Denis/Mihov (2002).
253
Q.v. Figure 12, p.59.
254
Q.v. 3.1.2.1 Senior debt, p.42.
49
Risky debt hypothesis
Whereas in the US high yield bonds enjoy a more senior ranking in the capital structure as mezzanine debt, they are of subordinated nature in Europe.255 This translates into their deflated recovery rates and increased expected costs of financial distress. However, the individual investor has to bear relatively little risk, the dispersed counterparty structure increases costs of renegotiation in the case of default.256 It can be derived that high yield bonds have significant costs of financial distress attached to them, which have to be borne by shareholders. Costly contracting hypothesis
Agency costs of debt seem to be quite acute as indicated by information asymmetries and misaligned incentives of bondholders and shareholders. Due to the public character of documentation the time spans between information updates can be significantly lower than for private documentation257, thus implying worse information. Divergence of the incentive structures is obvious as high yield investors are interested in securing their interest and principal payments rather than maximising shareholder value. Nor do weak covenant restrictions help to protect bondholders from wealth appropriation by shareholders. Bondholders will thus impose the expected losses on shareholders, as can be seen in the elevated interest payments.258 Agency costs of equity should be aggravated by managers being less subject to tight bank monitoring. Dispersed public bondholders cannot effectively monitor management.259 However, fixed interest payments are able to discipline management.260 Our evaluation of high yield bonds seems to be rather gloomy, but this financing instrument
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enjoys benefits for shareholders. It is accessible even for issuers of lower credit quality261,
255
Cp. Fitch Ratings (2003), p.6.
256
Public debt restructurings are made difficult through free-rider problems among public debt holders. Small
debt holders have no incentives to tender in an exchange because they will have little effect on the outcome of the exchange and, by not tendering, they can avoid bearing any of the costs of debt relief [cp. Perotti/Spier (1993), p.1139 and Asquith/Gertner/Scharfstein (1994), p.626]. 257
Whereas private bondholders are informed on a monthly basis, public bondholders only receive quarterly
updates [source: Interview with Jeremy Selway (21. June 2004)]. 258
Q.v. Table 11, p.42.
259
Cp. Stulz (1990), p.11 i.c.w. p.18 and Berger/Ofek/Yermack (1997), p.1421.
260
Cp. Jensen (1986), p.324.
50
enjoys a liquidity benefit for investors that should result in a price reduction for shareholders262, and gives valuable financial flexibility to the firm263. 3.1.2.4.
Preferred equity
Preferred equity is accounted as equity of the firm, but is different from ordinary equity given that it enjoys preference over the latter in dividend payments and assets of the corporation in the case of bankruptcy.264 The security is entitled to receive a predefined dividend which, conversely, is paid on the discretion of management. Should a company’s cash flow not be sufficient to pay the preferred dividend in one year, it will be rolled over to next year in the case of cumulative preferred shares.265 Should equity investment in addition to their ordinary equity contribution be demanded from financial sponsors, preferred equity is an attractive alternative due to its preferred nature.266 Private placement drives down placement costs for this security. Tax hypothesis
Dividend payments and placement costs are not tax deductible, but assets financed with preferred shares can be depreciated.267 This let’s preferred shares look quite unattractive from a tax point of view.268 Risky debt hypothesis
The risky debt argument does not hold for preferred shares, as default on this instrument does not trigger bankruptcy.269
261
Cp. Denis/Mihov (2002), p.8.
262
Cp. Kwan/Carleton (1995), p.1.
263
However the flexibility argument is the flip side of the free cash flow hypothesis, i.e. restraining management
behaviour through decreased flexibility, Damodaran attributes positive value to financial flexibility in a firm’s capital structure [cp. Damodaran (1997), p.457]. Gilson and Warner show that the financial flexibility argument Copyright © 2009. Diplomica Verlag. All rights reserved.
is able to explain high yield offerings [cp. Gilson/Warner (1997), p.29]. 264
Cp. Ross/Westerfield/Jaffe (1996), p.373.
265
Cumulative preferred shares are quite common in an LBO [cp. Krebs (1990), p.61].
266
Source: Interview with Simon Steffen (1. July 2004).
267
Cp. Barclay/Smith (1995b), p.900.
268
The US Tax Code allows for a 70% tax deduction of dividends received on preferred shares by corporate
investors [cp. Brealey/Myers (2000), p.393]. This is not the case in European leveraged transactions [cp. Merrill Lynch (2003c)]. 269
Cp. Barclay/Smith (1995b), p.900.
51
Costly contracting hypothesis
The non-binding nature of dividend payments pared with the low yield on preferred stocks270 leads to the conclusion that preferred stock holders make their profit primarily through capital gains and are consequently interested in shareholder value maximization. We conclude that Agency costs of debt do not play a role in preferred stocks. Agency costs of equity are acute, as preferred dividends do not constitute a means of disciplining managers due to their non-binding nature. The specific structure of a Buy-Out transaction, however, does ameliorate costs by granting extensive information rights to holders of preferred stock.271 Information and control rights are enhanced through the typical incidence of ordinary and preferred stock holders in the case of an LBO. 3.1.2.5.
Ordinary equity
The final layer of an LBO capital structure is ordinary equity. It is typically provided by financial sponsors and management. Equity capital has an infinite length of commitment and provides, with its residual dividend payment, an effective means to absorb cash flow shocks.272 Privately placed equity enjoys placement and listing cost advantages over public equity.273 Tax hypothesis
For individual investors, ordinary equity has the same tax implications as preferred equity.274 Risky debt hypothesis
The risky debt argument does not hold for preferred shares, as default on this instrument does
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not trigger bankruptcy.275
270
Cp. Ross/Westerfield/Jaffe (1996), p.374.
271
Source: Interview with Jean-Philippe Maltais (14. June 2004).
272
Equity capital does not require yearly cash outlays and will thus provide a buffer in the case of a downturn
[cp. Krebs (1990), p.60]. 273
In an empirical study of US companies Block finds that the cost of being public is the number one reason for
going private by smaller firms. Increased regulation drove the costs of being public from $m 0.90 up to $m 1.95 [cp. Block (2003), p.4]. With increased regulatory scrutiny similar developments are expected in Europe [cp. Pfanner (2003), p.1]. 274
Q.v. 3.1.2.4 Preferred equity, p.51.
275
Cp. Barclay/Smith (1995b), p.900.
52
Costly contracting hypothesis
Ordinary equity constitutes a pure equity instrument, thus Agency costs of debt are not relevant. The typical structure of ordinary share capital in an LBO transaction provides superior information and incentive structures that are able to effectively fight Agency costs of equity. Financial sponsors seem to have a comparative advantage in monitoring management276. Incentive problems can be reduced by making managers owners of the company. This alignment of incentives is performed through required equity investments of management277 and by granting of equity ratchets278. Equity ratchets can also be used as a screening device to discourage lower productivity managers from entering the deal.279 Garvey shows that those management shareholdings are an efficient means in resolving the Agency costs of free cash flow.280 A relatively new development is equity syndication. To lower their risk exposure281 equity investors increasingly turn towards syndication.282 3.1.2.6.
Summary
Within this chapter we provided the reader with a qualitative insight on how individual financing instruments can add value to an equity investor in a Buy-Out transaction through reducing costs associated with the tax, risky debt and costly contracting hypothesis. Table 13 summarises our findings. 276
Cp. Cotter/Peck (2001), p.103. Fitch does rate transactions with financial sponsor involvement more
favourably due to their expertise in controlling management [cp. Fitch Ratings (2003), p.7]. 277
Managers are asked to invest a substantial amount of their private wealth, i.e. 2-3 yearly gross salaries [cp.
Schuler (2004), p.48]. 278
The granting of equity ratchets lets managers participate over proportionally in the firm’s performance [cp.
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Thompson/Wright (1989), p.1]. Jensen notes that “the salary of the typical LBO business-unit manager is almost 20 times more sensitive to performance than that of the typical public-company manager” [Jensen (1989), p.132]. This leads to strong incentives to boost shareholder value. 279
Cp. Thompson/Wright (1989), p.18.
280
Cp. Garvey (1992), p.160.
281
Cp. Taylor Wessing (2004), p.7. In addition Manigart et al. identify access to deal flow and resources as an
important motive for equity syndication [cp. Manigart et al. (2003), p.3]. 282
In 2003 35% of equity investments have been syndicated [cp. EVCA (2004a), p.16] with increases expected
to happen in the future [cp. EVCA (2004d), p.4].
53
Table 13
Qualitative evidence from contractual specifications
Tax hypothesis
Risky
debt Costly contracting hypothesis
hypothesis Senior debt
Mezzanine High Yield
Strong support for However, this tax advantage. instruments is not a means to fight costs of financial distress modern contractual features allow for a re-duction of those costs. Strong support for Evidence on support tax advantage. for costs of financial distress. Strong support for Strong evidence on tax advantage. support for costs of financial distress.
Preferred equity
No tax advantage.
No evidence.
Ordinary equity
No tax advantage.
No evidence.
Modest evidence for Agency costs of debt increase. Agency costs of equity seem to be reduced.
Agency costs of equity and debt seem to be both reduced. Strong evidence for Agency costs of debt increase. Modest evidence for Agency costs of equity increase. No evidence on Agency costs of debt increase. Modest evidence on Agency costs of equity increase. No evidence on Agency costs of debt increase. Modest evidence on Agency costs of equity increase.
Source: Own analysis.
3.1.3.
Availability of funds
Within chapters 3.1.1 and 3.1.2 we gained useful insight as to what problems exist in preBuy-Out target companies and how financial instruments found in Buy-Out transactions can reduce those problems. The optimal capital structure would thus be a function of asset and liability characteristics. In reality, however, the supply of financing instruments is not endless, but limited through the offerings of capital providers. In the following we shall give a short wrap-up on the restrictions of supply on financing instruments that capital providers are likely Copyright © 2009. Diplomica Verlag. All rights reserved.
to impose. Financial sponsors, as the primary providers of equity capital, have different country and industry foci that restrict their investment policy. Additionally, their statutes typically provide
54
Table 14
Large cap financial sponsors
Financial Sponsor
Ideal Minority Country focus deal position size (TEV in €bn) Apax 0.5 – No UK, 1.0 Continental Europe Blackstone na na UK, Continental Europe GS Private na No UK, Equity Continental Europe KKR 0.3 – Yes UK, 1.0 Continental Europe Permira 0.2 – No UK, 3.0 Continental Europe
Industry focus
Biggest European transactions in 2003 (TEV in €bn)
Real estate, TMT Real estate, TMT Industrials
Deutsche telecom cable assets (1.8), Inmarsat (1.3)
Industrials
Scottish & Newcastle (3.6), Celanese (3.1) Deutsche telecom cable assets (1.8), Cablecom (1.4) MTU Aero Engines (1.5)
Industrials, Seat PagineGialle TMT Inmarsat (1.3)
(5.7),
Source: EVCA (2003).
restrictions on the maximum investment in one deal. In the capitalisation process financial sponsors are primarily interested in increasing their return on equity through the leverage effect.283 However, increased leverage translates into higher equity risk.284 Financial sponsors consequently see themselves confronted with risk and return trade-offs that determine their ultimate equity contribution and consequently their compensation.285 Another provider of equity capital is management. Although, on average, managers contribute only 3% to the cost of the Buy-Out, they typically control 22% of the ownership by holding equity ratchets.286 This translates into lofty return expectations of 90% on their equity stake
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pre-Buy-Out.287 However, they take big personal risks by investing on average 25% of their
283
Cp. Krebs (1990), p.74 and q.v. 7.2 Leverage effect, p.81 for a discussion of the leverage effect.
284
Cp. Ross/Westerfield/Jaffe (1996), p.322.
285
Targeted IRR of financial sponsors is around 25-35% [cp. Merrill Lynch (2003b)]. However average realized
returns are closer to 14% with a standard deviation of 0.32 [q.v. Figure 1, p.5]. 286
Cp. Kaplan/Stein (1993), p.341 and Thompson/Wright (1989), p.1.
287
Cp. Kitching (1989), p.75.
55
personal net worth.288 We see that they will wage those risks against their return expectations in providing capital. The primary goal of debt providers is to secure interest and principal payments with the target company’s assets and projected cash flow as collateral.289 Thus, we have a natural barrier on debt volume with assets being limited and interest payments having to be supported by cash flow.290 Nevertheless, debt providers are not only interested in securing their payments, but wish to monetise on their capital by generating high interest receivables.291 That is the reason why they are willing to provide lower ranking securities. We conclude that the final capital structure of the Buy-Out target is a trade-off between the risk and returns of the capital providers.292 3.1.4.
Summary
This chapter introduced three determinants of capital structure in Buy-Out transactions: Asset characteristics of the target company, liability characteristics of the financing instruments and their availability. In private equity practice, the determination of the final capital structure of a target company is a complex process that demands the interaction of a wide array of specialised service providers.293 Financial models are being built that include assumptions on the target’s asset characteristics, e.g. available cash in the company, the availability of funds, e.g. senior debt tranches, and effects of liability instruments, e.g. the company’s future business development induced by managers’ altered incentive structures. An example of a financial model can be found in appendix 7.4. 3.2.
Evidence from European Buy-Out capitalisation
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Having introduced the determinants of Buy-Out capital structures in the last chapter, we will now turn towards observing the actual capitalisations of European Buy-Outs and search for
288
Cp. Kitching (1989), p.75.
289
Cp. Hoffmann/Ramke (1992), p.81.
290
Cp. Boemle (1986), p.45.
291
Cp. Arbeitskreis Finanzierung der Schmalenbach-Gesellschaft (1990), p.837.
292
Cp. De Ridder (1990), p.58.
293
Cp. De Ridder (1990), p.49.
56
evidence of these determinants. We will first observe the evolution of sources and uses of funds in European LBO transactions from an aggregated industry perspective and then zoom into individual markets for financing instruments. Figure 10
Sources and uses of funds in the European Buy-Out market
EBITDA multiple 9,0x 8,0x 7,0x 6,0x
42%
38%
5,0x 4,0x
2,0x
35%
14%
14%
44%
95% 48%
40%
15%
7% 95%
3,0x
40%
96%
11% 96%
53%
50%
35%
32%
11%
17%
96% 49%
94%
95%
54%
51%
1,0x 0,0x
1998
1999
2000
2001 Senior debt
2002 Hybrid products
2003 Equity
Fees
2004 † Offer price
Note:
Figures are expressed in EBITDA multiples to make them comparable over the years, Median LTM figures are shown as of June 2004, †Includes refinancing. Source: Own analysis i.c.w. Standard & Poor’s (2004a and 2004b).
As far as the uses of funds are concerned, we can clearly see that acquisition multiples have decreased over the last seven years. It is noteworthy that Buy-Outs seem to show little correlation to public markets.294 When in 2000 public markets hyped due to the internet boom, Buy-Out markets saw significant reductions in valuations. Recently, fees have been under pressure, but are supposed to pick up over the next few years in the wake of increased LBO activity.295 The sources of acquisition funds have seen more aggressive financing296 with equity injections accounting for only 32% of transaction value in 2004. The decrease in equity has been mainly financed by a growth in the use of hybrid products that now account for 17% of
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transaction value. Senior debt has been roughly stable at around 50% of transaction value. We will now zoom into individual markets for financing instruments to identify the underlying trends.
294
Cp. EVCA (2004c), p.6.
295
Cp. Standard & Poor's (2004b), p.2 and interview with Jean-Philippe Maltais (14. June 2004).
296
Cp. Hickey (2003), p.1 and Hickey (2004), p.1.
57
Overall market quality of senior debt issued seems to have been declining over the last six years with a constantly increasing issuance of lower quality B&C term loans not offset by higher quality A term loans.297 Figure 11
European senior debt issuance
€bn 35 30 25 20 15 10 5 0
29%
1998
30%
1999
30%
2000
36%
2001
43%
2002 Senior A
39%
2003 Senior B&C
Note:
Only senior debt supporting LBO transactions has been included, Percentage figures show senior B&C loans as percentage of total senior debt loans. Source: Merrill Lynch (2004c), p.7 i.c.w. Standard & Poor’s (2004a), p.1.
As collateral assets have only slightly increased with reduced deal flow over the last years, this seems to be quite coherent with the availability determinant of the capitalisation structure.298 In the hybrid product market, mezzanine has seen a constant growth, while high yield bonds issuance seems to be in terminal decline. Only recently, high yield bond issuance has been
Copyright © 2009. Diplomica Verlag. All rights reserved.
supported by fallen angels.299
297
Q.v. Figure 11, p.58.
298
Senior A loans are only provided on an asset based lending scheme [cp. Merrill Lynch (2003a), p.5].
299
Q.v. Figure 12, p.59. Fallen angels are companies whose ratings have been cut below investment grade, i.e.
their bonds are consequently classified as high yield bonds.
58
Figure 12
European issuances of hybrid products
€bn 25 20 15 10 5 0
14%
1998
10%
1999
28%
2000
37%
2001
58%
30%
2002 Mezzanine
2003 High Yield
Note : Percentage figures show mezzanine loans as percentage of total hybrid products. Source: Merrill Lynch (2204c), p.7 et seq. .
The constant growth in mezzanine loans can be attributed, at least partially, to the innovations that have happened in that segment of the market. The most innovative instrument was the Focus Wickes hybrid300, which was billed as a mix of high yield and mezzanine, and conceived for sale to both markets.301 This product’s unique structure is a superior tool to fight Agency costs of debt and equity, and thus provides evidence for liability characteristics constituting a determinate of Buy-Out capital structures. The equity product market has experienced a persistent oversupply of capital.302 It seems that a short supply of attractive investment opportunities, suited for Buy-Out transactions, was the cause of this phenomenon. This leads us to the conclusion that asset characteristics do have an
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impact on a Buy-Out capitalisation.
300
Named after the target company Focus Wickes.
301
Cp. u.a. (2003), p.1.
302
Q.v. Figure 13, p.60.
59
Figure 13 €bn 80
Funding vs. investment in European equity products 8.4 €bn
0.5 €bn
18.6 €bn
22.4 €bn
0.2 €bn
6.6 €bn
1998
1999
2000
2001
2002
2003
70 60 50 40 30 20 10 0
Funds Raised (CAGR 5%)
Investments (CAGR 8%)
Note: Investment gap shown in blue circle. Source: 3i/PWC (2004), p.19.
Within this chapter we have analysed markets for individual financing instruments by providing examples of positive evidence for Buy-Out capital structures being subject to the determinants: Asset characteristics of the target company, liability characteristics of the financing instruments and their availability. Within the next chapter we shall look beyond the capitalisation process and identify other
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sources of value in Buy-Outs.
60
4. The capitalisation process and other sources of value Having dedicated significant time to the capitalisation as a means to generate value, we will now briefly discuss other value levers in Buy-Out transactions. In an M&A situation, a company is usually acquired because it delivers potential synergies with existing businesses of the acquirer. However, in an LBO type of transaction, value has to be created on a stand alone basis.303 The most complete framework to analyse the array of value levers in Buy-Outs, is provided by Berg and Gottschalg. They distinguish between three
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types of value levers: primary value levers, secondary value levers and value capturing.304
303
Cp. Baker/ Montgomery (1994) cited in Berg/Gottschalg (2003), p.3.
304
Cp. Berg/Gottschalg (2003), p.8 et seq.
61
Table 15
Levers for value generation in Buy-Outs
Lever
Type of value lever Foundation of lever
1. Financial Arbitrage
Value capturing
2. Financial engineering
Primary lever
Changes in market valuation
8
Private
8
information about the target company Superior market information Superior dealmaking capabilities Optimization of corporate scope value Optimization of capital structure
Primary lever
operational effectiveness 4. Increasing strategic distinctiveness 5. Reducing Agency costs
6. Parenting
Primary lever
value Increased efficiency Cost-cutting
8
and margin improvement Reduction of capital requirements Removal of managerial inefficiencies value Corporate refocusing Buy and build strategies
Secondary lever
Secondary lever
8 8 8 9 9 8
Reduction of corporate tax
3. Increasing
Covered in this paper
value Reducing Agency costs of free cash flow Improvement of incentive alignment Improvement of monitoring and controlling value Restoring entrepreneurial spirit
Advising and enabling Note: 8 Not included in this research; 9 Included in this research. Source: Berg/Gottschalg (2003), pp.11-34.
8 8 8 8 9 9 9 8 8
Value capturing levers do not have a direct impact on the performance of the company, but
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affect its valuation, thereby generating returns for financial sponsors. Primary value levers do directly affect the bottom line of the company by improvements in financial engineering, operational effectiveness and strategic distinctiveness. The secondary levers do not have a direct impact on the performance of the company, but are enhancing primary value levers.305 Empirically, direct value levers have received most of the attention in literature with superior
305
62
Cp. Berg/Gottschalg (2003), p.8 et seq.
performance of Buy-Outs found in the areas of increases in sales306, income307, cash flow308, productivity309, and decreased expenditures310.311 When looking at value levers in Buy-Out transactions from a historical perspective we can see that foci shifted. In the 1980’s, Buy-Out transactions for the most part generated value through financial leverage. Capital markets were inefficient and financial sponsors were swamped with cheap debt to extract high returns on their equity investments. Value capturing was also possible at historically low acquisition prices. After capital market inefficiencies had been substantially reduced,312 the 1990’s explored primary value levers as a means to extract value from BuyOut transactions. Operational improvements were the main focus of that decade.313 Figure 14
Components of realised returns
100% 24% 41% 22% 50%
14%
11%
11% 43%
34% 0% 1986-1990 Operating improvement Multiple expansion
1996-2000 Multiple arbitrage Financial leverage
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Note: Components of realised returns shown as percentage of total realised returns. Source: Jin/Wang (2001), p.13.
306
Cp. Bull (1989), Muscarella/Vetsuypens (1990), Singh (1990).
307
Cp. Kaplan (1989b), Singh (1990).
308
Cp. Bull (1989), Smith (1990), Opler (1992).
309
Cp. Lichtenberg/Siegel (1989).
310
Cp. Kaplan (1989b), Singh (1990).
311
For an extensive literature review grouped by value levers please refer to Gottschalg/Berg (2003), pp.44-50.
312
Cp. Jin/Wang (2001), p.5.
313
Q.v. Figure 14, p.63.
63
The 2000’s experience yet another trend in value generation focus with secondary value levers becoming increasingly important. The boom in secondary Buy-Outs314 can be attributed to this phenomenon. After several years of ownership by a financial sponsor, portfolio companies have typically undertaken every step to extract value on financial, operational, and strategic grounds. However, hidden value can still be extracted through better motivation and advice of the company. The role of the financial sponsor shifts from financier to motivator.315 We conclude that the capitalisation process is embedded in a plethora of different value levers affecting firm value. Financial sponsors will have to tackle the full array of those value levers
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to continue generating above average returns for their investors.
314
Secondary Buy-Outs as a percentage of total Buy-Outs have been growing in Europe from 6% in 1997 to
20% in 2002 [cp. Goldman Sachs (2003), p.3]. 315
64
Source: Unnamed interview partner (20. July 2004).
5. Summary and outlook Within this paper we departed on the quest for a theory on optimal capital structure. After laying the theoretical basis, we encountered the existence of such a capital structure for both, the case of pure and hybrid financing instruments. However, we came across problems with the applicability of our findings. Theoretical models were either too complex or not quantitative enough to allow for precise decisions on firm capitalisation. So we turned towards the practice of Buy-Out capitalisation as observed in European markets. We found that capital structure decisions are based on the three determinants, asset characteristics, liability characteristics and availability of funding. After a thorough discussion of those determinates, we turned towards observing the latest trends in European Buy-Out funding and found evidence for those three determinants. The last stop on our journey was to embed the capitalisation process into a framework for value levers in Buy-Out transactions. We saw that value levers are diverse and have to be fully tackled to reach maximum value creation potential. Returning from our quest for the optimal capital structure we can reflect on the insights generated through this paper. First, value was added through explaining existing theories on capital structure in a coherent form. Particularly the necessary details to reach full understanding of theoretical concepts, typically omitted by standard textbooks, were covered. Secondly, an extensive review of literature has been performed in a structured manner to give the reader the chance to broaden his knowledge on both theoretical and empirical concepts. Thirdly, an overview of the European Buy-Out financing market, its instruments, players, and latest trends has been given. Fourthly, the capitalisation process was embedded in a framework for value generation in
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Buy-Outs. On delivering those insights we took a positive view on research, thereby asking about how the capitalisation process works and not how it should work. This can only be the first step of a research aimed at delivering applicable decision guidelines for managers.316 Economic theory is still far away from providing financial managers with quantitative recommendations 316
A central criterion in determining the quality of scientific research is informational content [Cp. Popper
(1984), p.347] in relation to reality [Cp. Chmielewicz (1994), p.123].
65
to replace the prevailing rules of thumb for capitalisation practices. However, new theoretical concepts are being elaborated and the necessary empirical tools to test them are being developed. As mentioned above, the research duo Barclay and Smith seem to be the fathers of a new class of researchers that tries to integrate existing theories and broaden the scope of explaining variables. The coming years should see great advancements on the capital structure
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question that we are eager to follow.
66
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80
7. Appendix 7.1.
Additional sources of information
In addition to literature research, valuable insight was generated through unstructured interviews with interview partners from the investment community and academia. Table 16
Interview partners from the investment community
Interview partner
Company
Interview date
Fontana, C.
Barclays Capital
15. July 2004
Gurcel, J.
Barclays Capital
8. June 2004
Maltais, J.-P.
Merrill Lynch
14. June 2004
Selway, J.
Barclays Capital
21. June 2004
Steffen, S.
Merrill Lynch
1. July 2004
Strevens, N.
Barclays Capital
5. June 2004
Unnamed
Top five financial sponsor firm
20. July 2004
Source: Own analysis. Table 17
Interview partners from academia
Interview partner
University
Title
Interview date
Barclay, M.J.
William E. Simon Graduate School of Business
Professor
15. July 2004
Chaplinsky, S.
Darden Graduate School of Business Administration
Professor
17. July 2004
Administration (University of Rochester) (University of Virginia) Keiber, K.L.
WHU
Associate Professor
27. Mai 2004
Sarig, O.
Arison School of Business (University of Tel Aviv)
Professor (Dean)
30. May 2004
Source: Own analysis.
Additionally contacts to research centres have been maintained (CMBOR, CEPRES, etc.) and conferences
like
the
European
Venture
Market
in
Berlin
(http://www.europeanventuremarket.com) have been visited. 7.2.
Leverage effect
The leverage effect was first introduced in literature by Modigliani and Miller as their proposition II. It states that the equity cost of capital, i.e. the required return on equity, is rising linearly with leverage317:
Copyright © 2009. Diplomica Verlag. All rights reserved.
Formula 7-1
k LS = k A + (k A − R f )
B SL
If the company’s return on assets is greater than the cost of risk free debt than the equityholders could increase their return on equity simply by taking on more leverage. Figure 15 shows this relation graphically.
317
Cp. Modigliani/Miller (1958), p.271.
81
Figure 15
Graphical representation of Modigliani and Miller’s proposition II
k LS
k LS
k A − Rf 1
kA
kWACC
Rf
Note:
B SL
k A = Return on assets of the company, k LS = Equity cost of capital of the levered company (Return on equity), k WACC = Weighted average cost of capital, R f = Cost of risk-free debt.
Source: Own analysis i.c.w. Ross/Westerfield/Jaffe (1996), p.395.
Applicability of the leverage effect to finance practice is limited due to the restrictive assumption of debt being risk-less and the constant return on assets. In reality debt is not risk-less and hence its costs should rise with leverage.318 This would make the term (k A − R f ) decrease in leverage and should lead to a U-shaped function for the return on equity. In bad years the company’s return on assets could drop below the interest rate on debt outstanding. Then the term
(k A − R f )
becomes negative and rising leverage yields a
decreasing return on equity. This can yield to negative returns and finally to bankruptcy. We see that the applicability of the leverage concept is limited, however not irrelevant. 7.3.
Derivation of the Miller Model319
In the case of personal and corporate taxes the stockholders of a levered company receive Formula 7-2
(EBIT − Rf F ) ⋅ (1 − t C ) ⋅ (1 − t S )
and the bondholders receive Copyright © 2009. Diplomica Verlag. All rights reserved.
Formula 7-3
R f F ⋅ (1 − t B )
To arrive at the firm value of the levered company we have to discount the sum of both cash flows with their appropriate discount rate:
318
Cp. Ross/Westerfield/Jaffe (1996), p.322 and q.v. 2.2.2 Risky debt hypothesis, p.17.
319
Cp. Miller (1977), p.267.
82
VL =
Formula 7-4
EBIT (1 − t C )(1 − t S ) k US
+
R f F (1 − t B ) ⎡ (1 − t C )(1 − t S ) ⎤ ⎢1 − ⎥ (1 − t B ) R f (1 − t B ) ⎣ ⎦
Simply regrouping terms we arrive at Formula 2-5, p.14. q.e.d. 7.4.
Financial model for capitalisation analysis
Offer summary
Implied multiples
Offer price (20.0% premium to price of $15.00) ($)
18,00
Hamster diluted shares (m)
110,0
Offer Value
1.980,0
Net Debt (incl option proceeds)
83,2
Transaction expenses and financing fees
18,3
Transaction Value
2.081,5
Debt paydown schedule 2000
2001
2002
Revenue
1,65x
1,44x
1,25x
EBITDA
12,1x
9,6x
8,3x
800
EBIT
24,3x
34,2x
18,6x
700
Net income
31,3x
48,0x
24,4x
500
Operating cash flow
21,1x
11,7x
10,5x
400
Transaction value to:
Offer value to:
600
Sources of Funds
300
Debt
O/s hip
Spred
Rate
($m)
% Debt
Uses of Funds 95,0%
100
Refinance Hamster instruments
80,0
4,0%
0
20,0%
Transaction expenses
10,3
0,5%
120,0
15,0%
Financing fees
8,0
0,4%
10,5%
40,0
5,0%
1.978,3
100,0%
11,0%
40,0
5,0%
250
8,5%
240,0
30,0%
Offer (net of option proceeds)
Senior B
300
9,0%
160,0
20,0%
Senior C
350
9,5%
160,0
Senior D
400
10,0%
450 500
Mezzanine
5%
High Yield
Total Uses of Funds
550
11,5%
40,0
5,0%
Revolver
600
12,0%
0,0
0,0%
800,0
100,0%
Revenue
Rate
($m)
7,0%
60,0
% Equity 5,1%
EBITDA
O/ship
Preferred Stock A Preferred Stock B PIK
10,0%
Loan Stock
8,0%
50,0
4,2%
9,0%
106,8
9,1%
9,0%
0,0
0,0%
2000
2001
2002
2003
Revol ver
2004 Seni or A
2005
2006
Seni or B
2007 Seni or C
2008
2009
Seni or D
NewCo financial summary
HY Discount Note
Equity
200
1.880,0
Senior A
Revenue growth
EBITDA margin EBITA EBITA margin
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1.437,5
1.653,1
1.901,1
2.186,3
2.251,8
2.319,4
2.389,0
2.460,7
2.610,5
15,0%
15,0%
15,0%
15,0%
3,0%
3,0%
3,0%
3,0%
2.534, 5 3,0%
215,6
248,0
285,2
327,9
337,8
347,9
358,3
369,1
380,2
391,6
15,0%
15,0%
15,0%
15,0%
15,0%
15,0%
15,0%
15,0%
15,0%
15,0%
85,3
136,1
185,7
235,5
248,4
258,6
266,8
273,3
293,2
299,6
5,9%
8,2%
9,8%
10,8%
11,0%
11,2%
11,2%
11,1%
11,6%
11,5% 174,7
3,0%
Equity - management
0,0%
0,0
0,0%
Net Income
(176,7)
(133,5)
(96,3)
(54,9)
(39,3)
(23,6)
(24,9)
152,4
168,9
Equity - LBO sponsors
80,0%
908,1
77,1%
NI margin
(12,3%)
(8,1%)
(5,1%)
(2,5%)
(1,7%)
(1,0%)
(1,0%)
6,2%
6,7%
6,7%
5,0%
53,4
4,5%
64,7
74,4
85,5
98,4
101,3
104,4
107,5
110,7
114,1
117,5
1.178
100,0%
Equity - other Total Sources of Funds
1.978
Capex % revenue Cash from Operations
IRR to LBO Sponsors
4,5%
4,5%
4,5%
4,5%
4,5%
4,5%
4,5%
4,5%
4,5%
4,5%
119,8
142,7
165,7
197,8
237,0
252,6
255,0
270,3
279,1
291,3
% revenue
8,3%
8,6%
8,7%
9,0%
10,5%
10,9%
10,7%
11,0%
11,0%
11,2%
Unlevered FCF
108,4
118,0
125,6
139,4
169,5
172,7
171,8
177,0
178,9
184,7
8,8%
6,4%
11,0%
21,6%
1,9%
(0,6%)
3,0%
1,1%
3,3%
Unlevered FCF growth Exit in Year
EBITDA Multiple:
2003
2004
2005
2006
12,0x
28,9%
27,7%
23,4%
20,5%
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
13,0x
33,7%
31,1%
25,8%
22,5%
Senior debt
743,3
683,3
611,5
510,4
471,9
332,0
192,9
228,0
189,2
145,8
14,0x
38,3%
34,1%
28,1%
24,2%
Other debt
139,7
146,9
154,7
173,5
94,3
103,0
103,0
23,2
23,2
23,2
Total debt
883,0
830,1
766,2
683,9
566,2
435,0
295,9
251,2
212,4
169,0
Cash
(20,0)
(20,0)
(20,0)
(20,0)
(20,0)
(20,0)
(20,0)
(20,0)
(20,0)
(20,0)
Net debt
863,0
810,1
746,2
663,9
546,2
415,0
275,9
231,2
192,4
149,0
0,0
0,0
0,0
0,0
0,0
0,0
0,0
0,0
0,0
0,0
720,0
784,2
854,9
929,3
IRR to PIK Holders Exit in Year EBITDA Multiple:
Capitalization
2003
2004
2005
2006
12,0x
52,9%
43,6%
35,6%
30,6%
Equity
1.011,5
888,7
804,1
762,0
736,6
728,3
13,0x
56,6%
46,1%
37,4%
31,9%
Total cap, net
1.874,4
1.698,8
1.550,3
1.425,8
1.282,8
1.143,3
995,9
1.015,3
60,2%
48,5%
39,2%
33,3%
Net debt / total cap
46,0%
47,7%
48,1%
46,6%
42,6%
36,3%
27,7%
22,8%
1.047, 3 18,4%
1.078,2
14,0x
3,6x
2,9x
2,3x
1,7x
1,5x
1,2x
0,7x
0,6x
0,5x
0,4x
(9,4x)
(22,9x)
35,2x
8,2x
6,1x
4,4x
2,6x
0,8x
0,7x
0,6x
4,2x
3,5x
2,8x
2,2x
1,9x
1,4x
1,0x
0,7x
0,6x
0,5x
(11,0x)
(27,5x)
43,3x
10,6x
7,7x
5,5x
3,7x
1,0x
0,8x
0,6x
(6,2x)
(8,1x)
(11,9x)
(24,1x)
(30,9x)
(38,5x)
(45,9x)
1,7x
1,3x
1,0x
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2,3x
2,8x
3,4x
4,2x
4,7x
6,0x
7,7x
9,7x
11,2x
12,6x
(0,9x)
(0,4x)
0,2x
0,9x
1,1x
1,6x
2,1x
7,2x
8,6x
9,6x
2,4x
2,8x
3,4x
4,3x
4,8x
6,0x
7,7x
9,7x
11,2x
12,6x
MI + Existing Pref. Cap.
Senior debt / EBITDA IRR to Mezzanine Holders
Senior debt / EBIT Exit in Year
EBITDA Multiple:
Total debt / EBITDA
2003
2004
2005
2006
12,0x
65,5%
53,4%
36,8%
31,7%
13,0x
69,9%
56,3%
39,3%
33,7%
14,0x
74,1%
59,1%
41,6%
35,5%
IRR to Other Ordinary Shareholders
Copyright © 2009. Diplomica Verlag. All rights reserved.
Credit ratios EBITDA / interest exp
Exit in Year EBITDA Multiple:
Total debt / EBIT Total debt/(EBIT-capex)
13,8%
EBIT / interest exp
2003
2004
2005
2006
12,0x
31,5%
29,7%
24,9%
21,8%
EBIT / senior interest
(1,2x)
(0,5x)
0,3x
1,3x
1,7x
2,4x
3,9x
12,8x
13,7x
16,7x
13,0x
36,5%
33,1%
27,4%
23,7%
EBIT / cash interest
(0,9x)
(0,4x)
0,2x
0,9x
1,2x
1,6x
2,1x
7,2x
8,6x
9,6x
14,0x
41,1%
36,2%
29,7%
25,5%
(EBITDA-capex) / cash int.
1,7x
2,0x
2,4x
3,0x
3,4x
4,2x
5,4x
6,8x
7,8x
8,8x
EBITDA / cash interest
83
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