Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 34

Brealey−Meyers: Principles of Corporate Finance, Seventh Edition X. Mergers, Corporate Control, and Governance 34. Control Governance, and Financial Architecture © The McGraw−Hill Companies, 2003 C H A P T E R T H I R T Y - F O U R C O N T R O L , GOVERNANCE, AND F I N A N C I A L ARCHITECTURE 962 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition X. Mergers, Corporate Control, and Governance 34. Control Governance, and Financial Architecture © The McGraw−Hill Companies, 2003 FIRST, SOME DEFINITIONS. Corporate control means the power to make investment and financing de-cisions. A hostile takeover bid is an attempt to force a change in corporate control. In popular usage, corporate governance refers to the role of the board of directors, shareholder voting, proxy fights, and to other actions taken by shareholders to influence corporate decisions. In the last chapter we saw a striking example: Pressure from institutional shareholders helped force AMP Corporation to abandon its legal defenses and accept a takeover. Economists use the term governance more generally to cover all the mechanisms by which man-agers are led to act in the interests of the corporation’s owners. A perfect system of corporate gov-ernance would give managers all the right incentives to make value-maximizing investment and fi-nancing decisions. It would assure that cash is paid out to investors when the company runs out of positive-NPV investment opportunities. It would give managers and employees fair compensation but prevent excessive perks and other private benefits. This chapter considers control and governance in the United States and other industrialized countries. It picks up where the last chapter left off—mergers and acquisitions are, after all, changes in corporate control. We will cover other mechanisms for changing or exercising control, including leveraged buyouts (LBOs), spin-offs and carve-outs, and conglomerates versus private equity partnerships. The first section starts with yet another famous takeover battle, the leveraged buyout of RJR Nabisco. Then we move to a general evaluation of LBOs, leveraged restructurings, privatizations, and spin-offs. The main point of these transactions is not just to change control, although existing management is often booted out, but also to change incentives for managers and improve finan-cial performance. Section 34.3 looks at conglomerates. “Conglomerate” usually means a large, public company with operations in several unrelated businesses or markets. We ask why conglomerates in the United States are a declining species, while in some other countries, for example Korea and India, they seem to be the dominant corporate form. Even in the United States, there are many successful temporary conglomerates, although they are not public companies.1 Section 34.4 shows how ownership and control vary internationally. We use Germany and Japan as the main examples. There is a common theme to these three sections. You can’t think about control and governance without thinking still more broadly about financial architecture, that is, about the financial organiza-tion of the business. Financial architecture is partly corporate control (who runs the business?) and partly governance (making sure managers act in shareholders’ interests). But it also includes the le-gal form of organization (e.g., corporation vs. partnership), sources of financing (e.g., public vs. pri-vate equity), and relationships with financial institutions. The financial architectures of LBOs and most public corporations are fundamentally different. The financial architecture of a Korean conglomerate (a chaebol) is fundamentally different from a conglomerate in the United States. Where financial ar-chitecture differs, governance and control are different too. Much of corporate finance (and much of this book) assumes a particular financial architecture— that of a public corporation with actively traded shares, dispersed ownership, and relatively easy ac-cess to financial markets. But there are other ways to organize and finance a business. Arrangements for ownership and control vary greatly country by country. Even in the United States many success-ful businesses are not corporations, many corporations are not public, and many public corporations have concentrated, not dispersed, ownership. 1What’s a temporary conglomerate? Sorry, you’ll have to wait for the punch line. 963 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition X. Mergers, Corporate Control, and Governance 34. Control Governance, and Financial Architecture © The McGraw−Hill Companies, 2003 964 PART X Mergers, Corporate Control, and Governance 34.1 LEVERAGED BUYOUTS, SPIN-OFFS, AND RESTRUCTURINGS Leveraged buyouts differ from ordinary acquisitions in two immediately obvious ways. First, a large fraction of the purchase price is debt-financed. Some, often all, of this debt is junk, that is, below investment-grade. Second, the LBO goes private, and its shares no longer trade on the open market.2 The LBO’s stock is held by a partnership of (usually institutional) investors. When this group is led by the com-pany’s management, the acquisition is called a management buyout (MBO). In the 1970s and 1980s many management buyouts were arranged for un-wanted divisions of large, diversified companies. Smaller divisions outside the companies’ main lines of business sometimes lacked top management’s interest and commitment, and divisional management chafed under corporate bureau-cracy. Many such divisions flowered when spun off as MBOs. Their managers, pushed by the need to generate cash for debt service and encouraged by a sub-stantial personal stake in the business, found ways to cut costs and compete more effectively. In the 1980s MBO/LBO activity shifted to buyouts of entire businesses, including large, mature public corporations. Table 34.1 lists the largest LBOs of the 1980s plus examples of transactions from 1997 to 2001. More recent LBOs are generally smaller and not leveraged as aggressively as the deals of the 1980s. But LBO activity is still im-pressive in aggregate: Buyout firms raised over $60 billion in new capital in 2000.3 Acquirer KKR KKR KKR Thompson Co. Wings Holdings KKR TF Investments Macy Acquisitions Corp. Bain Capital Cyprus Group, with management* Clayton, Dubilier, & Rice Berkshire Partners Heartland Industrial Partners Target RJR Nabisco Beatrice Safeway Southland (7-11) NWA, Inc. Owens-Illinois Hospital Corp of America R. H. Macy & Co. Sealy Corp. WESCO Distribution, Inc. North American Van Lines William Carter Co. Springs Industries Industry Food, tobacco Food Supermarkets Convenience stores Airlines Glass Hospitals Department stores Mattresses Data communications Trucking Children’s clothing Household textiles Year Price 1989 $24,720 1986 6,250 1986 4,240 1987 4,000 1989 3,690 1987 3,690 1989 3,690 1986 3,500 1997 811 1998 1,100 1998 200 2001 450 2001 846 TABLE 34.1 The 10 largest LBOs of the 1980s, plus examples of more recent deals. Price in $ millions. *Management participated in the buyout—a partial MBO. Source: A. Kaufman and E. J. Englander, “Kohlberg Kravis Roberts & Co. and the Restructuring of American Capitalism,” Business History Review 67 (Spring 1993), p. 78; Mergers and Acquisitions 33 (November/December 1998), p. 43, and various later issues. 2Sometimes a small stub of stock is not acquired and continues to trade. 3LBO Signposts, Mergers & Acquisitions, March 2001, p. 24. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition X. Mergers, Corporate Control, and Governance 34. Control Governance, and Financial Architecture © The McGraw−Hill Companies, 2003 CHAPTER 34 Control, Governance, and Financial Architecture 965 Table 34.1 starts with the largest, most dramatic, and best-documented LBO of all time: the $25 billion takeover of RJR Nabisco by Kohlberg, Kravis, Roberts (KKR). The players, tactics, and controversies of LBOs are writ large in this case. RJR Nabisco On October 28, 1988, the board of directors of RJR Nabisco revealed that Ross John-son, the company’s chief executive officer, had formed a group of investors that was prepared to buy all RJR’s stock for $75 per share in cash and take the company private. Johnson’s group was backed up and advised by Shearson Lehman Hutton, the investment banking subsidiary of American Express. RJR’s share price imme-diately moved to about $75, handing shareholders a 36 percent gain over the pre- vious day’s price of $56. At the same time RJR’s bonds fell, since it was clear that existing bondholders would soon have a lot more company.4 Johnson’s offer lifted RJR onto the auction block. Once the company was in play, its board of directors was obliged to consider other offers, which were not long in coming. Four days later KKR bid $90 per share, $79 in cash plus PIK preferred val- ued at $11. (PIK means “pay in kind.” The preferred dividends would be paid not in cash but in more preferred shares.)5 The resulting bidding contest had as many turns and surprises as a Dickens novel. In the end it was Johnson’s group against KKR. KKR offered $109 per share, after adding $1 per share (roughly $230 million) in the last hour.6 The KKR bid was $81 in cash, convertible subordinated debentures valued at about $10, and PIK pre-ferred shares valued at about $18. Johnson’s group bid $112 in cash and securities. But the RJR board chose KKR. Although Johnson’s group had offered $3 per share more, its security valuations were viewed as “softer” and perhaps overstated. The Johnson group’s proposal also contained a management compensation package that seemed extremely generous and had generated an avalanche of bad press. But where did the merger benefits come from? What could justify offering $109 per share, about $25 billion in all, for a company that only 33 days previously was selling for $56 per share? KKR and the other bidders were betting on two things. First, they expected to generate billions in additional cash from interest tax shields, reduced capital expenditures, and sales of assets not strictly necessary to RJR’s core businesses. Asset sales alone were projected to generate $5 billion. Second, they ex-pected to make the core businesses significantly more profitable, mainly by cutting back on expenses and bureaucracy. Apparently there was plenty to cut, including the RJR “Air Force,” which at one point included 10 corporate jets. In the year after KKR took over, new management was installed that sold assets and cut back operating expenses and capital spending. There were also layoffs. As expected, high interest charges meant a net loss of $976 million for 1989, but pre-tax operating income actually increased, despite extensive asset sales, including the sale of RJR’s European food operations. Inside the firm, things were going well. But outside there was confusion, and prices in the junk bond market were rapidly declining, implying much higher future 4N. Mohan and C.R. Chen track the abnormal returns of RJR securities in “AReview of the RJR Nabisco Buyout,” Journal of Applied Corporate Finance 3 (Summer 1990), pp. 102–108. 5See Section 25.8. 6The whole story is reconstructed by B. Burrough and J. Helyar in Barbarians at the Gate: The Fall of RJR Nabisco, Harper & Row, New York, 1990—see especially Ch. 18—and in a movie with the same title. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition X. Mergers, Corporate Control, and Governance 34. Control Governance, and Financial Architecture © The McGraw−Hill Companies, 2003 966 PART X Mergers, Corporate Control, and Governance interest charges for RJR and stricter terms on any refinancing. In mid-1990 KKR made an additional equity investment, and in December 1990 it announced an offer of cash and new shares in exchange for $753 million of junk bonds. RJR’s chief fi- nancial officer described the exchange offer as “one further step in the deleveraging of the company.”7 For RJR, the world’s largest LBO, it seemed that high debt was a temporary, not permanent, virtue. RJR, like many other firms that were taken private through LBOs, enjoyed only a short period as a private company. In 1991 RJR went public again with the sale of $1.1 billion of stock.8 KKR progressively sold off its investment, and its remaining stake in the company was sold in 1995 at roughly the original purchase price. Barbarians at the Gate? The RJR Nabisco LBO crystallized views on LBOs, the junk bond market, and the takeover business. For many it exemplified all that was wrong with finance in the 1980s, especially the willingness of “raiders” to carve up established companies, leaving them with enormous debt burdens, basically in order to get rich quick. There was plenty of confusion, stupidity, and greed in the LBO business. Not all the people involved were nice. On the other hand, LBOs generated enormous in-creases in market value, and most of the gains went to the selling stockholders, not to the raiders. For example, the biggest winners in the RJR Nabisco LBO were the company’s stockholders. The most important sources of added value came from making RJR Nabisco leaner and meaner. The company’s new management was obliged to pay out mas-sive amounts of cash to service the LBO debt. It also had an equity stake in the busi-ness and therefore had strong incentives to sell off nonessential assets, cut costs, and improve operating profits. LBOs are almost by definition diet deals. But there were other motives. Here are some of them. The Junk Bond Markets LBOs and debt-financed takeovers may have been driven by artificially cheap funding from the junk bond markets. With hindsight, it seems that investors in junk bonds underestimated the risks of default in junk bonds. Default rates climbed painfully from 1988 through 1991, when 10 percent of outstanding junk bonds with a face value of $18.9 billion defaulted.9 The junk bond market also became much less liquid after the demise in 1990 of Drexel Burn-ham, the chief market maker, although the market recovered in the mid-1990s. Leverage and Taxes Borrowing money saves taxes, as we explained in Chapter 18. But taxes were not the main driving force behind LBOs. The value of interest tax shields was just not big enough to explain the observed gains in market value.10 7G. Andress, “RJR Swallows Hard, Offers $5-a-Share Stock,” The Wall Street Journal, December 18, 1990, pp. C1–C2. 8Northwest Airlines, Safeway Stores, Kaiser Aluminum, and Burlington Industries are other examples of LBOs that reverted to being public companies. 9See R. A. Waldman, E. I. Altman, and A. R. Ginsberg, “Defaults and Returns on High Yield Bonds: Analysis through 1997,” Salomon Smith Barney, New York, January 30, 1998. See also Section 24.5. 10Moreover, there are some tax costs to LBOs. For example, selling shareholders realize capital gains and pay taxes that otherwise could be deferred. See L. Stiglin, S. N. Kaplan, and M. C. Jensen, “Effects of LBOs on Tax Revenues of the U.S. Treasury,” Tax Notes 42 (February 6, 1989), pp. 727–733. ... - tailieumienphi.vn