Prof. Ian Giddy, New York University
Leveraged Recapitalization is a strategy where a company takes on significant additional debt with the purpose of either paying a large dividend or repurchasing shares. The result is a far more financially leveraged company -- usually in excess of the "optimal" debt capacity. After the large dividend has been paid, the market value of the shares will drop. A share is referred to as a "stub" when a financial recap results in the decline if its price to 25% or less of its previous market value. In a successful recap the value of the dividend plus the value of the stub exceeds the pre-recap share price.
The simplest measure of value added comes from the tax shield gained when a firm, which has debt capacity resulting from free cash flows in excess of ongoing needs, increases its leverage. The classic Modigliani-Miller calcuation of the present value of the tax shield is obtained by multiplying the amount of debt by the tax rate of the firm. Other results of leverage include the disciplinary effects of having to meet debt service payments, and the possible negative effects of the costs of financial distress.
The technique can be used, and has been used, as a "shark repellant" to ward off a hostile takeover, actual or potential. This is done by adding debt, eliminating idle cash and debt capacity. Prospective bidders would face the daunting task of returning the firm to leverage ratios closer to historical industry levels. The recap may also give management a higher percentage of share ownership and control. Although such recaps are designed as a takeover defense, a high percentage of firms that adopt them are subsequently acquired. The technique can also be employed proactively, as a means of placing free cash flows into shareholders' hands, and employing debt's disciplinary effect to improve performance, thus increasing shareholder value. A related motivation is giving a founder-owner liquidity.
The market response to announcements of leveraged recaps depends on whether they are defensive or proactive. For defensive recaps, the effects are so varied -- negative as well as positive -- as to make research results inconclusive. On average the effects seem to be positive (Gupta and Rosenthal, 1991). Long run returns in excess of expected for proactive recaps seem to be of the order of 30%, similar to the level in tender offers. (But for a negative view, see " Debtor's Prison? ")
In the case of Sealed Air's leveraged recap (HBS Case 9-294-122) , management purposefully and successfully used the leveraged recapitalization as a watershed event, creating a crisis that disrupted the status quo and promoted internal change, which included establishing a new objective, changing compensation systems, and reorganizing manufacturing and capital budgeting processes. This case provides an illustration of how financing decisions affect organizational structure, management decision making, and firm value.
As Sealed Air suggests, the critical feature in both kinds of recaps is whether other operating improvements are made. A key indicator of whether leverage is having the desired disciplinary effect is the post-recap balance sheet progress. When successful, the large overhang of debt service obligations galvanizes management to improve operational performance thus generating sufficient cash flows to pay down the debt.
Exchange Offers involve giving one or more classes of claimholders the option to trade their holdings for a different class of securities of the firm. Typical examples are allowing common shareholders to exchange their shares for bonds or preferred stock, or vice-versa. Exchange offers may have motivations similar to those of leveraged recapitalizations, taking advantage of free cash flows or altering management's share of control, or they may be distress-induced workouts.
Most of us would suppose that nobody would elect to exchange one security for another unless the latter was more valuable than the first, giving the investor a positive return. Yet according to research studies, some types of exchange offers result in negative returns, while others produce positive net returns. The effects seem to depend on whether the exchanges have one or more of the following consequences:
Based on these, one should be able to evaluate the net effect, positive or negative, of the following types of exchange offers:
Dual-Class Recapitalizations entail the creation of a second
class of common stock that has limited voting rights but typically a preferential
claim on the company's cash flows, in the form of a higher dividend. For example,
the company proposes to create a Class A share with one-share-one-vote, and
Class B with 5 votes per share. Class A shares carry a higher dividend rate
than Class B, perhaps double. As a result of a DCR, officers and directors
will usually end up with 55 to 65 percent of common stock voting rights. In
a high percentage of dual-class firms, the control group represents founding
families or their decendants. In most cases the firm creates the new class
by distributing limited voting shares pro rata to current shareholders. These
shareholders can then, if they choose, sell the limited-right shares to the
public, thus securing liquidity without sacrificing control -- a motivation
typical of closely held businesses in transition.