LEVERAGED RECAPITALIZATIONS

During the latter half of the 1980s, leveraged recapitalizations (recaps) emerged as a popular response of U.S. companies to the increasingly competitive operating environment. In a leveraged recapitalization, a firm replaces the majority of its equity with a package of debt securities consisting of both senior bank debt and subordinated debentures. Although these transactions could be either defensive or preemptive maneuvers, the vast majority of leveraged recapitalizations were employed as defensive tactics to ward off hostile takeovers. The financial leveraging of the firm discouraged corporate raiders who could no longer borrow against the assets of the target firm to finance the acquisition.

Candidates for a leveraged recapitalization should have a relatively debt-free capital structure, steady and predictable cash flows, and an experienced and capable management team. The majority of firms undertaking these transactions are in mature, slow growth, non-technology-based industries that do not require substantial ongoing capital expenditures to remain competitive.

TYPES OF LEVERAGED
RECAPITALIZATIONS

There are two generic categories of leveraged recapitalizations: leveraged cashouts and leveraged share repurchases. A leveraged cashout (LCO) involves a debt-financed special dividend paid by a firm to its shareholders. In addition, existing shareholders also receive a "stub," a stock certificate that represents ownership in the restructured company. Since the stubs are publicly traded, shareholders continue to have the opportunity to share in the future gains (or losses) of the firm. LCOs also allow management to increase their proportional shareholdings instead of receiving the cash payout.

In a leveraged share repurchase (LSR), the company repurchases a significant percentage of its common stock through a tender offer in a transaction financed with bank and/or high-yield debt. Like the LCO, an LSR replaces outside equity with debt that has the impact of significantly increasing the financial leverage of the firm. Assuming that the firm is able to earn a return on its operating assets greater than the after-tax cost of debt, LSRs should result in higher earnings per share due to the reduction in the number of shares outstanding after the transaction. Whether this, in turn, increases the market value of the company's common stock depends upon how the market assesses the new level of risk in the company's capital structure.

The structure of leveraged recapitalization transactions is similar to that employed in leveraged buyouts (LBOs). In both cases, the firm significantly increases its financial leverage, and senior managers/employees generally receive additional equity ownership in the corporation. The tax shields associated with the interest expense of the additional debt used to finance the transactions are one source of additional value. Moreover, the additional equity interests of managers and employees should improve incentives to enhance productivity since the new organizational structure more closely links managerial rewards to employee performance. Both LBOs and recaps are accompanied by a restructuring in which the company sells off assets that are redundant or no longer a strategic fit in order to reduce debt. Studies of leveraged recapitalization announcements indicate that these transactions, like leveraged buyouts, are associated with increases in firms' stock prices. Furthermore, the wealth of bondholders declines because of the additional debt in the capital structure, but not by a significant amount.

Leveraged recapitalizations, however, differ from LBOs in a number of fundamental ways. First, following a leveraged recapitalization, the firm remains publicly traded. This differs from an LBO in which the firm is taken private. With a recap, the company continues to incur the costs of providing information to shareholders as well as the expenses associated with satisfying reporting requirements of the Securities and Exchange Commission for publicly held firms. Second, companies that undertake leveraged recapitalizations still maintain access to the public capital markets that may permit these firms to raise capital on more attractive terms than private firms. Third, in comparison to leveraged recapitalizations, leveraged buyouts may impose costs on managers by forcing managers to hold portfolios that are poorly diversified and/or illiquid due to reduced share marketability of the nonpublic shares. Thus, there is less potential for costly disagreements among stockholders in a recap since shareholders can readily sell their holdings if they disagree with corporate policies.

LEVERAGED RECAPITALIZATIONS AND
OPERATING PERFORMANCE

Financial theory suggests that leveraged recapitalizations should result in greater operating efficiency. First, corporate managers' percentage of ownership normally increases in LCOs because executives receive new shares of equivalent value in lieu of cash. Consequently, managers have a reduced incentive to take advantage of corporate perquisites (such as large expense accounts or support staffs) in a manner that reduces corporate profitability. The additional equity ownership also provides performance incentives to managers and employees since their economic well-being is now more closely linked to the firm's performance. Second, the debt taken on in leveraged recapitalizations effectively compels management to pay out future free cash flows. Accordingly, these transactions reduce the cash flow available for discretionary spending making it less likely that management will spend money on subpar investment projects. Third, high levels of financial leverage have a powerful disciplining effect since default on the debt could cost managers their managerial independence and even their jobs. Risk-averse managers, fearing the high debt level of the newly recapitalized company, should have a strong motivation to generate additional cash flows.

The principal disadvantage associated with these transactions is the risk incurred from the large amount of debt. In considering a recap, the company must ensure that its cash flows are sufficient to service the additional debt. In order to meet its debt obligations, a highly leveraged company needs steady and predictable cash flows. A firm that encounters cash flow problems jeopardizes its future operating flexibility, and may be forced to sell assets or declare bankruptcy. Therefore, following a recapitalization, management needs to focus on the fundamentals of the business, selling underperforming or underutilized assets and paying down debt quickly.

Empirical studies indicate that managers significantly improve their management of the firm's working capital after undertaking a leveraged recapitalization. Managers substantially decrease days of sales outstanding and improve inventory turnover. In addition, firms are able to generate more sales per dollar of assets. The results for profitability measures that are calculated before interest expense indicate that both the operating return on assets and operating profit margin increase. This suggests that firms increase their gross profit margins and reduce their selling, general, and administrative expense following recapitalizations.

Improvement in postrecapitalization cash flows, however, appears to be achieved at the expense of long-term viability. Following recaps, firms experience significant decreases in sales and capital expenditures reflecting lower levels of discretionary investment spending and asset sales. This reduction in capital expenditures could have negative implications for the long-term value of these firms.