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A tale of two eras.

THE 1980s were characterized by heightened merger and acquisition (MA) activity and the increased us of debt (D)--the MAD period. These activities peaked in 1988 and have been essentially reversed since 1989, a period characterized by financial restructuring (R), equitizing (E), and contracting (C) businesses--the REC period. This paper will describe these two eras, their causes, and their economic implications.


During the decade of the 1980s, substantial shifts in business and financial strategies took place, reflecting in part changes in the economic and financial environment. According to the Federal Reserve Flow of Funds data, debt patterns for the major sectors (Federal, State and Local, Business, Household) during the period 1977-92 varied within time segments. During 1977-92, U.S. federal government debt increased at a compound annual rate of 11.9 percent, more than 38 percent higher than the 8.6 percent compound annual growth rate in business debt for the same years.

The federal government share of total nonfinancial debt grew from about 20 percent to 26 percent during 1977-92, whereas the share of business debt declined from about 37 percent to 31 percent. The leveraging of the 1980s was much higher for governments and households than for business. The so-called leveraging of America, the debt binge of the 1980s, is therefore even more applicable to the other sectors.

Business Debt Patterns

Turning to the composition of business debt, credit market debt represents about 65 percent of total liabilities. It excludes trade debt, which is generally larger than bank loans outstanding by a factor of 135-150 percent. Credit market debt, therefore, represents a relatively broad measure of business obligations, but it is available only on a net basis rather than a gross basis. The net credit market debt of U.S. nonfinancial corporate business increased by $1.2 trillion during the years 1980-88, an average annual increase of $134 billion. But this metric masks some important patterns within the decade. Table 1 shows that the years 1984-88 were the years of the largest increase in issuance and in debt outstanding. In constant dollars, the average annual net credit market debt issuance was relatively small for other time segments and was actually negative for 1989-92.
Table 1
Changes in Net Credit Market Debt, 1970-92
(Dollars in Billions)

 Period Sum Annual Average
Year Current $ Constant $ Current $ Constant $

1970-79 474 227 47 23
1980-83 300 36 75 9
1984-88 905 666 181 133
1980-88 1205 702 134 78
1989-92 314 -13 78 -3

Source: Flow of Funds, Balance Sheets, C.9, 3/10/93, pp. 35-37

Significant changes were also taking place in the types of net credit market debt sources. Compared with the decade of the 1970s, the share of corporate bonds remained about constant at somewhat less than 50 percent of the total. Bank loans declined from a 31 percent share of net credit market debt (NCMD) outstanding in 1982 to only 22 percent by 1992.

Another dimension of the role of debt during the 1980s is measured by changes in leverage ratios. Leverage can be measured by the use of balance sheet data for the ratios of debt to equity or by income statement data using the ratio of interest expense to cash flows. The flow of funds data permit equity or net worth to be calculated on three bases: historical costs (book), current cost estimates of assets, and the market value of equities.

Based on historical costs, total liabilities rose from 76 percent of equity in 1980 to 132 percent by 1989. Using the current cost estimate of net worth, the leverage ratio during the same period rose from about 45 percent to approximately 78 percent. When the market values of equities are employed in the denominator, the leverage ratio remains essentially unchanged at about $1 of liabilities to $1 of market value of equities. Thus the rising trend of equity values during the 1980s neutralized the rising dollar values of liabilities incurred by nonfarm, nonfinancial corporations.

When measured by the ratio of interest expense to cash flow, the leverage trend was upward during the 1980s. The ratio of interest payments to cash flow rose from 0.16 in 1980 to a peak of 0.25 by 1990. For noncorporate business as a whole, concerns about the use of debt may have been exaggerated. However, it is clear from the data that the ratio of interest expense to cash flows indeed increased. Also, for individual companies, particularly those engaged in leveraged buyouts and defensive recapitalizations, debt ratios rose to substantial levels, as high as 800 to 900 percent. Reasons for the Increased Use of Debt

Most important was the favorable economic climate, characterized by a period of relative stability and sustained economic growth. Of all of the factors influencing the debt versus equity choice, the sales and profitability prospects for an industry and the firms in it are likely to be a major determinant. These influences were further reinforced by the tax laws and tax law changes during the 1980s. The tax laws favor debt over equity in that debt interest is a deductible expense for tax purposes, but dividends from common stock are not. Lower capital gains rates encouraged earnings retention. But the Tax Reform Act of 1986 (TRA) substantially reduced the preferential capital gains tax treatment for retained earnings. TRA also reduced personal income-tax rates, which mitigated the tax burden on interest payment recipients. Also nondebt tax shields such as accelerated depreciation were reduced, making the use of debt tax shields more desirable. Clearly, the tax laws after TRA further favored the use of debt financing.

In addition, debt was used to help finance takeovers, and the leverage employed after a takeover usually increased. High-yield debt represented about one-fourth of new public debt issues for the peak period 1986-88 |Altman, 1993, p. 108~. The ability of raiders to borrow to buy firms changed the fundamental nature of the takeover game. All firms, no matter how large, became subject to takeover. The level of takeover activity increased during the 1980s, so that the associated debt financing increased as well.

Perhaps of equal significance, many firms increased their debt levels as a defensive measure against takeovers. In extreme cases, firms engaged in leveraged recapitalizations, incurring substantial increases in debt and paying large dividends as a form of a scorched earth policy to avoid takeovers. In addition, leveraged buyouts used debt-to-equity ratios as high as 900 percent with cash flow coverage of interest obligations exceeding one to one only under relatively optimistic assumptions about the future state of the economy. The relatively narrow interest spread between investment grade and noninvestment grade debt further favored highly leveraged transactions (HLTs). M&A activity, which also stimulated the use of debt, increased during the 1980s in all of the developed countries of the world and peaked in the U.S. during 1984-89, as shown in Table 2.
Table 2
Merger Activity and LBOs
(Dollars in Billions)

 Total M&As LBOs Ratio
 Annual Annual of LBOs
Years Total Average Totals Average to M&As

1981-83 210 70 12.0 4.0 5.7%
1984-89 1107 185 157.0 26.2 14.2%
1990-92 274 91 19.2 6.4 7.0%

Sources: Merrill Lynch, Mergerstat Review, various issues, and
Securities Data Co., M&A Magazine.

The reasons for the growth in M&As during the 1980s, may be summarized as follows:

1. Competitive pressures: international--rise of foreign competitors; technology-competition between industries; increased consumer discretionary income and competition between uses of funds.

2. Turbulent economic environment and need to adapt to change and new markets. Round out product lines and strengthen market position. Complementary products or production processes.

3. Changing manufacturing methods--shift from economies of scale to flexible manufacturing systems and economies of scope. Oil shocks caused repeated adjustments in mix of production input factors.

4. Changed management methods. Changed management of human resources--from hierarchy to participative management.

5. Fluctuating exchange rates--changing prices of buying and selling goods and companies.

6. Deregulation accelerated in 1970s in airlines, banking, the S&L industry, other financial services, broadcasting, cable, communications, transportation, oil and gas. These industries accounted for almost one-half of all MA activities during the 1980s.

7. Innovations in financing methods that made most firms subject to takeovers. Use of below investment-grade debt. Layers of senior and subordinated debt financing.

8. Changed antitrust policy that recognized increased competition reflecting the above seven factors. Antitrust became more restrictive during the 1980s in the U.K. and in the EEC countries, yet MA activity increased.

9. Changes in tax policy, with revisions almost every year during the 1980s. Changed relations between corporate rates, personal tax rates, and capital gains tax rates.

10. Rising P/E ratios and stock prices beginning in mid-1982. Always associated with high MA activity. Helps offset mistakes if higher stock prices move company values generally upward.

11. Some firms had market values below their current replacement cost. Could add capacity more cheaply through a takeover than by plant and equipment outlays and expenses of building an organization.

12. Divestitures to record gains from pooling accounting. Recorded on books at historical accounting costs regardless of price paid. When sold at current values could record gains.

Excesses undoubtedly developed during the hectic 1980s. Particularly in the later stages of the MAD era, prices paid in acquisitions and leveraged buyouts were too high by reasonable criteria, making it unlikely that these investments would earn their required cost of capital. In addition, the world economic outlook changed. The initial uncertainties with respect to the Gulf War slowed consumer spending in the U.S. The subsequent dismantling of the Soviet Union and the end of the Cold War brought other adjustments. Defense expenditures declined substantially. The costs of German reunification were greater than expected. Relatively high interest rates persisted in Western Europe. The bursting of the Japanese bubble also took place. These factors caused the booming M&A activity to subside until a resurgence began in mid-1993. CHANGED FINANCIAL STRATEGIES AND POLICIES (REC)

The sluggishness in the economic environment that began in late 1989 (declared officially over at the end of the first quarter of 1991, but whose effects have not been fully resolved into 1993) had a number of impacts on business financial strategies and policies. The following were the major developments: (1) the return of equity issuance: (2) the decline in stock retirement activities; (3) diverse motives for new equity issues; (4) financial restructuring and interest costs; (5) the reduced role of commercial banks in business financing; (6) the shift in valuation attractiveness between the public (IPO) and private markets; and (7) growth of the derivatives markets.

Positive Net Equity Issuance

The average annual gross new equity issuance during 1991 and 1992 totaled some $64 billion. Net equity issuance over the same period totaled $22 billion. This amount is in contrast to the 1984-90 period when net equity retired totaled $641 billion. The main motive for the increase in gross equity issuance was the aim of deleveraging to improve the ratio of cash flows to interest expense. Business firms were attracted to the equity markets by the improvement in price-to-earnings ratios and in market-to-book ratios. Measured by the S&P 400 industrials over the period from early 1989 through the end of 1992, the price/earnings ratio moved from about 15 to 26; for all non financial corporations the market/book ratio rose from less than one before 1988 to 1.5 by 1992.


Comparing the annual averages in stock retirements for 1984-90 to 1991-92, the decline from mergers and acquisitions was from $61 billion to $16 billion per year and for leveraged buyouts from $24 billion to less than $1 billion per year. Stock repurchases peaked in 1988 at about $44 billion following the stock market crash in October 1987. The rate of stock repurchase activity during 1991-92 fell to about one-half peak levels. With high stock market levels in 1991 and 1992, the undervalued-stock motive for repurchases decreased. The lower pace of MA activity reduced the use of stock repurchases as a defense against takeovers. Surplus cash holdings stimulated a resurgence in share repurchase activity in 1993.

Multiple influences motivated new equity issuance. A sample of the fifty largest equity issues during 1991-92 totaled $30 billion |Remolona, et al., 1992-1993~. Firms with prior losses, seeking to maintain credit ratings for the sale of commercial paper under favorable terms, accounted for $13 billion. Another group totaling about $11 billion appeared to have the primary motive of deleveraging and included Time Warner, RJR Nabisco, and Sears Roebuck. Secondary offerings and repurchases totaled about $4 billion. Equity issues for expansion accounted for $2.25 billion, about 7.5 percent of the total. Financial Restructuring

Firms engaged in financial restructuring during 1991-92 in an effort to lower interest expense. The average retirement rate for the period 1970-86 was about 33 percent, about double that for the years 1987-92, during which the ten-year Treasury bond rate fell almost 200 basis points to 7.01 percent. Bond calls enabled firms to refinance at lower rates. For example, a sample of junk bonds called in 1991 resulted in a total weighted average reduction in coupons of 4.78 percentage points, a reduction from over 15 percent to slightly above 10 percent. The net effect of all refinancing for 1991-92 was $2.8 billion savings at an annual rate, but small compared with the direct effect of lower short-term rates, which represented savings at an annual rate of $27.3 billion |Remolona, et al., 1992-93~.

Methods of deleveraging took many forms. A basic method is to sell equity to retire debt or use direct equity-for-debt exchanges. Proceeds from the sales of assets were also used to retire debt. With lower interest rates, conditions were favorable for calling debt before maturity. The sale of a portion of the equity of a subsidiary could be used to retire debt of the parent. Special deals were also arranged, such as the sale of preferred stock to a supplier in return for a long-term purchasing agreement. The bankruptcy process was also used to scale down debt claims.

Maturity extensions increased interest expense at an annual rate of $3.5 billion during 1991-92. Two opposing corporate motives with respect to financial restructuring have been suggested. One, associated with financial managers, is to lower interest expenses. An alternative motive, associated with the chief executive or business economist, is to improve the long-run viability of the company. With debt refinancing at longer maturities, some interest savings may be sacrificed. However, longer-term debt financing enables the firm to formulate and put in place longer-term economic strategies. The argument is that sound strategies can produce profitability rates that will more than offset the savings foregone by moving from shorter-period financing to longer-period financing, even during a period when the yield curve has a relatively steep slope.

Financial Market Developments

Another development has been the resurgence of the initial public offering (IPO) market in 1991-93. Valuation relationships appear to have become more attractive in the public markets compared to the private markets represented by LBOs. The average annual gross proceeds of IPOs in 1991-92 were $32.5 billion, about 35 percent above the previous "hot" IPO markets of 1986-88 |Calian, 1993~. In contrast, M&A levels during the same 1991-92 period averaged about $85 billion, or 66 percent below their peak level of $247 billion in 1988. Reverse LBOs totaled $13.5 billion in 1991-92. The reverse LBOs in great measure used their funds to retire debt. The regular IPOs used only about one-fourth of their funds for debt retirement; the remainder was used almost equally for taking out existing shareholders and for "general corporate purposes" |Remolona, et al., 1992-93~.

Of great significance is the growth in the use of financial derivatives. Financial derivatives are contracts such as puts, calls, futures or forwards, and swaps whose values depend upon the prices of other assets or prices. The total amount of financial derivatives outstanding worldwide reached $10 trillion by the end of 1991 |Remolona, 1992-93~. This has raised concerns about a huge market created without adequate monitoring and protections.

But the role of derivatives should be seen as a positive rather than a negative financial innovation. Derivatives are created to manage existing risks. Because firms have exposures to fluctuations in commodity prices, in interest rates, changes in exchange rates, and from the relative maturity structure of assets and liabilities, derivatives are generated to manage or control these risks. Interest rate swaps, for example, enable a firm to convert a pattern of interest payment requirements to one that is more desirable from the standpoint of the firm's expected revenues and costs. In this way, the vulnerability of firms to interest rate and price fluctuations should be mitigated. However, derivatives do not enable a firm to manage risks arising from competition in prices, product quality, costs, marketing effectiveness, etc. These are areas critical to a firm's relative competitive advantage in the product markets in which it operates.

On balance, financial policies since 1989 have strengthened the viability of business firms and have made balance sheet positions as well as interest coverages less vulnerable to economic declines.


The 1980s were the decade of M&As, LBOs, and the associated leveraging. The decade had both positive and negative aspects as listed below:

Positive Aspects of M&A Activity

1. On average, targets gained, bidders lost; in total, gains were positive. Thus overall, value was created.

2. Postmerger performance has been improved. Empirical studies show that asset management improved without adverse affect on plant and equipment expenditures or R&D outlays.

3. The subsequent imitation by other companies of improved management of assets is evidence that these practices were sound and not simply financial manipulation.

4. Assets that did not fit or were not managed well were divested to buyers with better fit.

5. Many firms particularly of medium and small size could not qualify for investment-grade financing. High-yield debt filled a financing gap for such companies.

6. Increased ownership stake by managers resulted, especially in LBOs.

7. M&As helped solve the corporate governance problem by strengthening the market for corporate control. In some cases, management improved.

8. Recent efforts by institutional investors and outside board members to change top executives are evidence that corporate governance controls needed to be strengthened.

Negative Aspects of M&A Activity

1. Considerable management time was diverted to fend off potential raiders. Also increased use of debt mainly to prevent takeovers.

2. Defensive leverage recaps resulted in excessive debt. Firms whose bonds had carried prime credit ratings deteriorated to below investment grade.

3. Sometimes M&As did not solve the fundamental strategic problems of the industry, but merely represented financial manipulation. M&A activity by some firms pushed other firms to do the same defensively.

4. Some companies with good long-term strategies became vulnerable to takeover because short-term performance was depressed by investments for longer-term strategies.

5. Downsizing may represent a failure to solve underlying economic problems of firms and industries.

6. Sometimes short-term performance improvement was artificial because of reduced R&D and P&E outlays.

7. The development of antitakeover measures and poison pills could facilitate management entrenchment to avoid the fundamental improvements required.

Uncertainties and Unsolved Issues

1. Does increasing financial leverage contribute to improved firm performance or divert from it? Does high debt simply represent a willingness to bear more risk with insufficient consideration of cyclical downturns or even adverse longer-term developments?

2. Was executive talent diverted by financial restructuring from dealing with fundamental strategic industry problems?

A further criticism of the MAD activity of the 1980s is that funds were used to buy other companies rather than to make plant and equipment expenditures. Similarly, since 1989 funds have been used to retire debt. It is claimed that the alternative would have been to use the funds for plant and equipment activity that would increase output and provide jobs. Such arguments involve a fallacy. The funds used to pay for companies during the 1980s or to retire debt during the deleveraging period since 1989 did not evaporate. They were received by claimants and remained in the economic system. The earlier MAD or the subsequent deleveraging activities did not destroy funds.

The economic issues are more fundamental. The usual prescription for job creation is "increasing the rate of economic growth." But a feedback process is involved. If the U.S. is losing competitiveness in an increasing number of industries, the underlying problems cannot be solved by expansionary macroeconomic policies. Nor does downsizing or buying and selling companies address the basic problem.

The auto industry illustrates the issues. U.S. companies faced excess world auto capacity and produced cars whose price and quality resulted in market share and loss. U.S. auto firms have improved the relative price and quality of their products. recovering some loss of market share. Excess capacity in an industry is remedied by exit of the least efficient plants. The general principle applicable is that "shrinking the firm" is evidence of some noncompetitive operations: it is not a complete solution to the loss of market share. Macroeconomic policies may help deal with cyclical problems but do not solve inability to meet price and quality competition. (Some interaction effects and considerations of open access to markets require some qualifications, but the fundamental principles are not altered.)

Takeovers and mergers that have potentials for improving operations (improved products, better production processes, more efficient management of resources, etc.) have potentials for improving a firm's position in its industry and may enable the industry to expand its share of the economy and contribute to overall economic growth. Buying and selling companies without achieving improved performance may redistribute wealth, but may not necessarily increase value in the economy.

Most retrospective assessments of economic performance of the 1980s have acknowledged high performance in job creation, rising total compensation of workers, improved multifactor productivity, increased high-tech investment in support of productivity improvement, etc. However the economic performance of the 1980s is ultimately assessed, it has not been possible to date to separate the relative roles of macroeconomic policies and the many facets of M&A activity that took place. Takeovers and mergers have several economic functions. One is to make the market for control more effective in order to discipline managers to perform more efficiently. Another is to facilitate the reorganization of asset ownership and control among firms to contribute to industry strategic adjustments to change. The economic role of financial strategies and the takeover market is to contribute to effective performance of the firm measured by relevant criteria such as market share, value creation, returns to shareholders, etc. If the economic functions of M&As are achieved, they can contribute to improved performance of the economy.


The recession that began toward the end of 1989 changed business attitudes and expectations. The long period of stable economic expansion ended and servicing the debt taken on during the 1980s began to be onerous. Interest burdens and bankruptcy levels increased, causing firms to seek to deleverage.

Changes in financial policies took place between the 1980-88 period compared with 1989-93. Equity retirement and debt issuance in 1980-88 shifted to equity issuance and debt retirement in the 1989-93 period, Some suggest that deleveraging has not gone far enough and that firms are still vulnerable to a rise in interest rates or and economic downturn. But a considerable adjustment has been made.

The policies in the 1980-88 period were not perfect. Excesses occurred and mistakes were made. Some well-managed companies had to take actions to protect themselves from takeover because their performance was so attractive. Because the general economy appeared to favor the use of debt financing, some firms were pushed to incur more debt to deter takeover attempts. LBOs, share repurchases, ESOPs, were pursued as defenses against takeovers rather than for their intrinsic merits.

Some of the reorganization and restructuring that took place in 1980-88 stemmed from general economic forces. Some were stimulated by particular industry characteristics, such as competitive developments or evolving technologies. Some restructuring resulted from shifting budget allocations away from the defense industry. Some were caused by changes in consumer tastes. Some resulted from failure of managements to make the required adjustments to change. A resurgence of M&A activity began in the latter half of 1993 as a consequence of changed potentials in individual industries such as the information industry. Another source of M&A activity was the failure of effective corporate governance. Strong evidence of this is found in the increased activity by financial institutions to mount pressure for management and policy changes in firms judged to be underperforming. During 1993 institutional investors and outside board members forced companies to change their top managements, notable in companies such as IBM, General Motors, American Express, and Eastman Kodak. These actions are evidence that corporate governance systems in U.S. corporations had not been working effectively.

The changes in corporate policies reflect a response by decentralized decisionmakers to external signals. No major new laws were passed nor new regulations issued by government to bring about these changes. This is not to argue that no mistakes were made during the hectic years of 1980-88. Nor is it to argue that during 1989-93 all the necessary corrections were made. But it is strong evidence that the system is flexible and capable of change. Hopefully, the continuing adjustment of corporate financial policies and the reallocations of resource control by M&As will help move the economy toward improved performance.


Altman, Edward I., Corporate Financial Distress and Bankruptcy, New York: John Wiley & Sons, Inc. 1993.

Calian, Sara, "New-Stock Offerings to Surge This Fall," Wall Street Journal, 8/30/93, pp. C1, 6.

Remolona, E.M., "The Recent Growth of Financial Derivative Markets," Federal Reserve Bank of New York, Quarterly Review, Winter 1992-93, pp. 28-43.

-----; R.N. McCauley; J.S. Ruud; and R. Iacono, "Corporate Refinancing in the 1990s," Federal Reserve Bank of New York, Quarterly Review, Winter 1992-93, pp. 1-27.

J. Fred Weston is Professor Emeritus of Business Economics and Finance at the Anderson Graduate School of Management, University of California, Los Angeles, CA, a Fellow of NABE, and an Associate Editor of this Journal. Yehning Chen is a Research Associate in the Research Program in Competition and Business Policy at UCLA.
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Title Annotation:a comparison of the business environment during the 1980s and 1989-93
Author:Weston, J. Fred; Chen, Yehning
Publication:Business Economics
Date:Jan 1, 1994
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