Corporate leverage and the restructuring movement of the 1980s.
Many observers warn that corporate leverage has risen to dangerous levels. This paper surveys recent patterns in corporate financing, putting them in historical context. The primary conclusion is that corporate-financial policy has indeed changed, particularly since 1983. However, the major change has not been the increased use of debt per se, but the use of debt to retire equity. This equity retirement has in turn been closely associated with the corporate restructuring movement. Public policy discussions, therefore, should not focus on restricting corporate financing behavior by itself, but should see the changes in corporate financing as an instrument of corporate restructuring.
MANY FINANCIAL MARKET observers warn that U.S. corporations have relied too heavily on debt financing in the 1980s. Citing the leveraged buyout boom, the rise of the junk bond market and the sharp increase in corporate share repurchases, they characterize the 1980s as a decade of dangerous financial excess. One of the effects of too much debt, critics argue, is that heavy interest burdens force management to focus on short-run results to the detriment of the research and modernization expenditures needed to promote long-run growth in productivity. In addition, they point to the harsh penalties that will be exacted by the inevitable coming of the next recession. One possible outcome is that a wave of corporate bankruptcies could result in unemployment, destruction of value and a severe threat to the viability of financial institutions. Alternatively, the Federal Reserve might feel pressured to forestall a financial crisis by easing liquidity and the result could be a surge in inflation.
However, other observers argue that these fears are much overblown. They assert that U.S. corporate leverage is not out of line with either historical experience or leverage in other countries. In addition, they cite recent innovations in risk management, which may have increased the levels of debt that corporations can safely handle. To the extent that there has been a true increase in corporate leverage, they argue further that this has played a vital role in many slow-growth industries in realigning the objectives of managers and investors.
The primary conclusion of the present article is that corporate financial policy has in fact exhibited some changes in recent years and that these are associated not so much with the increased use of debt per se, but with the use of debt to retire equity. This development is in turn closely associated with the corporate restructuring movement of the 1980s. Hence, the public policy issues that have been viewed solely in the context of corporate financing behavior can be discussed more fruitfully in the broader context of this restructuring movement.
TRENDS IN CORPORATE LEVERAGE
increases in Aggregate Corporate Debt
During the 1970s, total liabilities of U.S. nonfinancial corporations grew at a compound annual rate of 8.7 percent and their total credit market debt outstanding grew at a 9. 1 percent annual rate. Compared with the 10 percent annual growth rate in nominal GNP, the increase in corporate debt roughly kept pace with overall economic activity during this period. During 1980-88, by contrast, annual growth in corporations' total liabilities and credit market debt outstanding increased to 10.2 percent and 10.6 percent, respectively, while nominal GNP grew at only a 7.7 percent annual rate. This more rapid growth of corporate debt relative to economic activity is further reflected in the decline in interest coverage ratios for U.S. nonfinancial corporations from 7.7 in 1970 and 7.4 in 1980 to 5.7 by 1988. Interest payments consumed 35 percent of corporate earnings before interest and taxes in 1988, compared with 23 percent in 1970.
By some measures, recent increases in debt also appear large in historical perspective. Table 1, for example, shows the components of total corporate funds sources for selected periods from 1900 to the present. Looking first at the breakdown between stock issues, debt and internal funds (retained earnings plus depreciation), the proportion of new funds accounted for by debt is quite large in the most recent period, 1984-85. It is further apparent from column (1) that one of the most unusual features of this period has been the large-scale net retirement of corporate equity. For most periods, especially those since World War II, new stock issues have been a relatively small source of total corporate funds, and thus the debt proportion has tended to rise when internal funds have been in short supply (or, as shown in column (6), when internal funds have been low relative to capital expenditures). This pattern can be seen especially clearly in the period 1970-74. In the years since 1983, by contrast, internal funds have been plentiful relative to both total funds sources and capital expenditures, so that, on balance, new debt funds have been used to retire equity.
Reported debt financing can be exaggerated and internal funds correspondingly understated during periods of inflation, because conventional accounting measures do not include the loss to bondholders and simultaneous gain to shareholders from inflation-induced decreases in the real value of debt outstanding. For example, internal funds and debt financing proportions have been adjusted to include this effect in columns (4) and (5) of Table 1, and it can be seen that the adjusted debt financing proportion during the high-inflation period, 1970-74, is not as large. But the period since 1983 has been one of relatively low inflation, and the effect of the adjustment here is to make the most recent debt proportion seem even larger in comparison to many earlier periods.
Another measure of corporate leverage, which presents a rather different picture, is the ratio of the market value of corporate debt to the market value of total assets (debt plus equity). The rationale for using this measure is that market values reflect investors' estimates of future cash flows. Thus a market value leverage measure should incorporate estimates of both the burden of promised interest relative to expected market rates and the amount of the cash flows available to service the debt.
The market value debt ratios shown in Figure 1 are taken from Holland and Myers (1979), updated for the most recent years. The market value of debt is estimated by capitalizing net interest payments made by U. S. nonfinancial corporations in each year at that year's Moody's Baa bond rate. The market value of equity is estimated by capitalizing net dividends paid at the Standard & Poor's composite dividend yield.
Looking at these figures, it is less clear that there has been a surge in corporate leverage in the latter half of the 1980s. There does appear to have been an increase in the past two years, and debt ratios have been consistently higher in both the 1970s and 1980s than they were in the 1950s and 1960s. Nevertheless, the most recent debt ratios have not exhibited any steady uptrend and are still below the 1974 peak. While a comparison with Depression-era ratios may not be entirely comforting, it should also be noted that, by this measure, corporate leverage has been somewhat lower, on average, than it was during the period 1930-45.
What general conclusions can we draw from these figures? Certainly, corporate leverage has increased in recent years and has been higher, on average, during the past two decades than during the years immediately following World War II. However, U. S. corporate leverage was quite low by historical standards after the war, and it is still lower than levels prevailing in Japan and Europe. Recent behavior may indicate either a return to earlier levels or a movement toward leverage standards in other industrialized nations. It is also apparent that the recent increase in leverage looks greater in terms of cash flow measures than it does in terms of market value measures. Thus, U.S. corporations have been more aggressive about borrowing against asset values and expected future cash flows rather than against current cash flow. Whether this will turn out in retrospect to have been wise depends, of course, on the accuracy of the estimates embodied in market values. Finally, the most unusual aspect, in historical terms, of recent financing patterns has been not so much the increase in corporate leverage but the net retirement of equity. Any attempt to explain corporate financing behavior of the late 1980s must ultimately confront this fact.
The Changing Pattern of Debt issuance
An increase in aggregate corporate leverage is not necessarily dangerous in and of itself. That depends on whether the types of debt issued are likely to cause trouble in the event of a downturn and whether that debt has been issued disproportionately by highly cyclical firms.
A comparison between types of debt issued in the periods 1977-83 and 1984-89 is shown in Table 2. The most striking change between the two periods is the sharp decline in the relative importance of bank loans and the corresponding increase in issuance of corporate bonds. In the late 1980s, U.S. corporations turned increasingly to public markets and less to intermediated forms of debt. In turn, a salient feature of the move toward public debt markets has been the remarkable growth in newly-issued "junk", or below-investment grade, bonds. Fueled by more than $140 billion in new issues during the period 1984-89, junk bonds outstanding grew from barely $10 billion at the beginning of the decade to more than $200 billion, or over 20 percent of the total public corporate bond market, at its close.
In part, the junk bond market's growth is another way in which current developments represent a return to earlier corporate financing behavior. junk bonds previously flourished in the early part of the century, accounting for 17 percent of publicly issued straight corporate bonds during the period 190943. But as U.S. corporations retrenched financially during and immediately after World War II, the supply of new issues subsequently dwindled, and it was not until 1977 that newly issued junk bonds reappeared in any significant amount.
In other respects, though, the market's recent growth may be different from the experience earlier in the century. While it is difficult to determine precisely how the proceeds from a bond issue are used, it seems clear that junk bonds have been increasingly issued for restructuring purposes. For 1984, for example, it has been estimated that anywhere from 11 to 41 percent of the proceeds from newly issued junk bonds went to finance mergers, takeovers, leveraged buyouts or other corporate restructuring transactions in some way. In 1987 and 1988, by contrast, Drexel Burnham Lambert, Inc. (1989) has estimated that, on average, 80 percent of junk bond issue proceeds were connected with restructuring transactions either directly or indirectly (through refinancing bridge loans, for example). junk bonds by no means dominate the financing of restructurings. In 1988, for example, mergers alone required $180 billion in financing, whereas proceeds from the sale of junk bonds totaled only $26 billion. Nevertheless, the junk bond market has come to be intimately associated with the restructuring movement.
Is the move toward greater reliance on publicly issued debt in general and junk bonds in particular dangerous for the economy? in part, the answer to that question depends on the frequency with which this debt will have to be refinanced and the ease of doing so. On that score, the increased issuance of bonds lengthens the average maturity of corporate debt, so that it does not have to be refinanced as frequently. During the period 1984-89, for example, long-term corporate debt (defined as bonds and mortgages) grew at a compound annual rate of 11.6 percent, while short-term debt grew at a rate of 9 percent. In comparison, the analogous growth rates for the 1977-83 period were 9.6 percent for long-term debt and 16 percent for short-term debt.
The ease of refinancing and the potential repercussions of defaults on other sectors of the economy also depend to a considerable extent on who holds this debt. The corporate bond market in the U.S. is heavily institutional. While that does not rule out a wave of panic selling, the predominant investors are at least professional and experienced, and, for the most part, their liabilities are either long term or are not fixed in nominal terms. Drexel Burnham Lambert (1989), estimates that, at year-end 1988, 30 percent of junk bonds were held by mutual funds, another 30 percent by insurance companies and 15 percent by pension funds. Savings and loan associations, whose junk bond investments have been the subject of much controversy, held only 7 percent of all junk bonds outstanding. The remainder was divided among foreign investors, individuals and corporations.
Finally, the dangers of corporate debt depend, to a considerable degree, on who has done the borrowing, that is, how much of the increased corporate debt has been incurred by those industries or sectors most susceptible to cyclical downturns? On this issue, Roach (1989) presents evidence that a substantial amount of this borrowing can be attributed to relatively stable, less cyclical industries. He finds, for example, that borrowing by nondurables manufacturing, services and public utilities industries was responsible for approximately 95 percent of the total increase in U.S. business net interest expense during the period 1982-88.
When we look beneath the increase in aggregate corporate leverage, then, at least two factors may serve to mitigate the fears that this trend has raised. First, during the most recent period, a greater proportion of debt funds has been raised through long-term obligations, which are less susceptible to refinancing difficulties during a liquidity crisis. The predominantly institutional ownership of this debt may or may not prove helpful in the face of liquidity problems, but at least the bonds will not have to be refinanced as often as short-term debt. Second, a substantial amount of the increased borrowing seems to have been concentrated in those industries that are less sensitive to business cycle downturns. To get a better understanding of the possible dangers or benefits of recent patterns in corporate finance, we must now consider why these developments have occurred.
WHAT HAS CAUSED THE CHANGE IN CORPORATE FINANCING BEHAVIOR?
Regardless of what measures we use, it seems clear that some major changes in corporate financing behavior have been taking place. Explanations for these changes abound. Some of them focus on the role of the tax code in favoring debt financing, others emphasize the incentive aspects of debt and still others point to an increasing tendency to underestimate the true risks of leverage. In order to sort out these different explanations and assess their ability to help us understand current events, it is convenient to arrange them in a simple supply and demand framework.
In choosing a capital structure, a corporation is essentially supplying a package of financial services to investors, that is, the corporation divides the returns from its tangible assets among different securities that it issues, and the returns from these securities offer different combinations of risk, liquidity, total rate of return, and capital gains versus cash income. Capital structure decisions will be influenced, then, by investors' relative demands for particular combinations of financial services. At the same time, corporations will be influenced by the costs of producing a given combination of financial services. If investors demand protection from interest rate risk, for example, corporations could respond by issuing floating rate notes, but their tendency to do so will be checked at some point by the costs of managing that risk themselves. Finally, corporate capital structures will be influenced by the degree of competition from other providers of financial services. Even if there is heavy demand for interest rate risk protection, it will not be in the interests of business corporations to meet that demand if financial institutions can do so more cheaply.
Influence of Tax Code
On the demand side of the market, the tax code affects the relative attractiveness of corporate debt and equity securities. Equity returns are more heavily weighted toward capital gains than are bond returns, so an increase in capital gains tax rates relative to ordinary income tax rates, such as occurred under the Tax Reform Act of 1986, could increase the demand for bonds relative to equity. In addition, individual investors have been shifting their assets during the postwar period away from direct securities and toward claims on intermediaries. To the extent that these intermediated claims must be backed by debt claims, because of either regulation or standards of financial prudence, the demand for corporate debt may have increased relative to equity.
While there are reasons to believe that an increased demand for corporate debt issues may have occurred in recent years, however, demand-side factors do not really explain the timing of the recent changes in corporate financial behavior. That behavior appears to have been changing at least two years prior to the Tax Reform Act of 1986, for example. At the same time, changes in household portfolios have occurred gradually over a long period, and thus they seem incapable of explaining short-run swings in corporate financial policy.
On the supply side, taxes are also a factor, because the corporate tax rate affects the relative advantage of interest deductibility. In addition, the more readily available are substitute tax shields, such as allowed depreciation writeoffs and investment tax credits, the less will be corporations' incentive to issue debt. In recent years, the effect of tax factors at the corporate level has been ambiguous. The corporate tax rate has been reduced, lessening the absolute advantage to interest deductibility, but the investment tax credit has been repealed, and depreciation schedules have been lengthened, thus decreasing the availability of substitute tax shields. Overall, tax factors would thus seem to be, at best, a very incomplete explanation for recent capital structure changes.
Cost of Financial Distress
Another supply side factor is the cost of financial distress. In fact, a commonly held theory of corporate capital structure asserts that firms trade off the tax advantage of debt against the costs that may be imposed on the firm's operations by the possibility of bankruptcy. Thus, even if tax factors had a neutral effect on capital structure, a reduction in bankruptcy costs could increase firms' willingness to issue debt. Jensen (1989) argues that precisely this has occurred through the types of lending structures that are common in leveraged buyouts (LBOs). Because of their high debt levels, LBO firms are likely to encounter financial difficulty sooner when their cash flows decline than are conventionally financed firms. Rather than being a negative development, however, Jensen argues that the early onset of financial distress forces the firm to restructure sooner, before the major portion of its value has been destroyed. In particular, since the firm still has a high going-concern value when it encounters difficulty, there is an incentive to avoid jeopardizing this value through costly and time-consuming formal bankruptcy proceedings. The relatively small number of lenders and their tendency to own both debt and equity securities in an LBO firm further reduces interest-group conflict. While this argument points to an increased supply of corporate debt in the face of innovative solutions to the problem of financial distress, it should be noted that the increase will not be universal. Rather, those firms best suited to the innovative lending structures should be the ones issuing the most new debt. In the end, then, Jensen's argument leads us to look more closely at the corporate restructuring movement.
The information Factor
A third supply-side factor is the information that corporate securities issues convey to investors. Outside investors may not be as well-informed about a firm's true value as are its managers. Thus managers can benefit existing shareholders at the expense of new investors by issuing stock or other securities when they are overvalued. Understanding this, however, investors will interpret the announcement of a stock issue as a sign that the current price is too high, so the mere announcement of a new issue will cause the price to fall. Myers (1984) argues that the possibility of this effect will in turn lead managers to follow a "pecking order" of funds sources. They will use internal funds first, to the extent they are available. Next, they will turn to debt, whose value is less dependent than equity on the true value of the firm's assets and which is thus less susceptible to the information effect described above. Finally, they will turn to new equity issues only as a last resort.
This pecking order theory is consistent with the broad patterns in corporate financing for most of this century. Looking at Table 1, for example, new stock issues have been a relatively small source of funds in most periods, particularly since World War II, while debt has tended to increase when internal funds have fallen relative to capital expenditure needs. The big exception to this pattern is the most recent period, during which debt issuance has risen even though internal funds have been plentiful. As pointed out above, this new debt has been associated with the net retirement of equity that has been a prominent feature of corporate restructuring transactions. Once again, attempts to explain recent changes in corporate financing behavior point in the direction of the corporate restructuring movement.
A final major factor on the supply side is the incentive effects that different types of capital structures exert on corporate managers and shareholders. A firm with large future investment opportunities and a highly leveraged capital structure, for example, may find its debt load an impediment to new investment. Because bondholders will share in any superior returns from the new investment, the shareholders' incentive to undertake it may be weakened. Conversely, a capital structure with little leverage may encourage overinvestment in times when favorable investment opportunities are in short supply. Such a firm may generate a substantial yearly cash flow, but rather than paying it out to shareholders, management may prefer to keep this cash under its own control inside the firm. The result may be investment in mergers or other projects beyond the level that will maximize shareholder value. For such firms, Jensen (1988) has emphasized the benefits of debt in forcing managers to pay out their "free cash flow", rather than reinvesting it in the firm. Even if debt forces management to focus on the short run, as its critics assert, this may be a desirable outcome for firms whose free cash flow outstrips their investment opportunities.
This factor, too, points in the direction of the corporate restructuring movement. Real capital costs have tended to be quite high compared with real returns to capital in the 1980s, so that, for the economy as a whole, recent years could be interpreted as a period of relatively weak investment opportunities. Moreover, looking at financing patterns across industries, Blair and Litan (1990) have found evidence that large increases in leverage during the 1980s were associated with slow growth in investment and low returns to capital relative to capital costs. Thus a good deal of the increased debt and the equity retirement that have marked the latter part of the 1980s may be associated with those industries that were most in need of financial restructuring to force the payout of free cash flow to investors.
SHOULD SOMETHING BE DONE ABOUT CORPORATE LEVERAGE?
For the most part, those decrying the dangers of corporate leverage have aimed their policy proposals not at debt in general but at specific kinds of debt. It has been proposed, for example, that the tax deductibility of interest be limited when the debt is used for a hostile takeover attempt or when the debt proportion in a corporate control transaction exceeds a certain level. It has been recommended that hostile tender offers be prohibited if more than 25 percent of the financing comes from securities issues collateralized by the target's assets. Restrictions on lending to leveraged buyouts or on ownership of junk bonds have been proposed or enacted at federal and state levels for commercial banks, thrift institutions and insurance companies.
Not all of these proposals are aimed at imagined problems. The relationship between risk-taking by depository institutions and the viability of the deposit insurance system is a legitimate concern. Likewise, one may justifiably ask whether the tax system should favor the use of one form of financing over another.
However, most of the proposed remedies to date would seem to miss the point. junk bonds and LBO loans are not the only or even the primary way in which financial institutions can take risk. A solution to the deposit insurance problem requires a much broader perspective. In a similar vein, there is no evidence that the tax treatment of financing instruments has been a major motivating factor in the growth of junk bonds, LBOs or hostile takeovers. The timing of these developments simply doesn't fit with changes in the tax code. There is not even a strong correlation between corporate leverage in general and tax code changes. In view of the evidence that increases in leverage have been concentrated in those industries where investment returns have been weakest relative to the cost of capital, perhaps a more fruitful discussion at this point would concern the effect of taxes on investment incentives.
The evidence described above does point to a change in corporate financing behavior within the past five to ten years, and this change appears to be closely associated with the corporate restructuring movement. Undoubtedly, some of the companies that have adopted highly leveraged capital structures in recent years will prove ultimately to have overreached. But for the most part, these firms appear to be taking calculated risks rather than reckless gambles. They are taking on additional financial risk in exchange for the perceived benefits of restructuring. Before we take steps to limit their risk, therefore, these offsetting benefits should be better understood.
1. Unless otherwise stated, all figures are taken from Federal Reserve Flow of Funds or Department of Commerce National Income and Product Accounts data.
2. There is purposely one year of overlap between the periods 1980-84 and 1984-89. This is to allow inclusion of 1984, the first year of large net stock retirements, with the period 1985-89, which has also seen net retirement of equity in each year.
3. When assets are estimated at their replacement value, the ratio of corporate debt to assets is also no higher in the 1980s than it was during the first two decades of the twentieth century. See Kopcke (1989).
REFERENCES Baribeau, Mark B. 1989. "Leverage Risk in the Nonfinancial Corporate Sector", Business Economics, July, pp. 34-39. Bernanke, Ben S., and john Y. Campbell. 1988. "Is There a Corporate Debt Crisis?", Brookings Papers on Economic Activity, 1:1988, pp. 83-139. Blair, Margaret M., and Robert E. Litan. 1990. "Explaining Corporate Leverage and LBO Activity in the Eighties", in John B. Shoven, ed., Taxes and Corporate Restructuring (Washington, D. C.: The Brookings Institution), forthcoming. Drexel Bumham Lambert, Inc. 1989 High Yield Market Report. Friedman, Benjamin M. 1986. "Increasing Indebtedness and Financial Stability in the United States", in Federal Reserve Bank of Kansas City, Debt, Financial Stability and Public Policy, pp. 27-53. Goldsmith, Raymond W. 1958. Financial Intermediaries in the American Economy Since 1900 (Princeton, N.J.: Princeton University Press). Holland, Daniel M. and Stewart C. Myers. 1979. "Trends in Corporate Profitability and Capital Costs", in Robert Lindsay, ed., The Nation's Capital Needs: Three Studies (New York: Committee for Economic Development). Jensen, Michael C. 1989. "Active Investors, LBOs and the Privatization of Bankruptcy", Journal of Applied Corporate Finance, Spring, pp. 35-44. _________1988. "Takeovers: Their Causes and Consequences", Journal of Economic Perspectives, Winter. pp. 21-48. Kopcke, Richard W. 1989. "The Roles of Debt and Equity in Financing Corporate Investments", New England Economic,Review, July/August, pp. 25-48. __________and Eric S. Rosengren. 1990. Regulation of Debt and Equity", in Are the Distinctions Between Debt and Equity Disappearing?, Federal Reserve Bank of Boston Conference Series No. 33, forthcoming. Myers, Stewart C. 1984. "The Capital Structure Puzzle", Journal of Finance, July, pp. 575-92. Perry, Kevin J. and Robert A. Taggart, jr. 1988. "The Growing Role of junk Bonds in Corporate Finance", Journal of Applied Corporate Finance, Spring, pp. 37-45. Roach, Stephen S. 1989. "Living With Corporate Debt", Journal of Applied Corporate Finance, Spring, pp. 19-29. Taggart, Robert A. Jr. 1986. "Corporate Financing: Too Much Debt?", Financial Analysts journal, May/ June, pp. 35-42. Winch, Kevin F. 1988. "Junk Bonds: 1988 Status Report", Congressional Research Service Report, December 30.
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|Author:||Taggart, Robert A., Jr.|
|Date:||Apr 1, 1990|
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