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Ownership structure, leverage, and firm value: the case of leveraged recapitalizations.

This paper present a comprehensive empirical examination of a relatively new form of leverage-increasing transaction: a leveraged recapitalization (sometimes referred to as "leveraged recap" or "LR"). The typical LR is similar to a leveraged buyout (LBO), but differs from LBOs in at least two important ways. First, the firm which undergoes an LR remains publicity traded, as opposed to an LBO, where the firm is taken private. Second, an LR usually provides existing shareholders with a single large payout of cash and/or debt securities, but permits them to maintain an equity position in the restructured firm. Stockholders should derive all the benefits of having their stock publicly traded - liquidity, and the disciple of the market, without having to bear the cost of going public again as is the case for many LBOs.

Amihud [1] suggests that there appears to be no sound economic rationale for going private via an LBO except for firms which disclose no information about themselves after the restructuring. He implies that most of the benefits of LBOs should be obtainable by public corporations. Since the magnitude of the tax shields created by increased leveraged are comparable to LBOs (especially since the 1986 Tax Reform Act), a comparison of the wealth effects of LBOs versus LRs provides insight into the question of whether private ownership is necessary for obtaining the effeciency increases which contribute to the wealth gains in such transactions.

Our research differs from that done previously in at least three important respects. First, we document abnormal returns to holders of equity and dept securities over the entire restructuring process. That is, rather than compute abnormal returns for an arbitrary period around the recap announcement, we present evidence on returns for different windows starting prior to the restructuring announcement and continuing on through its completion and beyond. In doing so we are able to identify the marginal effect of the recap on firm value at various stages of the restructuring process. Second, we examine differences between the financial characteristics of firms which have undergone leveraged recaps and other firms in their industry. This and other tests provide the basis for analyzing two possible sources of equityholder wealth gains: declines in the value of outstanding debt securities and reduction an agency problems associated with free cash flow (Jensen [12, 13]. Finally, since firm which execute an LR remain publicity traded after the restructuring, market price data is used to draw inferences about the firm's post LR performance, something not directly observable with LBOs.

I. Background

A. Types of Transactions

The typical LR transaction entails making fa substantial debt financed payout to existing equityholders. The payout can be cash or a mix of cash and debt securities; in some cases the existing equity is exchanged for a new equity security plus cash and debt securities. The transactions can be classified into six categories (a more detailed discussion appears in the Appendix): (i) A substantial cash dividend financed with bank debt, highyield bonds or both. Subsequently, the stock sells at a fraction of its previous value and has been called a "stub" in Wall Street parlance. (ii) Cash (financed as above) and a new share of stock (sometimes a fraction of the original share) and exchanged for old shares. Again, a stub is created. (iii) A significant cash dividend is paid along with high-yield debt securities (and/or high-yield preferred stock), and a stub is created. (iv) A cash tender offer for a substantial fraction of the shares outstanding. This is financed with bank debt and/or high-yield debt. (v) Cash and high-yield debt are exchanged for a significant fraction of the stock outstanding. (vi) A significant fraction of the stock is tendered and prior for with high-yield securities.

B. Comparison of Leveraged Recapitalizations

and Leveraged Buyouts.

An examination of the characteristics of LBOs and LRs yields the following points of comparison.

Similarities: (i) In both transactions, there is a substantial increase

in debt/equity or debt/total capital. (ii) In both cases, there is substantial pressure on management

to run the firm more efficiently, and to be

less wasteful of free cash flow. (iii) Both transactions results in a substantial increase or

the potential for a substantial increase in management/employee

ownership of equity. This leads to

greater alignment of stockholders and managerial

interests. (iv) All the potential negatives of increased leverage are

applicable to both types of transactions (e.g., forcing

the foregoing of investment in risky project or

those with excess cash flows far in the future). (v) In general, the tax implications for the firm are

similar. (vi) If a dividend is paid by firm undergoing an LR, a

tax-paying investor incurs an ordinary tax liability in

the year of the dividend. If stocks is tendered for

cash, a capital gains liability is incurred. In an LBO,

a capital gains liability is incurred for car received.

With both LBOs and LRs, if payment-in-kind preferred

or debt or zero coupon is exchanged for

equity, a tax liability is incurred without any concomitant

cash inflow.

Differences: (i) LBOs go private while LRs remain public. (ii) Due to strip financing, major creditors may be

major stockholders in LBOs, thereby reducing

monitoring and agency costs. In LRs, unless debt is

paid to the stockholders, stockholders do not become

bondholders as well. (iii) In LBOs, managers are responsible to a small but

powerful group of shareholders (e.g., LBO specialists

or institutional investors to whom they must

report). In LRs, there may still be a large number

of (smaller) equityholders. Shareholders servicing

costs should be lower with LBOs. (iv) With LRs, there is no possibility that managers/buyout

investors benefit at the expense of public

shareholders, as has been suggested for LBOs.

However, indirect evidence presented by Kaplan

[14] does not support public stockholders being

taken advantage of in LBOs.

C. Implications of Significant Leverage

Increases

Previous published research has concentrated on LBOs. Studies by DeAngelo, DeAngelo and Rice [8], Torabzadeh and Bertin [22], Marais, Schipper and Smith [18], Lehn and Poulsen [16] and Kaplan [14] have found average premia of 21.1% to 56.3% and excess returns of 13% to 34.2% earned by existing stockholders. Kleiman [15], is the only published paper on leverage recaps, reported that for a sample of eight firms which executed an LR in 1985-1987 the two-day announcement period abnormal return was 10.2% and the 60-day abnormal return was 33.3%.

More recently, Handa and Radhakrishnan [11] looked at a sample of 42 realized and failed leveraged recap. They found a two-day abnormal return around the time of the recap announcement of 5.52%, and cumulative abnormal returns of 13.56% over the period -60 to +60 days surrounding the announcement. They also looked at bond returns of these firms and found differing resutls depending on the period of time around the LR announcement. However, Handa and Radhakrishnan did not report the separate results of the successful and failed recaps, and their sample does not include seven firms which are in our sample.

Handa and Radhakrishnan [11] argue that LRs can be viewed as a defensive maneuver by management to ward off hostile bids. Denis [9] examines special payouts to shareholders in response to hostile takeover activity. He looks at 49 firms which engaged in open market repurchases, tender offers, exchange offers and special dividends. His results indicate that special dividend payouts result in positive returns to stockholders. Our results are consistent with the findings of both Handa and Radhakrishnan [11] and Denis [9]. However, apart from sampling differences, our paper differs from the above in that (i) we provide a more extensive and detailed analysis of securityholder wealth effects, (ii) we explore the role of reductions in the agency cost of free cash flow as a possible source for observed value gains, and (iii) we provide an analysis of the post-recapitalization price behavior of these firms.

As noted above, the market price response to LBO and LR announcements is positive. One of the obvious possible sources of increased value in both LBOs and LRs is the massive tax shield created by the substantial increase in debt. It should be noted that one of the tax benefits associated with LBOs, namely increased depreciation deductions associated with the step-up of assets for transactions completed prior to the end of 1986, have not been available to firms doing LRs. However, the use of ESOPs as a financing mechanism along with their concomitant tax advantages have been used in both types of restructurings.

The large increase in debt in such transactions creates another possible source of value enhancement for equityholders in the form of wealth transfers away from current debtholders.(1) Evidence on wealth transfers away from debtholders is inconclusive. Masulis [19], Travlos and Millon [24] and Lehn and Poulsen [16] find some evidence of wealth transfers. Cornett and Travlos [6] and Marais, Schipper and Smith [18] do not find significant declines in debt values following LBO announcements.

A third argument in favor of LBOs and LRs is their role in bonding management's interests with those of the firm's equityholders. In both types of transactions, management's stake in the restructured firm is often substantially increased, thereby presumably aligning managerial and stockholder interests. In addition, as pointed out by Jensen [12,13], increases in equity holdings by management and the need to service a large debt load can result in efficiency gains. (Also, see Kaplan [14]). Recently, Lehn and Poulsen [17] provide empirical evidence of a strong relationship between premiums pain in LBOs and a proxy for free cash flow.

It is also possible to view LRs as the final bid in a multiple party fight for control of a valuable asset. Presumably, the highest price bidder wins and in the case of LRs, that would be the firm itself. If the management was trying to entrench itself, then one would expect to find an attenuated positive stock response at the time of the LR announcement or a negative one soon thereafter.

II. Sample Selection and Description

This study is based on a sample 27 firms which completed a leveraged recapitalization in the period 1984 through 1982.(2) Of these, 18 firms were targets of takeover bids, and the remaining nine firms were not in play. While the sample size is small, it is, to the best of our knowledge, comprehensive. The Wall Street Journal Index, Dow Jones News Retrieval, Mergers and Acquisitions, and assorted merger and restructuring announcements advertised in the Wall Street Journal were used to identify the sample of firms, whether they were in play, and appropriate dates relative to the recap announcement.

For each firm, we calculate the ratio of total debt to total capital prior to the leveraged recap and on a pro forma basis as given by the firms in the proxy materials distributed to stockholders. Total debt is short-term debt plus long-term debt (book values), and total capital is total debt plus the market value of equity. The market value of equity before the recap is computed using market prices and shares outstanding 90 days prior to the recap announcement; the post recap equity value is based on prices and shares outstanding on the day that the recap is completed. Exhibit 1 presents the summary data for the firms in our sample. As expected, there is a substantial increase in the amount of debt in the capital structure. The mean ratios are 0.2246 and 0.6656 prior to the recap and after the recap, respectively. The difference in means is significant at the 1% level.
Exhibit 1. Historical and Pop Forma Total Debt (TD)
 to Total Capital (TC) Ratios and Differences
 TD/TC TD/TC
Company Before After Differences
CBS 0.1352 0.3422 0.2070
Colt Industries 0.1932 0.8311 0.6379
FMC Corporation 0.1749 0.7292 0.5543
Fruehauf 0.4583 0.9635 0.5052
Harcourt Brace 0.4204 0.8047 0.3843
Holiday Corporation 0.3858 0.8139 0.4281
Holly Corporation 0.0069 0.3616 0.3547
INCO 0.1666 0.3459 0.1793
Interco 0.2686 0.9604 0.6918
Kroger 0.0317 0.8776 0.8459
Litton Industries 0.0689 0.4029 0.3340
Multimedia 0.0781 0.8084 0.7303
Newmont Mining 0.0357 0.3180 0.2823
Optical Coating 0.1853 0.6094 0.4241
Owens Corning 0.2703 0.8374 0.5672
Phillips Petroleum 0.2481 0.5788 0.3307
Quantum Chemical 0.3737 0.6474 0.2737
Santa Fe 0.1794 0.6437 0.4643
Shoney's 0.0315 0.6385 0.6070
Standard Brand Paints 0.1018 0.6966 0.5948
Swank 0.3157 0.7731 0.4574
Topps 0.1094 0.4127 0.3033
Tyler 0.5025 0.6050 0.1025
USG Corporation 0.2945 0.8868 0.5923
Union Carbide 0.4470 0.7529 0.3059
Unocal 0.1577 0.6319 0.4742
Viacom International 0.4220 0.6976 0.2755
Average 0.2246 0.6656 0.4410
Standard deviation 0.1521 0.1982 0.1807
T-value 12.6851


We also calculate levels of equity holdings of various ownership groups before and after the recap. The results are presented in Exhibit 2. Notice that in general there is a large increase in management ownership either directly or indirectly through retirement plans or ESOPs. The increase in managerial ownership is similar in direction to what happens in LBOs, although smaller in magnitude. Our results are, however, not directly comparable to those found in LBO studies (Kaplan [14]), since in LBOs some of the pre-buyout management do not participate in the LBO, while in the LRs management in general does not change. Moreover, for a number of LR firms additional increases in management ownership accrue through ESOPs or profit-sharing plans.(3) This is not the case for LBOs.

[TABULAR DATA OMITTED]

III. Methodology

A. Equity Returns

Daily returns data for equity securities are obtained from the CRSP daily returns and NASDAQ files and Data Resources, Inc. Firms are classified as being in play prior to the recap announcement if there was an actual bid for the firm or there were news stories naming the firm as a potential target. Examples of the latter are 13D filings and rumors of a forthcoming bid. This procedure resulted in 18 of the 27 sample firms being classified as in play prior to the recap announcement. For the sample of firms that were in play (n = 18), three separate events are examined: the start of takeover activity (TS), the announcement of a leveraged recapitalization (RA), and the completion of the recap (C). For the sample of firms that were not in play (N = 9), two events are examined: RA and C. For the sample of firms in play (not in play) results are reported for the period starting 30 days prior to the start of takeover activity (the recapitalization announcement). Time lines indicating the estimation intervals used in each case are given below.
 Firms in Play
TS-30 TS RA C C+150
 Anticipation Bidding Resolution Postcompletion
 Firms Not in Play
RA-30 RA C C+150
 Anticipation Resolution Postcompletion


Abnormal returns in event time are computed using standard event study methodology (for example, see Travlos [23]). Since LRs entail significant changes in leverage, it is possible for firm betas to change after the restructuring. The portfolio average beta for the preannouncement period is 0.88 and is insignificantly different from one. for the postcompletion period, the portfolio average beta is 1.16 (significantly greater than one at the 10% level). Further, seven of the 27 sample firms exhibit significant increases in beta, and the change in the portfolio average beta is significant at the 5% level. To allow for the effect of beta changes, market model parameters for the periods preceding and following the LR announcements are computed using "uncontaminated" time windows preceding and following the announcement.

For each firm, and for all days in event time up to and including the RA date, market model coefficients are computed using daily returns for the period t = (-150, -31) relative to TC (for firms in play) and RA (for firms not in play). Daily abnormal returns for the period RA + 1 to C + 150 in event time are computed using market model coefficients estimated from daily returns for the period t = (C + 150, C + 270) in event time.

B. Bond Returns

Data on bond prices are obtained from the Wall Street Journal, and the Data Resources corporate bond database. Transaction prices are converted to daily rates of return by adding in the accumulated current day and previous day accrued interest respectively, to the current and previous day closing prices. To account for the problem of trading lapses, we use a methodology similar to Travlos [23]. The one-day return following a period of nontrading is calculated as:

[Mathematical Expressions Omitted]

where

[R.sub.it] = the return of bond i and day t

[B.sub.it] = the price of bond i on day t

[N.sub.t] = the number of days since the last coupon

payment

[C.sub.i] = the annual coupon of bond i

[Alpha.sub.t] = the number of days between the previous

trade and the current trade.

If a firm had more than one bond outstanding (that was not called) at the time of the recap announcement, daily returns are averaged across these bonds. This prevents the results from being overly influenced by returns on multiple bond issues of a single firm.

Bond abnormal returns are computed for event time windows similar to those for equity abnormal returns. Due to a paucity of data, however, bond abnormal returns are computed for the period TS-1 onwards for firms in play and RA-1 onwards for those not in play. A market adjusted returns approach is utilized, with the Dow Jones Bond Index series serving as the bond market index. Significance tests on bondholder abnormal returns are constructed using the market adjusted returns approach (see Brown and Warner [14]), and also the nonparametric binomial proportions test (see Conover [7]). Since the bond samples are small, however, significance levels should b interpreted with caution.

IV. Results

As noted earlier, 18 of the 27 sample firms were in play prior to the LR announcement while nine firms were not play. We report results for these two samples separately: for a period starting 30 days prior to the onset of takeover activity for firms in play and continuing on to 150 trading days after completion of the LR. For firms that were not in play, we report results for a period starting 30 days prior to the LR announcement and continuing on to 150 trading days after the completion of the LR.

A. Equity Returns for Firms in Play

Exhibit 3 presents equity and debt abnormal returns for firms that were in play prior to the LR announcement. There is a buildup in the equity CAAR of 7.87% (significant at the 1% level) in the 28-day period preceding the start of takeover activity. In the two-day window including the start of takeover activity, the CAAR is 5.95% (significant at the 5% level). The reaction is particularly dramatic on day 0 with an AAR of 5.54% which is significant at the 1% level.

[TABULAR DATA OMITTED]

In the period from one day after the start of takeover activity to two days before the announcement of the leveraged recap, the CAAR is 11.17% (significant at the 5% level).(4) This is the time period when bidding for the target firms was in progress, and precedes the LR announcement. The results show that a substantial proportion of the premium earned by equityholders of these firms occurs prior to the announcement of the LR. The CAAR over the two-day LR announcement window is 1.74%, and the day 0 AAR is significant at the 5% level. The relatively small price increase upon the LR announcement is understandable - it is simply another bid in an ongoing bidding process.

From the day following the recap announcement until two days prior to its completion, the CAAR is 3.33%. Overall, from the day before the recap announcement the CAAR is 9.66%, as uncertainty about the finality of the restructuring is resolved. Some of this additional return is possibly due to the market trying to price some of the complex debt securities that are issued in some of the recaps.

Finally, in the 150-day period following the recap announcement, the CAAR increasingly by another 13.22% (significant at the 10% level). This is an interesting result in itself, in that Bradley, Desai and Kim [3] and Varaiya and Ferris [25] report that winning firms in multiple bidder contests experience significant declines in value. A similar result, for the case of mergers, was reported by Asquith [2] who found negative abnormal returns to the merged entity in the post-merger period. Since firms which executed LRs are in essence winning bidders in a multiple bidder contest, the absence of negative abnormal returns in the postcompletion period suggests that the winning bid (effectively, the cash/security payment to equityholders) did not constitute "overpayment" in these cases.

B. Debt Returns for Firms in Play

Exhibit 3 shows the abnormal returns to debtholders for firms in play. The number of firms on any one day tends to vary due to trading gaps in the bonds of individual firms. There are no significant negative returns over the period from one day prior to the beginning of takeover activity to 15 days after the completion of the recap. There is a cumulative average loss of 3.56% (significant at the 10% level)(5) over the period from one day before the start of takeover activity through two days prior to the recap announcement, suggesting that the bond market was adjusting values downwards in anticipation of an eventually successful bid. The CAAR is 0.17% over the two-day announcement period. Interestingly, the preannouncement pattern is reversed with an AAR of 2.51% (statistically insignificant) in the period from one day following the recap announcement until two days prior to the completion of the restructuring. By 150 days following the completion of the recap the CAAR is 4.67%. These results are not supportive of a wealth transfer away from the debtholders.

To get some additional insight into the bondholder wealth transfer away from the debtholders.

To get some additional insight into the bondholder wealth effects of the LR, we examined the impact of the restructuring on bond ratings. For five of the eight firms in this sample, either Moody's or S&P or both lowered the ratings on outstanding debt securities in the post-announcement period. It may be noted that ratings changes are generally preceded by an announcement that the firm's debt is being put on credit watch. For our sample, these announcements occurred in the period preceding the LR announcement, and possibly drove the observed negative abnormal returns in the (TS + 1, RA-2) window. The insignificant positive abnormal returns in the postannouncement period suggest that the actual ratings change announcement had been anticipated by the market and had no further detrimental impact on bond values. Overall, rating downgrades suggest that the restructuring had a small negative impact on outstanding debt securities. When viewed over a longer time window, however, the effect appears to have been transitory.

C. Equity Returns for Firms Not in Play

Exhibit 4 presents equity and debt abnormal returns for firms that were not in play prior to the LR announcement. In the 28-day period prior to the recap announcement, the CAAR is 0.47%, with significant positive AARs on days -3 and -2. The latter is consistent with earlier studies which find small price runups in the period preceding the announcement of a bid in corporate control contests. Over the two-day window surrounding the recap announcement, the CAAR is 15.57%, with AARs on both days -1 and 0 being highly significant. Given that these firms were not the targets of ongoing bidding, the large announcement period price response is not surprising. For these firms, the CAAR over the 30-day period up to and including the recap announcement is 15.09%. This compares with 26.73% for the firms in play. The difference is possibly due to multiple bidding taking place in the latter sample, with the recap firm itself being the final and winning bidder.

Over the period from one day following the recap announcement to two days prior to completion, the CAAR is 7.31%. Over the entire period from 30 days prior to the recap announcement through completion, the cumulative abnormal return is 22.99% for the firms not in play compared to 34.65% for the firms in play. Finally, the CAAR is 10.86% in the 150-day period following completion of the recap, which is not statistically different from the 13.22% postcompletion CAAR for firms in play.

In both LBOs and LRs, firms engage in asset sales designed to streamline the firm and pay down debt in the postcompletion period. While in LBOs the wealth effects of such asset restructurings are unobservable, our results indicate that for LRs they are value enhancing on average. The significant positive abnormal returns for both sets of sample firms are also consistent with the proposition that the restructured firm experiences increases in efficiency which result in further increases in value.

(1) See Miller [20] for a through review of many of these explanations. (2) We excluded two firms in which an equity stake in the form of warrants to buy equity remained publicly traded since the warrants trade in the "pink sheet" over-the-counter market. (3) One might argue that an increase in managerial ownership through either an ESOP or profit-sharing plan is different from direct ownership. However, there are at least two reasons why the likely increased bonding between management and stockholders should not be diluted through indirect ownership. First, if the value of the ESOP or profit-sharing plan is enhanced by value-maximizing decisions of management, then clearly management will benefit. Second, there appears to be evidence that management retains control over ESOPs through the selection of trustees (Gordon and Pound [10]), and uses that influence in votes on antitakeover amendments (Clyde [5]). (4) Assessing the significance of a CAAR value between two different events is complicated by the fact that the number of days between such events varies by firm. The significance level of the CAAR between two events is assessed using a T-test and also the nonparametric binomial proportions test. The T-statistic (two-tailed) is significant; the binomial proportions test, however, yields an insignificant results. (5) As in the case noted in footnote 4, the T-statistic is significant but the binomial proportions test is not.

The postcompletion results also yield some interesting insights into the motivations (and wealth effects) in LBOs and LRs. For LBOs, DeAngelo, DeAngelo and Rice [8] reported a CAAR of 30.53% for the 30-day period culminating in the LBO announcement. For our sample of LRs, the CAAR for the 30-day period culminating in the LR announcement is 13.61%, suggesting that equityholders obtain a much larger wealth gain in LBOs (relative to LRs). Note however that if the asset restructuring that occurs in both types of transactions is in fact value enhancing then the restructured firm should generate additional (postcompletion) gains for their owners. Since the original equityholders in LBO transactions do not get the opportunity to share in any postcompletion gains, the CAAR through announcement should be larger in these cases. In LR transactions, the CAAR through the announcement day is smaller, possibly due to the expectation of significant additional gains in the postrestructuring period. The results suggest that this is in fact the case, with the CAAR increasing to 25.86% by day t = + 150.

Finally, it is worth noting that of the 27 firms in our sample, four have experienced financial distress since their recapitalizations. Interestingly, all four are firms which have been classified as stubs. A fifth firm, also a stub, experienced cash flow problems but does not now appear to be in financial distress. One firm, also a stub, was acquired in a leveraged buyout two years after its leveraged recapitalization.

D. Debt Returns for Firms Not in Play

Abnormal returns to debtholders of firms not in play are also presented in Exhibit 4. Due to the very small sample size, care must be taken in interpreting these results. The pattern of abnormal returns in largely similar to the one found for firms in play with the principal exception of a negative CAAR of 3.09% (statistically insignificant) over the period from one day following the recap announcement to two days before completion. Again, over the period up to 150 days following the completion, the cumulative abnormal return is positive. [TABULAR DATA OMITTED]

For two of the five sample firms, the bond rating was lowered in the postannouncement period, which may explain the timing of the observed negative abnormal return of 3.09% (note that since these firms were not in play prior to the LR announcement, their debt had not been placed on credit watch). Again, it appears that the restructuring had a small negative impact on bondholder wealth; when viewed over a longer time horizon, however, bondholder losses appear to be transitory.

E. Stubs Versus Nonstubs

Leveraged recaps are purported to be value-increasing transactions since they increase the magnitude of the tax shield and should also lead to increase in efficiency. In an effort to investigate whether the magnitude of the leverage change occurring in different recaps resulted in differential value changes, we classified firms as stubs if the stock price was a small fraction (25% or less) of their prerecap price following the restructuring. Stub firms experienced the greater increase in leverage as indicated by a mean TC/TC of 0.7178 after the recap versus 0.2465 before. For nonstub firms, the mean TD/TC was 0.5416 and 0.1725, respectively. All of the stub firms are included in the Solomon Brothers Stub Index (this index is not exhaustive of all firms which have undergone LRs.) Other firms not in that index but meeting our criterion were also classified as stubs. We classified 19 of the firms as stubs and eight firms as nonstubs. Abnormal returns in event time are reported for a period starting 30 days before the LR announcement through 150 days after completion.

F. Equity Returns for Stubs Versus Nonstubs

Exhibit 5 presents equity abnormal returns for firms classified as stubs and nonstubs. The CAARs for the 28-day period preceding the recap announcement are comparable for these samples: 6.64% for stubs and 8.74% for nonstubs (both significant at the 1% level). In the two-day recap announcement window, the CAAR for stubs is 9.24% (significant at the 1% level), and the AARs on both days t = -1 and t = 0 are significantly positive. For nonstubs, the comparable CAAR is -0.50% (statistically insignificant). Interestingly, the AARs on days t = -4 and t = -2 are statistically significant; the AARs on days t = -1 and t = 0 are, however, insignificant. This result is presumably due to the fact that seven of the eight nonstub firms were in play prior to the LR announcement. [TABULAR DATA OMITTED]

For firms classified as stubs, the CAAR continues to increase in the postannouncement period, reaching 33.53% by day t = + 150. In contrast, the firms classified as nonstubs experience no additional gains in the postannouncement period; the CAAR over the period t = (+ 1, + 150) is -0.61% (statistically insignificant). Finally, over the periods t = (-30, + 150) and t = (-1, + 150) the difference in the CAARs for the two samples is significant at the 10% and 5% levels, respectively. It would appear that the market distinguishes between stub firms and nonstub firms, with the restructuring of the former with its greater use of leverage as creating more value.(6)

V. Testable Hypotheses for Free Cash

Flow

Under the free cash flow hypothesis, firms which execute LRs should have financial characteristics which distinguish them from other firms in their industry.(7) The primary variable which would distinguish such firms is the level of free cash flow, which represents the residual cash flow after all positive net present value capital expenditures have been made (Jensen [12, 13]). Therefore, under this hypothesis, firms which execute an LR should display levels of free cash flow (or its empirical proxy, a measure of distributable cash flow) which are higher than the industry aggregate. Further, the premium paid in the LR should be positively correlated with the firm's level of free (or distributable) cash flow. Finally, since agency problems associated with free cash flow should decline with increasing levels of managerial ownership, the free cash flow hypothesis suggests that premiums should be positively correlated with changes in management equity holdings resulting from the restructuring.

Evidence in support of the free cash flow hypothesis as a plausible motivation underlying the LR requires a comparison of the financial characteristics of the sample firms with a set of control firms - those which did not executive an LR. The control used for each of the sample firms is the set of all firms in the same four-digit SIC code which did not undergo an LR and had complete data in the COMPUSTAT files for the entire study period. In constructing control characteristics, individual firm values for each variable are first summed to obtain an industry figure. An industry average is then computed, and the sample firm compared against his industry average. The number of firms in any one industry ranged from two to 78 and the mean number of firms in an industry was 18.

Six different characteristics are used to compare the sample and control firms: (i) distributable cash flow (DCF), (ii) leverage, (iii) size, (iv) capital expenditures, (v) five-year growth in capital expenditures, and (vi) five-year growth in sales. The firs four variables are computed for the fiscal year preceding the start of takeover activity (for firms in play), or the recap announcement (for firms not in play). Growth rates in capital expenditures and sales are estimated over the five years preceding the lR. The variables are defined as follows:

DCF = CF/EQ where:

CF = Income - Tax - Interest - Pfddiv

Income = operating income before depreciation

Tax = total income taxes minus change in

deferred taxes over the past two years

Interest = gross interest expense on short!term

and long!term debt

Pfddiv = dividend on preferred stock

EQ = market value of equity

There are two aspects of the above DCF measure which merit explanation - common dividends and capital expenditures have not been deducted in estimating DCF. Given Jensen's definition of free cash flow - residual cash flow after all positive net present value capital expenditures had been made - it would appear that our measure is inappropriate. However, since it is not possible to specify whether or not the firm's capital expenditures are value-maximizing, subtracting capital expenditures from the cash flow measure may introduce a bias; if capital expenditures have been nonvalue-maximizing, then reducing the cash flow by this amount would hide the fact that the firm actually has a much higher level of free cash flow than the measure suggests. To avoid this problem, we use a measure of distributable cash flow - one which estimates the residual or discretionary cash flow available to the firm. Secondly, since common dividends constitute a discretionary cash flow, they are not deducted from the cash flow measure.(8)

Two different measures of leverage are employed: the long-term debt (at book value) to market value of equity ratio, and, the long-term debt (at book value) to total assets ratio. The measure of size is the market value of equity, and capital expenditures are measured as the ratio of capital expenditures to market value of equity.

A. Results

Exhibit 6 reports the values of the variables discussed above for the sample firms and the industry aggregates. Results from parametric and nonparametric statistical tests of the difference in means between sample and industry aggregates for each variable are also given in Exhibit 6. [TABULAR DATA OMITTED]

The results suggest that firms which have undergone leveraged recapitalizations are significantly larger then the average firm in the industry and have significantly higher levels of distributable cash flows. These results are consistent with the notion of a reduction in agency problems associated with free cash flow as a contributor to the observed equity gains. The magnitude of debt usage, capital expenditures and growth rates of sales and capital expenditures for these firms are, however, comparable to industry levels. The lack of difference between levels and growth rates in capital expenditures is also not inconsistent with the free cash flow hypothesis, since the hypothesis also suggests that such capital expenditures could be "wasteful", or nonvalue-maximizing.

In an effort to further clarify some of these issues, we used an OLS regression to check if the level of distributable cash flow (DCF) and changes in executive ownership (EXEC) have any power to explain premiums paid in each of the LRs. As discussed in the section before, the premium should be positively related to the level of distributable cash flow and changes in executive holdings. The measure of DCF used in the regression has been defined earlier. The changes in executive holding enters as a dummy variable where EXEC = 1 (EXEC = 0) for values above (below) the median change in executive holdings. The premium is computed as the cumulative standardized abnormal return over the period from 30 days prior to the start of takeover activity to the completion date for firms in play and over the period starting 30 days before the recapitalization announcement to the completion date for firms that were not in play.

Regression results for the two different specifications are given below (two-tailed t-statistics are in parentheses). DCF is the only explanatory variable in the first regression. In the second specification, changes in executive ownership (EXEC) are also included as an explanatory variable.(9)

Premium = 4.64 + 86.05 DCF
 (0.63) (2.[04.sup.*])
F = 4.[17.sup.*] [R.sup.2.sub.adj] = 0.1126


Premium = -1.97 + 96.81 DCF + 10.65 EXEC
 (-0.81) (2.35[).sup.*] (1.67[).sup.**]
F = 3.[64.sup.*] [R.sup.2.sub.adj] = 0.1741


(means(*) significant at the 5% level and ** means significant at the 10% level.)

Results from the two regressions are comparable. The coefficient for distributable cash flow is positive and significant (at the 5% level) in both regressions, providing support for the free cash flow hypothesis. The coefficient for changes in executive holdings has the appropriate sign and is marginally significant (at the 10% level). Overall, these results are supportive of the arguments contained in Jensen [12, 13] regarding the role of debt in reducing the agency problems associated with free cash flow.

VI. Summary and Conclusions

This paper reports on an empirical examination into a relatively new form of corporate restructuring - the leveraged recapitalization. As the name suggests, the firm greatly increases its leverage but as contrasted with the leveraged buyout, the firm remains publicly traded. We provide a comprehensive analysis of this form of restructuring for all successful LRs in the period through 1988. In the majority of cases in our study, an LR is the culmination of ongoing takeover threats against the firm. In general, as with LBOs, there is a substantial increase in managerial ownership of firm equity following the recapitalization.

Results show that the leveraged recapitalization increases the wealth of the firm's equityholders. In cases where the firm was a target of ongoing takeover attempts, equity value increases over the entire bidding period, and the incremental wealth impact of the LR itself is relatively small. Firms which were not the target of ongoing takeover attempts experience large market adjusted increases in equity value upon the announcement of a proposed LR. Interestingly, further increases in equity values are observed in the postannouncement period, suggesting that the market does not instantenously impound the benefits of the LR and/or the pricing of the new debt securities to be issued in the transaction. When firms are classified as stubs or nonstubs, we observe subtantially greater positive equity abnormal returns for the former firms.

When estimated through the announcement window, excess returns accruing to stockholders of leveraged recaps appear to be smaller than those earned by public stockholders bought out in LBOs. If, however, the additional gains to LR equityholders that accrue in the postcompletion period are also included, then the overall excess returns from the two types of transactions are similar in magnitude. This result supports the notion that LRs are as wealth-enhancing as LBOs without having to go private. We report on two possible explanations for the observed increases in equity values - a wealth tranfer away from existing bondholders and Jensen's free cash flow hypothesis. The data does not provide support for the wealth transfer hypothesis. However, we do find support for the free cash flow hypothesis.

Appendix - Types of Leveraged

Recapitalization Transactions

1. CBS - Offered to purchase up to 6,365,000 shares of common stock by exchanging each share tendered for $40 in cash and $110 principal amount of senior notes. The cash portion was financed with bank loans and private placement of preferred stock.

2. Colt Industries - Each original share was exchanged for $85 in cash and one new share. The retirement savings plan got additional shares in lieu of cash. The transaction was financed by bank loans, the sale of subordinated bonds and cash on hand.

3. FMC - Each original share was exchanged for $80 in cash plus one new share. The PAYSOP, pension plan and certain members of management exchanged old shares for 5.667 new shares and no cash. The Thrift Plan exchanged old shares for $25 in cash and 4.209 new shares. The cash portion was financed with bank loans and the sale of subordinated bonds.

4. Fruehauf - Each old share was exchanged for approximately $37 in cash, 0.44 shares of new payment-in-kind preferred stock, and 0.25 shares of new class B stock. Management and an LBO firm received new class A stock (with a controlling vote). The cash portion was financed with bank loans and the sale of subordinated bonds.

5. Harcourt Brace - Each share received a $40 cash dividend and one share of new payment-in-kind preferred stock. The cash portion was financed with bank loans, the sale of subordinated bonds and high-yielding preferred stock.

6. Holiday - Each share received a $65 cash dividend. Management was given restricted shares equal to 10% of the fully diluted stock outstanding. The dividend was financed by bank loans and the sale of subordinated bonds.

7. Holly - After adjusting for a concomitant stock split, each share received a $13.35 cash dividend and 0.864 shares of new stock. The firm's ESOP wound up with 20% of the stock. The cash portion was financed with cash on hand and with the sale of notes.

8. INCO - A dividend of $10 in cash was paid and financed with cash on hand and bank loans.

9. Interco - Each share received $38.60 in cash, $11 per share in principal amount of senior subordinated debentures, $6.55 principal amount in subordinated discount debentures, $5.60 principal in junior payment-in-kind subordinated debentures, and $9.00 in exchangeable preferred stock with warrants attached. The cash portion was financed with bank loans.

10. Kroger - Each share received $40 in cash and $17 principal amount of junior subordinated debentures. The cash portion was financed with bank loans and the sale of subordinated bonds.

11. Litton - The firm offered to purchase up to 11,400,000 shares of stock outstanding (27.1$ of the stock) in exchange for $29.20 in floating rate subordinated debentures, $29.20 in subordinated notes and $29.20 in subordinated debentures.

12. Multimedia - Shareholders were offered four options. They could exchange each old share for : (i) $125 principal amount of subordinated discount debentures and the right to buy 0.527 new shares at $5.27 per share or 0.58 new shares at $5.80 per share; (ii) $39.90 in cash and $29.73 principal amount of subordinated discount debentures; (iii) $34.63 in cash, $29.73 principal amount in subordinated discount debentures and 0.527 new shares; (iv) $34.10 in cash, $29.73 principal amount of subordinated discount debentures and 0.58 new shares. The cash portion was financed with bank loans and the sale of debentures.

13. Newmount Mining - A $33 cash dividend was paid and financed with bank loans.

14. Optical Coating - The firm tendered for 3,674,000 shares of stock (61% of the stock outstanding) at $18 per share. This was financed with bank loans, preferred stock and cash on hand.

15. Owens Corning Fiberglass - Each share received $52 in cash and $35 principal amount in junior subordinated debt and one new share. Management and employees received no cash but more shares. The cash portion was financed with bank loans and the sale of debentures.

16. Phillips Petroleum - The firm offered to exchange 72,580,000 shares (46.9% of the stock) for $29 principal amount of floating rate senior notes, $18 principal amount of senior notes and $15 principal amount of subordinated debentures.

17. Quantum Chemical - A %50 cash dividend was paid. This was financed with bridge loans and refinanced with the sale of subordinated bonds and cash on hand.

18. Santa Fe Southern Pacific - A $25 cash dividend and $5 principal amount of senior subordinated debentures were paid to each share. The cash portion was financed with bank loans.

19. Shoney's - Each share received $16 in cash and $4 principal amount of subordinated debentures. The cash portion was financed with bank loans and cash on hand.

20. Standard Brand Paints - The firm offered to buy up to 6,000,000 shares (53% of the stock) at between $25 and $28 per share. This was financed with bank loans and the sale of senior notes and preferred stock.

21. Swank - Each share received $17 in cash and one new share. Shares held by management and employee plans received no cash but exchanged their shares for approximately 9.5 new shares. The cash portion was financed with bank loans.

22. Topps - A $10 cash dividend was paid and financed with bank loans.

23. Tyler - A $10 cash dividend was paid. This was preceded by asset sales which when combined with the dividend substantially increased the firm's leverage.

24. Union Carbide - The firm offered to buy up to 47.1 million shares (35% of the stock) in exchange for $25 principal amount of senior debentures, two issues of senior notes each with a $20 principal amount and $20 in cash. The cash portion was financed with bank loans.

25. USG - Each share received $37 in cash, $5 principal amount of high-yielding junior subordinated payment-in-kind debentures and one new share of common. The cash portion was financed with bank loans and the sale of senior subordinated debentures.

26. Unocal - The firm offered to buy up to 87.2 million shares (50.5% of the stock) for $20 principal amount of senior notes, $32 principal amount of floating rate senior notes, and $20 principal amount of senior extendible notes.

27. Viacom - Each share received $42.75 in cash, 0.30 shares of extendible payment-in-kind preferred stock and 0.2 new shares of common stock. The cash portion was financed with bank loans, the sale of senior subordinated debentures and a cash investment by the major investor.

(6) For nine of the 19 firms classified as stubs there were bond issues outstanding. For these nine firms, the CAAR from 30 days before the LR announcement through the announcement day is -0.04% (statistically insignificant), suggesting that bondholder wealth losses were marginal at worst. Further, there is no evidence of further significant declines in the CAAR in the 150-day period following the LR announcement, and the CAAR by day t = + 150 positive. For the three nonstub firms with traded bonds, the CAAR for the 31-day period culminating in the LR announcement is -8.17%. While this is consistent with a wealth transfer, the small sample size makes it difficult to draw any conclusions. In general, the evidence, apart from this exception, suggests that wealth increases for equityholders are not at the expense of the firm's bondholders.

(7) Handa and Radhakrishnan [11] do not test the free cash flow hypothesis. Denis [9] mentions the free cash flow hypothesis but does not test it.

(8) Our definition of DCF differs from Lehn and Poulsen [17] in that do not deduct common stock dividends. We feel that our DCF measure is more consistent with that described in Miller and Modigliani [21] and takes into account the fact that common dividends are a discretionary item.

(9) One firm, Topps Co., had been public for only one year prior to the LR and complete data was not available. The regression results are based on the remaining sample of 26 firms.

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Title Annotation:Topics in Capital Restructuring; inlcudes appendix
Author:Gupta, Atul; Rosenthal, Leonard
Publication:Financial Management
Date:Sep 22, 1991
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