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You can be your own white knight.

You can be your own white knight There's a lesson to be learned from the 1980s. Poison pills and other anti-takeover provisions may be useful roadblocks, but they can do little to stop a well-financed raider with an attractive offer for shareholders. The best protection against unfriendly acquisitions is a fully valued stock, and the key for CFOs in defending against a raid is to think like a raider and make a preemptive strike.

One popular method of maximizing shareholder value while remaining independent is to perform a leveraged recapitalization, or a recap. Recaps provide benefits to both shareholders and manegement. Shareholders receive a large, onetime dividend and an ongoing interest in the company through a remaining equity stake, known as stub equity. Management receives an increased equity stake and remains independent.

The cost of a leveraged recapitalization tends to ne lower than taking the company private in an LBO. Required rates of return on stub equities are in the 20-percent range, while professional LBO investors typically require a 30- to 40- percent return. Because the stub's value is higher, the dividend component (comprised of borrowed money) is less.

Finally, recaps solve the dilemma faced by CFOs slowly growing, mature companies: what to do with the excess cash flow that entices raiders into making a bid.

Consider several recapitalizations in recent years: Multimedia, Colt Industries, Owens Corning, FMC, Holiday Corp., Harcourt Brace Jovanovich, and USG. These recapitalizations provide examples of solid operating companies that took on huge sums of debt to maximize shareholders value and remain independent. They are also examples of how successful recaps can be, with profitable ongoing operations and investments that have generally outperformed the S&P 500. As seen in the figure on pages 50 and 51, credit statistics and the stub performance of previous recaps help illustrate the potential rewards and risks inherent in the anti-takeover measure.

CFOs can maximize shareholder value while remaining independent by using the same tools that raiders use: divestitures and high-yield bonds. Cost-cutting strategies also have to be employed, including making painful decisions like eliminating jobs.

An employee Stock Ownership Plan (ESOP) is a more benign tool that can be used in a recap to obtain tax and financial advantages. With an ESOP, CFO's may be able to obtain an interest rate approximately 20 percent below the comparable non-ESOP rate (because of the tax advantages for banks). And because the loan principal is tax deductible if a leveraged ESOP is in place, the cost of debt is even lower. In addition, giving employees a financial stake in the firm's success can improve morale and productivity. During the traumatic post-transaction period, this commitment to the firm's success is invaluable.

The case of the

prime target corporation

To illustrate how a typical recap works, consider the following. Prime Target Corporation (PTC) is a takeover candidate. In response to this threat, management has considered several defensive measures and has decided to recapitalize and implement poison pill provisions. Depending on the state of incorporation and the facts and circumstances surrounding the transaction, the recap may take the form of a merger/reclassification, a stock repurchase, or a cash dividend.

The company has 10 million shares of stock trading at $17 per share. A total of 850,000 shares are owned by management before the recapitalization (an ownership position of 8.5 percent). The recapitalization plan that the company has chosen enables the public shareholders to receive $14 in cash, a high-yield bond worth $6, and one new share (the "stub") in the recapitalized entity valued at $14. The total offer would thus have an indicated value of $24 per share.

Unlike the public shareholders, management foregoes the cash and high-yield bond portion of the package and, instead, receives the $24 in value by receiving six stub shares at $4 each.

Following the transaction, 14,250,000 shares are outstanding (public shares are unchanged at 9,150,000, and management shares grow to 5,100,000, or 850,000 x 6). Management's stake has thus increased from 8.5 percent to 36 percent, dramatically increasing its financial incentive to successfully restructure the corporation and pay off debt.

PTC is now relatively safe from a hostile takeover as management has a much larger voting interest, anti-takeover provisions are in place, and the company is already highly levered. In addition, public shareholders are pleased because they essentially "cashed out" of their investment but still maintain an equity security with potential for significant appreciation.

Requirements and risks

Not even company is suitable for a leveraged recapitalization. Essential company characteristics include a relatively debt-free capital structure, reliable cash flows, and a tough and capable management team. Another desirable characteristic, though not always necessary, is readily marketable units that can be sold to service debt if necessary.

Recaps so far have occured during the longest peacetime economic expansion in U.S. history. Their success in less prosperous times is untested. In the event of a recession, the CFO may face the most painful aspect of a recapitalization: implementing further cost-cutting measures. These strategies include selling off marketable units, slashing operating costs, selling the corporation, or even declaring bankruptcy. Issuing more debt or making a stock offering, two common alternatives for most poorly performing firms, are not viable options for the troubled, highly levered company.

The composition and nature of recap funding will vary from transaction to transaction, but generally follows a pattern including the following components:

* Senior debt (usually banks) -- This normally comprises 50 to 70 percent of total funding and carries an interest rate of 150 to 300 basis points over prime. The loan is typically secured by assets based on the following ratios: accounts receivable at 80 percent; inventory at 60 percent; and plant, property, and equipment (the liquidation value) at 60 to 80 percent, though this ratio can vary widely.

* High-yield bonds -- These typically comprise 20 to 40 percent of total funding and can command a wide range of interest rates but are normally 400 to 500 basis points over prime. These bonds are not secured with assets but are debenture bonds, subordinate to bank debt.

* Equity -- Stock comprises 5 to 20 percent of funding. Unless it is preferred stock, it does not carry a stated interest rate. Minority investors, i.e., those public shareholders who own the stub equity, require a 20- to 25-percent rate of return.

It is important to recognize that there are many subgroups within the three funding sources. For example, senior debt may include mortgage loans as well as loans secured with current assets. Included in the high-yield bond funding may be zero-coupon bonds or their close relative, payment-in-kind (PIK) securities.

PIKs are relatively expensive instrument that allows the issuer to forego cash interest payments for three to five years and, instead, pay investors with more bonds. This allows the company to conserve cash in the critical early years of a recap. Preferred stock may also be offered in PIK form, allowing the company to forego dividend payments for three to five years. These variations are but a sample of the instruments available to finance a recap.

Although often overshadowed by the issues of interest rates and payback periods, another issue--covenants--can be vitally important in a recap because it influences the firm's future operating flexibility.

Covenants are negotiated in each transaction, and specifics vary from loan to loan. Essentially, covenants act as bank-imposed requirements and restrictions on the company's future performance and operations. Covenants are written into the basic credit agreement and usually include:

* Minimum interest and fixed charge coverage ratios.

* Minimum earnings.

* Maintenance of a minimum net worth and working capital balance.

* Limitations on capital expenditures, dividends, future acquisitions, salaries and compensation, asset dispositions, and sale-leaseback transactions.

* Mandatory submission of financial reports.

From the CFO's standpoint, covenants should be as lenient as possible to allow maximum operating flexibility.

Companies must also understand that recaps cause debt to rise to unprecedented levels, often eliminating shareholders' equity for book purposes. This equity erosion raises concern about fraudulent conveyance. The key to protecting against fraudulent conveyance is to prove the company was financially solvent at the time of the transaction. This can be accomplished by obtaining what is known as a solvency opinion.

Solency opinions are designed to help protect the security interest of senior creditors in a highly leveraged transaction and are typically a condition of lending.

A solvency opinion provides an estimate of the fair saleable value of the company's assets, as well as a valuation of its liabilities (identified and contingent). The opinion is based on an analysis of the following financial and valuation issues:

* Whether the aggregate fair saleable value of the company's assets is greater than the amount of its post-transaction liabilities.

* Whether the corporation will be able to repay its obligations as they come due in the usual course of business.

* Whether the corporation will be left with an unreasonably small capital base to conduct its business after the transaction has taken place.

The role of the CFO

The CFO is the point man for the many participants in a recapitalization, including lenders, investment bankers, attorneys, CPAs, valuation consultants, and the SEC. Internally, he or she must act as financial counselor to the board of directors and management.

The CFO should not underestimate his importance in guiding the corporation safety through the maze of available options. Though investment bankers are expert at structuring and financing seemingly impossible deals, they are still outsiders. It is ultimately up to the CFO, with his intimate knowledge and hands-on experience with the company, to evaluate the feasibility of the options.

In a recap, the CFO has the unenviable position of being the final judge of the company's ability to do the deal. This is an emotional as well as a professional burden. Loyalty to colleagues and a desire to make the recapitalization work must be balanced by objective analysis of the company's debt capacity. to make matters more difficult, the CFO must evaluate the company's options while he continues to attend what seems to be an endless series of meetings and negotiations with various parties, including the bankers and senior creditors.

Three of the most critical issues that the CFO must address when evaluating the options are:

* Current debt capacity of the company.

* Possible cost-cutting, asset sales, and similar measures that can be taken to increase debt capacity.

* Maximum debt capacity of the company considering the possibility of future recessions, rising interest rates, competitive conditions, corporate culture, and the long-term growth and development of the firm.

The CFO should also be prepared to assist the bank in this due diligence investigation. This process includes an examination of five to 10 years of historical financial information; earnings and net cash flow projections; a realistic worst-case scenario; contingent liabilities; including hazardous waste liabilities; and a company and industry analysis.

A recapitalization may be one of the most challenging and difficult tasks that a CFO will ever face. But with proper planning and thoughtful execution, there can be personal as well as professional fulfillment in helping the company remain independent.
COPYRIGHT 1989 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Management Strategy; Includes a related article on the resurgent mergers and acquisitions market.
Author:Hackett, Lee P.
Publication:Financial Executive
Date:Sep 1, 1989
Words:1845
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