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How Risky Is the Debt in Highly Leveraged Transactions
Abstract
This paper estimates the systematic risk of the debt in public leveraged recapitalizations. We calculate this risk as a function of the difference in systematic equity risk before and after the recapitalization. The increase in equity risk is surprisingly small after a recapitalization, ranging from 37% to 57%, depending on the estimation method. If total company risk is unchanged, the implied systematic risk of the post-recapitalization debt in twelve transactions averages 0.65. Alternatively, if the entire market-adjusted premium in the leveraged recapitalization represents a reduction in fixed costs, the implied systematic risk of this debt averages 0.40.
... The PE fund's engagements are terminated at the so-called exit either by being written off or sold. A comprehensive overview of PE is given by: Lowenstein (1985), Sahlman and Stevenson (1985), Smith (1986), Jensen (1989a), Jensen (1989b), Kaplan (1989a), Kaplan (1989b), Kaplan and Stein (1990), Sahlman (1990), Jensen (1991), Kaplan (1991), Bygrave and Timmons (1992), Kaplan and Stein (1993), Gompers and Lerner (1997), Black and Gilson (1998), Gompers (1998), Wright and Robbie (1998), Gompers and Lerner (1999), Gompers and Lerner (2000), Lerner (2000) and Cotter and Peck (2001). nor modifications to the capital structure could improve company performance. ...
... investment-grade debt betas range from 0.19 to 0.25 and their high-yield betas range from 0.29 to 0.54. Kaplan and Stein (1990) determine implied debt betas for a sample of 12 leveraged recapitalisations of publicly quoted companies. 30 They calculate equity beta factors before and after the transactions and provide the implied debt betas under two different assumptions. ...
... In this case, the corresponding average (median) implied systematic debt risk is 0.40 (0.35). The method developed by Kaplan and Stein (1990) also offers an alternative way of calculating reduced operating beta factors. If a fixed beta factor for the debt is inserted into their model, a hypothetical reduced operating beta factor can be calculated. ...
Weinvestigate,the risk-adjusted performance ,of Private Equity (PE) investments ,on a
... Other studies have uncovered evidence of changes in factor loadings over specific corporate events. Using a small sample of leveraged recapitalizations, Kaplan and Stein (1990[20] ) find that asset betas seem to have decreased after the increase in financial leverage. Healy and Palepu (1990[17]) find that after a seasoned equity issue, business risk appears to have increased. ...
... Healy and Palepu, 1990[17] ) or other corporate events (e.g. Grullon and Michaely, 2004[14] and Kaplan and Stein, 1990[20]) is that exchange offers are relatively 'clean' events. By construction there are no new investment projects or major cost-cutting or reorganization programs in the sample that may change the correlation between asset returns and the market. ...
... Compared to other event-type studies that include some evidence on factor loadings (e.g. Kaplan and Stein, 1990[20] and Healy and Palepu, 1990[17]) the sample of exchange offers used in this paper is very clean. The assets of the company remain unchanged and there are no major reorganization or cost-cutting programs announced around the exchange offer. ...
This paper tests Modigliani-Miller proposition 2, which states that expected stock returns should increase in financial leverage. Past cross-sectional studies have uncovered evidence contradicting this proposition. We employ a time-series approach which allows us to better control for the firm's unlevered (business) risk i.e. asset betas. In addition, we allow for time-varying (non-zero) debt betas, use different measures of financial leverage and consider the Fama-French 3-factor model as an alternative to the CAPM. Using a sample of pure capital structure changes in the form of exchange offers, we find that implied asset betas change after the offer has closed and by too much to be consistent with proposition 2. We conclude that the factor loadings of highly levered companies are too low and find some supporting evidence from a simple trading strategy involving firms with extreme levels of financial leverage.
... In the CAPM framework under credit risk, the equity beta is reduced and the debt beta is introduced. The debt beta approach has been developed since the 1970s (Haugen and Pappas, 1971;Conine, 1980;Harris and Pringle, 1985;Kaplan and Stein, 1990). While Haugen and Pappas (1971) and Harris and Pringle (1985) at least mention that a combined stock-corporate bond index is needed to compute the debt beta, more recent literature omits this fact and mainly focuses on tax shield analyses under credit risk (Ruback, 2002;Fernandez, 2004;Arzac and Glosten, 2005). ...
... As a result, the WACC cannot be calculated via stock index betas. This is the reason why, i.a., Kaplan and Stein (1990) and Damodaran (2012, 411) have to make an assumption about the systematic risk of corporate bonds in terms of stock market risk. In either case, this method implies an inconsistent debt-equity ratio. ...
Credit risk analysis represents a growing field in financial research since decades. However, in cost of capital computations, credit risk is merely taken into consideration at the level of the debt beta approach. Our paper proves that applications of the debt beta approach suffer from unrealistic assumptions. As an advantageous approach, we develop an alternative framework to determine costs of capital based on Merton’s model. We present (quasi-) analytic formulas for costs of equity and debt which are consistent with Modigliani-Miller theory in continuous-time and discrete-time settings without taxes. Our framework is superior to the debt beta approach regarding the quantity and quality of required data in peer group analysis. Since equity and debt are represented by options in Merton’s model, we compute expected option rates of return. Thereby, our paper is also related to the recently growing literature on expected option returns.
... It is well-known that Private Equity (PE) funds acquire companies in leveraged buyouts (LBO) using substantial amount of debt (Kaplan and Stromberg, 2009). The sharp increase in portfolio company leverage following a PE-sponsored buyout has generated conflicting views. 1 One well-known view is that PE fund managers over-leverage their portfolio companies (Kaplan and Stein, 1990;Andrade and Kaplan, 1998), and buyout capital structure is primarily driven by credit market conditions instead of debt capacity of a given firm (Axelson, Jenkinson, Strömberg, and Weisbach, 2013). The alternate view is that high leverage is efficient since PE leads to lower debt-equity conflicts for a given debt ratio relative to public firms (Malenko and Malenko, 2015), thereby allowing PE-backed firms to trade off the benefits of higher debt against potentially lower expected cost of financial distress. ...
Detractors have warned that Private Equity (PE) funds tend to over-lever their portfolio companies because of an option-like payoff, building up default risk and debt overhang. This paper argues PE-ownership leads to substantially higher levels of optimal (value-maximizing) leverage, by reducing the expected cost of financial distress. Using data from a large sample of PE buyouts, I estimate a dynamic trade-off model where leverage is chosen by the PE investor. The model is able to explain both the level and change in leverage documented empirically following buyouts. The increase in optimal leverage is driven primarily by a reduction in the portfolio company's asset volatility and, to a lesser extent, an increase in asset return. Counterfactual analysis shows significant loss in firmvalue if PE sub-optimally chose lower leverage. Consistent with lower asset volatility, additional tests show PE-backed firms experience lower volatility of sales and receive greater equity injections for distress resolution, compared to non PE-backed firms. Overall, my findings broaden our understanding of factors that drive buyout leverage.
... We use ROA and operating cash flow to total assets (Cashflow/TA) lagged one year to control for firm profitability and Leverage measured as total debt divided by total assets lagged one year. Where buyouts are excessively funded with debt, the probability of a distressed company leading to failure may be higher (Kaplan & Stein, 1990;Wilson & Wright, 2013). Seventh, we added dummy variables representing firms at particular risk of failure owing to their agethat is, firms younger than 3 years (AgeRisk1) and firms between 3 and 9 years of age (AgeRisk2). ...
Previous research has focused on a private equity (PE) firm’s role as principal in its relationship with an investee, but few studies have looked into their role as agents for their investors. We examine how a PE firm’s relationship as agent for limited partners (LPs) and banks influences its incentives to resolve financial distress in the investee. We examine the effect of PE fundraising reputation, PE fundraising activity, and PE bank affiliation on the likelihood of a financially distressed buyout ending in bankruptcy. We build a unique data set of 338 distressed buyouts in the United Kingdom to test our hypotheses.
... In the CAPM framework under credit risk, the equity beta is reduced and the debt beta is introduced. The debt beta approach has been developed since the 1970s (Haugen and Pappas, 1971; Conine, 1980; Harris and Pringle, 1985; Kaplan and Stein, 1990). ...
... Given that we are interested in evaluating representative firms, we normalize parameter c to 1. 17 We assume that the market cost of debt r B is 0.06, which is consistent with the empirical evidence on the cost of debt (e.g., Kaplan and Stein 1990;Cooper and Davydenko 2007). We derive r A using CAPM with the corresponding (unlevered) industry betas estimated by Fama and French (1997) and assuming an expected market return r M ð Þ of 0.08. ...
We use a dynamic model of the firm to ascertain both the value and the determinants of the debt tax shields. For a representative U.S. firm, we find that the value of the interest tax shields represents less than 5 % of firm value, and it varies considerably across U.S. industries. Our results also show that this component of firm value behaves counter-cyclically over the business cycle. Finally, besides the interest rate on debt and the corporate income tax rate, we find that the curvature of the production function is one of the main determinants of the tax advantage of debt.
... In this application, the set of possible comparable firms is drawn from among the 136 HLTs in Stein (1990 and 1993) involved within one year in a corporate change-of-control transaction comparable to that of the target firm. The added requirement of matching the target firm's industry reduced the number of observations available for the comparable industry transaction method to 38. ...
The comparable company method of valuation does not account for the value of corporate control. Therefore, the method must be adjusted if it is being used to value a company involved in a change-of-control transaction. We provide two alternative ways to adjust the comparable company method for the value of corporate control. The efficacy of the adjusted comparable company method is confirmed on 51 highly leveraged transactions (HLTs) from Kaplan and Ruback (1995).
... Yet, one may still wonder how a leveraged buyout investment can have a low beta. Kaplan and Stein (1990) …nd that in highly leveraged transactions, a sharp increase in debt coincides with a "surprisingly small" increase in equity beta. Hence, increased leverage may have a countervailing e¤ect on the asset beta. ...
This thesis is composed by three articles in seemingly unrelated fields. The first article is exploring the effects of short-sales constraints on the delay of information incorporation into stock prices. The second one is estimating the risk and risk-adjusted return of private equity funds. The last one is investigating whether stock price behaviors are temporarily different around the so-called price barriers. Although the topics are not connected, the methodologies are centered on a classical issue in empirical finance, the market beta. For short-sales constraints, the lagged market beta is used as a barometer to evaluate the price delays of stocks caused by the policy. For private equity funds, their beta is estimated by our new GMM-style methodology. In the last paper, we use the change of the contemporaneous beta to detect the price barriers and then evaluate the barrier effects.
... On the other hand, BO beta estimates using index returns and reported in Section 4.1.4 are about 1. Also see (Kaplan and Stein 1990). 22 Phalippou and Gottshalg (2009) use the term Profitability Index (PI) to refer to this measure; however, because Ljungqvist and Richardson (2003) use the term PI to refer to a slightly different performance measure, for consistency we refer to it as PME, as defined in Kaplan and Schoar (2005). ...
We review the theory and evidence on venture capital (VC) and other private equity: why professional private equity exists, what private equity managers do with their portfolio companies, what returns they earn, who earns more and why, what determines the design of contracts signed between (i) private equity managers and their portfolio companies and (ii) private equity managers and their investors (limited partners), and how/whether these contractual designs affect outcomes. Findings highlight the importance of private ownership, and information asymmetry and illiquidity associated with it, as a key explanatory factor of what makes private equity different from other asset classes.
... One can guess that, for assets with very low credit risk, this should not be much of an operational issue, as the beta and risk premium on this type of corporate debt must be small. However, for risky loans, the beta and risk premium could increase significantly (Kaplan and Stein, 1990). ...
This chapter discusses asset & liability management (ALM), the control of value creation and risks in a bank. Unlike the usual practice of restricting ALM to the control of interest rate and liquidity risks, it proposes a framework to analyze both value creation and the control of risks. It provides a microeconomic-based valuation model of a bank. This allows an integrated discussion of fund transfer pricing, deposit pricing (fixed and undefined maturities), loan pricing, the evaluation of credit risk provisions, the measurement of interest rate risk for fixed and undefined maturities, the diversification of risks, and the allocation of economic capital. Besides a comprehensive summary of the literature on ALM in Banking, it makes six contributions related to transfer pricing, risk-adjusted pricing of loans, provisioning of credit risk, the relevant maturity to price and hedge deposits with uncertain maturities, the after-tax valuation of equity, and the hedging of economic profit.
... However, Denis and Kadlec (1994), after correcting for potential biases due to infrequent trading and price adjustment delays, find no evidence of changes in beta after equity offerings or share repurchases. Finally, Kaplan and Stein (1990) find that equity betas do increase after leveraged recapitalizations that substantially increase leverage, but much less than predicted by the Hamada model. 15 See, for example, Aharony, Jones, and Swary (1980), Altman and Brenner (1981), and McEnally and Todd (1993). ...
Price changes can be associated with either increases or decreases in systematic risk. Most of the existing literature focuses on the leverage effect, which suggests that betas decrease (increase) as stock prices increase (decrease). Alternatively, betas may move in the same direction as stock prices if growth opportunities have higher betas and are more volatile than assets in place. Our empirical work indicates that the latter effect dominates, even for a sub-sample of highly levered firms that presumably have relatively fewer growth opportunities. We also link variations in betas to firm characteristics that proxy for the proportion of the firm invested by growth opportunities. These growth opportunity proxies explain a large portion of cross-sectional differences in betas. Finally, we find preliminary evidence that investors may under-react to the decrease in the beta of stocks that have performed particularly poorly.
... In extreme cases, use of the promised yield as the cost of debt could lead to the nonsensical result that the cost of debt exceeds the cost of equity. As Kaplan and Stein (1990) say \Because of default risk expected returns [on corporate debt] are undoubtedly lower than promised returns" (page 221). ...
This paper proposes a practical way of estimating the cost of risky debt for use in the cost of capital. The cost of debt is different from both the promised yield and the risk-free rate, which are sometimes used for this purpose, because of the expected probability of default. The Merton (1974) model of risky debt is employed to decompose the promised yield spread into expected default and return premium components. The advantage of the proposed approach is that all inputs are easily observable. The parameters of the Merton model implied by these inputs are used to compute the expected return on debt. It is argued that, although Merton's framework is simple and stylised, it can be used to estimate the expected return as a fraction of the observed promised market yield in a way consistent with equilibrium. The cost of debt is computed for parameter values that are typical for high grade and low grade debt. It is found that, while using the promised yield as the cost of debt may be adequate for high grade debt, it is likely to cause significant errors for high-yield bonds. In such cases the approach proposed in this paper can be used to adjust the WACC for the probability of default on the firm's debt.
... Although the availability of data on expected return on corporate bonds is currently not as widely available as data on expected return on shares, one can expect that, with the growth of corporate bonds, asset-backed securities markets, and credit derivatives, more information will be available on the expected return on corporate bonds. For instance, a study by Kaplan and Stein (1990) for the junk bond markets or by Delianedis and Santa Clara (1999) for the investment grade bond markets provide the following realized excess premium, the difference between realized returns on corporate bonds of different grades and return on federal risk-free bonds. These are reported in Table 2 It must be noted that the empirical evidence on bond risk premium was estimated before 12 the subprime crisis. ...
The purpose of the 'tutorial' paper is to present a model to value banks. First, three traditional models are summarised briefly. Next, a 'fundamental' bank valuation model is introduced. Based on sound economics and finance principles, it allows to identify the various sources of value and to derive managerial implications, such as the measurement of interest rate risk on non-maturing deposits. A first contribution includes the breakdown of the value of equity into two parts: a liquidation value and a franchise value. A second contribution is to call the attention of the corporate bond market, instead of the equity market, to find adequate risk premium to value banks. The valuation model concerns on-balance sheet banking business, such as deposit taking and lending. Off-balance sheet business, such as advisory services, can be valued with standard corporate finance tools.
... For more information on the LBO wave of the 1980s, seeKaplan & Stein (1990, 1993 andKaplan (1991).Denis (1994) suggests that high leverage alone does not improve performance as much as a combination of high leverage and management reorganization does. One exception to the view that LBOs are unambiguously positive for value isMatsa (2008), who finds that LBOs in the supermarket industry lead to costly underinvestment in inventories.www.annualreviews.org ...
We review recent evidence and future directions for empirical research on financial contracting in the context of corporate finance. Specifically, we survey evidence pertaining to incentive conflicts, control rights, collateral, renegotiation, and interactions between financial contracts and other governance mechanisms. We also discuss directions for future research, concluding that the financial contracting approach offers a potentially fruitful perspective for empirical researchers seeking to better understand a variety of issues in corporate finance including capital structure, investment policy, payout policy, and corporate governance.
Measures of private equity performance based on cash flows do not account for a discount‐rate risk premium that is a component of CAPM alpha. We create secondary market PE indices and find that PE discount rates vary considerably. NAVs are too smooth because they fail to reflect variation in discount rates. While the CAPM alpha for our index is zero, the GPME based on cash flows is large and positive. We obtain similar results for a set of synthetic funds that invest in small cap stocks. Ignoring variation in PE discount rates can lead to a misallocation of capital. This article is protected by copyright. All rights reserved
Almost exactly 30 years ago, a famous article by Michael Jensen in the Harvard Business Review predicted that private equity would ‘eclipse’ the public corporation because it was a superior form of corporate ownership. Trends since 1989 seem to bear out Jensen’s prediction. Much time and energy has gone into studying whether the private equity model does see companies being run better for investors and society. Progress has been made and most studies find positive results. But samples are usually relatively small. And the relative complexity of private equity transactions, combined with a high level of privacy, makes it hard to find financial statements that are tractable enough for meaningful analysis. After 30 years of research, we argue that a conclusive answer to the question remains further away than might seem to be the case. In the meantime, the appropriate regulatory response involves narrowing the ‘regulatory gap’ between public and private markets.
The bond market is an important source of financing for Private Equity (PE) sponsored transactions. Using the methodology suggested by Bessembinder et al. (2009), we find that PE-sponsored bonds underperform comparable benchmarks. This is especially true for bonds with credit ratings below investment grade and those issued in hot bond markets. Furthermore, bonds sponsored by more experienced PE groups (PEGs) underperform bonds associated with less experienced PE groups, while bonds backed by investment bank-affiliated PEGs underperform bonds sponsored by other PEGs. These findings highlight the risk and return relationship in the high-yield bond market related to leveraged buyouts (LBOs) and PEGs.
Obwohl erste Kapitalbeteiligungsgesellschaften bereits schon vor fast 30 Jahren gegründet wurden 1, zeigt die Akzeptanz gegenüber Beteiligungskapital erst mit Beginn der achtziger Jahre eine positive Entwicklung 2 3. Neben der zunehmenden Expansions- und Bridge -Finanzierung ist dies insbesondere auf die Beteiligung an MBO-Übernahmen zurückzuführen, die im Verhältnis zu den übrigen Finanzierungsanlässen zwar ein höheres Risiko, aber auch ein größeres Renditepotential beinhaltet 4.
Bond covenants protect against risk factors in Chinese global bonds. This paper examines the impact of bond covenants on credit spread valuation and the configural cue processing of analysts in the aftermath of the Global Financial Crisis at the beginning of the 2011 China economic slowdown. We used a mixed methods approach that incorporates surveys and interviews to collect data from bank and investment analysts representative of the market. The results reveal important and statistically significant relationships between Chinese global bond valuation and covenant protection against 1) information asymmetry; 2) the agency problem; 3) financial distress and 4) bankruptcy. Covenant protection against bankruptcy is identified as the most significant factor in main effects and two-factor interactive effects. This is followed by a moderate influence on bond valuation from covenant protection against agency problems, financial distress and information asymmetry risks.
This chapter examines abnormal performance and systematic risk of private equity investments around the world. The methodology extends the standard internal rate of return (IRR) approach and allows the estimation of systematic risk and abnormal returns of a cross-section of private equity investment cash flows. The empirical results show that the systematic risk (beta) for the venture and buyout investments is significantly different from 1.0, while abnormal returns (as measured by alpha) are significantly positive for both types of deals. Buyout investments are characterized by lower systematic risk and higher abnormal performance than venture capital investments.
The LBO phenomenon has recently experienced considerable attention in academic literature; especially wealth effects on the parties involved seem to be at the forefront of interest. However, empirical academic work on ex-post value creation and performance analysis is still in its infancy, predominantly due to the lack of available information on firms that have experienced and completed an LBO. Daniel Pindur analyzes value creation in successful LBOs on investment level conceptually and empirically from an LBO equity investor perspective. Based on the LBO transaction model, the author decomposes total proceeds to LBO equity investors and derives a two-tier framework of an internal and an external perspective, thereby structuring the conceptual discussion of various determinants affecting these components. Founded on a novel database with detailed company- and transaction-specific information for a sample of 42 realized European LBO investments, he then quantifies LBO investment performance measures and their components and identifies the determinants of value creation in LBO investments. © Deutscher Universitäts-Verlag | GWV Fachverlage GmbH, Wiesbaden 2007.
7 Flujo total para deuda y recursos propios y coste ponderado real de la deuda y los recursos propios. Apéndice 1: Resumen de las fórmulas más importantes a) Perpetuidades sin crecimiento b) Empresas con crecimiento constante c) Caso general Apéndice 2: Fórmulas alternativas para empresas con crecimiento constante. 8 ANEXOS 1 Esta nota surgió a raiz de una pregunta formulada por don Rafael Termes, que ayudó al autor a pensar en estos temas. Por esto -y por tantas otras cosas-le expreso otra vez mi agradecimiento.
Abstract Many empirical “anomalies” are actually consistent with the single beta capital asset pricing model if the empiricist utilizes an equity-only proxy for the true market portfolio. Equity betas estimated against this particular inefficient proxy will be understated, with the error increasing with the firm's leverage. Thus, firm-specific variables that correlate with leverage (such as book-to-market and size) will appear to explain returns after controlling for proxy beta simply because they capture the missing beta risk. Loadings on portfolios formed on relative leverage and relative distress completely subsume the powers of the Fama and French (1993) returns to small minus big market capitalization (SMB) portfolios and returns to high minus low book-to-market (HML) portfolios factors in explaining cross-sectional returns.
This paper addresses the problem to assess the effect of leverage on the cost of capital for buyout performance analyses. It draws on a unique and proprietary set of data on 133 US buyouts between 1984 and 2004. For each of them, we determine a public market equivalent that matches it with respect to its timing and its systematic risk. We show that under realistic mimicking conditions, the average cost of capital is below the commonly used benchmark S&P 500. Thereby, we control for two important aspects: for the risks taken by lenders in the buyout transactions (which affects the sponsors’ risks), and for the corresponding cost of debt (which lowers the return of the public market equivalent). Only with borrowing and lending at the risk-free rate is the average cost of capital close to the average index return. This finding is particularly important as existing literature on that topic tends to rely on benchmarks without a proper risk-adjustment.
This paper examines financial distress and its effect on organizational efficiency. Imperfect information and conflicts of interest among the firm's claimholders influence the outcome of financial distress. Methods for resolving distress and controlling conflicts of interest are discussed. New evidence on financial restructuring and distress costs is presented along with evidence on the organizational restructuring that accompanies financial distress. The evidence demonstrates that financial distress has benefits as well as costs, and that financial and ownership structure affect the net costs.
We report that 31% of the firms completing leveraged recapitalizations between 1985 and 1988 subsequently encounter financial distress. Following their recaps, the distressed firms exhibit (1) poor operating performance due largely to industry-wide problems, (2) surprisingly low proceeds from asset sales, and (3) negative stock price reactions to economic and regulatory events associated with the demise of the market for highly-leveraged transactions. The incidence of distress is not related to several characteristics that have previously been linked with poorly-structured deals. We thus attribute the high rate of distress primarily to unexpected macroeconomic and regulatory developments.
the consequences of this policy for economy-wide quantities such as investment and consumption. Contrary to conventional wisdom we find that changes in tax policy have only a small effect on equilibrium levels of corporate leverage. The intuition lies in the endogenous adjustment of debt prices in equilibrium that make debt relatively more attractive and largely offset the effect of the changes in tax policy.
Analysis of data on all public company management buyout (MBO) bids during 1988- 2003 finds (1) contestable public company MBO bids face significantly more competition, and are much less likely to be completed, than any other negotiated type of public company acquisition, and the prices offered in MBO bids that face actual competition are increased significantly more than MBO bids that do not face actual competition; (2) public company MBOs have over time been more aggressively protected by more and larger termination fees, resulting in less competition and higher completion rates; and (3) procedural techniques for improving fairness to target shareholders (special committees, shopping, and shareholder votes) have no observable impact on MBO bids. Based on these findings, I argue (1) contestable public company MBOs exposed to robust bid competition should face less judicial scrutiny than other conflict transactions, but (2) courts should be willing to scrutinize deal protections more closely in the context of MBOs than in arm's-length transactions, in order to protect and facilitate that competition.
Purpose
The tax advantage of debt is considered an important motivation for highly leveraged transactions. The German government limited the tax deductibility of interest expenses to 30.0 percent of earnings before interest, taxes, depreciation, and amortization (the interest barrier rule) in 2008 to reduce the tax incentives for debt financing. This study aims to evaluate the impact of the introduction of the interest barrier rule.
Design/methodology/approach
The paper analyzes the changes in the value of the tax shield for German leveraged buyouts as a result of the promulgation of an interest barrier rule. Tax shields are computed to quantify the wealth transfer from taxpayers to corporations.
Findings
Prior to the 2008 tax reform, tax shields contributed 8.4 percent to the transaction price, thereby raising the equity value by 33.0 percent on average. With the introduction of the interest barrier rule, the value of tax shields is reduced by 35.1 percent. Affecting more than 75 percent of buyouts, the rule significantly lessens the tax incentive for high levels of debt. The reduction of the corporate tax rate from 31.7 percent to 26.3 percent further lowers the value creation potential. The limited interest deductibility may therefore reduce the number of leveraged buyouts and hence economic growth, unless other non‐debt forms of financing can fulfill the need for capital.
Originality/value
As the first continental European study, this research concentrates on the impact of the German interest barrier rule on value creation in highly leveraged transactions. Conclusions can be drawn in a broader European context.
We investigate market reactions after Public to Private (P2P) announcements in the European market, using a data set from 1996-2002. Furthermore, we analyze different sources of value creation for pre-P2P shareholders. The results of our cross-sectional regression support the agency cost theory as companies with a high pre-P2P free float and thus conceivably weak monitoring by shareholders tend to show high abnormal P2P returns. We find that companies whose stock performed badly before the buyout as well as companies which are undervalued with respect to their industry peer group tend to have higher abnormal returns.
The expected cost of capital is a crucial component for most of the topics in corporate finance. Unfortunately in the presence of risky debt, it is systematically overestimated. This bias is increasing in leverage and the volatility of cash flows. We show the existence of the bias and assess its size. We finally propose a novel methodology to obtain a direct unbiased estimation of the expected return on assets. This method avoids the computational error that is obtained from the estimation of the individual components.
We explore the determinants of equity price risk for a large sample of non-financial corporations. By estimating both cross-sectional and time-series models, we show that operating and asset characteristics are by far the most important determinants of equity price risk. In contrast, for the average (median) firm, financial risk accounts for less than a third (15%) of observed stock price volatility. This explains why financial distress (as opposed to economic distress) was surprisingly uncommon in the nonfinancial sector during the recent crisis even as measures of equity volatility reached unprecedented highs.
The takeover boom of the 1980s challenged entrenched corporate management, who since the 1930s held the reins of corporate decision-making, often at the expense of shareholder interests. The effect was to transfer control over vast corporate resources to smaller, more focused and in many cases private corporations and individuals, who returned huge amounts of equity capital to shareholders. This accomplished the freeing of resources long trapped in mature industries and uneconomic conglomerates.The popular media's stories about this phenomenon differ markedly from the stories told by careful academic research. We examine these stories, the political reactions to them, and the economic effects of the reactions. We also evaluate the effect of corporate restructuring on capital investment and R&D. We explain the phenomenon of excess capacity, and the forces that lead to exit. Finally, we analyze the breakdown of internal control systems and make recommendations to strengthen them.
Since financial myths exploded in the 1980s, the perspective of time creates a unique opportunity to update and expand the analysis begun in Glenn Yago's 1991 book,Junk Bonds: How High Yield Securities Restructured Corporate America (Oxford University Press). At the time of its publication, Junk Bonds drew controversial responses from the Federal Reserve and government agencies. In retrospect, the evidence clearly casts favorable light on the role of high yield securities. The research presented here demonstrates how financial innovations enabled capital access for industrial restructuring, capital and labor productivity gains, and improved global competitiveness. Enough time has now passed to allow this dispassionate empirical analysis to shear away the hype and hysteria that surrounded the Wall Street scandals, Washington controversies, and media frenzy of the time. Beyond Junk Bonds provides a one-stop data, reference and case study presentation of the firms and securities in the contemporary high yield market and the financial innovations that spurred growth in the nineties and will continue to finance the future. The high yield market incubated successive waves of financial technologies that now proliferate beyond junk bonds to all the dimensions and dynamics of global debt and equity capital markets. It charts the recovery of the market in the 1990s, the recent wave of fallen angels, distressed credits and defaults, and suggests how the high yield market will be recreated in the global market of the 21st century. It explicates the linkages between the high yield market, and other credit and equity markets in managing a firm's capital structure to execute its business strategy. The weakening of the U. S. economy in 2001 and the huge shock to Wall Street from the terrorist attacks of September 11 witnessed a historic increase in the yield to maturity of high yield bonds. Despite the volatility in the flow of funds to high yield mutual funds and occasionally sharp increases in non-investment grade debt yields, the asset class has been one of the best performing fixed income investments of the past decades. In fact, high yield bonds offer an attractive risk-reward ratio competitive with more traditional asset classes. Anyone active in corporate finance, financial institutions and capital markets will find this book a must read for interpreting and understanding the recent history both of the high yield marketplace and its interaction with private equity, public equity, and fixed income markets.
I estimate the market's valuation of the net benefits to leverage using panel data from 1994 to 2004, identified from market values and betas of a company's debt and equity. The median firm captures net benefits of up to 5.5% of firm value. Small and profitable firms have high optimal leverage ratios, as predicted by theory, but in contrast to existing empirical evidence. Companies are on average slightly underlevered relative to the optimal leverage ratio at refinancing. This result is mainly due to zero leverage firms. I also look at implications for financial policy. Copyright (c) 2010 the American Finance Association.
When calculating a company's weighted average cost of capital, or WACC, common practise in estimating the expected costs of debt is to use the promised yield on new bonds. Although this practice makes sense in the case of investment-grade issuers of low probabilities of default, the use of yields in the case of risky, particularly high-yield, issuers could materially overstate the cost of debt and, along with it, the WACC. To avoid this distortion, the promised yields on risky debt should be adjusted downward to account for the probability of default and the expected losses associated with it. To make this adjustment, this article recommends and illustrates the use of Robert Merton's model of risky debt to decompose promised yield spreads into two components: expected return premiums and compensation for expected default losses. The advantage of the proposed approach is that all inputs are easily observed, consistent with current market conditions, and commonly used in calculating the cost of capital.
In this study, we explore the impact of cash flow volatility on the costs of debt. Further, we find that managers attempt to manage earnings for good financial performance according cash flow volatility
This paper examines the role of financial policy as a catalyst for organizational change. The subject is Sealed Air Corporation, a company with substantial free cash flow that undertakes a leveraged special dividend. While the stock price response to announcement is typical, Sealed Air exhibits dramatic, sustained, post-dividend performance improvement. Evidence indicates this performance results from managers' conscious and successful use of financial leverage as a tool to disrupt the status quo and promote internal change, including establishing a new objective, changing compensation systems, and reorganizing manufacturing and capital budgeting processes.
Research suggests that leveraged buyouts create value through significant operating performance improvements. There is little evidence that buyouts lead to widespread employee layoffs, wage reductions, or wealth transfers from bondholders. LBOs continue to be controversial, however. Future research should focus on the effect of buyouts on firms' strategic investments, buyout firms' performance under difficult economic conditions, and the frequency and costs of financial distress associated with buyouts. Research can also focus on improving the performance of public corporations by examining the individual contributions of debt, management ownership, and corporate governance changes to podt-buyout performance.
This paper applies the standard risk-neutral valuation framework to tax shields generated by dynamic debt policies. We derive a partial differential equation (PDE) for the value of the debt tax shield. For a class of dynamic debt policies that depend on the asset's free cash flows, value, and past performance, we obtain closed-form solutions for the PDE. We also derive the tax-adjusted cost of capital for free cash flows and analyze the conditions under which the weighted average cost of capital is an appropriate discount rate. Finally, we derive closed-form solutions for equity betas, which differ from the formulas that have traditionally been used to lever and unlever equity betas.
This paper presents evidence on changes in operating results for a sample of 76 large management buyouts of public companies completed between 1980 and 1986. In the three years after the buyout, these companies experience increases in operating income (before depreciation), decreases in capital expenditures, and increases in net cash flow. Consistent with the operating changes, the mean and median increases in market value (adjusted for market returns) are 96% and 77% from two months before the buyout announcement to the post-buyout sale. The evidence suggests the operating changes are due to improved incentives rather than layoffs or managerial exploitation of shareholders through inside information.
When shares are traded infrequently, beta estimates are often severely biased. This paper reviews the problems introduced by infrequent trading, and presents a method for measuring beta when share price data suffer from this problem. The method is used with monthly returns for a one-in-three random sample of all U.K. Stock Exchange shares from 1955 to 1974. Most of the bias in conventional beta estimates is eliminated when the proposed estimators are used in their place.
Nonsynchronous trading of securities introduces into the market model a potentially serious econometric problem of errors in variables. In this paper properties of the observed market model and associated ordinary least squares estimators are developed in detail. In addition, computationally convenient, consistent estimators for parameters of the market model are calculated and then applied to daily returns of securities listed in the NYSE and ASE.
Previously issued as WP#1913-89 in series.
This paper presents an aging analysis of 741 high yield bonds and finds default, exchange, and call percentages substantially higher than reported in earlier studies. By December 31, 1988, cumulative defaults are 34 percent for bonds issued in 1977 and 1978 and range from 19 to 27 percent for issue years 1979–1983 and from 3 to 9 percent for issue years 1984–1986. Exchanges are also a significant factor although they often are followed by default. Moreover, a significant percentage of high yield debt, 26–47 percent for 1977–1982, has been called. By December 31, 1988, approximately one third of the bonds issued in 1977–1982 has defaulted or been exchanged, and an additional one third had been called. On average, only 28 percent of these issues are still outstanding. There is no evidence that early results for more recent issue years differ markedly from issue years 1977 to 1982.
This study develops an alternative way to measure default risk and suggests an appropriate method to assess the performance of fixed-income investors over the entire spectrum of credit-quality classes. The approach seeks to measure the expected mortality of bonds and the consequent loss rates in a manner similar to the way actuaries assess mortality of human beings. The results show that all bond ratings outperform riskless Treasuries over a ten-year horizon and that, despite relatively high mortality rates, B-rated and CCC-rated securities outperform all other rating categories of the first four years after issuance, with BB-rated securities outperforming all others thereafter. Copyright 1989 by American Finance Association.
A vast and often confusing economics literature relates competition to investment in innovation. Following Joseph Schumpeter, one view is that monopoly and large scale promote investment in research and development by allowing a firm to capture a larger fraction of its benefits and by providing a more stable platform for a firm to invest in R&D. Others argue that competition promotes innovation by increasing the cost to a firm that fails to innovate. This lecture surveys the literature at a level that is appropriate for an advanced undergraduate or graduate class and attempts to identify primary determinants of investment in R&D. Key issues are the extent of competition in product markets and in R&D, the degree of protection from imitators, and the dynamics of R&D competition. Competition in the product market using existing technologies increases the incentive to invest in R&D for inventions that are protected from imitators (e.g., by strong patent rights). Competition in R&D can speed the arrival of innovations. Without exclusive rights to an innovation, competition in the product market can reduce incentives to invest in R&D by reducing each innovator's payoff. There are many complications. Under some circumstances, a firm with market power has an incentive and ability to preempt rivals, and the dynamics of innovation competition can make it unprofitable for others to catch up to a firm that is ahead in an innovation race.
The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows--more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why diversification programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.
Takeovers: Their causes and consequences
- Jensen
Original issue high yield bonds: Aging analyses of defaults, exchanges and calls
- Asquith