Why Capital Structure Matters - WSJ

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OPINION April 21, 2009

Why Capital Structure MattersCompanies that repurchased stock two years ago are in a world of hurt.

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Opinion

By MICHAEL MILKEN

Thirty-five years ago business publications were writing that major money-center banks

would fail, and quoted investors who said, "I'll never own a stock again!" Meanwhile,

some state and local governments as well as utilities seemed on the brink of collapse.

Corporate debt often sold for pennies on the dollar while profitable, growing companies

were starved for capital.

If that all sounds familiar today, it's worth

remembering that 1974 was also a

turning point. With financial institutions

weakened by the recession, public and

private markets began displacing banks

as the source of most corporate

financing. Bonds rallied strongly in 1975-

76, providing underpinning for the stock

market, which rose 75%. Some high-yield

funds achieved unleveraged, two-year

rates of return approaching 100%.

The accessibility of capital markets has grown continuously since 1974. Businesses are

not as dependent on banks, which now own less than a third of the loans they originate.

In the first quarter of 2009, many corporations took advantage of low absolute levels of

interest rates to raise $840 billion in the global bond market. That's 100% more than in

the first quarter of 2008, and is a typical increase at this stage of a market cycle. Just as

in the 1974 recession, investment-grade companies have started to reliquify. Once that

happens, the market begins to open for lower-rated bonds. Thus BB- and B-ratedcorporations are now raising capital through new issues of equity, debt and

convertibles.

This cyclical process today appears to be where it was in early 1975, when balance

sheets began to improve and corporations with strong capital structures started

acquiring others. In a single recent week, Roche raised more than $40 billion in the

public markets to help finance its merger with Genentech. Other companies such as

Altria, HCA, Staples and Dole Foods, have used bond proceeds to pay off short- term

bank debt, strengthening their balance sheets and helping restore bank liquidity. These

new corporate bond issues have provided investors with positive returns this year even

as other asset groups declined.

The late Nobel laureate Merton Miller and I, although good friends, long debated

Chad Crowe

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whether this kind of capital-structure management is an essential job of corporate

leaders. Miller believed that capital structure was not important in valuing a company's

securities or the risk of investing in them.

My belief -- first stated 40 years ago in a graduate thesis and later confirmed by

experience -- is that capital structure significantly affects both value and risk. The

optimal capital structure evolves constantly, and successful corporate leaders must

constantly consider six factors -- the company and its management, industry dynamics,

the state of capital markets, the economy, government regulation and social trends.

When these six factors indicate rising business risk, even a dollar of debt may be too

much for some companies.

Over the past four decades, many companies have struggled with the wrong capital

structures. During cycles of credit expansion, companies have often failed to build

enough liquidity to survive the inevitable contractions. Especially vulnerable are

enterprises with unpredictable revenue streams that end up with too much debt during

business slowdowns. It happened 40 years ago, it happened 20 years ago, and it's

happening again.

Overleveraging in many industries -- especially airlines, aerospace and technology --

started in the late 1960s. As the perceived risk of investing in such businesses grew in

the 1970s, the price at which their debt securities traded fell sharply. But by using the

capital markets to deleverage -- by paying off these securities at lower, discounted

prices through tax-free exchanges of equity for debt, debt for debt, assets for debt and

cash for debt -- most companies avoided default and saved jobs. (Congress laterimposed a tax on the difference between the tax basis of the debt and the discounted

price at which it was retired.)

Issuing new equity can of course depress a stock's value in two ways: It increases the

supply, thus lowering the price; and it "signals" that management thinks the stock price

is high relative to its true value. Conversely, a company that repurchases some of its

own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce

the supply and increase the price. Dozens of finance students have earned Ph.D.s by

describing such signaling dynamics. But history has shown that both theories about

lowering and raising stock prices are wrong with regard to deleveraging by companies

that are seen as credit risks.

Two recent examples are Alcoa and Johnson Controls each of which saw its stock price

increase sharply after a new equity issue last month. This has happened repeatedly

over the past 40 years. When a company uses the proceeds from issuance of stock or

an equity-linked security to deleverage by paying off debt, the perception of credit r isk

declines, and the stock price generally rises.

The decision to increase or decrease leverage depends on market conditions and

investors' receptivity to debt. The period from the late-1970s to the mid-1980s generally

favored debt financing. Then, in the late '80s, equity market values rose above the

replacement costs of such balance-sheet assets as plants and equipment for the first

time in 15 years. It was a signal to deleverage.

In this decade, many companies, financial institutions and governments again started to

overleverage, a concern we noted in several Milken Institute forums. Along with others,

including the U.S. Chamber of Commerce, we also pointed out that when companies

reduce fixed obligations through asset exchanges, any tax on the discount ultimately

costs jobs. Congress responded in the recent stimulus bill by deferring the tax for five

years and spreading the liability over an additional five years. As a result, companies

have already moved to repurchase or exchange more than $100 billion in debt to

strengthen their balance sheets. That has helped save jobs.

The new law is also helpful for companies that made the mistake of buying back their

stock with new debt or cash in the years before the market's recent fall. These

purchases peaked at more than $700 billion in 2007 near the market top -- and in many

cases, the value of the repurchased stock has dropped by more than half and has led

to ratings downgrades. Particularly hard hit were some of the world's largest companies

(i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial,

Lincoln National, Washington Mutual); retailers (Macy's, Home Depot); media companies



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(CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox).

Without stock buybacks, many such companies would have little debt and would have

greater flexibility during this period of increased credit constraints. In other words, their

current financial problems are self-imposed. Instead of entering the recession with

adequate liquidity and less debt with long maturities, they had the wrong capital

structure for the time.

The current recession started in real estate, just as in 1974. Back then, many real-

estate investment trusts lost as much as 90% of their value in less than a year because

they were too highly leveraged and too dependent on commercial paper at a time when

interest rates were doubling. This time around it was a combination of excessive

leverage in real-estate-related financial instruments, a serious lowering of underwriting

standards, and ratings that bore little relationship to reality. The experience of both

periods highlights two fallacies that seem to recur in 20-year cycles: that any loan to real

estate is a good loan, and that property values always rise. Fact: Over the past 120

years, home prices have declined about 40% of the time.

History isn't a sine wave of endlessly repeated patterns. It's more like a helix that brings

similar events around in a different orbit. But what we see today does echo the 1970s,

as companies use the capital markets to push out debt maturities and pay off loans.

That gives them breathing room and provides hope that history will repeat itself in a

strong economic recovery.

It doesn't matter whether a company is big or small. Capital structure matters. It always

has and always will.

Mr. Milken is chairman of the Milken Institute.

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