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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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