Corporate Buy-Outs: Diversifying Into Debt
Pity the poor defendant who can’t post bond, nervously twisting his cap in the cold marble halls of justice--a worry for law reformers as far back as Charles Dickens’ “Bleak House.”
Concern for impecunious defendants doesn’t usually extend to multinational oil giants like Texaco Inc. But last month a jury ordered Texaco to pay $10.5 billion to Pennzoil Co. If the judge upholds the award, Texaco may have to post a $12-billion bond in order to appeal. The company announced that it couldn’t raise that amount and would probably be forced to seek protection under the federal bankruptcy laws.
The jury’s award is silly and the judge in the case will decide early this week whether it should stand. But it is just one of the more bizarre fallouts from the recent spate of megamergers and corporate buy-outs that have been changing the face of U.S. industry. Last year, Texaco and Pennzoil battled for the right to take over Getty Oil. Getty finally threw in its lot with Texaco, but only after signing a preliminary agreement with Pennzoil. The jury found that Texaco and Getty acted improperly and ordered them to pay Pennzoil damages that are about the same as the Getty purchase price.
Since the stock market set the total value of Texaco at about $6.5 billion (down from about $8 billion before the jury’s award), the obvious question is how it could pay $10.5 billion. But then, how can a company worth $8 billion pay that much to buy Getty Oil in the first place?
The answer, of course, is that they borrowed the money. The takeover mania of the past several years has been fueled by a huge increase in company borrowings. For instance a recent buy-out of the Beatrice Cos., a sprawling food conglomerate, has left the company with total debt of almost $6 billion, or almost four times its stockholders’ equity.
Traditional accounting rules say that investors should get nervous whenever company debt exceeds equity by any amount. The big run-up in debt, or “leveraging” of company balance sheets, has led to alarmist predictions of the imminent collapse of corporate America and proposals that government should begin to pass rules to curb takeovers.
The takeovers and buy-outs have tended to follow three general patterns. Some are simply traditional corporate mergers by companies seeking to diversify their product lines. Tobacco companies like Philip Morris and R.J. Reynolds, for example, recently bought up General Foods and Nabisco as protection against a long-term trend away from cigarette smoking. The more headline-grabbing deals have been the predatory swoops by high-rolling takeover artists such as T. Boone Pickens and Carl C. Icahn going after big, but undervalued, companies like Gulf Oil, Philips Petroleum and TWA.
The most interesting takeovers of all have been the recent deals to “take companies private.” Private investors, often part of the company’s management team, buy up all outstanding public stock and are then free to run it as they see fit. They are not bound by SEC rules, do not have to publish annual reports, do not have to hold public shareholder meetings.
The Beatrice deal is the largest recent example of the going-private trend. The new chief executive, Donald P. Kelly, was the boss of a company bought by Beatrice last year and he lost his job in the merger shuffle. Other big companies that have taken their stock off the public markets include Uniroyal, Dr. Pepper, Levi Strauss and Denny’s Restaurants. Economists estimate that going-private deals have reduced the amount of company equity on the stock markets by 17%.
The missing equity, of course, is being replaced by debt. What almost all the mergers and takeovers have in common is that the new investors put up only a small amount of the purchase price. The rest is borrowed money secured by the assets of the company being purchased. The big debt load that Beatrice has taken on, for example, is to pay off the stockholders.
The debt is put up by banks and, most recently, by big-money players like pension funds and money managers who buy up “junk bonds”--a phrase that chills the hearts of financial conservatives. Junk bonds are high-risk bonds that pay a high rate of interest. Until Drexel Burnham Lambert, a Wall Street firm, pioneered junk bonds a few years ago, the corporate bond market was open only to the highest grade paper, carrying interest rates usually lower than that charged by banks for long-term loans, and certainly much lower than the 14%-18% “junk” rates.
Scary as the term may be, the advent of junk bonds probably does not portend a national disaster. Junk bonds that are subordinated to other business debts are actually a lot like stock.
The stock market has long grossly undervalued U.S. companies. Even with the recent bull market, the outstanding stock of publicly traded companies is worth only about 75% of the replacement value of their assets. It simply makes no sense for company treasurers to give away pieces of their companies at a discount by selling stock. Junk bonds are a much better deal, even with the high interest rates, because the interest payments are tax deductible, while dividend payments are not.
And the managers of most of the newly bought out companies don’t plan to leave all the debt on their balance sheets for long. Beatrice, for example, plans to pay off about $1.5 billion of debt right away by selling off divisions.
Stripping away assets to pay debt makes sense in many companies. The Reagan business tax cuts improved corporate cash flows dramatically, and many companies bought into businesses they knew little about. Oil companies, for example, diversified into everything from retailing to office products. The new restructurings often straighten out misguided judgments of five years ago.
A good argument can be made that privately held companies perform better than public ones. Managers who own more of the company will be less inclined to waste earnings on showy advertising or expensive offices. They can also concentrate on longer-term earnings without worrying about their stock price.
Any good idea carried to excess, of course, is dangerous. Lending to Mexico was smart in 1975; the problem was that no one knew when to stop. The banks and pension fund managers could work themselves into the same predicament with junk bonds and overleveraged corporate balance sheets. Cautious regulation may be called for. The Federal Reserve on Friday proposed placing the same margin requirements on junk bonds that apply to stock.
The basic direction of the U.S. corporate restructuring is probably a healthy one. The ability of the government to apply gentle, intelligent restraint will be a test of its national economic maturity.
