The recent spate of giant mergers and leveraged buyouts, financed by billions of dollars in loans and bonds, is again raising the question of whether corporate America will be crushed under the burden of paying interest on all that debt.
By some measures, corporate debt is at its highest levels since the 1920s. Instead of falling during the current economic recovery, as might have been expected, debt levels have risen. The share of corporate cash flow and profits required to pay interest are at the levels normally seen during a recession.
In reaction to recent takeover proposals--among them, two bids for RJR Nabisco and Philip Morris’ pursuit of Kraft--opinions have become even more sharply divided about whether this rising tide of debt is a bad omen for the economy.
Some academics and executives contend that corporations have borrowed beyond their means. High debt restricts the options of managements, which must pay interest rather than invest in new plants and equipment, they argue. Rising debt has also heightened risks that there will be a surge of bankruptcies and defaults during a recession or a period of escalating interest rates.
That in turn could worsen any economic downturn and strain a banking system already reeling from the highest failure rate since the Depression. The Federal Reserve Board has warned banks about such risks.
“The increase in debt does increase vulnerability,” said Ben Bernanke, a Princeton University economist and co-author of a recent study on rising corporate debt. “If a recession does occur, the economy is much more fragile.”
But other economists and business leaders contend that such fears are largely unfounded. While higher debt poses risks, they concede, the growth in debt on balance is beneficial--a sign of an expanding economy adjusting to lower inflation and lower interest rates. Also, firms that have taken on the most new debt are in industries least vulnerable to recession, they say.
Higher debt loads have also forced companies to become more efficient by shedding unproductive assets and focusing on their main lines of business. Although the rate of defaults and bankruptcies will go up in a recession, it will not cause massive dislocations as many fear, these experts argue.
“A lot of debt has been added to the balance sheets of corporate America, and on the surface one can get worried about it,” said Stephen S. Roach, senior economist at the investment firm of Morgan Stanley & Co. But new financing techniques and other arrangements in recent years actually have improved corporations’ ability to pay their debts, he argues.
Steady Rise in Debt
Whatever the arguments, few dispute the evidence that debt has risen steadily.
The total value of debt outstanding at non-financial corporations totaled $1.64 trillion at the end of 1987, up from $975 billion 5 years earlier. Corporate debt as a percentage of the nation’s gross national product rose to 36.2% last year, the highest level in the postwar period.
More important, a higher percentage of companies’ cash flow is needed to make debt payments. More than 20% of cash flow now goes to debt payment, versus only 12% to 15% during most of the 1970s, economist Bernanke said.
In addition, large U.S. companies with the highest debt burdens are paying interest that amounts to almost double their cash flow. Thus they must dip into cash reserves and incur losses, Bernanke said.
Much of the rising debt has come as a result of mergers and acquisitions, or overhauls by firms fighting off unfriendly takeovers. Rising debt has also resulted from increased use of so-called high-interest “junk” bonds as a way to finance takeovers or more mundane needs of smaller, fast-growing companies. The tax code also has fueled the debt binge by providing deductions for interest expense.
Most U.S. companies--particularly larger, more established ones--have been prudent with their debt burdens and face no immediate danger of bankruptcy under current conditions, most experts say. But higher debt could give some companies less margin for error if business conditions turn down.
Caught in a Squeeze
Such was the case with Revco, a Midwestern drugstore chain that was once one of the most well-regarded chains in the nation. The firm bought up shares from public stockholders in a 1986 leveraged buyout--a type of takeover using borrowed funds to be paid off with company assets or revenues--incurring large debts in the process. But sales and earnings proved disappointing, and the firm could not meet interest payments. In August, the firm filed for reorganization under the federal bankruptcy laws.
The risk of such calamities spreading to other firms will grow thanks to the recent spate of new takeovers and leveraged buyouts, some economists argue. Some companies may incur too much debt trying to fight off such deals.
Fruehauf Corp., a large producer of truck trailers, incurred $1.5 billion in debt in 1986 to fend off an unwanted bid by corporate raider Asher B. Edelman, leaving it with a sizable negative net worth. The firm has sold off numerous assets to pay down debt, but its truck-trailer business has dropped, resulting in losses and renegotiation of its bank loans.
But adherents to the belief that debt is not too high argue that cases such as Fruehauf are an exception, not the rule.
Leveraged buyouts and other takeovers actually make the economy more efficient, in part by reallocating investment capital to better uses, some experts argue. Companies that buy back their own stock or acquire other firms’ stock--usually because they aren’t making enough by reinvesting in their own business--pay out money to shareholders who can then reinvest that cash into stocks of faster-growing companies or other more productive uses.
Also, companies that have increased their debt the most, such as those in food processing, supermarkets and consumer products, are best able to handle it, argues Marko Budgyk, manager of credit analysis for Houlihan Lokey Howard & Zukin, a Los Angeles corporate valuation firm. That is because those industries enjoy more stable earnings and cash flow and thus can better weather a recession, Budgyk argues.
Some experts add that some companies have been too cautious about debt and should be encouraged to take on more, putting the capital to work to develop new products or invest in new plant and equipment.
Increased debt, borrowing proponents say, imposes greater discipline on managements, forcing them to cut costs, executive perks and layers of bureaucracy. Higher debt also could result in much-needed restructuring, with firms unloading low-return businesses and focusing on primary businesses.
Some analysts cite the case of Goodyear Tire & Rubber, which incurred $2.7 billion in debt to buy back its shares and fend off a hostile takeover bid by British financier Sir James Goldsmith. To pay off the borrowings, it sold almost all of its non-tire businesses--moves that some analysts say has left the company much leaner and more competitive.
Chevron is another company that has successfully managed debt, analysts say. The San Francisco-based oil company’s debt soared in 1984 when it acquired Gulf Oil in the largest-ever corporate takeover. But sales of assets and other prudent moves have whittled that debt considerably, and the firm now has enough cash reserves to make other investments. For example, it has agreed to pay $2.6 billion to buy Tenneco’s oil and gas reserves in the Gulf of Mexico, to be financed mostly from its cash reserves.
Some experts also argue that debt is not as dangerous or costly as it used to be because companies have been managing their balance sheets much more shrewdly. For example, a significant amount of short-term corporate debt--most susceptible to rising interest rates--has been converted into long-term debt in the last several years, economist Roach of Morgan Stanley said.