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The 1958 Modigliani-Miller theorem, one of the fundamentals of modern corporate finance, states that corporations should be indifferent as to whether they issue debt or equity. Of course the Theorem rests on a number of assumptions about perfect markets and rational investors which are twaddle in the real world, but that doesn’t stop professors from teaching it, and greedy corporate managers, investment bankers and buyout artists from using it to justify their nefarious schemes...
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In my own solidly prosperous home town of Cheltenham, for example, Boots occupies a large and well appointed store at the premier location in the community – at the intersection of the blue-collar “High Street” and the up-market Regency-era “Promenade.” The damage to the town’s real estate values, its employment and its community coherence from Boots’s disappearance will be very substantial indeed. THAT, not a percentage point or two on debt financing costs, is the true and ultimately hidden cost of the Theorem. Like most such second-order effects, it is ignored by simplistic academic nostrums."
The costs of modern financial theoryBy Martin Hutchinson
July 30, 2007
SourceMartin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.comIn the past week, a number of leveraged buyout transactions have fallen apart, whether temporarily or permanently one cannot yet say. The Alliance/Boots buyout in Britain, Cadbury Schweppes’ sale of its US drinks business and the Chrysler buyout in the US are just the best-known examples of multi-billion dollar transactions that can’t currently get completed. Naturally, these and other failures impose costs on the participants, but they raise a more fundamental question: how great are the costs imposed on the world by modern financial theory, in which debt financing is preferable to equity?
The 1958 Modigliani-Miller theorem, one of the fundamentals of modern corporate finance, states that corporations should be indifferent as to whether they issue debt or equity. Of course the Theorem rests on a number of assumptions about perfect markets and rational investors which are twaddle in the real world, but that doesn’t stop professors from teaching it, and greedy corporate managers, investment bankers and buyout artists from using it to justify their nefarious schemes. The Theorem has a further pernicious effect in treating managers as impartial arbiters of capital structure, rather than the representatives of shareholders they are paid to be. By treating debt and equity capital equally, it divorces equity capital from its true function of ownership and management from its true function of stewardship on behalf of the owners.
It follows from the Theorem that in an environment such as the United States in which corporations are taxed but debt interest is tax deductible, it is optimal to load up the balance sheet with as much leverage as the banks and the capital markets will give you. That maximum in recent years of mild steady economic growth and over-liquid capital markets has in practice been pretty close to 100% of your capital employed, plus a bit extra for management stock options and investment banker fees.
The result of the Theorem has been to leverage up corporate balance sheets far beyond the point at which operations are damaged and the costs ignored by the Theorem exceed any putative benefits. The beneficiaries of this are of course corporate management, who by indulging in unnecessary and expensive share buybacks can minimize the earnings dilution caused by their own excessive stock options grants. Cisco, the doyen of the tech sector in the late 1990s, has cleaned up its act since the millennium, but even so in the year to June 2006 it paid $8.3 billion, more than its net income of $5.6 billion or its operating cash flow of $7.9 billion, to repurchase 435 million shares at $19 per share. At the same time it issued 230 million shares through management stock options and allowed the exercise of 136 million stock options at an average price of $10 per share. Thus Cisco’s entire operations for that year, employing many thousands of highly skilled employees, were as far as its shareholders were concerned more or less futile.
In my business school days, after the Theorem had been promulgated but before it became ubiquitous, we spent a great deal of time trying to determine the optimal capital structure for a company. This was done by examining the company’s expected profitability and cash flow in a moderate sized recession, and then determining the level of debt which could be serviced by the company in that recession, given the need to keep banks and capital markets open to the company for necessary capital spending and possible expansion. (Generally, it was thought that except in brief moments of panic a ratio of 2 to 1 between the company’s pretax income and its interest payments was sufficient to maintain civilized relationships with financing sources.) We all recognized that debt was cheaper than equity, particularly after tax was taken into account, so the optimal structure was that which maximized the amount of relatively cheap debt, while maintaining financial flexibility in a recession – generally with a margin of safety which varied with the conservatism of the person doing the calculation. In principle quite simple, likely to preserve companies through all but the worst recessions and prevent bankruptcies unless something went severely wrong on the operating side.
Since the Theorem, this has all gone horribly wrong. Management doesn’t care too much whether the company survives the next recession, it wants to maximize its own returns before that recession hits. Private equity owners care still less; they want to asset-strip the company, cut costs as far as they dare and sell it, before the recession hits. (Incidentally, one can indulge in hollow laughter when reading in Friday’s Wall Street Journal that private equity funds are now trying to speed up the process of cutting costs and selling companies. Do you think that, like Andrew Marvell sensing mortality “at their back they always hear, Time’s winged chariot hurrying near”?)
Private equity owners and corporate management now prefer debt, even in jurisdictions where the tax treatment of debt interest does not give it an advantage. In Britain, for example, nearly all corporate income tax is reclaimable on share dividends, so that in terms of cash flow, equity has almost the same tax treatment as debt (only retained earnings are taxed more heavily.) In a well adjusted financial system, that would encourage corporations to pay out 100% of their earnings as dividends. In the world of the Theorem, management loads up with debt anyway.
So what of the deals which are falling apart? To what extent has the Theorem imposed additional costs on the economy, by leading buyouts to be attempted that should have been left alone?
In the case of Chrysler, it’s not surprising that the buyers can’t get the financing deal done. Automobile manufacturing is an extremely risky business, particularly for a company which is a laggard in its home market. Private equity buyers offered Daimler Chrysler an opportunity to get out of an investment it bitterly regretted having got into. Chrysler would only be viable if financed entirely by equity, probably as part of a much larger group, but its pension liabilities made it unattractive for any such group to invest in. The LBO deal was thus a complete waste of money, transferring fees unnecessarily to investment bankers and eventually causing losses to the providers of bridge financing, but beyond that it did not significantly alter the company’s likely destiny.
In the case of Cadbury Schweppes, there is a race against time before the onset of tighter money hits. Many business situations face this race against time, for example real estate projects which need to be financed and leased before the next downturn. In Cadbury Schweppes’ case however the impending downturn is the company’s friend not its enemy. If conditions in the debt markets remain favorable, the company will be forced by the fringe operator Nelson Peltz to split its Cadbury chocolate and Schweppes drinks businesses, product of a 1969 merger that made excellent operating sense then and subsequently. Doubtless the Cadbury business itself would then be subjected to a leveraged buyout, which might create value for shareholders but would certainly destroy a company founded in 1824.
If on the other hand the debt markets close, so that the spin-off of beverage businesses is not merely postponed but cancelled, then the company will be safe from predators and will be able to resume its centuries-long history of high-quality and ethical business. The Theorem’s cost in the latter case will be modest – just a few unnecessary legal bills and maybe some investment banking fees. In the former case, in which Cadbury Schweppes is broken up, the Theorem’s long term cost will be far higher than any possible saving from cheaper financing.
In the case of Alliance Boots, the acquired company was a highly profitable pharmacy and retailing operation, established in 1849 and probably good for another 158 years if the leveraged takeover and buyout industries had not intervened. It had already merged with Alliance Unichem in 2005, to the benefit of nobody very much beyond the managements concerned, so was a vulnerable target when the private equity industry came looking for assets to buy. Since the financing has run into difficulties and much of the Boots operating top management has opted to leave the company, notwithstanding the immensely attractive remuneration packages being dangled before them, it’s likely that this buyout will turn into a disaster, particularly if as seems likely a recession intervenes. Boots will be transformed from a huge and profitable retailing company into a husk of its former self and large numbers of British high streets and shopping centers will be landed with the problem of a large “anchor” space for which the occupant has gone out of business.
In my own solidly prosperous home town of Cheltenham, for example, Boots occupies a large and well appointed store at the premier location in the community – at the intersection of the blue-collar “High Street” and the up-market Regency-era “Promenade.” The damage to the town’s real estate values, its employment and its community coherence from Boots’s disappearance will be very substantial indeed. THAT, not a percentage point or two on debt financing costs, is the true and ultimately hidden cost of the Theorem. Like most such second-order effects, it is ignored by simplistic academic nostrums.
As a final example, the Sainsbury and Bancroft families, founders and controlling owners of Sainsbury’s and Dow Jones respectively are being advised loudly and persistently by Wall Street and its friends in the media that they should stop resisting the “raider” bids for their family companies and devote the cash proceeds from a sale to the usual wasteful if not destructive charitable activities. Certainly, Rupert Murdoch and the Qatar-based Delta Two fund are respectable. Nevertheless, can there be any doubt that the unique positions in their industries of both the British supermarket chain Sainsbury’s (founded in 1869) and Dow Jones, publishers of the Wall Street Journal (founded in 1882) would be severely damaged if not destroyed by the fast-buck operators, ignorant of the acquired operations’ traditions, who would be put in to manage them by the new owners? It currently seems likely that only family recalcitrance, hopefully accompanied by the emergence of unexpected financing difficulties, can stop these deals going through. As before, the Theorem’s views on capital structure and its elevation of theoretical return over all other considerations are likely to prove hugely damaging and costly to real-world businesses of enormous value.
Blackstone’s shares are now trading at over 20% below the private equity fund’s Initial Public Offering price, and it is rumored that the IPO for KKR, the granddaddy of all buyout titans, will be cancelled. Thus if the current difficulties in the financing market are extended we may see the end of the insane fashion for leverage and quick profits that has been so damaging to both the British and US economies.
Roll on, recession!