Chapter 13
Financial Restructuring
Value of the Firm
Start with the value of an all equity firm
Sources of potential increases or decreases in value
PV of tax shields
PV of other benefits or costs of leverage
PV of benefits or costs of control changes
PV of benefits or costs from M&As
PV of benefits or costs of changes in strategies, policies, operations, organization structure
(restructuring)
PV of costs of financial distress
Leverage and Leveraged Recapitalizations
Value enhancement of capital structure decisions
– Acquisition of other firms
• Debt as a source of funding for acquisition activity
• Takeover of firm to capture unused tax benefits of debt
– Defense against being acquired by others
• Increase debt level to make firm less attractive
• Use debt to reorganize management control of firm
Effects of the use of leveraged recaps
– Leveraged recap mechanism
• Relatively large issue of debt
• Payment of relatively large cash dividend to non-management shareholders
• Share repurchases
• Increase in share ownership by management
• Has been proposed as an alternative to merger when pooling is abolished, to avoid goodwill write-offs
of purchase accounting
– Leverage recap characteristics
• Book leverage measured by total debt to total capitalization increases from 20% to about 70%
• Management ownership share increases from 9% to 24% on average
– Market response to announcement of leveraged recap — defensive
• Defensive leveraged recap — action taken in response to actual takeovers or indications of likely
takeover bid
• Both positive and negative returns
–
Market response to announcement of leveraged recap — proactive
• Cumulative positive abnormal return of about 30%
• Return to bondholders of positive 5%
• Action is a part of a longer-run program of improving the performance of the firm
Subsequent performance
– High rate of financial distress
– Main factors influencing post-performance
• Macroeconomic and industry conditions
• Whether defensive or proactive
• Whether operating improvements were achieved
– Positive disciplinary role of debt
Role of leveraged recaps
– Leveraged recap more likely to succeed if
• Part of a strategic plan to improve performance of firm in relation to changing environments
• Success depends heavily on programs to improve performance
– Takeover defense
• Succeed by returning cash to shareholders
• Shareowners continue to hold equity stubs
• May discourage outside bidders — scorched-earth policy
• High percentage of firms which adopt leveraged recaps are subsequently acquired
Dual-Class Recapitalizations
• Dual-class recapitalization (DCR) mechanism
– Second class of common stock has limited voting rights and a preferential claim to cash flows
• Class A shares — one vote per share but higher dividend rate than other class
• Class B shares — cast multiple votes such as 3, 5, or 10 per share but dividend rate is lower than other
class
– New class may be created by distributing limited voting shares pro rata to current shareholders
– Some patterns
• Officers and directors have 55-65% of common stock voting rights
• Officers and directors have claim on about 25% of total cash flows
– In substantial number of cases of DCR, controlled group represents founding families or their descendants
• Reasons for dual-class recapitalizations
– Management can solidify control to carry out long-run programs
• Avoid pressure for good short-term results
• Operations are relatively complex and difficult to evaluate managerial performance
– Managers are compensated when plans come to fruition
– Negative — managers can entrench their position against takeover or being replaced
Exchange Offers
• Exchange offer mechanics
– Provides one or more classes of securities, right or option to exchange part or all of holdings for different
class of securities of firm
– Terms of offer involve new securities of greater market value than pre-exchange offer announcement
market value to induce security holders to accept offer
– Maximum number of securities that may be exchanged are usually specified
– Many exchange offers contingent upon acceptance of minimum number of securities to be exchanged
– Average life of offer is about seven weeks but frequently extended; initial announcement precedes
beginning of exchange offer by nine months
• Tax aspects of exchange offers
– When firm redeems debt at price below issue price, difference treated as ordinary corporate income
– Debt redeemed at price above issue price, difference treated as ordinary loss
– Stock tendered for debt, stockholders incur capital gain tax liability
– Debt for common stock exchange likely to occur when stock selling at relatively low prices —
shareholders incur little or no capital gain liability
Reorganization Processes for Financially Distressed Firms
• Distressed firm — when liquidation value of firm's assets is less than total face value of creditor claims
• Out-of-court procedures
– Exchange — residual or equity claim substituted for debt priority claim
– Extension — maturity of debt can be postponed
– Composition — obligations can be scaled down
• Merger into another firm — Clark and Ofek (1994)
– Bidder CAR positively related to post merger performance variables
– Market's event returns forecast post-merger results
– Bidders overpay for distressed targets
– Much of post-merger performance results dominated by industry factors
– Financially distressed target firms are more likely to be successfully restructured than those with poor
operating performance
– Positive returns to bidder for distressed targets that are smaller relative to bidder
– In majority of cases, takeovers do not successfully restructure distressed target — but may be the best
alternative available at the time
• Formal legal proceeding
– Firm allowed to continue — Chapter 11 reorganization where formal court procedures supervise
composition or modification of claims
– Firm ceases to exist
• Statutory assignment — assignee liquidates assets under formal legal procedures
• Liquidation under Chapter 7 — formal bankruptcy court supervised liquidation
Financial Engineering Strategies
• Use of calls, puts, swaps, forward and future contracts to influence payoffs
• Help limit financial exposure of business firms as well as of investors
• Facilitate merger transactions — can share risk exposures
• Liquidations and Takeover Bust-Ups
• Involuntary
– Creditors force firm to liquidate — “worth more dead than alive”
– Often associated with involuntary bankruptcy proceedings
• Voluntary
– Voluntary liquidations have more positive motivation
– Liquidation may realize more for shareholders if firm can be sold in parts
– Managers may decide to liquidate firm because of threat of "bust-up" takeover
