Question

The Buyout Binge

The 1980s were the decade of leveraging, or adding debt to capital structure. A Harvard Business Review article warned managers that if they didn’t “lever up” with debt, a hostile takeover would do it for them. Much of the debt binge had to be reversed in the 1990s-the decade of the de-levering.

In 2007, the deals were heating up again. The acquirers this time were private equity firms. Renewed concern arose that companies might be adding debt to the balance sheet as a defensive measure. Health Management Associates did so, announcing in January 2007 that it would take on $2.4 billion in new debt to finance a onetime $10 per share dividend. While the move would lower HMA’s credit rating from investment grade to junk levels, CFO Robert Farnham noted in a conference call that it would drop the company’s cost of capital from the low teens to 7.5% to 8%. The move makes a private equity buyout nearly impossible. Anheuser-Busch signaled that it was pursuing a similar strategy when it announced in December 2006 that was moving to an “aggressive leverage target”

Following the special dividend announcement, Health Management Associates stock value fell approximately 8%. Although both the stock price and bond prices might fall due to over-leveraging, stockholders were content because the cash they received more than offset the drop in the stock price. Moving to highly leveraged position may help shareholders, but it is generally harmful to the interest of bondholders and other lenders.

As private equity funds have consistently beaten market returns, Money has poured in by the billions. By some estimates, private equity funds collectively were sitting on a $400 billion war chest. Combine that cash with leverage, and private equity’s buying power increases fourfold or fivefold.

The danger, of course, is that with that much money available, deals will be made that should not be made, and some deals will simply be so expensive that making the payoff could be difficult. Witness the Chrysler buyout by Germany’s Daimler Corp.: the initial deal in 1998 was for 36 billion. In 2007, Cerebus Capital Managemet L.P., a private equity firm, bought 80 percent of Chrysler group from DaimlerChrysler AG for a mere $7.4 billion.

What effect will be decreased cost of capital have on firm’s future investments? What is your opinion of the leverage described in this article?

Answer 1

With the leverage in capital structure the overall cost of capital will come down and future projects might be evaluated at this level of capital but the important thing to take care is that excess debt in the capital structure increases the financial distress cost and the firm might not able to meet its financial obligation at certain point of time. Also, future Investment projects should not be evaluated at current cost of capital level. There are different levels of risk associated with different investment and this is important to adjust the current cost of capital for the risk premium associated with it. If a project with higher risk is being evaluated at current cost of capital then the outcome will be too optimistic. Leverage, to at certain extent is good for the overall cost of capital. Leverage magnifies the benefit. The important point to consider while taking on leverage is that the cost of financial distress associated with the debt level should be less than the benefit associated with it. High leverage can backfire if the company earnings suddenly falls and it is not able to meet its payment obligations then the insolvency might arise. In 1980, most companies took on leverage so that they are not takeover target by the private equity firms and just because it is easy to raise debt and company should not go to acquire any other company. The concept of winner's curse is something that should be considered. The amount paid to acquire any company should be justifiable.