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Controlling Financial Distress Costs in Leveraged Buyouts with Financial Innovations
Tim C. Opler
Vol. 22, No. 3 (Autumn, 1993), pp. 79-90
Stable URL: http://www.jstor.org/stable/3665929
Page Count: 12
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Leveraged buyouts have often been funded in ways which appear to reduce the risk and cost of financial distress. Leveraged buyout financing methods include the use of specialist sponsors, strip financing, covernants which require that excess cash flows be paid to debtholders, and debt provisions which allow deferral of interest payments in periods of financial distress. In theory, these methods of structuring deals reduce incentive problems between stakeholders of the firm and reduce the costs of resolving financial distress. For example, financing with a leveraged buyout sponsor such as Kohlberg, Kravis and Roberts brings in a third party with interests which are aligned both with those of debtholders and equityholders. This will limit conflict between parties and can also provide a mechanism for capital infusions in periods of distress. Similarly, the use of strip financing in which equity and debt are held by the same parties, can minimize conflict between stakeholders. The use of covenants which require payout of excess cash flows may also reduce incentive problems between financial claimants by restricting equityholder flexibility to reinvest resources in projects which debtholders perceive as risky and undesirable. This study finds that these innovative financing techniques were frequently used in 63 LBOs which occurred in 1987 and 1988 -- at the peak of the LBO boom. In addition, this study tests whether these financing methods lower the risk-adjusted weighted cost of debt in LBOs. To the extent that innovative financial techniques lower financing costs, then financial markets ex ante believe that their use lowers the deadweight costs of debt finance. The main results show that sponsorship by an LBO specialist lowers the weighted average cost of LBO debt and the imputed cost of capital by roughly 60 basis points. In contrast, there is no evidence that strip financing lowers the costs of debt finance. This may reflect contracting problems which allow strip financing arrangements to be circumvented when it is in the interest of some claimants to unbundle their claims to the detriment of others. Furthermore, asset sale covenants which force payout of cash are frequently used but not associated with lower financing costs. One factor which may explain this result is that asset sales may hinder the productivity of remaining assets with the effect of decreasing the probability of on-time payout of cash flows from remaining assets. In addition, debt provisions which allow deferral of interest payments on junior debt and which maintain a minimum bond value are used in many of the LBOs in the sample. While these provisions do not lower financing costs, their use indicates that LBO capital structures are designed to avoid the need for debt workouts or Chapter 11 proceedings in periods of financial distress. This research has important implications for public policy-makers worried about the risk that highly leveraged transactions can increase the fragility of the financial system in economic downturns. By pointing to the various sorts of "armor" used to minimize the risk and impact of financial distress in leveraged buyouts, this research suggests that many concerns about the adverse macroeconomic impact of LBOs expressed in the 1980s were unjustified. Debt covenants were used which assured rapid repayments of debt and which gave firms the flexibility to operate even with temporary shortages of cash (e.g., PIK debt). Many LBOs appear to have been financed in a way which specifically allowed firms to ride out temporary downturns in the economy. This research also has several implications for corporate financial policy. First, the results suggest that it is difficult to contractually sidestep conflicts between equityholders and debtholders in highly leveraged transactions with strip financing and covenants which force certain equityholder actions. The possibility that strip financing arrangements can be unbundled at the cost of debtholders appears to be a very real one. Second, the results highlight the value of guaranteeing debt financings with the involvement of an organization which has repeatedly transacted in the marketplace. LBO sponsors appear to play this role effectively as was argued by Michael Jensen in his widely discussed article "The Eclipse of the Public Corporation." There are already many contexts where similar guarantees take place (e.g., asset-backed securities, bank guarantees of commercial paper), and there may be areas where financial transactions can be structured to create further value. Finally, the empirical methods used in this research could be applied more broadly to establish pricing guidelines in the junk bond market. Traditional bond pricing methods rely on relatively simple one- and two-state variable arbitrage pricing models. While widely used, these methods are particularly difficult to apply when pricing complex bonds of highly leveraged firms with rich covenant structures and many layers of debt. Junk bonds instead could be priced "off the market" using a regression equation similar to that shown in this paper which shows the average market price of cash flow risk, leverage, covenant provisions, etc. For example, the regression model could be used in a trading context to identify bonds yielding more than expected, given issuer and security characteristics.
Financial Management © 1993 Financial Management Association International