Corporate Restructuring (posted 10 Mar 99)

One of the most high profile features of the business and investment worlds is corporate restructuring - the mergers and acquisitions (M&A), leveraged buyouts, divestitures, spin-offs and the like that are contested in the 'market for corporate control'. These recombinant techniques' of corporate finance often have an impact on the financial markets far beyond the individual companies and sectors they involve and, in theory, all return real control of companies to shareholders. Virtually without exception, stock prices of participating companies rise in response to announcements of corporate restructuring. But are such events good for investors beyond the very short term?

The late 1990s has seen yet another wave of M&A activity. Indeed, the number and value of mega-mergers in 1998 set new records. This has reawakened the populist cry that such mergers do not create new wealth, that they merely represent the trading of existing assets - rearranging the deck chairs on the Titanic. What is more, it is argued, the threat of takeover means that managements take too short-term a view, bolstering stock prices where possible, investing inadequately for the future and, where a company has been taken over in a leveraged buyout, perhaps burdening it with excessive debt.

On the other side of the debate, the primary argument in favor of M&A is that they are good for industrial efficiency: without the threat of their companies being taken over and, in all likelihood, the loss of their jobs, managers would act more in their own interests than those of the owners. In particular, this might imply an inefficient use of company resources, overinvestment, lower productivity and a general lack of concern about delivering shareholder value. Feeble supervision of corporations often leads to mismanagement, it is argued, and while increased shareholder activism is one option (see CORPORATE GOVERNANCE), takeovers are a more radical solution for remedying poor performance and safeguarding against economic mediocrity.

Certainly, a takeover bid is frequently beneficial to the shareholders of the target company in terms of immediate rises in the stock price (though acquisitions often have a negative effect on the profitability and stock price of the acquirer). And managements that resist takeover may be doing it for their own interests rather than those of their investors. Senior executives may use such bizarre devices as 'shark repellents' and 'poison pills', which make it extremely costly for shareholders to replace the incumbent board of directors.

Guru of corporate restructuring: Bruce Wasserstein

In the mid-1980s, there was an avalanche of takeovers of underperforming companies, the targets of institutions and arbitrageurs who suspected that, with the help of plentiful leverage, they could increase corporate values by 'mobilizing assets'. Often that term meant disposal of non-performing assets. In this earlier age of corporate restructuring, Bruce Wasserstein was an enfant terrible. M&A deals were being done at premiums of 30-40% above market prices and Wasserstein would be in the middle designing strategies to make them happen.

This was also the heyday of shark repellents and poison pills. Often, the other side would be lawyers and PR people trying to set defenses against shareholders who had corporate control in mind, artfully removing shareholder rights whenever they might be exercised to change corporate control. But the SEC formed an advisory committee to evaluate many of these activities and concluded that the market mechanisms must be left unimpeded.

Wasserstein's youthful energy tapped intensity suited to the pulsing business of deals. Always very well prepared, he worked with arbitrageurs, lawyers, accountants and regulators to move business combinations forward over institutions dedicated to thwart combinations, which, in the light of hindsight, seemed to favor one group of investors over another. He went on to found his own successful investment banking firm, his personality skills leading him on the correct path.

In his 1998 book Big Deal, Wasserstein surveys the 'the battle for control of America's leading corporations', including his own role in the past two decades or so. He describes five waves of mergers beginning in the mid-1800s: the first involved the building of the railroad empires; the second, in the 1920s, saw merger mania fueled by a frothy stock market and rapid industrial growth; the third happened during the go-go years of the 1960s and featured the rise of the conglomerate; the fourth occurred with the hostile takeovers of the 1980s, driven by names such as Icahn, Boesky and Milken; and finally, a fifth wave happening today. Wasserstein attributes the explosion of M&A activity at the turn of the century to the need for companies to reposition themselves in today's ever changing competitive environment:

'The patterns of industrial development through mergers, like those of economic activity, are crude and imperfect. However, there do seem to be elemental forces, Five Pistons, which drive the merger process:

· Regulatory and political change: many of the most active M&A sectors over the past few years - media and telecommunications, financial services, utilities, health care - have been stimulated by deregulation or other political turmoil. Before deregulation, a number of industries owed their very existence to regulatory boundaries.

· Technological change: technology creates new markets, introduces new competitors and is intertwined with regulatory change. Changes in technology make old regulatory boundaries obsolete and sometimes silly.

· Financial change: financial fluctuations have a similar catalytic effect. A booming stock market encourages stock deals. A low market with low interest rates can have an especially strong effect after a period of high inflation in which the cost of hard assets has increased more rapidly than stock prices. In this environment, it may be cheaper to buy hard assets indirectly by purchasing companies on the stock market. Falling interest rates and available capital lubricate the process.

· Leadership: of course, corporate combinations do not occur in a mechanistic fashion. A human element is involved - the man on horseback who leads a company to seminal change.

· The size-simplicity vortex: scale matters, and bigger seems to mean better to most managers. Maybe it's critical mass, or technology and globalization, or integration, or sheer vanity and ego, but there is a natural imperative towards scale. However, just as some companies keep getting bigger, others shed their skin and become smaller. The imperative towards focus and simplicity is as strong as that for size. The two competing elements create a vortex of change.'

Counterpoint

Why so many mega-mergers? The evidence seems to be very clear, at least on the academic side, that mergers ultimately do not pay off for buyers or sellers. Economically, they equalize themselves out in the normal process of bidding so that the gains do not accrue to one side or the other. Similarly, there is a tendency now to have smaller business units, which, because of the new computer tools, are as functional and more motivational than larger business units.

In the 1980s, the deals were adversarial and there were not enough goodies to go around. Now, they are not adversarial: they are friendly and there are plenty of goodies to go around. The reasons seem to lie first in a compliant US anti-trust division - which is strange under a Democratic administration - but even more in the payoffs that go to the agents involved. Executives get their stock options written up and then reissued after they are able to exercise their old options in advance in order to keep the managements around under the new corporate structure.

In addition, merger accounting allows for a great deal of flexibility of accounting for goodwill and burying old mistakes. A fresh slate is often good and a merger provides that opportunity. And, of course, there are the agents, brokers, lawyers, accountants and so on, who form part of the transaction costs of a merger and act as an incentive to keep it going. It is the agency function that makes it go plus the high price. That is the characteristic of mergers now, and it does not necessarily bode well for efficient business in the future.

Is the creation of new behemoths really what should be going on? Computer technology is empowering individuals to do marvelous things. Projects are taking the place of process. No longer do we have permanent constabularies of process administrators keeping the wheels of business moving. Instead, we have projects, where the 'administration' may include customers, employees, suppliers and temporary consultants to complete a project and then split apart. Business management of the future is very similar to movie production: bringing people together to engage in a creative function. and then split. People can be members of several creative teams at the same time. But in each one, we have to have one who has the 'fire-in-the-belly' to make it happen.

Yet companies do want to merge and become larger, perhaps propelled by the results of management consultant studies that say that is the thing to do. But everything that we know is on the empowerment of smaller and smaller groups, the behavior of smaller units of organizations, which pulls against exactly these structures towards higher and higher, larger and larger units of consolidation. Companies in the United States, at least, have learned that instant gratification comes from mergers, while operations come from smaller and smaller units. So we are shifting to having to feed our own financial greed with more and more artifices.

M&A activity seems to at its highest at the top of bull markets when borrowing is easy. It is probably no accident that the merger waves Wasserstein describes have tended to occur at moments of the greatest optimism and the highest valuation of financial markets. A hundred years ago there was talk of a new era. Similarly, in the 1920s and the 1960s, and again in the 1990s, the higher the stock market, the more intense the optimism, the greater the tendency towards consolidation. These are cyclical features of markets.

Where next?

Among investment styles and techniques, one is hardly ever mentioned but it is the one that is being used prominently today: event investing. Markets today are looking for events like earnings surprise anticipated - the so-called 'whisper number'; stock promotions - the stocks that are mentioned on news broadcasts; merger news that allows companies to rewrite history in their accounting statements and write up options for the management; and deals - deals between companies for strategic alliances and deals on sales.

Events and anticipation of events is what drives markets in very short-term environments, and that is what is happening today. Yes, we have momentum investing, but much more directly we have event investing, fueled by the communications on the internet, chats and even the old-fashioned way of your friendly broker calling you with a tip. But our communications have become much faster, more sophisticated and widespread, more popular - so event investing is what is ruling the day.

While mergers dominate as the millennium dawns, demergers may offer the best business and investment prospects for the future. For example, Andrew Campbell and his colleagues calculate that there is one trillion dollars worth of shareholder value locked up waiting to be released by the breakup of multi-business corporations in the United States and the UK. They claim that breaking up these firms into far more focused businesses will create enormous improvements in company performance and, along with it, vastly increased shareholder wealth. And they describe potential investment strategies to gain from it:

· Speculate ahead of a breakup: work out which companies may break up and invest in them before other investors have driven the price up and before an official breakup announcement is made.

· Avoid breakup candidates: a converse strategy involves avoiding potential breakup candidates altogether and instead investing in those companies which are already focused - they will outperform companies with value-destroying corporate centers

· Invest in a broad portfolio of breakups: breakups release value so invest in a broad range of breakups immediately after each break up is announced.

· Invest selectively in particular breakups: identify those companies which will increase in value most once broken off. These are likely to be those companies which are likely to be subsequently acquired by another focused company.

Read on

In print

David Sadtler, Andrew Campbell and Richard Koch, Breakup: When Large Companies are Worth More Dead than Alive
Bruce Wasserstein, Big Deal: The Battle for Control of America's Leading Corporations

Online

www.sternstewart.com - website offering access to the Journal of Applied Corporate Finance, edited by Don Chew, a good source of recent research and writing on corporate restructuring