Corporate Restructuring - An OverView

THEORIES OF RESTRUCTURING

As a foundation for analyzing the many forms of restructuring that have emerged, we review alternative theoretical explanations of their motives and consequences.

  1.  Inefficient Management - Removal of poor managers to increase efficiency.

  2.  Operating synergy - Economies of scale, scope and coordination.

  3.  Financial synergy - Lower cost of capital; also bidders have excess funds, targets need funds for growth opportunities.

  4.  Strategic realignment - Changing environments require adaptation.

  5.  Undervaluation - If the market emphasizes short-term earnings performance (myopia), corporations with long-term investment programs may be undervalued. Firms sometimes can buy a company more cheaply than it could add capacity by constructing new assets.

  6.  Information and signaling – Announcement of a restructuring may signal that future profitability will increase.

  7 Agency Problems and Managerialism - Agency theory holds that in corporations with widely dispersed ownership, individual shareholders do not have sufficient incentives to monitor the behavior of managers. The managerialism theory states that managers are motivated to increase the size of their firms to increase their salaries and for the satisfaction of commanding bigger empires - management entrenchment and aggrandizement. Jensen's free cash flow theory argues that firms should pay out their free cash flows and increase their debt to avoid unsound investments.

  8. Realignment of Managerial Incentives – By altering managerial compensation contracts, the motives of managers to improve common stock values for shareholders may be strengthened.

  9. Winner's Curse - Hubris - When bidding takes place for a valuable object with an uncertain value, the winning bid is likely to represent a positive valuation error. Hubris is one of the factors that causes the winner's curse phenomenon to occur in takeovers.

 10.Market Power - Takeovers may improve a firm's market position.

 11.Tax Considerations - Tax considerations are important in designing mergers and other forms of restructuring, but are not a dominant causal factor. Large tax benefits from net operating losses and tax credits occur infrequently. Asset step-ups to increase the basis for depreciation deductions are not a strong general influence. Higher leverage increases interest deductions, but a firm can        increase leverage without mergers. Also empirical studies show that when all parties are taken into account, the U.S. Treasury gains rather than loses even in highly leveraged LBOs(Leveraged Buyouts).

  12.Redistribution - To some extent gains may represent redistribution among stakeholders. We next present the results of research studies that provide tests of the alternative theories. An important objective of the empirical work is to determine whether social value is enhanced by restructuring activities. If restructuring activities improve efficiency, they produce social gains regardless of the theory that explains their source.

Corporate Restructuring Defenses

Along with the financial innovations that stimulated takeovers and restructuring, counterforces in the form of merger defenses have proliferated. Defenses may be grouped into five categories: defensive restructuring; poison pills; poison puts; antitakeover amendments; and golden parachutes.

Defensive restructuring. One form is a scorched earth policy by incurring large debt and selling off parts of the company, using the newly acquired funds to declare a large dividend to existing shareholders. A second involves selling off the crown jewels, that is, disposing of those segments of the business in which the bidder is most interested. A third is to dilute the bidder's voting percentage by issuing substantial new equity. A fourth is share repurchase without management sale. A fifth is to issue new securities to parties friendly to management, including the creation or expansion of an ESOP, allied with or controlled by management. A sixth form of defensive restructuring is to create barriers specific to the bidder. For example, antitrust suits may be filed against the bidder or the firm may purchase assets that will create antitrust issues for the bidder.

Poison pills. Poison pills are warrants issued to existing shareholders giving them the right to purchase surviving firm securities at very low prices in the event of a merger. The effect of poison pills is to dilute share values severely after a takeover. These risks may cause bidders to make offers conditional on the withdrawal of the poison pill. The poison pill gives incumbent management considerable bargaining power, because it can also set aside the warrants if, for example, later bidders offer higher prices and other inducements.

Poison puts. A third type of merger defense which permits the bondholders to put (sell) the bonds to the issuer corporation or its successor at par or at par plus some premium. It is too early to know the extent to which poison puts will be used and how effective they will be.

Golden parachutes. Golden parachutes are separation provisions in an employment contract that provide for payments to managers under a change-of-control clause. The rationale is to help reduce the conflict of interest between shareholders and managers. While the dollar amounts are large, the cost in most cases in less than 1 percent of the total takeover value. Recent changes in tax laws have limited tax deductions to the corporation for golden parachute payments and have imposed penalties upon the recipient. A theoretical argument for golden parachutes is that they motivate managers to make firm-specific investments of their human capital and to take a longer-term view in seeking to enhance values for shareholders.

Whether takeover defenses harm or benefit shareholders has not been resolved. Defenses may give management time to find competing bidders or otherwise increase values for shareholders. But takeover defenses may also discourage some bids and foster management entrenchment. In a series of cases the courts have held that shareholders have delegated important powers to management. The courts have adopted the business judgment rule, which supports management when they reject attractive offers on grounds that they can do better for their shareholders in the longer run.

Divestitures, A divestiture involves the sale of a portion of the firm to an outside third party. Event studies of divestitures have found significant positive abnormal two-day announcement returns of between 2 percent to 3 percent for selling firm shareholders, higher when the percentage of the firm sold is larger.