Taking finance seriously: How debt financing distorts bidding outcomes in corporate takeovers

Fordham Law Review

Volumn 76, Issue 4, 2008, Pages 1975-2026

  Bartlett III, Robert P ^a  

^a UNIVERSITY OF GEORGIA   (United States)

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EID: 42149101193     PISSN: 0015704X     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (289)

1. See Joshua Hamerman, Syndicated Loan Issuance for M&A Roars, Mergers & Acquisitions Report, Jan. 15, 2007, at 1.
2. See Merrill Lynch, Presentation to the Board of Directors of HCA, Inc. (May 25, 2006), available at http://www.secinfo.com/$/SEC/ Filing.asp?404;http://secinfo.com/dsVsf.v7Fu.9.htm.
3. See id. at 23.
4. Id.
5. Id. at 35.
6. See, e.g., John C. Coffee, Jr., Regulating the Market for Corporate Control: A Critical Assessment of the Tender Offer's Role in Corporate Governance, 84 Colum. L. Rev. 1145, 1148 n.5 (1984) ("Most of those who have participated in the debate over the desirability of encouraging competing bids have shared the view that takeovers promote efficiency . . . .");
7. Paul N. Cox, The Constitutional "Dynamics " of the Internal Affairs Rule - A Comment on CTS Corporation, 13 J. Corp. L. 317, 321 (1988) ("[T]he tender offer is favored on the ground that it facilitates the movement of assets to their highest uses, thereby ensuring efficient allocation of resources.");
8. Frank H. Easterbrook & Daniel R. Fischel, The Proper Role of a Target's Management in Responding to a Tender Offer, 94 Harv. L. Rev. 1161, 1182 (1981) ("Our argument relies on the premise that [hostile] tender offers increase social welfare by moving productive assets to higher valued uses and to the hands of better managers.");
9. Melvin Aron Eisenberg, The Structure of Corporation Law, 89 Colum. L. Rev. 1461, 1497 (1989) ("[A]t least some completed takeovers undoubtedly result in a substitution of more efficient managers for less efficient managers, or of more efficient allocations of resources for less efficient allocations.");
10. Ronald J. Gilson, Seeking Competitive Bids Versus Pure Passivity in Tender Offer Defense, 35 Stan. L. Rev. 51, 62 (1982) ("There is agreement that tender offers serve an allocational role, and that competitive pricing generally facilitates the shifting of assets to their most productive users.");
11. see also Edgar v. MITE Corp., 457 U.S. 624, 643 (1982) ("The effects of allowing the Illinois Secretary of State to block a nationwide tender offer are substantial. . . . The reallocation of economic resources to their highest valued use, a process which can improve efficiency and competition, is hindered.").
12. See, e.g., Easterbrook & Fischel, supra note 6, at 1175 (arguing against all defensive tactics on the ground that they impede hostile takeovers, thereby depriving shareholders of an acquisition premium that "reflects a . . . social gain from the superior employment of the firm's assets");
13. Stephen Fraidin & Jon D. Hanson, Toward Unlocking Lockups, 103 Yale L.J. 1739, 1743 (1994) ("According to [a] widely held view, target managements will, if permitted, use . . . defensive tactics to protect their jobs [in the face of a hostile takeover], and thus will obstruct the transfer of corporate assets to their highest valued use (that is, obstruct the goal of allocative efficiency). Consistent with that viewpoint, most corporate law scholars call for the abolition of virtually all takeover defenses . . . ." );
14. Ronald J. Gilson, The Case Against Shark Repellent Amendments: Structural Limitations on the Enabling Concept, 34 Stan. L. Rev. 775, 792 n.65 (1982) ("[T]he increase in managerial discretion [due to the use of defensive tactics] . . . represents a threat to societal interests in the efficient allocation of resources." (citations omitted));
15. Sean J. Griffith, The Costs and Benefits of Precommitment: An Appraisal of Omnicare v. NCS Healthcare, 29 J. Corp. L. 569, 582 (2004) ("[A] decision motivated by entrenchment to block a takeover . . . harms shareholders by impeding the efficient allocation of resources and muting the disciplinary effects of the market for corporate control.").
16. See, e.g., Easterbrook & Fischel, supra note 6, at 1174-82 (arguing against facilitating competing takeover bids because it needlessly reduces the efficacy of the tender offer process in "moving productive assets to higher valued uses and to the hands of better managers");
17. Ronald J. Gilson, A Structural Approach to Corporations: The Case Against Defensive Tactics in Tender Offers, 33 Stan. L. Rev. 819, 872 (1981) ("[E]ven if competitive bidding reduces the overall number of offerors, the increase in efficiency from allocating target assets to their most efficient user must be balanced against the reduction in efficiency from fewer offers.");
18. Lucian A. Bebchuk, Comment, The Case for Facilitating Competing Tender Offers, 95 Harv. L. Rev. 1028, 1030 (1982) (arguing that facilitating competing tender offers "has several socially beneficial effects, such as the allocation of targets' assets to their most valuable use.").
19. See, e.g., Fraidin & Hanson, supra note 7, at 1743 ("It seems fair to say . . . that most corporate law scholars and courts agree that some lockups should be invalidated as contrary to the interests of target shareholders and/or the goal of allocational efficiency.").
20. See, e.g., Easterbrook & Fischel, supra note 6, at 1176 n.40 ("Bidding usually serves the function of allocating goods to their highest valued uses; the best indication of the ability to put something to a valuable use is the willingness to pay for it.");
21. Gilson, supra note 8, at 872 ("As a general principle, allocating resources among competing claimants by price is desirable because it places resources with the most efficient users.");
22. Edward B. Rock, Antitrust and the Market for Corporate Control, 11 Cal. L. Rev. 1367, 1376 n.27 (1989) (assuming that "on the whole, allocational efficiency is increased if a target is acquired by the bidder willing to pay the most for it").
23. Paramount Commc'ns, Inc. v. QVC Network, Inc., 637 A.2d 34, 44 (Del. 1994).
24. Kenneth Klee, Finding the Mark, Deal, Jan. 19, 2007, available at http://www.thedeal.com (paid subscription required).
25. Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48 Am. Econ. Rev. 261, 277 (1958).
26. See generally id.
27. Merton H. Miller shared the prize in 1990 with Harry Markowitz (generally considered the pioneer of modern portfolio theory) and William F. Sharpe (creator of the capital asset pricing model). Franco Modigliani had previously been awarded a Nobel Prize in 1985 for his analyses of saving and of financial markets.
28. See Ronald J. Gilson & Renier Kraakman, The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias, 28 J. Corp. L. 715, 717-19 (2003).
29. The example that follows is based on a similar example found in Richard A. Brealey, Stewart C. Myers & Alan J. Marcus, Fundamentals of Corporate Finance 396-400 (4th ed. 2004).
30. Because we are assuming BigCo pays no corporate level income tax, BigCo can pay out all of its operating income as dividends. This assumption is relaxed below.
31. With no growth and perpetual dividends expected, stockholders' expected return on investment can be calculated using a simple dividend-discount valuation model. In general terms, this valuation model is a form of discounted cash flow (DCF) analysis, which is widely used to value financial assets and firms. See Aswath Damodaran, Corporate Finance: Theory and Practice 750 (2001). All DCF methodologies involve forecasting future cash flows and then discounting them to present value at a discount rate that reflects their riskiness.
32. See id. Under the dividend-discount model, the price of a single share should reflect expected dividends per year (DIV) divided by the firm's cost of equity capital (r): Price Per Share = DIV/r. Given a $10 price per share and expected dividends of $1.25 in perpetuity, we can solve for r by simply rearranging terms: r = $1.25/$10.
33. See Merton H. Miller, The Modigliani-Miller Propositions After Thirty Years, 2 J. Econ. Persp. 99, 100 (1988) (discussing the significant "[s]kepticism about the practical force of our invariance proposition" at the time it was published in 1958).
34. For example, under the assumptions utilized in the Modigliani-Miller irrelevance theorem, an investor with $10 to invest could go to a bank, borrow $10 at 10% interest and then invest $20 in two shares of the all-equity BigCo. Holding these two shares the investor would expect annual dividends of $1.50 in an economic slump ($0.75 × 2), $2.50 in regular economic conditions ($1.25 × 2) and $3.50 in an economic boom ($1.75 × 2). After paying $1 in interest each year, the investor's net returns would then be identical to the returns of investors in the recapitalized BigCo - that is $0.50 in an economic slump, $1.50 in normal economic conditions, and $2.50 in an economic boom. This opportunity for "homemade" leverage was a critical insight of Modigliani and Miller's paper.
35. See Modigliani & Miller, supra note 13, at 270 ("We conclude therefore that levered companies cannot command a premium over unlevered companies because investors have the opportunity of putting the equivalent leverage into their portfolio directly by borrowing on personal account.").
36. Again, this price was obtained using the dividend-discount model: Price = $1.50/.15 = $10.
37. The weighted average cost of capital reflects the average cost of capital for a firm in light of its capital structure. Stated differently, it represents the average return on investment that a firm must generate in its operations in order to keep all of its investors satisfied. See Brealey, Myers & Marcus, supra note 17, at 322.
38. In the words of Modigliani and Miller, "[T]he average cost of capital to any firm is completely independent of its capital structure and is equal to the capitalization rate of a pure equity stream of its class." Modigliani & Miller, supra note 13, at 268-69 (emphasis omitted).
39. See id. at 267-68.
40. See I.R.C. § 163(a) (2000) ("There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness."). For a general discussion of the deductibility of corporate interest payments, see 1 Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders § 5.03 (2007).
41. Because BigCo's income is assumed to continue in perpetuity, the dividend discount valuation model can be utilized to value the entire firm. See supra note 19.
42. The new debt would also result in an overall lower cost of capital for BigCo. Because interest is tax deductible, the government effectively pays 35% of BigCo's interest cost meaning that BigCo only needs to earn the after-tax rate of interest on its debt to keep its debt investors satisfied. In other words, BigCo's effective cost of debt decreases from 10% in a world without taxes to 6.5% (i.e., 10% × (1 - 35%)) in a world with taxes. See generally Brealey, Myers & Marcus, supra note 17, at 405-06.
43. See generally Franco Modigliani & Merton H. Miller, Corporate Income Taxes and the Cost of Capital: A Correction, 53 Am. Econ. Rev. 433 (1963).
44. See Miller, supra note 20, at 112.
45. See Glen T. Ryen, Geraldo M. Vasconcellos & Richard J. Kish, Capital Structure Decisions: What Have We Learned?, 40 Bus. Horizons 41, 41 (1997) ("The determination of an optimal capital structure has been one of the most contentious topics in the finance literature since Modigliani and Miller (MM) introduced their capital structure irrelevancy propositions in the American Economic Review in 1958.").
46. See Michael J. Barclay & Clifford W. Smith, The Capital Structure Puzzle: The Evidence Revisited, 17 J. Applied Corp. Fin. 8, 8 (2005) (describing the theoretical debate and noting that "[w]hat makes the capital structure debate especially intriguing is that the theories lead to such different, and in some ways diametrically opposed, decisions and outcomes").
47. Stewart C. Myers, Capital Structure, 15 J. Econ. Persp. 81, 81 (2001).
48. Miller, supra note 20, at 112.
49. See generally Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 Am. Econ. Rev. 323 (1986).
50. Id. at 323.
51. See id. at 324.
52. Myers, supra note 34, at 98.
53. The pecking order theory was originally articulated by Stewart Myers and Nicholas Majluf. See Stewart C. Myers & Nicholas S. Majluf, Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have, 13 J. Fin. Econ. 187 (1984).
54. See, e.g., Paul Asquith & David W. Mullins, Equity Issues and Offering Dilution, 15 J. Fin. Econ. 61, 70-74 (1986) (finding an average fall in price of about 3% of the preissue market capitalization of firms issuing equity securities); Nathalie Dierkens, Information Asymmetry and Equity Issues, 26 J. Fin. Quantitative Analysis 181, 188 (1991) (finding a price drop at the announcement of equity issuance to be greater among firms that have large measures of information asymmetry).
55. See Myers & Majluf, supra note 40, at 189.
56. See Myers, supra note 34, at 82.
57. See id. at 93.
58. See id. at 94.
59. See id. at 88-89. One study of troubled, highly leveraged firms found that the direct and indirect costs of financial distress amounted to 10% to 20%) of a firm's predistress market value. Gregor Andrade & Steven N. Kaplan, How Costly Is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions That Became Distressed, 53 J. Fin. 1443 (1998).
60. When a leveraged firm nears financial distress, there may be instances when stockholders can benefit at the expense of debt holders. For instance, stockholders may have an incentive to use a firm's remaining assets to pursue negative net present value projects that promise significant returns, albeit at extraordinary risk. The reason stems from the fact that if the gamble turns out to be a success, the stockholders will share in all of the upside after satisfying the firm's debt claims. If the gamble turns out to be a failure, however, they have lost nothing given that the creditors of the firm would have received all of the firm's assets in a liquidation. In effect, stockholders have an incentive to gamble with the debt holders' money. For a summary of the types of conflicts that can arise among debt holders and stockholders, see Myers, supra note 34, at 96-98.
61. See, e.g., Michael Bradley et al., On the Existence of an Optimal Capital Structure: Theory and Evidence, 39 J. Fin. 857, 869-76 (1984) (finding that the volatility of a firm's earnings is inversely related to its level of debt financing).
62. See Brealey, Myers & Marcus, supra note 17, at 394 (noting the average debt-to-firm value ratio of 7% for software companies compared with 65% for utility companies).
63. See, e.g., Milton Harris & Artur Raviv, The Theory of Capital Structure, 46 J. Fin. 297 (1991) (summarizing the findings of four studies that concluded that specific industries have a common leverage ratio, which over time is relatively stable);
64. see also Gay B. Hatfield et al., The Determination of Optimal Capital Structure: The Effect of Firm and Industry Debt Ratios on Market Value, 7 J. Fin. & Strategic Decisions 1 (1994) (summarizing literature examining the relationship between industry and debt-to-equity ratios).
65. See, e.g., Srinivasan Balakrishnan & Isaac Fox, Asset Specificity, Firm Heterogeneity and Capital Structure, 14 Strategic Mgmt. J. 3, 11 (1993) (finding that firm specific characteristics account for approximately 50% of the variance in leverage ratios while industry characteristics account for only 5% to 10%).
66. See Sheridan Titman & Roberto Wessels, The Determinants of Capital Structure Choice, 43 J. Fin. 1 (1988) (finding a significant negative relationship between firm profitability and leverage ratios);
67. John K. Wald, How Firm Characteristics Affect Capital Structure: An International Comparison, 22 J. Fin. Res. 161 (1999) (same).
68. See Balakrishnan & Fox, supra note 51, at 11-14.
69. See id. at 6, 8.
70. Id.
71. See infra text accompanying notes 4-5.
72. See generally Rick H. Mull & Drew B. Winters, IPOs, Public Market Access, and Firm Capital Structure, 20 J. Econ. Fin. 99, 106 (Supp. 1996) (finding that after controlling for other determinants of capital structure choice, private firms have significantly greater debt ratios than public firms);
73. Chris J. Muscarella & Michael R. Vetsuypens, Efficiency and Organizational Structure: A Study of Reverse LBOs, 45 J. Fin. 1389, 1408-09 (1990) (finding that firms that go public following a leveraged buyout (LBO) dramatically reduce their leverage ratios following the public offering);
74. see also Omer Brav, How Does Access to the Public Capital Market Affect Firms' Capital Structure? 2 (Nov. 22, 2004) (unpublished manuscript, on file with author) (finding that private firms have leverage ratios that are approximately 40% higher, on average, than their public counterparts).
75. See supra Part I.C.I.
76. See supra Part I.C.2.
77. See, e.g., Part I.C.3. Specifically, these higher costs may stem from the relationship between a firm's credit rating and its perceived risk of financial distress by shareholders. When a public company significantly increases its debt ratio, the three primary credit ratings agencies will ordinarily downgrade the company's credit rating in the course of reviewing the new issue.
78. See Darren J. Kisgen, Credit Ratings and Capital Structure, 61 J. Fin. 1035, 1038-39 (2006). Because these agencies will have access to highly confidential information regarding the company, shareholders commonly interpret the downgrade as a signal regarding the firm's ability to service the debt. As ratings are differentiated at discrete levels (AAA, AA, BBB, etc.), companies with the same ratings may be pooled together with all the companies in the pool perceived to be just eligible for the particular rating. The result is a discrete, and often, dramatic increase in the perceived financial distress costs associated with the new leverage level.
79. Id. In contrast, shareholders in privately held firms should have greater access to information concerning the firm's operating performance and potential default risk, allowing for a more accurate assessment of the firm's financial distress risk. This is especially true in a firm that has undergone an LBO, where a company's private equity investors have direct access to management. Indeed, this ability to monitor management directly (especially when combined with the equity incentives discussed below) further allows a company undergoing an LBO to reduce the financial distress risk of a highly leveraged capital structure.
80. See infra text accompanying note 89.
81. See supra note 49 and accompanying text (discussing low leverage levels of software firms).
82. This valuation was obtained using the Gordon growth model, which is one of the oldest methods for valuing firms. See Damodaran, supra note 19, at 129. In general, the model is a modified form of the simple dividend-discount formula,
83. supra note 19, and is appropriate to use where an all-equity firm's cash flows are assumed to grow at a constant rate. The formula can be expressed as [(last annual cash flows) × (1 + growth rate)]/(cost of equity - growth rate). For purposes of valuing BigCo, the perpetual stream of cash flows to be expected would equal BigCo's last full year of net operating income after taxes ($81,250,
84. see supra text accompanying note 28), and assuming nothing has changed the underlying risk of BigCo's business, BigCo's cost of equity would still equal 12.5%.
85. See supra text accompanying note 19. Accordingly, the Gordon growth model would calculate the discounted present value of BigCo as follows: (81,250 × 1.03)/(.125 - .03) = $880,921. Because $880,921 represents the value of all anticipated future cash flows from BigCo discounted to present value, it should be the maximum price StrategyCo should pay for BigCo. For a general discussion of the Gordon growth model,
86. see Damodaran, supra note 19, at 129-30.
87. Although such a loan would be large in magnitude, it would be well within the range of debt multiples used in LBOs during 2006. See infra text accompanying notes 91-95.
88. The present value of the tax shields can be calculated by discounting to present value the anticipated annual tax savings resulting from BigCo's interest payments. Given the assumption that this debt would remain outstanding forever and given a 35% tax rate, BigCo could expect to save each year $660,000 × (rate of interest) × 35%. Moreover, because tax shields are largely assumed to have the same risk as that of the interest payments generating them, the most common assumption is to discount the tax shields at the rate of interest. See Brealey, Myers & Marcus, supra note 17, at 403-04. As a result, the actual interest rate becomes irrelevant for purposes of calculating the present value of the tax shields, and the method for calculating the present value of tax shields is simplified as (tax rate) × (debt outstanding).
89. See id. In the case of ManagementCo's bid for BigCo, this can be demonstrated by using the following perpetuity formula: (660,000 × (F) × .35) / (F) = $660,000 × .35 = $231,000. The simplified formula (tax rate × debt) will be utilized in the remainder of this Article for calculating the present value of tax shields.
90. This value was obtained using the adjusted present value (APV) methodology, which is generally recognized as the optimal DCF analysis to use when a bidder plans to make a significant modification to a target's capital structure in connection with an acquisition. See Josh Lerner & Felda Hardymoon, Venture Capital and Private Equity: A Casebook 203-05 (2002). In general, the APV method begins by valuing a target on the assumption that it will be financed entirely with equity and then adding to this value the expected value of any changes to the target's capital structure.
91. See generally Timothy A. Luehrman, Using APV: A Better Tool for Valuing Operations, Harv. Bus. Rev., May-June 1997, at 3.
92. In our example, the APV method would thus add the present value of the anticipated tax shields arising from ManagementCo's financing structure ($231,000, as calculated in supra note 64) to the value of BigCo assuming ManagementCo financed it with all equity. Because ManagementCo expects no change in BigCo's cash flows after the acquisition, this latter figure would equal $650,000-the same valuation of the all-equity BigCo prior to the acquisition, as calculated supra in the text accompanying note 28.
93. If the value of a firm consists of the value of its debt plus the value of its equity, see supra text accompanying notes 19-20, $1,000,000 is the maximum amount of debt ManagementCo could use given that, when BigCo pays no income tax, the value of BigCo is $1,000,000,
94. see supra text accompany notes 19-24. Stated algebraically, we can calculate the maximum theoretical amount of debt that ManagementCo could use by setting the APV formula for valuing BigCo equal to BigCo's aggregate firm value (i.e., the value of its debt + equity): $650,000 + (.35 × BigCo debt) = BigCo debt + BigCo equity. By assuming that BigCo is funded with all debt and solving for BigCo's debt, we then get the following: BigCo debt = $650,000/.65 = $1,000,000.
95. As in supra note 64, if ManagementCo were to use $1,000,000 of debt financing, the resulting tax shields would be calculated by multiplying this amount by the tax rate of 35%.
96. The valuations used in Figure 5 were derived using the same methodologies utilized in supra notes 62 and 65, as modified to reflect StrategyCo's assumed rates of growth.
97. See Richard Brealey & Stewart Myers, Principles of Corporate Finance 66-67 (3d ed. 1988).
98. See Damodaran, supra note 19, at 129.
99. Id.
100. See, e.g., Comm. on Capital Mkts. Regulation, Interim Report 5 (2006), http://www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf [hereinafter Capital Markets Report] (reporting that a typical company having approximately $200 million in market capitalization must pay about $85,000 annually to list on the New York Stock Exchange).
101. In its closely followed study, the Committee on Capital Markets Regulation cited enhanced liability risk as a principal cause for the apparent diminished competitiveness of U.S. capital markets. In particular, it noted that private class action settlement costs have increased from $150 million in 1995 to $3.5 billion in 2005 (leaving out the $6.1 billion settlement associated with the WorldCom litigation). See id. at 5. At the same time, the committee also stressed that much of this enhanced litigation risk stemmed from more active public enforcement actions of both a civil and criminal nature. See id. at 71-91. The committee concluded that, in addition to the direct costs of enhanced monetary liability, liability risk also "has the effect of engendering greater uncertainty in the marketplace about just what is allowed, and what is not."
102. Id. at 67. Additionally, the enhanced liability risk appears to have increased the premiums charged to publicly traded firms for standard directors and officers (D&O) insurance policies.
103. See William J. Carney, The Costs of Being Public After Sarbanes-Oxley: The Irony of "Going Private, " 55 Emory L.J. 141, 147 (2006) (citing a study showing that "the cost of D&O insurance has risen by 25% to 40% for companies with healthy balance sheets, and as much as 300% to 400% for companies with financial troubles").
104. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 11, 15, 18, 28, 29 U.S.C.).
105. The Sarbanes-Oxley Act (SOX) is widely recognized as increasing the costs of registering securities under the Securities Exchange Act. See, e.g., Christian Leuz et al., Why Do Firms Go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations, 44 J. Acct. & Econ. (forthcoming 2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id= 592421 (noting that SOX has "substantially increased the internal resources necessary to comply with the new SEC reporting requirements, as well as the cost of retaining outside auditors and lawyers"). Much of the increased compliance cost is related to §404 of SOX which requires a company's management and its outside auditors to attest to the adequacy of a company's internal controls.
106. See Comm. on Capital Mkts. Regulation, supra note 71, at 5 (noting that the average cost of §404 in 2004 was $4.36 million for an average company). In addition to these direct costs, SOX may also entail indirect costs that result when "compliance activities consume[] increasing amounts of executive time."
107. Carney, supra note 72, at 151. Several studies have suggested that these increased costs alone have encouraged an increase in the number of publicly traded companies that have elected to become private companies since 2002.
108. See, e.g., Comm. on Capital Mkts. Regulation, supra note 71, at 4 (noting that going private transactions have "risen dramatically in recent years" and "[o]ne must consider whether the decision to 'go private' or to access the private equity market is a response to the regulatory and liability costs and burdens of the public U.S. market"). Indeed, the cost of complying with SOX is the "most frequently stated reason[] given by management in press releases to explain why their firms are going dark."
109. Leuz, supra, at 7;
110. see also Carney, supra note 72, at 149 (finding the same reasons in a sample of 13e-3 filings filed in 2004).
111. See Damodaran, supra note 19, at 131-34;
112. see also Lerner & Hardymoon, supra note 65, at 206-11 (describing methodology).
113. In 2006, the average debt-to-EBITDA ratio for all leveraged buyouts was 5.7. See Average Pro Forma Adjusted Credit Statistics of Leverages Buyout Loans 2006, Standard & Poor's M&A Stats, Dec. 2006, at 2, 2 [hereinafter S&P Leveraged Commentary]. For simplicity, the DCF models utilized here assume a debt-to-EBITDA ratio of 6.0. To ensure a more realistic assessment of the comparative advantage of debt financing, the DCF methodologies used in this example track closely the assumptions utilized in the analysis of a debt-financed acquisition in Luehrman,
114. supra note 65. This includes an assumption that at the end of year five, ManagementCo will refinance BigCo's debt with a new issue of longterm debt at 9% (although for simplicity, the models here assume a fixed interest rate of 10%>).
115. See Luehrman, supra note 65, at 153. In contrast to Luehrman, however, the models do not assume that BigCo's indebtedness will grow after year five as BigCo continues to grow.
116. See id. (assuming constant growth rate of debt of 5% per year after year five). Were the models to use this assumption, the resulting tax shields would be even larger and the competitive advantage of debt financing even greater than depicted in Figure 6.
117. See, e.g., Lerner & Hardymoon, supra note 65, at 199-200 ("The net present (NPV) method is one of the most common methods of cash flow valuation. . . . The NPV method incorporates the benefit of tax shields from tax-deductible interest payments in the discount rate (i.e., the Weighted Average Cost of Capital, or WACC).");
118. see also id. at 203 ("[In an APV analysis one first] considers] the cash flows generated by the assets of a company, ignoring its capital structure. The savings from tax-deductible interest payments are then valued separately.").
119. See supra text accompanying note 10.
120. See Roberta Romano, A Guide To Takeovers: Theory, Evidence, and Regulation, 9 Yale J. on Reg. 119, 134-36 (1992) (summarizing the literature);
121. see also Alan J. Auerbach & David Reishus, The Impact of Taxation on Mergers and Acquisitions, in Mergers and Acquisitions 69, 81 (Alan J. Auerbach ed., 1988) (examining empirical support for a tax-motivated theory of leveraged acquisitions);
122. Steven Kaplan, Management Buyouts: Evidence on Taxes as a Source of Value, 44 J. Fin. 611 (1989) (examining tax benefits available from leveraged management buyouts). In addition to the tax benefits of debt financing, other benefits of debt financing that have been studied include the ability to use a leveraged acquisition to expropriate wealth from a target company's existing bondholders,
123. see Romano, supra, at 137, and more benevolently, to alleviate the agency problems posed by a target company's managers,
124. see infra text accompanying notes 36-37.
125. Romano, supra note 79, at 134.
126. Google has historically used no debt financing to fund its operations, notwithstanding the fact that it generates considerable operating profit and thus bears a large income tax liability. It also uses a dual class voting structure to ensure voting control remains in the hands of Google's cofounders, Larry Page and Sergey Brin. This dual class voting structure, especially when combined with its lack of debt financing, represents a remarkably inefficient capital structure. Cf. Ronald Masulis et al., Agency Problems at Dual Class Companies (Nov. 12, 2006) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=961158 (finding that managers with greater control rights in excess of cash-flow rights are prone to waste corporate resources to pursue private benefits at the expense of shareholders). Nonetheless, by virtually any accounting measure, Google has been remarkably efficient in deploying its assets (all figures reported as of January 31, 2008): Reuters, Google Inc. Ratios, http://stocks.us.reuters.com/stocks/ratios.asp? rpc=66&symbol=GOOG.O#Efficiency (last visited Jan. 31, 2008). As discussed in Part I.C., Google is not unique in this regard; growth firms commonly utilize low levels of debt financing.
127. Paramount Commc'ns, Inc. v. QVC Network, Inc., 637 A.2d 34, 44 (Del. 1994).
128. Professors Audra Boone and Harold Mulherin found that there is actually considerably more "auction activity" involving publicly traded firms than has historically been believed. Audra Boone & Harold Mulherin, How Are Firms Sold?, 62 J. Fin. 847, 847 (2007). Whereas most prior studies of auctions have limited their inquiry to the public announcement of a takeover bid, Professors Boone and Mulherin reveal that "public takeover activity is only the tip of the iceberg of actual takeover competition during the 1990s."
129. Id. Rather, over half of the publicly traded targets in their study of 400 acquisitions conducted "private takeover auction[s]" prior to announcing a negotiated transaction.
130. Id. at 847-49. Significantly, while the auction process was revealed in a target's proxy solicitation, details of the auction (such as bidder names, offer prices, or financing arrangements) were not. See id. at 857.
131. In an all-cash acquisition of a publicly traded target, for example, the proxy rules do not necessarily require a bidder to disclose the source of its acquisition financing. See 17 C.F.R. § 240.14a-101 (2007) (Instructions to Item 14).
132. For instance, even in an LBO, it can be extremely difficult to calculate the size of a bidder's anticipated tax shields based on the financing information disclosed at the time of the transaction. Debt covenants traditionally require that any excess cash generated by the acquired business be used to repay outstanding indebtedness, thus requiring a target to pay down its debt obligations as quickly as possible. See, e.g., Carliss Baldwin, Technical Note on LBO Valuation (A) (Harv. Bus. Sch. Case No. 9-902-004, July 6, 2001), at 2. Accordingly, these "cash sweep" provisions might reduce the size of a bidder's anticipated tax shields. Complicating matters, however, is the fact that these provisions are generally demanded by senior lenders; the target's management and its LBO sponsors will generally "make every effort to eliminate or at least minimize loan principal payments in the early years of ownership."
133. Colin Blaydon and Fred Wainwright, The Balance Between Debt and Added Value, FT.com, Sept. 28, 2006, http://search.ft.com/ftArticle?queryText= the+balance+betweeb+debt+and+added&y=0&aje=false&x=0&id= 060928007405&ct=0. When lenders are forced to compete for deals as was the case for much of 2004 to 2007,
134. see infra text accompanying notes 141-49, lenders may be more generous in how quickly the debt must be repaid. In fact, the competition for leveraged loans during 2004 to 2007 resulted in lenders providing additional debt financing after an LBO that increased the level of transaction indebtedness.
135. See Blaydon & Wainright, supra ("A few quarters of good post-deal financial performance will present management with the opportunity to approach lenders to renegotiate terms and perhaps even increase the level of debt in a 'leveraged recapitalization.' In today's generous debt markets, senior acquisition debt has had much less stringent repayment requirements than has historically been the case."). In many transactions, this posttransaction indebtedness was utilized to fund a cash dividend payment to the LBO firms, thereby allowing them to recoup their initial equity contribution (often referred to as a "dividend recap").
136. See, e.g., Kenneth MacFadyen, Forget the New Year: PE Still Celebrating 2004, Buyouts, Jan. 3, 2005 ('"[W]ith the high yield market where it is, [LBO] sponsors don't mind putting more equity up front at [an LBO] closing, and then head back to the debt markets three to six months later and pull some of their equity out through a recap.'" (quoting Eduard Bagdasarian, managing director at Barrington Associates)).
137. This Article uses the traditional phrase "LBO firm" rather than the more colloquial "private equity firm" to make clear that the unit of analysis is a financial buyer who utilizes the LBO as its primary form of investment. The term "private equity firm," in contrast, is often associated with venture capital firms who do not engage in LBOs. The concept of a "strategic bidder" is one that is commonly used in both the academic and industry press. See, e.g., Paul M. Healy et al., Which Takeovers Are Profitable? Strategic or Financial?, 38 Sloan Mgmt. Rev. 45, 45 (1997) (describing strategic takeovers as "friendly transactions that typically involved stock payment for firms in overlapping businesses"). This Article conforms to the conventional industry usage of the term such that a "strategic bidder" refers to any publicly traded bidder seeking an acquisition opportunity in a related industry to realize potential operating synergies.
138. See Ronald J. Gilson, Reflections in a Distant Mirror: Japanese Corporate Governance Through American Eyes, 1998 Colum. Bus. L. Rev. 203, 212.
139. For an overview of the structure of an LBO firm, see Jack Levin, Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions ch. 10 (2006).
140. See id. ch. 5 (discussing buyout structure).
141. See Kenneth Lehn & Annette Poulsen, Free Cash Flow and Stockholder Gains in Going Private Transactions, 44 J. Fin. 771 (1989).
142. See Steven N. Kaplan & Jeremy C. Stein, The Evolution of Buyout Pricing and Financial Structure in the 1980s, 108 Q. J. Econ. 313, 326 (1993).
143. See S&P Leveraged Commentary, supra note 76, at 1. As mentioned in supra note 85, however, the total amount of debt financing anticipated to be used by the target may be more than this amount to the extent that an LBO firm conducts a postacquisition dividend recap.
144. The power of leverage to enhance investment returns can be demonstrated using a simple home purchase example. Assume a house is for sale for $150,000 and is expected to have a resale value in one year's time of $180,000. Acquiring the home with $150,000 in cash would therefore result in a return on investment of 20% (i.e., $30,000 profit/$150,000 investment). However, by using only $15,000 in cash (10%) and borrowing the rest of the purchase price ($135,000) at 10% interest, the investment return would increase nearly threefold. For an investment of $28,500 ($15,000 down payment + $13,500 interest for one year), the purchaser would receive a net payout of $45,000 ($180,000 sales price - $135,000 loan balance), yielding a one-year return of 58%. It is the power of leverage to enhance returns in this fashion that is a principle reason why LBO firms seek large amounts of debt financing. Conversely, it is for the same reason that the LBO markets will virtually evaporate when the debt markets contract. See Leslie Green, Platforms Play Solid, Add-Ons Anticipated, Buyouts, Mar. 26, 2001, at 1, 1.
145. See, e.g., Robert L. Kieschnick, Jr., Free Cash Flow and Stockholder Gains in Going Private Transactions Revisited, 25 J. Bus. Fin. & Acct. 187, 187-88 (1998) (finding the "size of the firm and its potential for tax reductions [from debt financing] to be significant determinants of the premiums paid to take it private" in a sample of LBOs completed during the 1980s);
146. see also Kaplan, supra note 79, at 619 (finding in a sample of buyouts completed in the 1980s that the median value of tax benefits from the value of anticipated interest deductions from an LBO ranged from 129.7% of the premium paid to prebuyout shareholders (assuming a tax rate of 46%) to 42.3% (assuming a tax rate of 15%)).
147. Not surprisingly, anecdotal evidence suggests that LBO firms will utilize as much debt in an acquisition as the debt markets will provide, in effect letting lenders set a target's leverage level. See David Snow, In Credit Crunch, Auctions Are Less Pleasant, Buyouts, Nov. 23, 1998, at 1, 22-23.
148. See Aloke Ghosh & Prem C. Jain, Financial Leverage Changes Associated with Corporate Mergers, 6 J. Corp. Fin. 377, 383 (2000).
149. See id. at 380. In effect, the earnings of one business might subsidize an earnings shortfall in the other business during an adverse market cycle, thus reducing the surviving firm's bankruptcy risk. The idea that an increase in debt capacity could result from a merger of two firms and thus provide a motive for a merger was first proposed by Wilbur G. Lewellen.
150. See Wilbur G. Lewellen, A Pure Financial Rationale for the Conglomerate Merger, 26 J. Fin. 349 (1971);
151. see also R.C. Stapleton, Mergers, Debt Capacity, and the Valuation of Corporate Loans, in Mergers and Acquisitions (Michael Keenan & Lawrence J. White eds., 1982) (discussing the possibility of creating value through mergers by making debt safer).
152. See Ghosh & Jain, supra note 96, at 380.
153. See id. at 386-87.
154. This appears to be a reasonable assumption. Ghosh and Jain found that almost all of the increase in financial leverage took place close to the completion date of the merger. See id. at 387. Moreover, in a cross-sectional regression analysis, they found that market-adjusted returns following the announcement of a merger were positively related to increases in financial leverage following the merger, suggesting that the stock market incorporated the future benefits of the anticipated tax shields when the merger was first announced.
155. See id. at 395-99.
156. Id. at 389-90.
157. See Yakov Amihud, Baruch Lev & Nickolaos G. Travlos, Corporate Control and the Choice of Investment Financing: The Case of Corporate Acquisitions, 45 J. Fin. 603, 604 (1990).
158. See supra text accompanying notes 57-60.
159. See Kenneth J. Martin, The Method of Payment in Corporate Acquisitions, Investment Opportunities, and Management Ownership, 51 J. Fin. 1227 (1996). Martin suggests that growth firms prefer stock as an acquisition currency for the same reason that growth firms issue equity rather than debt when raising capital: "[T]he discretion associated with equity financing is valuable for firms with good investment opportunities since it makes it more likely that these firms can fully take advantage of their investment opportunities."
160. Id. at 1229.
161. See Nickolaos G. Travlos, Corporate Takeover Bids, Method of Payment, and Bidding Firms' Stock Returns, 42 J. Fin. 943, 961 (1987). Recall that a principal contention of the pecking order theory is that managers time stock issuances to coincide with periods when a company's stock is perceived as overvalued.
162. See supra text accompanying notes 40-44.
163. See Martin, supra note 104, at 1229 ("Firms with poor investment opportunities issue debt if management is monitored by the capital providers to the firm and issue equity otherwise."). The role of agency costs in the financing of acquisitions, however, is not entirely clear in the financial literature. Notwithstanding Martin's conclusion that disloyal managers prefer stock acquisitions, others have contended that a bidder's managers who value control may prefer financing acquisitions with cash and debt. By using this form of financing, managers can avoid the dilution that would occur to their voting control if they issued new stock. For an empirical examination supporting this hypothesis,
164. see Amihud et al., supra note 102, at 607-15.
165. See Aloke Ghosh & William Ruland, Managerial Ownership, the Method of Payment for Acquisitions, and Executive Job Retention, 53 J. Fin. 785, 786 (1998).
166. See supra text accompanying note 87.
167. See, e.g., Bernard S. Black, Bidder Overpayment in Takeovers, 41 Stan. L. Rev. 597, 608 (1989) ("An important source of potential gain from takeovers is synergy between buyer and seller that permits the merged company to be run more efficiently. . . . The hypothesis that . . . operating synergy is a major source of stock price gains from takeovers has wide currency in the literature.").
168. See C. Edward Fee & Shawn Thomas, Sources of Gain in Horizontal Mergers: Evidence from Customer, Supplier, and Rival Firms, 74 J. Fin. Econ. 423, 424 (2004).
169. See Gregg A. Jarrell & Michael Bradley, The Economic Effects of Federal and State Regulations of Cash Tender Offers, 23 J. L. & Econ. 371, 381-82 (1980).
170. See B. Espen Eckbo, Horizontal Mergers, Collusion and Stockholder Wealth, 11 J. Fin. Econ. 241, 242 (1983).
171. See Ken C. Yook, Larger Return to Cash Acquisitions: Signaling Effect or Leverage Effect?, 76 J. Bus. 477, 480 n.3 (2003). These benefits are, of course, in addition to any enhanced cash flows a bidder might anticipate if the bidder believes the target is inefficiently managed.
172. See id.
173. See, e.g., Fee & Thomas, supra note 110, at 455-58 (finding evidence consistent with improved productive efficiency and buying power as sources of gains for horizontal mergers);
174. Paul M. Healy et al., Does Corporate Performance Improve After Mergers?,
175. J. Fin. Econ. 135 (1992) (finding in a study of the fifty largest U.S. mergers between 1979 and 1984 that "[m]erged firms show significant improvement in asset productivity relative to their industries, leading to higher operating cash flow returns"). But see Black, supra note 109, at 606 ("[E]xcept for horizontal mergers, where the case for operational synergy is strongest, there is a substantial gap between the observed stock price gains and the proposed sources for the gains.");
176. Aloke Ghosh, Does Operating Performance Really Improve Following Corporate Acquisitions?, 1 J. Corp. Fin. 151 (2001) (identifying methodological shortcomings in prior studies of acquisitions finding operating improvements). For a survey of the relevant literature examining this issue,
177. see Robert F. Bruner, Does M&A Pay? A Survey of Evidence for the Decision-Maker, 12 J. Applied Fin. 48 (2002).
178. See, e.g., Matthew T. Billett & Mike Ryngaert, Capital Structure, Asset Structure and Equity Takeover Premiums in Cash Tender Offers, 3 J. Corp. Fin. 141, 162 (1997) (finding that a target's abnormal equity returns were increasing in the target's liability-to-equity ratio and decreasing with respect to the financial asset-to-equity ratio, which is consistent with the idea that bidding firms pay a premium for control of target equity based on how much they believe they can revalue its nonfinancial assets);
179. Joel F. Houston et al., Where Do Merger Gains Come From? Bank Mergers from the Perspective of Insiders and Outsiders, 60 J. Fin. Econ. 285, 305-13 (2001) (finding in a sample of bank mergers a significant relationship between the present value of anticipated cost savings arising from a merger and announcement day returns of both the bidder and the target).
180. See, e.g., Fee & Thomas, supra note 110, at 424 ("Managers of firms undertaking horizontal mergers and acquisitions often cite improved productive efficiency as the primary source of anticipated gains to mergers.");
181. Yook, supra note 113, at 480 (commenting that publicly traded "[b]idders almost always allege that the creation of an enhanced combined effect is the driving motive for their acquisition attempts and that the acquisition creates value for shareholders").
182. Kate O'Sullivan, Rising Stakes: How the Strength of Private Equity Is Changing M&A for Corporate Buyers, CFO, July 2006, at 39, 39 (quoting John LeClaire, chairman of the private equity practice at Goodwin Procter LLP).
183. See Jennifer Lea Reed, Purchase Multiples Press to Rarefied Heights, Buyouts, Feb. 20, 1995, at 1.
184. Ronald A. Kahn & Susan W. Wilson, Private Equity, a la Porter; Its Present and Future, Buyouts, Jan. 29, 1996, at 16, 17.
185. Kenneth MacFadyen, LBO Floodgates Open in Third Quarter: Increased Stability Fuels $21.45B Quarter, Buyouts, Oct. 6, 2003, at 1, 55 (quoting Jamie Singleton, vice chairman of the Cypress Group).
186. See id. ("Private equity groups will find it increasingly difficult to compete. They've largely had the field to themselves and the strategics are coming back into the picture . . . . It will come down to how low [LBO firms] will be willing to lower their returns if they really want to compete." (quoting Glenn Gurtcheff, director and cohead of U.S. Bancorp Piper Jaffray's middle-market mergers and acquisitions group)).
187. Steve Rosenbush, Deals of the Year, in a Year of Deals, BusinessWeek, Dec. 19, 2006, http://www.businessweek.com/bwdaily/dnflash/ content/dec2006/db20061218_740232.htm (quoting Joe Ravitch, a senior media banker at Goldman Sachs);
188. see also Five Questions with . . . David Santoni Managing Director, Goldsmith Agio Helms, Buyouts, Jan. 23, 2006, at 51, 51 (noting that strategic buyers "are aggressively pursuing selective acquisitions but are oftentimes being outbid by financial buyers in competitive processes" (quoting David Santoni));
189. Klee, supra note 12 ('"Gone are the days when the strategic always had an advantage because of the synergies. It has shifted meaningfully so that we see private equity all over our spaces all the time. And they're teaching the sellers to have expectations around prices that have impacted and infected the entire seller's market.'" (quoting Anne Madden at Honeywell International, Inc.));
190. O'Sullivan, supra note 117, at 39 ("Strategic buyers . . . have plenty of cash themselves. But no longer can they expect financial buyers to shy away from competing on price . . . .");
191. Squawk Box (CNBC television broadcast Oct. 11, 2006) ("We don't have any debt. And we are looking for acquisitions. It is a little frustrating in my long experience now in this business, us strategic buyers used to be able to outbid financial buyers because of our perceived ability to find synergies or economies in companies that we acquired. Just now we are being outbid by financial buyers because we just won't overpay." (quoting Frank MacInnis, Chairman & CEO, EMCOR Group)).
192. Glenn Yago & Donald McCarthy, Milken Inst., The U.S. Leveraged Loan Market: A Primer, at i (2004).
193. In general, loans made by banks to corporate borrowers can be divided into two classes: investment grade and leveraged loans. Investment grade loans are loans considered to have a low rate of default risk as reflected in the ratings assigned to the loan by one of the recognized debt ratings agencies. Loans rated Baa3/BBB- or higher reflect a judgment by these agencies that the borrower has adequate payment capacity to honor the loans and the loans are therefore considered "investment grade." See Damodaran, supra note 19, at 176. The lower default risk associated with investment grade loans makes them easier to obtain from lenders and at lower interest rates. In general, a leveraged loan is defined as any loan that is not investment grade (i.e., any loan rated below Baa3/BBB-). For a discussion of the manner in which ratings agencies rate loans,
194. see id. at 111-19.
195. See Alison A. Taylor & Ruth Yang, Evolution of the Primary and Secondary Leveraged Loan Markets, in The Handbook of Loan Syndications and Trading 21, 23-24 (Allison Taylor & Alicia Sansone eds., 2007).
196. See Kaplan & Stein, supra note 91, at 330;
197. see also Taylor & Yang, supra note 125, at 23-24.
198. The emergence of these "high yield" or "junk" bonds as a source of acquisition financing was, of course, intimately tied with Michael Milken's ascent at the investment bank Drexel Burnham Lambert. As summarized by Roberta Romano, "Milken reinvented junk bonds as a financing mechanism for new ventures, and his support of a market for the new issues that he placed, enabled small firms to acquire large ones previously considered impervious to unsolicited bids, and changed the way business was conducted in the United States." Roberta Romano, After the Revolution in Corporate Law, 55 J. Legal Educ. 342, 348 (2005).
199. Kaplan and Stein, for instance, found that public debt was hardly utilized in LBOs that occurred prior to 1984 but increased greatly thereafter. In fact, much of the increase occurred within a single year's time, with the percentage of LBOs utilizing public debt increasing from 5.9% in 1984 to between 40% and 61.3% for the years 1985 through 1989. See Kaplan & Stein, supra note 91, at 337. Moreover, they found that the ratio of bank debt to total debt was 11.1% lower in buyouts using junk bonds.
200. See id. at 338. These findings led Kaplan and Stein to conclude that the utilization of public debt likely played a significant role in the "overheating" of the buyout market towards the end of the 1980s. They observed, "This pronounced crowding out of the bank debt by junk bonds is consistent with the notion that overheated junk bond investors were willing to bid more aggressively for buyout loans than were the relatively defensive bankers."
201. See id.
202. See id. at 331, 337.
203. According to Standard and Poor's data, public, high-yield bonds constituted only 3.42% of the average source of proceeds for LBOs completed in the fourth quarter of 2006 while bank debt represented 52.41%. See S&P Leveraged Commentary, supra note 76, at 1. The total amount of debt financing for LBOs during this time was 67.3%, indicating that public, high-yield bonds represented approximately 5% of the total debt financing used with bank debt representing over 77%.
204. See id. The role of high-yield bonds has in many ways been taken by the use of "second-lien" loans.
205. See, e.g., Christopher O'Leary, As Libor Keeps Rising, Issuers Start Worrying: When Will Investors Lose Their Taste for Second-Lien Loans?, Investment Dealers Digest, May 15, 2006, at 8, 8 ('"Second-lien issuance has taken the place of high-yield bond issuance . . . .'" (quoting Amy Gibson, a vice president in the high-yield group at 40/86 Advisors)); Robert Horton et al., Fitch Ratings, High Yield and Leveraged Loan Market Review: Fourth Quarter and 2006, at 3 (2007) ("Much of the second-lien issuance has directly replaced bonds."). Also known as junior secured or tranche B loans, second-lien loans are bank loans secured by a lien on substantially all of the borrower's assets, however, the security is subordinate to the claims of other first-lien loans. Prior to 2003, second-lien loans were not commonly sold in the syndicated loan market, but since then, second-lien loan use in syndicated loans has risen dramatically, representing 8% of total institutional loan volume in 2006.
206. See id. at 4. For an overview of second-lien loans,
207. see Marc Hanrahan & David Teh, Second Lien Loans, in The Handbook of Loan Syndications and Trading, supra note 125, at 108.
208. See Taylor & Yang, supra note 125, at 23-24.
209. See id. at 24.
210. In 1989, the Office of the Comptroller of the Currency, the Federal Reserve, and the Federal Deposit Insurance Corporation provided guidelines regarding highly leveraged transactions that resulted in limiting banks' holdings of leveraged loans. See Yago & McCarthy, supra note 123, at 16.
211. See Steven Miller, New World Order, Deal, Sept. 19, 2002, available at http://www.thedeal.com (paid subscription required).
212. See Taylor & Yang, supra note 125, at 24.
213. Figure 9 was derived from Scott Page & Payson Swaffield, An Introduction to the Loan Asset Class, in The Handbook of Loan Syndications and Trading, supra note 125, at 3, 3. Today, nonbank, institutional investors acquire almost 80% of all leveraged loan issuances.
214. See S&P Leveraged Commentary, supra note 76, at 3. The growing importance of institutional investors in the leveraged loan market is part of a broader twenty-year trend in all areas of lending where intermediaries such as bank lenders are being displaced by the ultimate source of funds, investors in the capital markets. In addition to leveraged loans, for instance, this process of disintermediation has occurred in the market for home mortgages, auto loans, and credit card receivables. For an overview of this process, see Steven L. Schwarcz, Structured Finance: A Guide to the Principles of Asset Securitization § 1:1 (3d ed. 2002).
215. See generally Page & Swaffield, supra note 136, at 6-18;
216. Yago & McCarthy, supra note 123, at 26-38.
217. Reuters Loan Pricing Corp., U.S. Secondary Loan Market Volume, http://www.loanpricing.com/analytics/pricing_service_volumel.htm (last visited Feb. 20, 2008).
218. See Yago & McCarthy, supra note 123.
219. See id. at 26.
220. For data on syndicated loan issuances, see Steven C. Miller, Standard & Poor's, The U.S. Leveraged Loan Market: Huge Deals, Few Bargains (2006), http://www2.standardandpoors.com/portal/site/sp/en/us/page.article/2,1,1,0, 1145997542521.html (reporting U.S. issuances for 2004 and 2005); Steven C. Miller, Standard & Poor's, Leveraged Loans: Record-Setting Leveraged Loan Market Shows No Signs of Slowing (Yet) (2007), http://www2.standardandpoors.eom/ portal/site/sp/en/us/page.article/2,1,1,0,1148406249020. html (reporting U.S. issuances for 2006). For data on U.S. equity issuances, see Comm. on Capital Mkts. Regulation, supra note 71, at 44.
221. See William May et al., Fitch Ratings, CLOs More Concentrated in Shareholder-Friendly and Covenant Light Loans 1 (2006) ("One of the largest sources of increased demand for leveraged loans-both on an absolute and relative basis-has been collateralized loan obligations.").
222. A CLO uses the anticipated cash flows from its loan portfolio as the basis for issuing its own bonds with varying degrees of creditworthiness. As a consequence, a CLO can effectively turn a portfolio of noninvestment grade syndicated loans into a package of investment grade bonds, noninvestment grade bonds, and equity securities that it can sell to the public. For an overview of CLOs, see Bond Mkt. Ass'n, CDOs: A Primer, in The Handbook of Loan Syndications and Trading, supra note 125, at 709.
223. See Barry Bobrow et al., An Introduction to the Primary Market, in The Handbook of Loan Syndications and Trading, supra note 125, at 155, 165-66.
224. See id.
225. See, e.g., David Henry, Danger - Explosive Loans, BusinessWeek, Oct. 23, 2006, at 89, 89 (quoting editor of Creditflux, an industry news service as stating, "Just about every man and his dog is trying to do a CLO at the moment");
226. Judy McDermott, Healthy US CLO Issuance Expected to Continue . . . For Now, LSTA Loan Market Chronicle, 2005, at 64, 64, available at http://www.lsta.org/WorkArea/downloadasset.aspx?id=1570 ('"There's a crazy amount of oversubscription [for new CLO issues]. . . . Even with spreads where they are, [CLOs] can still get done.'" (quoting Fred Haddad, senior portfolio manager with GoldTree Asset Management)).
227. See, e.g., Harold Blatt, The Forces Behind Today's Secured Borrowing Market, Buyouts, June 6, 2005, at 40, 40 ("[T]here is significant increase in loan market liquidity and aggressive competition from cash flow lenders that has forced asset-based lenders to take more risk to win deals. As a result, debt to EBITDA multiples for leveraged buyouts (LBOs), for example, have climbed to 5 × EBITDA in 2005. That compares to 3.7 × EBITDA in 2001 . . . .");
228. George Ticknor & David Ruediger, Return of the Strategic Buyer: A Seller's Perspective, Buyouts, Mar. 28, 2005, at 22, 22 ("Banks and finance companies are eager to lend money at leverage multiples that are high by historic standards."). Much of the competition among lenders appears to have stemmed from a "liquidity supply and demand imbalance."
229. Blatt, supra, at 40. As a marketing director for Bank of America noted in 2005, "On the demand side, fewer companies are looking for external sources of financing since they're generating more than enough cash from their operations."
230. Id.;
231. see also Randy Myers, Money for Nothing: Bank Credit Is Easy, Maybe Too Easy. Don't Pass It Up, CFO, Apr. 2006, at 60, 62 ('"Everybody's looking for funded assets . . . . There is too much liquidity chasing too few dollars . . . . When a [credit] facility does become available where it would be drawn or utilized . . . banks just fall all over themselves to get involved.'" (quoting Joseph Chinnici, managing director and head of debt-capital markets for KeyBanc Capital Markets)).
232. In its 2006 underwriting survey, for instance, the Office of the Comptroller of the Currency noted that "competitive pressures have led to a third consecutive year of eased credit underwriting standards. Examiners report that national banks have eased underwriting standards for both commercial and retail credit products." Office of the Comptroller of the Currency, Survey of Credit Underwriting Practices 4 (2006), available at http://www.occ.treas.gov/2006Underwriting/2006UnderwritingSurvey.pdf. Moreover, it emphasized that competition for loans from nonbank investors "has influenced underwriting terms for leveraged loans and pushed credit spreads lower."
233. Id. Similar results were found in the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOS).
234. See Fed. Reserve Bd., The January 2007 Senior Loan Officer Opinion Survey on Bank Lending Practices (2007), http://www.federalreserve.gov/ boarddocs/SnLoanSurvey/200701/default.htm (finding that "[n]early all domestic banks and all U.S. branches and agencies of foreign banks . . . indicated having eased their lending standards and terms in the January survey cit[ing] more-aggressive [sic] competition from other banks or nonbank lenders as the most important reason for having done so"). One of the most important manifestations of this trend was the increase in "covenant lite" loans after 2004. Credit agreements ordinarily contain a number of financial and nonfinancial covenants on the part of the borrower, which are designed to help monitor borrower behavior and to align borrowers' actions with the interests of lenders over the life of the loan. Starting around 2004, lenders significantly eased covenant restrictions as lenders competed for loans. For instance, in a 2005 analysis of loan covenants, Fitch Ratings found that for noninvestment grade loans the average number of covenants incorporated into a typical noninvestment grade loan package in 2005 was six, down from an average of eight for the period 2002 through 2004.
235. See William May & Mariarosa Verde, Fitch Ratings, Loan Volumes Surge, Covenants Shrink in 2005 (2005).
236. Henny Sender, Toggle Notes Are Buyout Fuel: Debt Structure Helps Default Rate Stay Low, Driving Historic Boom, Wall St. J. (Europe), Feb. 22, 2007, at 19 (quoting Kewsong Lee).
237. See Vyvyan Tenorio & David Carey, The Temptations of Private Equity, Deal, Nov. 17, 2006, available at http://www.thedeal.com (paid subscription required).
238. Id.
239. Rosenbush, supra note 122.
240. Id.
241. Joan Harrison, Holding Back in the M&A Race? Strategic Buyers Rack Up the Deals but Do Nothing to Push the M&A Envelope, Mergers & Acquisitions, Jan. 2007, at 1.
242. Id. at 28.
243. Id.
244. The Uneasy Crown, Economist, Feb. 10, 2007, at 74, 75.
245. See Neil Harper & Antoon Schneider, Private Equity's New Challenge: A Changed Competitive Landscape Calls for a Different Business Model, McKinsey Q., Summer 2004.
246. See generally Bengt Holmstrom & Steven N. Kaplan, Corporate Governance and Merger Activity in the United States: Making Sense of the 1980s and 1990s, 15 J. Econ. Persp. 121 (2001).
247. See supra note 83;
248. see also Harper & Schneider, supra note 158, at 2 ("Almost all significant deals today are subject to a visible and public auction process as sellers seek the maximum price. In many large deals, the number of bidders, both alone and in consortia, can reach double digits.").
249. See Mike Wright et al., Firm Rebirth: Buyouts as Facilitators of Strategic Growth and Entrepreneurship, 15 Acad, of Mgmt. Executive 111, 122 (2001).
250. David Carey, Not Your Father's LBO, Deal, Sept. 29, 2006, available at http://www.thedeal.com (paid subscription required).
251. See Janet Whitman, Something Ventured: LBO Firms Seek Hands-On Expertise, Dow Jones News Serv., Apr. 2, 2003 (on file with the Fordham Law Review);
252. see also Harper & Schneider, supra note 158, at 4 ("Several buyout firms now recognize that they can create value (in conjunction with management teams) by participating more in managing the companies in their investment portfolio and by developing cross-industry functional skills-including marketing, pricing, lean manufacturing, and procurement and supply chain management."). At about this time, finance scholars also began to question whether the traditional agency cost view of LBOs was appropriate and to examine whether some LBOs might be motivated by a growth-oriented perspective.
253. See Mike Wright et al., Entrepreneurial Growth Through
254. Much of this campaign was directed at Europe where LBOs have traditionally been associated with significant layoffs. Anxiety over the growth of LBOs in Germany, for instance, appeared in Germany's 2005 general election campaign when Franz Müntefering, then-chairman of Germany's Social Democrat Party, famously criticized private equity firms as "a swarm of locust[s]." Peter Smith, 'Locusts' Swarm to Germany in Effort to Improve Image, FT.com, Feb. 19, 2006, http://search.ft.com/ftArticle?queryText= locusts+swarm+to+germany&y=0&aje=true&x=0&id= 060219003853&ct=0. In response, some of the largest LBO firms commenced a tour of Europe, emphasizing their focus on value creation and the jobs they create.
255. See, e.g., Hamilton E. James, President, Blackstone Group, Growing the Italian Economy: The Case for Private Equity Investment, Address at the Hotel Parco dei Principi, Rome (Nov. 27, 2006), available at http://italy.usembassy.gov/events/2006/PrivateEquity/JamesSpeech.pdf;
256. see also The Uneasy Crown, supra note 157 ("[S]ince the mid-1990s private-equity firms have taken every opportunity to stress that they do not depend on financial engineering. . . . Instead, they prefer to draw attention to other ways in which they improve the firms they own.").
257. See Carey, supra note 162;
258. see also Harper & Schneider, supra note 158, at 4 ("Several firms have begun to build groups of strategists, former operating executives, and turnaround specialists, while others have entered into alliances with third parties to provide such services."). Some notable former chief executive officers who were recruited by LBO firms include General Electric's Jack Welch, hired by Clayton Dubilier & Rice, Ford's Jacques Nasser, hired by One Equity Partners, and IBM's Lou Gerstner, hired by the Carlyle Group. By 2006, even Kohlberg Kravis Roberts & Co. (KKR) - the buyout firm that originated the cost-cutting LBO of the 1980s - claimed twenty-nine partners and managing directors that had come from operating backgrounds.
259. See Carey, supra note 162. KKR also reestablished an in-house consulting operation, Capstone, which is dedicated to brainstorming ways to foster growth among KKR's portfolio of operating companies. See id.
260. See Wright et al., supra note 161, at 116-17;
261. see also Kahn & Wilson, supra note 119, at 17 ("In order to . . . compete more effectively against strategic buyers, many private equity funds today are focusing on buy-and-build strategies and positioning themselves as financial/strategic buyers.").
262. See Harper & Schneider, supra note 158;
263. see also Five Questions with . . . Justin Abelow Director, Houlihan, Lokey, Howard & Zukin, Buyouts, Oct. 31, 2005, at 50, 50 (noting that LBO firms "are . . . increasingly organized internally into industry silos,. . . so even in the absence of [platform] portfolio companies they are bringing to bear highly-refined industry expertise.").
264. See Harper & Schneider, supra note 158.
265. See David Snow, Multiples Show Who's Hot, Who's Not, Buyouts, Feb. 21, 2000, at 1, 23 (noting that "financial buyers lately have been even more aggressive than strategic buyers in their bids, particularly when acquiring add-ons" because "[w]hen making an acquisition through a platform company, financial buyers can afford to make the same bids as traditional strategic buyers");
266. see also Five Questions with . . . Justin Abelow Director, Houlihan, Lokey, Howard & Zukin, supra note 167, at 50 ("[N]ow we are really seeing financials acting more like strategics, in a whole variety of ways. First, of course, they are acting increasingly through portfolio companies, effectively mimicking strategic synergies and therefore pricing behaviors.");
267. Jennifer Strauss, Amidst Turmoil, Multiples Stay Steady, Buyouts, Feb. 19, 2001, at 1, 1 (noting that the "line between financial buyers and strategic buyers started to blur last year as both groups paid similar prices for similar companies, which sources attributed to a higher degree of specialization with private equity portfolios.");
268. Kopin Tan, Multiples Jump, Yet Again, as LBO Firms Close Gap, Buyouts, Feb. 23, 1998, at 1, 46 ("Sources came up with a variety of reasons explaining the closing of the pricing gap. For a start, with more buyout firms pursuing buy-build strategies, G.P.s increasingly are chasing synergies and behaving like quasi-strategic buyers.").
269. See Equity Office Agrees to Be Acquired by the Blackstone Group, Bus. Wire, Nov. 20, 2006.
270. Vornado Realty Trust, Discussion of Offer to Acquire Equity Office Properties (Feb. 1, 2007), available at http://www.secinfo.com/d11MXs. u73h.htm.
271. Equity Office Agrees to Be Acquired by the Blackstone Group, supra note 170.
272. Blackstone Group, L.P., Pre-effective Amendment to Registration Statement (Amendment No. 9 to Form S-1) 165 (June 21, 2007), available at http://www.secinfo.com/dVut2.u4V3.htm.
273. Real Estate Group, Blackstone Group, Blackstone Advantages, http://www.blackstone.com/real_estate/advantages.html (last visited Feb. 20, 2008).
274. Equity Office Agrees to Be Acquired by the Blackstone Group, supra note 170.
275. Id.
276. Vornado Realty Trust, supra note 171.
277. Equity Office Properties Trust, Proxy Statement (Schedule 14A) (Feb. 2, 2007), available at http://www.secinfo.com/dsvRm.u1Ce.htm.
278. See id.
279. See Vornado Realty Trust, supra note 171.
280. Id.
281. Id.
282. Equity Office Properties Trust, Proxy Statement (Schedule 14A) (Jan. 29, 2007), available at http://www.secinfo.com/dsvRm.ul lz.htm.
283. In a REIT, 95% of the net income is passed through to the stockholders and not taxed at the corporate level. I.R.C. §§856-859 (2000).
284. Cf. Jeffrey F. Jaffe, Taxes and the Capital Structure of Partnerships, REITs, and Related Entities, 46 J. Fin. 401 (1991) (providing proof that the value of a REIT is invariant to leverage decisions due to the absence of corporate taxes).
285. Not surprisingly, a discussion of a bidder's anticipated acquisition financing is a standard part of most presentations made by a target's financial advisors to a target's board of directors. See, e.g., Credit Suisse Sec. (USA) LLC & Morgan Stanley & Co., Project Hero, Presentation to the Board of Directors of HCA Inc. (July 23, 2006), available at http://www.secinfo.eom/dsVsf.v7Fu.b.htm.
286. The significance of this point was vividly illustrated during late 2006 as the recent buyout wave reached its crest. Faced with the choice of approving or rejecting a buyout offer from an LBO firm, target shareholders began to vote down proposals with increasing frequency. In some cases, target shareholders explained their "no" votes on the basis that the target's own management should be able to effect the changes proposed by the LBO firms through a leveraged recapitalization, thereby allowing the target's existing stockholders to realize the considerable returns expected by the LBO bidders. Following the announcement of a proposed LBO of Clear Channel Communications, for instance, one prominent shareholder objected to the proposal on the grounds that the company's managers should engage in a "do-it-yourself leveraged buyout." Dennis K. Berman & Sarah McBride, Clear Channel Showdown Signals Investor Wariness of Private Buyouts, Wall St. J., Jan. 27, 2007, at Al. As the shareholder explained, "All the analyst reports say that private equity will be making 23% [annual returns] on their investment. I find 23% a rather attractive proposition, and I want it."
287. Id. (quoting Jeremy Hosking). One must, of course, take seriously the contention that a target's managers have indeed failed to optimize the target's business. Yet when it comes to mimicking an LBO firm's proposed capital structure, a target's shareholders and directors would be well advised to take seriously the central point of Part I: the ability to utilize aggressive amounts of debt financing varies among companies for reasons that may have nothing to do with agency problems. Failing to consider the very real limitations even loyal managers face in determining a firm's optimal capital structure risks overlooking-and perhaps even rejecting-the unique value offered by an LBO.
288. An examination of the relationship between the most recent LBO wave and tax revenue is very much in order. The primary academic study of the extent to which LBOs result in a reduction in the corporate tax base was last conducted in 1989 following the 1980s buyout wave. See Michael Jensen et al., Effects of LBOs on Tax Revenues of the U.S. Treasury, 42 Tax Notes 727 (1989). The authors estimated that, notwithstanding the reduction in corporate tax receipts due to the heavy use of leverage, the U.S. Treasury likely had a net gain in tax revenue from the buyout wave owing to an increase in capital gains taxes assessed on target shareholders, an increase in taxable interest payments paid to corporate debt holders, and an increase in corporate taxes as targets realized greater operating efficiencies. Given the considerable changes to the buyout market identified in this Article, it is unclear whether these conclusions would continue to hold today. In particular, many of the holders of leveraged loans are no longer banks, but institutional investors such as CLOs who may often be either tax exempt or non-U.S. taxpayers that pay no tax on portfolio interest.
289. See supra text accompanying notes 135-40. I am grateful to Vic Fleischer for this insight.