Thursday, August 17, 2006

Shareholder Friendly

Bloomberg has a fascinating article today (by Caroline Salas and Aparajita Saha-Bubna) on investment grade bonds that are getting hurt as companies increase leverage to finance special dividends and stock buybacks. The conversion of equity into cash for shareholders reduces the amount of junior capital supporting the senior bonded debt. From an academic finance perspective, this is an example of the shareholder/bondholder conflict as shareholders who control the company seek to maximize returns for themselves vs. keeping the company securely capitalized for the benefit of bond owners.

There are several reasons for this recent jump in shareholder friendly activity. One reason is the natural desire of boards and management to create tangible shareholder value: especially value that can be seen in the short term. Shareholders can directly perceive dividends and sense the effects of share buy backs. The virtues of a conservative capital structure are more subtle and remote. However investors must keep in mind Benjamin Graham’s observation that the junior capital can never be safer than senior capital.

A second reason is the growing influence of activist hedge funds and the "private equity put". Simply put, there are noisy, greedy and impatient investors with money out there. Hedge funds tend to seek corporate actions that lead to immediate returns. Private equity folks look for underleveraged and under priced companies that they can lever up and flip for a fast buck. Both hedge funds (LBO artists) can be mollified (deterred) by increasing stock prices, and making the company less suitable for asset stripping or a takeover.

Thanks to a glut of private equity capital, the threat of takeovers and buyouts is at levels not seen since the 1980s, and so the corporate governance focus is shifting to tangible value creation, at the cost of an increase in risk. Whether real value is created on a risk-adjusted basis is yet to be seen.

1 Comments:

At August 18, 2006 3:49 PM, Blogger quints said...

I will add one other motivation. Corporate executives are increasingly compensated with options. The options only increase in value as the stock does. So management teams in some circumstances propose buybacks to make their compensation more valuable. This hurts the bondholders. But, it also hurts the existing shareholders. The now valuable options cause dilution. Most shareholders are too passive and uninterested to object, but it happens regularly to their detriment.

 

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