Another significant challenge to M&M orthodoxy stems from an acquisition technique that came of age in the 1980s--the leveraged buyout. Some experts say the use of debt capital in an LBO to create value for shareholders proves that capital structure matters after all.
"In the '70s, people invented hostile takeovers as a way to recapture the approximately 50 percent of the value of American corporations that was being destroyed by its managers with nonoptimal operating policies," asserts Harvard Business School professor Michael Jensen. Jensen, together with the late University of Rochester professor William Meckling, published extensive research purporting to show the positive effect that debt can have on company value. Jensen's main point: A company's operating and investment decisions, and therefore its cash flows, are not independent of its debt-equity ratio.
Of all the real-world reasons that capital structure matters, Jensen's agency-cost argument seems to have taken the firmest hold on the corporate consciousness: witness the rise of stock options to keep managers focused on shareholder value.
"I think Mike Jensen's premise that there are agency costs is fundamentally right, and that debt has governance value that would not be there if the debt were not there," says Carl Ferenbach, managing director at Berkshire Partners LLC in Boston, a private-equity company that has done more than 50 leveraged transactions since 1984. "We have time and time again taken managers who were in a private-company context, privatized the businesses they ran, provided equity incentives, levered the company, and had tremendous investment outcomes. What was the driver? Was it the equity incentives or the debt? I don't have a clear answer for that, except to say that it was probably both."
Miller, however, remains unconvinced.
"Jensen's point that cash cows will lever up so that management will not use the money, because they will have to pay it in interest-- that is an interesting thought," concedes Miller. "But the big increase in value at these companies had nothing to do with leverage, in my view. It was the entrepreneur-- they had better managers and management focus."
What does Wall Street make of the debate around agency costs? "If you listen to the dialogue between investment bankers and CFOs and chief executive officers, you won't hear highbrow theories such as agency and information issues being directly discussed," says John Moon, vice president in the investment banking division of Goldman, Sachs & Co. and a PhD in business economics. "Nevertheless, if one is familiar with the concepts and uses them to step back and examine situations, one can see how they are very relevant to the real world."
Information Problems and Bankruptcy Costs
Moon points to another reason that capital structure matters in the real world: information asymmetries. This awkward-sounding term is used to describe the rather pedestrian notion that investors can be somewhat suspicious of equity offerings--managers may not be willing or able to tell all they know-- and drive down a company's stock price.
This "insider's advantage" has been cited in much of the post-M&M literature as one of the reasons that decisions to issue debt or equity can affect the value of a company.
While investor suspicion can affect the value of a company's securities, so can another "information problem": many investors just don't have the resources to get to know small companies. As a result, these companies have to pay a higher price for financing.
Take the case of Albuquerque-based Cobre Mining Co., purchased earlier this year by Phelps Dodge Corp., a mining company in Phoenix. When Cobre pitched an equity offering to institutional investors in 1997, it ultimately raised the funds it sought, but not without a good deal more difficulty than it anticipated, according to former Cobre CFO John F. Combs. Says Combs: "You can run all of the projections you like and be flexible about where you are going to price the equity, and still find the realities of the marketplace are that you just can't generate enough interest to get deals done with the kind of ease you would expect."
Another marketplace reality that, like information problems, can hurt the value of a firm is bankruptcy. M&M critics mean by that not bankruptcy per se--a worthless company is a worthless company--but the additional costs to shareholders of paying lawyers, accountants, and brokers as a company moves through bankruptcy. The risk of incurring these costs, say critics, is a significant factor in financing decisions.
"Early on, people realized that there were costs of going through bankruptcy," says Stewart C. Myers, professor of finance at MIT and co-author, with Richard Brealey, of the best-selling financial textbook Principles of Corporate Finance. "There is an argument over how big these costs are, but it is clear that there are some, and that is a reason not to go to extremely high debt ratios. The risk of bankruptcy also explains why companies with a lot of intangible assets and growth opportunities tend not to use debt." Myers says putting such companies through financial distress is like "putting a wedding cake through a car wash. There's not a lot left at the end."
Relevance Retained
Although everyone seems to have a favorite bone to pick with M&M, there seems to be little disagreement about one thing: while well-designed capital structures might create some value, most value comes from the decision making done by managers.
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