Capital Markets

Debtor’s Prison?

Researchers say too little equity may breed myopia in managers.
Marie LeoneSeptember 10, 2001

Modern finance theory posits that, all things being equal, debt is superior to equity as a source of capital. However, a new study suggests that borrowing can encourage myopic thinking on the part of management.

To be sure, debt carries significant tax benefits, is cheaper than equity, and provides more value to stockholders in a leveraged buyout. But the study’s authors–Anil Shivdasani, a vice president with Salomon Smith Barney in New York, and Urs Peyer, an assistant professor of finance at INSEAD, in France–find that a heavy debt load can hurt corporate growth by leading companies to focus too relentlessly on short-term cash flow, thereby losing strategic focus.

Shivdasani explains that if management lacks discipline, a major shift from equity to debt often causes capital to be funneled to projects or business units that generate quick returns. Essentially, adds Peyer, the company begins to manage for short-term cash flow as internal capital is earmarked for debt and interest repayment and long- term investment opportunities are neglected.

In the Service of Debt

The study, “Leverage and Internal Capital Markets: Evidence from Leveraged Recapitalization,” was published in the March issue of the Journal of Financial Economics, while the researchers were colleagues at the University of North Carolina at Chapel Hill. They studied 22 U.S. companies that underwent leveraged recapitalization between 1982 and 1994, including USG, Owens Corning, Phillips Petroleum, Texaco, Union Carbide, and Goodyear Tire and Rubber. Examining leveraged recaps allowed the duo to quantify a comparatively “pure” change in leverage, while the 12-year span gave them enough data to chart meaningful postrecap results. On average, the companies in the study had a 17 percent debt-to-total-capital ratio before they leveraged up. That rose to 50 percent after taking on the extra debt. By comparison, the average for their unrecapitalized peers was 21 percent.

The paydown was so aggressive at these companies that within three years of the recapitalization, the ratio sank to an average 30 percent. To ensure that the findings were not a “statistical artifact,” the researchers also examined company annual reports and press coverage immediately following the recaps. Almost all firms in the sample described measures, such as asset sales and reduction in capital expenditures, designed to improve cash flow, says Shivdasani. Several affirmed that generation of cash flow was a key strategic objective.

To give more weight to the findings, the team tested the market’s reaction to companies that managed for short-term cash flow. Using a stock-price-based yardstick–an excess value measure that calculates worth relative to corporate peers–they found that firms focused on short-term cash flow did decidedly worse during the three years following the leveraged recap than companies that managed to satisfy corporate economics.

Critics contend the study paints too broad a picture. Dennis Soter, head of the corporate finance practice of consulting firm Stern Stewart & Co., points out that the problem with many highly leveraged companies is their strategy, not their capital structure. He cites several poststudy cases, including SPX Corp., Equifax, and Ipalco Enterprises, that kept investment strategies intact despite leveraged recaps.

In April 1997, for instance, auto-parts manufacturer SPX completed a $100 million leveraged recap that raised its debt-to-capital ratio from 70 percent to 118 percent. A year later, after passing up smaller acquisition targets–and amid financial meltdowns in Asia, Russia, and Brazil–the junk-rated SPX raised a $1.65 billion loan package through a bank-loan syndication and scooped up $2 billion (in revenues) General Signal, a company twice its size. The move completed SPX’s repositioning from an auto-parts supplier to a higher-margin specialty services company–and boosted its prerecap stock price by more than 50 percent. Looks like the debt-versus-equity debate will go on for at least a little while longer. (For a chart from the study, see next page)


Company growth rate levels sink after recaps.*


Within industry

Capital expenditures -34% -43%
Sales -9% -21%
Asset -14% -21%

*Growth rates calculated from year prior to leveraged

recapitalization through one year after.

Source: “Leverage And Internal Capital Markets” Study, March 2001