Leveraged buybacks

Debt-financed share buybacks generate positive short-term and long-run abnormal stock returns. Leveraged buyback firms have more debt capacity, higher marginal tax rate, lower excess cash and lower growth prospects ex ante, increase leverage and reduce investments more sharply ex post than cash-financed buyback firms. Firms that are over-levered ex-ante are associated with lower returns and real investments following leveraged buybacks. The lower announcement returns of over-levered firms are concentrated on firms with weaker corporate governance. The evidence is consistent with leveraged buybacks enabling firms to optimize their leverage, on average benefiting shareholders. The benefits decrease with a firm's leverage ex ante.     

Management choice of buyback method: Australian evidence

This study investigates management choice of repurchase method for large Australian industrial companies from 1997 to 2007. We show that managers favour off‐market buybacks to distribute excess franking credits to shareholders when the buyback is larger and when the firm is generating more cash. On‐market buybacks are more likely when the firm is undervalued. These findings have implications for understanding how corporate managers approach the repurchase decision, the impact of taxes on corporate financial policy, and how transaction costs can influence the choice between an off‐market and an on‐market buyback.     

Excess Cash and Shareholder Payout Strategies

On March 19, 2012, Apple announced a program to distribute its “excess” cash to shareholders in the form of dividends and share buybacks. This announcement followed a pattern that is remarkably similar to the one leading up to Microsoft's announcement in 2004. Likewise IBM, the bluest of blue chips, made a path‐breaking decision to initiate share buybacks in the 1980s. And as recently as April 2012, IBM, along with many other large corporations, announced yet another major share buyback program together with an increase in its dividend. These actions underscore the reality that senior management's main job is to allocate capital efficiently—and that efficient allocation of capital means distributing it when necessary. In light of these events, and the demand from shareholders that appears to be driving them, this paper explores analytical and empirical issues related to excess cash and corporate payout policy. In so doing, it provides the outline of an analytical framework for executives when thinking about the allocation of excess cash among competing uses, including deleveraging, growth, special and regular dividends, and share buybacks. The essence of the framework is this: Once companies satisfy their demands for cash based on their expected financial transactions, their targeted capital structure, and prospective investment (mergers and acquisitions) considerations, management should turn its attention to capital structure and shareholder payout decisions. Assuming that the company's capital structure is reasonably close to its target, and that its rating agencies are supportive, management should aim to pay a level of dividends that (1) reflects the underlying strength and stability of their projected earnings streams and that (2) satisfies the expectations of its core shareholders while positioning itself for the future. For more cyclical and otherwise riskier companies, management should also consider the use of stock buybacks or special dividends as a way of paying out the more variable, or unexpected, part of their expected earnings stream.     

The Effects of Cash,Debt, and Insiders on Open Market Share Repurchases

The findings of the authors' recent study suggest, on balance, that stock repurchases function much like tax‐efficient special dividends, increasing when free cash flow is large and when debt levels are low, but not replacing regularly scheduled dividends. Repurchasing companies experience median event returns of about 2% around the repurchase announcements, with a related mean effect of roughly 3%. Companies with greater free cash flow and less debt are more likely than otherwise comparable companies to repurchase their shares. Furthermore, repurchasing companies that exhibit substandard preannouncement stock price returns and seek to buy back higher percentages of shares tend to elicit more positive stock price reactions. At the same time, the study provides some evidence that corporate managers attempt to use their inside information to profit from buybacks. For example, managing insiders in repurchasing firms decrease their selling activity and increase their buying activity two weeks before repurchase announcements to a greater extent than non‐managing insiders. But perhaps the most remarkable finding from this part of the study is how little insiders as a group seem to profit from their short‐term trading behavior—a finding that suggests that the market appears to anticipate much of this behavior.     

Proactive Leverage Increases and The Value of Financial Flexibility

Traditional tradeoff models of corporate capital structure, although still featured prominently in finance textbooks and widely accepted by practitioners, have been criticized by financial economists for doing a poor job of explaining observed debt ratios. Moreover, the observed ratios are far less stable than what would be predicted by the standard tradeoff models. In a study published several years ago in the Review of Financial Studies, the authors of this article aimed to shed more light on the underlying forces governing capital structure decisions by analyzing a set of major changes in capital structure in which companies initiated large increases in leverage through substantial new borrowings. They then attempted to explain why these companies chose to increase leverage and how their capital structures changed during the years after the large debt issues. As summarized in this article, the authors' findings indicate, first of all, that the large debt financings were used primarily to fund major corporate investments—and not, for example, to make large distributions to shareholders. And the changes in leverage ratios that came after the debt offerings were driven far more by the evolution of the companies' realized cash flows and their investment opportunities than by deliberate or decisive attempts to rebalance their capital structures toward a stationary target. In fact, many of the companies chose to take on even more debt when faced with cash‐flow deficits, despite operating with leverage that was already well above any reasonable estimate of their estimated target leverage. At the same time, companies that generated financial surpluses used them to reduce debt, even when their leverage had fallen well below their estimated targets. Taken as a whole, the findings of the authors' study support the idea that unused debt capacity represents an important source of financial flexibility, and that preserving such flexibility—and making use of it when valuable investment opportunities materialize—may well be the critical missing link in connecting capital structure theory with observed corporate behavior.     

STOCK BUYBACKS, CORPORATE PERFORMANCE, AND EVA

Most studies of corporate stock repurchase focus on the effect of stock buyback announcements on the stock price performance of companies announcing the programs, and on the corporate motives for undertaking stock buyback programs. The study described in this article examines the effects of actual stock buyback activities on corporate performance, addressing the question whether buybacks are associated with increases in economic value or EVA. In general, the study reports that the operating performance of buyback companies is better than that of non-buyback companies, and that performance improves in the year following the initiation of repurchasing activities. Although it is not the central focus of this study, the findings are consistent with both the free cash flow and the information signaling hypotheses as motives for engaging in stock buybacks.     

Morgan Stanley Roundtable on Capital Structure and Payout Policy

A group of finance academics and practitioners discusses a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerged was that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial fl exibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value by reducing taxes and controlling the corporate “free cash flow problem.” Both leveraged financing and cash distributions through dividends and stock buybacks represent a commitment by management to shareholders that the firm's excess cash will not be wasted on projects that produce growth at the expense of profitability. As for the choice between dividends and stock repurchases, dividends appear to provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve a higher degree of managerial fl exibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial fl exibility; too little can mean lost investment opportunities but too much can lead to overinvestment.     

MORGAN STANLEY ROUNDTABLE ON Capital Structure and Payout Policy

A group of distinguished finance academics and practitioners discuss a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerges is that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial flexibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value both by reducing taxes and controlling the corporate free cash flow problem. In such cases, both leveraged financing and cash distributions through dividends and stock buybacks signal management's commitment to its shareholders that the firm's excess cash will not be wasted on projects that produce low‐return growth that comes at the expense of profitability. As for the choice between dividends and stock repurchases, dividends provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve more flexibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial flexibility: too little can mean lost investment opportunities, but too much can lead to overinvestment.     

Liquidity,the Value of the Firm,and Corporate Finance

The theory of corporate finance has been based on the idea that a company's market value is determined mainly by just two variables: the company's expected after‐tax operating cash flows or earnings, and the risk associated with producing them. The authors argue that there is another important factor affecting a company's value: the liquidity of its own securities, debt as well as equity. The paper supports this argument by reviewing the large and growing body of evidence showing that differences—and changes—in liquidity can have major effects on the pricing of corporate stocks and bonds or, equivalently, on investors' required returns for holding them. The authors also suggest that the liquidity of a company's securities can be managed by corporate policies and actions. For those companies whose value is likely to be increased by having more liquid securities—which is by no means true of all companies (mature firms that don't need outside capital may well benefit from having more concentrated ownership and hence less liquidity)—management should consider actions such as reducing leverage and substituting dividends for stock repurchases as well as measures designed to increase the effectiveness of their disclosure and investor relations program and the size of their investor base.     

Do Managers Have Capital Structure Targets? Evidence from Corporate Spinoffs

The two main theories of capital structure—the tradeoff theory and the pecking order theory—have opposite predictions about the expected relationship between corporate leverage and profitability. According to the tradeoff theory, companies that earn higher profits will use more debt both to shield their income from corporate taxes and to discipline corporate investment policy. In contrast, the pecking order theory predicts that more profitable companies will borrow less mainly because they have less need to borrow.
Corporate spinoffs provide a unique opportunity to investigate the influence of profitability and other asset characteristics on the design of capital structure. In their study of 98 spinoffs over the period 1979–1997, the authors began by investigating the popular argument that managers routinely assign more debt to subsidiaries than parents in order to leave the parents less encumbered—a possibility they reject after finding that the average leverage ratios of the parents and spunoff units were roughly equal. At the same time, the authors reported large differences in the leverage ratios among both parents and spun-off units, and that the variation was explained primarily by differences in three factors: asset tangibility and the level and variability of cash operating profits. Consistent with the tradeoff theory (but not the pecking order), the study found a significantly positive correlation between a post-spinoff company's cash profitability and its assigned debt load, as well as a negative correlation between debt and the variability of operating cash flow.     

Save the Buyback,Save Jobs

In response to a recent New York Times op‐ed by Senators Schumer and Sanders deploring the effects of stock buybacks on workers and the economy, the authors explain the role of buybacks in increasing corporate productivity and in recycling “excess capital” from mature companies with limited growth and employment opportunities to the next generation of Apples and Amazons. Some companies, as Schumer and Sanders charge, are guilty of repurchasing shares in the name of “shareholder value maximization” instead of pursuing job‐creating investments. But as the authors argue, well‐run companies increase shareholder value not by boosting EPS through buybacks, but mainly by earning competitive returns on capital and investing in their long‐run “earnings power.” And by paying out capital they have no productive uses for, such companies give their own shareholders the opportunity to reinvest in other companies with promising prospects for growth and jobs. But the authors go on to note the tendency of companies to buy back shares not when their stock prices are low, but instead when the companies are flush with cash and nearer the top than the bottom of the business cycle. The result of this tendency, as research by Fortuna Advisors (the authors' firm) shows, is that fully three quarters of companies doing large buybacks during the period 2013‐2017 failed to produce an adequate “Buyback ROI,” a metric developed by Fortuna that indicates management's effectiveness in “timing” its stock repurchases. Given the usefulness of buybacks in recycling capital, the authors conclude that the most reliable solution to the corporate short termism and underinvestment problem is for companies to adopt better financial performance measures—including Buyback ROI—to guide their capital allocation. And when management determines that it has significantly more capital than value‐adding investments, but wants to avoid committing to unsustainable dividend increases, it should consider buybacks—but only if management is convinced that its stock price has not outpaced performance.     

Is a share buyback right for your company?

Contrary to popular wisdom, buybacks don't create value by raising earnings per share. But they do indeed create value, and in two very different ways. First, a buyback sends signals about the company's prospects to the market--hopefully, that prospects are so good that the best investment managers can make right now is in their own company. But investors won't see it that way if other, negative, signals are coming from the company, and it's rarely a good idea for companies in high-growth industries, where investors expect that money to be spent pursuing new opportunities. Second, when financed as a debt issue, a buyback is essentially an exchange of equity for debt, conferring the traditional benefits of leverage--a tax shield and a discipline for managers. For such a buyback to make sense, a company would need to have taxable profits in need of shielding, of course, and be able to predict its future cash flows fairly accurately. Justin Pettit has found that managers routinely underestimate how many shares they need to buy to send a credible signal to the markets, and he offers a way to calculate that number. He also goes through the iterative steps involved in working out how many shares must be purchased to reach a target level of debt. Then he takes a look at the advantages and disadvantages of the three most common ways that companies make the actual purchases--open-market purchases, fixed-price tender offers, and auction-based tender offers. When a company's performance is lagging, a share buyback can look attractive. Unfortunately, a buyback can backfire--unless executives understand why, when, and how to use this powerful and risky tool.     

The Leveraging of Corporate America: A Long‐Run Perspective on Changes in Capital Structure

In a study published recently in the Journal of Financial Economics, the authors of this article documented a substantial increase in the use of debt financing by U.S. companies over the past century. From 1920 until the mid‐1940s, the aggregate leverage of unregulated U.S. companies was low and stable, with the average debt‐to‐capital ratio staying within the narrow range of 10% to 15%. But during the next 25 years, the use of debt by U.S. companies more than doubled, rising to 35% of total capital. And since 1970, aggregate leverage has remained above 35%, peaking at 47% in 1992. Moreover, this pattern has been observed in companies of all sizes and operating in all unregulated sectors. Changes in the characteristics of U.S. public companies during this period provide little help in explaining the increase in corporate leverage. For example, the displacement of tangible by intangible assets in many sectors of the U.S. economy during the past 50 years would have led most economists to predict, holding all other things equal, a reduction rather than an increase in aggregate corporate leverage. Instead, according to the authors' findings, the main contributors to the increases in U.S. corporate leverage since the 1940s have been external changes, including increases in corporate income tax rates, the development of financial markets and intermediaries, and the reduction in government borrowing in the decades following World War II. The authors' analysis also identifies these last two changes—the development of financial markets, including the rise of institutional investors and shareholder activism, and the post‐War reduction in government debt—as having played the biggest roles in the leveraging of corporate America.     

Liquidity,the Value of the Firm,and Corporate Finance*

The theory of corporate finance has been based on the idea that a company's market value is determined mainly by just two variables: the company's expected aftertax operating cash flows or earnings, and the risk associated with producing them. The authors argue that there is another important factor affecting a company's value: the liquidity of its own securities, debt as well as equity. The paper supports this argument by reviewing the large and growing body of evidence showing that differences—and, perhaps even more important, sudden changes—in liquidity can have major effects on the pricing of corporate stocks and bonds or, equivalently, on investors' required returns for holding them. The authors also suggest that the liquidity of a company's securities can be managed by corporate policies and actions. For those companies whose value is likely to be increased by having more liquid securities—which is by no means true of all companies (for example, mature firms with little need for outside equity are likely to benefit from having more concentrated ownership and hence less liquidity)—management should consider actions such as reducing leverage and substituting dividends for stock repurchases as well as measures designed to increase the effectiveness of their disclosure and investor relations program and the size of their retail investor base.     

The Capital Structure Puzzle: Another Look at the Evidence

Since the formulation of the Miller and Modigliani propositions over 60 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that can be expected to maximize long‐run shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are irrelevant in the sense of having no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of more debt against the costs of financial distress. Still another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are generally preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy and other contracting costs, and information costs all appear to play important roles in corporate financing decisions. While much, if not most, of the evidence is consistent with the idea that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that managements are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (that is, total amounts of debt and equity) and flows (which security to issue at a particular time). Even when companies have leverage targets, it can make sense to deviate from those targets depending on the costs associated with moving back toward the target. And as the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the targets.     

THE CAPITAL STRUCTURE PUZZLE: ANOTHER LOOK AT THE EVIDENCE

Since the formulation of the M & M irrelevance propositions 40 years ago, financial economists have been debating whether there is such a thing as optimal capital structure—a proportion of debt to equity that maximizes current firm value. Some finance scholars have followed M & M by arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the increased probability and costs of financial distress. Yet another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M & M, the authors argue that taxes, bankruptcy (and other “contracting”) costs, and information costs (the main factor in the pecking order theory) all appear to play an important role in corporate financing decisions. While much if not most of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (leverage ratios) and flows (specific choices between debt and equity). Even if companies have target leverage ratios, there will be an optimal deviation from those targets—one that will depend on the transactions and information costs associated with adjusting back to the target relative to the costs of deviating from the target. As the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the target.     

Are U.S. Companies Really Holding That Much Cash—And If So,Why?

Non‐financial S&P 500 companies are now estimated to hold a total of $2.1 trillion of “cash,” a figure that is larger than the annual GDP of all but eight countries. In this report, J.P. Morgan's Corporate Finance Advisory team notes that while many observers have attributed the buildup to offshore cash growth alone, onshore cash levels are also up significantly. To be sure, the companies that have shown the greatest increases also tend to be highly successful, with strong cash flow and business performance. And the managers of such companies tend to prefer to retain much if not most of this cash to take advantage of investment opportunities and to maintain the flexibility to respond to the next economic downturn. Also adding to the cash build‐ups, the executives of large MNCs with significant overseas cash holdings typically try to avoid the higher tax bill triggered by repatriating funds to the U.S. Nevertheless, investors continue to expect growth and high returns on capital; and corporate distributions of capital in the form of dividends and stock buybacks can play an important role in encouraging companies to operate efficiently. While pursuing both of these goals—preservation of enough cash to weather downturns and invest in all positive‐NPV projects, and commitment to paying out excess capital—boards and senior decision makers should continuously reexamine their cash holdings and capital allocation policies to ensure they are appropriate not only for today's environment, but throughout the economic cycle.     

Valuing Companies with Cash‐Flow@Risk

The classic DCF approach to capital budgeting—the one that MBA students in the world's top business schools have been taught for the last 30 years—begins with the assumption that the corporate investment decision is “independent of” the financing decision. That is, the value of a given investment opportunity should not be affected by how a company is financed, whether mainly with debt or with equity. A corollary of this capital structure “irrelevance” proposition says that a company's investment decision should also not be influenced by its risk management policy—by whether a company hedges its various price exposures or chooses to leave them unhedged. In this article, the authors—one of whom is the CFO of the French high‐tech firm Gemalto—propose a practical alternative to DCF that is based on a concept they call “cash‐flow@risk.” Implementation of the concept involves dividing expected future cash flow into two components: a low‐risk part, or “certainty equivalent,” and a high‐risk part. The two cash flow streams are discounted at different rates (corresponding to debt and equity) when estimating their value. The concept of cash‐flow@risk derives directly from, and is fully consistent with, the concept of economic capital that was developed by Robert Merton and Andre Perold in the early 1990s and that has become the basis of Value at Risk (or VaR) capital allocation systems now used at most financial institutions. But because the approach in this article focuses on the volatility of operating cash flows instead of asset values, the authors argue that an internal capital allocation system based on cash‐flow@risk is likely to be much more suitable than VaR for industrial companies.     

Corporate payout policy in Australia and a test of the life‐cycle theory

We provide evidence on the frequency and size of payouts by Australian firms, and test whether the life‐cycle theory explains Australian corporate payout policies. Regular dividends remain the most popular mechanism for distributing cash to shareholders, despite a slight decline in the proportion of dividend payers since the relaxation of buyback regulations in 1998. Off‐market share buybacks return the largest amount of cash to shareholders. Dividend paying firms are larger, more profitable and have less growth options that nondividend paying firms. Consistent with the life‐cycle theory, we observe a highly significant relation between the decision to pay regular dividends and the proportion of shareholders’ equity that is earned rather than contributed.     

Strategic Financial Management: Lessons from Seasoned Equity Offerings

Each of today's three dominant academic theories of capital structure has trouble explaining the financing behavior of companies that have seasoned equity offerings (SEOs). In conflict with the tradeoff theory, the authors’ recent studies of some 7,000 SEOs by U.S. industrial companies over the period 1970‐2017 notes that the vast majority of them—on the order of 80%—had the effect of moving the companies away from, rather than toward, their target leverage ratios. Inconsistent with the pecking‐order theory, SEO issuers have tended to be financially healthy companies with low leverage and considerable unused debt capacity. And at odds with the market‐timing theory, SEOs appear to be driven more by the capital requirements associated with large investment projects than by favorable market conditions. The authors’ findings also show that, in the years following their stock offerings, the SEO companies tend to issue one or more debt offerings, which have the effect of raising their leverage back toward their targets. Whereas each of the three theories assumes some degree of shortsightedness among financial managers, the authors’ findings suggest that long‐run‐value‐maximizing CFOs manage their capital structures strategically as opposed to opportunistically. They consider the company's current leverage in relation to its longer‐run target, its investment opportunities and long‐term capital requirements, and the costs and benefits of alternative sequences of financing transactions. This framework, which the authors call strategic financial management, aims to provide if not a unifying, then a more integrated, explanation—one that draws on each of the three main theories to provide a more convincing account of the financing and leverage decisions of SEO issuers.