By Geri Westphal
Is shareholder activism compromising a firm’s optimal capital structure?
Treasurers today are being forced to reevaluate their company’s capital structure because of the increased pressure from shareholder activists. Executives complain, with justification, that meddling and second-guessing from shareholder activists is making it even harder for them to do their jobs.
Based on recent statistics from The Treasurers’ Group of Thirty Peer Group (T30), nearly half of the survey respondents said they were affected by shareholder activism during the past twelve months, with 40 percent expecting to see an increase in activism during the next twelve months.
Traditional Optimization
An optimal capital structure takes into consideration both the need for an efficient capital structure and the need for financial flexibility. According to the theory of static trade-off, a company balances the value of the tax benefit from deductibility of interest on the debt with the present value of the costs of financial distress. At the optimal level, the incremental tax shield benefit is exactly offset by the incremental cost of financial distress.
Measuring financial distress takes a look at a variety of scenarios that could include:
- Loss of access to A1/P1 short-term ratings (for CP)
- Loss of investment-grade rating
- Loss of several rating levels to the worst possible case
- Bankruptcy or liquidation
An organization’s capital structure should provide a buffer against downside events to avoid the substantial costs of financial distress and loss of access to capital markets. By evaluating a variety of what-if scenarios, a company can evaluate the financial cost associated with a range of outcomes and can plan the appropriate buffer to ensure strength and stability through times of financial distress. This is a key component to defining an optimal capital structure.
The Stress of Meddling and Second-Guessing
Leading activists boast that they are the heroes—pushing forward with shareholder campaigns in an effort to increase the value in their investment in the company by pressing the board and management to make changes to their capital structure. Basically, they are stripping the organization of what they perceive to be “too much cash.”
By forcing the target organization to increase their share buyback program, they are in effect altering a firms’ capital structure since the buyback of shares reduces equity, which in turn increases a firm’s leverage ratio. By demanding added leverage in the form of increased stock buyback, many believe the activists are forcing a boost in share price for the short term at the expense of long-term shareholder value.
Nearly half of T30 pre-meeting survey respondents said they were affected by shareholder activism during the past twelve months.
Having an optimal capital structure in place means you have met the needs of both equity and debt holders in the best way possible. It’s the balance of the two that is important. Shareholder activism is upsetting this balance.
Based on a report published on Reuters.com, bond investors fear that the rise in shareholder activism activity is prompting organizations to take on more debt, which can erode credit quality and potentially saddle bondholders with losses.
A big fear for bond investors is that this increased activity is a rerun of the leveraged buyout boom that began in the early 2000s when interest rates were low. By boosting leverage, there could be a knock-on effect of an increase in default rates and ratings downgrades. Perhaps many cannot wait for the views of Hillary Clinton to take root: “We need a new generation of committed, long-term investors to provide a counter-weight to the hit-and-run activists,” she said in a recent campaign speech.
Missing the Mark
If the goal of the activist strategy is to unlock the growing levels of cash-on-hand that the target organization has on its balance sheet, many times the goal is unachieved because in the continued low-interest rate environment, many corporations are keeping their cash-on-hand, and borrowing funds for stock buyback, making the per-share earnings look better for shareholders while reducing the overall quality of the balance sheet.
The trend of borrowing to increase stock buyback has more than doubled from 2013-2014, and more than 65 bond deals from mid-March to mid-June 2015 listed stock buyback or dividends as their primary use of proceeds. According to statistics from Bank of America Merrill Lynch presented at a recent NeuGroup Tech20 Peer Group Meeting, share repurchase activity has increased nearly 55 percent from 2010 to 2013, with S&P 500 companies spending just under $300 billion compared to $460 billion in 2013. Meanwhile, the levels for 2015 are expected to well exceed last year’s number with more than $460 billion in stock buybacks already announced during the January to May 2015 timeframe.
Changing Demographics
Another dynamic that has changed over the years is the composition of the corporation’s shareholder base.
According to the Harvard Business Review, in 1950 households owned more than 90 percent of the shares of US corporations. The individual investor seems to have been pushed aside by the professionals, with institutions now holding approximately 50 percent of the domestically owned shares of public companies. Add in institutional owners from overseas and hedge funds, and the true institutional share is probably closer to 65 percent or 70 percent. For the biggest corporations, the percentage is even higher.
With this new dynamic comes increased pressure on stock performance as the professional investors trade much more frequently than the individuals did. According to the same HBR report, in the 1950s the average holding period for an equity traded on the New York Stock Exchange was about seven years. Now it’s six months. In a more recent development, high-frequency traders, whose holding periods can sometimes be measured in milliseconds, now account for as much as 70 percent of daily volume on the NYSE.
In the 1950s, the average holding period for an equity traded on the New York Stock Exchange was about seven years. Now it’s six months.
The changing demographics, low interest-rate environment, and increased aggressiveness of the shareholder activist combine to create the perfect storm that may be forcing a change in a corporation’s optimal capital structure.
These changes are likely to have long-term impacts and could hinder a company’s ability to weather a series of unforeseen financial challenges. Is your buffer big enough?