CEOs of large publicly held companies are confronting a new and imposing challenge—managing the “value gap.” The stakes are huge. Those who meet the test get to keep their jobs. Those who don’t face unemployment, as new owners who don’t want their services acquire their companies.
The value gap is the difference between the market price of a share of a company’s common stock and the value of that share if the company were managed as though the current owners were the only constituency that mattered—that is, managed for the maximum share price possible at this time. For most companies, the size of the value gap is a function of three factors:
1. Opportunities for improved operations.
2. Untapped capacity for high-wire financial acrobatics.
3. Potential economic benefits to new owners of company assets that are less valuable to the current company owners.
Corporate chieftains like to blame Wall Street for the takeover battles that are shaking up their companies. But raiders and arbitrageurs aren’t the cause of hostile tender offers; they are a symptom of the large value gaps that persist throughout corporate America. Raiders are messengers whose impact ebbs and flows; the message endures.
That message is: public companies must become more efficient and more focused, and they must put incentives directly into the hands of people who will make the enterprise more enterprising. Shareholders may tolerate short-term gaps, cyclical gaps, or onetime setbacks in stock prices. But a large, sustained discount between actual and potential share price represents an engraved invitation to an unsolicited take-over. The value gap measures how much needs to be done.
Of course, much is already being done—whether CEOs like it or not. The dollar value of mergers and acquisitions between 1985 and 1987 exceeded $520 billion—ten times the value of mergers between 1975 and 1977. Put another way, businesses representing 5.5% to 7% of the total market value of all U.S. companies have disappeared through acquisitions in each of the past four years, as the first table shows.
U.S. Corporate Equity Disappearing Through Acquisitions Sources: W.T. Grimm & Company and Board of Governors of the Federal Reserve System.
And the pace of takeover activity seems destined to accelerate. There is now at least $17 billion of equity capital in leveraged buyout funds—capital that can be expanded by a factor of four through borrowing, which lifts the buyout potential to $85 billion. This pool of funds doesn’t include the vast amount of capital available to big corporations on the prowl for merger partners. Nor does it include foreign investors with currencies that have appreciated enormously versus the dollar. In short, an unprecedented amount of money is searching for targets of opportunity—which helps explain why mergers and takeovers valued at nearly $75 billion were announced in the first three months of 1988.
The search is intensifying all the time. Wall Street analysts are working day and night to identify companies with the largest value gaps. In November 1986, a prominent analyst ranked 40 large retailers by an index that measured the spread between current and potential share price. For 10 of them, the value gap ranged from 60% to 25% (see the second table).
Within 16 months, at least half of these companies had engaged in some form of restructuring or antitakeover maneuvering—voluntary or otherwise. Dayton-Hudson, Stop & Shop, and Supermarkets General all came under attack from the same raider, the Dart Group. Of the three, only Dayton-Hudson avoided a change of ownership, largely as a result of tough anti-takeover laws passed by a special session of the Minnesota legislature. Best Products issued preferred shares as a “poison pill” to ward off hostile bids, while Kroger spun off divisions in management-led buyouts.
As the pool of available capital grows, and the number of easy targets declines, acquirers will turn their attention to companies with smaller and smaller value gaps. No one is immune.
The graph, “Value Gap of a Hypothetical Company,” tracks the eight-year stock performance of a fictitious company ripe for a forced restructuring. The current share price is $50. If management streamlined operations (by aggressively reducing corporate overhead, for example), profits would increase and the share price might climb to $60. If management also borrowed heavily (say, creating a debt structure similar to that in a leveraged buyout), the share price might rise to $80. Finally, if the company sold any of its business units to buyers willing to pay more than what the assets are worth now, the share price might jump to $90. The value gap is the 80% difference between the market price of $50 and the potential price of $90.
Value Gap of a Hypothetical Company
This example may be hypothetical, but it more or less represents many companies’ stock performance for years. And in plenty of real-world cases, going back some time, value gaps of this size or wider have been closed within weeks or months.
Recall the actions of Donald Kelly during his tenure as CEO of Esmark, Inc. In early 1980, Esmark traded at about $24. The company had three significant business units: Swift & Company, Playtex, and a modest oil and gas operation. Analysts were describing the company as an undervalued asset situation. Indeed, Esmark’s equity in its oil and gas business alone was estimated to be worth more than the market value of the entire company. The value gap was huge, and Esmark was clearly vulnerable to a takeover.
So Kelly moved decisively. He announced plans to: (1) repair and divest a low-profit business (fresh meats); (2) lever up the company by using borrowed funds to repurchase half the outstanding shares; and (3) sell the oil and gas reserves to a buyer (Mobil) that was willing to pay a premium for these assets to avoid exploring at an even higher cost.
Estimated Value Gap for Ten Selected Retailers (November 1986) Source: Stuart M. Robbins, “Retailing: Breaking Up That Old Gang of Ours,” Donaldson, Lufkin & Jenrette, November 17, 1986.
Kelly’s plan remains one of the most striking examples of a company quickly closing the gap between its stock’s market price and potential value. Esmark’s share price doubled to $48 during the five-week period surrounding the plan’s unveiling. Before the announcement, the common stock market value was $660 million. After the announcement, the value of repurchased and outstanding shares totaled nearly $1.3 billion. This $636 million value gap reduction substantially lessened Esmark’s vulnerability to a takeover.
The cases and data that follow are meant to illuminate simple truths about a phenomenon that has been shrouded in needless complexity and confusion. New capital market forces make it imperative for CEOs to monitor the gap between what shareholders might be able to get for their stock and what they can realize now. Understanding what needs to be done is straightforward, but CEOs have a limited menu of options from which to choose.
Improve Operations
As Donald Kelly’s moves at Esmark demonstrate, when management attacks all three elements of the value gap simultaneously, it can make enormous strides in closing it. But in many situations it is not necessary, or even possible, to address the three factors at once.
Improvement in internal operations is usually the readiest element to address. The targets include revenue enhancement, cost reductions, and more effective use of existing assets, of which the easiest is reduction in overhead. Progress in other areas tends to come more slowly.
It’s important to understand that the financial effect of cost cutting goes beyond the savings themselves. Generating millions of dollars in additional profits not only adds value by increasing per-share earnings but also creates potential for leveraging the company. When interest rates are at 10%, a company that cuts $10 million in overhead can borrow $100 million, use the money to boost dividends or repurchase stock (either way immediately raising the market price), and pay the interest out of the overhead savings. Wasteful spending of $10 million per year amounts to a value gap of $100 million.
Recent events at Beatrice Companies illustrate this leveraging potential. In April 1986, all outstanding Beatrice stock was acquired in a $6.1 billion hostile tender offer. The price represented a premium of $1.7 billion above what the shares had been selling at just 30 days earlier. Within 12 months, the new owner-managers slashed corporate and business-unit overhead from $190 million to $90 million, including millions of dollars spent on corporate-image advertising and sponsoring auto races. The $100 million annual saving was enough to service the $800 million of junk bonds issued to help finance the deal. (The entity that acquired Beatrice issued $800 million of subordinated debt at an interest rate of 12.5%.) Had Beatrice’s former management acted on this excess overhead, it could have boosted profits and the share price (perhaps by borrowing against the cash flows and repurchasing stock) and thereby eliminated about half the takeover premium.
Use Leverage
The second important element of the value gap is the use of leverage in the capital structure. The assumption of high levels of debt can add to shareholder value in at least three ways. First, debt generates tax benefits through the deductibility of interest payments. Second, debt has a disciplining effect on corporate executives. As one authority argues, a highly leveraged capital structure “motivate[s] managers to disgorge…cash rather than invest it at below the cost of capital or waste it through organizational inefficiencies.”1 Finally, the use of extreme leverage is often accompanied by top management’s acquisition of a higher fraction of the remaining stock, which creates incentive effects that work to close the value gap.
The opportunity to use extreme leverage in a healthy business’s capital structure is a fairly recent phenomenon, sparked by the mushrooming junk bond market in the United States. The volume of junk bond financing and the pace of LBO activity have grown in parallel since 1982. Annual new issues of junk bonds in 1977 were $600 million, compared with $28.6 billion in 1987. Leveraged buyout transactions were worth $600 million in 1979, compared with $22.1 billion in 1987. In turn, the rising volume of leveraged buyout activity has sharply focused attention on the failure of companies to lessen the value gap by the aggressive use of leverage. LBO transactions have delivered big premiums to selling shareholders, as the list of the 20 largest LBOs shows. The principals in these transactions have often realized even more remarkable returns for themselves.
Value Gap Exposed in the 20 Largest LBOs Source: W.T. Grimm & Company.
A handful of corporations has recognized the desirability of achieving leverage ratios comparable to those of leveraged buyouts, without completely changing their equity ownership structures. These enterprises, the largest of which include Multimedia, FMC, Owens-Corning, Holiday Corporation, and Harcourt Brace Jovanovich, have executed what are called leveraged recapitalizations.
Perhaps the most dramatic example of the value gap associated with untapped borrowing capacity is the leveraged recapitalization that Colt Industries engineered. In July 1986, Colt announced that it would distribute more than $1.5 billion in cash to shareholders, a plan that required borrowing about $1.4 billion. Approximately $800 million came from commercial banks and $550 million from junk bond sales. Each Colt share, which sold at just under $67 before the announcement, was entitled to receive $85 in cash and one new share of a highly leveraged Colt Industries. The new Colt share was estimated to be worth more than $10, based on the performance of the “stub” share left over after the earlier FMC recapitalization. Colt’s stock price rose to $93.50 the day after the announcement.
Shares held in the Colt Retirement Savings Plan received an equivalently valued package of new shares. This increased the retirement plan’s overall stake from 7% to 30% of Colt’s outstanding shares. By insuring a “substantially disproportionate redemption” for them, this plan allowed other shareholders to report capital gains rather than ordinary gains, further enhancing the transaction’s value.
Colt’s balance sheet after the leveraged recapitalization looks rather curious. Its long-term debt rose by 400%, and Colt has a negative net worth in excess of $1 billion. Obviously, interest coverages will be tight for some time. In 1985, Colt’s earnings before interest and taxes (EBIT) were 16 times greater than its debt-service charges. EBIT for 1989 are projected to be only 1.6 times interest charges.
Nonetheless, Colt’s management closed a value gap in the area of financial acrobatics equal to 40% of the company’s total equity. It thus removed a dangerous source of takeover vulnerability, allowing management and other employees to contend with a different but presumably more acceptable threat—a higher probability of financial distress in the future. In March 1988, Colt announced a plan to purchase the company’s remaining public shares at $17 to complete a full-scale LBO.
Few companies have engaged in leveraged recapitalizations as drastic as Colt’s, although we can expect the strategy to become more popular. Far more companies have opted for a watered-down version by repurchasing significant amounts of their stock. A sample of the 25 largest common stock share repurchases in 1986 includes: Union Carbide’s equaling $3.3 billion; Goodyear Tire & Rubber’s, $2.6 billion; IBM’s, $2.1 billion; and SmithKline Beckman’s, $1.4 billion. Repurchases ratchet up the leverage in a company’s capital structure, but not enough to qualify as a leveraged recapitalization. Companies often take this more measured shift in leverage in response to a real or imagined threat of takeover, although with some huge businesses it is simply a convenient way to deal with excess liquidity. Stock buybacks are a partial yet effective step in managing the size of a company’s value gap.
Sell to the Best Buyer
The third big factor contributing to the value gap stems from the fact that business units operated by a new owner may have more economic value than they do in the hands of the existing owner. This additional value may come from many sources, including: (1) higher cash flows as a result of tax advantages; (2) scale economies from combining operations with the new owner’s related operations; or (3) incentive effects from more focused ownership. To the extent that a potential buyer must share the benefits of its enhanced economies with the existing owner (in the form of the price paid), a value gap will exist as long as the business unit continues to be owned by the less-than-best owner.
Here too, events at Beatrice show what can be done (see the table, “Selling Business Units to the Best Buyer—the Beatrice Example”). Within three months of the takeover, the new owners began selling off its parts to the “best buyers”—i.e., the highest bidders. Management partitioned the company into ten business groups. Nine units found buyers within 20 months of the acquisition, and the final unit is now on the block. Five units, representing one-third of the estimated disposition proceeds, went to management-led buyout groups. Another group, comprising one-sixth of the estimated proceeds, was spun off and brought public. The remaining four groups, representing one-half of the estimated disposition proceeds, have been or are expected to be sold to “synergy buyers,” where the efficiencies associated with combined operations should be rewarding.
Selling Business Units to the Best Buyer—the Beatrice Example Sources: James Sterngold, “Shaking Billions from Beatrice,” New York Times, September 6, 1987 and Beatrice Companies proxy statements.
In all, the sale of these businesses will generate $9.3 billion—$3.2 billion more than the cost of acquiring the entire company. This enormous value gap represented about 50% of what the new owners paid for Beatrice. Had the former executives recognized and addressed the financial penalties connected with maintaining this collection of businesses, Beatrice might not have been a sitting duck to a hostile bid.
What are the lessons for top management? First, it must measure and track the company’s value gap periodically. The size of a gap is always changing, based on the business’s stock market performance, interest rates, overall corporate liquidity, the health of the junk bond market, the vigor of antitrust enforcement, and other factors. Measuring the gap is the easy part. (If you don’t want to do it, Wall Street analysts will do it for you.) Managing it is much harder—not because it is conceptually challenging but because it may hurt executives, workers, and communities. Yet in virtually all instances, the costs of complacency are much higher.
CEOs face three choices. First, they can close their value gap by taking all or some of the same value-enhancing actions potential acquirers would. Put simply, CEOs can start thinking and acting like raiders. This pill is less bitter today than it was a few years ago; employees are beginning to accept the necessity of some of these changes. Top management can say “the devil made me do it” and be both honest and credible. Moreover, if management acts before the company attracts outsiders’ attention, it can adopt less painful measures than if it must defend itself against an actual takeover attempt. Early action to reduce the value gap by a material amount, say 30% or 40%, may be enough to convince hostile suitors to look elsewhere. But once a company is in play, every dollar of additional value matters. Remaining independent after a hostile bid usually requires steps painful in the extreme.
A second tactic is to throw legal hurdles in the path of potential acquirers. Poison pills, dual-class shares with different voting rights, and reincorporation in a state with tough antitakeover provisions can all be implemented. These hurdles may raise the cost of an acquisition above a sensible acquirer’s ceiling or make an unfriendly acquisition simply impossible.
A third option involves coordinated lobbying in Washington. A significant portion of the value gap at many companies is tax related, and lobbying at the national level can help shrink the gap. The elimination of mirror-image subsidiaries for business units that an acquirer will sell immediately and the abolition of the General Utilities doctrine have already reduced the value gap for many businesses. A proposal now circulating in Washington to remove the deductibility of interest expenses on debt incurred to finance acquisitions would also help close the gap. Ironically, perhaps, more vigorous antitrust enforcement against combinations that enhance product market shares (and thereby create economies of scale) would also narrow the gap.
Or CEOs can adopt an ostrich strategy and continue business as usual, harnessed to their yet unopened golden parachutes. Who knows, their companies may well remain unnoticed for a year or two while they reach retirement unscathed. But their successors can rest assured that subpar stock market performance will not be tolerated indefinitely.
1. Michael C. Jensen, “Takeovers: Their Causes and Consequences,” Journal of Economic Perspectives, Winter 1988, p. 21.