On March 22, 2013, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the “bank regulators”) released their final guidance on leveraged lending activities. [1] The final guidance does not deviate significantly from the proposed guidance released last year on March 26, 2012, but does attempt to provide clarity in response to the many comment letters relating to the proposed guidance received by the bank regulators. The final guidance is the latest revision and update to the interagency leveraged finance guidance first issued in April 2001. [2]

…continue reading: Bank Regulators Tackle Leveraged Lending

In my paper Inside Debt and Mergers and Acquisitions, forthcoming in the Journal of Financial and Quantitative Analysis, I examine the link between CEO inside debt holdings and corporate risk-taking in M&A activities and its implications for bondholder, shareholder, and firm value. M&As are among the largest and most readily observable forms of corporate investment, which tend to intensify the inherent conflict of interests among shareholders, bondholders, and managers. Manager’s pension benefits and deferred compensation are debt-like compensation since they represent fixed obligations by the company to make future payments to corporate insiders/managers (hence, these are usually referred to as “inside debt”). Inside debt is expected to align manager interests with those of external debtholders and alleviate managers’ risk-taking incentive since inside debt is typically unsecured and unfunded, and if the firms go bankrupt, managers have equal claims as those of other unsecured creditors. Therefore, M&As provide a unique ground for testing the potential effects of debt-like compensation on corporate investment and financing strategies and the implications of the stakeholders’ interests.

…continue reading: Inside Debt and Mergers and Acquisitions

Introduction

As the banking industry emerges from the 2008 financial crisis, there is no question that it caused great strain on banks of all sizes. Hundreds of community banks failed, and the largest institutions were unable to continue operating without massive, unprecedented government intervention. This region in particular experienced the full impact of the crisis and the stress it placed on small institutions. A key ingredient in the market disruption was inadequate capital protection. Looking forward, it is important that the regulatory community arrive at a capital framework that is appropriate for the range and complexity of risks in today’s financial system.

As someone who served on the Treasury Department’s crisis response team in 2008, it became clear that the market was punishing firms and business models that took on too much risk without sufficient capitalization. Yet, upon returning recently to government service I have been surprised at what I see as a lack of progress towards constraining excessive leverage. Some policymakers point to advancements in the Basel III agreement, developed by the Basel Committee on Banking Supervision, which implements a global leverage ratio for the first time. However, I think that it is difficult to argue that achieving a Tier 1 leverage ratio of three percent my 2018 is significant reform, particularly as this leverage ratio requirement is not solely anchored in tangible common equity.

…continue reading: Prominent Role for Leverage Ratio in Capital Framework

In the paper, Corporate Governance and Value Creation: Evidence from Private Equity, forthcoming in the Review of Financial Studies, my co-authors (Oliver Gottschalg, Moritz Hahn, and Conor Kehoe) and I attempt to bridge two strands of literature concerning PE, the first of which analyzes the operating performance of acquired companies, and the second that analyzes fund IRRs. In addition, we investigate how human capital factors are associated with value creation in PE deals. We focus on the following questions: (i) Are the returns to equity investments by large, mature PE houses simply due to financial leverage and luck or market timing from investing in well-performing sectors, or do these returns represent the value created at the enterprise level in the so-called portfolio companies, over and above the value created by the quoted sector peers? (ii) What is the effect of ownership by large, mature PE houses on the operating performance of portfolio companies relative to that of quoted peers, and how does this operating performance relate to the financial value created (if any) by these houses? (iii) Are there any distinguishing characteristics based on the background and experience of PE houses or partners involved in a deal that are best associated with value creation?

…continue reading: Corporate Governance and Value Creation

In our paper, Corporate Governance and Capital Structure Dynamics, forthcoming in the Journal of Finance, we examine the importance of manager-shareholder conflicts in capital structure choice and characterize their effects on the dynamics and cross section of corporate capital structure. To this end, we develop a dynamic tradeoff model that emphasizes the role of agency conflicts in firms’ financing decisions. The model features corporate and personal taxes, refinancing and liquidation costs, and costly renegotiation of debt in distress. In the model, each firm is run by a manager who sets the firm’s financing, restructuring, and default policies. Managers act in their own interests and can capture part of free cash flow to equity as private benefits within the limits imposed by shareholder protection. Debt constrains the manager by reducing the free cash flow and potential cash diversion (as in Jensen, 1986, Zwiebel, 1996, or Morellec, 2004). In this environment, we determine the optimal leveraging decision of managers and characterize the effects of manager-shareholder conflicts on target leverage and the pace and size of capital structure changes.

…continue reading: Corporate Governance and Capital Structure Dynamics

In the paper, Do Institutional Investors Influence Capital Structure Decisions?, which was recently made publicly available on SSRN, we analyze whether institutional holdings influence capital structure decisions, and whether firms’ financial leverage affects institutional investors’ decisions to hold their equity. Theories of capital structure imply that firms choose their leverage in response to market frictions such as agency costs and asymmetric information. Meanwhile, institutional monitoring and information-gathering affect firms’ agency costs and information environment, opening channels through which institutions may influence firms’ choices of leverage. In the agency framework, institutional investors serve as an external disciplinary mechanism for management, lessening the need for internal disciplinary mechanisms such as debt. In the asymmetric information framework, institutional investors decrease information asymmetry between outside and inside shareholders, which reduces the adverse selection costs of equity and lowers the cost of equity relative to debt, serving to decrease the amount of debt needed for a separating signaling equilibrium.

…continue reading: Do Institutional Investors Influence Capital Structure Decisions?

On October 11, 2011, the Financial Stability Oversight Council unanimously approved a second notice of proposed rulemaking and related interpretive guidance under the Dodd-Frank Act regarding the designation of systemically important “nonbank financial companies.” The new proposal, which was published in today’s Federal Register, describes the manner in which the Council proposes to apply the relevant statutory standards and the processes and procedures it intends to employ in carrying out its authority to designate systemically important nonbank financial companies. These designated companies are required to comply with enhanced prudential standards and are subject to consolidated supervision by the Board of Governors of the Federal Reserve System. Comments on the Council’s proposal are due by December 19, 2011.

Among the nonbank financial companies potentially subject to a systemically important designation by the Council are savings and loan holding companies, insurance companies, private equity firms, hedge funds, asset management companies, financial guarantors, and other U.S. and non-U.S. nonbank companies deemed to be “engaged primarily” in activities that are financial in nature.

…continue reading: Designation of Systemically Important Nonbank Financial Companies Under Dodd-Frank

In our paper, The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts: Evidence from U.S. Corporate Tax Returns, which was recently made publicly available on SSRN, we study post-LBO financial performance and behavior for approximately the universe of U.S. LBO firms taking place between 1995 and 2007.  We overcome the lack of public financial data for most LBOs firms that has limited prior research by instead analyzing confidential federal corporate tax return data. Since all U.S. corporations, including those that are privately-held, must file tax returns, we can observe post-LBO income and balance sheet information for nearly all U.S. LBO firms.

We use our large, representative sample to test a number of long-standing hypotheses regarding the motivation for LBOs and their role in the economy. Arguably the most influential view on LBOs is that of Jensen (1989), who regards the LBO structure as superior to the structure of the publicly-traded firm. He argues that the concentration of ownership and high level of debt in the LBO structure disciplines managers. The high level of debt eliminates free cash flow that managers might otherwise waste on “empire-building” activities. Indeed, levering up the firm more than would be optimal from a long-term perspective puts pressure on management to earn its way out of the firm’s debt load.

…continue reading: The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts

Rudiger Fahlenbrach, Robert Prilmeier and I have made available a paper on SSRN titled This Time Is the Same: Using Bank Performance in 1998 to Explain Bank Performance During the Recent Financial Crisis. In this paper, we show that banks that performed poorly during the Russian crisis of 1998 also performed poorly during the recent financial crisis.

Russia defaulted on its domestic debt on August 17, 1998. This event started a dramatic chain reaction. As Thomas Friedman from the New York Times put it, “the entire global economic system as we know it almost went into meltdown.” The Russian crisis was described as the biggest crisis since the Great Depression. The financial crisis that started in 2007 would eventually be described as the biggest financial crisis of the last 50 years, supplanting the crisis of 1998 for that designation.

The similarity between the crisis of 1998 and the recent financial crisis raises the question of how a bank’s experience in one crisis is related to its experience in another crisis. In our recent paper, we examine this question.

…continue reading: Using Bank Performance in 1998 to Explain Bank Performance During the Recent Financial Crisis

1. The Trillion Dollar Question

How would a trillion dollars affect the strategic M&A landscape? By now, virtually everybody who reads the financial press is aware that corporate cash balances are massive. In fact, the largest U.S. firms collectively have in excess of $1 trillion on their balance sheets. These firms have accumulated liquidity during the crisis by cutting back on shareholder distributions, capital expenditures, R&D and acquisitions. Since the crisis, these same firms have delevered by paying down debt and growing their earnings, further enhancing their liquidity positions. As one can see in Figure 1 below, cash balances surged from 5.9% to 10.7% of total assets and from $410bn to $1.1trn, while leverage declined from 3.0x to 2.0x.

As we discussed in several recent reports, the cash-rich environment is ripe for a significant increase in shareholder distributions. [1] Albeit resurging from crisis lows, existing dividend and buyback levels are not nearly enough to consume these firms’ cash flows, let alone put a dent into the record high cash balances. Moreover, distributions do not address the major issue facing large firms today: declining growth rates. The scarcity of organic growth opportunities is perhaps more concerning than any other current corporate issue. Over the last decade, large-cap long-term EPS growth rates declined from 13.2% to 11.2% currently.

…continue reading: The New Face of M&A: How a Trillion Dollars Will Change the Strategic Landscape