Vanderbilt University Roundtable on the Capital Structure Puzzle

April 2, 1998 Nashville, Tennessee JOEL STERN: Good afternoon. I'm Joel Stern, managing partner of Stern Stewart & Co., and, on behalf of our hosts here at Vanderbilt's Owen Graduate School of Management, I want to welcome you all to this discussion of corporate capital structure. Before getting into our subject matter, let me take a moment to thank Hans Stoll for organizing this conference on “Financial Markets and the Corporation.” I also want to take this opportunity to salute Professor Martin Weingartner—in whose honor this conference is being held—at the conclusion of a long and productive career. Marty's contributions to the field of corporate finance are many and considerable; and, though he may be stepping down from his formal position, we expect to continue to hear from him for many more years. The subject of today's meeting is corporate capital structure: Does capital structure matter? And, if so, how and why does it matter? Although these questions have been seriously debated in the academic finance profession for almost 40 years, we seem to be no closer to a definitive answer than we were in 1958, when Merton Miller and Franco Modigliani published their article presenting the first of their two famous “irrelevance” propositions. Following the M&M propositions, academic researchers in the 1960s and 1970s turned their attention to various market “imperfections” that might make firm value depend on capital structure and dividend policy. The main suspects were (1) a tax code that encourages debt by making interest payments, but not dividends, tax deductible, and (2) expected costs of financial distress, including corporate underinvestment, that can become important as you increase the amount of debt in the capital structure. Toward the end of the 1970s, there was also discussion of “signaling” effects—for example, the tendency for the stock market to respond negatively to announcements of new stock issues. A defining moment in the academic capital structure debate came in 1984, when Professor Stewart Myers devoted his Presidential address to the American Finance Association to something he called “The Capital Structure Puzzle.” The puzzle was this: Most academic discussions of capital structure were based on the assumption that companies make financing decisions that are guided by a target capital structure—a proportion of debt to equity that management aims to achieve, if not at all times, then at least as a long-run average. But the empirical evidence suggested otherwise. Rather than adhering to targets, Professor Myers observed, most large U.S. public companies behaved as if they were following a financial “pecking order.” They were funding investment with retained earnings rather than external financing if possible; and if external funding was necessary, they issued debt first and equity only as a last resort. Since then, the capital structure debate has raged on. Harvard professor Michael Jensen entered it in the mid-1980s, pointing to the success of LBOs and citing the beneficial effect of debt financing on management's tendency to overinvest in industries with excess capital and capacity. And, as if to oblige Professor Jensen, the market continued to supply large numbers of LBOs and other highly leveraged transactions throughout the rest of the decade. Then, in the early 1990s, we saw an almost complete halt to leveraged deals. But today, of course, leverage is back. A new wave of LBOs has shattered most of the old records, and junk-bond issuance is at all-time highs. So, if capital structure is irrelevant, then what's going on here? And do the successes of the LBO movement have anything to say to the managements of our largest public companies? Such effects seemed to confirm the existence of large “information costs” that might also influence corporate financing choices in predictable ways. With us here to discuss these issues, and to help us shed some light on this capital structure puzzle, is a small, but distinguished group of academics and practitioners. And let me introduce them briefly: STEWART MYERS, whose name I have already mentioned several times, is the Billard Professor of Corporate Finance at one of my favorite schools, the MIT Sloan School of Management. Stew has done research over the years in issues dealing with capital structure, valuation, and regulation. He has also been an adviser to a large number of corporations and financial institutions. And let me mention that, for us at Stern Stewart, the name Stewart Myers has a special significance. As most people here are well aware, Stew is the co-author, with Dick Brealey of the London Business School, of Principles of Corporate Finance, the leading textbook in corporate finance. Every person who gets hired at Stern Stewart is required to have read that volume by the time he or she walks in the door. ALICE PETERSON is Vice President and Treasurer of Sears, Roebuck and Co. As we all know, Sears has made dramatic improvements in operating performance and achieved large increases in shareholder value over the past few years. Alice joined Sears in 1989 as Director of Corporate Finance, 4 years before being made Vice President and Treasurer in 1993. Prior to coming to Sears, she held corporate finance and treasury positions at Kraft and at Pepsico. She earned her MBA here at Vanderbilt in 1981, and she serves on the boards of two New York Stock Exchange companies. JOHN McCONNELL is the Emanuel T. Weiler Professor of Finance at Purdue University. John has made extensive contributions to the field of corporate finance, especially in the analysis of innovative securities. I still remember an article on income bonds that John contributed to our old Chase Financial Quarterly, the original predecessor of our Journal of Applied Corporate Finance. And, in an issue of the JACF about 5 or 6 years ago, John coauthored (with Eduardo Schwartz) a fascinating account of the origins of LYONS, the very successful puttable, convertible securities pioneered by Merrill Lynch. Given John's ability to tell stories, none of us is surprised that he manages to win teaching awards at Purdue year after year. Last is DENNIS SOTER, my colleague and fellow partner at Stern Stewart. After graduating from the University of Rochester's Simon School of Business in 1972, Dennis joined me at the Chase Manhattan Bank. Then, in 1979, we parted ways. Dennis became Vice President in charge of corporate development at Brown Foreman, where he helped transform the firm from the maker of Jack Daniels (and other mild intoxicants) into a diversified consumer goods firm. Then he went to Ernst & Whinney, where he was the national practice director of M&A. Next, he joined Citizens Utilities and helped them to become something of an unregulated company as well as a regulated company. Several years ago, we were very fortunate in persuading each other that we should be together again. And Dennis now runs our corporate finance advisory activity and also oversees implementations of EVA in middle market-sized companies. In the past 2 years, as I'm sure Dennis will tell us, he served as financial adviser in three highly successful leveraged recapitalizations. Each of these three deals involved borrowing substantial amounts of new debt to buy back shares—and two involved major changes major changes in dividend policy as well. STERN: So, now that we know who the panelists are, let me turn the floor over to Professor Stewart Myers. You might not remember this, Stew, but in 1983 you were kind enough to publish an article in our Midland Corporate Finance Journal entitled “The Search for Optimal Capital Structure.” And it was not only a marvelous piece, but it was the lead article in the very first issue—Volume 1 Number 1—of that journal. Then, about 10 years passed, and you wrote a second article for us that was called “Still Searching for Optimal Capital Structure.” And that was also a wonderful piece—one that I use (along with the first one) in the courses I teach at Columbia and Carnegie Mellon. My question for you is: What is your current thinking on the capital structure debate? And what are you going to call your next article? STEWART MYERS: The next one is going to be called “Stop Searching for Optimal Capital Structure.” Let me take a minute or two to tell you why. Optimal capital structure is obviously something I've been concerned and struggling with ever since I arrived at the doctoral program at Stanford. I've been frustrated over the years by our inability to come up with any simple answer. But I am lately coming to a different view. Maybe it will start the discussion off. When we talk about optimal capital structure, we are thinking of the percentages of different securities on the right-hand side of the balance sheet. We tend to think in terms of the mix of debt and equity, at least to start, and then go on to consider other securities as well. We look at preferred stock, for example, and at hybrid securities like convertible debt. At what level do we understand how these financing choices affect firm value? At a tactical level, I think we understand it very well. For example, if you ask either academics or practitioners to analyze a financial innovation like the tax-deductible preferreds that John McConnell just finished telling us about, we do that pretty well. We understand how those things work, why they're designed the way they are, and what you need to do to get them sold. So, at this tactical level, we can be fairly satisfied with our understanding of capital structure. Where we tend to fall down in terms of neat or simple theories is in understanding the role of capital structure at what I will call the “strategic” level—that is, when you're trying to explain the debt ratios of companies on average or over long periods of time. We do have some useful insights about capital structure, and we know what ought to matter. But it's very difficult to put these insights together into a simple theory that predicts what managers are going to do—or tells us what they should be doing. Why aren't we cracking the problem? I think we are starting in the wrong place. We shouldn't be starting with the percentages of different kinds of financing on the right-hand side of the balance sheet. We should not be starting with capital structure, but with financial structure. By financial structure I mean the allocation of ownership and control, which includes the division of the risk and returns of the enterprise—and particularly of its intangible assets—between the insiders in the firm and the outsiders. What's really going on in the public corporation is a coinvestment by insiders, who bring their human capital to it, and by financial investors. These two groups share the intangible assets of the organization. And, in order to make that shared investment work, you've got to figure out issues of ownership and control, incentives, risk-sharing, and so forth. You've got to start by making sure you get all of those things right. That's what I call financial structure. Financial structure is not the same thing as a financing mix. Let me offer a simple example. Take a high-tech venture capital startup and compare it to Microsoft. Even though their debt ratios are likely to be identical—that is, zero—I think we'd all agree that they are not the same thing from a financial point of view. The same comparison could be made between a publicly held management consulting company and the usual private management consulting firm. Though their balance sheets might look exactly the same, I would say they're very different. In particular, I would predict that if you take a small consulting company public, it's almost sure to crater. The assets go home every night, and it's going to be very difficult to have the right incentives to keep key people in the company while at the same time satisfying outside investors. So, if Stern Stewart ever goes public, Joel, I'm going to wait 6 months and then sell you short. STERN: I actually had a dream that somebody was going to do that to us—but I had no idea, Stew, that it was going to be you! I must confess that such thoughts have passed through my mind. But, if we were to take such a course (which we have no plan to do), we would design the new firm so as to protect outside investors not so much from the possibility that the assets go home at night, but that they might move to the island of Maui, permanently. Incidentally, this is not an unreasonable issue because Booz-Allen did that once. You may not be aware of it, but in the 1970s Booz-Allen went public at a price in the mid-teens. The shares went as high as about $20 and then dropped to about $2—and they stayed between $2 and $6 for quite a while. The reason I know about it is that I served on the board of directors of a company with the Vice Chairman of Booz-Allen. And every time the possibility of going public was raised for this privately held company, he would say: “It's the wrong thing to do.” And he would drag us through this horrible experience once more. But Booz-Allen made a fundamental mistake—one that, if corrected, might have changed the outcome. They didn't differentiate between outsider shares and insider shares. If the insiders own shares that only gradually convert to outsider shares, the insiders aren't going anywhere. They could also have issued stock options to the employees with values tied to the value of the insider shares. With insider shares and options, it would take a long time for people to take out the wealth that they were building up in the firm. How do you feel about that idea, Stew? MYERS: I think you're just making my point. First of all, I don't think that it makes sense to take a small consulting company public. But if you did, you'd have to pay attention to financial structure—to issues like who owns what, who gets to make what decisions, what are the goals and performance measures, and how are people rewarded for meeting them. STERN: So, your concept of financial structure is essentially the same as what some people are calling corporate governance or organizational structure—it's the assignment of decision rights, monitoring, performance measures, incentives, and all of that? MYERS: Financial structure is my shorthand—just two words—for all of that sort of stuff. My point is that these issues of financial structure are the first-order concerns of most corporations. Management has to get them right. Now, that's not the same as saying that managers have to do all these things consciously. Sometimes they get it right because they do what other corporations have done and survived. Once an industrial corporation goes public, it's ordinarily a mid-cap firm with a financial structure well in place. In a sense, it has solved 80% of its problem—that is, as long as it keeps operating efficiently. Having solved that problem, I don't think most corporations worry a great deal about their debt-equity ratio. Obviously, they worry if it gets too high and they worry if it gets too low. But there's a big middle range where it doesn't seem to matter very much. I think that's why we're having a hard time pinning down exactly what the debt-equity ratio is or should be. It's a “second order” thing compared to the choice of financial structure. STERN: Well, people have pointed out that the tax-deductibility of interest expense makes debt a way of adding considerable value. And because of the value added by those tax shields, one could argue that aggressive use of debt may turn out to be the best defense against an unfriendly takeover. Doesn't that argument seem to imply that capital structure could at least become a first-order concern? MYERS: By raising the issue of hostile takeovers, I think you are mixing up the investment decision with the financing decision. I would like to keep them separate, at least as a starting point. Most takeover targets become targets not because they don't have enough debt, but because of bad investment decisions and poor operating performance. The primary cause of the wave of LBOs in the 1980s was not corporate failure to exploit the tax advantage of debt. Most of the LBOs—and I'm oversimplifying a little—were “diet deals.” They involved taking over mature companies with too much cash and too few investment opportunities and putting them on a diet. So, although there were tax savings, the transactions themselves were not tax-driven. DENNIS SOTER: Most of the companies that we have worked with over the years do spend a lot of time thinking about capital structure. Now, it's true that they typically do not think about it the way academics do—that is, in terms of a market debt-to-equity ratio. Most of them define their objectives in terms of bond ratings or book leverage. But they do have loosely defined financial strategies and some idea of what constitutes an appropriate mix of debt and equity in their capital structure. I'd like to ask Professor Myers a question: You used the term “optimal capital structure.” Would you define that for us? MYERS: In its simplest terms, optimal capital structure is the optimal percentage of debt on the balance sheet. SOTER: But optimal from what standpoint? MYERS: Maximizing the market value of the company. I'm not saying that's the wrong question, or an irrelevant or an uninteresting question. It's a very interesting question. But I think by focusing too narrowly on that, you miss these other things which I put under the rubric of financial structure—things which I tend to think are more important to corporate managers, and so more powerful in explaining the corporate behavior we see. STERN: I think you're right, at least in the sense that I regularly see behavior that doesn't appear to me to be value-maximizing. For example, in a roundtable discussion we ran a few years ago, one of the participants was an owner of a publicly traded company where he and his family owned about 37% of the equity. And I asked him why his debt ratio was so low. I said to him, “You're volunteering to pay an awful lot in taxes that you could avoid. Why don't you raise your debt ratio to the point where most of your pre-tax operating income is tax-sheltered?” You see, the amount of taxes he was paying was quite sizeable; it was some $12–$15 million a year that was literally going out the door that could have been saved just by changing the capital structure. Why do companies do that, Stew? MYERS: Tell me what he said first. STERN: He looked at me somewhat quizzically, and he said, “Well, don't you have to pay taxes?” MYERS: You're absolutely right. If you look at taxes alone, and you calculate the present value of the taxes that could be saved by greater use of debt, it seems like a big number. It's hard to explain why corporations don't seem to work very hard to take advantage of the tax shelter afforded by debt. I can't really explain why companies aren't taking advantage of those savings. I also agree with Dennis that corporations will say that they have target debt ratios. But the fact is they don't work very hard to get there. If a company is very profitable and doesn't have a need for external funds, it's probably going to work down to a low debt ratio. If it's short of funds, it's going to work up to a high debt ratio. These companies are not treating their debt ratio targets as if they were first-order goals. SOTER: Let me offer one possible clue to this capital structure puzzle by asking a question: Is it in the personal interests of the chief executive officer and the chief financial officer to employ leverage aggressively? Are they motivated through incentives, either through stock ownership or otherwise, to have an aggressive debt policy? I submit that very few CFOs of the largest U.S. public companies have enough equity ownership to even consider undertaking a leveraged recapitalization. If it's successful, he or she looks good for the moment. But if it's doesn't work, he'll never get another job in corporate America as a chief financial officer. So there is a great deal of personal risk for corporate management for which there may be little compensating reward. Without a significant ownership interest, who wouldn't prefer to have a single-A bond rating and sleep well at night? STERN: Unless they were subjected to an unfriendly takeover—in which case they would lose their jobs for sure. SOTER: Joel, you're citing an extreme example, one where there's so much unused debt capacity that a company invites a hostile bid. In my experience, there are many other companies that, although not takeover candidates, still have enough excess debt capacity that their shareholders would benefit from a leveraged recapitalization. JOHN McCONNELL: When I started my career many years ago, I taught a course on corporate capital structure, thinking that I knew something about it. Then, for a period of a few years, I quit teaching capital structure because I concluded I knew absolutely nothing. More recently, I've started teaching a course that I call capital structure, but which really amounts to a course in corporate governance. And, so, I think I've been undergoing an evolution in thinking that is quite similar to the one Stew has just described. And like you, Dennis, as Stew was defining optimal capital structure and describing the capital structure puzzle, I too was thinking about management incentives. Most of us, I suspect, would agree with the general proposition that there is a tax shield associated with debt financing. There would certainly be some disagreement about how valuable that tax shield is: Does it amount to a full 34 cents on the dollar of debt financing, or does that number fall to only 15 or 20 cents when you consider the taxes paid by debt holders? But, regardless of which end of this range you choose, most people in this room would probably agree that the value of such savings can be substantial. And thus most of us here would also likely agree that, for whatever reason, many public corporations are not using enough debt—not using the value-maximizing level of debt. But let me also respond to Dennis by saying that stock ownership may not be a complete answer to the question. I'm on the board of directors of a bank with about $600 million in assets, and there is great latitude as to the minimum capital ratio that the bank can have. The owners of the bank, however, insist for some reason upon keeping their capital ratio high. In so doing, they forgo not only possible tax benefits, but also the deposit insurance “funding arbitrage.” Like the company Joel was describing earlier, 47% of the stock of this particular bank is owned by a single family of investors. And if one thinks only in terms of their ownership incentives, it would seem that that particular ownership structure would be one that would have sufficiently strong incentives to induce managers to have a high leverage ratio. But instead, they have low leverage and considerable excess capital. And this case, by the way, is by no means an anomaly; it is quite representative of U.S. public corporations with heavy insider ownership. The studies that have looked at the relationship between insider stock ownership and leverage ratios show that, beyond a certain point, companies with very large insider ownership tend to have lower-than-average leverage ratios. Like other academic studies in which the relationship between ownership concentration and stock value is shown to be a bell-shaped curve, these studies of leverage and insider ownership suggest that insiders can actually own too much stock in their own firm. STERN: I was thinking along the same lines, John, when we were doing some work with the Coca-Cola Company. The CEO of Coke had a very large percentage of his own personal net worth tied up in the equity of the company. He was the third or fourth largest shareholder. And it occurred to me that the concentration of the CEO's wealth in Coke stock, and thus in an undiversified portfolio, could be a major factor in keeping the company from having a high debt ratio. That is, given his personal portfolio, it may have been rational for him to keep the financial risk of the company to a minimum. What this suggests to me is that, in cases with very large inside owners, we may need to devise a compensation scheme that helps overcome the owners’ risk aversion so as to align their risk-reward tradeoff with that of well-diversified shareholders. McCONNELL: What about the use of nonvoting stock? That would allow insiders to raise capital for investment opportunities without reducing their control over decision-making. For example, the CEO of Coca-Cola could have had the company issue nonvoting stock, and then concentrated his own holdings in the voting stock. Is something like that what you have in mind? STERN: No, that wouldn't be a solution to the problem I'm thinking about. The concern I have is that because the CEO's holdings represent such a large percentage of his own personal net worth, he was much more risk averse than institutional investors with well diversified portfolios. And this risk aversion may well have caused him to use less than the amount of leverage that would have optimal from the perspective of his institutional owners. McCONNELL: One possible solution to this problem—not for Coke, but at least in the case of small, closely held companies—would be for the CEO to sell a large fraction of his equity, thus allowing him to diversify his portfolio and allowing outsiders to have greater control over the firm. This could end up significantly increasing the value of the firm, at least in countries like the U.S. with its strong legal protections for small investors and well-functioning corporate control market. STERN: But, to return to our subject, we really don't have an explanation why public companies have low debt ratios—or at least low enough that they end up paying millions of dollars more in taxes than seems necessary. Since we have with us a senior executive from one of America's largest public companies, why don't we turn to her? Alice, what's your explanation of all this? And how do you think about corporate financial policy at Sears? ALICE PETERSON: Let me start by reinforcing Stewart Myers's point that capital structure is a relatively small part of a much larger, value-creating equation. At Sears, as in most companies, creating shareholder value is the main governing objective. Behind our mantra to make Sears a compelling place to shop, work, and invest, we use an EVA-type metric to track performance in the “invest” category. In order to create value for investors, companies need a business model to guide them in generating excess returns. Business models vary widely from company to company, even within the same industry. Such a business model incorporates overall objectives, organization, strategies, and financial goals. It occurs to me that Stewart Myers's broad definition of capital structure runs through our entire business model. We call our overall financial metric Shareholder Value Added. It is simply operating profits less the cost of all the capital it takes to create those profits. When we break down capital costs into the amount of capital times the cost of capital, we focus significantly more managerial effort on the amount of capital—and our approach is operationally focused. In other words, we want to attack the root need for the capital—and, for us, that's inventory and stores and fixturing. I often say that, of our 350,000 associates at Sears, nearly all of us have a daily impact on the amount of capital, but only a handful decide how to fund the capital needs. So, we spend disproportionately more time talking about how to get more profit using less assets. For the few of us who do focus on the righthand side of the balance sheet, there is considerable effort aimed at achieving the lowest long-term cost of capital by managing the capital structure. How does a company decide its optimal mix of debt and equity? At Sears we start by asking how much financial flexibility we want to pay for. That leads to a discussion in which we determine our target debt rating, which in turn translates into a target capital structure. With every strategic plan we're gauging the extent of free cash flow, the appropriate level of capital expenditures, and whether and to what extent we should be buying back stock. I can tell you we have dug seriously into the capital structure question several times over the last 5 years as we have IPO'd and spun off various business units and not only for the businesses leaving the portfolio, but for those remaining, too. So, what are these financial flexibility considerations? They include growth prospects and whether a company is inclined to grow organically or by acquisitions. They also include the need to position the company to weather extreme economic cycles and exogenous risks. Other considerations are ownership structure and stock positioning, as well as dividend policy, and our ability to manage overall enterprise risk. One consideration that doesn't show up on most companies’ list, but which is very important for Sears, is its ongoing debt-financing needs. Sears is different from its retail competitors by virtue of our successful credit business. Our $28 billion consumer receivables portfolio is the largest proprietary retail credit portfolio by a wide margin (the next largest is J.C. Penney at $5 billion). The $25+ billion in debt financing required to fund this profitable credit business is a key consideration in determining our target debt rating. We have targeted a ‘Single-A’ long-term debt rating to optimize our overall cost of capital. We think a “Double-A” rating is entirely too expensive, but feel that “Triple-B” greatly limits our flexibility. Importantly, impacts from a downgrade would disproportionately affect Sears versus our reta