A high-stakes game of Tug of War is being waged every day in the financial markets-and may come to a head in 2016. The struggle is over the claims on the cash flows generated by publicly traded companies. On one side are the equity shareholders, mainly concerned with appreciation in the share price but also payouts in the form of dividends. On the other side are the creditors who have loaned money to the company such as bondholders. They are less concerned with the stock price and more with the financial stability of the company and its ability to repay its debt obligations.
Managers and executives sometimes experience conflicts of interest when planning corporate strategy. It’s the Board of Director’s job to ensure this is minimized. For example, a manager’s performance (and compensation) is often evaluated by share price performance and other metrics like earnings per share (EPS) and return on equity (ROE). Earnings per share can be manipulated when companies repurchase stock in the open market, known as buybacks. This reduces the amount of shares outstanding, thus increasing earnings per share without any effect from the earnings power of the company.
ROE is calculated as the company’s Net Income divided by the number of shares of stock outstanding. This metric can be manipulated by adding more debt to the company’s capital structure because of the tax deductibility of interest payments on that debt. All else equal, the more debt you have the greater your ROE. But increased debt can jeopardize creditworthiness, resulting in credit downgrades by rating agencies. Downgrades typically reduce the value of existing bonds and makes future borrowing costs rise, hampering all stakeholders. So overaggressive management can realize short-term gains to improve their own compensation but jeopardize the longer-term solvency of the company.
Sometimes, managers are ‘forced’ to be aggressively shareholder friendly if an activist investor comes into the picture. Activist investors, often institutional investors, buy up large percentages of publicly traded shares, giving them enormous voting power. This includes winning seats on the Board of Directors, who can replace current management if they don’t go along with their plans. Then, they do everything in their legal power to increase the total return in the shares. This includes spinning-off underperforming businesses, unlocking the value of real estate assets by converting them into real estate investment trusts (REITS) and increasing dividend payouts to shareholders (themselves). But activists aren’t always aligned with creditor’s interests.
One way activists increase dividend payouts is by levering up the balance sheet, which hurts the longer-term prospects of bondholders. Publicly traded companies have taken advantage of extremely low interest rates to issue record amounts of debt in 2014.1 The strategy is to borrow money cheaply and use the proceeds to buy back shares (typically increasing the share price) and paying themselves fat dividends. None of these is positive for current creditors as it subordinates their interests to shareholders.
Companies that have been engaged in activist campaigns include McDonalds, Manitowoc and most dramatically, Darden Restaurants, the parent of Olive Garden restaurants. The New York based hedge fund, Starboard Capital, completely gutted Darden’s Board of Directors; replacing all twelve seats with ‘shareholder friendly’ members.2 Sometimes the changes are operational. For Olive Garden, this meant re-adding salt to the water when boiling the pasta and ditching the unlimited breadsticks so customers could save room for higher margin alcohol. Following the traditional playbook of many activists, Starboard also plans on spinning off underperforming units like high-end restaurant chain Capital Grille. While spinoffs are largely favored by shareholders for unlocking more ‘shareholder value’, they typically come at the expense of bondholders since the remaining company will be smaller and have a weaker credit profile. One problem with Olive Garden’s downgrade is that it takes the company from investment grade down to speculative grade status (junk), increasing borrowing costs for all stakeholders.3
Some companies executed several bond offerings. Apple has been one of the most active issuers of bonds, skillfully timing the offerings when interest rates (and their borrowing costs) are low. They issued the largest corporate bond issue ever at that time just one month before the absolute low in U.S. Treasury rates back in 2012.4 They even floated a bond offering priced in Japanese yen. These ‘Samurai bonds’ take advantage of not only low interest rates but currency opportunities, making the debt easier to pay back via weaker currency. Apple borrowed $2 billion of these Samurai Bonds at just 0.35% for five years.5 That’s pretty close to free money. But every time a company issues a subsequent bond offering, it increases the risk profile of all prior debt offerings. Even with a large amount of cash on its balance sheet, the company has issued corporate debt totaling $55 billion, just since 2013.6
But activism doesn’t always have to be credit negative. In the case of Canadian Pacific Railway, a shakeup of their board by Pershing Square Capital Management resulted in a credit upgrade because the new management was focused on reducing overhead and efficiencies. Further, if a company is junk rated to start, a spinoff may improve the underlying credit rating of the company since the company that’s acquiring the subsidiary or division typically assumes the debt.
Regardless, activists are much-maligned for these tactics. When times are good, they are well-loved but when conditions change, so do their reputations. Often they are long gone when the repercussions of their strategic decisions are fully realized. Sometimes this can be bankruptcy. Activists went by another name in the 1980’s, “corporate raiders” and were portrayed by characters like Gordon Gecko in the movie ‘Wall Street’. If there is a severe bear market for stocks, there could be public ire against activists, an easy scapegoat.
Corporate governance needs to include the perspective of creditors since they now include public pension funds, charitable foundations, university endowments and life insurance companies who depend on payments from corporate bonds to match their longer-term liabilities like retiree benefits and life insurance claims. 2016 may be the year legislators weigh in on the conflict. Don’t be surprised to see future legal clashes between the various stakeholders of these companies. Enterprise risk managers must assess the repercussions of all corporate strategy decisions and the potential legal risks involved.