Dismantling the economy’s legal infrastructure V-5-e: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 5: The growth of leveraged buyout loans

A consequence of the special protected status granted by the US government to the money center banks was that even after the LDC crisis they continued to raise money with ease and at low cost relative to smaller banks on both international and domestic markets. Thus, despite their demonstrated inferiority to smaller banks in managing their loan portfolios, vast sums were available – due only to their government-supported status – for them to lend. Furthermore, due to that same protected status, these banks would have the capacity to extend their loans indefinitely. Under these circumstances it is not surprising that money center banks sought out a new source of earning assets to replace the much reduced LDC loan market. Syndicated lending turned to “leveraged loans,” that is, the loans that are used to load corporations up with debt in leveraged buyouts.

Recall from a previous post that the Small Business Investment Incentive Act of 1980 had shifted the SEC’s mandate from one of protecting investors (both wealthy and non-wealthy) to one that also promoted the capital formation of small businesses. This was adopted in the name of helping the small businesses that were struggling due to the shift to “market-based lending” that favored big banks and big firms at the expense of SMEs. This law encoded into legislation the concept of the “accredited investor” and allowed large classes of investors to be exempt from the protections that had in the past been held to cover even the wealthy. Subsequently, in 1980 the SEC promulgated Rule 506 of Regulation D, which unlike all the rules that preceded it, permitted firms to use private offerings to raise an unlimited amount of funds from an unlimited number of accredited investors as long as the there was no “general solicitation.” (In the past, all of the SEC’s private offering rules strictly limited either the amount that could be raised or the number of investors from whom funds were raised.)

Regulation D made the leveraged loan market possible. Whereas junk bonds are issued in public offerings that meet the stringent requirements of SEC registration, leveraged loans are issued in private offerings and are subject to only a very limited set of investor protections. According to the SEC the adoption of Regulation D was motivated by a desire to promote the capital formation of small businesses. Ultimately, however, the “small businesses” that were able to grow due to the creation of the leveraged loan market were financial firms, not the non-financial SMEs that the legislators had in mind in when they passed the 1980 Act.

Private equity firms (also known as leveraged buyout firms) would use leveraged loans and a technique known as the “leveraged buyout” to either facilitate a management buyout or a hostile takeover of a corporation. In a management buyout private equity assists a corporation’s management in the purchase of the corporation’s assets from the owners of the corporation, subject to a majority vote of the corporation’s shareholders. Because the corporation’s management has a fiduciary duty to the firm’s owners and management’s interests are directly in conflict with the shareholders’ interests in these transactions, such transactions may be motivated by managers and private equity professionals who are arbitraging weaknesses in the law governing corporate management’s duty to shareholders.

In a hostile takeover the private equity firm is able to literally force debt on a corporation whose management believes such debt is not in the interests of the corporation. A hostile takeover is typically executed by the private equity firm making a conditional offer to shareholders to purchase their shares at a price above the market price – the condition is that the offer will only be executed if enough shareholders accept to give the private equity firm control.

To explain fully how buyouts operate it is important to review the well-established effects of taking on leverage. When an equity holder leverages her investment by borrowing to fund the investment, she increases the risk of her investment making it more likely that the project will go bankrupt and she will lose money, but at the same time in the event that the project makes money she increases her potential return. Because a firm is unlikely to go bankrupt immediately upon increasing its debt load, the immediate effect of leverage on the share price of a corporation is often an increase in the price. The cost of that increase is however the increased price volatility inherent in a leveraged investment – and the increased likelihood of a total loss or bankruptcy.

Both management buyouts and hostile takeovers typically take place in an environment where share prices are low relative to the value of firm assets, since this is the environment in which an increase in leverage is likely to result in a short-run positive effect on the share value. Both types of leveraged buyout then have the effect of paying an immediate higher return to current shareholders who are bought out and who give up their claim to the firm’s assets and the possibility of a future even higher return. They also both have the effect of significantly increasing the likelihood that the firm in question goes bankrupt.

What makes these deals of questionable economic value is the fact that the private equity firms (and in some cases the corporate managers) who organize these transactions are not simple equity investors in the new firms – and their incentives are typically not aligned with that of making sure that the firm that has been loaded up with debt will continue to be a going concern. Instead these organizers of leveraged buyouts are able to extract upfront fees and payment from the transactions, and thus have an interest in keeping a flow of leveraged buyouts going even if the end result will be a rush of bankruptcies, layoffs, and economic dislocation (Applebaum & Batt 2016).

Thus, the Small Business Investment Incentive Act and Regulation D had the effect of creating a leveraged loan market that was arguably designed to enable private equity firms to arbitrage weaknesses in the legal and regulatory structure governing corporate governance. Where do the money center banks fit in this picture? This new lending market was opening up just at the time that the money center banks were finding that they needed to cut back on the LDC loans, as the borrowers were close to default. The extraordinarily cheap funds that were available to the money center banks due to their government-guaranteed status could be put to use in the syndication of the leveraged loans that financed private equity and corporate buyouts.

Consider this new perversion of the financial system: The money center banks use their access to funding which due to government support was available at low cost in almost unlimited amounts in order to promote the development of a new type of financial firm which specializes in arbitraging weaknesses in the law governing US corporations for the purpose of loading US corporations with debt. The end result has been a massive leveraging of US corporations – even in circumstances where corporate management believes the debt is not in the long-run interests of the corporation. On the one hand, the threat of hostile takeover pushes corporate management to take a less and less conservative approach to debt, and, on the other, money center banks and private equity firms are able by charging fees on this process to profit generously from their arbitrage of corporate law. Effectively, the extraordinary leveraging of corporate America is a consequence of government-guarantees provided to money center banks and the banks’ search for a way to profit off of this this vast source of funds.

It’s worth pausing a moment to compare the post-Bretton Woods financial environment with the one that existed at the height of Bretton Woods. When banks were at risk of failure and did not have access to significant sources of so-called “market-based” funding, they had to behave like traditional banks that could only keep their liabilities in circulation by lending – prudently. There was in this traditional model a tight connection between lending, the circulation of bank deposits, and bank funding. This tight connection was broken by market-based lending with the 1970s growth of the Eurodollar market and the commercial paper market. Suddenly the largest banks were able to finance themselves on markets (in fact as we have seen due to a government guarantee) and no longer needed to worry about lending in order to put deposits into circulation. Indeed, due to the government guarantee the incentives for these banks to lend prudently had declined dramatically. They turned to lending to foreign countries and to lending on a term basis to corporations in a way that served to increase debt on corporate balance sheets and the flow of funds from nonfinancial corporations to the financial sector without in fact having much of a transformative effect on the activities of the corporations. In short, the growth of market-based lending is closely associated with the growth of bank lending, that is not productive, but instead seeks out borrowers who can be induced to make interest payments as a form of tithe to the financial sector. Indeed, this transformation of banking post-Bretton Woods may explain the puzzlingly high cost of financial intermediation in the current era (Philippon 2012; see also Philippon 2015).

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

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