Chapter 33 - Corporate Restructuring CHAPTER 33 Corporate Restructuring The values shown in the solutions may be rounded for display purposes. However, the answers were derived using a spreadsheet without any intermediate rounding. Answers to Problem Sets 1. a. LBO – Purchase of a business using mostly debt financing. The company goes private so that its stock no longer trades in the open market. b. MBO – An LBO that is undertaken by existing management. c. Spin-off – A parent company creates a new company with part of its assets and operations. Shares in the new business are distributed to the parent’s stockholders. d. Carve-out – Like a spin-off, but shares in the new business are sold in a public offering. e. Asset sale – A sale of specific assets rather than the entire firm. f. Privatization – The purchase of a government-owned business by private investors. Leveraged restructuring – A company increases its debt, pays the debt proceeds to stockholders, and thereby increases its debt–equity ratio. Est. Time: 06 - 10 g. 2. a. b. True False; The most successful LBOs and MBOs go public again as soon as debt has been paid down sufficiently and improvements in operating performance have been demonstrated. c. True d. False; Carried interest is earned by general partners on profits made by an organization. It is a call option that gives the general partners a potentially significant upside and provides incentives to take risks. e. True f. True Est. Time: 01 - 05 3. The story told in Barbarians at the Gate is a very complicated one. Those who favor mergers can find much evidence in this story to support their position, as can those who oppose mergers. In a similar fashion, those who espouse one © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. Chapter 33 - Corporate Restructuring particular theory or another as to why companies merge can find evidence here to support their position (and evidence to refute the positions of others). Thus, the answer will vary, depending on one’s views. Est. Time: Not applicable; requires further reading. 4. In general, firms with narrow margins in highly competitive environments are not good candidates for an LBO or an MBO. These firms are often highly efficient and do not have excess assets or unnecessary capital expenditures. Further, the thinness of the margins limits the amount of debt capacity. Est. Time: 01 - 05 5. The limited life of a private-equity partnership reassures the limited partners that the cash flow will not be reinvested in a wasteful manner. It also tends to ensure that partnerships focus on opportunities to reorganize poorly performing businesses and to provide them with new management before selling them off. In addition, the carried interest owned by private equity partnerships provides incentives for taking risk. Est. Time: 01 - 05 6. Private-equity partnerships are usually run by professional equity managers representing larger institutional investors. The institutional investors act as the limited partners while the professional managers act as general partners in the limited partnership. The general partners are companies that focus on funding and managing equity investments in closely held firms. The incentive for general partners is a management fee plus a share in the company profits, called “carried interest,” that they can increase if they successfully “fix” the firm. The limited partners get paid first, but are not entitled to all the profits. Further, the limited life of the partnership precludes wasteful reinvestment. These partnerships are designed to make investments in various types of firms from venture capital start-ups to mature firms that need to reinvigorate management. Est. Time: 06 - 10 7. In a private-equity partnership, the carried interest represents the general partners’ call option. The exercise price of this call option is the dollar amount of the limited partners’ investment in the partnership. In order for the general partners’ call option to be in the money, the general partners must earn back more than the limited partners’ investment. Therefore, the general partners clearly have an incentive to earn a profit on the limited partners’ investment. On the other hand, the general partners also have an incentive to take on risk; increased volatility increases the value of the call option, so the general partners might choose a risky investment over a less risky investment with a greater expected NPV. Est. Time: 06 - 10 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. Chapter 33 - Corporate Restructuring 8. In the 1960s and 1970s, when public conglomerations were at their height, the following advantages were claimed: First, diversification across industries was supposed to stabilize earnings and reduce risk. Second, a widely diversified firm can operate as its own internal capital market, thereby reducing the need for financing from outside investors. Third, the company’s managers arguably know more about investment opportunities than outside investors. In addition, transaction costs of issuing new securities are avoided. Est. Time: 01 - 05 9. Internal capital markets often misallocate capital. The market values of the conglomerate’s divisions cannot be observed separately, so it’s hard to set incentives and reward risk taking. Internal politics may also interfere with capital efficiency. In addition, investors can often diversify more easily on their own. Est. Time: 01 - 05 10. a. True. Carve-out or spin-off of a division improves incentives for the division’s managers. If the businesses are independent, it is easier to measure the performance of the division’s managers. b. False. Investors tend to treat spin-offs favorable, exemplified by abnormally high returns in most cases. c. False. Privatization generally results in increased efficiency, yet these companies grow faster which increases employment. d. True. Est. Time: 01 - 05 11. Answers will vary depending upon the examples chosen. Est. Time: 11 - 15 12. Although agency costs can be significant for public companies, anyone who has dealt with a governmental institution (or, for that matter, a nonprofit organization) has undoubtedly experienced the far greater problem of agency costs in organizations outside the private sector. Privatization can substantially reduce these costs, resulting in much greater efficiency. Competition in the private sector imposes a greater discipline within the enterprise, while also eliminating the impact of political influence. Management and other employees are often offered stronger incentives in a private enterprise than would be possible in a governmental organization. Est. Time: 06 - 10 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. Chapter 33 - Corporate Restructuring 13. Increased efficiency, broader share ownership, and revenue for the government Est. Time: 01 - 05 14. Chapter 7 usually leads to liquidation. Chapter 11 protects the firm from its creditors while a reorganization plan is developed. Est. Time: 01 - 05 a. False. It is in shareholders’ interests to attempt to rehabilitate the firm. They have nothing to lose if rehabilitation efforts fail (in which case the firm would file for bankruptcy anyways), but everything to gain if rehabilitation efforts succeed. b. True c. True d. False (tax-loss carry-forwards do not survive liquidation) Est. Time: 01 - 05 15. 16. Many of the problems with Chapter 11 bankruptcy could be mitigated by negotiating a prepackaged bankruptcy. Many problems arise from the fact that the two goals of Chapter 11 bankruptcy are often in conflict with each other: (1) to satisfy creditors and (2) to allow the firm to resolve its problems and continue to function as an ongoing business. Furthermore, there are conflicts within the different classes of securities holders. Senior creditors tend to favor a liquidation of the company so that their claims will be satisfied immediately, while junior creditors favor a reorganization of the business in the hope that they will receive some portion of their claims. There is also a conflict between secured creditors, who receive interest while the company is in Chapter 11 bankruptcy, and unsecured creditors who do not receive interest. These numerous conflicts increase the likelihood that extensive litigation will drain resources from the company while these issues are resolved. A prepackaged bankruptcy resolves these issues with a negotiated settlement. Est. Time: 06 - 10 17. There is always a chance that the company can recover, allowing creditors to be paid off and leaving something for shareholders. Also, the court may not observe absolute priority, so shareholders may be given some crumbs in a Chapter 11 reorganization. Est. Time: 01 - 05 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
