Thematic Investing—Corporate Restructuring C15.0042Lesson 5Edward M. KerschnerE. KerschnerWhat is “restructuring”?  Consolidation of industries (M&A—friendly and hostile) LBOs of entire companies (popular in 1980s) Streamlining of diversified companies by spinning off divisions to shareholders or via sales to other corporations Acquisitions designed to raise the acquirer’s technological sophistication or alter its business mix Heavy use of leverage and share repurchases to return capital to shareholders, raise EPS and discourage hostile tender offers.E. KerschnerTypes of “restructuring”?  Industry consolidation. Firms can get top-line growth with limited risk by acquiring a firm, cutting overhead, consolidating operations. Made sense in fragmented industries such as banking  Buy a nickel for four cents. Commodity firms such selling below replacement value  Strategic acquisitions: synergiesE. Kerschner It shifts resources to more profitable economic sectors. Allows investors to realize underlying values in their equity holdings that had not been reflected in rising profits and stockprices. Restructuring leads toward very large, focused companies (“Gorillas) and toward small, well-focused, entrepreneurial companies. The fear of being restructured by outsiders prompts managements to take difficult and controversial steps such as plant closings and layoffs, that raise profitability and stock prices.The benefits of restructuringE. Kerschner Disinflation, which radically altered the valuation structure ofboth real and financial assets, creating gross disparities between market prices and underlying “private market” values. The economic impact of disinflation, broadly defined to include industry deregulation, intense foreign competition and the shiftof the U.S. economy from manufacturing to services  Innovation on Wall Street: Junk bonds, M&A departments, bloc trading, merger arbitrage, LBOs.  Active support of government policymakers—a highly supportive legal and political environment. With foreign competition intense, antitrust concerns lost their urgency.Restructuring in 1980s fueled byE. Kerschner Low effective corporate tax rates. The accelerated depreciation in the 1981 tax bill dramatically improved corporate cash flow, increasing the ability of companies to service debt  Willingness of managements to leverage balance sheets. This was due, in part, to the enhanced stature of entrepreneurs and venture capitalistsRestructuring in 1980s fueled byE. Kerschner The Crash of 1987  The banking and S&L crisis of the late 80s/early 90s The demise of corporate raiders such as Boesky and their backers such as MilkenRestructuring in 1980s ended by “Highly Confident”E. Kerschner By the early 1990s, however, investors started to view companies as portfolios of businesses that should be disassembled and restructured in order to maximize shareholder values. Poor corporate profit growth—in the intensely competitive, deflationary environment of the early 1990s, many companies were producing poor financial results. Faced with the reality ofminimal top-line growth, managements focused on cutting costs in order to raise profits.Factors behind “destructuring”:E. Kerschner Restructuring is contagious; when one firm does it, so must competitors.  Restructuring is habit-forming. A firm does it more often than once because the first effort does not boost profitability as much as expected.  Giant pension funds and mutual funds owned large, illiquid positions in troubled companies pressured boards of directors to improve performance. More active institutional interest in the performance of corporations was widely viewed as beneficial to U.S. competitiveness.Factors behind “destructuring”:E. KerschnerFactors behind “destructuring”:In 1993, leadership of the DJIA was delineated not by classic market sectors such as “growth” or “cyclical” but by destructuring stories such as GM, Kodak, Goodyear Tire and Sears.1993 DJIA performanceYear to date through November 30-30 -20 -10 +0 +10 +20 +30 +40 +50 +60 +70GMCATS *EKGTUTXAXPUKCHVMCDALDGEINDUBSMMMJPMTXTIBMPGWXXONDDKOIPAABADISMRKZMO+64+59+53+50+30+29+26+26+25+20+18+15+12+9+8+8+7+7+7+6+5+3+1+0+0-3-4-7-21-27-27* S includes 0.4 DWD sharesE. Kerschner1994 M&A became more activeBy 1994, those companies that had already cut costs to the limit, turned to growing the top line again. However, in an environment that continued to be marked by low inflation and very low real growth, top line growth could not be achieved by merely adding new capacity where ample capacity still existed domestically and globally. Consequently, in its search for top-line growth, corporate America increasingly turned to strategic acquisitions—takeovers.Source: www.mergerstat.comM&A Activity02,0004,0006,0008,00010,00012,0001962 1967 1972 1977 1982 1987 1992 1997 200202004006008001000120014001600DealsValue ($bil)E. Kerschner M&A became more numerous in ‘94 for four reasons:• Pent-up demand after a three-year hiatus • Declining interest rates and an expanding economy increased the confidence of CEOs and their bankers• Rapid strategic changes in such sectors as health care, entertainment and telecom • The currency of acquisitions had become more valuable as P/Es of many firms had risen, while P/Es of others had remained low In the mid 1990s, M&A activity jumped to levels not seen since the merger mania years of the 1980s. However, toward the end of the decade, Strategic Action had run its course.1994 M&A became more activeE. KerschnerRestructuring Ends Again  As a result of destructuring, a large section of corporate America was lean, mean and highly competitive  Most of the logical acquisitions already had been made, and more than a few acquisitions that never should have taken place also occurred  Next catalyst for corporate transformation was the shift to the New Economy at the turn of the 21stcentury.E. KerschnerRestructuring and the New Economy  In the Information Age division of labor moves from the worker to the entire organization; moving from bureaucratic, verticallyintegrated organizations to flexible firms where decisions are driven by market forces. Just as, in the early 20th century, electric utilities permittedfirms and households to “outsource” the age-old function of power generation . . . . . . so in the early