Though corporate raiders and financiers have long extolled the virtues of debt as a way to rein in free-spending managers, a less enthusiastic group has continued to question the wisdom of the debt revolution and its effects on long-term corporate value.
A recent study shows that when companies take on too much debt, their investment policies become distorted: They begin to favor divisions that churn out cash over those that are geared toward potentially high-value, long-term returns.
Professor Anil Shivdasani and doctoral candidate Urs Peyer of the Kenan-Flagler Business School, the University of North Carolina at Chapel Hill, investigated investment patterns at 22 multidivisional companies that underwent leveraged recapitalizations between 1982 and 1994. (The number of divisions at these 22 companies varied over the study period from 176 to 233 due to acquisitions and divestitures.) The researchers focused on divisional investments during the three years before and after an increase in debt, hoping to determine how the increased debt loads altered management's investment policies. (The study, “Leverage and Internal Capital Markets: Evidence From Leveraged Recapitalizations,” appears in the March 2001 issue of the Journal of Financial Economics.)
“We found that prior to recapitalization, these companies were allocating more capital to the divisions that had the best growth opportunities over the long term for profitability,” said Shivdasani. “This changes dramatically after the transaction; the companies start to allocate more capital to those divisions that promise quick paybacks and large amounts of cash.”
Interestingly, the research also demonstrates a strong correlation between the amount of debt and distortion in the companies' investment policies. Higher debt levels force companies into placing even greater emphasis on high cash-flow divisions.
“Not only do these companies have a lot of debt, which carries a high rate of interest, but they also have a repayment schedule requiring that the principal be paid back relatively soon,” said Shivdasani. “In such situations, this pressure is the most binding, and misallocation is taking place.”
The actions of the managers at the companies studied are understandable, given the pressures of high-debt environments: Management wants to ensure that the “cash cows” in the company continue to produce to keep the company alive. So why worry about looking for long-term payoffs?
“The companies that changed their investment patterns more toward cash and less toward long-term profitability had the smallest overall value increase during the study,” said Shivdasani.