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The following excerpt is taken from the “Lessons of Restructuring” section of Gilson’s introduction to Creating Value through Corporate Restructuring.
Although the case studies in this book span a wide range of companies, industries, and contexts, some common issues and themes emerge. Taken together, they suggest there are three critical hurdles or challenges that management faces in any restructuring program:
1. Design. What type of restructuring is appropriate for dealing with the specific challenge, problem, or opportunity that the company faces?
2. Execution. How should the restructuring process be managed and the many barriers to restructuring overcome so that as much value is created as possible?
3. Marketing. How should the restructuring be explained and portrayed to investors so that value created inside the company is fully credited to its stock price?
Failure to address any one of these challenges can cause the restructuring to fail.
Having A Business Purpose
Restructuring is more likely to be successful when managers first understand the fundamental business/strategic problem or opportunity that their company faces. At Humana Inc., which jointly operated a hospital business and a health insurance business, management decided to split the businesses apart through a corporate spin-off because it realized the businesses were strategically incompatible—the customers of one business were competitors with the other. Alternative restructuring options that were considered, including issuing tracking stock, doing a leveraged buyout, or repurchasing shares, would not have solved this underlying business problem.
Chase Manhattan Bank and Chemical Bank used their merger as an opportunity to both reduce operating costs and achieve an important strategic objective. Combining the two banks created opportunities to eliminate overlaps in such areas as back-office staff, branch offices, and computing infrastructure. Management of both banks also believed that larger and more diversified financial institutions would increasingly have a comparative advantage in attracting new business from corporate and retail customers. The merger was therefore also viewed as a vehicle for increasing top-line revenue growth. Internal cost cutting alone would not have enabled either bank to achieve this second goal.
Scott Paper’s chief executive officer (CEO) decided to implement the layoffs quickly—in less than a year—to minimize workplace disruptions and gain credibility with the capital market. For some companies, however, strategic and business factors could warrant a more gradual approach to downsizing. For example, consider a firm that is shifting its strategic focus from a declining labor-intensive business to a more promising but less labor-intensive business. Ultimately this shift may necessitate downsizing the workforce. However, if the firm’s current business is still profitable, the transition between businesses—and resulting layoffs—may be appropriately staged over a number of years. This situation could be said to characterize the mainframe computer industry during the 1980s, when business customers moved away from mainframes towards UNIX-based “open architecture” computing systems. 6
Knowing When To Pull The Trigger
Many companies recognize the need to restructure too late, when fewer options remain and saving the company may be more difficult. Scott Paper’s new CEO was widely criticized in the news media for the magnitude of the layoffs he ordered. However, such drastic action was arguably necessary because the company had taken insufficient measures before that to address its long-standing financial problems. Some research suggests that voluntary or preemptive restructuring can generate more value than restructuring done under the imminent threat of bankruptcy or a hostile takeover. 7
Several companies featured in this book undertook major restructurings without being in a financial crisis. Compared to the rest of the U.S. airline industry, United Air Lines was in relatively strong financial condition when its employees agreed to almost $5 billion in wage and benefit reductions in 1994. And Humana was still profitable when it decided to do its spin-off.
What can be done to encourage companies to restructure sooner rather than later? In the case of United Air Lines, management in effect created a crisis that made employees more willing to compromise. Early in the negotiations, management threatened to break up the airline and lay off thousands of employees if a consensual agreement could not be reached. Management made the threat real by developing an actual restructuring plan, containing detailed financial projections and valuations. Moreover, United’s CEO at the time had a reputation for following words with deeds, and he was not liked by the unions. (With hindsight, it is debatable whether he really intended to pursue the more radical restructuring plan; however, what matters is that the unions believed he would.)
In Humana’s case, the company culture encouraged managers to constantly question the status quo and consider alternative ways of doing business. This sense of “organizational unease” was encouraged by Humana’s CEO-founder, who twice before had shifted the company’s course to a brand-new industry. As the company’s integrated product strategy began to exhibit some problems—although nothing approaching a crisis—a small group of senior managers decided to investigate. This effort, which took place off-site and lasted several weeks, uncovered a serious flaw in the strategy itself, setting the stage for the eventual restructuring.
At each of these companies, there was a set of factors in place that made early action possible. However, some of these factors—a strong or visionary CEO, for example—are clearly idiosyncratic and company-specific. Thus it remains a question whether firms can be systematically encouraged to preemptively restructure. One approach that has been suggested is to increase the firm’s financial leverage (so it has less of a cushion when the business begins to suffer); another is to increase senior managers’ equity stake so they are directly rewarded for restructuring that enhances value. Such approaches are not widespread, however. 8
The Devil Is In The Details
The decisions that managers have to make as part of implementing a restructuring plan are often critical to whether the restructuring succeeds or fails. In the language of economics, implementation is the process of managing market imperfections. The challenges that managers face here are many and varied.
In a bankruptcy restructuring, for example, one obvious objective is to reduce the firm’s overall debt load. However, cancellation of debt creates equivalent taxable income for the firm. Flagstar Companies, Inc. cut its debt by over $1 billion under a “prepackaged” bankruptcy plan. In addition, if ownership of the firm’s equity changes significantly, say because creditors exchange their claims for new stock, the firm can lose the often sizable tax benefit of its net operating loss carryforwards. 9 When Continental Airlines was readying to exit from Chapter 11, it had $1.4 billion of these carryforwards. However, to finance the reorganization, the company sold a majority of its stock to a group of investors—virtually guaranteeing a large ownership change.
Companies that try to restructure out of court to avoid the high costs of a formal bankruptcy proceeding can have difficulty restructuring their public bonds. If such bonds are widely held, individual bondholders may be unwilling to make concessions, preferring to free ride off the concessions of others. Thus it will be necessary to set the terms of the restructuring to reward bondholders who participate and penalize those who do not—all the while complying with securities laws that require equal treatment of creditors holding identical claims. This was the situation facing the Loewen Group Inc. as it stood at the crossroads of bankruptcy and out-of court restructuring.
Before a company can divest a subsidiary through a tax-free spin-off, management must first decide how corporate overhead will be allocated between the subsidiary and the parent. The allocation decision can be complicated by management’s understandable desire not to give away the best assets or people. It is also necessary to allocate debt between the two entities, which will generally entail some kind of refinancing. The transaction must meet certain stringent business purpose tests to qualify as tax-exempt. And if the two entities conducted business with each other before the spin-off, management must decide whether to extend this relationship through some formal contractual arrangement. Humana’s two divisions transacted extensively with one another before its spin-off, and abruptly cutting these ties risked doing long-term harm to both businesses.
Corporate downsizing also presents managers with formidable challenges. In addition to deciding how many employees should be laid off, management must decide which employees to target (e.g., white collar vs. factory workers, domestic vs. foreign employees, etc.) and set a timetable for the layoffs. It must also carefully manage the company’s relations with the remaining workforce and the press. This process becomes much more complicated when management’s compensation is tied to the financial success of the restructuring through stock options and other incentive compensation. And when layoffs are the by-product of a corporate merger, it is necessary to decide how they will be spread over the merging companies’ workforces. This decision can significantly impact the merger integration process and how the stock market values the merger, by sending employees and investors a signal about which merging company is dominant. 10
Bargaining Over The Allocation Of Value
Corporate restructuring usually requires claimholders to make significant concessions of some kind, and therefore has important distributive consequences. Restructuring affects not only the value of the firm, but also the wealth of individual claimholders. Disputes over how value should be allocated—and how claimholders should “share the pain”—arise in almost every restructuring. Many times these disputes can take a decidedly ugly turn. A key challenge for managers is to find ways to bridge or resolve such conflicts. Failure to do so means the restructuring may be delayed, or not happen, to the detriment of all parties.
Inter-claimholder conflicts played a large role in Navistar International’s restructuring. The company had amassed a $2.6 billion liability for the medical expenses of retired Navistar workers and their families, which it had promised—in writing—to fully fund. This liability had grown much faster than expected, to more than five times Navistar’s net worth. Claiming imminent bankruptcy, the company proposed cutting retirees’ benefits by over half. With billions of dollars at stake, the negotiations were highly contentious, and an expensive legal battle was waged in several courts.
FAG Kugelfischer also faced a major battle with its employees over the division of value. Kugelfischer’s high labor costs—the average German worker earned over 40 percent more than his/her U.S. counterpart—had made it increasingly difficult for it to compete in the global ball bearings market. However, opposition from the company’s powerful labor unions made cutting jobs or benefits very difficult. Moreover, under the German “social contract,” managers historically owed a duty to employees and other corporate stakeholders as well as to shareholders. So any attempt to cut labor expense could well have provoked a public backlash—especially since at the time the company’s home city of Schweinfurt had an unemployment rate of 16 percent.
For publicly traded companies, the success of a restructuring is ultimately judged by how much it contributes to the company’s market value.
Sometimes disputes over the allocation of value arise because claimholders disagree over what the entire company is worth. In Flagstar Companies’ bankruptcy, junior and senior creditors were over half a billion dollars apart in their valuations of the company. Since the restructuring plan proposed to give creditors a substantial amount of new common stock, their relative financial recoveries depended materially on what the firm, and this stock, was ultimately worth.
To bridge such disagreements over value, a deal can be structured to include an “insurance policy” that pays one party a sum tied to the future realized value of the firm. This sort of arrangement sometimes appears in mergers in the form of “earn-out provisions” and “collars.” 11 The terms of United Air Lines’ restructuring included a guarantee that employees would be given additional stock if the stock price subsequently increased (presumably because of their efforts). And in some bankruptcy reorganization plans, creditors are issued warrants or puts that hedge against changes in the value of the other claims they receive under the plan. 12 Despite how much sense these provisions would seem to make, however, in practice they are relatively uncommon. The reasons for this are not yet fully understood. 13
Getting The Highest Price
For publicly traded companies, the success of a restructuring is ultimately judged by how much it contributes to the company’s market value. However, managers cannot take for granted that investors will fully credit the company for all of the value that has been created inside.
There are many reasons why investors may undervalue or overvalue a restructuring. Many companies have no prior experience with restructuring, so there is no precedent to guide investors. Restructurings are often exceedingly complicated. (The shareholder prospectus that described United Air Lines’ proposed employee buyout contained almost 250 pages of text, exhibits, and appendices). When it filed for bankruptcy protection in Thailand, Alphatec Electronics Pcl had over 1,200 different secured and unsecured creditors, located in dozens of countries. And restructuring often produces wholesale changes in the firm’s assets, business operations, and capital structure.
So in most restructurings, managers face the additional important challenge of marketing the restructuring to the capital market. The most obvious way to do this is to disclose useful information to investors and analysts that they can use to value the restructuring more accurately. 14 However, managers are often limited in what they can disclose publicly. For example, detailed data on the location of employee layoffs in a firm could benefit the firm’s competitors by revealing its strengths and weaknesses in specific product and geographic markets. Disclosing such data might also further poison the company’s relationship with its workforce. In its public communications with analysts, United Air Lines’ management could not aggressively tout the size of the wage/benefit concessions that employees made to acquire the airline’s stock, since many employees entered the buyout feeling they had overpaid.
Management’s credibility obviously also matters in how its disclosures are received. Many restructurings try to improve company profitability two ways, by both reducing costs and raising revenues. Scott Paper Company’s restructuring was also designed to increase the firm’s revenue growth potential by leveraging the brand name value of its consumer tissue products business. Management was quite open in declaring this goal. However, experience suggests that investors and analysts generally reward promises of revenue growth much less than they do evidence of cost reductions. In public financial forecasts of the merger benefits, Chemical and Chase management downplayed the size of the potential revenue enhancements, even though privately they believed the likely benefits here were huge.
When conventional disclosure strategies are ineffective in a restructuring, sometimes more creative strategies can be devised. As part of its investor marketing effort, United Air Lines began to report a new measure of earnings—along with ordinary earnings calculated under Generally Accepted Accounting Principles (GAAP)—that excluded a large noncash charge created under the buyout structure. The new earnings measure, which corresponded more closely to cash flows, was designed to educate investors about the buyout’s financial benefits. Acceptance of this accounting innovation by the investment community was uneven at first, however.
Of course communicating with investors is relatively easy when the company is nonpublic and/or closely held. But having no stock price is a double-edged sword, as the case of Donald Salter Communications Inc. illustrates, since it is then harder to give managers incentives to maximize value during the restructuring.