WHEN WILL WE EVER LEARN?

10/5/09

This morning’s (i.e., Monday, 10/5/19’s) Wall Street Journal reports on the increasing trend of corporations’ borrowing not to invest in operations, or even to buy other companies, but, rather, to pay dividends, often special (i.e., one time, and usually very large) dividends, to shareholders. Such leveraging up to reward the shareholders was quite the rage in the past, especially for companies whose shareholders were private equity firms who, of course, were interested primarily in restoring the “competitiveness” of, and rooting out the waste in, the companies they acquired. Financial engineering, we were assured, was a mere afterthought, if it entered into the thought processes of the private equity wunderkinds at all. The Journal article cited the case of Dex Media, which borrowed heavily to pay a special dividends to its private equity owners, including Thomas H. Lee Partners, Bain Capital, and the Blackstone Group (which recently announced plans to purchase SeaWorld—Orca meat, anyone?). Dex later filed bankruptcy because it could not service the debt it took on to pay these groups that did so much to enhance its competitiveness and keep management on its toes. Lee, Bain, and Blackstone kept the money.

In illustrating this atavistic trend toward stiffing bondholders to pay shareholders The Journal cited the case of TransDigm Group, Inc.’s decision to borrow $425mm to pay a $360mm special dividend to shareholders, increasing debt from 3.1 times EBIT (earnings before interest and taxes) to 4.3 times EBIT. The new debt will get a rating of B3, pretty close to the bottom rungs of the junk ladder. Good luck with that, TransDigm.

While all this might seem appalling, even to those like yours truly, who a long time ago made his living in the junk bond market, it is a natural response to public policy. The Bush/Obama administration, along with its flunky at the Fed, Obsequious Ben Bernanke, decided that the proper response to a crisis that arose from too much borrowing was to make it easier to borrow. The Fed drove interest rates on super safe short term treasuries to record lows. As the economy recovered, spreads tightened, allowing corporations relatively easy access to cheap money. The companies, faced with such cheap money, made a perfectly rational decision to lever up their balance sheets. So such leveraging makes sense from a micro standpoint, especially when, as is the case, the shareholders get to keep their dividends even if the company winds up getting crushed by the debt it took on to pay those dividends.

From a macro standpoint, however, the trend toward further corporate leverage for purely financial reasons, if it continues, will be disastrous. With the government borrowing record amounts of money, even if the current trend towards greater savings by households proves more than an evanescent fluke (It won’t.), the last thing we need is more borrowing in the corporate sector.