Why Debt Can Hurt Corporate Growth

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. “Becoming more leveraged was good, on average, but by doing so these companies were actually hurting their value.”

The study's findings resonated with at least one chief financial officer, Carey White of Savi Inc. in Sunnyvale, California. Savi management bought the company from Raytheon Company in 1999 and has been working with low cash levels, forcing the company's managers to make tough decisions about investments.

“The conclusions of the study are valid. I would think that is exactly the behavior of a company that is strapped for cash,” said White. “First, you cut to the bone and then you cut development projects that have long-term payoffs. When you are less cash-constrained, you have greater ability to look at substantial investments in infrastructure and long-term projects that can really change the market.”

Then why do so many companies assume so much debt?

“Our conjecture is that the motivation behind these transactions is an external takeover threat,” said Peyer. “In the transactions that we looked at, more than 85% were preceded by a threat to take over the company, so we think management recapitalizes to retain control. And in some of these transactions, it has taken on too much debt in order to defeat the takeover bid.”

The researchers conclude that the high stakes of a high-debt environment are a double-edged sword. Although this milieu forces managers to be disciplined, it also incites enough fear to induce them to manage for cash flow at all costs. Spurred by numerous considerations — including self-interest (their career advancement, pensions, equity investments) — they are willing to sacrifice opportunities with the highest net present values for projects that maximize short-term cash flow.

“Theoretically, focusing on high cash flows is something good,” said Peyer, “but in this case, it turns out that managers are more concerned about keeping their jobs and their companies afloat.”