Once upon a time businesses borrowed long term money—if they borrowed at all—in order to fund plant, equipment and other long-lived productive assets. That kind of debt was self-liquidating in the sense that it usually generated a stream of income and cash flow that was sufficient to service and repay the debt, and to kick some earned surplus into the pot as well.
Today American businesses are borrowing like never before—but the only thing being liquidated is there own equity capital. That’s because trillions of debt is being issued to fund financial engineering maneuvers such as stock buybacks, M&A and LBOs, not the acquisition of productive assets that can actually fuel future output and productivity.
So it amounts to a great financial shuffle conducted entirely within the canyons of Wall Street. Financial engineering deals invariably shrink the float of outstanding stock among the corporations visiting underwriters. Likewise, they invariably leave with the mid-section of their balance sheets bloated with fixed obligations, while the bottom tier of shareholder equity has been strip-mined and hollowed out.
At the same time, none of this vast flow of capital leaves a trace on the actual operations- such as production, marketing and payrolls—of the businesses involved. Instead, prodigious sums of debt capital are being sold to yield-hungry bond managers and homegamers via mutual funds and then recycled back into windfall gains for stock market gamblers who chase momo plays and the stock price rips that usually accompany M&A, LBO or stock buyback announcements.
Needless to say, central bank financial repression is responsible for this destructive transformation of capital market function. It has made the after-tax cost of debt tantamount to free for big cap corporations—while fueling equity market bubbles that makes stock repurchases and other short-term financial engineering maneuvers irresistible to stock option obsessed inhabitants of the C-suites.
In this context, today’s WSJ saw fit to herald the $21 billion of quasi-junk bonds (BBB-) issued by Actavis PLC to fund its $66 billion acquisition of Allergen, a company which famously supplies Botox and similar life-enhancing products. Whether this mega-merger will result in any sustainable economic efficiency gains only time will tell, but the odds are not high. The overwhelming share of today’s red hot M&A deals fail to earn back the huge takeover premiums invariably paid. And, not infrequently, they are subsequently reborn as equally trumpeted corporate restructurings, spin-offs and other “value unlocking†maneuvers a few years down the road. It’s Wall Street’s version of “you stab ‘em and we slab -emâ€.
Yet there can be no doubt that funding the Allergan deal with $21 billion of freshly minted debt did accomplish the actual purpose of the financial engineering maneuver in question. Namely, it enabled Actavis to pay a bountiful 40% premium to the selling shareholders without diluting its own shares.
And why not? The after-tax cost of the new debt will amount to a miniscule 2.4%. Consequently, the C-suite at Actavis acquired what amounts to a quasi-free option on the spread-sheet merger synergies and economies of scale postulated for the deal by Wall Street and its in-house financial engineers.
If these projected profits do not materialize or, as in the more usual case, if they are off-set with diseconomies of scale or operational and commercial dysfunction, the carry cost of the acquired assets will be negligible until they can be disposed in a “restructuring†event. No wonder CNBC celebrates Merger Monday and gets giddy when CEOs purportedly exhibit “confidence†in the future by launching new M&A deals.
