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4.3. Junk bonds (2) – legends

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Mergers and Acquisitions – The Relentless Pursuit of Synergy

Institut de physique et de technologie de Moscou

4.4 (21 notes) | 2.7K étudiants inscrits

Cours 4 de 5 dans Understanding Modern Finance Spécialisation

The area of mergers and acquisitions (M&As) is special in finance. Incredible amounts of money are employed in such transactions. Deals draw a lot of public attention and dispute. Oftentimes, stories look more like fairy tales rather than financial reality. The key idea in any M&A transaction is to create value through a potentially synergetic activity. To this end, it is important to have a clear motive and implementation plan. Of special importance are the correct valuation, proper financing, and actual deal completion. But this is not the end – value mostly accrues from the post-merger integration. The understanding of the motives of various stakeholders is instrumental in the analysis of the potential creation of value. The learners will gain insight into the core value creating M&A strategies. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. Finally, the Course is very helpful in successful completion of the Specialization’s Final Project.

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4.4 (21 notes)

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M&A Financing. LBOs and MBOs

In Week 4 we study M&A financing. Motives, theories, and deal mechanics are fine – but where’s the money? If a transaction is friendly, a stock payment is likely to help. But what if there’s a conflict? Then a lot of cash is needed, and a lot of debt must be issued. One way is issuing junk bonds. We discuss both facts and myths about junk bonds. Then we consider LBO and MBO transactions. First, we analyze how a company may be taken private through heavy borrowing and further gradual debt repayment. We illustrate the mechanics of an LBO/MBO transaction on a detailed example. Finally, comments on a famous LBO case – RJR Nabisco – are provided.

4.1. M&A financing an overview11:09

4.2. Junk bonds (1) – facts12:11

4.3. Junk bonds (2) – legends11:14

4.4. Joint venture as a form of a merger7:42

4.5. LBOs and MBOs (1) – a way of financing11:04

4.6. LBOs and MBOs (2) – an example22:33

4.7. An example of an LBO – the RJR Nabisco case (1988)10:46

Enseigné par

Konstantin Kontor
Director and Professor of Finance and Strategy

Transcription

Now, let's say a few words about legends that surround junk bonds.

So, I'll put it like this.

Well, I'm not going to be comprehensive.

It's unrealistic when you talk about myths and legends but

certain things of that are oftentimes misunderstood.

We will specifically emphasize and we'll try to understand here.

I will start with the thing that is sort of

not a complete legend that we talked about at the very end of the previous episode

and that will put that like

junk bonds are super risky.

Well, we said that not quite because empirical studies have shown that

their actual performance proved to be better than was

expected by the yields that the investors were requiring.

And then we said that the other side of the coin is that when

you push hard and when you tell everyone that junk bonds are not super risky,

that is actually almost a free lunch.

And if you're successful in this pushing,

then a lot of people start to buy these junk bonds both

at their issuance and then later on in the market,

and as a result,

the whole idea that junk bonds are risky starts to be sort of let's say blurred.

So, this is a fact.

This is somewhat a legend.

But now, this whole idea led to something that can

be nicely and solidly labeled as a legend here.

Now one more thing here that I would like to point out is,

we said like not quite but let's put it here.

And then one more thing,

when there was explosive growth in these junk bonds,

remember when I talked about fallen angels,

I said that when a bond is issued that it's not junk.

It takes time, sometimes a lot of time,

to reach the point at which the bond does become

risky by the same token where they have a lot of

issues when you do not have

any defaults because defaults are likely to occur in the future.

So, there is some let's say grace period, triple quoted,

in which people enjoy the nice behavior of these bonds and those who happen to buy them.

At really high yields,

they can enjoy significant returns because if the bond performs nicely,

then there are lot more people who would like to buy it.

And therefore, if price goes up and the yield goes

down then the ones who stepped in first,

they can easily sell at a profit.

But now, the next thing that is like I

said can be better qualified as a legend is the following.

It says that the junk bonds were

the main source of

M&A Financing in the 80s.

Because this period of time, the 80s,

it's all associated with that,

we have junk bonds, we have Drexel,

we have Milken, and we have Leveraged Buyouts,

we have Management Buyouts,

we have Going Private and stuff like this.

We will talk about the last couple of things later this week.

But this was not true.

Remember, I said a few words and facts that there was the overall economic setup that

fostered competition that promised high returns and so on and so forth.

Now here, what actually happened was that the junk bonds,

they were on the surface of that.

Their overall contribution to the value of the M&A market was less than 10 percent.

And oftentimes, when people talk about the 80's and about these wealthiest times,

they all said, well, that was the age of junk bonds.

So, that's a classic legend.

So, indeed, junk bonds were seen they probably attracted the most attention.

They later with the most coverage but there were other sources of financing namely,

borrowing in privately first of all and sometimes

even in other instruments that have higher grades.

Now let's proceed with that.

Now the next thing that sometimes is seen to be the outgrowth of the previous legend is

that junk bonds caused

the M&A boom of the 1980's.

Well we already know that in terms of volume,

it was less than eight percent of the total value.

So, it is unlikely to have caused that.

Some people say well this was a catalyst.

Maybe, but if we compare that with the previous M&A boom of

the 60's well nothing of that kind

existed and that by no means prevented this boom from happening.

So, there were other ways to finance these mergers.

And the other thing,

which I believe is kind of important is that people say well this

was the overall idea of high risk here well that was.

But the likely result of all that was that this is a classic hen and egg story.

It's more likely that it was the other way round.

So, actually the M&A boom

led to the establishment

and growth of junk bonds.

Well because there are lot of transactions that were financed with private debt

they were not on the front pages of magazines and newspapers and on TV shows.

So that was like this.

And now, one more thing that is sort of also linked to that but I believe that

this is a legend too is that junk bonds

grew fastest of debt.

Well, this is wrong.

Let me give you some numbers and they are more detailed,

no handouts that if we take over the period of 1979 to 89, so this decade,

then at this time, the junk bonds,

they went up by about $190 billion.

Over the same period of time,

corporate debt went up

by so much 1.3 trillion.

So, it was about 15 percent less than that.

Not only that, we can say that around the same period of

time investment grade went up by 100 percent,

now loans by 150 percent

and then commercial paper more than quadrupled.

So, you can see that actually the situation was such that maybe it was

the overall growth of corporate debt that pushed

the junk bond market exactly as was the case in our analysis of legendary.

So, here I understand that when we sort of analyze these statements and we'll

label them legends and then say well this was not quite as a lot of people think it was.

Now, when you are sort of removing the veil of

this legend this is maybe not no more such a romantic thing and it's not so

nice but it really saves us

from seeing certain important stages

in the development of capital markets in the wrong way.

And that in itself is very much important.

Now here, I am sort of wrapping up

the discussion of these junk bonds because this is sort

of a more or less well not journalistic,

it's the discussion that is strict to the point.

But we are moving forward in our analysis of other forms of

financing of that played the key role in some major M&A transactions.

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