Academic journal article Federal Reserve Bulletin

Recent Developments in Corporate Finance

Academic journal article Federal Reserve Bulletin

Recent Developments in Corporate Finance

Article excerpt

Recent Developments in Corporate Finance

Recent years have seen dramatic changes in the financial structure of U.S. nonfinancial corporations, in corporate securities markets, and in corporate financing techniques. Many of these changes have been associated with the wave of mergers, acquisitions, and other corporate restructurings during the last half of the 1980s. In particular, the outstanding debt of the nonfinancial corporate sector soared as corporations borrowed heavily to finance retirements of equity resulting from restructuring activity. Furthermore, a substantial portion of this step-up in borrowing involved low-grade debt. At the same time, investors became more receptive to these bonds, responding to the promise of attractive yields and recognizing the opportunities for diversification of their portfolios. This shift not only provided funds for mergers and restructurings, but also enabled more firms that were less well-known to tap public debt markets.

With the repayment of the debt from many mergers hinging on subsequent sales of assets, acquirers turned to new sources of temporary financing from commercial and investment banks and made innovative use of bonds with deferred interest payments and variable coupon rates. Because bondholders were dissatisfied with losses occasioned by downgradings in the wake of unanticipated restructurings, many corporations included protection against this special risk in their new bond issues to reduce borrowing costs.

With the rise in debt, many measures of corporate financial condition deteriorated: Interest expenses claimed a significantly higher share of corporate cash flow; downgradings of debt accelerated; and bond default rates, while still relatively low, began to climb. In contrast, debt-equity ratios based on market values increased very little, as higher stock prices offset much of the growth in corporate indebtedness. Nonetheless, the nonfinancial corporate sector appears, on balance, to be more exposed to potential financial problems than it was in 1984. In this environment, banks and other investors have become more cautious in extending credit to finance highly leveraged mergers and acquisitions, a shift that has contributed to an increase in the use of equity financing and to a slowing in merger activity.

While the changes associated with the restructurings captured the public's attention, significant developments were occurring elsewhere during the last half of the decade. The differences between debt and equity as sources of funds to finance corporate activity narrowed significantly with the expansion in the use of financial instruments having features of both. Interest rate swaps and other methods for hedging interest rate risk also blurred the traditional distinction between short-term and long-term debt. Nonfinancial corporations relied more heavily on bonds, commercial paper, and loans from foreign banks for new funding and less on credit extended by domestic banks. For investment-grade nonfinancial corporations, medium-term notes became a growing source of funds. Issuance of privately placed debt was robust over the last half of the 1980s, despite growth in the public junk bond market, which many believed might supplant the private market. Moreover, in a recent ruling the Securities and Exchange Commission removed restrictions on secondary trading of private placements by larger institutional investors. The ruling likely will spur continued growth in the private market fed by increases in the participation by foreign issuers and, perhaps, by domestic issuers drawn from the public market.

Restructurings and Corporate Financial Developments

Merger and acquisition activity, which was instrumental in shaping corporate financial patterns, was strong throughout the decade (chart 1). The number of transactions rose moderately through 1983 and then accelerated between 1984 and 1986. Although the number fell over the remainder of the decade, it remained high by past standards. …

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