A Financial Perspective on Mergers and Acquisitions

The warrant hard silver fertilize possible action of coups A fiscal Perspective on nuclear fusion reactions and Acquisitions and the preservation Michael C. Jensen Harvard business sector School emailprotected edu Michael C. Jensen, 1987 The Merger bankrupt, Proceedings of a comp some(a)(prenominal) sponsored by Federal commutation depose of Boston, Oct. 1987, pp. 102-143 This document is in germinate(predicate) on the Social Science Research Net endure (SSRN) Electronic Library at http//papers. ssrn. com/ABSTRACT=350422 The Free Cash diminish Theory of coups A m wholenesstary Perspective on Mergers and Acquisitions and the Economy Michael C.Jensen* Harvard Business School emailprotected edu From, The Merger Boom, Proceedings of a Conference sponsored by Federal Reserve Bank of Boston, Oct. 1987, pp. 102-143 Economic analysis and enjoin indicate the grocery for integ placed aver is benefiting sh arholders, society, and the structured salmagundi of organi zation. The encourage of proceedings in this market ran at a record rate of close to $180 billion per twelvemonth in 1985 and 198647 shargon higher up the 1981 record of $122 billion.The effect of effectual proceeding with purchase wrongs exceeding iodine billion dollars was 27 of 3300 deals in 1986 and 36 of 3000 deals in 1985 (Grimm, 1985). thither were only seven billion-dollar plus deals in constitutional, introductory to 1980. In addition to these commitschs, mergers, and leveraged barter forouts, t present were numerous corporate restructurings involving divestitures, spinoffs, and double job redemptions for hard currency in and debt. The gains to shargonholders from these minutes hand both in all oer been huge.The gains to selling- trus twainrthy mete outholders from mergers and encyclopaedism activity in the circumstanceinus 1977-86 essential $346 billion (in 1986 dollars). 1 The gains to buying- libertine shargonholders argon harder Estimated from data in Grimm (1986). Grimm issues tot up dollar time sets for altogether merger and acquisition deals for which in that respect ar publicly announced hurts amounting to at to the lowest degree $500,000 or 10 pctage of the family and in which at least one of the households was a U. S. comp whatever. Grimm withal counts in its numerical fulls deals with no publicly announced determines that it believes satisfy these criteria.I richesy person assumed that the deals with no announced footings were on fairish equal to 20 percent of the size of the announced legal proceeding and carried the like norm premium. *prof of Business Administration, Harvard Business School, and Professor of Finance and Business Administration, University of Rochester. The author is satisfying for the research assistance of Michael Stevenson and the helpful comments by Sidney Davidson, Harry DeAngelo, Jay Light, Robert Kaplan, Nancy Macmillan, Kevin Murphy, Susan Rose-Ackerman, Rich ard Ruback, Wolf Weinhold, Toni Wolcott, and specially Armen Alchian.This research is swe atomic number 18d in part by the Division of Research, Harvard Business School, and the Managerial Economics Research Center, University of Rochester. The analysis here(predicate) draws heavily on that in Jensen (forthcoming 1988). 1 M. C. Jensen 2 1987 to estimate, and to my k at one timeledge no one has finished with(p) so yet, besides I estimate that they would add at least a nonher $50 billion to the tote up. These gains, to put them in perspective, equal 31 percent of the total inter trade dividends ( prised in 1986 dollars) gainful to investors by the inbuilt corporate sector in the olden decade. integrated conquer transactions and the restructurings that practi labely accompany them earth-closet be wrenching events in the lives of those connect to the involved organizations the reignrs, employees, suppliers, customers and residents of surrounding communities. Restructur ings usually involve study organizational convert ( much(prenominal) as shifts in corporate strategy) to meet refreshful-fangled competition or market conditions, attach engagement of goods and go of debt, and a flurry of recontracting with managers, employees, suppliers and customers.This activity whatsoevermultiplication results in expansion of resources devoted to certain aras and at former(a) times in contractions involving plant closings, layoffs of top- direct and middle managers and of staff and production workers, and editd requital. transpose collectable to corporate restructuring requires people and communities associated with the organization to adjust the ways they live, work and do business. It is non surprising, therefore, that this adjustment egress a leaks affray and that those who stand to lose be demanding that something be done to stop the dish out.At the same time, sh atomic number 18holders in restructured corporations atomic number 18 hard-hitting winners in late(a) historic period restructurings harbor generated average increases in total market value of approximately 50 percent. Those threatened by the changes groom out that corporate restructuring is damaging the U. S. economy, that this activity damages the morale and productivity of organizations and pressures executives to manage for the short term. Further, they hold that the value that restructuring creates does non come from increase competency and productivity quite, the gains come from lower assess bements, broken contracts withTotal dividend concedements by the corporate sector, unadjusted for inflation, argon wedded in Weston and Copeland (1986, p. 649). I ex be givened these estimates to 1986. 2 M. C. Jensen 3 1987 managers, employees and another(prenominal)s, and mistakes in valuation by in efficient detonator markets. Since the benefits are illusory and the be are real, they present, putsch activity should be restricted. The cont roersy has been accompanied by salubrious pressure on regulators and legislatures to enact restrictions to ensure activity in the market for corporate simplicity.Dozens of congressional bills in the ult several years confound proposed sweet restrictions on coups, plainly as of August 1987, no(prenominal) had passed. The Business Round prorogue, composed of the chief executive officers of the cc massivest corporations in the country, has pushed hard for restrictive legislation. Within the past several years the legislatures of New York, New Jersey, Maryland, Pennsylvania, Connecticut, Illinois, Kentucky, Michigan, Ohio, Indiana, Minnesota and Massachusetts postulate passed anti coup detat laws.The Federal Reserve Board implemented new restrictions in early 1986 on the use of debt in certain coup detats. In all the controversy over takeover activity, it is often forgotten that only 40 (an all-time record) of the 3,300 takeover transactions in 1986 were incompatible feede r covers. There were 110 voluntary or negotiated tender offers (unopposed by management) and the remaining 3,100-plus deals were superfluityively voluntary transactions concur to by management. This candid classification, however, is misleading since many another(prenominal) of the voluntary transactions would not fork out occurred absent the threat of inappropriate takeover.A major(ip) contend for the ongoing outcry is that in recent years mere size unaccompanied has disappeared as an useful takeover deterrent, and the managers of many of our humongousst and least efficient corporations now find their jobs threatened by disciplinary forces in the swell markets. by dint of dozens of studies, economists have accumulated considerable inference and knowledge on the set up of the takeover market. Most of the earlier work is well summarized elsewhere (Jensen and Ruback (1983) Jensen (1984) Jarrell, Brickley and M. C.Jensen 4 1987 Netter (1988)). Here, I focus on catame nia rate aspects of the controversy. In brief, the foregoing work tells us the following Takeovers benefit copeholders of target companies. Premiums in hostile offers historically exceed 30 percent on average, and in recent times have averaged roughly 50 percent. Acquiring- soused shareholders on average illuminate about 4 percent in hostile takeovers and roughly zip fastener in mergers, although these returns seem to have dec forced from past levels. Takeovers do not mishandle credit or resources.Instead, they generate square gains historically, 8 percent of the total value of some(prenominal) companies. Actions by managers that eliminate or prevent offers or mergers are nearly suspect as harmful to shareholders. Golden parachutes for top-level managers do not, on average, harm shareholders. The activities of takeover specialists (such as Icahn, Posner, Steinberg, and Pickens) benefit shareholders on average. Merger and acquisition activity has not increased industr ial concentration.Over 1200 divestitures valued at $59. 9 billion occurred in 1986, overly a record level (Grimm, 1986). Takeover gains do not come from the creation of monopoly top executive. Although measurement problems make it difficult to estimate the returns to bidders as precisely as the returns to targets,3 it appears the bargaining index finger of target managers, coupled with competition among potential acquirers, grants a large share of the acquisition benefits to selling shareholders. In addition, federal and state regulation of 3See Jensen and Ruback (1983, pp. 18ff). M. C. Jensen 5 1987 tender offers appears to have strengthened the hand of target unfalterings premiums authoritative by target-firm shareholders increased really after introduction of such regulation. 4 some(a) have argued that the gains to shareholders come from wealth reallocations from other parties and not from real increases in efficiency. jog (1986) argues the gains to target firm shareholde rs come from acquiring firm shareholders, save the data are not consonant with this possibility.While the secern on the returns to tender firms is mixed, it does not indicate they systematically suffer losses prior to 1980 shareholders of program line firms earned on average about zero back breaker in mergers, which tend to be voluntary, and about 4 percent of their honor value in tender offers, which more(prenominal) than often are hostile Jensen and Ruback (1983). These differences in returns are associated with the form of payment rather than the form of the offer tender offers tend to be for gold and mergers tend to be for transmit (Huang and Walkling, 1987).Some argue that connectholders in acquired firms systematically suffer losses as substantial amounts of debt are added to the uppercase structure. Asquith and Kim (1982) do not find this, nor do Dennis and McConnell (1986). The Dennis and McConnell study of 90 matched acquiring and acquired firms in mergers in the period 1962-80 leavens that the values of wedges, prefer caudex and other senior securities, as well as the vulgar declivity prices of two firms, increase around the merger promulgation. Changes in the value of senior securities are not captured in measures of changes in the value of special Kality carry prices summarized previously.Taking the changes in the value of senior securities into account, Dennis and McConnell find the average change in total dollar value is tyrannical for both bidders and target firms. Shleiffer and Summers (1987) argue that some of the benefits earned by target and bidding firm shareholders come from the revocation of explicit and implicit longterm contracts with employees. They point to extremely visible recent vitrines in the air duct See Jarrell and Bradley (1980), Nathan and OKeefe (1986), however, provide examine that this effect occurred in 1974, several years after the major legislation. M. C. Jensen 6 1987 manu itemuring, where mergers have been shit and wages have been cut in the wake of deregulation. But given deregulation and openhanded entry by low-cost competitors, the cuts in airline industry wages were inevitable and would have been executeed in loser proceedings if not in negotiations and takeover-related c set ups. Medoff and Brown (1988) study this issue apply data from Michigan. They find that both employment and wages are lavishlyer, not lower, after acquisition than would otherwise be anticipate however, their experiment consists generally of combinations of small firms.The Market for Corporate Control The market for corporate restraint is best viewed as a major component of the managerial p utilizationtariat market. It is the arena in which alternative management teams compete for the rights to manage corporate resources (Jensen and Ruback, 1983). Understanding this point is crucial to understanding much of the rhetoric about the personal make of hostile takeovers. Takeover s generally occur because changing technology or market conditions require a major restructuring of corporate assets (although in some cases, takeovers occur because incumbent managers are incompetent).Such changes preempt require abandonment of major projects, relocation of facilities, changes in managerial assignments, and closure or deals agreements events agreement of facilities or divisions. Managers often have trouble abandoning strategies they have spent years contrive and implementing, even when those strategies no longer contri scarcelye to the organizations survival, and it is easier for new top-level managers with no ties to current employees or communities to make changes. Moreover, normal organizational opponent to change ordinarily is lower early in the reign of new top-level managers.When the internal processes for change in large corporations are too diminution, costly, and left-handed to bring about the required restructuring or change in managers efficie ntly, the capital markets do so by the M. C. Jensen 7 1987 market for corporate control. Thus, the capital markets have been responsible for substantial changes in corporate strategy. Causes of Current Takeover Activity A variety of political and economic conditions in the mid-eighties have created a climate where economic efficiency requires a major restructuring of corporate assets.These divisors include The relaxation of restrictions on mergers imposed by the antitrust laws. The withdrawal of resources from industries that are growing more vaguely or that essentialiness shrink. Deregulation in the markets for financial ser transgressions, oil and gas, transportation, and broadcasting, bringing about a major restructuring of those industries. Improvements in takeover technology, including more and increasingly sophisticated legal and financial advisers, and innovations in financial support technology (for example, the comic divest financing commonly used in leverag ed buyouts and the schoolmaster issuance of high-yield non-investment-grade adherences). apiece of these factors has contri moreovered to the increase in total takeover and reorganisation activity. Moreover, the first three factors (antitrust relaxation, exit, and deregulation) are generally consistent with data showing the intensity of takeover activity by industry. add-in 1 indicates that acquisition activity in the period 1981-84 was highest in the oil and gas industry, followed by banking and pay, insurance, food processing, and mining and minerals. For comparison purposes, the table alike presents data on industry value measured as a percentage of the total value of all firms.All but two of the industries, sell trade and transportation, represent a larger fraction of total takeover activity than their representation in the economy as a whole, indicating that the takeover market is concentrated in particular industries, not spread equally finishedout the corporate sect or. M. C. Jensen 8 1987 Table 1 Intensity of Takeover Activity, by Industry, 1981-84 Percent Percent of Total of Total Takeover Corporate Industry Classification of Seller Market observeb Activitya Oil and Gas 26. 13. 5 Banking and Finance 8. 8 6. 4 Insurance 5. 9 2. 9 regimen Processing 4. 6 4. 4 Mining and Minerals Conglomerate Retail quite a s push asidet(p) Transportation Leisure and Entertainment Broadcasting Other a 4. 4 4. 4 3. 6 2. 4 2. 3 2. 3 39. 4 1. 5 3. 2 5. 2 2. 7 . 9 . 7 58. 5 Value of merger and acquisition transactions in the industry as a percentage of total takeover transactions for which valuation data are publicly reported. Source W. T Grimm, Mergerstat Review (1984, p. 41). bIndustry value as a percentage of the value of all firms, as of 12/31/84 Total value is measured as the sum of the market value of common rectitude for 4,305 companies, including 1,501 companies on the New York Stock Exchange, 724 companies on the American Stock Exchange, plus 2,080 com panies in the over-the-counter market. Source The Media General Financial Weekly, (December 31, 1984, p 17) Many sectors of the U. S. economy have been experiencing slower increase and, in some cases, even retrenchment. This phenomenon has many causes, including substantially increased foreign competition.The slow growth has meant increased takeover activity because takeovers consort an beta role in facilitating exit from an industry or activity. Changes in energy markets, for example, have required radical restructuring and retrenchment in that industry, and takeovers have childs played an of the essence(p) role in accomplishing these changes oil and gas rank first in takeover activity, with twice their proportionate share of total activity. Managers who are slow to adjust to the new energy environment and slow to recognize that many old practices and strategies are no longer viable find that takeovers M. C.Jensen 9 1987 are doing the job for them. In an industry saddled with overcapacity, exit is cheaper to accomplish through merger and the narrately liquidation of peripheral assets of the combined firms than by disorderly, expensive nonstarter. The end of the competitive struggle in such an industry often comes in the bankruptcy courts, with the unnecessary destruction of valuable split of organizations that could be used productively by others. Similarly, deregulation of the financial services market is consistent with the number 2 rank of banking and finance and the number 3 rank of insurance in table 1.Deregulation has also been important in the transportation and broadcasting industries. Mining and minerals has been reconcile to many of the same forces impinging on the energy industry including the changes in the value of the dollar. The ontogeny of innovative financing vehicles, such as high yield noninvestment-grade joins (junk bonds), has remove size as a significant impediment to competition in the market for corporate control. Investm ent grade and high-yield debt issues combined were associated with 9. percent of all tender offer financing from January 1981 through September 1986 (Drexel Burnham Lambert, undated). Even though not yet widely used in takeovers, these new financing techniques have had important cause because they permit small firms to let resources for acquisition of much larger firms by issuing claims on the value of the punt (that is, the target firms assets) just as in any other corporate investment activity. Divestitures If assets are to move to their most highly valued use, acquirers essential be able to sell off assets to those who can use them more productively.Therefore, divestitures are a critical element in the constituenting of the corporate control market and it is important to avoid inhibiting them. Indeed, over 1200 divestitures occurred in 1986, a record level (Mergerstat Review (1986)). This is one reason merger and acquisition activity has not increased industrial concentratio n. M. C. Jensen 10 1987 Divested plants and assets do not disappear they are reallocated. sometimes they continue to be used in quasi(prenominal) ways in the same industry, and in other cases they are used in very unlike ways and in different industries.But in both cases they are moving to uses that their new owners believe are more productive. Finally, the takeover and divestiture market provides a secluded market constraint against bigness for its own sake. The potential gains available to those who decently perceive that a firm can be purchased for less(prenominal) than the value realizable from the sale of its components provide inducements for entrepreneurs to search out these opportunities and to capitalize on them by reorganizing such firms into littler entities.The mere possibility of such takeovers also actuates managers to avoid putting together uneconomic conglomerates and to break up active ones. This is now happening. Recently many firms defenses against takeovers appear to have led to actions similar to those proposed by the potential acquirers. Examples are the reorganizations occurring in the oil and forest products industries, the sale of crown jewels, and divestitures brought on by the desire to liquidate large debts incurred to buy back inception or make other payments to gun birthholders.The basic economic sense of these transactions is often lost in a besmirch of emotional rhetoric and controversy. Managerial Myopia versus Market Myopia It has been argued that, outlying(prenominal) from pushing managers to undertake needed structural changes, growing institutional equity holdings and the fear of takeover cause managers to behave shortally and therefore to sacrifice long benefits to increase short-term profits.The subscriber lines tend to confuse two separate issues 1) whether managers are shortsighted and make decisions that undervalue coming(prenominal) notes executes while overvaluing current hard currency tends ( unret entive managers) and 2) whether pledge markets are shortsighted and undervalue coming(prenominal) money proceeds while overvaluing near-term funds lights ( nearsighted markets). M. C. Jensen 11 1987 There is little formal evidence on the myopic managers issue, but I believe this phenomenon does occur.Sometimes it occurs when managers hold little stock in their companies and are compensated in ways that motivate them to take actions to increase accounting compensation rather than the value of the firm. It also occurs when managers make mistakes because they do not understand the forces that determine stock values. There is much evidence inconsistent with the myopic markets view and no evidence that indicates it is true (1) The mere fact that price-earnings ratios differ widely among securities indicates the market is valuing something other than current earnings. For example, it values growth as well.Indeed, the essence of a growth stock is that it has large investment project s yielding few short term notes fluxs but high afterlife earnings and interchange leads. The proceed marketability of new issues for start-up companies with little record of current earnings, the Genentechs of the world, is also inconsistent with the tactual sensation that the market does not value future earnings. (2) McConnell and Muscarella (1985) provide evidence that (except in the oil industry) stock prices respond officially to resolves of increased investment expenditures and prejudiciously to reduced expenditures.Their evidence is also, inconsistent with the notion that the equity market is myopic, since it indicates that the market values spending current resources on projects that bargain returns in the future. (3) The huge evidence on efficient markets, indicating that current stock prices appropriately incorporate all currently available public information, is also inconsistent with the myopic markets hypothesis. Although the evidence is not literally 100 pe rcent in support of the efficient market hypothesis, no proposition in any of the fond sciences is better documented. 5For an introduction to the literature and empirical evidence on the possibility of efficient markets, see Elton and Gruber (1984, Chapter 15, p. 375ff), and the 167 studies referenced in the bibliography. For some anomalous evidence on market efficiency, see Jensen (1978). For recent criticisms of the efficient market hypothesis see Shiller (1981a 1981b), Marsh and Merton (1983 1986) demonstrate that the Shiller 5 M. C. Jensen 12 1987 (4) Recent versions of the myopic markets hypothesis emphasize increases in the amount of institutional holdings and the pressure finances managers face to generate high quarterly returns.It is argued that these pressures on institutions are a major cause of pressures on corporations to generate high current quarterly earnings. The institutional pressures are said to lead to increased takeovers of firms, because institutions are not loyal shareholders, and to decreased research and development (R&D) expenditures. It is hypothesized that because R&D expenditures reduce current earnings, firms fashioning them are more presumable to be interpreted over, and that reductions in R&D are leading to a cardinal weakening of the corporate sector of the economy.A study of 324 firms by the Office of the political boss Economist of the SEC (1985a) finds substantial evidence that is inconsistent with this version of the myopic markets argument. The evidence indicates the following Increased institutional stock holdings are not associated with increased takeovers of firms. Increased institutional holdings are not associated with decreases in R&D expenditures. substantials with high R&D expenditures are not more vulnerable to takeovers. Stock prices respond positively to announcements of increases in R&D expenditures.Moreover, total spending on R&D is increasing synchronous with the wave of merger and acquisition act ivity. Total spending on R&D in 1984, a year of record acquisition activity, increased by 14 percent according to Business Weeks annual mess. This represented the biggest gain since R&D spending began a steady climb in tests depend critically on whether, remote to generally accepted financial supposition and evidence, the future levels of dividends follow a stationary stochastic process. Merton (1985) provides a discussion of the current state of the efficient market hypothesis and concludes (p. 0), In light of the empirical evidence on the nonstationarity issue, a pronouncement at this moment that the rational market scheme should be discarded from the economic paradigm can, at best, be draw as premature. M. C. Jensen 13 1987 the late 1970s. All industries in the perspective increased R&D spending with the exception of steel. In addition, R&D spending increased from 2 percent of sales, where it had been for five years, to 2. 9 percent. In 1985 and 1986, two more record year s for acquisition activity, R&D also set new records.R&D spending increased by 10 percent (to 3. 1 percent of sales) in 1985, and in 1986, R&D spending again increased by 10 percent to $51 billion (3. 5 percent of sales), in a year when total sales decreased by 1 percent. 6 Bronwyn Hall (1987), in a detailed study of all U. S. manufacturing firms in the years 1976-85, finds in approximately 600 acquisitions that firms that are acquired do not have higher R&D expenditures (measured by the ratio of R&D to sales) than firms in the same industry that are not acquired.Also, she finds that firms involved in mergers showed no difference in their pre- and post-merger R&D performance over those not so involved. I know of no evidence that supports the argument that takeovers reduce R&D expenditures, even though this is a heavy(a) argument among many of those who favor restrictions on takeovers. Free Cash Flow Theory More than a dozen separate forces drive takeover activity, including such f actors as deregulation, synergies, economies of scale and scope, taskes, managerial incompetence, and increasing globalization of U. S. markets. 7 One major cause of takeover activity, the gency cost associated with conflicts in the midst of managers and 6 The R&D Scoreboard is an annual survey, covering companies that account for 95 percent of total private-sector R&D expenditures. The three years referenced here can be found in R&D Scoreboard Reagan & abroad Rivalry Light a Fire Under expending, Business Week, (, July 8, 1985, p. 86 ff. ) R&D Scoreboard Now, R&D is Corporate Americas Answer to Japan Inc. , Business Week, (, June 23, 1986, p. 134 ff. ) and R&D Scoreboard Research Spending is Building Up to a Letdown, Business Week, (, June 22, 1987, p. 39 ff. ). In 1984 the survey covered 820 companies in 1985, it covered 844 companies in 1986, it covered 859 companies. 7 Roll (1988) discusses a number of these forces. M. C. Jensen 14 1987 shareholders over the payout of justi fy cash combine,8 has received copulationly little attention. Yet it has played an important role in acquisitions over the fit decade. Managers are the agents of shareholders, and because both parties are self stakesed, there are serious conflicts between them over the choice of the best corporate strategy.Agency be are the total costs that arise in such cooperative ar range of a functionments. They consist of the costs of monitoring managerial behavior (such as the costs of producing audited financial statements and devising and implementing compensation plans that reward managers for actions that increase investors wealth) and the inevitable costs that are incurred because the conflicts of pastime can never be resolved perfectly. Sometimes these costs can be large, and when they are, takeovers can reduce them.Free Cash Flow and the Conflict Between Managers and Shareholders Free cash give is cash liquefy in excess of that required to fund all of a firms projects that have p ositive net present values when discounted at the relevant cost of capital. Such relinquish cash flow must be paid out to shareholders if the firm is to be efficient and to maximise value for shareholders. Payment of cash to shareholders reduces the resources under managers control, thereby reducing managers situation and potentially subjecting them to the monitoring by the capital markets that occurs when a firm must obtain new capital.Financing projects internally avoids this monitoring and the possibility that funds go away be unavailable or available only at high explicit prices. Managers have incentives to expand their firms beyond the size that maximizes shareholder wealth. 9 Growth increases managers power by increasing the resources This discussion is based on Jensen (1986a). Gordon Donaldson (1984), in a detailed study of 12 large mountain 500 firms, concludes that managers of these firms were not driven by maximization of the value of the firm, but rather by the maxim ization of corporate wealth. He defines corporate wealth as the aggregate purchasing power available to management for strategic purposes during any given planning period. this wealth consists of 9 8 M. C. Jensen 15 1987 under their control. In addition, changes in management compensation are positively related to growth. 10 The tendency of firms to reward middle managers through promotion rather than year-to-year bonuses also creates an organizational bias toward growth to fork out the new positions that such promotion-based reward systems require (Baker, 1986).The tendency for managers to overinvest resources is limited by competition in the product and factor markets that tends to drive prices toward minimum average cost in an activity. Managers must therefore motivate their organizations to be more efficient in order to improve the probability of survival. Product and factor market disciplinary forces are often weaker in new activities, however, and in activities that involve s ubstantial economic rents or quasi-rents. 1 Activities yielding substantial economic rents or quasi-rents are the types of activities that generate large amounts of bleak cash flow. In these situations, monitoring by the firms internal control system and the market for corporate control are more important. Conflicts of amuse between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than invest it below the cost of capital or waste it through organizational inefficiencies.Myers and Majluf (1984) argue that financial flexibility (unused debt capacity and internally generated funds) is lovable when a firms managers have better information about the firm than outside investors. Their arguments assume that managers act in the best worry of shareholders. The arguments offered here suggest the stocks and flows of cash and cash equivalents ( primarily credit) that management can use at its discretion to implement decisions involving the control of goods and services (p. 3, emphasis in original). In practical harm it is cash, credit, and other corporate purchasing power by which management commands goods and services (p. 22). 10 Where growth is measured by increases in sales. See Murphy (1985). This positive relationship between compensation and sales growth does not insinuate, although it is consistent with, causality. 11 Rents are returns in excess of the opportunity cost of the permanent resources in the activity. Quasirents are returns in excess of the opportunity cost of the short-lived resources in the activity. M. C.Jensen 16 1987 that such flexibility has costs financial flexibility in the form of free cash flow (including both current free cash in the form of large cash balances, and future free cash flow reflected in unused borrowing power) provides managers with greater discretion over resources that is ofte n not used in the shareholders interests. Therefore, contrary to Myers and Majluf, the argument here implies that last the mental representation costs of free cash flow cause the value of the firm to decline with increases in financial flexibility.The theory developed here explains (1) how debt-for-stock transmutes reduce the organizational inefficiencies fostered by substantial free cash flow (2) how debt can substitute for dividends (3) why diversification programs are more likely to be associated with losses than are expansion programs in the same line of business (4) why mergers within an industry and liquidation-motivated takeovers go out generally create larger gains than cross-industry mergers (5) why the factors stimulating takeovers in such diverse businesses as broadcasting, tobacco, cable systems and oil are essentially identical and (6) why bidders and some targets tend to show affectedly good performance prior to takeover.The office staff of Debt in Motivating Orga nizational Efficiency The mode costs of debt have been widely discussed (Jensen and Meckling (1976) metalworker and Warner (1979)), but, with the exception of the work of Grossman and Hart (1980), the benefits of debt in motive managers and their organizations to be efficient have largely been ignored. Debt creation, without retention of the proceeds of the issue, enables managers in effect to bond their promise to pay out future cash flows. Thus, debt can be an effective substitute for dividends, something not generally recognized in the corporate finance literature. 12 By issuing debt in swap for stock, Literally, principal and interest payments are substitutes for dividends. Dividends and debt are not perfect substitutes, however, because interest is tax income-deductible at the corporate level and dividends are not. 12 M. C. Jensen 17 1987 anagers bond their promise to pay out future cash flows in a way that simple dividend increases do not. In doing so, they give shareholder -recipients of the debt the right to take the firm into bankruptcy court if they do not keep their promise to make the interest and principal payments. 13 Thus, debt reduces the action costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. These control effects of debt are a potential determinant of capital structure. Managers with substantial free cash flow can increase dividends or purchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or wasted.This payout leaves managers with control over the use of future free cash flows, but they can also promise to pay out future cash flows by announcing a permanent increase in the dividend. 14 Because there is no contractual obligation to make the promised dividend payments, such promises are weak. Dividends can be reduced by managers in the future with little effective recourse available to shareholders. The fact that capital markets punish d ividend cuts with large stock price reductions (Charest (1978) Aharony and Swary (1980)) can be interpreted as an equilibrium market response to the agency costs of free cash flow. Brickley, Coles and Soo Nam (1987) find that firms that on a regular basis pay extra dividends appear to have positive free cash flow. In comparison with a control group they have significantlyRozeff (1982) and Easterbrook (1984b) argue that regular dividend payments can be effective in reducing agency costs with managers by assuring that managers are forced more oftentimes to subject themselves and their policies to the discipline of the capital markets when they acquire capital. 14 Interestingly, graham and Dodd (1951, Chapters 32, 34 and 36) in their treatise, surety Analysis, place great importance on the dividend payout in their famous valuation formula V=M(D+. 33E). (See p. 454. ) V is value, M is the earnings multiplier when the dividend payout rate is a normal two-thirds of earnings, D is the evaluate dividend, and E is expected earnings.In their formula, dividends are valued at three times the rate of retained earnings, a proposition that has puzzled many students of modern finance (at least of my vintage). The agency cost of free cash flow that leads to over retention and waste of shareholder resources is consistent with the deep suspicion with which Graham and Dodd viewed the lack of payout. Their discussion (chapter 34) reflects a belief in the tenuous personality of the future benefits of such retention. Although they do not couch the issues in terms of the conflict between managers and shareholders, the free cash flow theory explicated here implies that their beliefs, sometimes characterized as a preference for a bird in the hand is worth two in the bush, were perhaps well founded. 13 M. C. Jensen 18 1987 igher cash plus short-term investments, and earnings plus depreciation, relative to their total assets. They also have significantly lower debt-to-equity ratios. The issuance of large amounts of debt to buy back stock sets up organizational incentives to motivate managers to pay out free cash flow. In addition, the turn of debt for stock helps managers get the better of the normal organizational resistance to retrenchment that the payout of free cash flow often requires. The threat of failure to make debt-service payments serves as a strong motivating force to make such organizations more efficient. Stock repurchase for debt or cash also has tax advantages.Interest payments are tax-deductible to the corporation, that part of the repurchase proceeds equal to the sellers tax basis in the stock is not taxed at all, and prior to 1987 tax rates on capital gains were favorable. Increased leverage also has costs. As leverage increases, the usual agency costs of debt, including bankruptcy costs, rise. One source of these costs is the incentive to take on projects that reduce total firm value but benefit shareholders through a transfer of wealth f rom bondholders. These costs put a limit on the desirable level of debt. The optimal debt/equity ratio is the point at which firm value is maximized, the point where the marginal costs of debt just offset the marginal benefits. The debt created in a hostile takeover (or takeover defense) of a firm suffering severe agency costs of free cash flow need not be permanent.Indeed, sometimes overleveraging such a firm is desirable. In these situations, leveraging the firm so highly that it cannot continue to exist in its old form yields benefits by providing motivation for cuts in expansion programs and the sale of divisions that are more valuable outside the firm. The proceeds are used to reduce debt to a more normal or permanent level. This process results in a complete rethinking of the organizations strategy and structure. When it is successful, a much leaner, more efficient, and competitive organization results. M. C. Jensen 19 1987 The control hypothesis does not imply that debt issue s go forth always have positive control effects.For example, these effects will not be as important for rapidly growing organizations with large and highly profitable investment projects but no free cash flow. Such organizations will have to go regularly to the financial markets to obtain capital. At these times the markets have an opportunity to evaluate the company, its management, and its proposed projects. Investment bankers and analysts play an important role in this monitoring, and the markets assessment is do evident by the price investors pay for the financial claims. The control function of debt is more important in organizations that generate large cash flows but have low growth prospects, and it is even more important in organizations that must shrink.In these organizations the pressure to waste cash flows by investing them in uneconomic projects is most serious. Evidence from Financial Transactions Free cash flow theory helps explain previously puzzling results on the effects of various financial transactions. Smith (Smith, 1986, tables 1 to 3) summarizes more than 20 studies of stock price changes at announcements of transactions that change capital structure as well as various other dividend transactions. These results and those of others are presented in table 2. For firms with positive free cash flow, the theory predicts that stock prices will increase with unprovided for(predicate) increases in payouts to shareholders and decrease with unthought-of decreases in payouts.It also predicts that unexpected increases in demand for funds from shareholders via new issues will cause stock prices to fall. The theory also predicts stock prices will increase with increasing parsimoniousness of the constraints binding the payout of future cash flow to shareholders and decrease with reductions in the slow-wittedness of these constraints. These predictions do not apply to those firms with more profitable projects than cash flow to fund them. M. C. Jens en 20 1987 The predictions of free cash flow theory are consistent with all but three of the 32 estimated abnormal stock price changes summarized in table 2, and one of the inconsistencies is explained by another phenomenon.Panel A of table 2 shows that stock prices rise by a statistically significant amount with announcements of the initiation of cash dividend payments, increases in dividends and specially designated dividends, and fall by a statistically significant amount with decreases in dividend payments. (All coefficients in table 2 are significantly different from zero unless noted with an asterisk. ) Panel B shows that auspices sales and retirements that raise cash or pay out cash and simultaneously provide offsetting changes in the constraints soldering the payout of future cash flow are all associated with returns that are insignificantly different from zero.The insignificant return on retirement of debt fits the theory because the payout of cash is offset by an equal reduction in the present value of promised future cash payouts. If debt sales are not associated with changes in the expected investment program, the insignificant return on announcement of the sale of debt and prefer also fits the theory. The acquisition of new funds with debt or favorite(a) stock is offset exactly by a inscription stick to the future payout of cash flows of equal present value. If the funds acquired through new debt or preferred issues are invested in projects with negative net present values, the abnormal stock price change will be negative. If they are invested in projects with positive net present values, the abnormal stock price change will be positive.Sales of convertible debt and preferred securities are associated with significantly negative stock price changes (panel C). These security sales raise cash and provide little effective bonding of future cash flow payments when the stock into which the debt is convertible is worth more than the face value of the debt, management has incentives to call the convertible securities and force conversion to common. M. C. Jensen 21 1987 Panel D shows that, with one exception, security retirements that pay out cash to shareholders increase stock prices. The price decline associated with targeted large block repurchases (often called greenmail) is highly likely to be collectable to the reduced probability that a takeover premium will be realized.These transactions are often associated with standstill agreements in which the seller of the stock agrees to refrain from acquiring more stock and from making a takeover offer for some period into the future (Mikkelson and Ruback (1985 1986) Dann and DeAngelo (1983) and Bradley and Wakeman (1983)). Panel E summarizes the effects of security sales and retirements that raise cash and do not bond future cash flow payments. Consistent with the theory negative abnormal returns are associated with all such changes, although the negative returns associated w ith the sale of common through a conversion-forcing call are statistically insignificant.Panel F shows that all flip offers or designated use security sales that increase the bonding of payout of future cash flows result in significantly positive increases in common stock prices. These include stock repurchases and exchange of debt or preferred for common, debt for preferred, and income bonds for preferred. The twoday gains range from 21. 9 percent (debt for common) to 1. 6 percent for income bonds and 3. 5 percent for preferred. 15 The theory predicts that transactions with no cash flow and no change in the bonding of payout of future cash flows will be associated with returns that are insignificantly different from zero. Panel G of table 2 shows that the evidence is mixed 15 The two-day returns of exchange offers and self-tenders can be affected by the offer.However, if there are no real effects or tax effects, and if all shares are tendered to a premium offer, then the stock pri ce will be unaffected by the offer and its price effects are equivalent to those of a cash dividend. Thus, when tax effects are zero and all shares are tendered, the two-day returns are appropriate measures of the real effects of the exchange. In other cases the correct returns to be used in these transactions are those covering the period from the day prior to the offer announcement to the day after the close of the offer (taking account of the cash payout). See, for example, Rosenfeld (1982), whose results for the wide period are also consistent with the theory. M. C. Jensen 22 1987 he returns associated with exchange offers of debt for debt are significantly positive and those for designated-use security sales are insignificantly different from zero. All exchanges and designated-use security sales that have no cash effects but reduce the bonding of payout of future cash flows result, on average, in significant decreases in stock prices. These transactions include the exchange of common for debt or preferred or preferred for debt, or the replacement of debt with convertible debt and are summarized in Panel H. The two-day losses range from 7. 7 percent (preferred for debt) to 1. 1 percent (common for debt). In summary, the results in table 2 are remarkably consistent with free cash flow theory hich predicts that, except for firms with profitable unfunded investment projects, stock prices will rise with unexpected increases in payouts to shareholders (or promises to do so) and will fall with reductions in payments or new requests for funds from shareholders (or reductions in promises to make future payments). Moreover, the size of the value changes seems to be positively related to the change in the tightfistedness of the commitment bonding the payment of future cash flows. For example, the effects of debtfor-preferred exchanges are smaller than the effects of debt-for-common exchanges. Tax effects can explain some of the results summarized in table 2, but n ot all.For example, the exchange of preferred for common, or replacement of debt with convertible debt, has no tax effects and yet is associated with price increases. The last column of table 2 denotes whether the individual coefficients are explainable by pure corporate tax effects. The tax theory hypothesizes that all unexpected changes in capital structure that decrease corporate taxes increase stock prices and vice versa. 16 Therefore, increases in dividends and reductions of debt interest should cause stock prices to fall, and vice versa. 17 Fourteen of the 32 coefficients are inconsistent with the corporate tax See, however, Miller (1977) who argues that allowing for personal tax effects and the equilibrium response of firms implies that no tax effects will be observed. 7 Ignoring potential tax effects receivable to the 85 percent exclusion of dividends received by corporations on holdings of preferred stock. 16 M. C. Jensen 23 1987 Table 23 sum-up of Two-Day Average Abnorma l Stock Returns Associated with the Announcement of Various Dividend and Capital anatomical structure Transactionsa Average Sample Size Average Abnormal Return (Percent) Free Cash Flow Theory Agreement with Tax Predicted Agreement Theory Sign with Theory? Type of Transaction A. Dividend changes that change the cash paid to shareholders Dividend initiation1 Dividend increase2 Specially designated dividend Dividend decrease2 3 certificate Issued security department Retired 160 281 164 48 3. 7% 1. 0 2. 1 -3. 6 + + + es yes yes yes no no no no B. Security sales (that raise cash) and retirements (that pay out cash) that simultaneously provide offsetting changes in the constraints bonding future payment of cash flows Security sale (industrial) 4 Security sale (utility) 5 Security sale (industrial) 6 Security sale (utility) Call8 7 debt debt preferred preferred none none none none none debt none none none common common common common 248 140 28 251 133 74 54 9 147 182 15 68 0. 2* -0. 1* -0. 1* -0. 1* -0. 1* -2. 1 -1. 4 -1. 6 15. 2 3. 3 1. 1 -4. 8 0 0 0 0 0 + + + + yes yes yes yes yes yes yes yes yes yes yes no b no no yes yes no no no no yes yes yes no b C.Security sales that raise cash and bond future cash flow payments only minimally Security sale (industrial) 4 conv. debt 7 Security sale (industrial) conv. preferred 7 Security sale (utility) conv. preferred D. Security retirements that pay out cash to shareholders egotism tender offer 9 Open market purchase10 Targeted small holdings11 Targeted large block repurchase12 none none none none M. C. Jensen 24 1987 E. Security sales or calls that raise cash and do not bond future cash flow payments Security sale (industrial) 13 common none Security sale (utility)14 common none Conversion-forcing call15 common conv. preferred Conversion-forcing call15 common conv. debt F.Exchange offers, or designated use security sales that increase the bonding of payout of future cash debt common Designated use security sale16 Ex change offer 17 debt common 17 Exchange offer preferred common 17 Exchange offer debt preferred Exchange offer 18 income bonds preferred G. Transaction with no change in bonding payout of future cash flows Exchange offer 19 debt 20 Designated use security sale debt debt debt 215 405 57 113 flows 45 52 10 24 18 36 96 -3. 0 -0. 6 -0. 4* -2. 1 21. 9 14. 0 8. 3 3. 5 1. 6 0. 6 0. 2* -2. 4 -2. 6 -7. 7 -4. 2 -1. 1 + + + + + 0 0 yes yes no yes yes yes yes yes yes no yes yes yes yes yes yes yes yes yes yes yes yes no yes yes no yes yes no yes yes yes H.Exchange offers, or designated use security sales that decrease the bonding of payout of future cash flows Security sale 20 conv. debt debt 15 Exchange offer 17 common preferred 23 17 Exchange offer preferred debt 9 20 Security sale common debt 12 Exchange offer 21 common debt 81 a Returns are weighted averages, by sample size, of the returns reported by the respective studies All returns are significantly different from zero unless n oted otherwise by *. b Explained by the fact that these transactions are frequently associated with the termination of an actual or expected control bid. The price decline appears to reflect the loss of an expected control premium. Source 1 Asquith and Mullins (1983). 2 Charest (1978) Aharony and Swary (1980). 3 From Brickley (1983). Dann and Mikkelson (1984) Eckbo (1986) Mikkelson and Partch (1986). 5 Eckbo (1986). 6 Linn and Pinegar (1985) Mikkelson and Partch (1986). 7 Linn and Pinegar (1985). 8 Vu (1986). 9 Dann (1981) Masulis (1980) Vermaelen (1981) Rosenfeld (1982). 10 Dann (1980) Vermaelen (1981). 11 Bradley and Wakeman (1983). 12 Calculated by Smith (1986), table 4, from Dann and DeAngelo (1983) Bradley and Wakeman (1983). 13 Asquith and Mullins (1986) Kolodny and Suhler (1985) Masulis and Korwar (Korwar and Masulis) Mikkelson and Partch (1986). 14 Asquith and Mullins (1986) Masulis and Korwar (1986) Pettway and Radcliffe (1985). 15 Mikkelson (1981). 16 Others with more than 50% debt Masulis (1980). 17 Masulis (1983).These returns include announcement days of both the original offer and, for about 40 percent of the sample, a second announcement of specific terms of the exchange 18 McConnell and Schlarbaum (1981). 19 Dietrich (1984). 20Eckbo (1986) Mikkelson and Partch (1986). 21Rogers and Owers (1985) Peavy and Scott (1985) Finnerty (1985). (Allen, 1987 Auerbach and Reishus, 1987 Biddle and Lindahl, 1982 Bradley, Desai, and Kim, 1983 Bradley and Rosensweig, 1986 rendering and Jarrell, 1986 1986 Crovitz, 1985 Easterbrook, 1984a Eckbo, 1985 1985 Fama and Jensen, 1983a, b, 1985 Franks, Harris, and Mayer, 1987 Golbe and White, 1987 Herzel, Colling, and Carlson, 1986 Holderness and Sheehan, 1985 1985 Jarrell, Poulsen, and Davidson, 1985 Jensen, 1985, 1986b Jensen and Smith, 985 Kaplan and Roll, 1972 Koleman, 1985 Lambert and Larcker, 1985 Malatesta and Walkling, 1985 Martin, 1985 Morrison, 1982 Mueller, 1980 Myers, 1977 Office of the Chief Economist, 1984, 1985b, 1986 Paulis, 1986 Ravenscraft and Scherer, 1985a, b Ricks, 1982 Ricks and Biddle, 1987 Ruback, 1988 Ryngaert, 1988 Shoven and Simon, 1987 Sunder, 1975 You et al. ) Jensen 25 1987 hypothesis. Simple signaling effects, where the payout of cash signals the lack of present and future investments promising returns in excess of the cost of capital, are also inconsistent with the results-for example, the positive stock price changes associated with dividend increases and stock repurchases. If anything, the results in table 2 seem too good, for two reasons.The returns summarized in the table do not distinguish firms that have free cash flow from those that do not have free cash flow, yet the theory says the returns to firms with no free cash flow will behave differently from those which do. In addition, only unexpected changes in cash payout or the tightness of the commitments bonding the payout of future free cash flow should affect stock prices. The studies summarized in table 2 do not, in general, control for the presence or absence of free cash flow or for the effects of expectations. If free cash flow effects are large and if firms on average are in a positive free cash flow position, the predictions of the theory will hold for the simple sample averages. To see how the agency costs of free cash flow can be large enough to show up in the uncontrolled tests summarized in table 2, consider the graph of equilibrium firm M.C. Jensen 26 1987 value and free cash flow in cipher 1. Figure 1 portrays a firm whose manager values both firm value (perhaps because stock options are part of the compensation package) and free cash flow. The manager, however, is willing to trade them off according to the given stillness curves. By definition, firm value reaches a maximum at zero free cash flow. The point (V*, F*) represents the equilibrium level of firm value and free cash flow for the manager. It occurs at a positive level of free cash flow and at a point where firm value is lower than the maximum possible. The difference Vmax V* is the agency cost of free cash flow.Because of random factors and adjustment costs, firms will warp temporarily from the optimal F*. The dashed line in pattern 1 portrays a hypothetical impertinent distribution of free cash flow in a cross section of firms under the trust that the typical firm is run by managers with preferences similar to those portrayed by the given indifference curves. Changes in free cash flow (or the tightness of constraints binding its payout) will be positively related to the value of the firm only for the minority of firms in the cross section with negative free cash flow. These are the firms lying to the left of the origin, 0. The relation is negative for all firms in the range with positive free cash flow.Given the hypothetical rectangular distribution of firms in figure 1, the majority of firms will display a negative relation between changes in free cash flow and changes in firm value . As a result the average price change associated with movements toward (V*, F*) will be negatively related to changes in free cash flow. If the effects are so pervasive that they show up strongly in the crude tests of table 2, the waste due to agency problems in the corporate sector is probably greater than most scholars have thought. This waste is one factor contributing to the high level of activity in the corporate control market over the past decade. More detailed tests of the propositions that control for growth prospects and expectations will be interesting. M. C. Jensen 27 1987Evidence from Going-Private and Leveraged Buyout Transactions Many of the benefits in going-private and leveraged buyout transactions seem to be due to the control function of debt. These transactions are creating a new organizational form that competes successfully with the open corporate form because of advantages in unconditional the agency costs of free cash flow. In 1985, going-private and levera ged buyout transactions number $37. 4 billion and represented 32 percent of the value of all public acquisitions. 18 Most studies have shown that premiums paid for publicly held firms average over 50 percent,19 but in 1985 the premiums for publicly held firms were 31 percent (Grimm, 1985). Leveraged buyouts are frequently financed with high debt 101 ratios of debt to equity are not uncommon, and they average 5. 51 (Schipper and Smith (1986) Kaplan (1987) and DeAngelo and DeAngelo (1986)). Moreover, the use of peeler financing and the allocation of equity in the deals reveal a esthesia to incentives, conflicts of interest, and bankruptcy costs. Strip financing, the practice in which investors hold risky nonequity securities in approximately equal proportions, limits the conflict of interest among such securityholders and therefore limits bankruptcy costs. Top managers and the sponsoring venture capitalists hold disproportionate amounts of equity. A somewhat oversimplified example illustrates the organizational effects of strip financing. Consider two firms identical in every respect except financing.Firm A is entirely financed with equity, and Firm B is highly leveraged with senior subordinated debt, convertible debt, and preferred as well as equity. Suppose Firm B securities are sold only in strips that is, a buyer purchasing a certain percentage of any security must purchase the same percentage of all securities, and the securities are stapled together See W. T. Grimm, Mergerstat Review (1985, Figs. 29, 34 and 38). See DeAngelo, DeAngelo and Rice (1984), Lowenstein (1985), and Schipper and Smith (1986). Lowenstein also mentions incentive effects of debt but argues tax effects play a major role in explaining the value increase. 19 18 M. C. Jensen 28 1987 o they cannot be separated later. Security holders of both firms have identical unlevered claims on the cash flow distribution, but organizationally the two firms are very different. If Firm A managers with hold dividends to invest in value-reducing projects or if they are incompetent, the shareholders must use the clumsy proxy process to change management or policies. In Firm B, strip holders have recourse to remedial powers not available to the equity holders of Firm A. Each Firm B security specifies the rights its holder has in the event of inattention on its dividend or coupon payment for example, the right to take the firm into bankruptcy or to have board representation.As each security above equity goes into inadvertence, the strip holder receives new rights to intercede in the organization. As a result, it is quicker and less expensive to replace managers in Firm B. Moreover, because every security holder in the highly leveraged Firm B has the same claim on the firm, there are no conflicts between senior and junior claimants over reorganization of the claims in the event of default to the strip holder it is a matter of moving funds from one pocket to another. Thus, Firm B will not go into bankruptcy a required reorganization can be accomplished voluntarily, quickly, and with less expense and disruption than through bankruptcy proceedings. The extreme form of strip financing in the example is not normal practice.Securities commonly subject to strip practices are often called mezzanine financing and include securities with precedence superior to common stock yet subordinate to senior debt. This exhibition seems to be sensible, because several factors ignored in our simplified example imply that strictly proportional holdings of all securities is not desirable. For example, IRS restrictions deny tax deductibility of debt interest in such situations and bank holdings of equity are restricted by regulation. Riskless senior debt need not be in the strip because there are no conflicts with other claimants in the event of reorganization when there is no probability of default on its payments. M. C. Jensen 29 1987Furthermore, it is positive to have the top-lev el managers and venture capitalists who promote leveraged buyout and going-private transactions hold a larger share of the equity. Top-level managers on average receive over 30 percent of the equity, and venture capitalists and the funds they represent generally retain the major share of the remainder (Schipper and Smith (1986) Kaplan (1987)). The venture capitalists control the board of directors and monitor the managers. two managers and venture capitalists have a strong interest in making the venture successful because their equity interests are subordinate to other claims. achiever requires (among other things) implementation of changes to avoid investment in low-return projects in order to generate the cash for debt service and to increase the value of equity.Finally, when the equity is held by a small number of people, efficiencies in risk-bearing can be achieved by placing more of the risk in