Debt For Equity

By Daniel Indiviglio

The Wall Street has an interesting article today indicating that firms are increasingly issuing unsecured debt for questionable purposes. The most controversial: to issue special dividends to shareholders. Not all debt issuance is bad; some is very strategically important. But issuing more debt to pay your equity investors isn't usually advisable, particularly at a time like this.

Here's Liz Rappaport, author of the WSJ piece, elaborating:

The nascent trend is controversial because corporate borrowers are sinking themselves deeper into debt to pay out special dividends, buy back stock or finance acquisitions. While such moves were all the rage during the credit boom, most corporate-bond offerings during the recession have been used to reduce debt or stockpile cash.



The last sentence there is key. During a recession, if you can suddenly cash in on cheaper debt and retire older, more expensive debt, then that's a great move. Similarly, if you want to develop a cash cushion, in fear of a renewed credit crunch or future market turmoil, then that probably isn't a bad idea either.

As for the earlier reasons, their reasonableness varies. If there's a truly worthwhile acquisition opportunity, then with company valuations as low as there are, issuing some cheap debt to facilitate it might be sensible. Buying back stock and issuing dividends? That doesn't seem as bright.

Here's an example from the WSJ article:

Last week's sale of $425 million of bonds by aircraft-parts manufacturer TransDigm Group Inc. is one of the back-to-the-past corporate-bond deals causing concern among some analysts. More than $360 million of the proceeds will be used to pay a special cash dividend to shareholders and management of the Cleveland company.


The added debt increased TransDigm's borrowings to 4.3 times its earnings before interest and taxes, compared with 3.1 times before last week's deal. The expected dividend of $7.50 to $7.70 a share is equal to nearly all of the net income that TransDigm reported since the end of fiscal 2003, according to Moody's Investors Service.



Who might favor such moves? Equity investors who aren't in for the long-haul. Clearly, any shareholders who are hoping to get out of their position would love a nice dose of cash. But anyone hoping to remain invested for the long-term should treat such a move with skepticism: you're plaguing the company with greater debt for a one-time payback to equity holders. Even if that debt is cheap, this move doesn't really do anything to help the firm's operations or growth.

What I find really perplexing is why new creditors are willing to buy debt used for such poor reasons. If I'm looking to buy a few million dollars in unsecured corporate debt, I care about what that cash is going to be used for. A growth opportunity? Great. A capital cushion? Fine. Retiring more expensive debt? Excellent. Paying shareholders? No thanks.

This recession has really opened my eyes to how little investors worry about their debt purchases. They bought up poisonous mortgage-backed securities without thinking twice. Now we're seeing a new trend where companies issue unsecured debt to pay special dividends. Is there no end to the garbage that investors will gladly put their money in peril to scoop up?

Unfortunately, as credit remains easy and interest rates low, I'd expect such antics to continue. And since the Fed has indicated that it won't even think about raising rates anytime soon, we should be seeing a lot of this sort of behavior for a long time. Credit bubble anyone?

This article available online at:

http://www.theatlantic.com/business/archive/2009/10/debt-for-equity/27799/