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The following excerpt is taken from the "Lessons of Restructuring" section of Gilson's introduction to Creating Value through Corporate Restructuring.
Although the case studies in this book span a wide range of companies, industries, and contexts, some common issues and themes emerge. Taken together, they suggest there are three critical hurdles or challenges that management faces in any restructuring program:
1. Design. What type of restructuring is appropriate for dealing with the specific challenge, problem, or opportunity that the company faces?
2. Execution. How should the restructuring process be managed and the many barriers to restructuring overcome so that as much value is created as possible?
3. Marketing. How should the restructuring be explained and portrayed to investors so that value created inside the company is fully credited to its stock price?
Failure to address any one of these challenges can cause the restructuring to fail.
Having a Business Purpose
Restructuring is more likely to be successful when managers first understand the fundamental business/strategic problem or opportunity that their company faces. At Humana Inc., which jointly operated a hospital business and a health insurance business, management decided to split the businesses apart through a corporate spin-off because it realized the businesses were strategically incompatible—the customers of one business were competitors with the other. Alternative restructuring options that were considered, including issuing tracking stock, doing a leveraged buyout, or repurchasing shares, would not have solved this underlying business problem.
Chase Manhattan Bank and Chemical Bank used their merger as an opportunity to both reduce operating costs and achieve an important strategic objective. Combining the two banks created opportunities to eliminate overlaps in such areas as back-office staff, branch offices, and computing infrastructure. Management of both banks also believed that larger and more diversified financial institutions would increasingly have a comparative advantage in attracting new business from corporate and retail customers. The merger was therefore also viewed as a vehicle for increasing top-line revenue growth. Internal cost cutting alone would not have enabled either bank to achieve this second goal.
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Scott Paper's chief executive officer (CEO) decided to implement the layoffs quickly—in less than a year—to minimize workplace disruptions and gain credibility with the capital market. For some companies, however, strategic and business factors could warrant a more gradual approach to downsizing. For example, consider a firm that is shifting its strategic focus from a declining labor-intensive business to a more promising but less labor-intensive business. Ultimately this shift may necessitate downsizing the workforce. However, if the firm's current business is still profitable, the transition between businesses—and resulting layoffs—may be appropriately staged over a number of years. This situation could be said to characterize the mainframe computer industry during the 1980s, when business customers moved away from mainframes towards UNIX-based "open architecture" computing systems. 6
Knowing When to Pull the Trigger
Many companies recognize the need to restructure too late, when fewer options remain and saving the company may be more difficult. Scott Paper's new CEO was widely criticized in the news media for the magnitude of the layoffs he ordered. However, such drastic action was arguably necessary because the company had taken insufficient measures before that to address its long-standing financial problems. Some research suggests that voluntary or preemptive restructuring can generate more value than restructuring done under the imminent threat of bankruptcy or a hostile takeover. 7
Several companies featured in this book undertook major restructurings without being in a financial crisis. Compared to the rest of the U.S. airline industry, United Air Lines was in relatively strong financial condition when its employees agreed to almost $5 billion in wage and benefit reductions in 1994. And Humana was still profitable when it decided to do its spin-off.
What can be done to encourage companies to restructure sooner rather than later? In the case of United Air Lines, management in effect created a crisis that made employees more willing to compromise. Early in the negotiations, management threatened to break up the airline and lay off thousands of employees if a consensual agreement could not be reached. Management made the threat real by developing an actual restructuring plan, containing detailed financial projections and valuations. Moreover, United's CEO at the time had a reputation for following words with deeds, and he was not liked by the unions. (With hindsight, it is debatable whether he really intended to pursue the more radical restructuring plan; however, what matters is that the unions believed he would.)
In Humana's case, the company culture encouraged managers to constantly question the status quo and consider alternative ways of doing business. This sense of "organizational unease" was encouraged by Humana's CEO-founder, who twice before had shifted the company's course to a brand-new industry. As the company's integrated product strategy began to exhibit some problems—although nothing approaching a crisis—a small group of senior managers decided to investigate. This effort, which took place off-site and lasted several weeks, uncovered a serious flaw in the strategy itself, setting the stage for the eventual restructuring.
At each of these companies, there was a set of factors in place that made early action possible. However, some of these factors—a strong or visionary CEO, for example—are clearly idiosyncratic and company-specific. Thus it remains a question whether firms can be systematically encouraged to preemptively restructure. One approach that has been suggested is to increase the firm's financial leverage (so it has less of a cushion when the business begins to suffer); another is to increase senior managers' equity stake so they are directly rewarded for restructuring that enhances value. Such approaches are not widespread, however. 8
The Devil Is in the Details
The decisions that managers have to make as part of implementing a restructuring plan are often critical to whether the restructuring succeeds or fails. In the language of economics, implementation is the process of managing market imperfections. The challenges that managers face here are many and varied.
In a bankruptcy restructuring, for example, one obvious objective is to reduce the firm's overall debt load. However, cancellation of debt creates equivalent taxable income for the firm. Flagstar Companies, Inc. cut its debt by over $1 billion under a "prepackaged" bankruptcy plan. In addition, if ownership of the firm's equity changes significantly, say because creditors exchange their claims for new stock, the firm can lose the often sizable tax benefit of its net operating loss carryforwards. 9 When Continental Airlines was readying to exit from Chapter 11, it had $1.4 billion of these carryforwards. However, to finance the reorganization, the company sold a majority of its stock to a group of investors—virtually guaranteeing a large ownership change.
Companies that try to restructure out of court to avoid the high costs of a formal bankruptcy proceeding can have difficulty restructuring their public bonds. If such bonds are widely held, individual bondholders may be unwilling to make concessions, preferring to free ride off the concessions of others. Thus it will be necessary to set the terms of the restructuring to reward bondholders who participate and penalize those who do not—all the while complying with securities laws that require equal treatment of creditors holding identical claims. This was the situation facing the Loewen Group Inc. as it stood at the crossroads of bankruptcy and out-of court restructuring.
Before a company can divest a subsidiary through a tax-free spin-off, management must first decide how corporate overhead will be allocated between the subsidiary and the parent. The allocation decision can be complicated by management's understandable desire not to give away the best assets or people. It is also necessary to allocate debt between the two entities, which will generally entail some kind of refinancing. The transaction must meet certain stringent business purpose tests to qualify as tax-exempt. And if the two entities conducted business with each other before the spin-off, management must decide whether to extend this relationship through some formal contractual arrangement. Humana's two divisions transacted extensively with one another before its spin-off, and abruptly cutting these ties risked doing long-term harm to both businesses.
Corporate downsizing also presents managers with formidable challenges. In addition to deciding how many employees should be laid off, management must decide which employees to target (e.g., white collar vs. factory workers, domestic vs. foreign employees, etc.) and set a timetable for the layoffs. It must also carefully manage the company's relations with the remaining workforce and the press. This process becomes much more complicated when management's compensation is tied to the financial success of the restructuring through stock options and other incentive compensation. And when layoffs are the by-product of a corporate merger, it is necessary to decide how they will be spread over the merging companies' workforces. This decision can significantly impact the merger integration process and how the stock market values the merger, by sending employees and investors a signal about which merging company is dominant. 10
Bargaining Over the Allocation of Value
Corporate restructuring usually requires claimholders to make significant concessions of some kind, and therefore has important distributive consequences. Restructuring affects not only the value of the firm, but also the wealth of individual claimholders. Disputes over how value should be allocated—and how claimholders should "share the pain"—arise in almost every restructuring. Many times these disputes can take a decidedly ugly turn. A key challenge for managers is to find ways to bridge or resolve such conflicts. Failure to do so means the restructuring may be delayed, or not happen, to the detriment of all parties.
Inter-claimholder conflicts played a large role in Navistar International's restructuring. The company had amassed a $2.6 billion liability for the medical expenses of retired Navistar workers and their families, which it had promised—in writing—to fully fund. This liability had grown much faster than expected, to more than five times Navistar's net worth. Claiming imminent bankruptcy, the company proposed cutting retirees' benefits by over half. With billions of dollars at stake, the negotiations were highly contentious, and an expensive legal battle was waged in several courts.
FAG Kugelfischer also faced a major battle with its employees over the division of value. Kugelfischer's high labor costs—the average German worker earned over 40 percent more than his/her U.S. counterpart—had made it increasingly difficult for it to compete in the global ball bearings market. However, opposition from the company's powerful labor unions made cutting jobs or benefits very difficult. Moreover, under the German "social contract," managers historically owed a duty to employees and other corporate stakeholders as well as to shareholders. So any attempt to cut labor expense could well have provoked a public backlash—especially since at the time the company's home city of Schweinfurt had an unemployment rate of 16 percent.
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| For publicly traded companies, the success of a restructuring is ultimately judged by how much it contributes to the company's market value. | |
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| —Stuart Gilson |
Sometimes disputes over the allocation of value arise because claimholders disagree over what the entire company is worth. In Flagstar Companies' bankruptcy, junior and senior creditors were over half a billion dollars apart in their valuations of the company. Since the restructuring plan proposed to give creditors a substantial amount of new common stock, their relative financial recoveries depended materially on what the firm, and this stock, was ultimately worth.
To bridge such disagreements over value, a deal can be structured to include an "insurance policy" that pays one party a sum tied to the future realized value of the firm. This sort of arrangement sometimes appears in mergers in the form of "earn-out provisions" and "collars." 11 The terms of United Air Lines' restructuring included a guarantee that employees would be given additional stock if the stock price subsequently increased (presumably because of their efforts). And in some bankruptcy reorganization plans, creditors are issued warrants or puts that hedge against changes in the value of the other claims they receive under the plan. 12 Despite how much sense these provisions would seem to make, however, in practice they are relatively uncommon. The reasons for this are not yet fully understood. 13
Getting the Highest Price
For publicly traded companies, the success of a restructuring is ultimately judged by how much it contributes to the company's market value. However, managers cannot take for granted that investors will fully credit the company for all of the value that has been created inside.
There are many reasons why investors may undervalue or overvalue a restructuring. Many companies have no prior experience with restructuring, so there is no precedent to guide investors. Restructurings are often exceedingly complicated. (The shareholder prospectus that described United Air Lines' proposed employee buyout contained almost 250 pages of text, exhibits, and appendices). When it filed for bankruptcy protection in Thailand, Alphatec Electronics Pcl had over 1,200 different secured and unsecured creditors, located in dozens of countries. And restructuring often produces wholesale changes in the firm's assets, business operations, and capital structure.
So in most restructurings, managers face the additional important challenge of marketing the restructuring to the capital market. The most obvious way to do this is to disclose useful information to investors and analysts that they can use to value the restructuring more accurately. 14 However, managers are often limited in what they can disclose publicly. For example, detailed data on the location of employee layoffs in a firm could benefit the firm's competitors by revealing its strengths and weaknesses in specific product and geographic markets. Disclosing such data might also further poison the company's relationship with its workforce. In its public communications with analysts, United Air Lines' management could not aggressively tout the size of the wage/benefit concessions that employees made to acquire the airline's stock, since many employees entered the buyout feeling they had overpaid.
Management's credibility obviously also matters in how its disclosures are received. Many restructurings try to improve company profitability two ways, by both reducing costs and raising revenues. Scott Paper Company's restructuring was also designed to increase the firm's revenue growth potential by leveraging the brand name value of its consumer tissue products business. Management was quite open in declaring this goal. However, experience suggests that investors and analysts generally reward promises of revenue growth much less than they do evidence of cost reductions. In public financial forecasts of the merger benefits, Chemical and Chase management downplayed the size of the potential revenue enhancements, even though privately they believed the likely benefits here were huge.
When conventional disclosure strategies are ineffective in a restructuring, sometimes more creative strategies can be devised. As part of its investor marketing effort, United Air Lines began to report a new measure of earnings—along with ordinary earnings calculated under Generally Accepted Accounting Principles (GAAP)—that excluded a large noncash charge created under the buyout structure. The new earnings measure, which corresponded more closely to cash flows, was designed to educate investors about the buyout's financial benefits. Acceptance of this accounting innovation by the investment community was uneven at first, however.
Of course communicating with investors is relatively easy when the company is nonpublic and/or closely held. But having no stock price is a double-edged sword, as the case of Donald Salter Communications Inc. illustrates, since it is then harder to give managers incentives to maximize value during the restructuring.
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Five Questions for Stuart Gilson
Silverthorne: When should a company consider a major restructuring? Are there tell-tale signs?
Gilson: I define corporate restructuring as the process through which a company radically changes the contractual relationships that exist among its creditors, shareholders, employees, and other stakeholders. The goal of restructuring is to increase the overall market value of the business enterprise. Often the "value gap" that restructuring addresses is very large—in the billions of dollars possibly. My research at companies suggests there are three primary motivations for restructuring.
The first is the need to address poor financial performance. Here, the warning signs are usually pretty clear: declining or stagnating sales, accounting losses, or a falling stock price. In extreme cases such poor performance may cause the company to default on its debt, resulting in bankruptcy. Restructuring the debt can be difficult and costly, although in some cases legal strategies are available that can greatly accelerate the process. In the U.S., bankruptcy can also be used to revitalize the business—for example, by allowing companies to reject unfavorable leases, or sell unwanted assets in a competitive auction.
The second reason to restructure is to support a new corporate strategy, or to take advantage of a business opportunity. For example, in an equity spin-off, a diversified firm's businesses are split apart into independent entities, each with its own common stock. Spin-offs can make sense when a high-growth business is being held back by a bureaucratic corporate parent, or when it no longer makes sense for a company to be vertically integrated. Here, one sign that restructuring may be necessary is evidence that the stock market is valuing the entire company for less than its separate businesses would be valued if they were separate, independently-traded companies. (In other words, 2 + 2 = 3) To make this diagnosis, one obviously has to make all kinds of assumptions, but sometimes the implied value gap is just enormous.
The third reason companies restructure is to correct a large error in how the company is valued in the capital market. This problem, like the previous one, is especially prevalent for large diversified companies that operate in many different businesses. Financial analysts and investors may have an especially difficult time understanding what's going on in these companies, or may lack the industry expertise to assess the business prospects of all the company's operations. Even though each of the businesses may be well-run, investors may place too low a value on the overall portfolio. Restructuring tools like tracking stock, stock buybacks, or leverage buyouts, can be used to reduce this kind of value gap.
Q: You suggest that some companies could benefit by restructuring before they are hit with a financial crisis. When is a preemptive restructuring appropriate?
A: If a company waits too long to address problems with its business, the resulting restructuring may be very painful. This may deter executives from taking the full measures that are necessary to return the business to a sound footing. Or the resulting restructuring may severely disrupt the business. If it is necessary to layoff 20 percent of your workforce to achieve the same cost efficiency as your competitors, better to do this over several years than all at once—but the key is to recognize the problem as early as possible. This is why I recommend that companies do a "restructuring audit" on their businesses periodically, looking for opportunities to create value by voluntarily restructuring, before circumstances leave them with no choice.
Q: Which company in your mind executed the most successful restructuring, and which company the worst?
A: This is a hard one to answer, because the restructurings that I analyzed were intended to address a variety of different problems and challenges, and entailed a range of methods and approaches. I also deliberately sought out companies that managed the restructuring process successfully, despite facing huge obstacles, to highlight "best practice" (although in several cases I did not know what the outcome would be when I first contacted the companies.) Some of my choices for the most successful restructurings would strike many people as controversial. One would be the downsizing of Scott Paper Company under "Chainsaw" Al Dunlap, in which the company eliminated approximately a third of its workforce. Another would be the employee buyout of United Air Lines, in which the airline's pilots and machinists were given a majority of the company's stock in exchange for almost $5 billion in wage and benefit concessions. The two cases are fascinating contrasts. Scott Paper's restructuring involved large-scale job reductions, while United's gave employees job security (and even some control over the business). Despite how Scott's restructuring was often portrayed in the news media, however, the treatment of the affected workers was by and large pretty humane. Moreover, Dunlap's compensation for the restructuring, while very large in dollar terms, was tiny in relation to the total amount of shareholder wealth that was created. And the layoffs were carefully tailored to the needs of the business; they were not simply set arbitrarily high, to please Wall Street. In the case of United's restructuring, what impressed me was how complicated the whole thing was, how many different issues had to be addressed at the same time to keep the deal on track. In the end, management devised a whole new way of reporting the company's earnings, to address a deficiency in GAAP reporting rules as they pertain to employee buyouts. It took more than a year for analysts and investors to embrace the concept, but in the end I believe this accounting innovation played an important role in the ultimate financial success of the restructuring. Some critics have pointed to recent labor unrest at the airline as evidence that the restructuring failed, but this misses the point that for six years, the restructuring unambiguously reduced the firm's cash labor costs, by a significant amount—and at a time the other major airlines were laying off tens of thousands of employees.
Q: Who can benefit by reading this book?
A: I am trying to reach multiple audiences. Obviously one key target audience consists of educators and students, since the case studies in the book were developed for a course on corporate restructuring that I have taught here at Harvard Business School for the past eight years. (I have also taught these materials in a number of our executive education programs.) Currently there are very few courses offered on this topic at other business schools, I suspect in large part because, outside of the case study method, it is difficult for outsiders to know what transpires inside these companies, or understand management's perspective, given the sensitivity of the issues involved. I have been simply amazed at how frank and open the executives I worked with have been in discussing their experiences, and I do not know of another resource out there that can be used to teach students the actual practice of corporate restructuring. My goal was to show, through the lens of these managers and others involved, how a complicated and difficult restructuring actually gets done.
Q: My book is also targeted at corporate executives, general managers and practitioners. Hopefully, investment bankers, strategy consultants, and attorneys will find it to be a useful guide or reference. In addition to the case studies, the book has chapters that describe the different techniques for restructuring companies, and summarize scholarly research on corporate restructuring. There is also a chapter that describes techniques for valuing companies in a restructuring situation. I think the case study method is ideally suited to teaching best restructuring practices, because it forces you to put yourself in management's shoes, and understand the issues and challenges that managers actually face in these situations. The case study method is all about getting you to ask the right questions.
A: Did anything surprise you as you researched the book?
Q: Two things stand out. First is the candor and ingenuity of the executives I interviewed. Some of the approaches that they came up with for dealing with incredibly complicated and difficult challenges are, I think, truly ingenious. But the executives were also very open about discussing what, in their view, they might have done differently if given a second chance. A second surprise was how permanent restructuring has become in the daily fabric of business and commerce. One can no longer think of restructuring as a rare event that happens to "someone else." All around the world, as trade barriers continue to fall, and capital markets become more integrated, restructuring is becoming a daily event, and every manager can benefit from having a basic understanding of effective restructuring strategies and practices. Every year I issue a guarantee to my MBA students: Within three years of graduating, every single one of them will encounter a restructuring on their jobs—whether it involves their own company, or the restructuring of a competitor, customer, or supplier. So far not a single student has come back and told me I was wrong.
Footnotes
6. The computing technology used in open architecture systems uses more standardized components than mainframe computing technology (e.g., microprocessors in personal computers). The manufacture of these components was easily outsourced to low-wage countries like Thailand and Indonesia, creating redundancies in the workforce at home. However, the mainframe business continued to be profitable due to a core group of customers that found it too costly to switch technologies, such as schools, governments, and churches.
7. Gordon Donaldson, Corporate Restructuring: Managing the Change Process from Within (Boston: Harvard Business School Press, 1994).
8. For an overview of these issues see Michael Jenson, 1993, "The Modern Industrial Revolution and the Challenge to Internal Control Systems," Journal of Finance 48: 831-880. Wruck shows how a company can deliberately increase its debt load to encourage the organization to restructure more quickly (Karen Wruck, 1994, "Financial Policy, Internal Control, and Performance: Sealed Air Corporation's Leveraged Special Dividend," Journal of Financial Economics 36: 157-192). However, other research suggests that most companies do not undertake significant restructuring unless they are confronted with a crisis, such as a takeover threat or bankruptcy. (See David Denis, Diane Denis, and Atulya Sarin, 1997, "Agency Problems, Equity Ownership, and Corporate Diversification," Journal of Finance 52: 135-160.) One reason equity incentives may not be used more widely is the risk of a public backlash, if managers appear to be profiting at the expense of those hurt by the restructuring (Jay Dial and Kevin Murphy, 1995, "Incentives, Downsizing, and Value Creation at General Dynamics," Journal of Financial Economics 37: 261-314).
9. There are some exceptions. For a description of tax issues in bankruptcy restructuring, see Stuart Gilson, 1997, "Transactions Costs and Capital Structure Choice: Evidence from Financially Distressed Firms," Journal of Finance 52: 161-196.
10. Many mergers that are publicly portrayed as "mergers of equals" often appear to end up as anything but. See Bill Vlasic and Bradley Stertz, Taken for a Ride: How Daimler-Benz Drove Off with Chrysler (New York: William Morrow & Co., 2000 ).
11. When a merger is financed by swapping the stock of the bidder company for the stock of the target company, the target company shareholders face the risk that the stock they receive will subsequently lose value. A collar would directly compensate them for this loss.
12. See Stuart Gilson, Edith Hotchkiss, and Richard Ruback, 2000, "Valuation of Bankrupt Firms," Review of Financial Studies 13: 43-74.
13. See Micah Officer, 2000, "Collar Bids in Mergers and Acquisitions," University of Rochester Ph.D. dissertation paper.
14. Academic researchers have studied how discretionary corporate disclosures can increase firms' market values. For example, see Paul Healy and Krishna Palepu, 1995, "The Challenges of Investor Communication: The Case of CUC International, Inc.," Journal of Financial Economics 38: 111-140; and Paul Healy, Amy Hutton, and Krishna Palepu, 1999, "Stock Performance and Intermediation Changes Surrounding Sustained Increases in Disclosure," Contemporary Accounting Research 16: 485-520. Note that the idea of helping investors better understand the firm's market value is not inconsistent with the well-known efficient markets paradigm, which states that traded financial assets are correctly priced on average. This does not imply that every asset is always priced correctly, and so provides an opportunity for managers to correct mistakes in how their companies are valued.