Contemporary Trends in Corporate Finance

Brief: 194364

Title: Contemporary trends in corporate finance

This report looks at the contemporary trends in corporate finance in the UK. The major trends and their implications are analysed below.

Major trends in corporate finance

1. Growth in private equity

Private equity has grown rapidly over the last decade. Private equity has grown both in number of deals it is involved in and also the size of companies being taken private. In UK, a consortium led by CVC is bidding for J Sainsbury and another consortium led by KKR is bidding for Boots (Larsen, 2007 I). Both of the above two deals are valued at around A£10 billion.

The growth in private equity has been fuelled by the interest of new investors in private equity and availability of cheap debt. Pension funds and wealthy investors are now putting more of their investments in private equity resulting in huge amount of investment funds with private equity. Due to high amount of cash at their disposal, it makes more economical sense for private equity firms to invest in larger deals rather than chasing a large number of smaller deals.

UK has also been subject to higher buyout activity from non-UK buyout firms. Acquisitions in the UK by foreign companies in the first three quarters of 2005 exceeded the values for such deals for 2003 and 2004 (Dolbeck, 2005). Both CVC and KKR are US-based firms keenly pursuing buyouts in UK.

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Big high street banks have also set up their own private equity funds. Lloyds TSB’s LDC invests in UK mid-market with up to A£100 million in private equity[1].

2. Investment and participation by investment banks

Previously investment banks participation in private equity was limited to advising private equity and/or companies and raising capital for private equity companies. But in the last few years, investment banks have also started investing alongside private equity firms. Not only that investment banks are also raising their own funds to invest on their own or alongside with private equity firms. Merrill Lynch is even investing from its own funds[2]. Investment banks participation stems mainly because of the two reasons. First, they generate lucrative fees on the overall deal. Second, investment banks earn good returns on their money invested.

3. Emergence of hedge funds in diverse investment instruments

Hedge funds are investing in securities of longer term lock-in periods. Hedge funds active in the leveraged buyout market are providing subordinate debt and payment-in-kind securities. A consortium of hedge funds helped finance Malcolm Glazer's pound A£790 million takeover of Manchester United FC by taking payment-in-kind securities (The Lawyer, 2006). This has brought hedge funds in direct competition to established companies funding such investments. Hedge funds have also started taking active roles in changing companies in distress or special situations.

4. Availability of cheap debt

Growth in private equity has been fuelled by availability of cheap debt. Increase in corporate earnings over the last few years and reduced interest rates allowed banks to increase their lending for acquisitions. Stable economic environment in UK has also increased bank’s appetite for risk. Private equity investors are often borrrowing six to seven times the equity they are putting in the deal[3].

5. Emergence of activist investors

Activist investors – individual investors and / or hedge funds – are taking more active role in forcing companies to restructure and increase shareholders value. Cadbury Schweppes recently agreed to demerge its businesses and list them separately to increase shareholder value. The company had previously decided not to take this route but the turnaround came swiftly after appearance of the US activist Nelson Peltz as one of the main shareholders (Jackson, 2007). Hedge funds are now coming out in open and asking companies to take drastic actions to increase their returns.

Implications

1. Corporate debt to equity ratio

Companies with good and predictable cash flows are facing more prospects of being acquired by private equity firms. Mature businesses with significant proportion of their assets in tangible and physical assets offer good securities against which buyout firms can raise cheap loans. To reduce their likelihood of being taken over by buyout firms, companies are raising more debts and returning cash to shareholders. It is do or die scenario in some cases as companies reluctant to take on more leverage could find themselves on the receiving end of a takeover bid (Larsen, 2007 II). This has led to increase in debt to equity ratios of companies. Stagecoach plc is returning A£700 million to its shareholders. Because of disposal of some of its businesses, the company had a net fund position of A£140 million in October 06 (Stagecoach, 2007). Stagecoach will have to take debt to finance the return of capital to the shareholders.

According to Modigliani and Miller’s proposition II, the expected return on equity of a levered firm increases in proportion to the debt to equity ratio (Brealey & Myers). Higher debt should then raise shareholders return but it also increases the chances of bankruptcy. Some of the corporate decisions, made under the influence of active investors, may appear to be good for shareholders in short-term. Return of cash or separating businesses may increase shareholders value but would expose companies to risk of high interest rate or may not leave them with sufficient cash to pursue growth opportunities in future.

2. Increase in interest rates

Higher buyout activity and return of capital to shareholders have been funded by availability of cheap debt. But with the continuing increase in house prices and moderate to high inflation, Bank of England has been raising interest rates. Due to higher financial leverage, companies with higher debt will have to incur more interest charges if interest rates increase. Additionally consumers, who have taken more mortgages on their homes, will find that they have lower income at their disposal after paying higher mortgages. Lower income and higher interest charges will likely lead to reduction in companies earning and increase their chances of bankruptcy.

3. Dividend

With a view to avoid being acquired by buyout firms, companies are increasing dividend to better utilise cash sitting in the business or its ability to raise cheaper funds. This is also done under pressure from hedge funds who are pressurising companies to increase their share prices by efficient use of funding and return of capital.

Last few years have seen growth in private equity deals, both in number of deals and size of individual deals. This has been fuelled by the increase in funds available with buyout firms and also by the availability of more and cheap debt. Also activist investors are pushing firms to increase shareholder value. Companies are now taking steps to return capital to shareholders to avoid being taken private. All of the above has resulted in higher amount of debt for companies with stable cash flows and exposing them to bankruptcy risks in case interest rates rise further and consumers demand slows down.

BIBLIOGRAPHY & REFRENCES

Brealey, R.A. & S.C. Myers. “Principles of corporate finance”, Sixth edition, Tata Mcgraw-Hill Publishing Company Limited, pg. 481

Dolbeck, A. “Mergers and acquisitions around the world”, Weekly Corporate Growth Report, Santa Barbara, 19 December 2005, Iss. 1370, Pg. 1

Jackson, T. (2007). “The public company is battered but not broken”, Financial Times, 19 March 2007

Larsen, P.T. (2007, I). “Private equity bids keep on growing”, Financial Times, 28 March 2007

Larsen, P.T. (2007, II). “Takeovers reach a record high”, Financial Times, 25 January 2007

The Lawyer (2006). “Private equity funds bristle as hedge funds muscle in”, The Lawyer, London, Feb13, 2006. Pg. 13

Stagecoach (2007). “Proposed return of value of approximately A£700 million to Shareholders” (https://investegate.co.uk/Article.aspx?id=200703140701329088S), 14 March 2007.

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[1] Lloyds TSB LDC (https://www.ldc.co.uk/), 6th April 2007

[2] Larsen, P.T. (2007, I). “Private equity bids keep on growing”, Financial Times, 28 May 2007

[3] Larsen, P.T. (2007, I). “Private equity bids keep on growing”, Financial Times, 28 May 2007

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