History provides a valuable guide and lessons to finance, and the history of corporate restructuring is no exception. In particular, the Merger mania in the 1980’s provides a prime example of what can happen on Wall Street as companies struggle to survive and thrive in an ever-changing environment.
While textbooks can provide fantastic explanations about the details behind various forms of corporate restructuring such as mergers & acquisitions, buyouts, divestures, and more, this post will focus on the prevailing macroeconomic and political environments that either spurn or limit corporate restructuring.
The main factors that influenced the leveraged buyout spree in the 1980’s and are likely to continue to change the landscape of Wall Street include:
- Real Interest Rates, and their movements
- Corporate Tax Policies, and changes to these
- Politics: the public’s current feelings about antitrust enforcement and large corporations
- How the market discounts pretax earnings at the time
- Domestic currency strength and trends
- Financing sources for restructuring, and its availability in the marketplace
While I couldn’t possibly cover every potential factor, doing so as it relates to finance, Wall Street, macroeconomics, or even a company, is impossible… I will focus on these main attributes.
This obviously has the potential to be quite a complex dissertation, but corporate strategy has many moving pieces and is an advanced area of focus on its own.
Understanding these intricacies can especially help active investors picking individual stocks to better analyze company developments and/or anticipate developing secular trends to better position their portfolios for success.
I’ll end this article with a main investor takeaway, which ties all of the factors together and leaves an actionable strategy for the investors who follow these restructurings.
Much of this analysis I can’t take full credit for, as the merger mania spree of the 1980s was examined in-depth by famous billionaire George Soros in his classic The Alchemy of Finance—where he dubbed the period as The “Oligopolarization” of America.
A History of Interest Rates (Its Trends during Merger Mania)
First, to understand interest rates requires understanding the history of interest rates, and not just recent history but far back spanning many decades.
The reason for this prerequisite is that not only are there boom and bust credit cycles and stock market cycles, but there are also short term and very long term debt cycles that influence entire world economies and the financial systems under them.
One example of a well-respected investor who has discussed in detail about the prevalence of long term debt cycles, which can last (give-or-take) 50-75 years, is billionaire hedge fund manager Ray Dalio. Dalio has written extensively about this long term debt cycle and how he perceives it to have affected world powers and currencies throughout history, and how this can greatly impact the economics of the countries involved.
First, let’s look at three charts that display nominal interest rates over a very long time period, about 100+ years. I actually had to go deep into the weeds for this first one, as long term interest rate history is a surprisingly obscure topic of popular investment literature. The first two charts come from a report by the Reserve Bank of St. Louis entitled Interest Rates, 1914-1965 (source).
As nicely summarized in this report:
“Interest rates have generally been high and rising during periods of rapid economic expansion and have been low and declining during periods of economic contraction. Exceptions have occurred, such as the unusually high rates during the first year of the 1920-21 economic contraction, the sharp upward movement of rates during the depression in 1931, and the comparatively low rates during the period of heavy demand for goods and services during and immediately following World War II.”
This has a profound impact on corporate restructuring and the relative attractiveness of these activities, which we’ll discuss in a moment. First, let’s get up to speed on nominal interest rates from 1965 – present.
The following chart also comes from the Reserve Bank of St. Louis (FRED), using the 10 year Treasury as the data point:
And now we see an interesting phenomenon that I feel further enforces the ideas by Dalio concerning the “once in a person’s lifetime” long term debt cycle.
From the end of World War II (1940s) through the 1980s (when nominal interest rates reached record highs), the U.S. economy participated, and thrived in (I might add), a consistent rising interest rate environment. Since then, interest rates have been in a steady decline, and corporate America has again had a generally consistent, thriving period as well.
Where a 40 year period of generally falling interest rates followed a 40 year period of generally rising rates, the question whether another 40 year period of rising rates in on the horizon is open to interpretation. However, I will add that interest rates remained rock bottom low for about 10 years (mid 30’s – 40’s), which I don’t hear discussed about much.
Further side note: Keep in mind that this long term interest rate period happened simultaneously with a government blessed to obtain (and retain) world reserve currency status since 1945 which can also impact the corporate restructuring within a country as it relates to their global competitiveness and willingness to allow domestic monopolies, which has a huge impact on antitrust enforcement and number of mergers and acquisitions, more on this later.
Real Interest Rates and Corporate Restructuring
As George Soros wrote in his book, prevailing attitudes about valuations as they relate to company financials (obviously) have an impact on willingness for buyouts. I’ll take two quotes from his book, since he summarizes it skillfully:
“Shares traditionally have been valued as a multiple of earnings”
I’ll note that I’ve seen this idea seems to be reinforced from data by my podcast co-host Dave Ahern’s article about relative valuation, stating that over 80% of Wall Street analysts employ relative valuation metrics such as the P/E ratio in their analysis.
I’ve recently heard a podcast episode by Tobias Carlisle, where his guest Partha Mohanram (a Harvard PhD graduate who is the John H. Watson Chair in Value Investing at Rotman) also observed in his research that although finance tends to focus on free cash flows, earnings are a much better predictor of value than cash flows (which could be a hot debate for a long time, I’ll add).
And, regarding the impact of interest rates on M&A:
“Thus the traditional method of valuing shares has helped to create opportunities for acquisition, especially in periods, such as the Imperial Circle, when earnings are depressed and interest rates relatively high”
I’ll note that the Imperial Circle refers to the period when “Reaganomics” represented the fiscal and foreign policy of the United States (the 1980s).
So, just how “relatively high” were interest rates during the 1980’s merger mania? Here’s a chart:
So why is this the case?
This links to one of the major factors discussed at the beginning of this article: the willingness of Wall Street to discount earnings (pretax) higher than the current interest rate.
If these earnings are discounted higher than the interest rate (refresh yourself on the basics of DCF and WACC discount rates if needed), then there’s a chunk of earnings over and above the interest rate that can pay down the leveraged used for a buyout– leading to both its possibility and attractiveness.
But it was the corporate tax policy at the time that made leveraged buyouts not only possible, and not only mildly attractive, but extremely attractive and generally beneficial for the acquirer.
The Impact of Taxes and Politics on Corporate Restructuring
During the time of merger mania which followed the Carter administration, the corporate tax rate was an astronomical (according to today’s standards) 48%.
This, predictably made corporate debt more attractive, as interest expense was (and still is) tax deductible. So, borrowing cash to acquire a company actually led to tax savings and seemed to be an effective way to grow a corporation with some help from the government, who is taxing retained earnings that would be used to buy physical assets to grow a business.
Not only that, but as Soros stated:
“High real interest rates render financial assets more attractive, and physical investments less attractive”
Which makes sense because why would you buy a piece of equipment that’d earn a 6% ROIC, for example, when you can simply buy a government bond earning 8% or more annually?
The more we analyze the seemingly “insane” leveraged buyout spree of the 1980’s, the more it starts to make sense in the context of the business environment at the time. The way the system was structured incentivized increased corporate activity, whether intended and desired, or not.
Which should be the major takeaway from this research I’m sharing today:
Consider all factors (or at least as many as you can) that lead to Wall Street valuations or management allocation, as many factors can come into play—
Which leaves the idea of forecasting an impossibility and the philosophy of simply trying to purchase companies at a discount to their earning power a sound long term strategy over time, but I digress…
Note that the corporate tax rate changed with the Tax Reform Act of 1986, from 48% to 34%, which may have been a major contributing factor to the end of the leverage buyout spree at the tail end of the late 80’s.
Anyways, the story is not yet complete, as we still have another major influencing factor on the frequency of corporate restructuring: first politics, and then currency strength/ the economy.
Political Games and Its Impact on the Timing of Deals
Going back to the Carter administration, the fact of the matter is that he was a Democratic president, in contrast to Reagan the Republican.
I won’t attempt a biased political statement, but generally, a Democratic/ Liberal/ Left-leaning party tends to have a less favorable stance on big business—at least compared to the Right.
And additionally, depending on the intensity of emotions towards both big business and its tendency towards dominating market share (read: monopolies), the level of enforcement of antitrust laws can vary from time to time. Obviously, this can also greatly influence the frequency and type of corporate restructuring in any given economic cycle.
The stance of the Right on this policy, contributed to what Soros called “the oligopolarization of America”, wherein larger corporate mergers were less likely to be blocked as international competition began to enter the public discourse surrounding monopolies, as a strong U.S. dollar can make imports more attractive in relative price and hurt domestic activity.
Therefore, a large corporate merger that might’ve previously been more examined from an antitrust perspective (say during a Democratic administration) was one less obstacle for the massive leverage buyouts of the time.
What I find most interesting about this, and perhaps one of the best takeaways for investors from all of this, is that a growing political sentiment supporting enforcement of antitrust laws can cause M&A activity to not disappear, but simply shift to small companies who are excluded from the “big business” classification.
This is exactly what happened historically during the Carter administration, as Soros also shared:
“Between 1974 and 1979 the shares of small companies outperformed large ones by a considerable margin, and investors specializing in small capitalization stocks enjoyed a field day. Corporate activity, such as leveraged buyouts, was in fact concentrated in that sector”.
As seasoned investors know, various stock market factors fluctuate over the long term, and the large cap vs small cap debate may prove to favor small caps during times when (if) corporate restructuring activity is bristling AND the political environment is conducive to a stricter enforcement of antitrust laws—which could simply shift M&A activity to small cap stocks and lead to an outperformance of the group, as acquisitions often occur at premium to its valuation on the Street.
If this is indeed the case then the opposite must be true, at least in theory, where a looser antitrust policy (such as with a Right-leaning administration) combined with high corporate restructuring incentives should lead to better performance from large cap stocks vs. small cap.
That’s exactly what happened from 1980-1985 (the latter being the time that Soros wrote his chapter on “oligopolarization” as he shares:
“Since 1980, relative performance has shifted back in favor of large capitalization stocks, and mergermania has undoubtedly played a part in the move.”
The Takeaway for the Modern Investor
Everything discussed here begs the question on how are these various factors applicable to corporate restructuring and its effects on the decisions of managements on Wall Street and those trickling effects to the stocks in investors’ portfolios.
Going back to the 1st major takeaway I shared: many factors should be considered in addition to the standard, maybe “textbook”, business synergistic and other considerations for a major corporate activity.
But maybe even more importantly, at least from an investment perspective, is how can this awareness lead to better results in stock selection and valuation?
Well, maybe the answer lies in a popular trading maxim…
“Don’t fight the tape”.
Or maybe, the better answer is “it depends”, and I’d agree wholeheartedly on that.
I’ll leave you with a few more additional resources, not to answer the question for you (as finance is fluid, as is investments, valuation, politics, the economy, and more)—but rather to point you in the direction of better understanding and better applications to the problem you’re trying to solve:
- On interest rates:
- On the valuation standard for corporate finance:
- On how managements decide to allocate earnings/ cash flows: