The uneasy case for favoring long-term shareholders.

Author:Fried, Jesse M.
Position:V. Destroying Value in a Repurchasing Firm to Boost Long-Term Shareholder Returns through Conclusion, with footnotes and tables, p. 1592-1627

    Part IV explained that managers can and do use bargain repurchases to shift value from selling shareholders to long-term shareholders. If these bargain repurchases were economically costless, they would merely shift value among different types of shareholders without reducing the size of the pie. Managers could boost long-term shareholder returns without destroying value. Unfortunately, however, the use of bargain repurchases can give rise to economic costs that shrink the pie.

    This Part describes two such costs. Part V.A explains that the use of bargain share repurchases to boost long-term shareholder returns can destroy economic value by inefficiently shrinking the firm. Part V.B explains that managers can, and do, benefit long-term shareholders by engaging in costly price-depressing manipulation around share repurchases.

    1. Costly Contraction

      The use of bargain repurchases to benefit long-term shareholders can lead to "costly contraction": managers seeking to buy back stock at a low price may give up economically valuable projects to fund the repurchase, reducing the total amount of value available to all the firm's shareholders over time.

      1. How Inefficient Capital Allocation Can Benefit Long-Term Shareholders

        From an economic perspective, a firm should distribute cash to shareholders via a repurchase (or dividend) if, and only if, total economic value will be increased. (141) For example, suppose that the firm is considering distributing $100 in cash. If an outside project would yield a 15% return and an inside project would yield 10%, the cash should be distributed. But if the best outside project available to shareholders would yield a 10% return and an inside project would yield a 15% return, then the cash should not be distributed.

        Importantly, from this perspective, the firm's stock price should not be a relevant consideration in determining whether the firm should distribute cash via a repurchase. The stock price affects only the distribution of value among different types of shareholders. The only relevant consideration is whether the total economic pie will be bigger or smaller as a result of the repurchase.

        However, as we saw in Part IV, managers make payout decisions based on the stock price: when the stock price is low, they initiate or accelerate repurchases. When managers use an extraneous factor such as the stock price to determine the timing of payout, payout policy can become distorted from an economic perspective.

        Consider our simple analytical framework involving ABC Corporation. Recall that, absent a repurchase (or equity issuance), the payoff to long-term shareholders is $V/2. If there is a repurchase, and no value is created or destroyed, then the payoff to long-term shareholders is Therefore, long term shareholders benefit (assuming no value is created or destroyed) from a repurchase whenever $P $V/2, that is, whenever $P

        It might be helpful to offer a numerical example. Suppose that ABC has $110 in fixed assets and $80 in cash that, if invested in a firm project, will yield a return of 12.5% (or $10). Assume, for simplicity, that any cash distributed by ABC will generate a 0% return outside the firm. If ABC does not repurchase a share in the short term, $V will equal $200 ($110+$80+$10), and the long-term shareholder payout ($V/2) will equal $100. Suppose that, in the short term, ABC's shares trade at $80. If ABC repurchases a single share for $80, $V will equal $190 ($110+$80), and the long-term shareholder payout $(V-P) will equal $110. The long-term shareholder payout is higher if managers distribute cash that would generate $10 more economic value inside the firm. (142)

        Who loses if ABC's managers distribute cash that could generate a larger return inside the firm? Not the short-term shareholder, who would have sold its share for $80 in any event (but to a future shareholder, rather than to ABC). Indeed, if we relax the example's assumptions a little bit and consider the possibility that the repurchase might boost the short-term stock price (by, among other things, increasing competition for the short-term shareholder's share), then the repurchase might actually benefit the short-term shareholder. The loser is the future shareholder, which would have purchased a share for $80 (assuming, as I do in the example, that the repurchase does not boost the short-term stock price) that is actually worth $100.

        From a current-shareholder perspective, the outcome of costly contraction might not be objectionable. The long-term shareholder and the short-term shareholder come out ahead, jointly and perhaps even individually. But from an economic perspective, which takes into account the size of the total pie produced by the firm over time for all of its shareholders, current and future, destroying $10 of economic value to boost the payouts for current shareholders is undesirable.

      2. Must Economic Value Be Sacrificed To Engage in Bargain Repurchases?

        One might argue that a firm repurchasing its stock should be able to pursue both the valuable project and buy back stock that trades at a low price. In a world of perfectly efficient capital markets, this objection would have considerable force: the firm should be able to borrow cheaply enough to buy its own stock and invest in valuable new projects. (143)

        However, as I have explained elsewhere, (144) a firm may not be able to borrow enough money to fund the desirable project while also buying back stock at a low price. First, as economists have long understood, the information asymmetry between lenders and the firm may make it difficult for the firm to borrow money cost-effectively. (145) From their perches inside the firm, managers may understand that the firm's prospects are good. But lenders outside the firm, who have less information than the managers, may not be as confident. They may insist on loan terms that make the costs of financing the desirable project higher than the benefits.

        Second, the firm's contractual arrangements with other lenders might impede additional debt financing. Even if Lender A were willing to lend to the firm on cost-effective terms, loan covenants with Lenders B, C, and D might bar the firm from borrowing additional funds (from Lender A or any other creditor). (146) While renegotiation is possible in theory, it might be difficult in practice, particularly if the borrower must simultaneously renegotiate with multiple creditors to obtain the modifications needed to facilitate the new investment.

        In short, firms may need to choose between engaging in a bargain price repurchase and funding desirable projects. Indeed, empirical evidence suggests that repurchases often divert cash that would otherwise be used for research and development and other productive investments in the firm. (147) For example, one study found that repurchases appear to have a significantly negative effect on a firm's short-term investments and R&D, with a doubling of repurchases leading to an 8% reduction in R&D expenditures. (148)

    2. Costly Price-Depressing Manipulation Around Bargain Repurchases

      We saw in Part III that managers serving short-term shareholders may engage in costly price-boosting manipulation to lift the short-term stock price. We will now see that managers serving long-term shareholders may engage in costly price-depressing manipulation to reduce the short-term stock price around bargain repurchases; indeed, there is evidence that such costly price manipulation already occurs around repurchases.

      As Part IV explained, long-term shareholder returns in a repurchasing firm depend on the price at which the firm buys its own shares. Long-term shareholders benefit when the repurchase price is low (relative to the no-transaction value of the stock); the lower the price, the better off long-term shareholders will be. Managers repurchasing cheap shares in the short term can therefore benefit long-term shareholders by further depressing the short-term stock price. (149)

      Importantly, managers can help long-term shareholders by manipulating the stock price around repurchases even when some economic value is sacrificed. In particular, assuming that long-term shareholders' losses from value destruction are lower than the benefit of the reduced repurchase price, long-term shareholders will prefer that managers engage in costly price-depressing manipulation. (150)

      In fact, there is evidence that managers manipulate prices before and during repurchases, deliberately driving earnings and stock prices down to increase the amount of value transferred to long-term shareholders. One study examined 1720 OMR announcements between 1984 and 2002 that were followed by actual repurchases during the quarter of the announcement or the following quarter. (151) The study found significant negative earnings manipulation among firms that announced and conducted OMRs, but not among firms that announced OMRs but did not conduct them. (152)

      Not surprisingly, downward earnings manipulation was more aggressive in firms in which the equity ownership of the CEO was higher--that is, when the CEO's interests were more aligned with the interests of long-term shareholders. (153) This finding strongly suggests that, the more the board and management focus on maximizing long-term shareholder value, the more likely managers will be to engage in costly price-depressing manipulation.

      To be sure, long-term shareholders will not always benefit from costly price manipulation. If costly price manipulation destroys too much of the pie, then long-term shareholders will be made worse off. But the important point is that, just as short-term shareholders can benefit from costly price-boosting manipulation that lifts the short-term stock price, long-term shareholders can benefit from costly price-depressing manipulation of a kind that reduces the short-term stock price when the firm is...

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