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Recapitalization is a financial strategy of readjustment of a company’s capital structure by exchanging one type of financing for other. It is generally done with an objective of optimizing leverage and stabilizing the capital finance structure. The restructuring can be done by altering the debt-equity ratio of the company. It replaces one form of finance with another. For example, bonds can replace the preferred shares during this restructuring. A company can buy back its equity shares by issuing debt.
A Little More on What is Recapitalization
A company may undergo a recapitalization process for a number of reasons, including a drastic fall in stock price or a bankruptcy. It can also be done to prevent a hostile takeover, reduce the company’s debt burden, or to implement an exit strategy for venture capitalists.
One of the most common methods of recapitalization is a leveraged recapitalization. A company issues new bonds and buys back its own shares with the money earned from those bonds. A company often opts for this type of recapitalization on the occasions of a steep decline in the price of the shares of the company. It is done to increase the per share price of the company by reducing the number of outstanding shares in the market. Issuing debt in order to buy back the shares increases the debt-to-equity ratio in the capital structure. While funds used to pay dividends are taxable, the interest payments of debts are tax deductible.
Another method of restructuring is the equity recapitalization process. In this method, equity stocks are issued for raising money. Then, those funds are used for buying back the debt securities. This recapitalization process helps to reduce the debt-to-equity ratio of a company. A higher debt-to-equity ratio puts an extra burden on a company’s finances, as a company needs to pay interest on its debt securities. The high debt-to-equity ratio also increases the risk level of a company and makes it less lucrative to the investor. So, the companies opt for this type of recapitalization for reducing their debt burden.
Nationalization is another type of recapitalization. It happens when the government takes part in a recapitalization process either to prevent the bankruptcy of the business or to obtain a controlling interest. In this process, the government of the nation where the company is situated buys a significant number of shares of the company. It may be done to protect an institution or company that is considered to be important for the country’s economy from insolvency and liquidity. It may also be done by a government to take over the assets of a large company, (especially a foreign company) operating in the country.
References for Recapitalization
Academic Research on Recapitalization
Efficient recapitalization, Philippon, T., & Schnabl, P. (2013The Journal of Finance, 68(1), 1-42. This is an analysis of the various government interventions aimed at recapitalizing the banking sector which restricts lending to firms due to debt overhang. An efficient recapitalization program is shown to inject capital against preferred stock warrants and implementation of conditions on sufficient bank participation. If the lower aggregate credit risk surpasses the cost of implicit transfers to bank debt holders, an efficient recapitalization becomes profitable.
Will the US bank recapitalization succeed? Eight lessons from Japan, Hoshi, T., & Kashyap, A. K. (2010). Journal of Financial Economics, 97(3), 398-417. This is a case study of the financial crisis faced by the US in 2007 and by Japan in the 1990s. It investigates the partially successful Japanese policies in recapitalizing banks and derives lessons that are used in the assessment of the policies pursued by the US. It states that the US ignored some of these lessons and utilized others in enacting its policies.
Optimal bank capital with costly recapitalization, Peura, S., & Keppo, J. (2006). The Journal of Business, 79(4), 2163-2201. This article examines the optimal bank capital choice as a dynamic trade-off between the opportunity cost of equity, loss of franchise value after the violation of minimum regulatory capital and the recapitalization cost. It also develops a model using return data of bank accounting and evaluates its ability to explain observed bank capital ratios.
Dual class firms: Capitalization, ownership structure and recapitalization back into single class, Amoako-Adu, B., & Smith, B. F. (2001). Journal of Banking & Finance, 25(6), 1083-1111. This is an analysis of changes in capitalization and the control of dual-class firms before an IPO and after. The findings suggest that the combination of a large controlling who has family interests instead of concentrated ownership results in a dual-class capitalization. Disputes regarding restricted and superior voting shareholders are documented to show the possible corporate governance problems that involve dual-class capitalization.
Organizational form and the consequences of highly leveraged transactions: Kroger’s recapitalization and Safeway’s LBO, Denis, D. J. (1994). Journal of Financial Economics, 36(2), 193-224. This article presents a comparison between the leveraged recapitalization of Kroger Co. and the leveraged buyout of Safeway stores. An analysis of the differences in the resulting organizational form indicates that they lead to significant differences in post-HLT restructuring actions and value creation. The conclusion is that these differences enable Safeway managers to generate cash more productively unlike those in Kroger.
Recapitalization and banks’ performance: A case study of Nigerian banks, Adegbaju, A. A., & Olokoyo, F. O. (2008). African Economic and Business Review, 6(1). This study investigates the effects of the previous capitalization in the banking system on the performance of banks in Nigeria to determine if the recapitalization is of any benefit. It analyzed data obtained from NDIC using both descriptive and analytical techniques. The study recommends that banks should increase their total asset turnover and diversify their funds in order to improve their return on equity.
The recapitalization of capitalism, Miller, S. M. (1978). International Journal of Urban and Regional Research, 2(1-3), 202-212. This paper investigates the ideas of various important political and academic advocates that attempt to legalize a new policy. This is because the current economic crisis has spelled an end to the post-war policy based on Keynesian principles of directed growth, the welfare state, and full employment. There are attempts all over the world, particularly in capitalist countries, to recapitalize capitalism.
Recapitalization of one class of common stock into dual-class: Growth and long-run stock returns, Dimitrov, V., & Jain, P. C. (2006). Journal of Corporate Finance, 12(2), 342-366. This research uses a sample of 178 that shifted from a one-share-one-vote to a dual-class common structure to determine whether dual-class recapitalizations are corporate initiatives to enhance shareholder value. The research shows that growth is advantageous to shareholders. Averagely, the shareholders earn huge and abnormal positive returns in four years after the announcement.
Dynamic recapitalization policies and the role of call premia and issue discounts, Fischer, E. O., Heinkel, R., & Zechner, J. (1989). Journal of Financial and Quantitative Analysis, 24(4), 427-446. This study states that the benefit of leverage depends on the firm’s recapitalization policy in a dynamic structure. It states that if the bonds are callable at par, then the equity holders have a reason to recapitalize too early. The model in the study presents the optimal call premium and the issued discount as a function of the firm-specific characteristics.
The deterioration of bank balance sheets in Japan: Risk-taking and recapitalization, Horiuchi, A., & Shimizu, K. (1998). Pacific-Basin Finance Journal, 6(1-2), 1-26. This paper examines the slowdown in the credit supply of Japanese banks in the early 1990s to determine whether the slowdown was as a result of the deterioration of their equity capital as indicated by a capital crunch hypothesis. This hypothesis gives a prediction that a reduction in capital will cause banks to reduce their capital supply. However, after critical analysis, this hypothesis is rejected.
A comparative analysis of leveraged recapitalization versus leveraged buyout as a takeover defense, Bae, S. C., & Simet, D. P. (1998). Review of Financial Economics, 7(2), 157-172. This article examines two defensive schemes which are the leveraged buyout (LBO) and leveraged recapitalization (LR) and determines whether they differently affect stockholder returns and also the firm attributes associated with the shareholder gains in their announcements. It also suggests that averagely, the stock of both schemes show significant positive and abnormal returns in the announcement period.