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LEVERAGING THE UNDERINVESTMENT PROBLEM: HOW HIGH DEBT AND MANAGEMENT SHAREHOLDINGS SOLVE THE AGENCY COSTS OF FREE CASH FLOW
Author(s) -
Garvey Gerald T.
Publication year - 1992
Publication title -
journal of financial research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.319
H-Index - 49
eISSN - 1475-6803
pISSN - 0270-2592
DOI - 10.1111/j.1475-6803.1992.tb00795.x
Subject(s) - free cash flow , leverage (statistics) , debt , cash flow , incentive , agency cost , business , equity (law) , monetary economics , finance , leveraged buyout , economics , shareholder , microeconomics , private equity , corporate governance , machine learning , computer science , political science , law
It is argued that leveraged buyouts (LBOs) provide managers with a powerful incentive to release excess cash rather than invest in negative net present value projects. This incentive is attributed to the large debt obligations associated with “junk” bond financing and to an increase in the shareholdings of top management. In this paper I explore the conditions under which leverage and management shareholdings complement one another in resolving the agency costs of free cash flow and would therefore optimally be used “together” as in an LBO. Complementarity is shown to obtain under plausible conditions, essentially because increased leverage reduces equityholders' share of investment returns. Increased management shareholdings then leverage this underinvestment effect. My analysis also helps explain why top managers who participate in an LBO receive a highly leveraged equity claim rather than a share of the “strip” that is generally provided to outside investors.