Structured Finance, Acquisitions and Debt Agency

Abstract

Modern corporations use complex debt instruments and pursue acquisitions. In order to analyze the properties of some of these contracts in the event of an acquisition, this paper considers a company that has an incumbent capital structure, comprising one of five practically important structured debt contracts. An opportunity for an acquisition comes along that was not ex-ante contractible. The equity holder decides on the financing of this expansion by trading off tax advantages of debt against costs of bankruptcy. The model yields a number of insights for structured debt and acquisitions, four of which are as follows: First, a seniority clause offers the bondholder protection from agency, but it also decreases the equity holder’s incentives to finance the acquisition. Second, embedded call options are valuable even if interest rates are constant, because they allow the equity holder to issue a new bond at fair value. Third, bankruptcy remoteness is valuable, if assets are very risky. Fourth, convertible bonds are vulnerable to agency and the conversion option bears the same incentive problem as a seniority clause. These properties explains, for example, the otherwise puzzling practice of companies buying out convertible bond holders prior to an acquisition.

Keywords: Capital structure, mergers and acquisitions, structured finance

JEL Classification: G24, G32, G34