The Leveraged Recapitalization

Less than a year after Sealed Air embarked on a program to improve manufacturing efficiency and product quality, the company borrowed almost 90% of the market value of its common stock and paid it out as a special dividend to shareholders. Management purposefully and successfully used the leveraged recapitalization as a watershed event, creating a crisis that disrupted the status quo and promoted internal change, which included establishing a new objective, changing compensation systems, and reorganizing manufacturing and capital budgeting processes. This decision provides a context in which to explore how financing decisions affect organizational structure, management decision making, and firm value. It gives one an opportunity to analyze the concept of free cash flow, its effect on stock market prices and firm value, and the disciplinary role of high leverage.

In 1989 the company's stock price seemed depressed -- at best, it was going nowhere. Yet Sealed Air's business threw off a lot of cash. Prior to the recap the company had over $50 million in cash and short-term investments and Dermot Dunphy, CEO, expected cash on hand to more than double over the next year and a half.  Bruce Cruickshank described the company's situation, stating "there were no good acquisitions and we had nothing to do with the cash. Just increasing the dividend over the years was admitting defeat. We didn't want to be a public utility."

One reason that Sealed Air's stock was "undervalued" was because the company was generating "free cash flow". Free cash flow in excess of that required to fund all the company's positive net present value investment opportunities tempts companies to waste money. Pete Funkhouser, Senior Vice President, described this problem at Sealed Air, "We didn't need to manufacture efficiently, we didn't need to worry about cash. At Sealed Air, capital tended to have limited value attached to it - cash was perceived as being free and abundant." For some companies, the most productive use of free cash flow is to distribute it to shareholderss and allow them to reinvest of spend it as they choose. The market applied a discount to Sealed Air's stock because manaagers could not make a believable promise to disgorge the cash. Paying out today's cash balance ($54 million) would not solve the problem.  Borrowing and paying the proceeds to shareholders served to reinforce managements's promise not to retain future excess cash.  

Sealed Air's management faced many alternative uses for the company's cash. Among them were launching a capital expenditure program, buying another company, increasing the regular dividend,  or starting to manage a portfolio of securities. One could argue that the decision to recapitalize demonstrates a failure on the part of the top management team; they should have been able to find something productive to do with the money.  

In fact, Dunphy felt strongly that his job was not to be a portfolio manager, nor did he want to waste shareholders' money on a second-rate acquisition. He decided not only to pay out the cash on hand, but to borrow against the company's future cash flows and pay the $40 special dividend. Dunphy felt the market was "substantially undervaluing" the company's stock and seriously considered paying out $45 - almost the entire stock price - to demonstrate that there was excess value to be realized. Future cash flows would be committed to lenders who had a legally enforceable claim on a specified cash flow stream.

Financing the Transaction

Many shareholders felt this leverage would make the company riskier. Moreover, the banks had a negative reaction. First, management, as shareholders, would receive a substantial payout. Second, the company would end up with negative net worth. Many banks could not get a deal with negative net worth past the loan committee.

Despite these problems, Sealed Air managed to finance the special dividend. Banker's Trust led a syndicate that loaned 137 under a senior secured bank credit agreement. The loan imposed some stringent contraints on the company, including severe limitations on capital expenditures. The company also issued $170 million in subordinated bridge notes which were later refinanced with a public offering of senior subordinated notes. The remainder of the $340 million came from cash.

The Result

Following the announcement of the dividend, the comany's share price rose briefly -- then, after the share went ex-dividend, it fell to $12. After that, it rose steadly -- to $20 by the end of the year, and much higher in following years, as the company gradually brought its debt down to a more standard level.

Looking back, Dunphy reviewed the result. "There is no doubt that we executed a successful financial transaction. The danger is that it is only that - a financial transaction."

3. How much value was created? Where did it come from?