, Research Paper
The basic thrust of the case is an examination of debt management and how active management of a debt portfolio can positively affect a firm?s performance. The case examines Union Carbide Corporation?s (UCC) approach to debt management as an illustrative example of how corporate finance practices can have a material impact on a firm?s operating results. In the early 80s UCC was a very large firm which enjoyed a vertically integrated set of businesses that were structured to minimize the impacts of the cyclical nature of some of their larger components. UCC had always been able to balance the operating results of the firm through the separate environments of their distinct businesses. This ability had allowed them to take a somewhat laizze-faire attitude towards their debt portfolio. However, the well publicized accident in Bhopal and the subsequent loss of market value made UCC an attractive takeover candidate. UCC?s reaction to this and their subsequent corporate structure forced a change in UCC?s approach to debt and the associated management philosophy for their debt portfolio.
As part of their takeover defense in 1986 UCC increased their debt level significantly (debt/capital ratio approximately 88%) . As a result of this restructuring Union Carbide Corporation?s debt rating was reduced thereby requiring them to pay interest rates of 13%-15% on this huge debt load . The net result of this was that, in order to service this debt, UCC was forced to drastically reduce their capital and Research and Development spending. Obviously this was not a situation that UCC could continue to abide and as such they took significant steps to restructure the company in late 1986. As part of this restructuring UCC sold off many of its non-core businesses and used the proceeds from these sales to reduce the debt. One of the implications of this consolidation was that UCC lost their ability to offset the cyclical nature of their chemicals and plastics business with the more predictable, and more easily manipulated, consumer products business. The other major impact was that UCC?s revenues were significantly reduced thereby creating an increased focus on the cash flow requirements to service the debt. UCC?s Treasury department reacted to this change by proposing an active approach to managing the debt portfolio and its associated interest rate risk. This was an entirely appropriate response to the situation UCC had created for themselves. In fact I believe that active debt portfolio management is prudent for all firms. Most firms do not find themselves in the same debt situation as did UCC, and as such, do not need to expend the same level of effort in this area as UCC. This fact notwithstanding, firms should pay attention to their debt portfolios and understand the options available to them and the likely impacts of each of those options. Interest exposure is a real problem and should be understood and minimized. If firms do not actively manage their debt portfolios they open themselves up interest rate risks that may well catch them unawares. The impacts of a change in interest rates can be significant and, in the worst case, and if not anticipated and hopefully minimized can cause harm to the firm. On the other hand even if interest rate changes do not have a negative impact on the firm, swings that could have been exploited to the firm?s advantage go unnoticed and thereby disadvantage the firm competitively.
Interest rate risk management has several components. A firm must understand the debt requirements of its business and the various funding sources available to them. The recognition of these components, along with the firm?s ability to define and meet their requirements can have a significant impact upon the firm?s efficient use of capital. The more important debt is to a firm, the more important interest rate risk management is to the firm. In the case of UCC, their debt load dictated that they take an active approach to managing the interest rate risk associated with their capital structure. While most firms are not as heavily leveraged as UCC, I believe that all firms would benefit from active debt portfolio management. UCC?s treasury department study showed that their proposal would have resulted in a net benefit of $79.5M to UCC?s shareholders if it had been in place for the previous nine years . This figure represents over 3% of the total net income for nine year period (1982-1990), clearly this is a significant benefit worthy of pursuit.
One of the first steps undertaken by UCC?s Treasury Group was to develop what they termed a normalized portfolio of securities. Part of this approach was to always view the management of UCC?s debt from a portfolio perspective. That is to say that UCC would always view their options holistically rather than attempting to micromanage each individual security. Given this philosophy UCC developed a normalized portfolio which they felt represented the optimal mix of security durations and types (fixed and floating). The intention was to develop a benchmark that would provide the best possible advantage to UCC if left unmanaged. UCC would then compare their actual performance against the hypothetical performance of the “normalized” portfolio to determine if their active management had been beneficial to UCC. Being a proponent of objective measures I believe that this is very intriguing approach. The fact that a mechanism exists for measuring the department?s efficacy contributes to the likelihood of producing a valid measurement. When evaluating performance and impact it is always important to be able to measure the impact of the actions taken by the group being evaluated. One must always remember that a rising tide lifts all ships. This requires that you be able to separate the impact of the group being measured from the changes and impacts inherent to the environment in which they operate.
One of the key aspects of the Treasury Group?s proposal was to determine what types of things affected UCC?s debt portfolio performance. They undertook numerous studies to identify macroeconomic factors that correlated well with UCC?s profitability , as measured by the ROA of UCC?s Chemicals and Plastics business. The intent was to try and match interest rate costs to UCC?s performance. The net result of this analysis was to show that the only factors with a high degree of correlation were ROA versus short term interest rates (as measured by the federal funds rate and the prime rate), and ROA versus the shape of the yield curve . This correlation is very clear in exhibits 6 and 7 from the case. Another thing that is clear from these exhibits is the marked improvement in C&P?s ROA beginning in 1989. Although not clearly stated in the case I suspect that this is due to the active management of UCC?s debt portfolio. Exhibit 8 shows a decision matrix designed to show how UCC would react to various opinions about likely changes in short term rates or the yield curve. The exhibit shows how the Treasury Group would likely react in each instance.
UCC?s Treasury group?s formal strategy (case pages 9-12) clearly outlines their plan. In his presentation to the board, UCC Treasurer John Clerico, pointed out that even though UCC survived the most dangerous period, they would benefit from systematic active management of their interest rate risk. In my opinion the research conducted by UCC was very thorough. A key point that especially struck me was to find that the average duration UCC?s assets was approximately four years. Obviously UCC would want to have their normalized portfolio closely manage the assets acquired with the debt. As such, Clerico explained that the fictional normalized portfolio would have a four year duration, exhibit a smooth rollover profile, and comprise a 40/60 split between floating rate and fixed rate securities. Beyond this Clerico?s plan had three major elements:
Long Term Debt: For long term debt Clerico proposed that his group engage in limited active management. The intention behind this approach is to minimize the additional risk inherent in active management while actively monitoring the opportunities available for manipulating this debt. The net result is that the management of the long term debt would primarily consist of structuring the long term portfolio at the outset so that all that would be required on an ongoing basis would be to manage the timing of bond issuance and redemption and to use certain other tools to make specific adjustments to the portfolio to meet specific objectives (options, swaps, derivatives, etc). Clerico stated that the underlying assumption behind this approach is that management has superior knowledge about the marketability of its own securities and any potential arbitrage opportunities .
Short Term Debt: Clerico recommended an active approach to the management of short term debt. This active approach would take into account not only the Treasury group?s analysis of the short term opportunities available but also paid particular attention to UCC?s funding requirements. Clerico?s team would balance these two views to best determine how the short term portion of the portfolio should be allocated. The primary caveats Clerico expressed were that the short term hedging activities would be limited to certain types of instruments and should not be allowed to exceed the net amount of floating rate debt outstanding.
Performance Analysis: To me the key point in Clerico?s presentation was his proposal to subject his team to evaluation by comparing their results against those of a hypothetical normalized portfolio of securities. This concept would allow UCC to quickly ascertain how the Treasury group?s active management of their debt portfolio had reduced their costs. In addition to allow UCC?s management to evaluate the performance of the Treasury group this also provided the Treasury group with a touchstone against which they could validate their assumptions and monitor their own efforts.
In my opinion the formal proposal put forth by Clerico is very well conceived and if I were on the UCC board I would recommend it for adoption. It appears to have considered the different requirements of short and long term debt while providing a mechanism for measuring the efficacy of the program. I especially liked Clerico?s assertion that his group was responsible for insuring that UCC was cost advantaged to their competitors in terms of the cost of capital. In the words of Tom Howes “UCC?s businesses have the responsibility to maximize return on capital. UCC?s Treasury Group has the responsibility to minimize the cost of capital.” In short, my assessment is that UCC should adopt Clerico?s proposal and move forward with the program.