By the Editor
The coronavirus is wreaking havoc across our country. Extensive government-mandated business closures are causing serious economic damage. In response, our federal government is considering a variety of rescue packages for companies and individuals. One area of discussion is the treatment of stock buybacks, in particular for companies receiving rescue financing. Unfortunately, this debate has been clouded by a misunderstanding of this topic as well as longstanding political opposition to stock buybacks in general. Stock buybacks are an important tool for companies to efficiently manage their capital structures. During times of economic stress or after a taxpayer-funded rescue package, it is appropriate for companies to stop buying back their stock. Otherwise, it is counterproductive for politicians to meddle in private sector capital allocation decisions.
First, it is important to understand stock buybacks and how they are used by companies. As a company operates its business, management will plan on maintaining a capital structure with a target percentage of equity capital appropriate for the industry and the risk in the operating environment. This capital plan should include enough equity for a variety of economic situations, such as recessions, new investment opportunities, or the emergence of competitive threats. Equity is more expensive than debt, so holding too much equity is inefficient and reduces the productivity of our economy. On the other hand, too much debt can be risky. So managements strike a balance they believe will be appropriate for a range of economic situations.
It is not realistic to expect companies to carry enough surplus equity capital to deal with every hypothetical situation that could possibly occur, such as this once-in-a-century pandemic. Indeed, it would be extremely inefficient for companies to design their capital structures with such highly unlikely and difficult to predict events in mind. This would substantially reduce the growth rate and employment potential in our economy. To the extent American companies were required to maintain such excess amounts of equity, their global rivals would gain a significant competitive advantage.
Companies sometimes find themselves with more equity than required by their target equity to debt ratio. Often this occurs when companies cannot find enough investment opportunities that meet their minimum rate of return hurdles. When this happens, equity capital can be returned to shareholders via stock buybacks or dividends, allowing shareholders to earn a return on their investment. Shareholders can then reallocate this capital to other more compelling investment opportunities, thereby improving productivity and economic growth.
Buybacks are fundamentally similar to dividends. Both are ways to return excess equity capital to shareholders. Instead of using buybacks to manage its capital structure, a business could instead declare a one-time special dividend. Some taxable shareholders prefer stock buybacks as a way for companies to return capital because dividends are taxed when they are received while capital gains are not taxable until they are realized. From the company’s perspective, both approaches serve the same function.
All this seems fairly logical. So, why do some people find the concept of stock buybacks offensive? Some people imagine that if companies were prohibited from using buybacks to return excess capital to shareholders, this money would be paid to employees. But in our free market system, companies are already incentivized to pay their employees the going rate. Artificially forcing companies to pay employees above the market rate would put those companies at a competitive disadvantage, hurting the business. Over time, jobs would be lost.
Others say that if companies were forced to hold on to excess equity, then they would be motivated to invest those amounts. But if companies had good investment opportunities, they would already be using their equity for those purposes. Also, this concern misses the point that excess equity capital returned to shareholders via buybacks is recycled to other more attractive investments. This optimization of capital boosts our economy overall. Any prohibition of this healthy process would create an inefficient allocation of capital, slowing our economy.
A more legitimate complaint is that stock buybacks can be used to manipulate earnings per share measurements and improperly increase executive compensation. If this is happening, the problem is poorly designed management incentive packages. Corporate boards should establish executive compensation plans based on fundamental performance and not financial targets that can be artificially manipulated.
Opponents of stock buybacks have long argued that government should prohibit stock repurchases. This would be a terrible idea. The government has little understanding of the unique risks and opportunities faced by the wide variety of industries operating in our economy and has no expertise in how to direct companies to manage their capital structures. Government interference in capital allocation decisions would inevitably create a drag on our economic productivity.
Also, this type of prohibition would be complicated. Logically, a restriction on buybacks would also apply to one-time special dividends. How would this limit be defined? Perhaps by prohibiting distributions above the historical level of dividends increased by some “appropriate” growth rate. Such limitations would be cumbersome and difficult to estimate in our dynamic economy. This type of government micromanagement would likely have unintended adverse consequences. Companies with conservative dividend levels might worry that such a distribution cap could constrain their ability to disburse surplus equity capital. This could create an incentive for them to increase ongoing dividends to more aggressive levels to avoid the potential drag of trapped excess equity capital. Perversely, this could be a source of increased financial risk in the economy.
Turning to the current situation, how should we think about buybacks for companies receiving rescue packages? In the case of the coronavirus crisis, companies are faced with an unexpected external shock not of their own making and therefore seem deserving of rescue funding. Indeed, before the virus hit, the economy was performing strongly and most companies now being considered for rescue packages were doing well and had generally healthy balance sheets. Pre-crisis, these companies were properly capitalized for the existing operating environment. Some may have undertaken stock buybacks in the preceding years. But the unforeseeable disastrous impact of the crisis is not a valid reason to second guess their decisions to return excess capital to shareholders based on the economic situation at the time.
Having said that, it is entirely reasonable for the government to insist that any company receiving a rescue package must stop share buybacks until rescue funds have been repaid. Such a requirement is a normal protection for a lender to a distressed company. After the rescue financing has been repaid, these prohibitions should fall away and companies should be allowed to manage their capital structures as efficiently as possible.
There is nothing inherently bad about stock buybacks. Buybacks are a healthy way for companies to recycle equity capital to more efficient uses, thereby promoting the overall health of the economy. It is fair to prohibit buybacks for any company receiving a rescue package, but such restrictions should terminate when the rescue funding has been repaid. Apart from certain highly-regulated monopolies such as utilities, the government should not be in the business of telling companies what the right capital structure is for their particular situation. This would only put pressure on the growth potential of our companies. We should be careful that our crisis response does not create ongoing inefficiencies in the economy such as limitations on stock buybacks undertaken in the normal course.