pension fund perspective: mergers and the demand for stock

CFA Institute

Pension Fund Perspective: Mergers and the Demand for StockAuthor(s): Patrick J. ReganSource: Financial Analysts Journal, Vol. 45, No. 1 (Jan. - Feb., 1989), pp. 18-21Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479183 .

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Pension Fund PerspectiveBEA As

Mergers and The Demand For Stock

Over most of the past two decades, stock prices have moved upward as the demand for shares far exceeded the supply. The best aggregate statistics we have on the specific components of the supply/demand equation come from the Federal Reserve Board's Flow of Funds Quarterly Report. The data con- firm what analysts know intuitively: Since 1984, stock prices have risen pri- marily because of a shrinkage of supply, as cash mergers, leveraged buyouts, restructurings and corporate share repurchases have removed over $100 billion of stock per year. Adjusted for new issues of stock, the corporate sector has been absorbing $60 to $70 billion a year, which, when added to the $40 to $50 billion a year that institutional investors have been pumping into stocks, ac- counts for the great bull market.

Since the October 1987 crash, however, institutional investors, foreigners and individuals have been liquidating stocks, leaving corporations as the principal source of demand. For the first three quarters of 1988, foreign corporations were acquiring U.S. corporations at an $80 billion annual rate, while domestic corporate purchases were running at a $150 billion annual rate. Adjusted for new issues of $40 billion, the $190 billion demand for stocks was more than sufficient to absorb the net selling by individuals, institutions and foreigners. But if a recession or political action slows down the megamerger and LBO activity, who will provide the marginal demand for stocks?

Demand for Stock Shrinking The single largest factor in the Flow

of Funds report is the household sector, which holds about $9 trillion. Since 1974, households have held a steady 20 to 25 per cent of their financial assets in equities, with the ratio at the

high end just before the crash and at the low end now. Except for 1976, the household sector has sold stock on balance in each of the last 20 years. Since 1984, individuals have stepped up their selling to the tune of $100 billion a year, though some of the money was no doubt shifted to mutual funds.

The mutual fund industry suffered net redemptions in the 1970s and was a net seller of equities until 1982. From then until the third quarter of 1987, mutual fund assets surged, and their equity holdings rose fourfold to over $200 billion. But the combination of the crash and the tightening of Indi- vidual Retirement Account (IRA) de- ductions has forced mutual funds to again liquidate stocks.

Following the 1974 passage of the Employee Retirement Income Security Act (ERISA), private noninsured pension funds were a major source of demand for stocks. But they later shifted their asset mix toward bonds; equities dropped to a mere 50 per cent of assets in 1981, a ratio that has been pretty constant ever since. Beginning with 1985, private pension funds have actually been net sellers of equities. It is unlikely that pension funds would allow equities to fall below 50 per cent of assets, so there could be a renewed demand for stocks if bonds should outperform.

In contrast, public pension funds have had a voracious appetite for stocks. Until the 1980s, many state and local governments did not allow their pension funds to hold more than 25 to 50 per cent of their assets in common stock. As those laws were amended, the public funds raised their equity exposure. According to the Federal Reserve study, stocks constituted 21 to 22 per cent of public pension fund assets from 1977 until 1982. But by September 1987, helped by legislative changes and a bull market, they were up to 40 per cent of assets. Indeed, in

the first half of 1987, over 80 per cent of the public funds' cash flow went into stocks, an acquisition rate that resembled that of the private pension funds in the late 1960s and early 1970s.

Since the crash, though, that acquisition rate has been cut in half, and equities have dropped to 35 to 36 per cent of assets. The ratio is unlikely to climb above 40 per cent any time soon, which means that public funds will devote much less to equities than the $20 to $30 billion figures of recent years. In fact, in the fourth quarter of 1987, the annual figure was under $10 billion, the lowest since 1984's $7.3 billion.

The shifts of public pension funds are important, as they stepped up their acquisition of equities in 1985-87, at precisely the time private pension funds began cutting back on equities. In 1987, public funds acquired $26.4 billion of stock, while private pension funds sold $27.8 billion. But for the first half of 1988, based on the latest data available from the Federal Re- serve Board, public funds were buying at a $17 billion annual rate, not nearly sufficient to absorb the sales by the private pension funds, which were running at nearly a $32 billion annual rate.

The Federal Reserve category of "institutional investors" includes other groups in addition to the mutual funds and the public and private pension funds. The life insurance companies have maintained equities at 10 per cent of their assets for over a decade, and they account for a few billion dollars of demand each year. The property and casualty insurance companies have held 18 to 20 per cent of their assets in equities, but they have been selling stock in recent years, and the ratio now stands at the lower end of the range. Securities brokers and dealers are another source of marginal demand, but their net transactions have been modest. The final group is for- 1. Footnotes appear at end of article.

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1989 U 18



Table I Demand for Stock by Institutional Investors*

Holdings Acquisition Rate

Equities Equities Financial as % of Financial as % of

Year Assets Equities Total Assets Equities Total

1968 $ 522.6 $ 172.0 32.9% $ 37.8 $ 12.5 33.1% 1969 536.0 164.7 30.7 33.7 13.3 39.5 1970 568.7 173.8 30.6 34.4 11.2 32.4 1971 656.6 222.2 33.8 55.8 19.7 35.4 1972 753.4 271.5 36.0 70.6 23.2 32.9 1973 755.9 233.5 30.9 52.6 14.3 27.2 1974 760.7 178.0 23.4 67.4 6.0 8.9 1975 886.4 246.3 27.8 73.2 15.7 21.4 1976 1,016.6 288.0 28.3 101.0 11.4 11.3 1977 1,118.1 276.5 24.7 125.0 13.4 10.7 1978 1,306.0 313.7 24.0 161.8 15.0 9.3 1979 1,473.6 362.5 24.6 138.5 20.4 14.7 1980 1,718.9 456.6 26.6 159.6 28.9 18.1 1981 1,839.1 450.1 24.5 146.7 34.5 23.5 1982 2,068.9 544.1 26.3 158.5 31.8 20.1 1983 2,399.4 694.3 28.9 237.0 53.4 22.5 1984 2,677.6 694.2 25.9 285.1 10.5 3.7 1985 3,247.6 893.7 27.5 413.9 39.1 9.4 1986 3,964.3 1,090.8 27.5 570.8 52.7 9.2 1987 4,351.9 1,148.4 26.4 412.3 40.5 9.8

1987: 1 4,314.8 1,323.0 30.7 637.5 55.2 8.7 2 4,446.8 1,391.9 31.3 440.6 103.5 23.5 3 4,647.8 1,480.2 31.8 499.1 32.1 6.4 4 4,351.9 1,148.4 26.4 71.9 (29.1) NMt

1988: 1 4,573.8 1,233.2 27.0 496.5 (37.1) NMt 2 4,712.2 1,284.6 27.3 460.3 (13.1) NMt

Annual Growth 1968-1987 11.8% 10.5%

Source: S.G. Einhorn and P.C. Shangkuan, "Equities: Supply and Demand" (Goldman Sachs, New York, October 1988). *Includes private pension funds, public pension funds, life and other insurance companies, mutual funds, security brokers and dealers, and foreign investors. Dollars in billions. tNot meaningful.

eign investors, who were accumulat- ing approximately $5 billion of stock per year in the 1980s until 1986. That year they bought $17.8 billion of U.S. equities, and in the first three quarters of 1987 they accelerated their purchases to a $29 billion annual rate. Since the crash, however, they have been modest net sellers.

Table I shows that institutional investors as a whole have been net sellers since the crash (at a $26 billion annual rate), after several years of annual purchases of $40 to $50 billion. The most striking figure is the second quarter of 1987. With the Dow Jones Industrial Average at 2400, the institutional investors were gorging them- selves on stocks at an annualized rate of over $100 billion a year, led by the public pension funds ($44 billion), mu-

tual funds ($39 billion) and foreigners ($29 billion).

If the household sector and the institutional investors have been net sellers since the crash, who has been buying stock? The answer is not surprising- the corporations. Table II, prepared by Goldman Sachs, provides an amazing set of statistics. ' Throughout the 1970s and until 1984, corporations were a source of supply, as they typically issued $5 to $10 billion more in new shares than they retired. But with the rise of corporate raiders like T. Boone Pickens and Carl Icahn, 1984 marked the beginning of corporate restructur- ing and the megamerger.

As the table shows, the combination of cash mergers, leveraged buyouts and share repurchases has pulled an average of $100 billion a year out of the

system each year after 1984. Net of new issues of stock, corporations have been absorbing $60 to $70 billion a year in equities. And the pace has accelerated since the crash, as the net figure for the first three quarters of 1988 surged to over a $100 billion annual rate, more than enough to offset the net selling of the household sector and institutional investors. Table III shows that foreign corporate acquisitions of U.S. companies doubled from 1986's $19.4 billion to 1987's $36.1 billion. Based on Goldman Sachs' estimates, the figure doubled again in 1988, to a $60 billion annual rate.

Implications for the Future What are the implications of these

data? The household sector has been liquidating stocks for two decades, but

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1989 O 19



Table II Change in Shares (billions of dollars, at annual rate)

Net Gross Change Gross New Change in

Year in Shares* Issues Shares

1968 $ (3.5) $ 3.9 $ 0.5 1969 (3.0) 7.7 4.7 1970 0.5 7.2 7.7 1971 4.2 9.5 13.7 1972 3.7 10.7 14.5 1973 3.3 7.5 10.8 1974 1.3 4.0 5.3 1975 3.6 7.4 11.0 1976 4.7 8.3 13.0 1977 (2.5) 7.9 5.4 1978 (5.1) 7.5 2.4 1979 (12.9) 7.8 (5.2) 1980 (1.8) 16.9 15.0 1981 (32.3) 23.6 (8.8) 1982 (13.9) 25.0 11.1 1983 (17.2) 44.4 27.1 1984 (84.8) 18.5 (66.3) 1985 (97.0) 29.0 (68.0) 1986 (119.6) 50.3 (69.2) 1987 (99.9) 43.2 (56.6)

1987: 1 (89.5) 51.6 (37.9) 2 (123.3) 56.8 (66.5) 3 (107.7) 48.1 (59.6) 4 (78.9) 16.4 (62.5)

1988: 1 (116.8) 37.3 (79.5) 2 (612.6) 40.0 (122.5) 3t (150.0) 40.0 (110.0)

Source: S.G. Einhorn and P.C. Shangkuan, "Equities: Supply and Demand" (Goldman Sachs, New York, October 1988). *U. S. corporate demand for shares stemming from cash mergers, LBOs and share repurchases. tEstimated.

stocks are down to a historically low 20 per cent of financial assets, so the selling may dissipate. Private pension funds are now overfunded and have been net sellers of stock for the last few years. Given the recent volatility of the stock market and the rules of the Financial Accounting Standards

Board's Statement No. 87, it is unlikely that private pension funds will turn heavily to equities in the near future. But it is also unlikely that they will allow the ratio of stocks to financial assets to slip significantly below the current 50 per cent, which is a record low.

Public pension funds have poured their cash flow into equities over the last six years, spurred by the legislative changes that allowed greater equity exposure. But with stocks having grown from 21 per cent of public pension assets in 1981 to 36 per cent now, the major portion of the asset mix shift is behind us. Mutual funds benefited from huge inflows of IRA money, but the tax law changes reversed that trend in 1987. Foreign investors hold huge sums of dollars and U.S. Trea- sury securities. They generally follow a trend, and may come back to U.S. stocks once a strong uptrend becomes apparent.

The big unknown is the demand for stock by corporations. With the stock market at more than two times book value, corporate return on equity at 15 to 16 per cent and interest rates on Treasury notes and bonds at 9 per cent, the economics of stock buyback programs has to be questioned. Simi- larly, with recent acquisitions like Kraft going for five or six times book value, we have to wonder how much longer the merger boom can continue. That leaves us with the leveraged buyout funds as the key source of demand. They hold an estimated $25 billion and could conceivably buy $250 billion worth of companies.

Prior to the RJR Nabisco deal, the largest LBO had been the $6.2 billion takeover of Beatrice Foods by Kohl- berg, Kravis, Roberts & Co. In October 1987, the chairman of RJR let it be known that a management group might take the company private in a $17 billion deal, and Henry Kravis and KKR jumped in with a $25 billion offer in order to "protect his franchise." The move unleashed a torrent of negative publicity, as Business Week ran a cover story on "King Henry," Federal Re- serve Chairman Alan Greenspan warned the banking system on the dangers of LBO financing and Senator Robert Dole suggested that Congress re-examine the tax-deductibility of LBO debt.

Theodore Forstmann, head of KKR's arch-rival in LBO deals, Forst- mann Little & Co., wrote an op-ed piece for The Wall Street Journal decry- ing the deterioration of standards in LBO financing. According to Forst- mann:

Today's financial age has become a period of unbridled excess with ac- cepted risk soaring out of propor- tion to possible reward. Every week, with ever-increasing levels of irre- sponsibility, many billions of dollars in American assets are being sad- dled with debt that has virtually no chance of being repaid.2

Even Martin Lipton, whose law firm made a reported $20 million fee for two weeks' work on the sale of Kraft to Philip Morris in October, is worried

Table III Foreign-Company Acquisition of U.S. Companies

Amount Year (billions)

1984 $ 6.3 1985 14.0 1986 19.4 1987 36.1 1988 60.0*

Source: S.G. Einhorn and P.C. Shangkuan, "Equi- ties: Supply and Demand" (Goldman Sachs, New York, October 1988). *First nine-month data at annual rate; includes announced and completed deals.

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1989 O 20



that the merger and LBO game is nearly over:

The nation is in great jeopardy by everything that is going on. We are forcing an unlivable amount of leverage on American business. We are forcing every business to focus on short-term results and we are depriving our future generations of research and development. One of these days, we're going to have a tremendous crash.3

The LBO funds are not going to disappear. More likely, they will use less leverage and concentrate on mid- sized companies rather than the corporate giants that are so politically visible. Reduced availability of LBO debt financing will take the pressure off bluechip companies like Sears and Union Carbide, which have done restructurings and major stock buybacks to ward off potential raiders. Thus we would expect to see the dollar volume of mergers, LBOs, restructurings and stock buybacks shrink, although the activity may simply shift from the bluechips to smaller companies.

There may be a similar investment shift by public pension funds. As they rushed to boost their equity exposure, the favored vehicle was the index fund. Now they seem to be looking beyond the S&P 500 for some diversifi- cation, a trend that would aid the medium and smaller companies. Fi- nally, the household sector, mutual funds and private pension funds have historically low equity exposure. These are groups that have traditional- ly favored smaller companies over the bluechips, so their return to the demand side of the equation could tip the balance.

Footnotes

1. S. G. Einhorn and P. C. Shang- kuan, "Equities: Supply and De- mand" (Goldman Sachs, New York, October 1988).

2. T. J. Forstmann, "Violating Our Rules of Prudence," The Wall Street Journal, October 25, 1988, p. A-26.

3. N. R. Kleinfield, quoting Martin Lipton in "Some Familiar Faces in the Buyout Crowd," The New York Times, October 30, 1988, p. F-9. The fees derived by the Lipton law firm on takeovers were mentioned in S. J. Adler and L. P. Cohen, "Even Lawyers Gasp Over the Stiff Fees of Wachtel Lipton," The Wall Street Journal, November 2, 1988, p. A-10.

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pension fund perspective: mergers and the demand for stock

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