Over Cross Collateralization

Over-Cross-Collateralization: An Urban Problem

By John Troughton, Senior Director, Cushman & Wakefield

2008 Update

March 2008 Interview with Justin Fox of Time Magazine

In the 1980’s high-yield securities allowed mergers, acquisitions and leveraged buyouts to occur in an attempt to change the incentive structure and time horizon of management throughout America by providing the opportunity for them to have ownership participation in the enterprise. High-yield securities also provided takeover artists with the opportunity to take a company with an inefficient management structure private and restructure the company. Public companies also used high-yield securities to merge with each other in an attempt to grow the enterprise and take advantage of synergies and efficiencies.

During the debt construction and deal structuring process, management and takeover artists, merger and acquisitions professionals are all intent on structuring the deal in a way that the going-forward entity has the capability and flexibility to meet its high-yield debt obligations. Often there are portions of the firm that are likely to not be part of the going-forward entity, such as outdated plants and equipment and, often, real estate.

The financial institutions providing the bank and high-yield debt have every incentive to collateralize as much of the combined enterprise as possible. In the late 1980’s and early 1990’s – and more currently, today - many of America’s industrial companies were acquired and restructured through the process explained above. In some cases, the excess plants, equipment and real estate were valued at almost zero. Thus, when the financial engineers of a specific transaction would require the takeover artist or leveraged buyout professional to pledge underutilized assets – as well as utilized assets – to obtain financing, there was often little objection.

Additionally, on many occasions, plant, equipment and real estate assets across the Country were cross-collateralized. Sometimes the break-up fees for the financing, especially high-yield financing, were worth more than any single asset alone. Then came further restructurings, technological efficiencies, competitive pressures, and outsourcing with the result that many of America’s factory sites were shut down. America’s brand name companies often went through this process. Millions of workers across industries were terminated. New pundits and scholars called the process “deindustrialization,” but in cities and towns across America, former industrial plant sites remained idle.

Even as the economy improved and the technology to remediate contaminated sites improved dramatically, manufacturing plants and excess land remained dormant. One would suspect that with about half a decade of declining interest rates, the situation would reverse. Unfortunately, the situation of over-cross-collateralization has actually worsened for some of America’s cities. Holders of high-yield debt and securities often must be compensated for the interest differential throughout the term of the loan as well as the break-up fee to make selling excess real estate assets worthwhile.

Over-cross-collateralization is the financial outcome, but its repercussions are often devastating to communities where shuttered plants and vacant land reside. Imagine a city of hard-working people who just are unlucky enough to have the businesses they work for be involved in many of the notable takeovers since the mid-1980’s. In our imaginary city, half a dozen to a dozen takeovers and leveraged buyouts were at least partially responsible for 5,000 unemployed workers over a 15-year period. Further imagine that once a plant closes in our city, because the assets were over-cross-collateralized in the original financial transaction, it is difficult for the plant to be sold, redeveloped and transformed into a new job-generating facility. Imagine creating an entire generation of unemployed, formally high-wage blue-collar workers who have fathered yet another generation of children and young adults who have even less hope of working locally than their parents. Then imagine local political figures and community leaders who have still not realized that the industrial core of our imaginary city is gone, so they still look to the remaining industrial “base” for guidance on planning and land use decisions.

Our imaginary city above is represented in my home town which is Richmond, California, but it could also be Detroit, Pittsburg, Linden, and any other city where the forces of post-deindustrialization, mergers, acquisitions and leveraged buyouts, and over-cross-collateralization can form the “perfect storm” and wreck a city. In 2005, Richmond, California had the highest murder rate in California and was the eighth most dangerous city in the country. Over the past year, many of its leaders and the press have questioned why and how this happened. Richmond is the original home of Standard Oil of California – now Chevron. For a brief while, Richmond was the headquarters of Pixar animation studios. Richmond’s public schools have been a disaster since the 1980’s. Some would blame the effects of California’s Proposition 13. However, in a post-deindustrialized area, property tax appeals and artificially low property values also contribute to the public school system problem. And don’t forget those kids in the public school system who rarely got to see their parents go to work in a high-wage job because the factories were shut down. Most of the country last year got to see some of those kids beat one of their classmates in a cell-phone video shown around the world.

In an over-cross-collateralized environment, redevelopment agencies are rendered impotent because even if they have recently been inspired concerning their ability to use eminent domain, the cost for condemnation could include not only the value of the property, but also the loan break-up fee and possibly as much as a 500-basis point (or more) interest rate differential on a 30-year note in, say, year 20.

The future of America is at stake. We are currently in the middle of a new wave of mergers, acquisitions and leveraged buyouts. Although interest rates are historically low, the potential abuse of over-cross-collateralization could shape our entire workforce and competitiveness. People need to be able to re-take the urban areas of this Country. Residential sprawl, excessive traffic, deterioration of open space, and racial misunderstandings are symptoms of urban flight. New Urbanist developments need to enhance people’s lives by allowing them to work and live in close proximity. We need to re-use the factory sites and return to the urban core as we move to a service and information-based economy. Local and state governments should consider themselves direct stakeholders in mergers, acquisitions and takeover activities. After all, many of their pension funds are investors.

In the 1970’s, Richmond, California was one of the model cities in America. Without knowing why, it has been struggling for over a generation to redevelop itself. Currently some of the largest companies in America are being thought of as takeover targets – companies with employees and facilities across the Nation. In this next round of mergers, acquisitions and buyouts, the lessons of over-cross-collateralization should be learned to help prevent it.

John Troughton is a Senior Director with Cushman & Wakefield, a global real estate services provider headquartered in New York. January 2006. John can be reached at john.troughton@cushwake.com or (510) 908-5007.