Managing Corporate Debt

The Multi-Firm Bond Issue: A Fund Raising Financial Instrument

Edward I. Altman and Paul S. Tubiana

Edward I. Altman is Professor of Finance and Chairman of the M.B.A. Program at New York University. The final version of this paper was written while he was visiting at the Australian Graduate School of Management in Sydney. Paul Tubiana is a management consultant with the Peat, Marwick. Mitchell & Co. Paris office.

Introduction
The capital markets in the United States, and in most of the capitalist world, are oriented toward the individual private or public issuer. The concept of group-issuers has not evolved in most markets probably because of perceived legal and economic constraints. On the other hand, a great deal of financial analysis revolves around the group concept. For instance, issuers are often categorized by industrial groups for comparative risk and return analysis. Financial institutions such as commercial banks, investment banks, and securities firms are often organized
The authors acknowledge the helpful comments made by the reviewers and editors of this journal, as well as the following: Nejib Chaed for his collaboration on the French data; Professors Marti Subrahmanyam. Thomas Ho. and Bertrand Jacquillat for commenls; and Professor J. Fred Weston who first suggested this general theme for research. Partial sponsorship of this research was provided by the Salomon Brothers Center for the Study of Financial Institutions at New York University.

according to industry groups, geographical location, or size. And, individuals and institutions usually refer to their investments in a portfolio context. Nevertheless, little effort has been made by the issuers themselves to group together. A few exceptions to this can be found outside the U.S. in France (to be discussed later) and Japan,' but the closest we in the United States have come to a corporate group structure is the joint-venture and municipality cooperatives.' This paper introduces a financial innovation for
'Groups of firms across various sectors of the Japanese economy have traditionally formed powerful combinations of families known today as Keireisu or Guruupu (approximation of the English word "group") an outgrowth of the now illegal Zaibatsu. 'A recent (August 1978) example of ajoint-venture involving five oil companies is the $450 million tax-exempt bond issue used to construct the nation's first off-shore oil port (Louisiana Offshore Terminal Authority, Loop, Inc. project).

24

FINANCIAL MANAGEMENT/SUMMER 1981

raising debt capital for groups of companies and explores the corporate financing and investment implications of such an instrument. We call this instrument a Grouping which involves a number of entities sharing the proceeds and the repayment obligations of a debt issue. We will show that the Grouping concept has many attractive features for the corporate issuer, and also for the investor, compared to alternative individual firm debt and corporate bond fund portfolio strategies. We recognize that the Grouping mechanism would probably have an indifferent effect on "perfect" markets, but we will attempt to demonstrate a rationale for its existence. While this paper is not meant as a definitive treatment of all merits and problems of the Grouping concept, we believe that the proposal is worthy of serious consideration.

Groupings
Groupings involve a number of firms formed into a type of financial intermediary whose sole function is to raise debt capital, to distribute the bulk of the proceeds to its corporate shareholders, and to invest certain undistributed amounts; undistributed amounts are designated as a Guarantee Fund which is retained in the Grouping in case of individual firm defaults. We will emphasize the Guarantee Fund in our discussion, but it should be pointed out that other types of insurance mechanisms could be used to reduce the risk of loss of invested capital. A prototype grouping mechanism was created after World War II in France. The initial aim of this Groupement was to facilitate access to financial markets for small and medium-sized firms. The importance of Groupements, in terms of the amount of capital raised in France, has been considerable. From 1946 to 1977, approximately 34 billion francs (over $7 billion) has been raised by group corporate financing. In the period 1971-1977, 23 billion francs were raised by group financing. This accounted for approximately 31% of capital raised by private debt issues in France. Private corporate debt issues during that same period accounted for approximately 35% of the total bond financing in France. The balance was made up of public issues. The primary type of French group financings are known as "professional" issues. These include groups of firms that represent a particular sector or industry of the economy. For instance, there are group financing issues from tbe steel, electrical equipment, machinery, chemical, agricultural, construction, and

transport and tourism industries (among others) and from certain small public municipalities. Groupements are not limited to individual industries. Since 1970, interindustry combinations have been created and coordinated by banking underwriters. Such groups usually have a mutual interest, such as firms involved in anti-pollution activities. We will argue that, from a portfolio and legal standpoint, industrial groupings make little sense except possibly for the convenience (for the analytical purposes of organizers and prospective investors) of bringing together similar types of firms. The stockholders of Groupings are the firms which subscribe to a percentage of each issue. The proceeds from group financings are distributed as loans to the stockholders. The funds raised through group financings are for the general investment needs of its shareholders (firms); these are not joint ventures. Essentially, there is a pool of funds and a pool of projects structure within the firms rather than specific project financing. Firms are obliged to pay the interest and principal on their proportional subscription. In addition, to provide an insurance element, a certain percentage of the proceeds is subtracted from each participant's share and placed in a Guarantee Fund. The Guarantee Fund is a critical ingredient which has two purposes. First, it serves to repay a small portion of the loan that each company has contracted for with the Grouping, and second, it guarantees (up to its capacity) tbe payment of the interest and principal of the entire grouping to investors. The percentage of the Guarantee Fund can vary from group to group and in France sometimes reaches 10%. The Guarantee Fund itself can be invested in securities. It is somewhat analogous to the debt service reserve funds prevalent in United States municipal financings.'

Yield to Maturity (Ex Ante) Specif icotions

Calculation of the effective cost of group financing issues is somewhat complex. The variables that affect the effective rate are 1) coupon or interest rate, price, maturity structure, and underwriting and management fees (essentially yield to maturity ingredients);
'In France, for instance, the Guarantee Fund may be invested in government bonds, other group bonds, and finally, in some riskier situations, in the stock market. The Guarantee Fund has been used successfully in France on several occasions; in the bankruptcies of Societe Saut du Tarn, Societc Pompey, and most recently Acierges Paris Outreau, in the steel industry; the bankruptcy of Societe Balchaut in the agricultural industry, and the bankruptcies of S.D, and ACER in the electrical industry. Groupements investors were completely indemnified by the Guarantee Fund and, in all cases, no losses were incurred.

ALTMAN AND TUBIANA/MULTI-FIRM BOND IS5UE

35

and 2) the implicit cost involved with the amount "invested" in the Guarantee Fund and the returns on those funds which are invested. The cost to the individual participant in group financings is a function of the interest and principal repayments made to the Grouping entity. It is affected by the fact that the firms do not receive 100% of their subscribed amount. The amount received is the subscription total minus flotation costs and minus the amount which is contributed to the Guarantee Fund. The Fund is expected to be returned at maturity (or earlier) to the participating company. The effective pre-tax cost of borrowing paid by the participating firm is somewhat complex in its form, increasing in complexity as more terms and conditions are considered. For a Grouping issue, the following terms are relevant: B= b= P= F= GF = y= Face value of the bond issue; Face value of a single bond; Market value of the bond at the time ofissue; Flotation costs; Guarantee Fund; Rate of return on the invested Guarantee Fund; Xj = Shareof the Grouping subscribed tobyfirmj ; i = Coupon rate; I = Bi = total interest payment; r = Effective cost of borrowing; n = Number of years to maturity; and O = Operating (Groupings) cost.

collected at the time of issuance and the other half in period h, the cost of borrowing r for firm j will now be: [P-F-GF/2]X, =

t=l

I + O + GF/2 - y,GF,/2 (1+r)'' S It + Ot - ytGFt ^ B - G F t=h+l (I+r)' (1+r)"

(3)

In addition to the GF factor. Groupings can amortize the issue by partial redemptions prior to maturity. Amortization can be complemented by call provisions at the option of the Grouping's management. The difference between these two types of redemptions is the source of funds. In the first case, i.e., serial bonds or sinking fund term bonds, the individual firms provide redemption capital while optional redemption involves the use of the GF. Because the investment yield (y) on the Guarantee Fund is uncertain, the effective ex post yield cannot be perfectly determined ex ante (even if we assume no default).

Issuer Considerations
Individual firms would need to determine whether or not to apply for participation in these "financial intermediaries." The small to inter mediate-sized firm has a great deal to gain by participating. Access to the debt capital market is extremely difficult for most of these smaller firms, and private placements, while somewhat more accessible, are not readily available. The United States government and the nation's bond exchanges might be enthusiastic about this innovation, for capital infusions to firms of any size are normally considered to be a positive long-run ingredient to sustained growth. One of the primary motivations for the development of Groupements in France was to foster capital investment fiows to small and medium-sized firms. This objective, however, has only been partially achieved, which may be a result of the Grouping process and market dynamics in France. Small firms have benefited from Group financings (especially in those industries characterized by more intense competition among a large number of firms), but the larger firms have dominated the market in terms of the percentage of capital raised. We would speculate that somewhat greater access to group financings

For a simple corporate bond issue, the effective cost, assuming no default, is the discount rate r such that Equation (I) holds:

P-F =

It

t=I (t+r)'

(1)

For a simple Grouping bond where the Guarantee Fund is collected at the time of issuance, dividends (effectively, returns from the Guarantee Fund) are paid to the Grouping's participants periodically, and the Guarantee Fund is repaid in full at maturity, we have r for any firm j equal: [P-F-GF]Xj = X, " 2 It + Ot - yGFt , B - GF 1=1
(2)

The Grouping may collect the guarantee fund in one or more installments. For example, if half of the GF is

FINANCIAL MANAGEMENT/SUMMER 1981

would be observed in the United States because of our market's experience with greater variability in interest rate risk premiums. Hence, the investor could be compensated for greater risk taking. (Homogeneity of interest rates in France in both individual firm and Groupement bond issues is illustrated later in Exhibit 5.) Groupings could provide an important additional source of capital for small firms. The relatively small amounts acquired by these firms could provide, in many cases, a significant percentage of their project financing needs. In addition, the Grouping can act as a financial and technical consultant to its participants, permitting the small firm to proceed without acquiring expertise in the issuance of financiai instruments. The Grouping structure might be particularly attractive to a consortium of small to medium-sized organizations, e.g., commercial banks, for which traditional sources of bank debt capital are currently quite limited. An important consideration in this whole process is whether or not a group of small firms, or a group composed of small, intermediate and larger firms, will be attractive to investors. While we attempt to discuss this point in general terms below, we believe that smaller sized firms can tap the capital markets on a fairly regular basis. We can note here that such tiaditional sources of capital as private placements could be diverted to, or augmented by. Grouping issues especially if there is a perceived risk reduction. As workout situations on defaulted loans become more frequent as they are currently Groupings very well might be attractive to investors. For publicly-traded debt in the United States, 6% of all new industrial issues rated below A in the period 1977-1979 were under $10 million in size, and 38% were under $20 million, indicating that smaller-sized issues, and possibly smaller firms, have some appeal in this market. The motivation for participation by larger, more creditworthy firms is less obvious. If these firms could raise funds individually at similar interest rates, then why join the consortium? In France, we clearly do observe large firms participating in both individual and group issues. The Groupement structure enables them to tap the bond market for relatively small amounts of funds which would not be economical for individual issues. This implies economies of scale with respect to the amount of funds raised from individual issues. If a small amount, e.g.. $5 million, is needed and the firm wants to borrow long-term or not use up their debt capacity with commercial banks, then the Grouping alternative might be attractive. Indeed, in

most European countries, independence from financial institutions is considered to be an important objective of the firm's financial management. This appears to be a less important objective in the United States but still could be a factor. A potentially attractive feature of Groupings for the issuer is the ability to practice what might be called "financial fine tuning." Access to the debt capital market on a rather continuous basis for various amounts of capital at costs which are not prohibitive would seem to be attractive. If a target debt-equity ratio is thought desirable, the Grouping mechanism provides a means for achieving the target more smoothly (see Weston and Brigham [10, Chapter 21] for a discussion of timing of financial policy). Of course, if the yield curve facing the firm is upward sloping and commercial paper is available, then raising short-term funds would probably be preferable to the longer-term Grouping concept. The commercial paper market, however, is not available to all firms that could take advantage of a Grouping issue (although interim bank financing might be available, up to a point).

Issue Size and Flotation Costs

An important Grouping issuer consideration is issuer costs. A bond issued by multiple issuers is clearly going to be larger in size than individual issues. There is evidence that some degree of economies-ofscale exists with respect to the size of the issue. Johnson, Morton, and Findlay [6] found that the size of the issuer was the most important variable in explaining flotation costs of both new bond and new stock issues. The larger the issuer the lower the fiotation costs on a percentage basis. Other significant variables for bond issues were proxies for risk and seasoning, whether or not warrants were attached, and the type of offering, e.g., direct placement, best effort selling, or complete underwriting. One established measure of the "cost" to the firm of issuing securities is the difference, or spread, between the purchase price paid by the securityholder (price to public) and the proceeds received by the issuing entity (price to company). The spread is the commission received by the underwriter. Because the notation costs incurred by underwriters are relatively insensitive to issue size (holding risk constant), we might expect that competitive conditions would limit commissions to a relatively fixed amount (variable percent of issue size).* We examined newly-issued industrial and public

ALTMAN AND TUBIANA/MULTI-FIRM BOND ISSUE

Utility bonds for the period 1977-1979 and found that for investment grade industrial securities (bond ratings of A or higher) the spread is uniform for all companies at 0.875% of the issue amount (negotiated public utility bond offerings all carry the same (0.875%) interest spread). We do observe spread differentials for below A-rated industrial bonds and for competitively traded public utility bonds (all industrials are negotiated offerings). Our empirical tests for the correlation between size and spread concentrate on the industrial bonds.

Regression Results Spread vs. Size

We observed interest rate spreads on a sample of 136 industrial bonds, newly issued over the three year
Mt is true that certain costs are semi-variable with respect to size. These include SEC registration, exchange listing, and some rating agency costs. For example. Moody's charges .002 of the issue size, with a $20,000 maximum, for rating corporate issues. A Grouping issue might add an additional cost element because oT the added analysis costs pertaining to a number of firms rather than a single entity.

period 1977-1979. The issue size and spread distributions are given in Exhibit 1. The average issue size for the entire 136 bond sample is $35.2 million with the average increasing with the higher ratings, i.e., $26.9 miUion, $38.1, and $51.4 million for B, BB, and BBB, respectively {Exhibit 2). Note that the majority of bonds (86 of 136) have spreads between 2 to 4%. We find fairly strong indications of a size-spread negative correlation implying a size-economy effect for bond issues rated below investment grade. The correlation for the entire sample is -0.512 (Exhibit 2), significantly indicating the inverse relationship noted above. The simple regression, with size as the explanatory variable, explained 25.7% of the variance in underwriting spread." Since underwriters argue that the spread helps to compensate them for risk, and to the extent that the
'The exact industrial bond equation was y (Spread) = 3.637-.024 {Size of Issue in millions). The relevant statistics are adjusted R' = 0.257. F = 33.69. t (Size) = -6.907. N = 136.

Exhibit 1. Issue Size and Percent Spread Distribution, New Industrial Bond Sample, 1977-1979*
($ Millions) Issue Size Cumulative Percent Percent Spread Cumulative Percent

Number 8 44 32 15 13 23 1 136

Percent

Number

Percent 8 20

0-10 10-20 20-30 30-40 40-50 50-100 > 100

6 32 23 11 10 17 1
100%

38
61 72 82 99 100

< 1.00 1.01-2,00 2,01-3.00 3.01-4.00 4.01-5.00 5.01-6.00

II 27 41 45 9

30 33

3
136

7 2
100%

8 28 58 91 98

100

*A11 bonds rated below A.

Exhibit 2 . Size-Spread Correlation: Industrial Bonds Rated Below A, 1977-1979

Average Size (S million) Average Spread % Size t-statistic

Sample

Adjusted R

Correlation

Al! Years, All Bonds BBB BB B 1977 1978 1979

33.2 51.4 38.1 26.9 44.2 32.5 33.5

136 36 22 78 31 59 46

2.786 1.303 2.648 3.509 1.593 3,073 3.176

0.257 0.038 0.091 0.153 0.039 0.303 0.358

-.512 -.220 -.318 -.403 -.207 -.568 -.602

-5.80 -1.45 -2.28 -3.84 -1.80 -8.75 -9.45

Source: Raw data from Salomon Brothers, Inc. Year-End Summary of New Industrial Bond Issues.

FINANCIAL MANAGEMENT/SUMMER 1981

size of successively lower-rated bonds is smaller and smaller, size and risk will also be negatively correlated. Therefore, it is possible that the negative correlation that we observed between size and spread is spurious, and that the real determinant is investment risk. In order to test for this, we segregated the bonds into their respective bond ratings and ran the correlation tests within rating classes. We also segregated the analysis by year within the three-year analysis period. The results (Exhibit 2) further confirm our initial hypothesis that the size of an issue helps to explain the percentage spread paid by firms. The correlations within rating class are all significantly negative, although not as "large" as the correlation for the entire sample combined. This infers that the spread is partially accounted for by risk-taking and partially by the size of the issue. It is also true that a substantial proportion of the spread is not explained by either factor.

Term to Maturity and Size vs. Spread Relationship

Investment bankers refer to the term to maturity as a possible further determinant of their compensation charge to clients. Practitioners argue that spreads should increase with term to maturity. While term to maturity is not particularly germane to the Grouping bond issue question, we did attempt to improve the explanatory power of our regressions by including the maturity variable as a second explanatory measure. The results, in general, show no significant association between spread and term to maturity with insignificant correlations and explanatory power. The only regression that does show a significant correlation is the B-rated bond sample, but the sign of the coefficient is negative, indicating an inverse relationship. Multivariate regressions yield similar results including that of the B-bond sample. We conclude that term to maturity shows no evidence of influencing spreads. We have shown evidence of spread differentials in the bond market. Since the Grouping structure allows larger bond issue size than individual firms can, presumably we can expect a reduction in the spread for Groupings especially in the lower end of the bond rating spectrum.

ability risk of holding corporate bonds refers to the risk associated with selling the bonds for cash at the market price. If the price that one receives is affected by supply conditions (issue size), then a Grouping mechanism that increases the number of bonds outstanding relative to individual firm issues can infiuence interest rates. If security markets were "perfect," it would not be valid to discuss the size-economy relation. The question is, therefore, whether marketability can infiuence risk premiums, i.e.. if size contributes to the degree of imperfection in the market for a particular security. In his important study on risk premiums. Fisher [3] found a distinct marketability affect. Utilizing the total market value of publicly traded bonds as a proxy for marketability. Fisher found a significant negative relationship of this measure with risk premiums. He concluded that the smaller the number of bonds a firm has outstanding, the less frequently the bonds will be expected to change hands and the thinner the market the more uncertain will be the market price. Fisher did note that marketability might also be measured by the spread between bid and ask prices and the volume of trading on the bonds. For practical reasons, he could not use these measures. Tambini [9] and Ashcraft [I] replicated Fisher's study with essentially similar results. Our point with respect to the Grouping mechanism is that the number of bonds outstanding relative to any single issuer's totals will be greater, thereby possibly lowering marketability risk and the effective cost.

Participation Constraints
One might logically question larger firms' participation in Groupings for competitive reasons. If the Grouping will enable smaller firms to tap the financial market, firms that do not have to rely on such a mechanism could experience a reduction in their competitive advantage. An additional constraint that could limit participation in Groupings is the difficulty of constructing the terms of the offering to conform to the desires of each subscriber. Since the bond indenture includes specification of maturity structure, firms would either attempt to infiuence the organization of a Grouping or shop around for one conforming to their needs. We do not feel that this constraint will be material once there is general acceptance of the Grouping concept, but it certainly is likely tbat costs to the underwriterorganizer would increase as would the spread charged at least for initial financings of the Grouping innovation.

Secondary Market Considerations

The issue size argument can be carried forward to the secondary market as well. The so-called market-

ALTMAN AND TUBIANA/MULTI-FIRM BOND ISSUE

Investor Considerations
From the standpoint of an issuing company, Groupings present some rather attractive characteristics. The question is whether there are capital sources willing to invest in these securities. There is evidence that investors are attracted to portfolios or groups of fixed income securities. The success of so-called corporate bond funds or income funds testifies to this. For one thing, transaction costs will probably be lower for the bond fund manager than for the individual constructing his own portfolio. These funds offer a group of individual firm issues" to investors with certain riskreturn expectations. While bond funds offer a high degree of safety, they do not guarantee payment of interest and repayment of principal. Defaults on highrated securities are not common in the United States, but they do occur from time to time, and the bond fund shareholder will incur a pro rata loss in both interest and principal." The primary institutional and economic differences between the existing bond fund portfolio concept and the Grouping innovation are the types of underwriting organization that create the portfolio and the added protection to investors afforded by the Guarantee Fund. We will demonstrate the latter with simplifying assumptions about interest rates (zero) and investment horizons (one-period). Risk reduction in a multi-period term structure context is also discussed. Assume an investor has the choice of either purchasing individual debt from firms A, B, and C (or the equivalent corporate bond fund composed of the three securities) or investing in a Grouping with the same three partners. We assume two states of the world with equal probabilities, that the cash fiows available to meet each firm's single-period debt obligation are not dependent on any other firm, and that the Grouping has a Guarantee Fund equal to 10%. The equivalent debt service reserve fund, therefore, for each individual security is also 10%. The relevant possible cash flows and related items for each firm are:

Probability

Cash Flows

.5 .5 Riskless Debt Actual Debt Guarantee or Sinking Kund

A $100 $ 50 $ 50 $ 60 10%

B $200 $100 $100 $120 10%

c
$300 $150 $150 $180 10%

Under any possible case, the respective firms can support $50, $100, and $150 worth of debt risklessly. We assume, however, that risky debt is 20% higher for each. We examine in Exhibit 3 the eight possible outcomes and the resulting loss (if any) to investors purchasing either the individual debt securities (or the bond fund) or the Grouping made up of the three firms. With the exception of the last case (number 8), when all three firms default on the issues (or their pro rata share of the issue), investment in the Grouping is more favorable than the individual debt issues. The larger the Grouping, in terms of the number of firms represented, the smaller the hkehhood of risk parity between it and existing debt structures. In addition, large Groupings foster risk reduction because the Guarantee Fund available for any single firm's problems will probably be greater. Consider cases 5 and 6. In the former, firms A and B realize cash flows insufficient to meet the fixed debt payment. The loss to debtholders in Firm A is the $10 shortfall minus its own sinking fund of $6, or $4. Firm B's loss is the $20 shortfall minus the sinking fund of $12, or $8. The investor who owned a bond fund composed of these securities would lose a like amount. The Grouping investor, though, receives the promised amount, because the Guarantee Fund, $6-M2-l-18 or $36, exceeds the shortfall of $10(A) + 20(B) = $30. If A and C default (case 6), observe that the Guarantee Fund ($36) is insufficient to cover the entire shortfall of $IO(A) + S30(B) = $40. Still, the loss is less under the Grouping structure. In essence, therefore, we have identified a means of altering the distribution of cash flows available to meet fixed debt obligations (F) for the firm participating in a Grouping. Consider the illustration in Exhibit 4. Cash flows available to cover fixed debt costs equal CFA for Firm A, and fixed costs equal FA. The Guarantee Fund portion (GA) essentially increases the available cash fiows to ( C F ' A ) which will be, except in case numbers 6 and 8, sufficient to cover FA. Exhibit 4 assumes a continuous cash flow frequency distribution instead of the binomial distribution postulated in our numerical example. We have assumed a one-period case with no specified interest rate. The results are similar, although more complex, in a multi-period, positive interest rate world. For instance, if Firm A only realized
During the period 1970-1977, over $2.4 billion (135 issues) of publicly held corporate debt defaulted. The default rate, however, was relatively low, under 1% of aggregate debt outstanding (Moody's Bond Record, 1970-1977).

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FINANCIAL MANAGEMENT/SUMMER 1981

Exhibit 3 . Risk Assessment Example; Individual or Bond Fund Structure vs. Grouping Structure
Loss to Investor, Individual Firm Debt Structure Firm Amount Loss to Investor, Grouping Debt Structure Firm Amount

Case Number

Firm Casb Flows B

1 2 3 4 5 6 7 8

100 50 100 100 50 50 100

200

300 300 300 150 300 150 150 150

4.0 8.0 12.0 4.0 8.0 4.0 12.0 8.0 12.0 4.0 8.0 12.0

1.0 3.0 5.6 8.4 4.0 8.0 12.0

200
100

A B C
A B A C B C A

200
100 200

A C B C A B C

100 100

50

B C Actual Debt 60 120 180

$50 in cash flow each year, and the coupon rate were 10%, the Guarantee Fund would be able to cover the annual interest shortfall of $6 for 6 years. If this situation continued. Firm A would default to the Grouping and the Guarantee Fund would be depleted. Investors in the Grouping, however, would then receive their full claim on the remaining two firms and whatever they could collect on A. The benefit over the individual firm debt structure would be the present value of six years of interest payments plus the present value of the principal recovered in years 6 and 7 (and thereafter) minus the present va!ue of the return on the defaulted recovery amount (assumed less than par Exhibit 4 . Cash Flow Distribution Under a Grouping Structure

value) that would be recovered in period 1 after the individual firm had defaulted.

Some Further Considerations

Analytical portfolio investment strategies will reduce the likelihood of multi-firm repayment shortfalls in a Grouping. In addition, it would be possible to form portfolios of several Groupings which themselves have desirable covariance features. The Grouping is not necessarily a substitute for other securities or entire portfolio strategies, e.g., bond funds, but is one additional "security" to be evaluated in a total portfolio. Viewed in this light, the argument that the investor is constrained to accept a fixed percentage of each member firm in a Grouping would appear to be trivial. There are a number of aspects that must be noted with respect to how this Grouping instrument relates to financial theory. In a world free of transactions costs, scale economies, and other market imperfections (such as discontinuous firm access to markets), the owner of the firm should be indifferent as to the particular form of financial instrument utilized. For one thing, if debtholders viewed the Grouping as risk reducing, thereby increasing the value of the debt, a wealth transfer from the equityholders to debtholders would occur, because the former's receipts would be a residual source should the

GA = Grouping Amount a = Guarantee Fund Percentage

ALTMAN AND TUBIANA/MULTI-FIRM BOND ISSUI

31

Guarantee Fund be depleted by a lack of repayment from one of the Grouping participants. The amount of the wealth transfer might vary, however, as it is dependent on many factors including the types of firms involved. An investor could conceivably adopt a strategy involving a combination of risky debt securities and riskless government debt to achieve a risk-return structure equivalent to what the Grouping provides. The proportion of government debt would equal the Guarantee Fund percentage, i.e., the investor rather than the Grouping invests in risk-free securities. If option strategies were relatively costless, the investor could also write a call option on the debt to insure against default (reduced bankruptcy costs) of its risky debt securities. (Since writing options on debt would probably exist on the over-the-counter market, if at all, the transactions costs would be sizeable. This would especially be true for relatively small debt issues.) In this case, the exercise price would be equal to the face value of the debt. Of course, a portfolio of cash and a Grouping would also be possible, and conceivably options could be traded on Groupings as well.

Groupings vs. Individual Issues

If Groupings afford lower default risk than do individual firm bond issues, we would expect yields and prices to reflect this differential; that is. Groupings would sell at slightly lower yields. Ideally, we would like to compare yields of Groupings with individual firm bonds where the same companies participate in the group financing. If this is not possible, then firms within particular industrial sectors could be analyzed. Groupings and individual issues exist only on the domestic French market and, in rare cases, on the Eurobond market. After observing market yield comparisons on the French market, we can summarize the results as indicating that the two types of debt securities (individual firm bonds and groupements) sell at approximately the same yields; in some instances the Grouping yield is slightly lower, and in others the large individual firm yield is lower. The relative homogeneity of yields that we find (Exhibit 5) is a unique characteristic of the French market, which is regulated by the Minister of Finance. In many cases the government is likely to intercede should default of firm or Grouping issues occur. This is exactly what took place in September 1978 for both individual and Grouping issues in the French steel industry. In the 1978 steel industry crisis in France, the Federal government formed a new public company to

refund the interest and principal to individual steel company bondholders and to creditors of the steel industry's Groupement. The new securities are government bonds, and in the resulting situation the government and the steel industry's Groupement are the main shareholders of the reorganized steel companies. This is an example of the potential problems of Groupings in a specific industry. We analyze four separate industry Groupings {steel, electronics, machines, and construction) in terms of the yields to maturity of both the Groupement and individual firms which comprise the industry most of these firms are also group members. The bonds are exactly equivalent in terms of reimbursement clauses, callability, tax status, and so on. The data were derived from a bond yield service (DAFSA, [2]). Note that the rates are extremely close for all issues including a comparison of rates among the groups themselves (panel E, Exhibit 5). In some cases, yields on individual issues are slightly below their equivalent Groupement issue, e.g.. in the machinery industry. This is perhaps explained by the fact that the Grouping contains numerous participating firms which themselves have different default risk profiles. Many of the individual firm issues depicted (panel D for example) might very well be firms with low default risk characteristics compared to the average firm in the Grouping. We would expect this to be the case, as only the very largest and financially soundest firms can float individual bond issues in France.

Legal Considerations
The most obvious legal problem that Groupings might encounter is antitrust claims. The Justice Department or the Federal Trade Commission would no doubt be extremely wary of Groupings on the basis that such an organization might restrain competition. It can be argued that, on the contrary, Groupings could foster competition and that, on balance, the mechanism is a worthy experiment. We have observed that the French Groupement system is built around an industry-based organization, and to the extent that the firms exchange information on costs, prices, or investment plans, there is a potential for collusion among the participants. We have argued that the industry-based Grouping is not desirable although it does present analytical economies. Moreover, the Grouping's coordinating institution does not necessarily have to be made up of members representing the shareholders of the group.

FINANCIAL MANAGEMENT/SUMMER 1981

Exhibit 5. Yield to Maturity Comparisons, French Groupings and Individual Corporate Issues
Yield %

steel [A]

11

Construction [B]

A
1 0 1 Machinery

[D]

Grouping Comparison 1976 GROUPINGS 1978 1980 1984 1986 1988 1990 1992

MATURITY

FIRMS Source: "Taux de Rendement des Principles Obligations Cotces en France," DAFSA No. 112, 31.12.76 ("Rate of Return on Principle Debt Quoted in France, 12/76.")

ALTMAN AND TUBIANA/MULTI-FIRM BOND I5SUE

33

While a certain amount of credit and financial solvency information would be requested from firms that are being considered as potential members, this need not go beyond the rather extensive data already available from annual reports, 10-K's (for publicly held companies), and credit bureau documents. For the small privately-held firm in the U.S., the demand for more comprehensive data than is usually provided to the public would have to be weighed against potential benefits of a new and cheaper financing source. A potentially more serious anti-competition problem exists if the individual firms now have a disincentive to compete vigorously. If a group member fails, recall that the Guarantee Fund can repay creditors. The fund is therefore depleted, leaving less for return at maturity to the surviving members. Since members are responsible only for their pro rata share of the issue and not jointly responsible for any shortfall, this disincentive is somewhat mitigated. We do not know if this disincentive would be serious enough, at the margin, to diminish competition, but it is worth noting that this potential already exists under the joint venture structure. We think there are pro-competitive elements inherent in the Grouping concept. An adequate, fairly continuous financing source for the smaller-sized company would no doubt enhance the firm's ability to compete. Even the larger firm's competitiveness is enhanced if, as an individual entity, it had experienced financing difficulties in the past. We hope this paper's description of the Grouping financial innovation may lead to a full discussion of its merits and drawbacks so that theorists and practitioners might accept, modify, or reject its ap-

plicability.

References
1. V. Ashcraft, "The Evaluation of Credit Risk," Unpublished MBA Thesis, New York University, Graduate School of Business, 1979. 2. DAFSA, "Taux de rendement des principles obligations cotees en France," No. 112, 31.12.76, Paris, France. ("Rate of Return on Principle Debt Quoted in France, December 31, 1976.") 3. L. Fisher, "Determinants of Risk Premiums On Corporate Bonds," Journal of Political Economy (June 1959), pp. 113-136. 4. Groupement de L'industrie Siderurgique, Prospectus, April 13, 1976. (Prospectus for a Steel Industry Groupement Issue, Luxemburg Stock Exchange, April 13, 1976.) 5. Groupements Pour Le Lancement D'enprunts Obligataires. Bulletin de la Caisse Rationale des Marches de L 'etat. 2* trimestre, 1974. (Groupements for the Issuance of Debt Obligations.) 6. K. Johnson, T. G. Morton, and M. C. Findlay, III, "An Empirical Analysis of the Flotation Costs of Corporate Securities," Journal of Finance (September 1975), pp. 1129-1133. 7. B. King, "Market and Industry Factors in Stock Price Behavior," Journal of Business (January 1966), pp. 139-190. 8. Moodys Bond Record. Monthly, 1970-1977. 9. L. Tambini, "Financial Policy and Corporate Income Tax," in A. C. Harberger and M. J. Bailey eds.. The Taxation of Income from Capital, Washington, D.C., Brookings Institution, 1969, pp. 185-222. 10. J. F. Weston and E, F. Brigham, Managerial Finance. 5th ed.. New York, Holt, Rinehart and Winston, 1977.

CREDIT RESEARCH EOUNDATION AWARD ANNOUNCEMENT

The second Credit Research Foundation Award goes to Verlyn D. Richards and Eugene J. Laughlin of Kansas State University for their paper, "A Cash Conversion Cycle Approach to Liquidity Analysis," which appeared in the Spring 1980 issue of Financial Management. This award has been established by the Credit Research Foundation to be presented to the author or authors of the best article on receivables management published in any given year in Financial Management (but only in those years during which a worthy paper has appeared). The award consists of a $500 cash prize to be presented at the Association annual meeting following the year in which the paper appeared. The Association thanks the Credit Research Foundation for their support of such research.