Neutral Recapitalizations: Predictions and Tests Concerning Valuation and Welfare

PREVIOUS STUDIES [1, 2, 5, 7, 8, 14, 15, 18, 19] have demonstrated that, in a perfect market, recapitalizations may affect the absolute values of firms but would not alter the relative values of firms in a risk class. Using indirect tests additional studies [12, 13] have shown that with the introduction of market imperfections, specifically the impounding of funds from short sales, not only might absolute values of firms change, but in addition the relative values of firms in a risk class may be influenced by recapitalizations. Thus, it has been concluded that recapitalizations "matter". However, no predictions concerning "how" recapitalizations affect valuation and welfare have been derived. The reason for this omission is that, in general, implications for welfare of investors and vaulation of securities caused by arbitrary recapitalizations are ambiguous since these recapitalizations may affect the state dependent endowments of investors and/or the set of trading instruments available in the capital market. That is, it is impossible to predict the welfare and valuation implications of an arbitrary recapitalization without precise knowledge of investors' marginal rates of substitution before and after the recapitalization-clearly a monumental data problem. In this paper, I develop and test welfare and valuation predictions for a specific type of recapitalization-a neutral recapitalization-that avoids the data problems associated with an arbitrary recapitalization. A neutral recapitalization has the property that it does not alter the state dependent endowments of any investor. Using a partial equilibrium farmework similar to that used in Abnormal Performance Index (API) studies, I show that a neutral recapitalization that expands investors' trading opportunities would increase the value of the recapitalizing firm and the welfare of its shareholders. A case study of the recapitalization of Source Capital Inc., a closed-end investment company that became a dual-purpose fund, provides empirical evidence consistent with the theoretical predictions.