The Unintended Consequence of Limiting Buybacks

Proposed legislation to curb share buybacks — the practice of public companies buying back their own shares, often to support their stock prices — could have an unintended consequence in the form of a leveraged buyout boom, according to a new research note.

U.S. Senators Chuck Schumer (D-N.Y.) and Bernie Sanders (D-Vermont) are proposing a limit on the practice, which they say only benefits shareholders, company executives and hedge fund activists. But if the proposal is enacted, it will instead fuel a spate of leveraged buyouts, argues Brian Reynolds, an analyst at Canadian investment bank Canaccord Genuity.

He said clients of the bank have been asking about the effect of the potential buyback ban, particularly since Canaccord has argued that the long bull run has been fueled primarily by companies buying their own stock and driving prices higher.

Reynolds contends that pension funds, under pressure to close the gap between how much money they have on hand to meet their obligations to retirees and how much they need, have bought the majority of newly issued private credit and public debt issued by companies to then buy back their stock.

“The problem is that our nation’s public pensions have become the dominant global investor, are grossly underfunded and thus have to reach for risk, and are essentially unregulated because of states’ belief that they are sovereign,” wrote Reynolds. "Thus, they reach for yield and have generated repeated financial boom and bust cycles since the early 1990s.”

If buybacks are banned, pension funds’ appetite for credit is unlikely to be affected, and the money will instead flow into a string of leveraged buyouts “that would propel stocks higher until the next financial crisis,” wrote Reynolds in the note, distributed only to clients and obtained by Institutional Investor.

[IIDeep Dive:When Pensions Run Out of Cash]

Alternative credit provides higher returns than public debt, while also protecting capital of pensions’ portfolios, at least in theory. Pensions’ demand has been behind the record number of fund raises by asset managers specializing in credit.

The Canaccord Genuity analyst is already expecting an LBO surge sometime in the next few years, as banks shift from a carry trade and begin financing buy-outs. If a proposal limiting buybacks is enacted around the same time, it will just exacerbate the trend, Reynolds argued. The analyst has written prolifically about pension funds’ unceasing appetite for alternative credit and the resulting development of so-called shadow banking products.

In aNew York Timesopinion piece published on February 3, Schumer and Sanders called stock buybacks “corporate self-indulgence.” The Senators wrote that between 2008 and 2017, 466 of the Standard & Poor's 500 companies spent around $4 trillion on stock buybacks, about 53 percent of profits.