Leveraged buyouts (LBOs) differ from ordinary acquisitions in two immediately obvious ways. First, the target company goes private, and its shares no longer trade on the open market. Second, the acquirer finances a large fraction of the purchase price by bank loans and bonds, which are secured by the assets and cash flows of the target company. Some, if not all, of the bonds are junk—that is, below investment-grade. Equity financing for LBOs comes from private-equity investment partnerships, which we describe shortly. In the case of the earlier LBOs, debt ratios of 90% were not uncommon, though in recent years, LBOs have been financed with nearly equal amounts of debt and equity.
When a buyout is led by existing management, the transaction is called a management buyout or MBO. In the 1970s and 1980s, many MBOs were arranged for unwanted divisions of large diversified companies. Smaller divisions outside the companies’ main lines of business sometimes failed to attract top management’s interest and commitment, and divisional management chafed under corporate bureaucracy. Many such divisions flowered when spun off as MBOs. Their managers, pushed by the need to generate cash for debt service and encouraged by a substantial personal stake in the business, found ways to cut costs and compete more effectively.
LBO activity shifted to buyouts of entire businesses, including large, mature, public corporations. The years 2006 and 2007 witnessed an exceptional volume of such deals. They included the acquisition of TXU, a Texas utility, in a record $45 billion cash-and-debt buyout. The company was acquired by a group led by private-equity firms Kohlberg Kravis Roberts and TPG Capital. The underlying bet was that increasing natural gas prices would provide the company’s coal-based generating plants with an edge. It did not happen. Natural gas prices declined as production by fracking took off, and in 2014, TXU (now renamed Energy Future Holdings) became one of the country’s largest nonfinancial bankruptcies.
One of the most interesting deals of 2007 was DaimlerChrysler’s decision to sell an 80% stake in Chrysler to Cerberus Capital Management. Chrysler, one of Detroit’s original Big Three automakers, merged into DaimlerChrysler in 1998, but the expected synergies between the Chrysler and Mercedes-Benz product lines were hard to grasp. The Chrysler division had some profitable years, but lost $1.5 billion in 2006. Prospects looked grim. DaimlerChrysler (now Daimler AG) paid Cerberus $677 million to take Chrysler off its hands. Cerberus assumed about $18 billion in pension and employee health-care liabilities, however, and agreed to invest $6 billion in Chrysler and its finance subsidiary.1 Two years later, Chrysler filed for bankruptcy, wiping out Cerberus’s investment. Subsequently, Chrysler was acquired by Fiat.
With the onset of the credit crisis, the LBO boom of 2006-2007 withered rapidly. Although buyout firms entered 2008 with large amounts of capital to invest, banks and investment institutions became much more wary of lending to LBOs. By 2009, the value of buyout deals had fallen by 90% from its 2007 high. Since then, the market has slowly recovered, but the targets have generally been tiddlers compared with those of the boom years. Table 32.1 lists some recent transactions.
1. The RJR Nabisco LBO
The largest, most dramatic, and best documented LBO of the 1980s was the $25 billion takeover of RJR Nabisco by the private-equity partnership, Kohlberg Kravis Roberts (KKR). The players, tactics, and controversies of LBOs are writ large in this case.
The battle for RJR began in October 1988 when the board of directors of RJR Nabisco revealed that Ross Johnson, the company’s chief executive officer, had formed a group of investors that proposed to buy all of RJR’s stock for $75 per share in cash and take the firm private. RJR’s share price immediately moved to about $75, handing shareholders a 36% gain over the previous day’s price of $56. At the same time, RJR’s bonds fell because it was clear that existing bondholders would soon have a lot more company.
Johnson’s offer lifted RJR onto the auction block. Once the company was in play, its board of directors was obliged to consider other offers, which were not long in coming. Four days later, KKR bid $90 per share, $79 in cash plus PIK preferred stock valued at $11. (PIK means “pay in kind.” The company could choose to pay preferred dividends with more preferred shares rather than cash.)
The resulting bidding contest had as many turns and surprises as a Dickens novel. In the end it was Johnson’s group against KKR. KKR bid $109 per share, after adding $1 per share (roughly $230 million) in the last hour. The KKR bid was $81 in cash, convertible subordinated bonds valued at about $10, and PIK preferred shares valued at about $18. Johnson’s group bid $112 in cash and securities.
But the RJR board chose KKR. Although Johnson’s group had offered $3 a share more, its security valuations were viewed as “softer” and perhaps overstated. The Johnson group’s proposal also contained a management compensation package that seemed extremely generous and had generated an avalanche of bad press.
But where did the merger benefits come from? What could justify offering $109 per share, about $25 billion in all, for a company that only 33 days previously was selling for $56 per share? KKR and other bidders were betting on two things. First, they expected to generate billions in additional cash from interest tax shields, reduced capital expenditures, and sales of assets that were not strictly necessary to RJR’s core businesses. Asset sales alone were projected to generate $5 billion. Second, they expected to make the core businesses significantly more profitable, mainly by cutting back on expenses and bureaucracy. Apparently, there was plenty to cut, including the RJR “Air Force,” which at one point included 10 corporate jets.
In the year after KKR took over, a new management team set out to sell assets and cut back operating expenses and capital spending. There were also layoffs. As expected, high interest charges meant a net loss of nearly a billion dollars in the first year, but pretax operating income actually increased, despite extensive asset sales.
Inside the firm, things were going well. But outside there was confusion, and prices in the junk bond market were declining rapidly, implying much higher future interest charges for RJR and stricter terms on any refinancing. In 1990, KKR made an additional equity investment in the firm and the company retired some of its junk bonds. RJR’s chief financial officer described the move as “one further step in the deleveraging of the company.” For RJR, the world’s largest LBO, it seemed that high debt was a temporary, not a permanent, virtue.
RJR, like many other firms that were taken private through LBOs, enjoyed only a short period as a private company. It went public again in 1991 with the sale of $1.1 billion of stock. KKR progressively sold off its investment, and its last remaining stake in the company was sold in 1995 at roughly the original purchase price.
2. Barbarians at the Gate?
The RJR Nabisco LBO crystallized views on LBOs, the junk bond market, and the takeover business. For many it exemplified all that was wrong with finance in the late 1980s, especially the willingness of “raiders” to carve up established companies, leaving them with enormous debt burdens, basically in order to get rich quick.
There was plenty of confusion, stupidity, and greed in the LBO business. Not all the people involved were nice. On the other hand, LBOs generated large increases in market value, and most of the gains went to the selling shareholders, not to the raiders. For example, the biggest winners in the RJR Nabisco LBO were the company’s stockholders.
The most important sources of added value came from making RJR Nabisco leaner and meaner. The company’s new management was obliged to pay out massive amounts of cash to service the LBO debt. It also had an equity stake in the business and, therefore, strong incentives to sell off nonessential assets, cut costs, and improve operating profits.
LBOs are almost by definition diet deals. But there were other motives. Here are some of them.
The Junk Bond Markets LBOs and debt-financed takeovers may have been driven by artificially cheap funding from the junk bond markets. With hindsight, it seems that investors underestimated the risks of default in junk bonds. Default rates climbed painfully, reaching 10.3% in 1991. The market also became temporarily much less liquid after the demise in 1990 of Drexel Burnham, the investment banking firm that was the chief market maker in junk bonds.
Leverage and Taxes Borrowing money saves taxes, as we explained in Chapter 18. But taxes were not the main driving force behind LBOs. The value of interest tax shields was simply not big enough to explain the observed gains in market value. For example, Richard Ruback estimated the present value of additional interest tax shields generated by the RJR LBO at $1.8 billion. But the gain in market value to RJR stockholders was about $8 billion.
High levels of leverage remain an essential characteristic of LBOs. But the interest tax shields that LBOs can use are now limited. Starting in 2018, the amount of interest payments that can be deducted for tax purposes is limited to 30% of EBITDA. Most public companies will not be affected by this restriction, but it could have serious consequences for LBOs.
Of course, if interest tax shields were the main motive for LBOs’ high debt, then LBO managers would not be so concerned to pay down debt. We saw that this was one of the first tasks facing RJR Nabisco’s new management.
Other Stakeholders We should look at the total gain to all investors in an LBO, not just to the selling stockholders. It’s possible that the latter’s gain is just someone else’s loss and that no value is generated overall.
Bondholders are the obvious losers. The debt that they thought was secure can turn into junk when the borrower goes through an LBO. We noted how market prices of RJR debt fell sharply when Ross Johnson’s first LBO offer was announced. But again, the losses suffered by bondholders in LBOs are not nearly large enough to explain stockholder gains. For example, Mohan and Chen’s estimate of losses to RJR bondholders was at most $575 million—painful to the bondholders, but far below the stockholders’ gain.
Leverage and Incentives Managers and employees of LBOs work harder and often smarter. They have to generate cash for debt service. Moreover, managers’ personal fortunes are riding on the LBOs’ success. They become owners rather than organization men and women.
It’s hard to measure the payoff from better incentives, but there is some evidence of improved operating efficiency in LBOs. Kaplan, who studied 48 MBOs during the 1980s, found average increases in operating income of 24% three years after the buyouts. Ratios of operating income and net cash flow to assets and sales increased dramatically. He observed cutbacks in capital expenditures but not in employment. Kaplan concludes that these “operating changes are due to improved incentives rather than layoffs.”
We have reviewed several motives for LBOs. We do not say that all LBOs are good. On the contrary, there have been many cases of poor judgment, as the bankruptcies of TXU and Chrysler illustrated. Yet, we do quarrel with those who portray LBOs solely as undertaken by Wall Street barbarians breaking up the traditional strengths of corporate America.
3. Leveraged Restructurings
The essence of a leveraged buyout is of course leverage. So why not take on the leverage and dispense with the buyout? Here is one well-documented success story of a leveraged restructuring.
In 1989, Sealed Air was a very profitable company. The problem was that its profits were coming too easily because its main products were protected by patents. When the patents expired, strong competition was inevitable, and the company was not ready for it. The years of relatively easy profits had resulted in too much slack:
We didn’t need to manufacture efficiently; we didn’t need to worry about cash. At Sealed Air, capital tended to have limited value attached to it—cash was perceived as being free and abundant.
The company’s solution was to borrow the money to pay a $328 million special cash dividend. In one stroke the company’s debt increased 10 times. Its book equity went from $162 million to minus $161 million. Debt went from 13% of total book assets to 136%. The company hoped that this leveraged restructuring would “disrupt the status quo, promote internal change,” and simulate “the pressures of Sealed Air’s more competitive future.” The shakeup was reinforced by new performance measures and incentives, including increases in stock ownership by employees.
It worked. Sales and operating profits increased steadily without major new capital investments, and net working capital fell by half, releasing cash to help service the company’s debt. The stock price quadrupled in the five years following the restructuring.
Sealed Air’s restructuring was not typical. It is an exemplar chosen with hindsight. It was also undertaken by a successful firm under no outside pressure. But it clearly shows the motive for most leveraged restructurings. They are designed to force mature, successful, but overweight companies to disgorge cash, reduce operating costs, and use assets more efficiently.
4. LBOs and Leveraged Restructurings
The financial characteristics of LBOs and leveraged restructurings are similar. The three main characteristics of LBOs are:
- High debt. The debt is not intended to be permanent. It is designed to be paid down. The requirement to generate cash for debt service is intended to curb wasteful investment and force improvements in operating efficiency. Of course, this solution only makes sense for companies that are generating lots of cash and have few investment opportunities.
- Incentives. Managers are given a greater stake in the business via stock options or direct ownership of shares.
- Private ownership. The LBO goes private. It is owned by a partnership of private investors who monitor performance and can act right away if something goes awry. But private ownership is not intended to be permanent. The most successful LBOs go public again as soon as debt has been paid down sufficiently and improvements in operating performance have been demonstrated.
Leveraged restructurings share the first two characteristics but continue as public companies.