Abstract
The main objective of this term paper is to research the causes and consequences of leveraged buyouts and its impact on the target firm's financially. With this term report, I have tried to cover what is leveraged buyout, reasons for the occurrence of LBOs and its consequences on the target firm.
Leveraged Buy-Outs
A leveraged buyout or LBO tend to be occurs when a financial sponsor acquires a controlling interest in a company's equity and where most of the percentage of the purchase price is financed through borrowing. The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. In simple terms, LBO is simply the purchase of a firm by an outside individual, another firm or the incumbent management with the purchase being financed by large amounts of debt; the resulting firm of LBO is said to be 'highly leveraged' firm. The target firm of LBO can be a free standing entity or a division of a public corporation. (Garfinkel, 1989)
Though the companies of all sizes and industries have been the target of leveraged buyout transactions, but because of the importance of debt and the ability of the acquired firm to make regular loan payments after the completion of a leveraged buyout, some features of potential target firms make for more attractive leveraged buyout candidates, include:
A multi-year history of stable and recurring cash flows.
The potential for new management to make operational or other improvements to the firm to boost cash flows.
Market conditions and perceptions that depress the valuation or stock price.
Hard assets such as property, plant and equipment, receivables and inventory that may be used as collateral for lower cost secured debt.
Low-existing debt loads. (Encyclopedia,2010)
History of LBO
When a firm goes through the activity of LBO, its entire equity is purchases by a small group of investors. This group mostly consists of firm's upper management. In order to attract existing shareholders to sell the firm's outstanding shares, the group often offers a premium above the stock's prevailing market value. The capital they need to purchase the shares is obtained by issuing debt, in the form of bonds, against the firm's assets and cash flows. With the perspective of balance sheet all the actions takes place on right-hand side. That is, the direction involves the exchange of debt for equity. And the result of such transaction is that creditors have a large claim, and owners have a small claim on the firm's assets. The thing is to be noticed here that, the assets on the left-hand side of the firm's balance sheet do not change. Instead, what changes is how they are financed. (Garfinkel, 1989)
During the 1980s leveraged buyouts became a huge part of America's landscape. This largely was the result of single investment banking firm, and efforts of one of its principals, Michael Milken. It was Milken who determined that high yield bonds could fill an existing funding gap in corporate financing. The bonds, commonly referred to as junk bonds because of their riskiness, would be enticing to investors who otherwise might not be willing to take an equity position in high-risk firms. A market is developed by Drexel for junk bonds which served as an investment bank for corporate raiders and management groups who are interested in taking over existing corporations. Before, Milken was prosecuted and convicted of securities violations, the market flourished for several years. And then, Drelex Burham Lambert ultimately went bankrupt, but the firm's legacy lives on in the active market for high-yield debt. (Garfinkel, 1989)
Causes of leveraged buyouts:
Tax incentives: Tax savings provide a strong incentive for LBOs. First, by issuing added debt, firms increase interest deductions. Second, they reap depreciation benefits. Third, both the principal and the interest on loans incurred by employee stock ownership plans (ESOPs) are tax deductible. ESOPs can buy the shares of the company by borrowing from a commercial bank and can exclude from income up to 50 percent of the interest paid (Lowenstein, 1985). In support of the proposition, the literature (Kaplan, 1988; Lehn & Poulsen, 1988, 1989; Lowenstein, 1985) consistently shows that tax benefits are a significant predictor of the size of the premium paid to pre-buyout stockholders. Kaplan (1988) concluded that the "potential tax benefits generated by the buyouts are large, ranging from 31 to 135 percent of the premium paid to pre-buyout shareholders." However, he maintained the tax benefits largely go to the pre-LBO stockholders, and the post-LBO equity holders only get the benefit of the efficiency improvements. The tax benefits would be entirely bid away to pre-LBO stockholders, if there was some sort of contest among different bidders, but LBOs do not always involve a bidding contest. Although taxes play a definite role in explaining LBO premiums, the large range of the benefits suggests that the role taxes play is complex (Long & Ravenscraft, 1989). There may be no net government revenue loss, only redistribution of who pays the taxes. It depends on three key factors: (a) the size of the stockholder's premium and capital gain; (b) the tax bracket and status of the person or institution that gets the capital gain (many institutional investors such as foundations, pension funds, and universities do not have to pay taxes); and (c) the size of the recapture of previous depreciation deductions and investment tax credits that offset the benefits of the step up in the asset basis. KKR (1989) found a net increase in taxes paid of $2.9 billion as the capital gains tax paid by shareholders and investors and the interest income tax paid by debt holders more than compensates for the tax reductions that the LBO firm receives. However, KKR's work is affected by conflict of interest.
Ethical problems and Redistribution: Behaviorists maintain that economists not only misunderstand the role of slack but that LBOs are fraught with ethical problems and are, at best, merely redistributive. The redistributional arguments are that the premiums above existing market price that are paid to the existing stockholders-around 40 to 50 percent-are not due to any expected increase in efficiency. They are the result of insider information and tax advantages and occur at the expense of existing employees (see Figure 2). The high premiums come from taking wealth from other stakeholders-lenders, taxpayers, and employees. The higher debt lowers the value of existing debt, reduces corporate taxes, and shifts bargaining power from employees to managers. The inherent informational asymmetries between insider managers and outsider stockholders create a severe conflict of interest between management's fiduciary responsibility to sell at the highest possible price and its natural self-interest to buy at the lowest possible price (Bruner & Paine, 1988; Lowenstein, 1985). Because the information that shareholders and other outsiders have is to an extent controllable by the firm's managers, they may have an incentive to manipulate the information to understate the firm's value and then buy it at a bargain price. There are a variety of legal safeguards available to the stockholders. Since 1979, SEC rules have required firms to make statements on the fairness of the transaction. Litigation remedies also exist, including injunction or court appraisal as to a "fair price." In most LBOs, the board hires investment bankers to make independent appraisals. Because LBOs frequently occur in response to hostile tender offers or rumors of them, the ultimate protection for shareholders would be the market for corporate control (Lehn & Poulsen, 1988, 1989; Schleifer & Vishny,1988). Pre buyout stockholder premiums are a positive function of the number of bidders (Lowenstein, 1985). The very fact that an LBO bid has been made and that the structure of the bid is known may provide important information about manager/insider valuations (DeAngelo et al., 1984;Stoughton, 1988). A bidding war or an auction would provide additional shareholder protection. Lowenstein (1985) suggested requiring one by law. If the market for corporate control is not perfectly efficient, and if the absence of a bidding war suggests lower value, Lowenstein's (1985) proposal would be fairer to 1992 Fox and Marcus 71 stockholders. However, a law requiring an auction process might lower the likelihood that a bid is made in the first place (DeAngelo & DeAngelo, 1987). Because internal firm accounting data are used to establish the price, it is difficult to determine if a fair price has been established. The only empirical work on this topic is DeAngelo (1986). She showed that even though litigation and investment banker evaluations use accounting information to establish fair prices, there is no evidence that managers have systematically understated earnings in the period prior to the LBO announcement. There is very little empirical evidence on this issue. Despite any legal or capital market safeguards, to a large extent it is still management that makes the information available to outsiders.
Consequences of leveraged buyouts:
Increased Efficiency/Greater Profitability: Typically, a firm can raise cash flows by improving operating efficiency, increasing sales, reducing taxes or dividends, or by selling assets. The empirical evidence shows that after LBOs there is significant improvement in operating efficiency and profitability with no decline in expenditures for such items as maintenance and advertising. Four articles (Kaplan, 1988; Muscarella & Vetsuypens, 1989; Singh, 1989; Smith, 1988) deal with the post-buyout performance, and they obtain similar results: improvements 74 Academy of Management Review January in operating income and operating margins (operating income/sales), and small increases in advertising and maintenance expenses. Both Kaplan (1988) and Smith (1989) found improvements in the management of working capital. Thus, it appears that a tightening of working capital management is a source of improved performance. These studies, however, are short term in nature. Kaplan (1988) looked at performance for only 2 years after the buyout, and Smith's (1988) results focused on performance the first year after the buyout. The gains made may not endure for longer periods. Safeway, for instance, 4 years after its LBO still had to live with an interest bill of $400 million a year, a negative net worth of $389 million, and $3.1 billion remaining in debt (Faludi, 1990). Its net income in 1988 was $2.5 million, down from $31 million the year before. In the first year of the LBO, it lost $488 million. More research is needed about the longer term effects of LBOs. With regard to the results of existing studies on the longer term effects, Muscarella and Vetsuypens (1989) found significant improvements in median gross profit, operating income, gross margin percent, and operating margin. The improvement in sales is relatively small (9.4%) and there is no net improvement in such items as net income after taxes or sales per employee. Singh (1989) found similar significant improvements in performance. A main reason is improved working capital, management inventory turnover, and accounts receivable. Also interesting are Singh's (1989) results for sales. In each of the 3 years prior to going public again, LBO firms had significantly higher sales than their industry averages. Most of the higher sales growth rates were in LBOs that had been divisions of large, diversified corporations. Whole diversified corporations that went private had no significant increase in sales. Singh (1989) argued that performance improvements are not just due to increased financial and operational control but also to a more aggressive autonomous and entrepreneurial management team.
Lower R&D Spending/ Reduced Competitiveness: Critics also charge that mergers, takeovers, and leveraged buyouts lead to excessive managerial focus on short-term performance at the expense of R&D (Andrews, 1987; Hill et al., 1988; Reich, 1989; Shleifer & Summers, 1988). Economists, in contrast, predict that the firm would continue to invest in R&D because the managers have a large personal stake in the business and are not likely to sacrifice future profits by cutting back on R&D to achieve short-term gains (Hall, 1988; Graves, 1988; Lichtenberg & Siegel, 1989b; National Science Foundation, 1989; Pound, Lehn, & Jarrel, 1986). With regard to R&D spending after LBOs, the major difficulty is in finding cases. Most post-LBO firms do not have to file reports with the SEC. KKR (1989) reported a 15 percent jump in R&D spending in the sample of 17 firms it surveyed. However, Long and Ravenscraft (1989) criticized these findings on the grounds that the authors have not controlled for industry effects. Kaplan(1989) stated that only 7 of the 40 firms for which he has assembled data performed R&D either before or after the buyout. Lichtenberg and Siegel 1992 Fox and Marcus 77 (1989b) suggested that R&D intensity increases at about the same rate for their sample of 43 R&D performing LBOs as non-LBO firms for the period 1981-1986. However, the average R&D intensity of LBO firms is about half that of R&D performers as a whole. These findings are consistent with Hall (1989), who found that LBOs do not tend to occur in R&D-intensive sectors or firms. Instead, they occur in mature industries that typically do not need massive amounts of R&D. On this basis, Hall (1989) concluded that LBOs cannot have much of an impact on R&D spending. Thus, R&D spending does not decline after LBOs because LBOs take place in less R&D- intensive industries.
Conclusion
Leveraged management buyouts are becoming a more frequent and more important means of restructuring corporate assets. They are very important phenomena because they signify a movement toward convergence in the patterns of leverage and ownership among multinationals where by U.S. multinationals are becoming more like Japanese firms with regard to debt and more like West German firms with regard to ownership. In contrast to other aspects of the corporate control market (mergers, tender offers, and proxy contests) there is relatively little literature on management buyouts. In terms of both intellectual interest and social consequences, understanding post-buyout performance is especially important. On the one hand, if Jensen (1989) is correct and LBOs are a new, more efficient, and cooperative organizational form, with more LBOs we would expect to see significant improvements in productivity in the American economy. If Reich (1989), Lowenstein (1985), and others, on the other hand, are correct and LBOs are little more than a tax dodge that have negative effects on employees, they will increase risk, yield greater waste, and result only in resource and asset reshuffling.
