The 1980's LBO Boom

Leveraged buyouts are probably one of the most remarkable success stories of the 1980's. One of the major events that received widespread publicity concerned the substantial profits generated in the Gibson Greeting Cards transaction. The company was first taken private in 1982 and taken public again a year and a half later. A management group led by Wesray Capital bought Gibson from RCA in 1982 for $80 million, contributing only $1 million of its own capital. Without significant changes in the company - although perhaps benefiting from the bull market which began in 1982 - the going public price eighteen months thereafter was $290 million. One of the Wesray principals, former Treasury Secretary William Simon, received $66 million in cash and stock on his investment of $330,000.

Substantial returns on investment turned LBOs into one of the most lucrative investment ideas of the 1980's, attracting many participants, including banks, insurance companies, Wall Street firms, pension funds, and wealthy individuals. From 1981 to 1989 there were over 1,400 "going private" transactions. The traditional LBO deals were small until the first mega deal, the Wometco transaction, which was valued in excess of $1 billion in 1984. Since then, the LBO market had enjoyed explosive growth, with the size of the total leveraged buyout market increasing from $4.5 billion of completed transactions in 1983 to $76.6 billion in 1989. The twenty largest LBO transactions for the period 1983 to 1987 had a total purchase price of $76.5 billion (Source: M&A Database).

1. Financing Structure

The extraordinary increase since the mid 1980's in the size and complexity of LBO deals have been accompanied by a massive influx of innovative financing achieved through a variety of financial intermediaries.

Capital for a leveraged buyout generally consists of the following: (i) senior debt, (ii) senior subordinated debt, (iii) subordinated debt, (iv) mezzanine financing, (v) bridge financing, and (vi) equity layers (see Exhibit 4 for a detailed description of capital structure components). The equity layers in the 80's were usually relatively thin, contributing less than twenty percent of the total capitalization of the new entity. Commercial banks were generally the main source of senior debt, with institutional investors providing mezzanine financing, equity financing, and pools of capital, with or without specified uses. The latter are referred to as blind pools.

2. Sources of Value Created

Over the years there has been much debate regarding the value created by LBO transactions. Skeptics argued that the LBO is simply a means for Wall Street to earn paper profits by arbitraging the valuation differences between public and private markets. Studies by academics and professionals, however, have provided ample evidence of substantial value contributed by leveraged buyouts.

For example, a recent paper examined 90 post-LBO firms that returned to public market through IPOs between 1983 and 1988 (Holthausen and Larcker, 1996). It found numerous points indicating value. In the year before re-entry into public market, the LBO companies had almost doubled the pre-interest, after-tax profits of their competitors, used only half as much working capital, and maintained similar levels of employment. Additionally, the firms had larger marketing budgets. Total capital expenditure was lower, but this was in line with the expectation for the industries with excess capacities. After all, these industries were where most of the LBOs occurred. In addition, for at least four years after the IPOs, these 90 firms continued to outperform their peers both in terms of stock returns and operating returns. Given that the average IPO significantly underperforms market average over a three-year period after going public, such performance improvement by post-LBO firms seems quite impressive (Ibbotson, Ritter, and Sindelar, 1994).

One obvious source of value created is a large reduction in tax burden that a highly leveraged firm obtains through the tax deductibility of interest payments. This was significant because in the 1970's most companies consistently operated at sub-optimal debt-to-capital ratio (see Exhibit 2). In those days the corporations applied financial portfolio theory to strategic design. They strove to increase size and diversity. Continued growth took priority over shareholder value. Consequently debt was used very moderately to minimize the risk of defaulting on interest or principal payments and to allow investments in continued growth. The LBO substituted equity with heavy debt, thus utilizing the previously ignored debt tax shield (at the cost of financial distress, which is discussed later).

Another indirect source of value created is increased clarity in the strategic goals of the enterprise. Diversification, often times empire building, was the main theme in corporate America in the 70's. It was not uncommon to find cheese producers clustering with film producers under the same corporate umbrella. Often overly diversified corporations suffered from disadvantages such as high overhead, slow reaction time, misaligned incentives, politicized decision-making, and a confusing image delivered to investors. The spun-off units after LBO transactions hence were able to operate with more focused strategic goals and achieve better performance.

The most important source of value is the effects on capital and incentive structures, best articulated by the "carrot and stick" mechanism (Jensen, 1986). The mechanism is as follows: First, managerial incentive is through equity participation (the "carrot"). Prior to LBOs, management-owned stock or stock-related compensation was rare. With LBOs, the buyout firms typically owned 80-90% of the target, and operating management owned about 10%. This resulted in an ownership structure that was clearly aligned with the interests of the management and owners, hence reducing agency costs in managing the firm. As manager's ownership significantly increased, it gave them strong incentive to work harder. Second, managerial discipline was tightened through high debt service requirements (the "stick"). Jensen characterizes LBO targets as "firms or divisions of larger firms that have stable business histories and substantial free cash flow (i.e., low growth prospects and high potential for generating cash flows) - situations where agency costs of free cash flow are likely to be high". Managers in such firms have an incentive to spend free cash flow on value-dissipating investments that increase firm size, because a larger firm offers incumbent management greater compensation, greater power, and greater opportunities for advancement. So one benefit of the high level of post-buyout debt is the forced distribution by management of the firm's free cash flow to debt servicing rather than to value-dissipating investments.

Of course, heavy debt can be risky as the expected cost of financial distress increases with the leverage ratio. A firm is said to be in financial distress if (i) the firm's earnings before interest, taxes, depreciation and amortization (EBITDA) is less than its interest expense, (ii) it attempts to restructure its debt, or (iii) it defaults on its debt (Andrade and Kaplan, 1997). In the early 80's, however, most LBO targeted companies were "mature, stable, asset-rich companies with low capital needs." The LBO financing structure was relatively conservative and appropriate for the underlying business risk. Hence the combined benefits of debt outweighed its disadvantages, bringing significant success to a majority of LBO transactions.

3. Market Context

The growth of the high yield bond market undoubtedly contributed to the growth in the LBO activities. Early in the 80's, junk bonds were primarily used as a substitute for bank debt for various firms, such as those that were relatively unknown, those in high-risk, those in start-up industries, or those that for various other reasons didn't have good access to public markets for investment financing. Later in the decade, firms that previously had strong credit ratings also began issuing low-rated but high-yielding bonds to finance acquisitions and buyouts. According to Morgan Stanley, the high yield bond market grew from an average of $7 billion in 1970 to an average of $59 billion in 1985 and an average of $146 billion in 1988. Moreover, data developed by E. Alan Brumberger at Drexel Burnham Lambert Inc. shows that in 1982 only 3% of the high yield bonds issued were in conjunction with LBOs, while by 1985 the amount had increased to 50%.

Although traditional LBOs relied primarily on bank financing, the role of financial participants such as investment bankers greatly facilitated the growth of the LBO market. These investment bankers provided multiple services, such as fair counsel on the terms of the transaction, highly confident letters stating that financing will be available, and bridge financing to provide interim loans to complete the deal. The substantial fees were highly chased after, especially following the elimination of fixed fees in the brokerage industry.