Sharp Decline in the Late 1980's

1. End of the Leveraging Mania

Although the early LBO market created value through significant shareholder gains and increases in operating efficiency, things started to head south by the late 1980's. The first eight months of 1989 saw $4 billion worth of junk bond defaults and debt moratoriums. The first signs of crisis were manifested through the financial difficulties of Canadian entrepreneur Robert Campeau's retail empire in September 1989. Mr. Campeau's failure to meet a scheduled interest payment caused a two percent abnormal return (return adjusted for market movements) in the average stock prices of leveraged firms during the three-day period. Junk bond spreads widened from 500 to 700 basis points and gross inflows into junk bond mutual funds sagged.

The second sign of trouble came just one month later when Citibank and Chase failed to provide the necessary $7.2 billion funds to Stephen Wolf, CEO of United Airlines (UAL), to take UAL private. The news that the loan could not be syndicated shook the stock market, sending risk arbitrageurs rushing to unload their shares in hand.

Bad news gathered pace: many U.S. firms sought Chapter 11 bankruptcy protection. In 1990, the number of corporate bankruptcies that involved more than $100 million in liabilities each reached 24 and amounted to an aggregate of $27 billion in liabilities. The number of such large filings rose in 1991 to 31, while total liabilities stood at $21 billion. In 1992, the number of large bankruptcies declined sharply but the debts involved dropped down only slightly. The LBO market suffered a decline that was so sharp that many people predicted the death of the LBO and junk bond markets.

2. What Went Wrong

According to an article by Kaplan and Stein (1993), of the 41 LBOs between 1980 and 1984 with purchase prices of $100 million or more, only one had defaulted on its debt by the end of 1991. By contrast, at least 26 of 83 large deals done between 1985 and 1989 had defaulted, and 18 had gone into bankruptcy, by the end of 1991. Kaplan and Stein's analysis yields the following "overheated hypothesis:"

Beginning in 1985, junk bond investors poured boatloads of money into the booming buyout market, hoping to imitate the success of early deals. This pushed prices up and fundamentally changed the buyout pricing and financing structure. In particular:

• Buyout prices as multiples of cash flows rose sharply, and multiples were especially high in deals financed with junk bonds.
• As prices rose, buyouts were undertaken in riskier industries, and with higher leverage ratios. High industry risk was positively related to the probability of distress and default. Indeed, buyouts in the riskiest industries, for example, retailing, were 19% more likely to experience distress and 14% more likely to default than the average buyout.
• Recognizing the increased risk inherent in later LBOs, banks made a few "defensive" structural adjustments by taking smaller positions and at the same time accelerating principal repayment schedule. For example, bank debt represented over 70% of total debt in the period 1982 to 1984, but dropped to 42% in 1985. The rapid repayment schedules sharply lowered the ratio of cash flow to total debt servicing obligations, which in turn increased the probability that companies would run into financial distress.
• Beginning in 1985, financing from the public junk bond market displaced not only private subordinated debt, but also to some degree senior bank debt. Another type of widely-held debt, called cram down debt,[1] was also frequently issued. Many junk bond and cram down debt holders agreed to increasing the use of deferred interest in the buyouts, in which much of the bank debt was scheduled to be paid off before deferred interest debt that was predominantly public subordinated debt (either junk or cram down debt). This further juniorized the subordinated debt, potentially transferring value to the senior bank lenders at the expense of the junior creditors. Also declined was the use of strip financing,[2] therefore increased the expected restructuring costs due to increased conflicts of interests between creditors and shareholders.
• Management, investment bankers and other interested deal promoters were able to get more money upfront out of the later deals, reducing the commitments of all related parties to the long-run success of the deals.

Also worth mentioning is the fact that the coverage ratios [3] went so low that the post-LBO firms had to rely on asset sales and the speedy realization of major operation improvement in order to make the first interest payment. So even if the deal was done in the right industry for the right company at the right time, such a financial structure sometimes forced managers into a series of shortsighted value-destroying actions.

Some have argued that politics and not economics stopped the leveraging business. For example, during the late 1980's, banks were forced by regulators, rating agencies and the stock market to reduce their highly leveraged transaction exposures. This in turn reduced banks' willingness and ability to work with highly leveraged post-buyout firms that failed to meet debt service requirements. As a result, it became more difficult to restructure distressed firms out of bankruptcy. However, examination of the legal developments in the late 80's and early 90's by McCauley, Ruud and Lacono (1999) suggests that although there was a political reaction to excessive leveraging LBO market, which spurred significant legal developments, these developments did not kill the LBO market. The legal changes may have been significant but cannot be blamed for the end of the LBO business. The leveraging mania expired when its own excessive risk became apparent and no new creditors were willing to accept additional risks.

It was debt euphoria and greed for profits that sent the leveraging businesses in the 80's to its sad end. According to Brancato (1989), prior to 1983, debt of non-financial corporations fluctuated within a narrow range of 33 to 35 percent of GNP. In 1988, that figure rose to approximately 42 percent of GNP. For the period 1984 to the third quarter of 1988, a total of $793.8 billion of corporate bonds had been added to the credit markets, and a total of $422.3 billion of corporate equities had been withdrawn. The explosive increase in the aggregate debt in the economy exponentially increased the risks and costs of financial distress. As a consequence, the overall quality of outstanding debt deteriorated markedly. In addition, the total volume of deals dropped precipitously from a high of $76.6 billion in 1989 to only $6.9 billion in 1991.