LBOs in the 1990's

As the 1980's yielded to the 1990's, U.S. corporations returned to the equity market at full scale. The reasons for such return included capturing the equity market expansion fresh out of the recession and de-leveraging to ease corporations out of the heavy debt burden. Leveraged buyouts went out of fashion in 1991 and showed only a moderate recovery half a decade later.

Starting in 1996, the buyout market started to gain wide attention again, reaching a total transaction value of $24.2 billion from a $6.5 billion in 1995, according to Mergers & Acquisitions (1997). The transaction volume was not as high as those in the LBO boom of the late 80's, but it was about the same level as those in 1984 and 1985 (see Exhibit 3). The rise can be partially attributed to the buoyant mergers and acquisitions market that was incredibly strong in 1996 as CEOs were focusing on both strategic acquisitions and pruning their non-core-businesses. Overall, 10,000 M&A deals were conducted in 1996, totaling $657.4 billion in transaction value, overshadowing the prior record set the year before of $522.4 billion for just over 9,000 deals.

Another factor in the resurgence of LBOs in the mid-90's was the unprecedented flood of capital that flew into buyout funds from institutional investors, pension funds, and high net-worth investors. Buyout funds raised nearly $15.8 billion in the first nine months of 1996. The third quarter of 1996 took in $8.3 billion in new money, more than the total amount raised in all of 1993, according to Buyouts magazine (1996).

The LBOs funds made a triumphant return in 1996, having received a great deal of new funding from investors and having come back to the market with a new, warm image of supportive capital providers rather than cold hostile raiders. That year LBO shops grew in numbers not seen since the late 80's.

The LBO deals in the 1990's, however, were very different from those in the 1980's. The 1990s' LBOs were done with fewer ideal targets, more intense competition, less leveraged capital structure, different sources of value created, and a sharply reduced mean industry return.

1. Fewer Ideal Targets

First and foremost, there were far fewer good LBO targets available during the 1990's than during the 1980's. During the early 80's, U.S. productivity, as measured by hourly output, grew at only a nearly stagnant 1% annually. Company valuations were extremely low. In addition, the existence of a good number of inefficient conglomerates provided amply room for buyout firms to utilize their financial acumen and artistry to discipline free cash flow and incentives management. All these factors combined to create a perfect environment for LBO transactions.

By comparison, the U.S. productivity growth rate soared to an annual average of 3.1% by the mid 1990's, thanks to technology advances and an entrepreneurial boom. An interesting study by Holmstrom and Kaplan (2001) suggests that U.S. companies were increasingly following the principles pioneered by the LBOs of the 80's. Enhancing shareholder value had become a tenet that was widely accepted by corporate America . Incentive-based compensation was also fairly common. Internal corporate governance mechanisms had become much more effective in the 1990's, thus leaving little room for corporate raiders or buyout firms to optimize performance with their standard toolkits. Holmstrom and Kaplan's study has been confirmed in a recent survey of buyout general partners by Asset Alternatives, a research firm specializing in private equity industry. Furthermore, as Exhibit 5 shows, both large-cap and small-cap valuations as of 2000 are still above historical value investing levels, resulting in fewer bargains being available. This has increased the difficulty for buyout firms to profit upon exits. In addition, the U.S. economy has been shifting from manufacturing industries towards service industries, and the latter are harder to leverage due to the higher intangible asset base. As a consequence of all above factors, ideal buyout targets are much harder to get in the 1990's and 2000's than in the 1980's.

2. More Intense Competition

Second, the competition in the buyout market was much more intense during the 1990's than during the 1980's. One reason for this increased competition was that the successes of buyout firms during the 80's drew many imitators to join the buyout bandwagon. This was the case despite the industry's decline in the late 80's. Such veterans as Henry R. Kravis and Theodore J. Forstmann -- founders in the 1970's of two of the earliest LBO firms -- once had free rein in the 80s; now they faced 850 competitors. In addition, much larger amounts of money had been raised by the industry. According to Asset Alternatives' 2001 research report, aggregate buyout fundraising expanded from 1991 to 2000 at an annual rate of 34%. The expansion could (at least partially) be attributed to the significant growth of large state pension systems. This vast pool of buyout funds tended to concentrate their activities on certain industries at the expense of depressing industry-wide returns. Finally and most importantly, financial buyout firms were finding themselves competing against a wide range of players, including strategic buyers. As the latter generally could provide higher bid prices resulting from business synergies, financial buyers were being forced to focus on smaller businesses and parts of conglomerates.

3. Less Leveraged Capital Structure

Third, the supply of capital to finance the buyout transactions in the 1990's differed greatly from those in the 1980's. The good news was that since the 80's, the high yield market experienced much growth marked by a few ebbs and flows. This supported LBOs from time to time. In addition, the mezzanine market experienced steady growth throughout the last decade with its increasingly important role for buyout deals that were too small to be financed in the high yield market. The bad news, though, was that the senior debt market was lagging behind the growth of buyout equity. Also, the substantial consolidation among financial institutions in the late 90's increased the bargaining power of senior lenders at the expense of buyout firms. In general, because of the extra risk of bankruptcies and low credit ratings, creditors were no longer willing to accept the extremely high leverage ratios prevalent in the 80's and thus forced buyout firms to put in more equity capital and reduced their buyout returns significantly. According to Portfolio Management Data (Exhibit 6) and Asset Alternatives (Exhibit 7), the leverage ratios have dropped from about four times equity in the 80's to only two times equity in the 90's, increasing the equity component from 18% in the 80's to 32% in the 90's.

4. Different Sources of Value Created

As a result of the above factors, fund managers have been trying hard to extract value from a very different set of sources. At their origin, buyouts, especially leveraged buyouts, had been perceived historically as an organizational efficiency tool to streamline organizational processes, reduce workforces, and decrease unit costs. This efficiency approach has been especially useful with mature firms, where the debt structure and limits to managerial spending decrease the downside risk and possible failure of the firm because the decrease in leverage, operating improvement became the primary source of LBO value creation in the 1990s. According to Asset Alternatives, a recent survey of general partners in the buyout business shows that from 1986 to 1990, financial leverage contributed 41% to average buyout returns, followed by operating improvement (34%), multiple expansion (14%),[4] and multiple arbitrage(11%);[5] by contrast, from 1996 to 2000 operating improvement contributed 43% to average buyout returns, followed by financial leverage (24%), multiple expansion (22%), and multiple arbitrage (11%).

5. Sharply Reduced Mean Industry Return

The buyout firms in the 1990's were competing in a much more challenging and different environment than their counterparts in the 1980's. The industry became more mature and specialized. The mean industry return dropped sharply, making the abnormally high returns achieved by the early LBO deals simply impossible for the buyout firms in the 90's (Exhibit 9). According to Business Week, (October 2000), LBO performance has drifted downward from an annualized return of 35% in 1989 to 20% in the first quarter of 2000.