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Leveraged buyouts: their impact on R&D spending.

Abstract

* Leveraged buyouts (LBOs) have become an important part of the world's economy. Prior research, has produced conflicting results on whether LBOs erode. R&D efforts (National Science Foundation, 1989) or lead to greater R&D expenditures (Kohlberg/Kravis/Roberts and Company, 1989).

* This research investigates the impact of such activities on research and development (R&D) spending through both course and fine grained research methods.

Key Words

* Examining a data base of 227 buyouts, the present research found that numerous LBOs have occurred in traditionally high R&D performing, however, the indication is that buyouts in such industries do not negatively impact R&D.

Leveraged buyouts (LBOs) have become an integral part of world business. In the United States they comprise over 20 percent of the dollar volume of all merger and acquisition activity (Fortier 1989). In Britain, it is estimated that over 1,500 buyouts have already occurred (Clutterbuck and Devine 1987) and such activities continue to represent a significant part of the market for corporate control (Wright, Chiplin, Thompson, and Robbie 1990). Similar levels of activity have also begun to occur on the Continent of Europe (Osborne 1990). In spite of this mounting level of activity little is known about the impact of LBOs on strategic posturing.

One strategic area that has drawn a measure of interest concerns the impact of LBOs on research and development (R&D) spending. In general, it has been shown that suppressed R&D spending leads to lower productivity in a nation's economy (Scherer and Ross 1989). In the case of the United States, non- military R&D spending is believed to be declining (Hill, Hitt and Hoskinsson 1988). LBOs have been suggested as one explanation for this decrease (National Science Foundation, 1989). For example Walter Adams, Michigan State University, argued that:

(In an LBO) one of the things that gets squeezed is R&D, because that's an investment in the future. Whatever costs are postponable are likely to go by the boards (Skryzcki 1988).

The belief that LBOs negatively impact R&D spending is based on the high debt levels associated with such strategic restructurings. Previous research has found that a firm's debt level negatively impacts its R&D spending. At higher debt levels expenses that have no immediate return such as R&D, are frequently cut (Baysinger and Hoskinsson 1989).

That R&D spending is diminished by LBOs is not universally accepted. Two counter arguments have been raised. First, some have argued that LBOs do not occur in industries that conduct R&D (Jensen 1989). For example, Professor Lawrence Summers of Harvard University argued:

... most LBOs occur in mature industries that do not spend a lot on research, so there is not yet much evidence to support claims that R&D is severely cramped by LBOs (cited in Academy Industry Program, 1990, p. 9).

Another argument in counterpoint, is that LBOs may actually lead to greater R&D spending (Kohlberg/Kravis/Roberts and Co. 1989). In a publicly traded company, managers that have little or no ownership stake may not have a long term perspective. However, it is argued that in an LBO, R&D spending increases since LBOs bring a firm's ownership and control into greater alignment (Jensen 1989). In other words, if R&D spending is critical to a firm's future an investor group will take a long term perspective on investing in R&D.

In spite of conflicting arguments all sides of the LBO/R&D controversy little research has been performed. This research effort will provide greater insight into this controversy by combining coarse and fine grained research methodologies (Harrigan 1983). Initially, a course grained examination will investigate if buyouts occur in R&D) intensive industries. Next, a fine grained methodology will be used to examine the impact of a buyout in the cases of five firms in R&D intensive industries.

Literature Review

Definition

The term leveraged buyout has been used to describe a wide variety of transactions characterized by a firm having significant levels of debt. For clarity, in this research an LBO is defined as occurring when a small group of investors, often including a target firm's management, takes it private by purchasing all of the firm's outstanding stock (Fortier 1989). The investor group's leverage typically is at least 85 percent of the target firm's purchase price (Easterwood et al. 1989).

Prior research has used the terms LBO and management buyout (MBO) in an inconsistent and somewhat confusing manner (cf. Kaplan 1989a, Maupin 1987). The terms are similar since they both refer to a previously publicly traded firm being turned into a privately held entity through the use of high debt levels. However, MBOs are a special LBO case where incumbent managers lead a buyout. As strictly defined, LBOs may or may not involve a firm's incumbent management. Differentiating between MBOs and LBOs can be difficult. Also, exact information on the nature of a buyout and the percentage of an investing group's ownership is not always available. Thus, out of practical necessity, a less restrictive definition of an LBO was utilized in this research.

Buyout literature

The research based LBO literature is limited. However, researchers do agree on one factor when examining either LBOs or MBOs; the shareholders of a target firm taken private, almost invariably, experience significant gains in the value of their stock. These buyout benefits typically apply to both divisional divestitures (Hite and Vetsuypens 1989) and total firm buyouts (Torabzadeh and Bertin 1987). the total premium paid to a target firm's shareholders can be substantial. For example, Lehn and Poulsen (1989) found that stockholders obtained a premium of 36.1 percent of the stock's value between the 20 days before the LBO announcement and the time the action was completed.

Research in the finance literature has focused on the characteristics of target firms prior to being taken private and subsequent returns to stockholders. A summary of the studies that have investigated the pre- and post-buyout characteristics of target firms is presented in Table 1. As indicated, most research has shown that firms experiencing an LBO reduce capital expenditures. For example, it has been found that the median percent change for the ratio of capital expenditures to sales while a firm is privately held in an LBO is 11.4 percent (Muscarella and Vetsuypens 1990). Additionally, LBO firms strive to use their assets more efficiently; sales per employee have been found to increase 3.14 percent from an LBO (Muscarella and Vetsuypens 1990). These facts demonstrate that firms experiencing an LBO emphasize maximizing cash flow by avoiding investment in unnecessary assets and better utilizing the assets the firms do possess. It is reasonable to expect that spending for such long term investment as R&D might be eliminated or decreased to satisfy short term cash flow pressures.

[TABULAR DATA OMITTED]

R&D and Buyouts

The prior research has found mixed results on whether LBOs negatively impact R&D (see Table 1). Three studies have found indications that buyouts do not negatively impact R&D (Kohlberg/Kravis/Roberts and Company 1989, Lichtenberg and Siegel 1989, Muscarella and Vetsuypens 1990). The three studies arrived at this conclusion using widely divergent data bases and methods of analysis. For example, Muscarella and Vetsuypens (1990) examined R&D spending by 12 reverse LBO firms the year before they returned to public trading. Reverse LBOs are companies that are taken private and later return to public trading. It was found that these firms did not have substantially lower levels of R&D spending than did a set of firms randomly drawn from the Compustat files. In contrast, Kohlberg/Kravis/Roberts and Company (KKR) examined 17 firms in which they had participated in the buyout and which they still held privately. They found that R&D spending actually increased by 15 percent following the LBO. Finally, Lichtenberg and Siegel (1989) used Census Bureau data of buyout firms still privately held and found relative R&D spending increased following and LBO but at a rate less than the overall R&D spending in all industries. They argued that their findings "cast doubt" on the hypothesis that LBOs are associated with a reduction in R&D spending.

However, other studies have analyzed their samples of LBO firms differently and have argued that this lack of a negative impact from buyouts on R&D is because buyouts occur in non-research oriented industries. For example, Kaplan examined the propensity of his mixed sample of buyouts and reverse buyouts to conduct R&D prior to their being taken private (cited in Jensen 1989). He found that only seven firms out of the total sample of 76 companies spent more than one percent of sales on R&D prior to the LBO. From this finding it has been argued that buyouts principally occurred in industries where R&D normally does not occur (Jensen 1989). Similarly, while Smith (1990) found that buyouts did not negatively impact R&D, she argued that research and development expenses were "immaterial" to her sample of firms. This lack of information was interpreted by these researchers to mean buyouts do not occur in R&D intensive industries.

Finally, others have found a negative impact of buyouts on R&D. The NSF obtained the IRS records for eight "leveraged buyouts, buybacks, or other major restructurings" (National Science Foundation, 1989). The NSF sample of eight firms experienced a 12.8 percent reduction in R&D spending and attributed that reduction to the restructuring activities. Overall the study concluded that "restructurings including leverage buyouts (LBOs) appear to be a major factor responsible for the lack of real growth in industrial R&D spending ind the mid-eighties".

In summary, the literature on buyouts has several important implications. First, the argument has been made that the preponderance of buyouts occur in industries in which R&D is normally limited (Jensen 1989). Second, to date there have been mixed indications of the impact of LBOs on R&D spending. However, much of this research is limited by the fact that the data they used is not publicly available. Data from the IRS, Census Bureau, or that which is privately supplied by a buyout firm can provide interesting results but does not allow replicable findings to be derived. Finally, other researchers demonstrated that LBOs utilize their assets more efficiently and try to maximize cash flow; these items could work to the detriment of R&D spending as firms minimize cash outlays for anything that does not have an immediate payoff.

LBOS' impact on R&D

The above literature raised two central questions about the impact of LBOs on R&D. 1. Do LBOs occur in industries where R&D is a significant factor? 2. If so, what is the impact of LBOs on R&D intensive firms?

Sample and data collection

Previous research has relied on limited samples and descriptive information to evaluate whether LBOs have occurred in industries where R&D is a significant factor. For this research a sample of 227 buyouts in the United States that had value greater than $ 35 million dollars and where completed between the years 1982 and 1986 was identified. This sample was obtained with the aid of Morgan Stanley and Company. The brokerage firm's database represents all LBOs that occur in the U.S. The number of LBOs reported by Morgan Stanley is exactly the same as found by Lichtenberg and Siegel (1989) using Census Bureau data for the same parameters. The sample included 74 divisional divestitures and 153 full company buyouts.

The research next conducted a fine grained, in-depth examination of the impact on R&D of the buyout on individual firms. One of the difficulties in performing research on LBOs is obtaining financial or qualitative information on firms once they become privately held. An examination of the finance literature provides an innovative method to overcome this difficulty. Two of the studies (Kaplan 1989b, Smith 1990) identified in Table 1 that examined firms post-buyout characteristics firms used "reverse" buyouts as part of their sample. In addition, two other studies relied solely on reverse buyouts for their data (Muscarella and Vetsuypens 1990, Singh 1990). Reverse buyouts refer to firms that have been taken into private hands through an LBO that returned to public trading at a later date. Using reverse buyouts as a potential sample of data base offers the benefit of having post-LBO financial data. Additionally, extensive qualitative information is typically written about the firm, and their LBO experience, as they return to public trading.

It may be argued that reverse LBOs are not reflective of the entire buyout population. However, there are several factors that mitigate this concern for generalizability. First, the two studies (Muscarella and Vetsuypens 1990, Singh 1990) that used reverse buyouts in their sample found many of the same results as did the one study (Bull 1989) that had access to LBO firms that were still privately held. Smith (1990) comparing a subsample of reverse LBOs to other buyouts found no difference between the two groups. Second, third parties typically participate with management in raising needed equity. These parties generally expect to be able to cash in on their investment eventually; returning a firm to public ownership is one such means (Academy Industry Program, 1990, p. 33). Thus, it is reasonable to expect that LBO firms are very similar to reverse LBO firms. Finally, only those studies that rely on such publicly available data are replicable. Reliance on private interviews and Internal Revenue Service data provide interesting results but do not meet this criteria. Therefore, a sub-sample of buyouts that occurred from 1982-1986 but which later returned to public trading, reverse buyouts, was identified.

However, this sub-sample was further limited. Firm R&D spending is relatively difficult to obtain. Research and development spending is not broken out by all firms as an expense item. Only when a firm's auditors evaluate R&D expenses as being material are they separately reported. An expense is determined to be material if it impacts a firm's evaluation by stockholders and outside analysts. The result is that most firms report their R&D expenses as part of their firm's general and administrative expenses.

To illustrate, Vista Chemical is a firm that underwent an LBO in 1984 and returned to public trading in 1987. Its prospectus 1987 mentions 90 R&D reseachers and discusses Vista's construction of a new research facility. Yet, the prospectus reports no separate line-item expense for R&D. Another illustration is the Formica Corporation, which underwent an LBO in 1985 and returned to public trading in 1987. The President's letter and the management discussion of financial results which appeared in its 1987 annual report both cite R&D spending and what the Formica hoped to accomplish with these efforts. However, in the accompanying financial report, R&D spending was rolled into Formica's general and administrative expenses. Only five of the reverse buyouts that occurred in R&D intensive industries, an average of three percent or more of sales spent on R&D from 1982-1986, had identifiable R&D expenditures.

Therefore, the in-depth qualitative analysis was limited to these five reverse buyouts. These firms were involved in four industries (measured by three digit SIC code). The average time firms were privately held was over 2 and one-half years.

Industry analysis

To analyze the industries in which the 227 buyout firms belonged Ward's Business Directory of U.S. Private Companies and Standard and Poor's Industries of LBO Occurrence Register were examined. From the analysis of the 213 firms whose principal 4 digit SIC code could be identified, 149 different industries were found to be in the sample.

Information was then sought on the R&D propensity of these industries. The data source selected was the National Science Foundation. The measure used was R&D intensity, R&D/sales. This measure has received wide use in the relevant literature (Baysinger and Hoskinsson 1989, Hambrick and McMillan 1985) and allows R&D spending to be considered in light of a firm's size. To alleviate individual differences that might be introduced in any given year industry R&D intensity was averaged over five years, 1982-1986.

An analysis of our sample of 213 firms and the industries on which the NSF gathers data reveals that 61 percent of the LBOs occurred in industries where R&D is conducted. The propensity of these industries to conduct R&D was examined next. Several different levels of R&D/sales have been used in the prior literature to classify an industry as research intensive. Kaplan (cited in Jensen 1989), used a one percent of sales being spent on R&D to evaluate research intensity. Using that criteria, 33 percent of all LBOs occur in R&D intensive industries. A more common standard is for research intensive industries to be considered as those who spend three percent or more of sales on R&D (Maidique and Hayes 1984). This criteria resulted in the classification of 16 percent of all LBOs in research intensive industries.

This evidence demonstrates that it is an overstatement to assume that LBOs occur in industries where R&D does not occur. It was shown that 61 percent of all LBOs occur in industries that conduct research. R&D expenditures is an expense in these industries which may be diminished in an LBO. However, potentially most affected by the LBOs are the 16 percent of LBOs that are in research intensive industries.

Firm analysis

The next question raised is what impact did these LBOs have on individual firm's R&D spending levels. The qualitative analysis of this issue may be questioned for its replicability and representativeness. However, this type of analysis can provide rich insight into how firms treated R&D spending following and LBO and direct future empirical investigations (Harrigan 1983).

Quantitatively, examining the change in R&D expenditures of the five indicates that while these firms were privately held, three firms increased R&D spending, one had no change and one decreased R&D spending (see Table 2). However, more insightful is the examination of whether these firms changed their strategic posture towards R&D spending while they were privately held. R&D spending can be a source of competitive advantage (Franko 1989). Therefore, the focus of the examination was how the buyout changed these five firms strategic posture towards R&D as a source of competitive advantage.

[TABULAR DATA OMITTED]

One of the five firms, Rexene, sought to build its R&D into just such an a competitive advantage while it was privately held. Rexene Corporation was created when its managers purchased a division of Burlington Northern which produces plastic resins and films. Prior to its buyout, in 1983, the firm spent 3.1 percent of its sales on R&D, slightly above the industry average. Similarly, examining written material on the firm it is described as competitive in its R&D but not as outstanding.

However, by 1987 the year before the firm went public again, it was spending 9.1 percent of its sales on R&D, approximately double the industry average. The President and CEO of the corporation in the 1988 financial statement described the corporation's strategic plan as:

... based largely on the skills and capabilities of our technical and research specialists. This group creates new and improved products that address specific customer needs.

Therefore, while Rexene's R&D was acceptable prior to the buyout it clearly had become central to the firm by the time it returned to public trading.

The other four firms examined, even those that increased their R&D spending, did not appear to be trying to use or build their R&D spending into a source of competitive advantage either before or during the time the firm was privately held. For example, Atari spent only 3.1 percent of its sales on R&D the year following the LBO, as compared to an industry average of 10.3 percent. It was written about the firm at the time of buyout

Atari also is cutting expenditures in its research and development group by concentrating on projects designed to yield products in one to four years. It plans to reduce efforts on projects of five to seven years (Landro 1984).

Atari increased its percentage of sales spent on R&D while it was privately held to 5.6 percent. However, the industry average grew to 11.7 percent during that time. The firm, rather than emphasize its R&D to expand its products acceptance, purchased a large retail outlet, the Federated Stores, soon after returning to public trading. It was written about Atari's effort to use vertical integration to gain acceptance for its products:

You can't buy your distribution. You have to earn it. (Wells 1987).

Therefore, while the firm's R&D may have increased while it was privately held, relative to its competitors Atari did not emphasize its R&D as a source of competitive advantage prior to or after its buyout. Instead the firm sought alternative means to promote the acceptance of its products, vertical integration.

Similarly, Genicom increased its R&D spending while it was privately held. However, the strategic posture of the firm toward R&D did not change during this time. General Electric sold the division that became Genicom to its managers in 1983 because it "did not possess a technological edge" (Alper 1983). While the f-irm was privately held, the increase in R&D was designed to develop new products not new processes. The concern of the firm was to retain current technology rather than develop new technological capabilities.

Only one of the five firms examined decreased their R&D spending while privately held. Calgon Carbon was divested by Merck and Co. in 1985. The percentage of sales spent by the firm on R&D decreased by almost one-third while Calgon was privately held. However, this change does not represent a shift in the strategic posture of the firm. Calgon despite being in a high technology industry emphasized enhancement of its current products not new process developments both prior to and after the buyout. For example, Merck's 1984 Annual Report discusses Calgon's product development program and provides three examples of new products, but no new processes are discussed. Similarly, Calgon's president in his 1987 letter to the stockholders discusses the firms research efforts as trying to create "differentiated products". Therefore again, while Calgon's R&D percentage may have shifted slightly, its strategic posture towards R&D still does not appear to have substantially changed.

Finally, the last firm examined, Charter Power, also did not substantially change its R&D orientation during the buyout. Charter Power was created through a divisional buyout of the battery power division of the Allied Corporation. Its R&D expenditure level stayed constant while the firm was privately held. The only major change noted was that some "fundamental metallurgical research" was dropped after the buyout (Prospectus Charter Power, 1987). However, that research was not a large expenditure.

Discussion

Based on this sample only limited assertations can be made about the impact of LBOs and R&D. The indication, though, is that some of the assumptions that have been made about LBOs should be challenged. For example, it has been widely accepted that LBOs occur principally where R&D spending is unimportant (Jensen 1989). However, this may not be the case. Most of the firms in this sample involve companies in the manufacturing sectors of the U.S. economy. These industries still conduct R&D even though it may not be an intense activity. The loss of the R&D output of the finns in these sectors can still pose a potential threat to the U.S. productivity.

There is also evidence that neither Jensen (1989) nor the National Science Foundation (1989) are right, LBOs do not categorically either hurt or help a firm's R&D effort. Instead, it appears the buyout left firm's posture towards R&D largely unchanged.

It is true that firms in high R&D intensive industries may cut expenses to meed excessive debt payments. In such industries the costs of building R&D into a competitive advantage can be very expensive. The LBO firm may not be able to afford such expensive competition. However, in the qualitative cases examined here, R&D was not source of competitive advantage prior to the buyout and the buyout itself did not appear to change the firm's orientation to R&D substantially. In the one case where there was a substantial change, Rexene, R&D spending increased. However, it is possible that if the buyout firms substantially change the economics of the R&D intensive industries, the future may see more R&D leaders undergoing a buyout.

Conclusion

This research has examined the topic of leveraged buyouts. The level of LBOs now represents 20 percent of all merger and acquisition activity in the United States, and it is a growing phenomenon in Europe. To date, the strategic management literature has largely ignored this critical topic. However, the evidence gathered here strongly supports the need for further research since in the one area investigated, R&D expenditures, this research challenges the previously assumed characteristics of LBOs. It will only be through greater investigation that a better understanding of LBOs and their impact on firms will be obtained. It is hoped that the discussion began by this paper will encourage such an investigation.

The topics that should be investigated in the future include greater investigation of the LBOs on R&D spending. This study has added to the analysis concerning R&D expenditures but further investigations using larger samples should be conducted. Particular attention should be focused on changes in the buyout firms' strategic posture towards R&D. Small changes in the percentage change in expenditures may not give an accurate indication of what is occurring in the firm. In addition, what actions produce success in a buyout, how buyouts impact declining firms, and the impact of third party investors, such as Kohlberg/Kravis/Roberts and Co. (1989), on buyout performance are all topics of great importance. No single study can answer such questions but a stream of research should be begin on this critical topic.

This paper should also aid policy makers in Europe as they evaluate what controls or encouragement should be developed for buyouts. Such corporate restructurings are growing in Europe. This research indicates that from the experience of the United States concern for buyouts impact on R&D is not without merit. However to date, there is no evidence of negative relationship between buyouts and R&D.

In summary, this research has made several contributions to the literature. First, it has highlighted a method (adopted from the finance literature) for investigating LBOs and the actions associated with them. Prior use of reverse LBOs has found many of the same results that the one study that gained access to privately held LBO firms found. The establishment of this form of investigation allows researchers to begin far greater investigations of leverage buyouts. Second, the research has established that LBOs occur in both R&D and non-R&D performing industries. It therefore, cannot be assumed that buyouts do not negatively impact R&D. Finally, the research indicates that LBOs have not been negatively impacting R&D. The last contribution is limited by the small sample and the qualitative nature of the analysis. However, the finding does provide insight and should help direct future research.

Future research needs to continue to investigate and expand our understanding of this critical area. This will require a program of active study over a period of years to complete. However, the large dollar volume of LBO activity justifies such a commitment of resources.
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Author:Bruton, Gary D.; Scifres, Elton
Publication:Management International Review
Date:Jan 1, 1992
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