Making buyouts work: public policy and private management.
Whether you are for or against leveraged buyouts and foreign investment in U.S. business depends largely on your vantage point.
If you are a member of management, sometimes referred to by advocates of buyouts as "entrenched" management, and you have no opportunity to participate in the takeover transaction, not only is the takeover of your company deleterious but all takeovers are. Similarly, if competition, particularly foreign competition, is troublesome, then all forms of foreign investment in U.S. industry become undesirable.
In any event, the recent surge in leveraged buyouts is a significant and, in many ways, a positive trend. Following a buyout, refinanced companies become focused, bold, and impatient creatures - needing cash flow to live and steady growth to flourish. To meet their revolver or term loan payments, they must meet cash flow goals. To do this, they cut unnecessary frills and excessive expenses, emphasize marketing and sales, and reduce hierarchy costs and decision-making time in the day-to-day running of the business.
Also, marginal operations are sold and the core business becomes the main focus. LBOs and MBOs have been made famous because of the wealth they create for investors and managers who assemble them. What is often forgotten is that such gains are not based on illusory stock market conditions. Success stories, by and large, have been the result of exemplary management.
Critics who oppose the concept remind us that LBOs often involve high levels of risk and other potential drawbacks. Is the trend toward buyouts leading to overleveraged, vulnerable companies? Do they cause excessive relocations? Do they threaten federal revenues? These are among the questions Congress is now asking as it considers further regulation of corporate acquisitions. Many legislators have indicated the simplest way to curtail the acquisitions is to limit or eliminate the deduction of interest expense.
But as we look to the next decade of American business and the certainty of much change, we need to take a step back and consider the buyout phenomenon. Buyouts have had a profound effect on the way many companies do business. The issue has left the confines of corporate boardrooms and, quite properly, entered the realm of public policy. But, as new laws are proposed, it is essential that we understand what is accomplished by leveraged buyouts. We must do this if only to encourage its benefits and discourage its abuses.
The tax question
Perhaps the first notion to address is the idea that LBOs and MBOs are tax ploys, that they relieve companies of income tax burdens and deprive the Federal Treasury of much-needed revenues. A recent survey by Kohlberg Kravis & Roberts, a major force in the LBO movement, indicates tax revenues are not diminished by highly leveraged companies. In fact, the opposite may be true. Capital gains taxes owed by selling stockholders are significant in many such transactions. Interest income to banks is taxable in part as regular income.
Also, the buyer and seller must pay substantial transaction fees, all of which are taxable to the recipients. All of these monies flow into the economy, generating additional taxes repeatedly. It is impossible to calculate the precise net effect of takeovers on tax revenues, but the relationship is complex and needs to be carefully considered in any amendment to current interest/cost taxability.
To be effective, legislation must first address the question of how to distinguish between good and bad interest. Two sources of funds have financed U.S. growth: equity and debt. To eliminate the debt opportunity by making it too expensive is to devastate the introduction of growth capital at a time when it is needed badly. Also, such action plays into the hands of foreign investors, who often can borrow at rates far below those in this country, further tilting an already uneven playing field.
It is folly to curtail the free market function relative to corporate restructures, recapitalizations, mergers, and acquisitions in an effort to stifle a corporate activity started in this country in the late 1800s with obvious effects. Let history teach us how U.S. Steel and General Motors were created.
Ultimately, the consequences of takeovers should be more than marginally positive because of the promise of healthier companies created by them. The most important thing buyouts do is inspire management to be more efficient and energetic. The reasons for this are uncomplicated. The cost today to enjoy the luxury of being a listed company varies based on size but rarely is less than $500 thousand and can run to the tens of millions. A leveraged company is no longer playing to the constituency of analysts, institutional investors, or stockholders - and this frees management to produce cash flow to meet the capital requirements of its core business as well as its debt service. The new management will cut expenses to levels it would not have dreamed of when it was part of a larger corporation. It may sacrifice "reported" earnings and it may scrap some fictional long-term objectives, but buyouts are the best medicine known for reorienting management to those parts of the business with most promise.
Obviously, not every spin-off will work as planned, but one important success in this area was the MBO of Harley-Davidson. AMF Corporation had purchased Harley some years before at a time when motorcycles were making meaningful strides in the American market. Unfortunately for the American conglomerate, most of the sales were enjoyed by the Japanese, who were beating domestic manufacturers soundly on their own turf. Under discouraging circumstances, AMF sold the unit to management in a leveraged buyout transaction at an attractive price. Free of the burden of home-office overhead and free to make quick value-related decisions, the management team immediately made moves to turn the situation around.
For one, members of management embarked on a marketing campaign far more aggressive than the parent had ever attempted. They also made important design modifications, improved quality control on the assembly line, introduced just-in-time inventory control, and cut costs, particularly administrative expenses. Another move was to send upper management to Washington to lobby for trade relief against cheaper foreign competition. While AMF had made similar legislative efforts through a D.C.-based public relations counsel, the presence of management on Capitol Hill was a crucial ingredient in getting bills passed. Within a few years, Harley was profitable, and upper management - and, subsequently, public shareholders - attained significant wealth for their efforts.
Harley-Davidson is a best-case scenario of what can happen when management takes over. Not all takeovers work as well, but as a response to global competition, it is instructive. American business is beset by many forces that cannot be controlled by management, including the cost of both capital and labor and the foreign government subsidies benefitting the competition. But one thing management can control is the way it runs its business internally. Those changes are made most effectively when management and ownership are closely tied.
That foreign competition is one of the primary reasons companies want to curtail investment in the U.S. by other countries. But, in fact, foreign investment has revitalized several U.S. industries - tires, steel, automobiles, and chemicals - making everyone else more alert to the need to upgrade, modernize, and manage effectively.
Without the threat of foreign competition and the intervention of a number of LBOs, major companies in these industries would have likely disappeared. Major firms in the glass container industry were saved from oblivion by an LBO transaction.
Consider Goodrich Tire, Armstrong Tire and Rubber, Anchor Hocking Glass Container, Celanese, and the U.S. automotive industry as a whole, awakened by foreign competition and investments. Moreover, the threat of such investment, from a foreign or LBO source, has turned inefficient companies to acts of restructuring not previously contemplated.
What's the problem
Increasing criticism has been levied at LBOs because the target companies are up in price. Higher prices are, in fact, a function of demand and reduced supply. Many investment houses have assembled funds to bid on buyout candidates, a situation that has tended to bid prices upward somewhat over the past few years. Of course, the question is, how high is too high?
The current price levels may well mean an end to the super-high rates of return that early LBO and MBO movements earned. In one of the more famous early LBOs, a team headed by former Treasury Secretary William Simon purchased Gibson Greeting Cards. The group rapidly tripled the net income, increased the company's value dramatically, and came away with mammoth gains. More recently, successful buyouts have not earned comparable returns, but their size has increased many-fold, yielding even larger total sums to handfuls of investors and managers.
But while management has gained a comfort with buyouts, government also needs to understand their true benefits and refine its approach to them. Many legislators, though not all, understand that borrowed capital and sweat equity is a promising formula for the creation of new wealth and a more efficient industrial community.
Promoting the right circumstances for LBOs and MBOs ought to be urgent business for this government, because it is clear many American companies are going to be purchased whether American investors are encouraged to bid on them or not. As value is perceived in underutilized domestic industries, foreign capital is actively bidding on American companies, and indeed on entire markets in a promising industry group. Because other industrialized countries have more lenient tax laws and accounting practices than we do, they are in a good position to compete. English investors, for example, can raise equity capital via "rights offerings" almost with the ease that we raise debt. In most other countries, accounting practices permit goodwill to be written off immediately against equity, not a yearly hit to earnings. Furthermore, the low-valued dollar is just one more factor making it hard for American investors to compete in this bidding.
Still, the LBO/MBO industry is subject to much censure. One point of contention is the idea that undercapitalized firms may collapse in the event of economic downturn. Indeed, they could, but well-structured deals usually result in companies that manage themselves cautiously enough to survive the moderate recessions that are inevitable. Moreover, the market itself addresses this problem. Higher levels of equity are being demanded by banks, especially as buyout prices rise. While concerns about over-leverage lead some to demand limitations on buyouts, Congress has a different choice. It could cease double taxation on stock dividends, thereby lowering the cost of equity capital. This would have a favorable impact on debt-equity ratios. However, to do this in conjunction with legislation to eliminate the deductibility of interest is folly.
Leveraged companies face another problem: the field of research and development. R&D expenses are a likely area to cut costs when periodic debt payments take priority. The broad answer to this problem is that R&D can and should be achieved more efficiently than it has been in the past. Many companies have made important research breakthroughs on reduced budgets. Also, American companies have developed products - such as the video cassette recorder - that are not now being produced by those firms or even in this country. But leveraged companies do not ignore research; in the best cases, they make efficient use of R&D dollars. An obvious imperative is for companies to investigate collective research, through universities and joint ventures.
The shifting ownership of companies is a complicated business. Managers and investors need to understand the risks as well as the rewards of highly leveraged situations and how to deal with them intelligently. Furthermore, the government needs to understand that public policy is extremely important in determining the eventual outcome of the changing environment of American business.
It's fascinating that activities such as these tend to face the greatest critical outcry after the major danger is already past. In point of fact, the LBO/MBO phenomenon is now operating at noticeably reduced levels. This second stage of the movement is characterized by deals with lower leverage and greater up-front equity. Of course, the diminished activity may have escaped your notice if your firm happens to be a currently targeted company.
- Ettore Barbatelli, Sr.
Mr. Barbatelli is chairman and CEO of Valuation Research Corporation.
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|Title Annotation:||Takeover Management|
|Author:||Barbatelli, Ettore, Sr.|
|Date:||Nov 1, 1989|
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