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Operating performance in leveraged buyouts: evidence from 1985-1989.

* This study investigates the consequences of leveraged buyouts (LBOs) on operating performance using a sample of 44 going-private transactions completed in the period 1985-1989. Previous studies have documented increases in before- and after-tax cash flows following LBOs (see Bull [1], Kaplan [7], Kaplan and Stein [8], Kitching [9], Long and Ravenscraft [11], Muscarella and Vetsuypens [12], and Smith [17]).(1) Kaplan [7] and Smith [17] have also shown that capital expenditures decline following LBOs. Kaplan [7] has argued that this decline represents reductions in wasteful investments. These authors have also shown that there are few changes in employment, R&D and maintenance expenditures following LBOs.

The Kaplan and Smith studies have been widely cited as evidence that leveraged buyouts result in efficiency improvements. However, these studies consider leveraged buyouts which occurred in the early and mid-1980s. Several observers have noted that, in the latter half of the 1980s, the leveraged buyout market evolved to the point where pricier and riskier transactions took place (see Kaplan and Stein [8], Jensen [6], and Summers [19]). Quite possibly, the returns from taking firms private declined over time as opportunities dried up for remedying agency problems easily through leverage and increases in management.(2) Thus, real operating gains may have been more difficult to achieve in later deals. Consistent with this account, Long and Ravenscraft [11] find that operating profit margins declined by an average of 2% following 107 leveraged buyouts which occurred in the 1985-1987 period. This suggests that the dramatic operating improvements documented in earlier LBOs were due to an unusual abundance of attractive LBO targets and that "the number and type of firms that can be revitalized through LBOs is limited." (Long and Ravenscraft [11, p. 17]).

Like Long and Ravenscraft [11], this paper documents changes in operating performance following LBOs of the mid- and late 1980s.(3) However, there are several differences between these studies. First, this study examines solely the largest LBOs of the late 1980s. In particular, this study documents changes in operating performance following all but two of the 20 largest LBOs which occurred between 1985 and 1990. The largest LBOs are likely to have the largest impact on the economy and thus are naturally of the most interest to policymakers. Second, this study examines LBOs which occurred through 1989, whereas Long and Ravenscraft studied LBOs through 1987. The last two years, 1988 and 1989, are important in evaluating the LBO phenomenon since many of the largest LBOs (e.g., RJR/Nabisco) occurred in these years.

The main results of this study can be summarized as follows:

* Operating profits/sales rise by an average of 16.5%

from one year before until two years after the LBOs

in the sample. After adjustment for industry trends,

operating profits divided by sales rise by an average

of 11.6%.

* Operating profits per employee rise by an average

of 31.8$ in the two years following the LBOs in the

sample. After industry adjustment, the rise is


* Cash flow net of investment rises even more


* LBOs have little impact on R&D, but result in sharp

declines in capital expenditures and income taxes


The results are broadly comparable with those of Kaplan [7] and Smith [17]. Kaplan finds that operating profits/sales rise by an average of 11.9% in the two years after LBOs. This rise goes to 23.3% after industry adjustment. This study shows a larger rise before industry adjustment and a smaller rise afterwards. Smith [17] shows that industry-adjusted operating cash flows per employee rise significantly after LBOs. The rise documented here is similar. While conclusions about changes in operating performance following LBOs will depend on the sample and the definitions of variables examined, the results presented in this paper suggest that the LBOs of the late 1980s produced positive operating improvements that are roughly the same as those observed by Kaplan [7] and Smith [17]. They are also significantly higher than those reported by Long and Ravenscraft [11] and somewhat higher than those reported in Kaplan and Stein [8].

The remainder of this paper is organized as follows. Section I describes the sample and performance measurement benchmarks. Section II presents results on operating performance and compares the results to those obtained previously. Section III summarizes and concludes.

I. Data and Performance Measurement

The sample consists of 44 large leveraged buyouts completed between 1985 and 1989 (see Exhibit 2). This sample contains all firms listed in the 1990 Forbes Private 400 that completed LBOs in 1985-1989 and had financial information in Compact Disclosure, Moody's Industrial Manual, or the COMPUSTAT II PST, FC and research files for the year prior to the buyout until at least one year afterwards.(4) This financial information is provided by LBO firms because of SEC disclosure requirements associated with their issue of publicly traded bonds, preferred stock or warrants. The remaining 60 LBO firms in the Forbes 400 were not selected because they did not have publicly traded securities, because they had no pre-LBO financials, because they were a division of a larger firm, or because they were taken private in late 1989 or in 1990. Exhibit 1 shows the distribution of sample firms by year. Roughly 75% of the LBOs were completed in 1988 and 1989.
Exhibit 1. Distribution of Sample Leveraged Buyouts By
Year 1985 1986 1987 1988 1989
 of LBOs 1 4 7 21 11

The sample selection procedure may introduce biases of two sorts in the final results. The first arises because the sample excludes firms that went private since 1985 and went public before November 1990. Firms which go public again perform better than average (see Muscarella and Vetsuypens [12]), biasing the results downward.(5) In addition, firms which experienced marked declines in sales may have dropped out of the Forbes Private 400.(6) The second bias arises from excluding firms without publicly traded debt. However, only two of the 20 largest LBO companies in the 1990 Forbes Private 400 were excluded for this reason (NWA - Forbes Rank #11 and Montgomery Ward & Co. - Forbes Rank #14).(7) In addition, this exclusion criterion does not appear to have introduced important biases in past studies. Smith [17], for example, shows that firms excluded from her sample for similar reasons experienced nearly identical change in the employees-to-sales ratio, a good proxy for change in subsequent operating performance.

Several accounting measures of performance are employed in this study: (i) Operating cash flow, which is operating income or net sales minus cost of goods sold and selling, general and administrative expenses. This measures cash flow before depreciation, interest and taxes. (ii) Net cash flow, which is cash flow minus capital expenditures. This variable measures the cash produced by a firm that is available for discretionary expenditures, payment of taxes, repayment of debt or payment of dividends to equity holders.

Exhibit 2 shows the identity of firms in the sample and their sales revenues one year before and two years after completing a leveraged buyout. The firms are ordered by their sales rank in the Forbes Private 400. The largest firms in the exhibit are RJR Nabisco, Southland, R.H. Macy and Supermarkets General. As stated earlier, this study focuses on the largest LBOs which occurred in the 1985-1989 period. Most of the firms in the sample reported revenues exceeding $1 billion in their most recently available annual financial statement as of December 1990. Only one of the firms had revenues less than $500 million.

Exhibit 3 reports summary statistics about the sample. The exhibit shows that the sample consists of firms with total sales of $89.9 billion and a total of 826,677 employees before their leveraged buyouts. The median firm had sales of $870 million before buyout and had 13,685 employees. The exhibit also shows that the total sales and total employees for the sample firms declined slightly in the first year after going private. However, total sales rose by two years after going private, and the median firm experienced an increase in sales even after the first year. Similarly, the total operating cash flow of the firms in the sample rose from $8.87 billion in the year before going private to $11.37 billion two years after going private. This represents a total increase in operating cash flow of $2.5 billion. This estimate obviously weights the largest firms in the sample more, particularly RJR/Nabisco, and is a good way to observe the overall effects of LBOs for investors. Exhibit 3 also shows a significant decline in total taxes paid (roughly 80%) attributable to the increased interest expense on the debt taken on in LBOs. Total capital expenditures of the sample firms declined by slightly less than $2 billion. R&D expense for the sample V firms was low to begin with and showed little appreciable change following buyout.

II. Empirical Results

A. Impact of LBOs on Operating Performance

Post-LBO operating changes for representative firms can be observed by measuring the median change in operating performance variables before and after LBOs as shown in Exhibit 4. This exhibit provides the median change for two time windows (year -1 to +1 and year -1 to +2) before and after industry adjustment.(8) Statistical significance of changes in operating performance is assessed using Wilcoxon signed rank tests.(9)

Exhibit 4 shows that median operating cash flow to sales rises by 16.6% from one year before until two years after the sample LBOs. After adjustment for industry trends, the operating profit margin rose by an average of 11.6%. Operating profits per employee rise by an average of 31.8% in the two years following the LBOs in the sample. After industry adjustment, this rise is 40.3%. The rise in operating cash flow per employee suggests that LBO are associated with significant improvements in labor productivity (also see Lichtenberg and Siegel [10]). Net cash flow also rises after LBOs. The median rise, before and after industry adjustment (66%) and 50%, respectively), is greater than that documented in terms of operating cash flow and represents an economically and statistically significant rise in cash payout potential.

An important discretionary expense item is spending on new plant and equipment. LBO firms may decrease their capital expenditures after going private either because previous expenditures were wasteful (e.g., Jensen [5]) or because of the pressure to service debt (e.g., Myers [13]). Panel B of Exhibit 5 shows that the median capital expenditure to sales ratio declines by almost 40% by two years after an LBO.

Because of the tax deductibility of interest, LBO firms are likely to pay less taxes in the first years after going private. Exhibit 5 gives evidence consistent with this view. The exhibit shows that median taxes, taxes/sales and taxes/employees all decline by more than 80% after LBOs. Most firms in the sample do not report R&D expense because it is negligible relative to sales. Panel F of Exhibit 5 shows the median change in R&D intensity for those firms which do report positive R&D. This exhibit shows a small decline in R&D expense relative to sales two years after the sample LBOs.

B. Comparison to Previous Studies

Exhibit 6 compares changes in key operating ratios observed in this study to those observed in six previous studies. Kaplan [7] finds that operating cash flow to sales rises by 11.9% in the two years after 34 LBOs from the 1980-1986 period. Muscarella and Vetsuypens [12] find that the median cash flow to sales to 28 firms rises by 23.5% from the completion of an LBO until after going public again (1976-1987). The improvement of 16.5% observed for the firms studied here is inbetween the improvement observed in these two other studies. The improvement observed after industry adjustment is also comparable to that observed in Kaplan's study. Smith [17] finds that operating cash flow per employee rises by $1369 (-1, +2 years) relative to a pre-buyout median of $8793 for 12 firms which completed LBOs in the 1977-1986 period. The equivalent improvement in this study is $1188 relative to a base of $8088. This improvement is quite similar and suggests that later LBOs did not result in smaller efficiency gains.(10) This pattern is not consistent with the argument that changes in the LBO market after 1985 dried up the supply of profitable LBO opportunities. This pattern is also different from that observed by Long and Ravenscraft [11] who find that operating cash flow in 107 post-1985 LBOs actually decreases by 2%. The difference in the results of this study and Long and Ravenscraft [11] are likely to be due to differences in sample composition; perhaps the smaller average size of the LBOs in their sample accounts for the difference.

In a particularly thorough study of post-LBO performance, Smith [17] finds that profit margins rise after LBOs, while taxes, capital expenditures and R&D expenses fall. She also finds little change in the level of employment. This study also finds sharp declines in taxes paid and capital expenditures. There appears to be little change in R&D expense. This study also shows no significant change in the level of employment after LBOs.

III. Conclusion

This study investigates change in operating performance following 44 LBOs of the last half of the 1980s. The median post-LBO operating cash flow to sales ratio of firms in the sample rises by 11.6% after industry adjustment. This rise is comparable to that observed in earlier LBOs by Kaplan [7], Muscarella and Vetsuypens [12], and Smith [17], although some differences in sample selection criteria and variable definitions qualify this comparison. All told, the LBOs in this sample were followed by increases in operating cash flow in excess of $2 billion, suggesting that these transactions have yielded significant efficiency gains for investors. Increases in net cash flow were even higher. Because the analysis was limited to the first two years after LBOs, the results do not show the full impact of an LBO on operating performance. The total impact of an LBO over its lifetime is likely to change as new cost-cutting measures are undertaken in the years following a deal (see Muscarella and Vetsuypens [12]). This study also finds that capital expenditures, income taxes and R&D expense decline after LBOs are completed.

While improvements in cash flow following LBOs suggest that these transactions mitigate management-shareholder agency conflict and force disgorgement of free cash flow, it is possible that other factors account for the results observed here (see Palepu [16]). Possibly, improvements come from cutting "invisible" discretionary expenses important for long-run performance (see Stein [18]) or from factors having nothing to do with LBOs known to insiders prior to going private. This study has provided little evidence regarding these possibilities beyond that offered in Kaplan [7] and Smith [17].


The finding that LBOs in the 1985-1989 period were not accompanied by smaller operating improvements than observed in earlier transactions suggests that these transactions were not "more marginal" as has been suggested by some observers. This casts doubt on the contention that the collapse of the LBO market in 1989 and 1990 evidenced the unusual and transitory nature of the leveraged buyout transaction. Rather, the combination of high prices in this market (see Kaplan and Stein [8]), the rise in interest rates in 1988 and 1989, the bankruptcy of the leading junk bond issuer, and heightened government pressure on banks and insurance institutions were likely to have contributed to the market collapse. This is not to say that all firms are well-suited for an LBO. Firms with expected financial distress costs make poor LBO candidates (see Opler and Titman [14]). Nonetheless, as interest rates decline, economic conditions improve and regulatory pressures on banks ease, it is quite possible that firms will continue to reap the benefits of LBOs in the 1990s. (1)Similar studies which examine operating performance after corporate mergers include Healy, Palepu and Ruback [3], Jarrell [4], and Opler and Weston [15]. (2)This view has been expressed often in the press. See, for example, Faltermeyer [2], who suggests that deals in the latter half of the 1980s were particularly nonproductive. (3)A second study which examines returns on LBOs in the late 1980s is Kaplan and Stein [8]. These authors find that 18 LBOs in 1985-1986 resulted in a growth in operating margins, from one year before until two years after, of -5.4%, and that 22 LBOs in the 1987-1988 period were followed by operating margin growth of 19.2%. These growth rates are not industry-adjusted. (4)LBOs are defined as transactions where the equity of a separate, publicly traded firm was delisted and replaced largely with debt while the firm was not merged into firm. In an LBO, management takes a significant dollar amount of equity in the new, private firm (this may not be large percentage-wise in big deals such as RJR/Nabisco). Cases where delisted firms are merged into shell organizations established by LBO sponsors (e.g., Hillsborough Holdings) are also classified as LBOs. This definition is similar to that used by Kaplan [7] and Smith [17]. (5)For example, Safeway Stores, which experienced strong operating improvements, was not in the 1990 list because of its public offering. (6)I examined earlier Forbes 400 lists in search of large buyouts which were subsequently followed by sharp sales declines. Firms which became financially distressed (e.g., Revco, Hillsborough and Southland) were not removed from the list. However, Beatrice was not included in the list because it was fully broken up by the end of 1990. The firm's operating income had risen from $169 million in 1985 to $343 million in 1989 with even sales revenue. (7)Qualitative credit reviews by Standard & Poor's suggest that the NWA buyout has not performed badly. (8)Industry-adjusted changes are computed by subtracting the median change for all firms in the same three-digit SIC code on COMPUSTAT over the same time period. (9)The test statistic is computed as [Mathematical Expression Omitted], where [Mathematical Expression Omitted] is the rank of the absolute value of the ith observation of the variable studied after discarding zero values. n is the number of nonzero values of the variable and the summation is over positive values of the variable. Average ranks are used for tied values. The significance level of S is computed by treating [S [(n - 1).sup.1/2]] / [[(nV - [S.sup.2]).sup.1/2]] as a Student's t variate with n-1 degrees of freedom. Here [Mathematical Expression Omitted] where the sum is calculated over groups tied in absolute value and [t.sub.i] is the number of tied values in the ith group. (10)The results of this study and Smith [17] are not fully comparable because Smith used a measure of operating cash flows which removed accruals (e.g., pertaining to decreases in noncash working capital) and adjusted out inventory write-ups. All else being equal, nonremoval of changes in net noncash cash flow will bias the operating improvements in this study downward since Smith [17] observes reduced working capital relative to sales. In addition, to the extent that firms include depreciation and amortization expenses in their cost of goods sold or selling, and general and administrative expenses, the approach used in this study may underreport operating improvements relative to Smith [17].


[1]I. Bull, "Management Performance in Leveraged Buyouts: An Empirical Analysis," in Leveraged Management Buyouts: Causes and Consequences, Y. Amihud (ed.), New York, New York University Press, 1989. [2]E. Faltermayer, "The Deal Decade: Verdict on the '80s," Fortune (August 26, 1991), pp. 58-70. [3]P.M. Healy, K.G. Palepu, and R.S. Ruback, "Does Corporate Performance Improve After Mergers?," NBER Working Paper No. 3348, May 1990. [4]S.L. Jarrell, "Do Takeovers Generate Value? Evidence on the Capital Market's Ability to Assess Takeovers," Working Paper, Southern Methodist University, July 1991. [5]M.C. Jensen, "Agency Costs of Free Cash Flow, Corporate Finance and Takeovers," American Economic Review (May 1986), pp. 323-329. [6]M.C. Jensen, Discussion in LBO Conference, Journal of Applied Corporate Finance (Summer 1990), pp. 6-37. [7]S.N. Kaplan, "The Effects of Management Buyouts on Operating Performance and Value," Journal of Financial Economics (November 1989), pp. 217-254. [8]S.N. Kaplan and J.C. Stein, "The Evolution of Buyout Pricing and Financial Structure in the 1980s," Working Paper, University of Chicago, September 1991. [9]J. Kitching, "Early Returns on LBOs," Harvard Business Review (November-December 1989), pp. 74-81. [10]F.R. Lichtenberg and D. Siegel, "The Effects of Leveraged Buyouts on Productivity and Related Aspects of Firm Behavior," Journal of Financial Economics (September 1990), pp. 165-194. [11]W.F. Long and D.J. Ravenscraft, "The Aftermath of LBOs," Working Paper, University of North Carolina, April 1991. [12]C.J. Muscarella and M.R. Vetsuypens, "Efficiency and Organizational Structure: A Study of Reverse LBOs," Journal of Finance (December 1990), pp. 1389-1414. [13]S.C. Myers, "Determinants of Corporate Borrowing," Journal of Financial Economics (March 1977), pp. 147-175. [14]T.C. Opler and S. Titman, "The Characteristics of Leveraged Buyout Firms," Working Paper $9-91, University of California-Los Angeles, May 1991. [15]T.C. Opler and J.F. Weston, "The Impact of Mergers on Operating Performance," Working Paper, University of California-Los Angeles, September 1991. [16]K.G. Palepu, "Consequences of Leveraged Buyouts," Journal of Financial Economics (September 1990), pp. 247-262. [17]A.J. Smith, "Capital Ownership Structure and Performance: The Case of Management Buyouts," Journal of Financial Economics (September 1990), pp. 143-165. [18]J.C. Stein, "Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior," Quarterly Journal of Economics (November 1989), pp. 655-669. [19]L. Summers, Discussion in LBO Conference, Journal of Applied Corporate Finance, (Summer 1990), pp. 6-37. Tim C. Opler is an Assistant Professor in the Edwin L. Cox School of Business, Southern Methodist University, Dallas, Texas.
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Title Annotation:Leveraged Buyouts Special Issue
Author:Opler, Tim C.
Publication:Financial Management
Date:Mar 22, 1992
Previous Article:On the capital structure of leveraged buyouts.
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