By John Thackray
If denunciations could have put a stop to leveraged buyouts,
there would be none today. In the summer of 1984 the LBO was a
target for virulent criticism by Paul Volcker, chairman of the
Fed, by John Shad, chairman of the Securities and Exchange
Commission, by Felix Rohatyn, senior panner of Lazard Freres,
and by Barry Sullivan, chairman of First Chicago.
The gist of all the denunciations was that top-heavy
reversed pyramids of debt were being created; and they would
soon come crashing down, destroying assets and jobs.
All this had some effect - for a time. "In the spring of
1984 there were lots of banks looking for deals. In the summer
it went to zero," a major player in the LBO market
Ralph McDonald Jr., an, executive vice president with
Bankers Trust, said: "There were tremors in the banking
community, and good deals got tougher to do because of
"There is still insecurity in the LBO industry, because
there is still a lot of public criticism," said Carl Ferenbach
of Thomas H. Lee.
However, there has been a spectacular rise in the number and
scale of LBOs. This highly geared form of financing is probably
here to stay. Because there is a huge number of private
business sales richly financed with debt, comprehensive
statistics on LBO activity nationwide are impossible to find.
But the growth of public deals has been astonishing, and these*
numbers tell us much about the rising impact of formally
organized and professionally managed institutional LBO
According to data provided by Merrill Lynch Capital Markets,
in the eleven and a half months to mid-December 1985 a record
$31.5 billion of LBOs were completed; double the volume of a
year earlier and three times that of 1983.
"In the late 1970s nobody knew what an LBO was. I mean
nobody at the big investment banks - not just the cocktail
party crowd," said Theodore Forstmann, partner in Forstmann
"It used to be just a few people buying companies
selectively. I never thought it would be the size of today, -
said Ira Hechler, a private investor who did dozens of deals
alongside Oppenheimer and Company in the 1970s.
"Just a few years ago this used to be a mom-and-pop
industry. Now we've grown to be a highly examined and
well-publicized activity," observed Joseph Rice, managing
partner of Clayton and Dubilier.
For all this publicity, there is still little understanding
of this diverse market. There are purely tax-driven LBOs,
junk-bond driven ones and those dependent on employee stock
ownership programmes (ESOPs). There are bust-up LBOs (that is,
the company's assets are sold off to finance the acquisition)
and those designed for longterm appreciation. There's leverage
predicted on cash flows, or on fixed-asset values and,
increasingly, on sanguine growth forecasts.
There is a new genre, the hostile LBO, and there are both
fiduciary and principal investors. "There are many segments and
cross-currents in the market," said Forstmann. "Seven or eight
years ago it was a very simple business and everybody worked
along roughly the same lines. But now it is difficult to figure
out who is doing what, and, often, to make sense of what's
There are three sectors of the market: senior bank debt,
mezzanine subordinated debt and - the hardest of all to raise
equity. Who's who in each category?
In bank debt, Manufacturers Hanover Trust is clearly the
front runner - although its lead has shrunk in the last year.
Bankers Trust is also important, and has a close relationship
with Kohlberg, Kravia, Roberts and Company (KKR). Citicorp,
once strictly an asset-based lender, has aggressively expanded
into the mainstream of cash flow lending.
Morgan Guaranty is smaller. But it has a strong appetite for
transactions where it not only lends the senior debt, but gets
a fair slice of the mezzanine and equity also. "Most banks like
an equity kicker. But we don't always get it. Morgan says it
always requires one, but I suspect that's not true," said the
head of a specialist LBO team at a rival bank.
Chase and Chemical are at present episodic LBO lenders. So
is First Chicago, notwithstanding the anti-LBO rhetoric of
Sullivan. Its Chicago neighbour,Continental Illinois, is
reported to be back in the marketplace in a small way. Security
Pacific, Wells Fargo, Marine Midland, Bank of Boston, Bank of
New York, Irving Trust, the Candian big four and some regional
banks have all done deals.
For commercial banks, LBOs represent one of the few areas of
high-profit lending today. The agent on a bank syndicate can
command fees of 1% of the transaction size, get around 0.75 %
on the portion of the loan taken down, and frequently charge
fees for hedging the LBO's floating-rate debt.
"The flow of LBOs is created by lenders. They don't just
support the market; they make it happen," claimed Robert E.
Koe, president of Heller Financial, which, along with General
Electric Credit and Citicorp, is a significant asset-based
lender to the LBO trade.
As the flow of deals has grown, the dominant banks have
become pivotal to a deal's success. A couple of years back it
was easier for regionals, or the money-centre banks that lacked
dedicated LBO lending teams, to execute the largest deals there
"Today there is a tendency for the large players to speak
for bigger pieces of the loan in the beginning," observed
McDonald of Bankers Trust. "As we've done more big deals, we've
become more confident that we - along with two or three other
banks - can guarantee that the deal will get done."
But the larger deals have imposed stresses and strains even
on Manufacturers Hanover, Bankers Trust and Citicorp. These
three, for example, each took $350 million for a $1.5 billion
senior debt syndication of the $6.2 billion Beatrice LBO.
Ultimately, the IR asset sales were successful. "For a while I
was concerned that it was going to fall on its face or that the
lead banks would be embarrassed by not being able to sell off
prudent amounts of the loan," said the chief of one of these
In the mezzanine sector the subordinated debt lenders are
also making LBO happen in record volumes. This is the business
of the insurance companies. And here the Prudential dominates
its rivals: Teachers, New England Life, Metropolitan, Northwest
Mutual, Equitable, New York Life. But it is said of insurance
companies that they have lost market share in LBOs because of
the slowness of their bureaucracies and their often
Several of them have lately teamed up with Wall Street
outfits closer to the deal flows. First Boston has a new
mezzanine pool of $250 million, chiefly bankrolled by
Metropolitan Life. The Bass Brothers Partnership has a similar
arrangement with Equitable. Late last year Morgan Stanley
closed a mezzanine fund, part of a $450 million package raised
in partnership with CIGNA, which includes equity and senior
Other familiar names in the mezzanine category are the
Textron and General Electric pension funds, Morgan Guaranty's
Comingled Convertible Bond Fund, the Trust Company of the West
and Bridge Capital (which specialises in smaller deals).
But the above-mentioned players probably provided less than
a quarter of the total mezzanine money raised last year. For
the jumbo-sized LBOs that characterized 1985, all roads led to
Drexel Burnham Lambert, kingpin of the junk (or high yield)
LBOs are not affected by the Fed's latest ruling on junk
None of the large LBOs done today would have flown without
junk financing," said Rice of Clayton and Dubilier. He knows
whereof he speaks. His firm took Uniroyal private last year on
a $1.2 billion white knight transaction, $600 million financed
by junk bonds underwritten by Drexel. "The mezzanine market is
deeper and wider than ever; and this has afforded us financial
opportunities we've never enjoyed before," Rice added.
Other Wall Street firms have mounted serious challenges to
Drexel - notably Morgan Stanley, First Boston and Salomon
Brothers - to enhance their deal-making powers. Although Drexel
appeared to experience a decline in standing in the 1985
underwriting tables, when its market share slumped to 56% of
high-yield securities from 64% the previous year, within the
LBO community Drexel remained the single largest deal-making
"If you take out mortgage passthroughs, utility companies
and financial services companies from the underwriting data,
you get the real corporate America. And here we are the lead
manager and bigger than the next three firms put together,"
claimed Drexel's managing director, Chris Andersen. "We are the
dominant factor in LBOs, in entrepreneurial financing and in
leveraged tender offers."
The rise of junk on the LBO scene is a mixed blessing from
the senior lender's point of view. On the plus side, junk
expands the ratio of subordinated debt within the structure -
eating some of the financing that in older times would have
On the negative side, commercial bankers report that they
must consistently lock horns with Drexel on the terms and
conditions that apply under interest payment defaults. "It is a
very sophisticated battle, about who gets to push whom around
as the deal goes sour, and one that never gets into the
papers," a senior bank executive reported. Traditionally,
privately placed insurance company mezzanines were truly
subordinate. This Drexel paper is usually public and has
guarantees about the payment of interest that bankers
"From a senior lender's perspective, if he can't cut off the
junior debt's interest, that could get him in the tank real
fast,' the senior executive went on. "The battlefield today is
the terms and rights of senior and junior debt holders."
When the mezzanine is a small club of lenders, they can be
approached and negotiated with in the event of defaults. With
public paper, the bankers would have to go to court, be subject
to the law's delay and, they suspect, have their claims to
seniority curtailed or denied, in a legal climate more inclined
to be charitable to debtors than a few years back.
As for equity investors, they include almost everybody on
Wall Street and more than half the institutional investors on
Main Street too. There is hardly a self-respecting investment
bank today that doesn't participate. The few exceptions include
Salomon Brothers. And every merchant banking boutique boasts
that it has been the architect of one or two deals - very often
divisional buyouts of large corporations.
The firm that casts the largest shadow is KKR, whose record
of 60% compound return over 17 years has captured the
imagination of an institutional investor community anxious to
expand from portfolio to direct corporate investing.
Last year KKR, with little difficulty, raised the largest
LBO equity war chest in history - $2 billion. The next largest
in size and stature is Forstmann Little, which has $500 million
of pooled monies - part equity, part a captive mezzanine fund
that offers investors current return. Gibbons Green van
Amerogian, founded in 1969, is the oldest of this breed and has
a proven track record.
Beyond this, it is hard to say who the LBO equity players
are. They are among the most tight-lipped and publicity-shy
creatures in finance. Some ot the better-known middlesized deal
makers are: Adler and Shaykin, Kelso (specialists in ESOPs),
Clayton and Dubilier, Thomas H. Lee, Wesray (headed by the
former US Treasury Secretary William Simon) Odyssey Panners,
the Charterhouse Group, Carl Marks, Rothschild Inc., AEA
Investors, Weiss, Peck and Greer.
There are also numerous investment banking firms who swim in
this sea. Some, like First Boston and Goldman Sachs, invest
their own money as principals as opportunities present
themselves. Others have more ambitious and formal plans. Last
year Merrill Lynch raised $400 million from institutions for an
equity pot, and has declared that it'll also invest firm
capital as principal in LBO deals.
"A new investing group seems to crop up every day," said
Ferenbach of Thomas H. Lee.
LBO artists have been flying from coast to coast and across
the Atlantic. They have generally found it a hard sell abroad.
"Only certain countries - like the United Kingdom, or Germany -
seem sufficiently advanced to understand the LBO form," said
Robert F. Mancuso, president of Merrill Lynch Capital
"Europe has been a disappointment for almost everyone trying
to raise investors for LBOs," said Scott Newquist of Morgan
Stanley. But he added: "In Britain this has changed rapidly in
the last six months." He observed that Bankers Trust, Citicorp
and the Prudential had already set up beachheads in the UK.
The appetites of US investors still seem insatiable. There
is probably around $5 billion committed at present to equity
partnerships; enough to support some $25 billion of mezzanine
debt and another $30 billion of senior debt.
In practice there's more than this potential $60 billion
looking for LBOs. Any credible management group could, with a
few phone calls, command hundreds of millions for the right
deal. "If you had enough good quality deals going around -
which there aren't; there are hat-dly any - the supply of funds
is limitless." said Gilbert Butler, president of Butler Capital
Corporation, a $400 million equity and mezzanine pool.
Too much money has been chasing too few (teals in this
market for about a year and a half. More than anything else,
this overhang ot" LBO-hungry, money has revolutionized the
business: changing the size, the structures and the kind of
corporate vehicles that the conventional wisdom considers
appropriate for LBO gearing.
LBOs used to be imposed only on small-to-medium-sized
manufacturing firms with predictable market shares and cash
flows. The criteria have changed. Service companies are now OK;
so are fast food chains; so tire conglomerates; so are natural
resources; so are firms in the throes of change, facing very
uncertain futures, such as Macy's or Levi-Strauss.
"If you asked people a few years ago if a retail firm should
do an LBO, the general opinion would have been no," observed
Ferenbach. "The perception then was that because sales are
heavily concentrated in the two months before Christmas, cash
flows are difficult to predict. All that is now water under the
bridge. Retailing is a hot area."
But at least retailing has tangible inventory and, usually,
valuable real estate that the lenders can look to for comfort.
This is not so true of broadcasting - another hot area lately -
where the collateral is the goodwill of the franchise.
"Today financial institutions don't need as many fixed
assets as they did three years ago," said Newquist of Morgan
Stanley. "Broadcasting and media are the ultimate of that
trend. They have no fixed assets to speak of, but have an
ongoing business with a high market value."
This tendency to apply LBO vehicles to a wider array of
industries is sure to continue. Adler and Shaykin have
pioneered high-tech LBOs. Late last year Bankers Trust was
reported to be giving careful study to an LBO of a software and
data processing company -- a notoriously unpredictable
Deal pricings have obviously been inflated by the excess of
investible funds on the one hand; and, on the other, by
entrepreneurial greed unleashed by the large amount of
publicity for LBOs "Prices are sky high," said Forstmann. "The
baloney is being sliced very thin."
This is why junk bonds matter, and why junk zeros are all
the rage. Farley Industries has financed an LBO takeover of
Northwest Industries with preferreds that pay no interest for
three years. National Gypsum has an LBO proposal combined with
a debenture that would pay no dividends for five years.
"Junk paper provides the difference between what the cash
flow will support and the prices that are often being asked,"
said Frank Wright, formerly executive vice president of
Manufacturers Hanover, and now head of Lincolnshire Management,
which is in the process of raising a targeted $500 million
equity pool. Wright added: "Whenever you see zeros, you know
cash flows are tight and it's been a hard sell."
"We're definitely getting into the era of funny money," said
Ferenbach. "It's cosmetic, and sort of silly - but it closes
the price gap."
Forstmann said: "It doesn't make sense to me that, when a
company can't pay interest - bang! You issue a zero. This paper
is just created to get the deals done." Forstmann gets
indignant at LBOs like Farley Northwest where the a outs on the
zeros are predicted on nothing better than future growth. "All
the cushions are gone. You have cases where, if a company
doesn't grow at 12% a year, the zeros don't pay off."
Speed is now vital in LBOs - speed of calculation, speed of
due diligence, speed in marshalling financial resources. Two
years ago the typical LBO would be worked out over many months.
Now the better deals get sewn up in a couple of weeks. But in
the process the deal-makers behave like figures in a speeded up
"Time-frames are short as the deals get bigger," said a
Bankers Trust senior vice president, Terence Mogan.
"These deals are not luxurious in terms of time," said
Mancuso of Merrill Lynch.
"The ideal LBO offers two ways out the door for the banker,"
explained McDonald of Bankers Trust. "One door is a predictable
cash flow; the other is marketable assets that can be flipped
to repay the loan." In the founding days of LBOs both doors
were essential. The ideal was attainable. "Now increasingly we
find transactions where we have to make a leap of faith,"
McDonald observed. "There is only one door; but you believe
there will be two ways out in six months."
The doors through which all deals pass are getting narrower
and narrower. Hence the emergence of two-step financings; the
borrower gets an interim package against promises of asset
sales. After these are arranged, a permanent package is put in
place. A case in point was the landmark purchase of Esmark by
KKR: not only the largest one of its kind, but the one that
introduced a new level of hostile pressure on incumbent
management. (Being hand-in-glove with management was a cardinal
rule in the old days.)
Clearly KKR and its allies were doing a lot of' improving as
the deal unfolded. When the organizers unveiled their scheme,
KKR said it had a one-step package, and that loans would be
forthcoming without any asset sales. But when lenders
scrutinized the structure closely they scuttled this notion,
and KKR was forced to agree to $1.45 billion of disinvestments
within a year and a half.
"KKR was pipedreaming. In the real world there was no way
that the cash flow alone could repay the debt," said one of the
Another deal where the packagers seemed far from being in
control of events was the proposed management buyout of R H
Macy, initially valued at $70 a share, or $3.58 billion. Soon
thereafter rumours circulated in the LBO community that lenders
were questioning the underlying real estate valuations.
Eventually the price set was $100 million less (or $2 less a
share). This adjustment was clearly an embarrassment to Goldman
Sachs, which was both the agent and, reportedly, an investor in
The old pattern of interdependence is quickly vanishing. For
instance, GECC, which was once content to be just a classic
asset-based lender, now gobbles up all the strips in an
attractive deal - not just warrants but real senior and
Equity players have set up, formally and informally, captive
mezzanine and senior debt pools. Insurance companies invest at
all levels of seniority too.
"The guy who organizes a deal wants to be able to write a
cheque instantly for the whole amount. He doesn't want to say,
'Yes, we'll do it subject to financing.' Because, if he wastes
any time, he'll lose to a competing group," said Butler.
Many people seem to be shooting from the hip; saying yes to
a proposal and then regretting it later. That's why there has
been such a startling increase in deals announced but not
Never before have deals been sold so aggressively through
the LBO community. Many are undone by greed.
"The public, markets are merciless with mistakes. If an
equity group chooses the wrong source for the debt, and it
falls through, it becomes very difficult to save the deal,"
No story about LBOs can be complete without the fear factor.
If, in mid-1984, the industry was tipsy on leverage as Volcker,
Shad, Rohatyn and Sullivan argued, it is quite drunk on the
stuff today. Many of the creatures of the LBO industry worried
Volcker when he studied the condition of the banking industry's
Perhaps, taken in toto, the LBO loans don't worry the Fed
quite as much today as in the summer of 1984, when regulators
foresaw another energy loan, or LDC or REIT crisis.
The larger commercial banks have done a good job explaining
their risk exposures to regulators and showing how their
portfolios have geographical and industry sector diversity.
"LBOs are high risk; but the risk is in the form of
structure - not in the fundamentals of the business," McDonald
explained. "We try to avoid tending to too many companies in
the same industry. There's not a great danger of many of our
LBO loans going bad at once."
In terms of public defaults, the LBOs have led a charmed
life for over a decade. There have been very few outright
bankruptcies Thatcher Glass and the Brentano Books being the
oft-cited cases. Still, beneath the surface there is a
persistent stream of workouts and recapitalizations that never
make the headlines. "In this business the failures are a case
of diminished expectations for the investors: not disasters
really," said Rice.
For London's merchant banks, Christmas came two weeks early
in 1985. Even as the finishing touches were being applied to
the City's office decorations, four takeover bids - worth over
[British pound]7 billion or $10.2 billion landed with a heavy
slap on the desk of the Takeover Panel of the London Stock
Exchange. London's mergers and acquisitions dealmakers may
grumble that British fees are niggardly compared to the
pay-offs demanded by US investment houses, but these four deals
alone promised to net anything from [British pound]4 to 7
million ($5.8 to 10.2 million) for the merchant banks
There was an unseasonal twist to the merry-making, however.
Three of the four bids - Hanson's for Imperial, GEC's for
Plessey, Elders for Allied Lyons - were unsolicited and
opposed. Only Imperial's defensive bid for United Biscuits was
issued on a friendly basis. London had never before seen a
takeover of more than [British pound]1 billion. To have four
such proposals, three of them contested, within days of each
other, was almost as worrying as it was exciting.
What was once a gentlemanly business, the corporate finance
equivalent of shaking hands, had suddenly become a gloves-off
"The whole atmosphere's changed," said Morgan Grenfell's
director and head of corporate finance, Graham Walsh. "We're
seeing companies who suddenly want to take advantage of their
own high credit ratings, we're seeing a willingness to manage
in the longer term, and we're seeing investor confidence in
That's not the only change. In gaining its reputation as the
biggest and most formidable M&A house in the city, Morgan
Grenfell has tested the rules governing takeovers in London.
The most striking example came on December 11, closing date for
Scottish & Newcastle's tender offer for brewers Matthew
By 3.30 pm, on Wednesday, December 11, it seemed to be all
over. Scottish & Newcastle Breweries had won only 47.5% of
the shares in its target, The [British pound]125 million bid
appeared to have been beaten back.
Then Morgan Grenfell, acting for Scottish & Newcastle,
appealed to the Takeover Panel at the Stock Exchange. It asked
for an extension period of 90 minutes, usually used for
counting the shares, The Takeover Panel agreed. By 5 pm
Scottish & Newcastle held 50.3% of Matthew Brown stock,
just enough to seize control of the company.
"I was in my office just after half past three when the
Takeover Panel rang to say they'd permitted an extension,"
recalled Nicholas Jones, head of the Schroders team acting for
Matthew Brown. "I went round to the Stock Exchange immediately,
and I was there when Morgan Grenfell informed the Stock
Exchange they had gained 51%. I immediately told John Walker
Haworth [director general of the Takeover Panel] that I was
appealing against the decision."
Morgan Grenfell exploited a technical quirk in the Takeover
Code, the framework for takeover conduct in the UK. Under the
old rulebook, the offer closed at 3.30 pm, but the merchant
banks had until 9.30 the following morning to check the tally
and announce the result. The new rulebook, published in April
1985, obliged the merchant banks to both close the offer and
announce the result at 3.30 pm.
In July, the rulebook re-introduced the gap, scheduling the
announcement time to 5 pm. "The extra time was clearly a way ot
giving us an hour and a half more to do our sums," said Jones
"My case in the appeal was that Morgan Grenfell's action just
about accorded with the letter, but certainly didn't comply
with the spirit, of the rule."
Jones won. The full board of the Takeover Panel met the
following morning, and after a two-hour session overturned the
executive ruling which had permitted Morgan Grenfell to use the
extra hour and a half. The merchant banks had been canvassed
beforehand about their willingness to stand by the Panel's
decision: both Morgan Grenfell and Schroders (which had
publicly threatened to go to law) agreed to abide by the
board's ruling. They did, amidst a general mood of backslapping
that the city's self-regulatory system had triumphed against
all odds, proving once again that it could act more swiftly,
more fairly, and more cheaply than a statutory, legal-based
'Both sides had a hearing, and it was resolved by lunchtime
the following day," said Walker Howarth, who was appointed
Director General of the Takeover Panel in December. "The system
worked effectively and well, and everyone acknowledged that. We
interpret the rulebook flexibly but firmly, whereas a legal
structure would be cumbersome, out of date, and expensive."
The Matthew Brown decision was hailed as a blow for
self-regulation before the publication of the government's
Financial Services Bill. But it couldn't disguise the fact that
the rules themselves were under pressure.
"It was pretty sharp practice by Morgan Grenfell," said
Schroder's Jones. "It's precisely that sort of thing that's
driving us towards a statutory rulebook. The rulebook that we
have now is already much longer and more complicated than it
ever used to be, because people have been ignoring the spirit
of it and questioning the letter."
The rulebook, when it was devised in the late 1960s, was
barely more than 15 pages. Now it's over 100. In its revised
version last April it was printed as a loose leaf binder an
acknowledgement that it is in a state of constant
One of the facts the Takeover Panel has had to recognize in
recent years is the newfound aggression of the merchant banks
acting in this area. "There's no doubt," said Walker Haworth,
"that more banks actively propose deals to their clients. It's
one of the biggest changes on the present scene - the change
from bank-inspired to relationshipinspired deals."
Morgan Grenfell decided to be number one in M&A five
years ago. "We built up a team which now numbers 90
executives," said Walsh, a former director-general of the
Takeover Panel. The strategy paid off: Morgan Grenfell has
topped M&A league tables for the last three years. In the
process, it's been accused of pinching clients from rival banks
and condemned for stretching even the elastic rulebook of the
This new, pugnacious style is only one of several factors
which threaten the stability of the M&A market in London.
New financing techniques, like heavily leveraged buyouts, and
new players, like the American investment banks, have
challenged the hold of the merchant banks on this compartment
of corporate finance.
This has created volatility in the corporate sector.
"Suddenly," said one executive at a British merchant bank,
"investors, banks, and rival companies are pointing at the guy
with the white Rolls Royce and asking, 'Is he doing a good
job?' Managements are having to look over their shoulders and
wonder whether they're safe." The same spirit of change now
affects the dealmakers themselves.
"It used to be," said Schroders' Jones, "that if one of our
clients was approached with a proposal for a merger or
acquisition, it would come to us and ask what it should do.
That's all changed. It's much more horses for courses now.
People look around for the best team they can find for the job
in hand, and don't worry so much about their existing
The greatest catalyst to this process of change is the
unprecedented volume of takeover activity, both domestic and
crossborder, in London. It's overturning traditional business
practices. In a single week last year two Warburg clients, Tate
and Lyle and STC, bid for Brooke Bond and ICL - also Warburg
clients. "You can't manufacture answers to these situations,"
said one Warburg man, "because sometimes you can't act for
In 1984 there were 89 completed takeovers in the UK, worth a
total of [British pound]4.4 billion. In the first eleven months
of 1984, worth [British pound]5.3 billion. In December alone
there were 34 bids outstanding, worth around [British
It's still the case that the majority of bids are not
contested. Even recently, in the eighteen months up to June
1985, only 55 out of 169 bids were opposed, and only 20
defences were successful. The. majority of UK takeovers have
traditionally been amicably resolved without recourse to the
kind of fierce, public antagonisms which have suddenly become
the norm. The grocery group Argyll's bid for the upmarket
Scotch whisky manufacturer, Distillers, was especially
spiteful. Argyll claimed that Distillers didn't have a clue
about marketing; Distillers attacked Argyll's record with its
Companies defending themselves are quick to buy advertizing
space in London's newspapers to publicize their case, partly in
the knowledge that if they lose the fight it's the aggressors'
money they'll have spent. This raising of the stakes has caused
some curious anomalies in cases where the bidder already holds
30% of the target's equity, like Guinness Peat in Britannia, or
Scottish and Newcastle in Matthew Brown. These two bids failed,
leaving the aggressor with one third of the costs of the
defence (in Britannia's case over [British pound]1
"Ironically," said Hill Samuel's director of corporate
finance Richard Crick, "the money spent on advertizing
sometimes should have been spent anyway. It just took the
takeover to push the management into promoting the company
But the level of takeovers which are opposed has increased
sharply. Fifteen of the 34 deals which were live at the end of
December were opposed. Of the large bids in the market over the
New Year, only one (Imperial's for United Biscuits) was
friendly. Deals have become more complicated, too. "Offer
documents used to be 12 pages long; now they're 90," said
Morgan Grenfell director Richard Webb. Even Morgan Grenfell's
formidable reputation was dented by three defeats in rapid
succession: Scottish & Newcastle Breweries' failure to
acquire Matthew Brown, Guinness Peat's failure to acquire
Britannia Arrow, and James Neill's failure to ward off the
advances of Spear and Jackson.
"There are vastly more contested bids now than there used to
be," said Hill Samuel's Crick, "and there are more successful
defences than there were." This uncertainty has provoked a
hitherto untapped aggression in the City's corporate finance
departments, and it has put the prized fees the merchant banks
enjoy from M&A deals up for grabs. London's merchant banks
still dominate the market for high-priced corporate finance
Morgan Grenfell acted in 74 closed deals worth a total
market value of $7.9 billion in 1985. Next came Schroders (106
deals, $4.6 billion) Hill Samuel (100 deals, $4.2 billion)
Warburg (47 deals, $4.3 billion) and Kleinwort Benson (19
deals, $937 million). But American investment banks,
especially, have entered the Ray. Merrill Lynch participated in
12 international M&A deals from London, worth approximately
$3.5 billion, including the biggest-ever management buyout in
the UK, for Mardon.
"I think the UK merchant banks are under a continuous and
accelerating threat", said Nahum Vaskevitch, managing director
of Merrill Lynch's investment banking division. "In corporate
finance you need contacts and ideas - but everyone has
contacts; very few have brilliant ideas."
Merrill Lynch's coup for Mardon was in September last year.
Mardon was a packing subsidiary of British American Tobacco,
and the management of Lawson Jones (the Canadian star performer
within the Mardon Group) successfully raised [British pound]173
million, as well as organising a [British pound]100 million
refinancing, in competition with Metal Box. Finance was
provided by Citibank and the Bank o Nova Scotia.
"It proved that a management could compete on a large scale
with a third-party bidder . . . and win," said Vaskevitch "And
it demonstrated that a leveraged buyout could compete with
another corporate buyer . . . and win. It showed too that a
management buyout is a very successful defence, because the
bidding company becomes very reluctant to purchase a
disaffected, losing team."
This kind of leveraging represents another challenge to the
traditional structure of M&A in London. UK takeovers
historically have been financed by equity. That's especially
true when, as now, the equity can be issued into a booming
stock market. Even GEC, in its [British pound]1.8 billion bid
for Plessey, proposed an equity-financed takeover rather than
drawing upon its famous [British pound]2 billion cash mountain.
But equity financing, until now the domain of merchant and
investment banks, his been threatened by the notion of
The most daring of these was Elders' bid for Allied Lyons, a
leveraged bid for a company four times the size of the bidder.
The [British pound]1.8 billion bid has been referred to the
Monopolies and Mergers Commission for investigation, a
six-month delay which may enable Allied Lyons to improve its
performance and prepare its defence.
But the method of a borrowing-based takeover, with that
degree of leverage, is quite new in the UK. Citibank agreed
with merchant bank Hill Samuel to make the loan, which was in
the form of loan notes repayable after four years. The deal set
a precedent which was soon followed. Argyll's opposed bid for
Distillers (valued at [British pound]1.8 billion) included a
borrowing component of [British pound]600 million, arranged by
Samuel Montagu and underwritten by Midland, Cii Charterhouse
Japhet, and Montagu.
Said Col in Scotland, executive director of Citicorp's
investment bank: "There are two components in a takeover,
advice and finance. In M&A you can't separate them. You
need both." Leveraged bids based on borrowing, not equity, are
a natural way for commercial banks to enter the lucrative
M&A business. 'Equity doesn't measure performance, doesn't
encourage cash-flow discipline, the way leveraging does," said
For commercial banks, too, financing acquisitions through
direct lending is a response to the nasty contraction in bank
lending since the beginning of the Third World debt crisis.
"Commercial banks are looking for new ways to lend money," said
Merrill Lynch's Vaskevitch. "Equity financing investing -
doesn't make them feel comfortable. But they're stating to
realize that they'd rather lend to an LBO (leveraged buyout)
than to an LDC."
The merchant banks are well aware of the challenge this new
form of financing represents. 'If big money, big leveraging,
really came in," said Morgan Grenfell director Graham Walsh,
"then we would be under pressure. I think what we'd see is
partnerships between merchant banks on the advisory side and
financial institutions on the other side."
M&A used to be a speciality in itself, within corporate
finance. Now there are subsidiary areas of expertise. Hill
Samuel has gained a reputation, alongside its general
prominence in M&A, for putting together rescue packages for
ailing companies, many of which involve third parties.
"There's often a thin line between a takeover and a rescue
financing," said Hill Samuel's Richard Heley "The injection of
new capital can alter the ownership of the company at a stroke.
That's how Robert Maxwell acquired BPCC (British Printing and
Communications Corporation) in 1981, and we've seen it more
recently with Olivetti and Acorn, for example, or BTR
(Birmingham Tyre and Rubber) and Dunlop."
Capital-raising remains a key component of all deals
involving takeovers. But there's another sense in which capital
could play a decisive role in determing the position of the
British merchant banks: underwriting, The Takeover Code insists
that, even in an equityfinanced takeover, there must always be
a cash alternative to the share offer. That involves the
M&A bank in underwriting, and that favours the banks with
deployable capital. The present structure of equity
underwriting in London, which demands a bank-broker team to
manage each issue, works in favour of the established domestic
relationships. Dual capacity will challenge that structure; and
the US-style bought deal would challenge it further.
'What's a merchant bank to do," asked Merrill's Vaskevitch,
"when one of his overseas rivals can go to any company and say,
"We'll take your whole rights issue, right away, and here's the
cheque'? That's something they can't compete against, with
their capital the way it is right now."
There's already pressure on underwriting commissions in the
city's other markets. That squeeze will extend to underwriting
fees on corporate equity issues. Banks experiencing fee
pressure on underwriting might easily find themselves able to
lift the price of their advice. 'To that extent the entry of
the US houses into the market might just inflate the fee
structure," said Nicholas Jones, corporate finance director at
J Henry Schroder Wagg. 'You might expect competition to lower
fees, but as the deals grow more complex so the fees go up. And
the American houses are used to fees which make ours seem very
Whether equity financing will even remain the preferred form
of takeover funding isn't yet clear. It's popular, obviously,
in bullish stock markets; leveraged borrowing is fashionable in
periods when interest rates are low. "The first chill wind in
interest rates could hit those transactions,' said Morgan
Grenfell's Walsh"because borrowing is a running cost, not
capital. It needs to be serviced. I don't see many companies,
even the very large ones, who'd be happy to have higher
leverage in their debt than they already have."
One development that might have favoured the US investment
banks in London hasn't materialized: US companies bidding into
the UK. The British, led by Hanson Trust, have attacked US
companies with some vigour. The reverse hasn't been true. "I've
been very disappointed," said Merrill Lynch's Vaskevitch.
"There have been instances, but not many. I should have thought
that UK companies were distinctly attractive to US buyers, but
it hasn't happened, even when the exchange rate was so
favourable. There's a lot of fear: I can think of at least six
occasions when a US buyer expressed initial interest and
refused to pursue it. I guess the American CEO just doesn't
like to lose in public."
Another American influence that has yet to ignite in London
is the colourful arsenal of defensive and aggressive weaponry
by which US corporations can blast their way out of - and into
- their opponents' boardrooms. Poison pill defences, selling
the crown jewels, greenmailing, the lock-up recently exercised
by Merrill Lynch in an attempt to thwart Hanson Trust's
interest in SCM - the tense gamesmanship that characterizes
takeover battles in the US have failed to catch on in the UK.
That's chiefly a tribute to the non-statutory but effective
code of practice laid down by the Takeover Panel at the Stock
Exchange. Rule 21 of the Takeover Code stipulates thatboards
cannot take any action to frustrate an offer unless they obtain
the consent of the shareholders at a general meeting. Even
when, as is the case, 60 % to 70 % of the stock in most
companies is held by 10 institutions, that cuts out many of the
manoeuvrings that accompany takeovers in New York. 'Boards
under attack can't damage the shareholdings merely in order to
save the company - that's the heart of it," said Hill Samuel's
Richard Crick. "We see an awful lot of white knights, of
course, but the only really effective defence against a
threatened takeover is good stock performance."
The Takeover Panel also reviews the proposed financing
structure of every takeover. "We have to know that the money's
actually there," said Walker Haworth. "We have no role in
considering the industrial logic that's for the Monopolies and
Mergers Commission - but we do need evidence of the finance
behind the deal."
London may pride itself on playing by rules that are simpler
and fairer that those in New York; whether the Takeover Panel
can contain the unruly pressures in, the market today isn't
certain, though. Most merchant banks are keen that it
"Matthew Brown was a good example of how self-regulation
should work," said a senior executive at one"But it was also a
good example of the kind of thing that can happen when you have
a sloppily-worded document. The Takeover Panel solved the
situation very well, but it created the situation in the first
The atmosphere in which takeovers are conducted has clearly
changed. -Companies are much more beholden to the whims of the
institutional shareholders than ever before," said Antos
Glogowski at Daiwa Europe.
The institutional shareholders may be growing more active in
their investment strategies, more willing to shake up the
managements of the companies in which they hold stock, but
there's no sign that they're any more seduced by high-risk
paper than they have been in the past. Junk-bond financing
hasn't made an impact in London, and few expect it to. "Can you
see the man from the Pru snapping up very speculative, triple-D
paper issued for a takeover?" asked Hill Samuel's Crick.
Others think differently. "The corporate bond market is dead
at the moment,' said one Warburg insider. 'But with the
increasing number of convertible issues we'll see the
development of credit sophistication - there might even be a
credit-rating agency for corpotions - and that'll help junk