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Leveraged buyouts: The LBO craze flourishes amid warnings of disaster

Thackray, John
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When Euromoney first pointed out the dangers of the leveraged buyout (April 1984) the fashion was new and exciting. Too exciting, declared Paul Volcker, who subdued the general enthusiasm for a time. But the fashion came back, with complications explained in full for the first time here.

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 recalled.

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 this.'

"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 monies.

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 Little.

"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 happening."

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.