Leveraged buyouts: The LBO craze flourishes amid warnings of disaster
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Leveraged buyouts: The LBO craze flourishes amid warnings of disaster

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.

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 were.

"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 syndicators.

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 uncompetitive pricing.

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 debt tranches.

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) bond market.

LBOs are not affected by the Fed's latest ruling on junk bonds.

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 force.

"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 been senior.

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 loathe.

"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 Partners.

"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 business.

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 movie.

"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 bankers involved.

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 deal.

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 subordinated debt.

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 consummated.

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," said Mancuso.

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 assets.

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 involved.

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 scrap.

"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 management teams."

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 Brown.

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 system.

'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 amendment.

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 Takeover Panel.

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 relationships."

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 either client."

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 pound]10.5 billion.

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 cheap brands.

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 million.)

"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 properly."

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 advice.

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 borrowing-financed bids.

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 Scotland.

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 modest."

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. (Page 122.)

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 should.

"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 place.'

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 bonds."

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