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.
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 partner 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 – fora 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 long-term 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 Canadian 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 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 of the better-known middle-sized 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 Partners, 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 $2S 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 hardly 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 been chasing too few deals in this market for about a year and a half. More than anything else, this overhang of 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 are 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 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 payouts 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 lending 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.