active investors, lbos, and the privatization of bankruptcy

Active Investors, LBOS, and

the Privatization of Bankruptcy

Michael C. Jensen Harvard Business School

[email protected]

Abstract

From the 1960s to the 1980s the corporate control market generated considerable controversy, first with the merger and acquisition movement of the 1960s, then with the hostile tender offers of the 1970s and most recently, with the leveraged buyouts and leveraged restructurings of the 1980s.

These control transactions are the manifestation of powerful underlying economic forces that, on the whole, are productive for the economy. Thorough understanding is made difficult by the fact that change, as always, is threatening - and in this case the threats disturb many powerful interests.

One popular hypothesis offered for the current activity is that Wall Street is engineering transactions to buy and sell fine old firms out of pure greed. The notion is that these transactions reduce productivity, but generate high fees for investment bankers and lawyers. The facts do not support this hypothesis even though mergers and acquisitions professionals undoubtedly prefer more deals to less, and thus sometimes encourage deals (like diversifying acquisitions) that are not productive.

There has been much study of corporate control activity, and although the results are not uniform, the evidence indicates control transactions generate value for shareholders. The evidence also suggests that this value comes from real increases in productivity rather than from simple wealth transfers to shareholders from other parties such as creditors, labor, government, customers or suppliers.

My purpose here is to outline an explanation of the fundamental underlying cause of this activity that has to date received no attention. In this paper I define “active investors,” explain their fundamentally important role in generating corporate efficiency, show how current corporate control activity is part of a larger set of economic changes sweeping the world, provide perspective on how LBOs, restructurings, and increased leverage in the corporate sector fit into the overall picture, and discuss some reasons why high debt ratios and insolvency are less costly now than in the past. Because of its topical relevance, I pay particular attention to LBOs and their role in the restoration of competitiveness in the American corporation. Keywords: active investors, investors, mergers & acquisitions, control transactions, corporate control activity, takeover activity, corporate efficiency, LBOs, restructurings

Copyright M. C. Jensen 1989

Statement before the House Ways and Means Committee, February 1, 1989.

Reprinted in Journal of Applied Corporate Finance, Vol. 2, No. 1 (Spring 1989), pp. 35-44, and in Michael C. Jensen, A Theory of the Firm: Governance, Residual Claims and Organizational Forms (Harvard University Press,

December 2000) available at http://hupress.harvard.edu/catalog/JENTHF.html

You may redistribute this document freely, but please do not post the electronic file on the web. I welcome web links

to this document at http://ssrn.com/abstract=244152. I revise my papers regularly, and providing a link to the original ensures that readers will receive the most recent version. Thank you, Michael C. Jensen

http://hupress.harvard.edu/catalog/JENTHF.html

http://ssrn.com/abstract=244152

35VOLUME 2 NUMBER 1 SPRING 1989

STATEMENT BY

Michael C. JensenEDSEL BRYANT FORD PROFESSOR OFBUSINESS ADMINISTRATION,HARVARD BUSINESS SCHOOLBEFORE THE HOUSE WAYS AND MEANS COMMITTEEFebruary 1, 1989

The corporate sector of the U.S. economy hasbeen experiencing major change, and the rate ofchange continues as we head into the last year ofthe 198Os. Over the past two decades the corporatecontrol market has generated considerable contro-versy, first with the merger and acquisition move-ment of the 196Os, then with the hostile tenderoffers of the 197Os and, most recently, with theleveraged buyouts and leveraged restructurings ofthe 198Os. The controversy has been renewed withthe recent $25 billion KKR leveraged buyout of RJR-Nabisco, a transaction almost double the size of thelargest previous acquisition to date, the $13.2 billionChevron purchase of Gulf Oil in 1985.

These control transactions are the most visibleaspect of a much larger phenomenon that is not yetwell understood. Though controversy surroundsthem, and despite the fact that they are not allproductive, these transactions are the manifestationof powerful underlying economic forces that, on thewhole, are productive for the economy. Thoroughunderstanding is made difficult by the fact thatchange, as always, is threatening-and in this case thethreats disturb many powerful interests.

One popular hypothesis offered for the currentactivity is that Wall Street is engineering transactionsto buy and sell fine old firms out of pure greed. Thenotion is that these transactions reduce productivity,but generate high fees for investment bankers andlawyers. The facts do not support this hypothesiseven though mergers and acquisitions professionalsundoubtedly prefer more deals to less, and thussometimes encourage deals (like diversifyingacquisitions) that are not productive.

There has been much study of corporate controlactivity, and although the results are not uniform, theevidence indicates control transactions generatevalue for shareholders. The evidence also suggeststhat this value comes from real increases in produc-tivity rather than from simple wealth transfers toshareholders from other parties such as creditors,labor, government, customers or suppliers.1

I have analyzed the causes and consequences oftakeover activity in the U.S. elsewhere.2 My purposehere is to outline an explanation of the fundamentalunderlying cause of this activity that has to date re-ceived no attention. I propose to show how currentcorporate control activity is part of a larger develop-

“Active Investors, LBOs, and thePrivatization of Bankruptcy*”

Seigel (1987, 1989) analyze Census data on 18,000 plants and 33,000 auxiliaryestablishments in the U.S. manufacturing sector in the period 1972-81 and find thatchanges in ownership significantly increase productivity and reduce administrativeoverhead. See F. Lichtenberg and D. Seigel, “Productivity and Changes of Ownershipin Manufacturing Plants,” Brookings Papers on Economic Activity, 1987, and “TheEffect of Takeovers on the Employment and Wages of Central Office and OtherPersonnel,” unpublished manuscript, Columbia University, 1989.

2. See Michael C. Jensen, “The Agency Costs of Free Cash Flow: CorporateFinance and Takeovers,” American Economic Review, Vol. 76 No. 2 (May, 1986); seealso my articles “The Takeover Controversy: Analysis and Evidence,” MidlandCorporate Finance Journal, Vol. 4 No. 2 (Summer, 1986), pp.6-32, and “Takeovers:Their Causes and Consequences,” Journal of Economic Perspectives, Vol. 1, No. 1(Winter, 1988), pp. 21-48.

LBOS AND CORPORATE DEBTSelections from the Senate and House Hearings on

*This is part of an ongoing research effort that includes Clifford Holderness, JayLight, Dennis Sheehan, and John Pound. General research support has been receivedfrom the Harvard Business School Division of Research and a grant has been awardedby Drexel Burnham Lambert to the University of Rochester.

For the argument that takeover gains to shareholders come from wealthredistribution from other parties, see Andrei Shleifer and Lawrence Summers,“Breach of Trust in Hostile Takeovers,” in Corporate Takeovers: Causes and Conse-quences, Alan Auerbach, ed. (University of Chicago Press, 1988). However, noevidence has yet been produced that supports this argument. For surveys of theevidence on the effects of control-related transactions, see Michael C. Jensen andRichard Ruback, “The Market for Corporate Control: The Scientific Evidence,”Journal of Financial Economics 11 (1983) and Greg Jarrell, James Brickley, andJeffrey Netter, “The Market for Corporate Control: The Empirical Evidence Since1980,” Journal of Economic Perspectives, (Winter, 1988), pp. 49-68. Lichtenberg and

36JOURNAL OF APPPLIED CORPORATE FINANCE

ment, to provide perspective on how IBOs,restructurings, and increased leverage in the cor-porate sector fit into the overall picture, and todiscuss some reasons why high debt ratios andinsolvency are less costly now than in the pastBecause of its topical relevance, I pay particularattention to LBOs and their role in the restorationof competitiveness in the American corporation.

ACTIVE INVESTORS AND THEIRIMPORTANCE

The role of institutional investors and financialinstitutions in the corporate sector has changed greatlyover the last 50 years as institutions” have beendriven out of the role of active investors. By activeinvestor I don’t mean one who indulges in portfoliochurning. I mean an investor who actually monitorsmanagement, sits on boards, is sometimes involved indismissing management, is often intimately involvedin the strategic direction of the company, and onoccasion even manages. That description fits Carl Icahn,Irwin Jacobs, and Kohlberg, Kravis, Roberts (KKR).

Before the mid-1930s, investment banks andcommercial banks played a much more important roleon boards of directors, monitoring management andoccasionally engineering changes in management. Atthe peak of their activities, J.P. Morgan and several ofhis partners served on boards of directors and playeda major role in the strategic direction of many firms.

Bankers’ roles have changed over the past 50years as a result of a number of factors. One importantsource of this change is a set of laws established inthe 1930s that increased the costs of being activelyinvolved in the strategic direction of a company whilealso holding large amounts of its debt and equity. Forexample, under the definitions of the 1934 SEC Act,an institution or individual is considered an “insider”if it owns more than 10 percent of the shares of a compa-ny, serves on its board of directors, or holds a positionas officer. And the 16-b Short Swing Profit Rules in theSEC Act require an institution satisfying any insiderconditions to pay to the company 100 percent of theprofits earned on investments held less than sixmonths. Commercial bank equity holdings are signi-ficantly restricted and Glass Steagall restricts bankinvolvement in investment banking activities. The

Chandler Act restricts the involvement by banks inthe reorganization of companies in which they havesubstantial debt holdings. In addition, the 1940Investment Company Act puts restrictions on themaximum holdings of investment funds. Thesefactors do much to explain why money managers donot serve on boards today, and seldom think of gettinginvolved in the strategy of their portfolio companies.

The restrictive laws of the 1930s were passedafter an outpouring of populist attacks on theinvestment banking and financial community, asexemplified by the Pecora hearings of the 1930sand the Pujo hearings in 1913. Current attacks onWall Street are reminiscent of that era.

The result of these political and other forces overthe past 50 years has been to leave managersincreasingly unmonitored. In the U.S. at present, whenthe institutional holders of over 40 percent of corporateequity become dissatisfied with management, theyhave few options other than to sell their shares.Moreover, managers’ complaints about the churningof financial institutions’ portfolios ring hollow: One canguess they much prefer the churning system to onein which those institutions actually have direct powerto correct a management problem. Few CEOs lookkindly on the prospect of having institutions withsubstantial stock ownership sitting on their corporateboard. That would bring about the monitoring ofmanagerial activities by people who more closely bearthe wealth consequences of managerial mistakes andwho are not beholden to the CEO for their jobs. Asfinancial institution monitors left the scene in the post-1940 period, managers commonly came to believecompanies belonged to them and that stockholderswere merely one of many stockholders the firm hadto serve.3 This process took time, and the cultures ofthese organizations slowly changed as senior manag-ers brought up in the old regime were replaced withyounger managers.

The banning of financial institutions from fulfill-ing their critically important monitoring role hasresulted in major inefficiencies. The increase in“agency costs” (loosely speaking, the efficiency lossresulting from the separation between ownership andcontrol in widely held public corporations) appears tohave peaked in the mid to late 1960s when asubstantial part of corporate America generated large

3. Even the most voracious maximizer of stockholder wealth must care aboutthe other constituencies of the corporation. Value maximizing implies the corporationshould expend resources (to the point where marginal costs equal marginal benefits)in the service of customers, employees, communities, and other parties who affect

firm value by influencing the terms on which they contract with the organization orthrough the threat of restrictive regulation or decline in reputation. If this is themeaning of “stakeholder theory,” there is no conflict with value maximization as thecorporate objective.

BEFORE THE MID-1930S, BANKS PLAYED A MUCH MORE IMPORTANT ROLE ON BOARDS OFDIRECTORS. AS FINANCIAL INSTITUTION MONITORS LEFT THE SCENE IN THE POST-1940 PERIOD,MANAGERS COMMONLY CAME TO BELIEVE COMPANIES BELONGED TO THEM AND THATSTOCKHOLDERS WERE MERELY ONE OF MANY STOCKHOLDERS THE FIRM HAD TO SERVE.


cash flows but had few profitable investment projects.With this excess cash, these firms launched diversifi-cation programs that led to the assembly of conglom-erates, a course since proven to be unproductive.4

While most attacks on takeovers have been directedat acquisitions by entrepreneurs such as Icahn andGoldsmith, it is the diversification acquisitions by thelargest corporations (such as GE, GM, the major oilcompanies, etc.) that have proven to be unproductive.The recent criticism levied at the KKR takeover seemsmisplaced given the evidence—especially given thelack of controversy surrounding the Phillip Morristakeover of Kraft which, if past evidence is any guide,will prove to be counterproductive.

The fact that takeover and restructuring premi-ums regularly average about 50 percent indicates thatmanagers have been able to destroy up to 30 percentof the value of the organizations they lead beforefacing serious threat of disturbance. This destructionof value generates large profit opportunities, and theresponse to these incentives has been the creationof innovative financial institutions to recapture thelost value. Takeovers and LBOs are among theproducts of these institutions. My estimates indicatethat over the 10 years from 1975 to 1986, corporatecontrol activities alone (i.e., mergers, tender offers,divestitures, spin-offs, buybacks, and LBOs) createdmore than $400 billion in value for investors.

Along with the takeover specialists came othernew financial institutions such as the family funds(owned by the Bass Brothers, the Pritzkers, and theBronfmans) and Warren Buffet’s Berkshire Hathaway-institutions that discovered ways to bear the costassociated with insider status. Coniston Partners isanother version of this new organizational responseto the monitoring problem, and so is the Lazard FrèresCorporate Partners Fund. These new institutions havediscovered ways different from those of J.P. Morganto resolve the monitoring problem. They purchaseentire companies and play an active role in them; infact, they often are the board of directors.

The modern trend toward merchant banking inwhich Wall Street firms take equity positions in theirown deals is another manifestation of this phenom-enon. KKR is much more than an expediter of LBOtransactions. It plays an important role in manage-ment after the transaction. In general, LBO specialists

control the boards of directors in the companies theyhelp take private. They choose the managers of thefirm and influence the corporate strategy in importantways. Buyout specialists are very different from theusual outside or public directors that supposedlyrepresent shareholders. Buyout specialists own, orrepresent in their buyout funds, an average of 60percent of the firm’s equity5 and therefore have greatincentive to take the job seriously, in contrast to publicdirectors with little or no equity interest.

The development of new financial institutionsas a response to problems caused by the lack ofeffective monitoring of corporate managers contin-ues to grow. Such innovation is likely to continueunless handicapped by new legislation, tax penal-ties, or unfavorable public opinion. The attack onWall Street and investment bankers that has beenprogressing in recent years may be the modernequivalent to the populist attacks in the decades priorto 1940 that led to the crippling of Americancorporations in the 1960s and 1970s.

THE LBO ASSOCIATION: A NEWORGANIZATIONAL FORM

It is instructive to think about LBO associationssuch as KKR and Forstmann-Little as new organiza-tional Forms-in effect, a new model of generalmanagement. These organizations are similar in manyrespects to diversified conglomerates or to the Japa-nese groups of firms known as “keretsu” It isnoteworthy that the corporate sectors in Japan andGermany are significantlv different from the Americancorporate model of diffuse ownership monitored bypublic directors. In both these economies, banks andassociations of firms are more important than in the U.S.Indeed, one way to see the current conflict betweenthe Business Roundtable and Wall Street is that WallStreet is now a direct competitor to the corporateheadquarters office of the typical conglomerate.6

Moreover, the evidence on the relative success of theactive investor versus the public director organiza-tional form seems to indicate that many CEOS of largediversified corporations have no future in their jobs;one way or the other many of those jobs are beingeliminated in favor of operating level jobs by compe-tition in the organizational dimension.

5. See Steve N. Kaplan, “Sources of Value in Management Buyouts,” unpublisheddoctoral thesis, Harvard Business School (March, 1989).

6. A point originally made by Amar Bhide, Harvard Business School.

4. See Jensen (1986) and Jensen (1988), as cited in footnote 2.

BUYOUT SPECIALISTS OWN, OR REPRESENT IN THEIR BUYOUT FUNDS, AN AVERAGE OF60 PERCENT OF THE FIRM’S EQUITY5 AND THEREFORE HAVE GREAT INCENTIVE TOTAKE THE JOB SERIOUSLY, IN CONTRAST TO PUBLIC DIRECTORS WITH LITTLE OR NOEQUITY INTEREST.


LBO associations such as KKR are one alterna-tive to conglomerate organizations and, judging fromtheir past performance, they apparently generatelarge increases in efficiency. Figure 1 illustrates theparallels and differences between these organiza-tional forms. LBO associations, portrayed in thebottom of the figure, are run by partnerships insteadof the headquarters office in the typical large, multi-business diversified corporation. These partnershipsperform the monitoring and peak coordination func-tion with a staff numbering in the tens of people, andreplace the typical corporate headquarters staff ofthousands. The leaders of these partnerships havelarge equity ownership in the outcomes and directfiduciary relationships as general partners to thelimited partner investors in their buyout funds.

7. See Kaplan (1989), as cited in note 5.

The LBO partnerships play a role that is similarin many ways to that of the main banks in the Japanesegroups of companies. The banks (and LBO partner-ships) hold substantial amounts of equity and debt intheir client firms and are deeply involved in themonitoring and strategic direction of these firms.Moreover, the business unit heads in the typical LBOassociation, unlike those in Westinghouse or GE, alsohave substantial equity ownership that gives them apay-to-performance sensitivity which, on average, is20 times higher than the average corporate CEO. Ina sample of LBOs examined by Steven Kaplan, theaverage CEO receives $64 per $1,000 change inshareholder wealth from his 6.4 percent equityinterest alone.7 The typical corporate CEO, by contrast,is paid in a way that is insensitive to performance as

The LBO association is headed by a small partnership organization that substitutes compensation incentives (mostly throughequity ownership) and top-level over sight by a board with large equity ownership for the large bureaucratic monitoring of thetypical corpoarte headquarters. For simplicity, the board of directors of each LBO firm has been omitted. The LBO PartnershipHeadquarters generally holds 60% of the stock in its own name or that of the Limited Partnership fund and controls each ofthese boards.

FIGURE 1CORRESPONDENCEBETWEEN THE TYPICALDIVERSIFIED FIRM ANDTHE TYPICAL LBOASSOCIATION(COMPETINGORGANIZATIONAL FORMS)

ONE WAY TO SEE THE CURRENT CONFLICT BETWEEN THE BUSINESS ROUNDTABLEAND WALL STREET IS THAT WALL STREET IS NOW A DIRECT COMPETITOR TO THECORPORATE HEADQUARTERS OFFICE OF THE TYPICAL CONGLOMERATE.


measured by changes in CEO wealth. In a study Iconducted with Kevin Murphy, we found that theaverage CEO in the Forbes 1000 firms receives totalpay (including salary, bonus, deferred compensa-tion, stock options and equity) that changes about$3.25 per $1,000 change in stockholder value.8

The proper comparison, however, of the pay-performance sensitivity of the compensation packageof the conglomerate CEO is not with the CEOs of theLBOs but rather with the Managing Partner or Partnersof the partnership headquarters (e.g., the KKR’s of thisworld). Little is publicly known about the compensa-tion plans of these partnerships, but the pay-to-performance sensitivity (including ownership inter-ests, of course) appears to be very large, even relativeto that of the managers of the LBOs. The effectiveownership interest in the gains realized by the buyoutpool generally runs about 20 percent or more for thegeneral partners as a group. LBO business unit headsalso have far less of a bureaucracy to deal with, andfar more decision rights, in the running of theirbusinesses. In effect, the LBO association substitutesincentives provided by compensation and ownershipplans for the direct monitoring and often centralizeddecision-making in the typical corporate bureaucracy.The compensation and ownership plans make therewards to managers highly sensitive to the perfor-mance of their business unit, something that rarelyoccurs in major corporations.9

In addition, the contractual relation between thepartnership headquarters and the suppliers of capitalto the buyout funds is very different from that betweenthe corporate headquarters and stockholders in thediversified firm. The buyout funds are organized aslimited partnerships, in which the managers of thepartnership headquarters are the general partners.Unlike the diversified firm, the contract with thelimited partners denies partnership headquarters theright to transfer cash or other resources from one LBObusiness unit to another. Generally all cash payoutsfrom each LBO business unit must be paid out directlyto the limited partners of the buyout funds. Thisreduces the waste of free cash flow that is so prevalentin diversified corporations.10

THE EMPIRICAL EVIDENCE ON THE SOURCEOF LBO GMNS

The evidence on LBOs and management buy-outs is growing rapidly. In general, this evidenceshows that abnormal gains to stockholders aresignificantly positive and in the same range as gainsfrom takeovers. Stock prices rise about 14 percentto 25 percent on the announcement of the offer, andthe total premium paid to public shareholdersranges from 40 percent to 56 percent.11 The recentstudy by Kaplan, mentioned earlier, shows that forthose buyouts that eventually come back public orare otherwise sold, the total value (adjusted formarket movements) increases 73 percent from twomonths before a buyout to the final sale about 5years after the buyout Pre-buyout shareholders earnpremiums of about 35 percent, and the post-buyoutinvestors earn about 27 percent.12

This 27 percent return to post-buyout investors,it is important to note, is measured on the totalpurchase price of the pre-buyout equity and not theequity of the post-buyout firm. The median net-of-market return on the post-buyout equity alone isabout 600 percent, but these returns are distorted bythe fact that the equity is highly leveraged. In effect,the equity returns are almost a pure risk premium andtherefore independent of the amount invested.Calculating the returns on the entire capital base usedto purchase the pre-buyout equity, or the fraction ofthe total wealth gains that go to the pre-buyoutshareholders, gives a better picture of the distributionof the total wealth created in the buyout. Averagetotal buyout fees amount to 5.5 percent of the equitytwo months prior to the buyout proposal.

Some assert that post-buyout shareholders, es-pecially managers, earn “too much” in these transac-tions, and that managers are exploiting shareholdersby using their inside information about the firm to buyit at below-market prices. Kaplan, however, findsevidence that managers holding substantial amounts ofequity who are not part of the post-buyout manage-ment team are systematically selling their shares intothe buyout This is irrational behavior if the buyout is

8. Michael C. Jensen and Kevin J. Murphy, “Performance Pay and TopManagement Incentives,” Harvard Business School Working Paper #89-059, (1989).

9. See George F. Baker, Michael C. Jensen, and Kevin J. Murphy, “Compensationand Incentives: Practice vs. Theory,” Journal of Finance, (July, 1988), 593-616. Seealso Jensen and Murphy (1989), cited in note 8.

10. For a discussion of the waste of free cash flow see my article, “The AgencyCosts of Free Cash Flow: Corporate Finance and Takeovers,” American EconomicReview, cited in note 2.

11. Evidence on stock price increases comes from Harry DeAngelo, LindaDeAngelo, and Ed Rice, “Going Private Minority Freezeouts and Shareholder Wealth,”Journal of Financial Economics, 27 (1984) PP. 367-401. See also Kenneth Lehn andAnnette Poulsen, “Leveraged Buyouts: Wealth Created or Wealth Redistributed?,”in Public Policy toward Corporate Mergers, M. Weidenbaum and K. Chilton, eds.(Transition Books, New Brunswick, NJ, 1988).

12. Kaplan (1989), as cited in note 5. The average total returns before adjustmentfor market returns are 220% with pre-buyout shareholders earning 47% and post-buyout shareholders earning 128%.

IN EFFECT, THE LBO ASSOCIATION SUBSTITUTES INCENTIVES PROVIDED BYCOMPENSATION AND OWNERSHIP PLANS FOR THE DIRECT MONITORING AND OFTENCENTRALIZED DECISION-MAKING IN THE TYPICAL CORPORATE BUREAUCRACY.


significantly underpriced in light of inside informa-tion and if such non-participating insiders have thesame information as that of the continuing manage-ment team. Moreover, shareholders have manylegal forums to press their claims because virtuallyall announcements of buyouts are followed by suitsfrom the plaintiffs’ bar. In addition, buyout firmssvstematically underperform the post-buyout pro-jections they make in the proxy materials providedto selling shareholders.13

If, however, the buyout gains are due to themajor changes in ownership and debt that occur atthe buyout and the real changes in operations theyengender, there may be no alternative but to allowmanagers to acquire substantial equity interests.These equity interests give them the incentive tomake such highly leveraged companies successfuland compensates them for the risks they are takingwith their careers. One of the major risks, as RossJohnson of RJR-Nabisco found out, is that a substan-tial fraction of proposed buyouts fail, and competingbids are an important reason for this failure.

Managers are subject to severe conflicts ofinterest in buyout transactions because they cannotsimultaneously act as both buyer and agent for theseller. The system seems to work well, however,to protect shareholder interests. Directors are liableif they behave inappropriately and sacrifice share-holder interests in favor of managers, and share-holders receive protection from the fact that a bidsignificantly below the real value of the company(risk-adjusted, of course) is likely to be met bycompeting outside bids. This is exactly what hap-pened in the RJR case, where the initial manage-ment bid of $75 per share was topped by twooutside bidders for an eventual stated price of $109per share, an increase of $7.7 billion. In this casethe system worked well to ensure that shareholderinterests were served.

There are now several credible studies that haveexamined the operating characteristics of largesamples of LBOs after the buyout and have foundreal increases in productivity. The Kaplan study citedabove finds average increases in operating earningsof 42 percent from the year prior to the buyout to the

third year after the buyout, and increases of 25 percentwhen adjusted for industry and business cvcle trends.He also finds 96 percent increases in cash flow in thesame period (80 percent increases after adjustment forindustry and business cycle trends).

A study by Abbie Smith also finds significantincreases in operating earnings and net cash flows.In addition she documents improvements in profitmargins, sales per employee, working capital,inventories, and receivables, and finds no evidenceof delays in payments to suppliers. She finds nochanges in maintenance, repairs and advertising asa fraction of sales, and no evidence that these itemsare being cut in ways that harm the long-run healthof the enterprise.14

Corporate debt rises significantly, from about20 percent of assets to almost 90 percent after abuyout.15 Some argue that a major part of theshareholder benefits are simply wealth transfersfrom bondholders who suffer when their bonds areleft outstanding in the new company with itsmassive total debt. While it is undoubtedly true thatsome bondholders have lost in these transactions,there is no evidence that bondholders lose onaverage. Convertible bond and preferred stock-holders generally gain a statistically significantamount in such transactions, while straight bondholders show no significant gains or losses.16 Thisresult is somewhat surprising since, in the majorityof cases, the old bonds experience significantdowngradings by rating agencies.

The bondholder loss issue has been promi-nent in the press as Metropolitan Life has filed suitagainst RJR-Nabisco for restitution of the losses itexperienced on its RJR-Nabisco bond holdings.The press, however, has greatly exaggerated theamount of the wealth loss to the RJR bondholders.The original announcement of the Johnson/ShearsonLehman offer occurred on October 20. In theperiod September 29,1988 to November 29,1988,the bondholders of RJR-Nabisco suffered losses ofslightly under $300 million.17 This loss is trivialrelative to the $12.1 billion gain to RJR sharehold-ers (calculated at the stated price of $109 pershare).

13. Ibid.14. Abbie Smith, “Corporate Ownership Structure and Performance: The Case

of Management Buyouts,” unpublished manuscript, University of Chicago GraduateSchool of Business, January, 1989.

15. See Kaplan (1988), as cited in note 5. See also L. Marais, K. Schipper, andAbbie Smith, “Wealth effects of Going Private for Senior Securities,” Journal ofFinancial Economics (forthcoming).

16. See Marais, Schipper and Smith (forthcoming), cited in note 15.17. Press reports typically estimate bondholder losses at $1 billion on RJR’s $5

billion of debt outstanding prior to the buyout. While it is true that RJR’s longest bondfell 20 percent on announcement of the proposal, much of RJR’s debt was shorterterm, and the effect on the shorter-term debt was much smaller.

THE KAPLAN STUDY OF LBOS FINDS AVERAGE INCREASES IN OPERATING EARNINGS OF42 PERCENT FROM THE YEAR PRIOR TO THE BUYOUT TO THE THIRD YEAR AFTER THEBUYOUT...IT ALSO FINDS 96 PERCENT INCREASES IN CASH FLOW IN THE SAME PERIOD(80 PERCENT INCREASES AFTER ADJUSTMENT FOR INDUSTRY AND BUSINESS CYCLE


ings caused by the buyout; (4) the tax payments bythe buyout firm creditors who receive the interestpayments; and (5) the increased taxes generated bythe more efficient use of the firm’s capital.

Direct estimates of the total effect on Treasury taxrevenues taking account of all such gains and lossesindicate the present value of revenues actuallyincreases by about 10 million under the 1986 tax ruleson the average buyout with a price of $500 millionConverted to an equivalent annual increase of $11million in perpetuity, these revenues represent anannual increase of approximately 61 percent over theaverage $18 million tax payment by buyout firms inthe year prior to the buyout. On a current account basis-that is, considering only the tax effects in the year afterthe buyout-the Treasury gains $41 million over theaverage pre-buyout tax payments.19 Conservativeestimates indicate that, at worst, the Treasury isunlikely to be a net loser from these transactions. If thevalue increases are the result of real productivitychanges, rather than merely transfers of wealth fromother parties, then it is not surprising that the Treasuryis a winner. In the controversial RJR-Nabisco case, the$12 billion plus gains are likely to generate netincremental tax revenues to the treasury totaling $3.8billion in present value terms, and about $3.3 billionsolely in the year following the buyout. Before thebuyout, RJR-Nabisco was paying about $370 millionin federal taxes.

HIGH LEVERAGE AND THE PRIVATIZATIONOF BANKRUPTCY

One important and interesting characteristic ofthe LBO organization is its intensive use of debt. Thedebt-to-value ratio in the business units of theseorganizations averages close to 90 percent on abook value basis.20 LBOs, however, are not the onlyorganizations that are making use of high debt ratios.Public corporations are also following suit as wit-nessed by recapitalizations, highly leveraged merg-ers, and stock repurchases.

There has been much concern in the press andin public policy circles about the dangers of highdebt ratios in these new organizations. What is notgenerally recognized, however, is that high debt hasbenefits as a monitoring and incentive device, espe-

In any event the expropriation of wealth frombondholders is not a continuing problem because thetechnology to protect bondholders from losses in theevent of substantial restructuring and increases in debtis available. Poison puts or other covenant provisionsthat require repurchase of the bonds during suchevents can be used to eliminate such restructuring risk.One view of the RJR situation is that the Met and otherbondholders gambled that no restructuring wouldoccur in order to reap the premium they wouldhave given up if the protection had been includedin the bonds they bought in 1988. Having gambledand lost, they are now asking for compensation.

The effects of LBOs on labor have not beenthoroughly studied to date, but evidence in the Kaplanstudy indicates that median employment increases by4.9 percent after a buyout (although, adjusted forindustry conditions, it falls by 6.2 percent).18 Thus,employment does not systematically fall after abuyout. No data has been found that allows inferenceon whether wages are cut after a buyout.

There is also concern about the effect of LBOs onR&D expenditures. This concern seems unwarrantedbecause the low-growth, old-line firms that make goodcandidates for highly leveraged LBOs don’t typicallyinvest in R&D. Kaplan and Smith, for example, eachfound only seven firms in their respective samples of76 and 58 firms that engaged in enough R&D to reportit in their financial statements.

Another area of controversy is the amount ofvalue transferred from the U.S. Treasury in the formof tax subsidies to buyout transactions. The argumentis that the massive increases in tax-deductible interestpayments virtually eliminate tax obligations for buy-out firms. In the year following the buyout, Kaplanfinds that 50 percent of the firms pay no taxes.However, because of operating improvements andthe retirement of some debt, average tax paymentsare essentially back to the pre-buyout level by thethird year after the buyout. Moreover, these subsidyarguments ignore five sources of added tax revenues:(1) the large increases in tax payments generated bythe buyout in the form of capital gains tax paymentsby pre-buyout shareholders who are forced to realizeall the gains in their holdings; (2) the capital gains taxespaid on the sale of assets by the LBO firms; (3) the taxpayments on the large increases in operating earn-

18. The increase in employment is statistically significant, and the difference fromindustry trends is insignificantly different from zero. The data cover only companieswithout significant divestitures in the post-buyout period.

19. These estimates are discussed in detail in Michael C. Jensen, Steven N. Kaplan,and Laura Stiglin, “The Effects of LBOs on Tax Revenues of the U.S. Treasury,” TaxNotes, Vol. 42 No. 6 (February 6, 1989), pp. 727-733.

20. Kaplan (1988), as cited in note 5.

IN THE CONTROVERSIAL RJR-NABISCO CASE, THE $12 BILLION PLUS GAINSARE LIKELY TO GENERATE NET INCREMENTAL TAX REVENUES TO THETREASURY TOTALING $3.8 BILLION IN PRESENT VALUE TERMS.


cially in slow-growing or shrinking firms. Even lesswell-known, the costs for a firm in insolvency—thesituation in which a firm cannot meet its contractualobligations to make payments—are likely to bemuch smaller in the new world of high leverageratios than they have been historically. The reasonis illustrated in Figure 2.

In a world of 20 percent debt-to-value ratios(with value based on the going concern value of ahealthy company), the liquidation or salvage valueis much closer to the face value of the debt than inthe same company with an 85 percent debt/valueratio.21 Figure 2 shows a $100 million companyunder these two leverage ratios, and assumes thatthe salvage or liquidation value of the assets is 10percent of the going concern value of $10 million.Thus, if the company experiences such a decline in

21. I am indebted to Mark Wolfson for helping me see this point.

value during bad times that it cannot meet itspayments on $20 million of debt, it is also likely thatits value is below its liquidation value.

An identical company with an 85 percent debtratio, however, is nowhere near liquidation whenit experiences times sufficiently difficult to cause itto be unable to meet the payments on its $85 millionof debt. That situation could occur when thecompany still has total value in excess of $80million. In this case there is $70 million in value thatcan be preserved by resolving the insolvencyproblem in a fashion that minimizes the value lostthrough the bankruptcy process. In the former case,when the firm is worth less than $20 million, theremay be so little value left that the economicallysensible action is liquidation, with all its attendantconflicts and dislocation.

The darkest shaded area represents the liquidation value for a given firm with assumed value of $100 million dollars.Traditionally leveraged, the firm would have about a 20% debt-to-value ratio (on a healthy going concern basis), while itwould have about 85% debt in the new leverage model characterizing LBO and restructuring transactions. The much largervalue at risk in the new leverage model if the firm should go into bankruptcy, represented by the next darkest shaded area,provides larger incentives to bring about private reorganization outside of the courts.

FIGURE 2RELATION BETWEENINSOLVENCY POINT ANDLIQUIDATION VALUEWHEN THE DEBT/VALUERATIO IS LOW VS. HIGH

IN EFFECT, BANKRUPTCY WILL BE TAKEN OUT OF THE COURTS AND “PRIVATIZED.”THIS INSTITUTIONAL INNOVATION WILL TAKE PLACE TO RECOGNIZE THE LARGEECONOMIC VALUE THAT CAN BE PRESERVED BY PRIVATELY RESOLVING THECONFLICTS OF INTEREST AMONG CLAIMANTS TO THE FIRM.


The incentives to preserve value in the newleverage model imply that a very different set ofinstitutional arrangements and practices will arise tosubstitute for the usual bankruptcy process. Ineffect, bankruptcy will be taken out of the courts and“privatized.” This institutional innovation will takeplace to recognize the large economic value that canbe preserved by privately resolving the conflicts ofinterest among claimants to the firm. When thegoing concern value of the firm is vastly greater thanthe liquidation value, it is likely to be more costlyto trigger the cumbersome court-supervised bank-ruptcy process that diverts management time andattention away from managing the enterprise tofocus on the abrogation of contracts that the bank-ruptcy process is set up to accomplish.

These large poteintial losses provide incen-tives for the parties to accomplish reorganization ofthe claims more efficiently outside the courtroom.This fact is reflected in the strip financing practicescommonly observed in LBOs whereby claimantshold approximately proportional strips of all secu-rities and thereby reduce the conflicts of interestamong classes of claimants.22 Incentives to managethe insolvency process better are also reflected inthe extremely low frequency with which these neworganizations actually enter bankruptcy. The recentRevco case is both the largest such bankruptcy ofan LBO and one of the handful that have occurred.

LBOs frequently get in trouble, but theyseldom enter formal bankruptcy. Instead they arereorganized in a short period of time (severalmonths is common), often under new manage-ment, and at apparently lower cost than wouldoccur in the courts. The process has not beenformally studied yet, so good empirical data iscurrently unavailable.

Some assert that the success of LBOs has beenensured by the greatest bull market in history. thestory is not that simple, however, because during thelast eight years, major sectors of the economy haveexperienced bad times, and buyouts have occurredin many of these sectors. So although they have notbeen tested by a general recession, they havesurvived well the trials of subsectors of the economyin the recent past (textiles and apparel are examples).

In addition, there are indications that organiza-tions such as Drexel Burnham Lambert (which hasbeen most active in facilitating the intensive use of

debt) has anticipated these problems They seemsensitive to the potential gains from innovation inthe work-out and reorganization process. Suchinnovation is to be expected when there are largeefficiency gains to be realized from new reorgani-zation and recontracting procedures to deal withinsolvency.

There is reason to believe, however, that actionsby regulatory authorities will generate serious bank-ruptcy problems among Drexel’s clients if its abilityto handle the reorganization and work-out process ishampered. Drexel’s position in the high-yield bondmarket gives it a unique ability to perform thisfunction and no substitute is likely to emerge soon.

There has been much concern about the ability ofLBO firms to withstand sharp increases in interest rates,given that the bank debt which frequently amounts to50 percent of the total debt is primarily at floating rates.This problem is mitigated by the fact that most LBOs nowprotect themselves against sharp increases in interestrates by purchasing caps that limit any increase or byusing swaps that convert the floating-rate debt to fixedrates. Indeed it has become common for banks torequire such protection for the buyout firm as a conditionfor lending. These new financial techniques are anothermeans where-by some of the risks can be hedged awayin the market, and therefore the total risks to the buyoutfirm are less than they would have been in past yearsat equivalent debt levels.

It will undoubtedly take time for the institutionalinnovation in reorganization practices ton mature andfor participants in the process ton understand thatinsolvency will be a more frequent and less costlyevent than it has been historically. It is also reasonableto predict that this will be an area of intense futureacademic study.

It is likely we will discover that debt and insol-vency can serve a very important control function toreplace what seems to be the failed model in whichthe public board of directors monitors managementand its strategy directly Although I have not studied itin detail, and therefore my conclusions are tentative.the recent Revco bankruptcy seems to be an exampleRevco’s management pursued a strategy to upgradeits drugstores to department stores. The strategy failed,but the high debt load prevented the company frompursuing the flawed project for long because insol-vency and bankruptcy allowed the creditors andowners ton replace managers and force abandonment

22. See Jensen (1988), as cited in note 2.

LBOS FREQUENTLY GET IN TROUBLE, BUT THEY SELDOM ENTER FORMAL BANKRUPTCY.INSTEAD THEY ARE REORGANIZED IN A SHORT PERIOD OF TIME (SEVERAL MONTHS ISCOMMON), OFTEN UNDER NEW MANAGEMENT, AND AT APPARENTLY LOWER COSTTHAN WOULD OCCUR IN THE COURTS.


of the strategy. Such rapid change in management andstrategy would probably not have occurred under theusual public director/low leverage control model ofthe typical American corporation.

It is interesting that the Japanese system seemsto have many of the characteristics of the evolvingAmerican system. Japanese firms make intensiveuse of leverage and Japanese banks appear tonallow a company ton go into bankruptcy only whenit is economic ton liquidate it that is, only when thefirm is more valuable dead than alive. This appearston be the norm in the American LBO communityas well as leader of the consortium of banks lendington any firm, the Japanese main bank takes respon-sibility for evaluating the economic viability of aninsolvent firm, and for planning its recovery,including the infusion of new capital and top-levelmanagerial manpower (often drawn from the bankitself). Other members of the lending consortiumcommonly follow the lead of the main bank andcontribute additional funding, if required, ton thereorganization effort. The main bank bonds its roleby making the largest commitment of funds ton theeffort. Viewed in this light, the most puzzling aspectof the Revco experience is why Revco’s investmentbankers and creditors let the firm get into the formalbankruptcy process.

CONCLUSION

LBOs are an interesting example of controltransfers that highlight the effect of changes inorganizational form and incentives on productivity.It appears there is no explanation for most of the gainsother than real increases in operating efficiencies.That in itself is interesting because these are gener-ally situations in which the same managers with thesame assets are able, when provided better incen-tives, to almost double the productivity and value ofthe enterprise. It is also surprising that it is so difficultton find losers in these transactions. Some middle andupper managers lose their jobs as the inefficient andbloated corporate staffs are replaced by LBO partner-ship headquarters units. Such LBO associations relyon incentives (created by equity ownership, perfor-mance-sensitive compensation, and high debt obli-gations) and decentralized decision-making as

substitutes for direct involvement by corporateheadquarters in decision-making.

As major innovations in corporate organizationcontinue, mistakes will be made. This is natural andnot counterproductive. How can we learn withoutpushing new policies ton the margin? the surprisingthing to me is that there have been son few major

mistakes or problems in a revolution in busi-ness practice as large as that occurring over the lastdecade. Many of the proposed changes in publicpolicy toward these transactions threaten to stiflethis recreation of the competitiveness of the Ameri-can corporation. Perhaps the most dangerous ofthese policy proposals are those that, like theAmerican Law Institute’s, would limit the formationof debt and the distribution of resources fromcorporations by imposing various tax penalties.23

Removal of biases towards higher debt in the taxsystem would be desirable, but not if the proposedsolutions create large inefficiencies as the A.L.I.’snow threatens to do.

The best and simplest way ton remove any tax-induced bias toward debt is to eliminate the doubletaxation of dividends by making them tax deductibleat the corporate level. This change would generatelarge additional efficiency gains in the economybecause It would reduce the incentives for corpo-rations ton retain substantial amounts of funds evenwhen they have no profitable projects in which toinvest. This change would eliminate some of Themost inefficient acquisitions that take place. Theseacquisitions are frequently engineered by managersflooded with free cash flow they are unable to investin the businesses they understand but are reluctantton pay out to shareholders for reinvestment else-where in the economy Some of the best examplesof this have occurred in the oil, tire, and tobaccoindustrial industries that have been forced to shrinktheir operations in the last decade. As in the past,elimination of the double taxation of dividends islikely ton be opposed by corporate managers whowish ton avoid pressure for increased payouts toshareholders Reforming the bankruptcy process tonlimit the courts’ abrogation of the contractual priorityof claims voluntarily agreed ton by security holdersis also an important function that policymakersshould address.

23. The American Law Institute has proposed a minimum tax on corpoaretdistributions as an alternative way to accompish “debt disqualification,” American LawInstitute, Federal Income Tax Project, Tax Advisory Group Draft No. 18, SubchapterC (Supplemental Study), Part I. Distribution Issues, (November 3, 1988)). This proposal

would exacerbate the major free cash flow problem facing the American corporatesector by locking into place penaltied for the distributions that must occur to resolvethe problem. See Jensen (1986, 1988), as cited in note 2.

AS LEADER OF THE CONSORTIUM OF BANKS LENDING TO ANY FIRM. THE JAPANESE MAINBANK TAKES RESPONSIBILITY FOR EVALU ATING THE ECONOMIC VIABILITY OF AN INSOLVENTFIRM, AND FOR PLANNING ITS RECOVERY INCLUDING TH E INFU SION OF NEW CAPITAL ANDTOP-LEVELMANAGERIAL MANPOWER (OFTEN DRAWN FROM THE BANK ITSELF ).

active investors, lbos, and the privatization of bankruptcy

Documents