The wave of debt-financed mergers and buy-outs, once considered so inexorable that it required the attention of Congress and the Federal Reserve Board, has lately run into a breakwater.
In the last few months, no fewer than four highly publicized takeover offers have been reworked to reduce the offer price, in most cases because investors could not be found to finance the higher bids.
As a result, some investment bankers say they are beginning to detect a crest in the merger cycle.
"It's natural in markets that things go to excess," one mergers and acquisitions professional at a major Wall Street firm said. "In mid-1984, it was obvious to those of us in the trade that the piper would have to be paid."
Whether that moment has arrived is still open to debate. Most merger experts believe that commercial banks, institutional money managers and other big investors are so eager to place their funds in these high-yielding deals that the vogue for debt-financed takeovers has far to go before petering out.
"If there was a general softening in the economy, I think you'd see some more stringent standards," says Guy P. Wyser-Pratte, head of the arbitrage department at Prudential-Bache Securities.
Among the major takeover bids that have run into financing problems are these:
- Atlanta entrepreneur Ted Turner's acquisition of MGM/UA Entertainment, for which he initially offered $29 a share in cash, later reduced to $25 a share and finalized last Thursday at $20 a share.
- Carl C. Icahn's takeover of Trans World Airlines, which ran afoul of the airline's burgeoning business problems. After Paine Webber Inc. failed to interest investors with a deal for $19.50 per share in cash and $4.50 per share in preferred stock, the investment banking firm of Drexel Burnham Lambert stepped in and reworked the transaction as a no-cash offer. By then, the airline had reported quarterly losses of double the projected $70 million.
- The buy-out of R. H. Macy, the department store company, by its own management, which initially offered $70 a share but completed the deal at $68 a share after the financial community derided the first offer as overpriced and bankers balked at putting up the necessary financing.
In at least one other case, a buyer reduced the cash portion of its offer at a late stage. That is the buy-out of Beatrice Cos. financed by Kohlberg Kravis Roberts & Co., a private firm that specializes in leveraged buy-outs (in which the target company's assets are used as collateral for loans to the group buying it out).
But many takeover experts think that Kohlberg Kravis may have strategically overbid at first to drive counterbidders away, then renegotiated its proposal as the only buyer in the market.
The Beatrice board met to consider the new bid last week, but it is expected to accede.
Some say the price cuts on so many high-profile deals in such a short period may just reflect a confluence of unrelated misfortunes.
"I don't think there is a trend," says Leon Black, a managing director of Drexel Burnham Lambert, which is known for its imaginativeness in arranging mergers financed with high-yield, or "junk" debt, and the lead investment banker on the Turner and Icahn offers. "Right now there is a coincidence of a few highly visible deals in different industries involving companies with material adverse changes" in their financial results.
Icahn's bid for TWA, initially negotiated by Paine Webber, was considered risky even when it included $19.50 a share in cash and $4.50 in preferred stock, and the collapse of the airline's business late last year simply added to its aura of fantasy.
"That was a poorly priced transaction from the beginning," says one institutional investor who has been an enthusiastic buyer of other highly leveraged deals. "When Paine Webber sent us their documents, I could see I wasn't going to end up with any equity in the deal. It was a bad joke."
In the end, Drexel Burnham fashioned a bid in which shareholders will get preferred stock and junk bonds that will not pay dividends or interest in cash for four years.
Poor Credit Rating
Turner's takeover of MGM, financiers say, has also been troubled by the entrepreneur's less-than-sterling credit rating and reports of sliding financial results at the target company.
The difficulty in financing high-stakes buy-out deals is not exactly a new phenomenon, even in what many consider an overheated market.
One year ago, the leveraged buy-out of Denny's, the La Mirada-based fast-food chain, suffered months of delays while Merrill Lynch struggled to raise $800 million. Denny's was finally taken private at a reduced price of $765 million.
Perhaps the biggest buy-out to meet financing problems was that of City Investing, the diversified financial-services company. In late 1984, City considered two leveraged buy-outs for more than $1.8 billion--one to be arranged by Merrill Lynch.
Takeover experts say both were overpriced and underfinanced. The company never was bought, opting instead to liquidate for a fraction of the leveraged buy-out figures.
Whether or not the four troubled deals are just a coincidence, Wall Street sources are hardly lacking for explanations of why the leveraged takeover market may be ready to pull back.
One is the bull market of 1985. "With the stock market up substantially, everything is getting more pricey," says Daniel Good, head of mergers and acquisitions at E. F. Hutton. "A while ago, you could have bought Beatrice for $32 a share instead of $48."
Then there is the junk bond issue. So many heavily leveraged takeovers were accomplished by using these high-yield, deeply subordinated bonds to raise money that Congress and the Federal Reserve Board stepped in, the first with a series of hearings and the second with an important ruling designed to restrict the share of a purchase price that could be backed by the securities.
May Be More Cautious
Whether the Fed's initiative will have much impact, particularly on the imaginative financiers at Drexel Burnham, is open to question. But some believe that Washington's attention may make investors more cautious about deals in which the bonds play an important role.
"Junk bonds have become such a popular issue that financial institutions pay more attention to the numbers" in such deals, says William Farley, the Chicago businessman whose $1.2-billion takeover of Northwest Industries was one of the biggest deals that Drexel Burnham handled last year.
A third consideration may be the economy, a crucial factor for transactions built on the assumption that strong growth will help pay off heavy takeover debt.
Farley says bankers may be projecting a recession ahead. "In 1982, it was reasonably comfortable to project that the next five years would be good ones," he says. "Now, it's harder to say what the next few years will bring--and the first two, three or four years are the crucial ones for many of these companies."
The merger vogue of 1984-85 has generated so much mania that for a time it seemed that almost any deal, no matter how economically dubious, could be constructed.
Companies mentioned as targets, particularly in the industries that were periodically in vogue, would watch their share prices soar on rumors; the prices of those that actually became targets continued to rise on investors' assumptions that almost any initial bid could be topped.
Certainly the merger field is not lacking for transactions done at prices and under conditions suggesting that their motivating factors have less to do with economic sense and financial prudence than unadorned executive brio.
"I've certainly felt at times that deals get done that I couldn't believe," one commercial banker says.
Sources in the financial community say there is still more than enough money available for investment in high-yielding takeovers to finance plenty of speculative deals.
40 Banks Interested
Some people close to New York businessman Ronald Perelman's takeover of Revlon--one that depends for its success on Perelman's selling off most of Revlon's units at exceptionally high prices--say more than 40 domestic and foreign banks expressed an interest in lending $50 million each or more to the deal. In the end, the $1.8-billion takeover involved about $300 million in bank debt and $1.5 billion in subordinated bonds and preferred stock.
If the takeover market does show signs of tightening, investment professionals say, the role of commercial banks in generating funds may become especially important.
Banks already play a key role in leveraged buy-outs because their presence as senior lenders assures bondholders that a company's management will be held to strict financial controls in the first few years after a buy-out, when the company's health is most precarious and the commercial banks' exposure is greatest. Buy-out experts say the involvement of one of the top leveraged buy-out banks--in relative order of importance they are Manufacturers Hanover Trust, Bankers Trust, Citibank and Morgan Guaranty Trust--helps an investment banker sell other investors on a deal.
These sources say that such deals as the City Investing, Denny's and Macy's buy-outs ran into trouble because investment houses new to the leveraged buy-out field and inexperienced at credit analysis could not craft proposals attractive to the commercial banks.
Commercial bankers say that Drexel Burnham remains the pre-eminent investment bank in leveraged buy-outs because of its skill in fashioning alluring bank incentives.
"Drexel's been leaning over backwards to make the bank portion easier," one commercial banker says.
Sought Longer Terms
The financing banks are particularly attracted to transactions in which the term of their loans is short and in which asset sales will provide the cash necessary to pay them off even sooner.
One banker contends that the Macy's buy-out ran into difficulty because its investment bank, Goldman, Sachs & Co., tried to persuade banks to make loans with terms of as long as seven or eight years, although Macy's relatively meager capacity to raise cash from asset sales left little chance of reducing the average life of the loans to less than 4 1/2 to five years.
Compare that to the recent leveraged buy-out of SCOA Industries, a much smaller regional department store chain that completed a $637-million deal through Drexel Burnham by offering banks maximum maturities of five years and the likelihood that asset sales would pay down half the debt in 18 months.
"SCOA will probably get better pricing (on its debt) than Macy's," which is a $3.5-billion deal, one banker says.
Some bankers say a tighter market for takeover money might benefit no one as much as the deal-makers at Drexel Burnham, who combine an unbeatable ability to sell investors junk bonds with an exceptional skill at tailoring deals to attract commercial bankers.
Drexel Burnham's financing of Farley's takeover of Northwest Industries--one of the most extravagantly leveraged deals in recent times--gave the banks maximum maturities of five to six years.
The cash Farley has raised by selling off Northwest assets has already reduced the outstanding bank debt to about $300 million from $550 million.
"That was a very conservative deal for the bankers," one source said.