A Search for Social Utility in the Leveraged-Buyout Game
Donald Kelly can make money--no doubt about that.
In 1986, Kelly and a group of investors bought the Beatrice Companies, a huge conglomerate, for $6.2 billion. They borrowed most of the money and put up about $400 million of their own. Since then, Kelly has sold some of Beatrice’s businesses for nearly $5 billion. Much of the rest of the debt has been repaid, and the remaining company may be worth $2 billion. Kelly’s investors have easily quintupled their money.
What are we to make of this? It highlights modern capitalism’s ambiguity. In theory, free enterprise marries private wealth and public good. People get rich because they do something--introduce a new technology, for example--that makes everyone richer. But there’s often a thin line between creating new wealth and rearranging the old. When fortunes are made as quickly as Kelly’s, has society truly been made better off? Or do these riches merely reflect shrewd speculations?
The answer, if Beatrice’s case is typical, is a bit of both. Beatrice is the largest example so far of a new type of takeover: the leveraged buyout, or LBO. The social value of LBOs lies in their ability to break up cumbersome conglomerates and to motivate managers to run their companies efficiently. But LBOs also involve speculation or, less politely, gambling.
In an LBO, a group of investors buys all a company’s stock, mostly with borrowed money. The company then “goes private” because its stock is no longer traded on major stock exchanges. In 1979, there were 16 LBOs worth less than $1 billion, according to W.T. Grimm & Co., a consulting company. By 1986, 76 LBOs were worth more than $20 billion.
Typically, the investors include the company’s top executives. Kelly, for example, had headed Esmark, a firm that had been bought by Beatrice. In turn, Kelly took over Beatrice; he and other new Beatrice executives now hold 12.5% of the company’s stock. The theory is simple: with managers as investors, conflicts between shareholders and executives are muted. Shareholders want higher profits. By contrasts, managers often strive to enhance their companies’ size or prestige.
Consider Beatrice. When Kelly arrived, it was out of control: a textbook case of growth for growth’s sake. Through many mergers, its sales had expanded past $11 billion. The result was a jumble of unrelated businesses.
Kelly dismantled the jigsaw puzzle. Some businesses--Avis and Playtex among them--were sold to investor groups, including managers, in other LBOs. Kelly also streamlined Beatrice. The company puts these savings at $100 million.
These steps have social value. Busting up oversized conglomerates and huge corporate bureaucracies improves the economy’s efficiency. Companies are likely to do better when they’re smaller and more specialized.
But the profitability of LBOs isn’t based only on these improvements. What Kelly and others have done can be likened to buying and selling real estate in a rising market. Suppose you buy a $100,000 home with a 90% mortgage. The huge loan generates large tax savings, because the interest payments are deductible. You then make some modest improvements on the home and sell it for $140,000. Depending on the cost of improvements, you’ve multiplied your investment three to four times.
The comparison makes LBOs less magical. Tax savings have no social value. Real estate booms also end. Profits turn into losses, because prices for homes or offices got unrealistically inflated. Some of today’s LBO profits could likewise become losses. Maybe some of the buyers of Beatrice’s businesses were saps and paid too much. Who knows? A favorable economy has made the LBO game seem effortless. The risks have been disguised. A rising stock market makes it easier to sell companies at higher prices. An expanding economy makes it easier to carry heavy debt.
But good times don’t last forever. There will be a recession. The stock market will go down. Some LBOs will go sour. They won’t be able to meet their debt payments. Where does the good of LBOs leave off and the speculation begin? It’s hard to tell, because huge debt is at the center of both. It’s what compels managers to streamline their businesses. It’s also the path to instant riches. The two are intertwined. Therein lies the source of much cynicism about business.
Americans don’t mind great riches when they seem justified by great accomplishments. Great entrepreneurs and managers are more admired than envied. But the connection between great wealth and great accomplishment seems murkier and murkier. Great fortunes often seem far removed from tangible advances with widespread social worth. The truth is that there is no automatic connection.
