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How LBOs Work

The proposed $17-billion management buyout of food and tobacco giant RJR Nabisco would by far be the biggest in a long line of corporate takeovers that have jolted American industry and financial markets throughout the 1980s.(Main stories, Part 1, Page 1.)

One-fourth of the companies on Forbes magazine’s 1987 roster of the 400 largest non-public U.S. companies had gone private through leveraged buyouts, or LBOs, since 1980. Among them are some of America’s best-known businesses: R. H. Macy, Levitz Furniture, Owens-Illinois, Borg-Warner, Burlington Industries and Levi Strauss, for example.

Private ownership shields companies from stock market pressures and allows them to maintain greater confidentiality about their operations. They may enjoy tax advantages and a freer hand in restructuring their operations as well. But a privately held company may find it hard to pump money into the business. After all, it can’t sell stock. Every buyout is different. But the primary elements of most are similar.

1. Two basic conditions may prompt a publicly held company’s management to consider taking the company private. Management decides that the stock market has not fully recognized the value of the company’s assets and sees an opportunity to buy the business for less than its real worth. Management decides that it is vulnerable to a takeover by someone else--a corporate raider or another company--and seeks to retain control by buying the company. 2. Management hires an investment banker to engineer a leveraged buyout of the firm--a purchase paid for with debt, typically high-yielding “junk bonds,” backed by the assets of the company. 3. The investment bankers structure the financing of the deal. They identify purchasers of the junk bonds--often investing in the deal themselves--or arrange for an array of backers, including major banks, insurance companies and pension plans. Top managers will retain a 10% to 20% share of the company for themselves. At the same time, the bankers and management develop a business plan for the company they plan to buy out. The plan must generate enough income--through sales of parts of the business, manpower reductions, streamlined operations or company growth--to pay off within a few years a large portion of the massive debt created by the buyout. 4. The company announces a tender offer, inviting stockholders to sell their shares back to the firm. To encourage sales, the price will be higher than the shares’ current price on the stock market. But management will try to keep the price as low as it can to moderate the cost of the buyout. It is at this stage, too, that competing bidders may surface, trying to wrest control of the business from management. 5. Management and its lenders now own the firm. But they must set about reducing the debt. Subsidiaries and divisions may be sold. Units may be spun off as independent, publicly held companies. The company probably will be streamlined--jobs eliminated, costs cut, programs canceled. Alternatively, the company may set out on a growth program if the business plan called for expansion to generate income. 6. One to five years after going private, management is ready to “exit” the leveraged buyout. If its program was successful, the debt has been reduced and the company’s value will be much higher than when the firm went private. The value of managers’ ownership interest will have grown anywhere from 20% to 100%. There are several exit routes available. Management can merge the company or sell it to another firm. Management can undertake another leveraged buyout, paying investors with the money borrowed in the new deal and further restructuring the company. Management can sell stock and take the firm public again, hoping the market will recognize that the stock now is worth more than it was before the buyout. Sources: Gary L. Wedbush, Wedbush Securities, and Frederic M. Roberts, F. M. Roberts & Co., both of Los Angeles.

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