Most investors would be thrilled to double their money in two or three years. But in the high-stakes game of leveraged buyouts, profits can be much, much bigger.
Take the case of William E. Simon. The former Treasury secretary invested about $330,000 in 1981 to buy a stake in Gibson Greetings through an LBO--a deal enabling him and other investors to acquire the greeting card company largely through borrowings and use the company’s profits and assets to pay off the debt.
Less than two years later, the value of that investment had risen to $70 million, 200 times his initial investment. Simon also made more than 100 times his money through another LBO involving Anchor Glass Container.
The potential for such hefty profits are a primary reason behind a proliferation of megabuck LBOs in recent months, capped Thursday when food giant RJR Nabisco’s management said it might propose a $17.6-billion buyout. The deal, if completed, would be the largest business transaction ever.
While not all managers, millionaire investors or institutions investing in LBOs have made Simon-sized profits, the average return, nonetheless, is in the range of 30% to 50% over two or three years, says Martin Sikora, editor of Mergers & Acquisitions magazine. Only a few LBOs lose money for investors, although a recession or sharply higher interest rates could result in many newer LBO deals going sour.
“Most of the deals work out well,” Sikora says.
The list of companies involved in successful LBOs has mushroomed since this takeover technique gained popularity in the early 1980s. The Harley-Davidson motorcycle firm, Avis car rental business, Beatrice food conglomerate, Owens-Illinois glass company, Dr Pepper soft-drink concern, Lear Siegler aerospace firm and Safeway Stores are among companies that have reaped, or are expected to reap, large LBO profits for certain investors.
At least six of Forbes magazine’s 400 richest Americans, including Simon, earned their fortunes principally through LBOs, with many others earning part of their riches through this device.
John W. Kluge, ranked second on the Forbes list, earned much of his $3.2 billion in net worth through a $1.3-billion buyout of Metromedia Broadcasting that he led in 1984. Kluge, chairman of Metromedia, then sold off the firm bit by bit, including seven television stations to Australian media baron Rupert Murdoch, amassing huge profits along the way.
New York financier Ronald O. Perelman (net worth $1 billion) earned his place on the list through LBOs of several firms, including Revlon and MacAndrews & Forbes Holdings.
Jerome S. Kohlberg Jr., Henry R. Kravis and George R. Roberts (each estimated at more than $330 million in net worth) earned their places through dozens of deals put together by Kohlberg, Kravis, Roberts, an investment firm they formed in 1976 that largely pioneered modern LBOs. The firm, responsible for many of the largest LBOs ever, is now said to hold a war chest of $5.6 billion ready to be invested in the deals.
Leonard I. Green and Theodore J. Forstmann, of the giant LBO firms of Gibbons, Green, Van Amerongen and Forstmann, Little & Co., respectively, also are said to have amassed major fortunes by investing in deals that they also managed.
Financed by Borrowing
The biggest beneficiaries of LBOs, however, are pension funds, foundations and endowments that take huge equity stakes in deals, says Douglas K. Le Bon, vice president of special investments at Wilshire Associates, a Santa Monica investment advisory firm. Big winners include the public pension funds of the states of New York, Michigan, Minnesota, Oregon, Washington, Iowa and Massachusetts, Le Bon says.
How has so much money been made in LBOs?
To buy their companies’ stock through LBOs, managements and outside investors typically put up some of their own money but borrow far more. Typically, about 10 times more money is borrowed than put up by the investors--meaning that they can acquire $100 million of stock using only about $10 million of their own funds.
The idea is to pay back the debt using profits from operations or proceeds from sales of assets. Then, after paying off much of the debt and improving the company’s performance--the management and investors sell stock back to public investors, with the idea of getting far more than they paid to buy the stock originally.
The big profits can be made through any of several ways.
First, managements or investors may buy the firm at a stock price that--while a premium over the prevailing price at the time--is still far less than the real worth of the firm. They may, for example, have inside knowledge of the true value of assets or products that is not known by existing shareholders or outsiders. “Managements don’t always tell the board all the things going on,” says one LBO expert.
At Harley-Davidson, top executives and investors who took the firm private in 1981 for 25 cents a share sold shares to the public in 1986 for $11 a share.
Some experts even contend that some managements have depressed their firms’ earnings--possibly by making higher-than-normal capital expenditures, taking writeoffs or using other accounting methods--just before launching LBOs. Such lower earnings depress the stock price, allowing the management or investors to pay a lower price to acquire the firm through the LBO.
Managements and investors also have profited by laying off workers, cutting management layers, closing factories, cutting corporate jets and other perks, selling assets, achieving greater efficiencies.
In some cases, however, managements acquire other firms to expand. At Owens-Illinois, taken private in a $3.6-billion deal in 1987, management this year acquired a major competitor, Brockway Inc., increasing earnings and boosting economies of scale.
Managements also may work harder, given their high ownership stakes. And having their companies private means they don’t have to worry about keeping quarterly earnings high for the sake of shareholders, and thus can manage more for the long term.
Companies taken private through LBOs also benefit from tax breaks enabling them to write off interest expenses on the huge debt.
And managements and investors have simply gained through a stronger economy and lower interest rates, says James Van Horne, a finance professor at Stanford University. Indeed, some of the most profitable LBOs, such as Simon’s, were launched in the early 1980s when the economy was in recession and interest rates were high, Van Horne says. Managements and investors thus bought stocks for cheap, and later refinanced borrowings at lower interest rates.
Sometimes all of these factors came together. Such was the case of Anchor Glass, which Simon helped acquire in 1983 through an LBO put together by his Wesray Capital Corp. investment firm. Managers cut the work force, slashed expenses and made a successful acquisition. Simon also was willing to take on much more debt than average, giving it bigger risks but bigger bang for his buck. Shares that Simon had acquired for 19 cents apiece were sold to the public at $20.50 a share in 1986.
“He had a good sense of timing,” says one LBO expert.
But not all LBOs have been winners. In one recent case, Revco, a Midwestern drug chain that went private in a $1.3-billion LBO in 1986, filed for bankruptcy protection earlier this year following troubles in making payments on its huge debt.