Cutting Back on Leveraged Buyouts
The leveraged buyout of RJR Nabisco was a landmark in U.S. finance. The price tag of $25 billion, to be paid mostly in cash, made it by far the largest corporate takeover, a record that may last a long time. The attention the deal has attracted renews interest in three questions that have been raised by the LBO craze. Can our corporate system tolerate chief executives who self deal, maximizing their own profits rather than the profits of the shareholders they purportedly represent? How can the market value of a firm before a buyout be so different from its value in a buyout? Should Washington be concerned about the leveraged buyouts and act to stop or hinder them?
Before the first buyout bid, RJR Nabisco was trading at about $55 a share for a total market value of $12.5 billion. The initial buyout bid of $17 billion came from a group headed by the company’s president, F. Ross Johnson, who subsequently upped his offer to $25 billion in an unsuccessful attempt to compete with two rival bidders. Thus, Johnson appears initially to have tried to buy the company from his own shareholders for at least $8 billion less than he thought it was worth. Because the stockholders stood tomake a good profit even on Johnson’s initial bid, they are not in any uproar over these maneuverings. But something has gone awry in the relation between management and shareholders when the CEO can attempt a buyout at what he believes to be far less than full value.
This leads to the second question, which is why the market value of a firm as it trades on the stock exchange can be so far below what it is worth as a buyout. One important reason has to do with tax savings. The $25-billion purchase of RJR Nabisco will be funded mainly through new debt, including $13.3 billion of loans from a consortium of banks and $5 billion in high-yielding “junk bonds.” The plan is to retire up to half of the bank debt by selling off parts of the company, leaving the tobacco business and some other pieces to meet interest payments on the remaining debt. The tax saving arises because interest payments will wipe out future profit and tax liabilities and will generate rebates of taxes paid in earlier years.
Another reason is that the parts of the company to be sold are expected to bring more than the market’s implicit valuation of those parts before the buyout. Presumably, the parts are sold to a firm that thereby gains market access that fits well with its other activities. Finally, it is possible that the new owners may institute economies and efficiencies to enhance the profitability of the firm’s remaining operations.
But even if all these elements are present in a deal, they do not explain why the firm did not take the same steps in the absence of the buyout. If F. Ross Johnson planned to institute these changes once the company was his, why did he not institute them for his stockholders? And if the potential for such changes is there, why have only a small fraction of companies pursued it? The answer may simply be inertia, which is now being overcome. It may be that an increasing percentage of firms will be financially restructured, partly dismantled and streamlined so as to enhance their total value to shareholders.
Which brings up the policy issue. On what grounds should the government care about LBOs and try to impede them? For one thing, as a firm substitutes debt for equity in an LBO, the government pays for part of the increase in the value of the firm’s stock through the tax revenues that it loses. For another, greater leverage substantially raises the bankruptcy risk of a firm if its sales decline or interest rates rise sharply.
Those who made a lot of money on the deal itself would not be hurt. But the lenders who financed it would find they had been too optimistic about the firm’s prospects.
One could still argue that bankruptcy is a problem for the firm and those that lend it money, and not for the government. But if bankruptcies rise many fold in the next recession, that may destabilize the economy further and make the recession much more severe than it otherwise would be. What is more, much of the money is lent by insured financial institutions, so the government has a stake in the outcome as the insurer.
Finally, an LBO alters a firm’s incentives and goals from longer term to near term because it must increase its immediate cash flows to service all the new debt. The government may oppose the LBO trend because it wants to lengthen corporate horizons so as to improve productivity and competitiveness through new investment, innovation and product planning, which have long gestation periods.
The public attention that the RJR Nabisco deal attracted increases the likelihood that Congress will work hard at this issue. But there is no consensus about what, if anything, should be changed. One possibility is to equalize the tax treatment of interest and dividend payments. Interest is an expense subtracted before arriving at taxable profits. Dividends are paid out of after-tax profits. However, it is difficult to see how this favored tax treatment of interest could be changed for just new debt used to finance leveraged buyouts of similar restructurings. And it would be ruinous to firms to change the tax treatment of all interest so as to put it on a par with dividends.
The alternative to equalize would permit firms to treat dividends as a cost, paying them out of pretax profits. However, this would cost a great deal of revenue by virtually eliminating the corporate tax. Not only would taxable profits be reduced by the present amount of dividends, but a firm would be able to adjust dividends each year so as to eliminate as much of taxable corporate profits as it wanted to, thus increasing the revenue loss further. Only retained earnings would be taxed, so firms would be under pressure to retain nothing.
By forcing firms to raise needed cash in capital markets rather than by retaining earnings, such a change in the treatment of dividends might, in one sense, improve the allocation of capital in the economy by subjecting all proposed uses of cash to market scrutiny.
But the transactions cost of continually needing to raise funds might well impede total investment and risk taking and, as with the creation of LBOs themselves, turn the focus of corporations away from the longer run.
Because it is not obvious what to do, Congress may end up doing nothing about leveraged buyouts and the like through taxation or direct interventions. It may be that Washington’s best handle will be through its regulatory authority over thrifts and banks. If the leveraging of U.S. business is to be contained, drying up the source of funds that has been fueling it may be the only effective weapon.
