From J.P. Morgan to RJR, Congress Lags Behind LBOs

Almost everyone knows that the recent leveraged buyout of RJR Nabisco Inc. by the investment firm of Kohlberg, Kravis, Roberts, valued at about $25 billion, is the biggest business deal in history.

Fewer people know that the deal it beat out for first place happened 87 years ago, when J. Pierpont Morgan emerged from a series of titanic confrontations with Carnegie, Harriman and Rockefeller interests to take total control of U.S. Steel Co., an enormous national conglomerate of steel mills, coal mines and shipping and railroad lines--the biggest company in the history of the world.

Morgan, he of the massive silences, towering rages and sudden tears, whose associates all “made liberal profits, toiled madly and died young,” put together his U.S. Steel deal with $1.4 billion (about $23 billion in today’s dollars) in preferred stock, common shares, 60-year mortgage bonds and a bewildering variety of other instruments. The total face value of the company’s paper was far in excess of its visible assets--”pure water,” the financial press sniffed.

Morgan’s deal would still be the biggest in history, in fact, if Andrew Carnegie had not agreed to a price so quickly, for Morgan was willing to pay much more. The purchasers of Morgan’s “watered” paper--the term “junk bond” had not been invented yet--eventually all made large profits on the deal.

Leveraged buyouts, or “LBOs,” have been around a long time. “Leverage” is Wall Street jargon for debt. In a typical LBO, investors put up about 15% of the cash for the deal and borrow the rest. Banks lend about half the debt and usually hold a mortgage on all or most of the company’s assets. The rest comes from insurance companies, mutual funds and other big players who buy the “junk bonds”--bonds that pay a high rate of interest but little security beyond the hope of the company’s success.

The jargon has changed since Morgan’s day but the principles of leveraged takeovers are much the same. Much else has not changed. Morgan exaggerated the benefits from his activities, just as today’s deal makers do, and the financial press exaggerated the dangers, just as they do today.

There have been several distinct phases of the 1980s buyout boom. The first deals, beginning about 1982, were pure asset plays. Stock market prices were low--the Dow Jones industrial average had been virtually unchanged for 15 years. The stock price of oil companies, for example, was typically much lower than the value of the oil they owned. It was inevitable that canny entrepreneurs, such as T. Boone Pickens, would realize they could borrow money, buy the stock, then sell the oil to pay off the loan.

The second round of LBOs focused on company cash flows. Partly because the tax code makes interest payments deductible, a company often threw off enough cash to handle a burden of debt considerably higher than the total price of its stock. It made sense for managers to team with an investment bank to borrow the money to buy out their own company. A company’s own managers were arguably in a better position to estimate their long-run cash flows than the public markets, particularly since they knew better than anyone which layers of bureaucracy to cut to improve earnings.

By the mid-1980s, LBOs were a full-fledged Wall Street industry. A small group of highly specialized buyout firms--like Kohlberg, Kravis, Roberts--organized the deals. Banks set up LBO lending departments. Drexel Burnham Lambert’s Michael Milken and a host of imitators created a market for the junk bonds. Insurance companies and mutual funds organized specialized portfolios to invest in junk bonds, and the major Japanese financial houses set aside large amounts of capital for LBOs.

Financial markets are dimwitted and slow-moving, and it took about five years for stock prices to move toward some approximation of companies’ LBO values. (Slow-footed creatures often have trouble stopping as well--hence the 1987 crash.)

Higher stock prices, of course, make good deals harder to find. A scarcity of deals, the large amounts of capital looking for LBOs and the big fee opportunities for deal makers--Kohlberg Kravis reportedly made $75 million in fees on RJR Nabisco--intensifies the LBO competition.

A number of recent transactions, like RJR Nabisco itself, and Robert Campeau’s purchase of Federated Department Stores, appear to be so high-priced that they leave little margin for error--hence the sudden worries that overleveraged corporate America is heading for a crash. The worries, while not groundless, are usually exaggerated.

In the first place, while corporate debt has risen sharply in the 1980s, debt service still consumes only about 20% of corporate cash flows, a readily sustainable level. Some individual overleveraged companies may be heading for trouble, of course, but the overall data are not alarming.

LBO investors, in addition, are big boys; mom and pop are not in the market at all. The high rates of interest on junk bonds reflect the probability of an LBO getting into trouble, and most investors have staying power to wait out bad patches. Junk bonds are really a new form of stock with a high current pay-out as long as a company is successful.

Moreover, there is no doubt that LBOs and the threat of LBOs have been debureaucratizing big companies. Multiple layers of management, the corporate jets, the soccer-field offices, the company artwork, are all being sacrificed to produce cash. In that sense, LBOs are a form of owner revolt. Because of the sorry record of U.S. big-company management, stockholders and bondholders want company earnings paid out directly; they will decide for themselves how to reinvest.

Finally, LBOs do not “consume capital.” Money paid out in debt service or to buy junk bonds doesn’t disappear down black holes. It simply changes hands, and the new holders can reinvest it as they please.

There are legitimate worries. Federal Reserve Chairman Alan Greenspan is rightly concerned about heavy bank lending to LBOs. Banks play a key role in our monetary system. When they get in trouble, as Continental Illinois National Bank & Trust Co. did during the oil-lending fad, or as many others did during the Third World lending fad, they run to the government for help. Some limits on LBO portfolios would seem prudent.

Investment banks often take large risks relative to their capital when they “bridge” LBO deals. Typically, a group of investment banks will buy all the junk bonds to sell them out to investors later. A big deal that turned sour during the bridge period could put some investment banks under water and cause a thrombosis in the financial markets.

Finally, there is the persistent worry that the cruel cash discipline in LBO companies will reduce productive investment and research. The evidence, in fact, is mixed--although a recent National Science Foundation study found that LBO companies, on average, spend much less on R&D; than their peers.

LBOs were an outgrowth of the low stock prices and low investor opinion of corporate management in the early 1980s. The high prices of recent deals suggest that the fad has probably run its course. The political instinct to rush in and regulate usually comes at the last stages of a financial cycle--too late, that is, to cause much harm or do much good.