Don't Stop All Leveraged Buyouts: Just Some
LEVERAGED buyouts have been a hot topic in the financial press since their size and number multiplied in recent years. The debate on LBOs, a takeover mechanism whereby a group of investors buys a publicly owned corporation with the use of borrowed funds, is dominated by two polar alternatives. One says LBOs promote a more efficient and competitive economy. Therefore they should be encouraged. The other position is that LBOs are an invention of shrewd lawyers and wheeler-dealers and should be prohibited or at least made much more difficult.
But a third and less dramatic view takes into account the fact that there are two kinds of LBOs - arm's length LBOs and management-initiated LBOs.
Most LBOs, especially the smaller ones, are of the arm's-length variety. They involve a corporation's selling off a division to private investors. In more than 70 percent of the LBOs recorded between 1984 and 1987, this was the case.
Usually a competitive process is used, such as hiring an investment banking firm to solicit bids from potential buyers. The division's management may be one of the bidders. Thus there is a separation of the people bidding for the unit and the people representing the existing owners.
There is considerable evidence attesting to improvements that occur following such a change in ownership. The new management reduces the high overhead and reporting requirements imposed on operating divisions of large enterprises.
Moreover, collapsing the many layers of management between an operating division with annual sales of $20 million and the headquarters of a $10 billion-a-year corporation speeds up the decisionmaking process. That enables the newly independent enterprise to respond to opportunities foreclosed to the larger firm.
The prospective owners, though, may not have adequate financing to acquire the unit without substantial leverage (i.e., borrowing). Indeed, given the tax advantages of debt over equity, there is a powerful incentive to minimize the capital they bring to the new firm.
The second category of LBOs, usually involving larger companies, is a striking contrast. Typically, the company's management together with outside investors buy out the shareholders of a public company - and ``go private.'' The conflict of interest is fundamental. The same people who are paid to work for the shareholders represent their own personal interest.
Some contend that LBOs are necessary to provide more incentives for management to make tough decisions. But if a $1 million-a-year executive (with all sorts of stock options and fringe benefits) does not have adequate incentive to make the difficult choices required to enhance shareholder value, the answer is obvious: Fire the lazy, greedy executive. As for the desire to free management of controls imposed by the externally elected board of directors, this board member can only respond that the typical corporate board operates with a very light touch.
In any event, LBOs constitute a dynamic sector of a growth industry. In 1981, 99 leveraged buyouts were reported, with a total value of $3.1 billion - or less than 4 percent of the aggregate value of mergers and acquisitions for the year. In 1987, the 259 LBOs were valued at $35.6 billion, or almost 22 percent of the total. In part because of the gigantic leveraged buyout of RJR Nabisco, LBOs in 1988 may have exceeded $60 billion.
The most desirable policy response is to focus on the aspect of existing public policy that gives rise to LBOs. That is the double taxation of dividends, which provides a powerful incentive for debt over equity.
It is silly to berate business executives who respond to the status quo by adopting forms of organization that make the most of it. The sensible answer is to eliminate the preference for debt by doing away with the discriminatory treatment of dividends in our tax system. But the large budget deficits make that most unlikely at this time.
THUS, I urge the Securities and Exchange Commission to refocus its efforts on curbing the use of ``insider information.'' I am referring to the use of special company information by managements that initiate LBOs. That ``inside'' information allows them to buy the shares of their own companies at lower prices than they would have to if the owners - and other bidders - were privy to the same knowledge.
The SEC should presume that improper use of insider information exists anytime the management of a company offers to buy out the existing shareholders. That would put a crimp in management-initiated LBOs, without interfering with the very proper and useful arm's-length LBOs.