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BARBARIANS AT THE GATE?

The buyout of RJR crystallized views on LBOs, the junk bond market, and the takeover business. For many it exemplified all that was wrong with finance in the 1980s, especially the willingness of БІАААмraidersБІАААн to carve up established companies, leaving them with enormous debt burdens, basically in order to get rich quick.

There was plenty of confusion, stupidity, and greed in the LBO business. Not all the people involved were nice. On the other hand, LBOs generated enormous increases in market value, and most of the gains went to selling stockholders, not raiders. For example, the biggest winners in the RJR Nabisco LBO were the company`s stockholders. We should therefore consider briefly where these gains may have come from before we try to pass judgment on LBOs. There are several possibilities.

The Junk Bond Markets. LBOs and debt-financed takeovers may have been driven by artificially cheap funding from the junk bond markets. With hindsight it seems that investors in junk bonds underestimated the risks of default. Default rates climbed painfully between 1989 and 1991. At the same time the junk bond market became much less liquid after the demise of Drexel Burnham Lambert, the chief market maker. Yields rose dramatically, and new issues dried up. Suddenly junk-financed LBOs seemed to disappear from the scene.13

Leverage and Taxes. As we explained earlier, borrowing money saves taxes. But taxes were not the main driving force behind LBOs. The value of interest tax shields was just not big enough to explain the observed gains in market value. Of course, if interest tax shields were the main motive for LBOs` high debt, then LBO managers would not be so concerned to pay off debt. We saw that this was one of the first tasks facing RJR Nabisco`s new management.

Other Stakeholders. It is possible that the gain to the selling stockholders is just someone else`s loss and that no value is generated overall. Therefore, we should look at the total gain to all investors in an LBO, not just the selling stockholders. Bondholders are the obvious losers. The debt they thought was well-secured may turn into junk when the borrower goes through an LBO. We noted how market prices of RJR Nabisco debt fell sharply when Ross Johnson`s first LBO offer was announced. But again, the value losses suffered by bondholders in LBOs are not nearly large enough to explain stockholder gains.

Leverage and Incentives. Managers and employees of LBOs work harder and often smarter. They have to generate cash to service the extra debt. Moreover, managers` personal fortunes are riding on the LBO`s success. They become owners rather than organization men or women.

It is hard to measure the payoff from better incentives, but there is some evidence of improved operating efficiency in LBOs. Kaplan, who studied 48 management buyouts between 1980 and 1986, found average increases in operating income of 24 percent over the following 3 years. Ratios of operating income and net cash flow to assets and sales increased dramatically. He observed cutbacks in capital expenditures but not in employment. Kaplan suggests that these operating changes БІАААмare due to improved incentives rather than layoffs or managerial exploitation of shareholders through inside information.БІАААн

Free Cash Flow. The free-cash-flow theory of takeovers is basically that mature firms with a surplus of cash will tend to waste it. This contrasts with standard finance theory, which says that firms with more cash than positive-NPV investment opportunities should give the cash back to investors through higher dividends or share repurchases. But we see firms like RJR Nabisco spending on corporate luxuries and questionable capital investments. One benefit of LBOs is to put such companies on a diet and force them to pay out cash to service debt.

The free-cash-flow theory predicts that mature, БІАААмcash cowБІАААн companies will be the most likely targets of LBOs. We can find many examples that fit the theory, including RJR Nabisco. The theory says that the gains in market value generated by LBOs are just the present values of the future cash flows that would otherwise have been frittered away.

We do not endorse the free-cash-flow theory as the sole explanation for LBOs. We have mentioned several other plausible rationales, and we suspect that most LBOs are driven by a mixture of motives. Nor do we say that all LBOs are beneficial. On the contrary, there are many mistakes and even soundly motivated LBOs can be dangerous, as the bankruptcies of Campeau, Revco, National Gypsum, and many other highly leveraged companies prove. However, we do take issue with those who portray LBOs simply as Wall Street barbarians breaking up the traditional strengths of corporate America. In many cases LBOs have generated true gains.

In the next section we sum up the long-run impact of mergers and acquisitions, including LBOs, in the United States economy. We warn you, however, that there are no neat answers. Our assessment has to be mixed and tentative.