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LEVERAGED BUYOUTS

Sometimes a group of investors takes over a firm by means of a leveraged buyout, or LBO. The LBO group takes the firm private and its shares no longer trade in the securities markets. Usually a considerable proportion of LBO financing is borrowed, hence the term leveraged buyout.

If the investor group is led by the management of the firm, the takeover is called a management buyout, or MBO. In this case, the firm`s managers actually buy the firm from the shareholders and continue to run it. They become owner- managers. We will discuss LBOs and MBOs later.

METHOD 4: DIVESTITURES AND SPIN-OFFS

Firms not only acquire businesses; they also sell them. Divestitures are part of the market for corporate control. In recent years the number of divestitures has been about half the number of mergers.

Instead of selling a business to another firm, companies may spin off the business by separating it from the parent firm and distributing stock in the newly independent company to the shareholders of the parent company. For example, in 1996, AT&T was split into four separate firms: AT&T continued to operate telecommunication services, Lucent took responsibility for telecommunication equipment manufacturing, NCR took on the computer business, and AT&T Capital, which handled leasing, was spun off and sold to another firm. Instead of holding shares in one megafirm, AT&T`s shareholders were given shares in Lucent and NCR as well as AT&T. Investors clearly welcomed this move: when the announcement of the split was made in 1995, AT&T`s shares jumped 11 percent.

Probably the most frequent motive for spin-offs is improved efficiency. Companies sometimes refer to a business as being a ¬poor fit. ­ By spinning off a poor fit, the management of the parent company can concentrate on its main activity. If each business must stand on its own feet, there is no risk that funds will be siphoned off from one in order to support unprofitable investments in the other. Moreover, if the two parts of the business are independent, it is easy to see the value of each and to reward managers accordingly.

Sensible Motives for Mergers

We now look more closely at mergers and acquisitions and consider when they do and do not make sense. Mergers are often categorized as horizontal, vertical, or conglomerate. A horizontal merger is one that takes place between two firms in the same line of business; the merged firms are former competitors. Most of the mergers around the turn of the twentieth century were of this type. Recent examples of horizontal mergers have occurred in banking, such as the merger between Deutsche Bank and Bankers Trust, and in oil, such as the merger between Exxon and Mobil.

A horizontal merger can be blocked if it would be anticompetitive or create too much market power. The Mobil and Exxon merger was challenged, but it was finally consummated after the two companies agreed to sell a number of service stations to other retailers.

During the 1920s, vertical mergers were predominant. A vertical merger is one in which the buyer expands backward toward the source of raw material or forward in the direction of the ultimate consumer. Thus a soft drink manufacturer might buy a sugar producer (expanding backward) or a fast-food chain as an outlet for its product (expanding forward). Pepsi owns BurgerKing, for example.

A conglomerate merger involves companies in unrelated lines of business. For example, before it went belly up in 1999, the Korean conglomerate, Daewoo, had nearly 400 different subsidiaries and 150,000 employees. It built ships in Korea, manufactured microwaves in France, TVs in Mexico, cars in Poland, fertilizers in Vietnam, and managed hotels in China and a bank in Hungary. No U.S. company is as diversified as Daewoo, but in the 1960s and 1970s it was common in the United States for unrelated businesses to merge. However, the number of conglomerate mergers declined in the 1980s.

In fact much of the action in the 1980s came from breaking up the conglomerates that had been formed 10 to 20 years earlier.

We have already seen that one motive for a merger is to replace the existing management team. If this motive is important, one would expect that poorly performing firms would tend to be targets for acquisition; this seems to be the case.3 However, firms also acquire other firms for reasons that have nothing to do with inadequate management. Many mergers and acquisitions are motivated by possible gains in efficiency from combining operations. These mergers create synergies. By this we mean that the two firms are worth more together than apart.

A merger adds value only if synergies, better management, or other changes make the two firms worth more together than apart.

It would be convenient if we could say that certain types of mergers are usually successful and other types fail. Unfortunately, there are no such simple generalizations. Many mergers that appear to make sense nevertheless fail because managers cannot handle the complex task of integrating two firms with different production processes, accounting methods, and corporate cultures. Moreover, the value of most businesses depends on human assets ¤ managers, skilled workers, scientists, and engineers. If these people are not happy in their new roles in the acquiring firm, the best of them will leave. Beware of paying too much for assets that go down in the elevator and out to the parking lot at the close of each business day. With this caveat in mind, we will now consider possible sources of synergy.

TENDER OFFER Takeover attempt in which outsiders directly offer to buy the stock of the firm`s shareholders.

ACQUISITION Takeover of a firm by purchase of that firm`s common stock or assets.

LEVERAGED BUYOUT (LBO) Acquisition of the firm by a private group using substantial borrowed funds.

MANAGEMENT BUYOUT (MBO) Acquisition of the firm by its own management in a leveraged buyout.