Barbarians at the Gate
Gabriel Chen
Leveraged buyouts (LBOs), as described in “Barbarians at the Gate,” are debt-financed transactions (typically via bank loans and bonds) aimed at taking a public corporation private. While the Internal Revenue Code, which made interest but not dividends deductible from taxable income, was instrumental in getting LBOs off the ground, the prevalence of junk bonds led to the LBO boom of the 1980s. One of the major events that received widespread publicity concerned the substantial profits generated in the Gibson Greeting Cards transaction. The company was first taken private in 1982 and taken public again a year and a half later (p.140). Without significant changes in the company - although benefiting from the bull market which began in 1982 - the going public price eighteen months thereafter was $290 million. With junk bonds, which were primarily used as a substitute for bank debt for various firms, LBO buyers were able to mount split-second tender offers of their own for the first time (p.141). Measured by the total sales of acquired companies, “the LBO phenomenon increased tenfold between 1979 and 1983” (p.140). Substantial returns on investment turned LBOs into one of the most lucrative investment ideas of the 1980's, attracting many participants, including banks, insurance companies, Wall Street firms, pension funds, and wealthy individuals.
Ross Johnson underestimated the importance of the initial offer. Johnson and his management group, worried by the fact that their stock was undervalued at $55 a share, proposed an LBO at $75 to the company’s board of directors. His decision to put the company in play based on frustration about how flat tobacco sales were dragging down RJR’s share price looks frivolous in retrospect. Unswayed by Johnson’s veiled bribe – an offer of post-LBO directorship seats and the opportunity to watch their own stock holdings grow as much as four-fold – members of an independent board appointed to evaluate the offer issued a press release instead of keeping the deal quiet until the last moment. If Johnson had proposed an LBO at a higher price, the outcome could have been very different. It might be that Johnson was unwilling to incur such a large debt requiring wholesale cuts of the kind he dreaded, i.e. the planes and the Atlanta headquarters would have to be reassessed. However, not a single valuation put RJR’s value below $80 a share; most were in fact closer to $90 (p.209). Johnson’s own people even said the company was worth $82 to $111 (p.210).
Johnson’s mistake was replicated by Larry Ellison when the Oracle CEO announced a $16 a share offer for PeopleSoft on June 6th this year, just four days after PeopleSoft said it would buy J.D. Edwards, a smaller rival. The low share offer led to PeopleSoft’s boss Craig Conway saying he “could imagine no price or combination of price and other conditions to recommend accepting the offer” (The Economist, Jun 26 2003). Ellison raised his bid to $19.50 on June 18th. By early September, PeopleSoft’s shares had climbed above Oracle’s greatest offer of $19.50 a share. Oracle ignored the news, but it is the rare takeover that is consummated when the bidder offers a lower price than the company trading at. A few weeks ago, PeopleSoft, benefiting from its July acquisition of J.D. Edwards, announced its “third-quarter earnings and revenue will top its prior targets” (AFX News Limited). This would invariably make Ellison’s $19.50-a-share takeover bid more difficult and possibly more costly.
Johnson’s key mistake, it appeared, was to rely on Shearson Lehman Hutton and Salomon Bros. to support his initial bid. Both firms were badly hurt after the 1987 stock market crash, and neither had much experience in management-led leveraged buy-outs. Johnson’s competitors were KKR and Drexel, the biggest players in so-called leveraged buy-outs and junk finance respectively. Yet, firms nowadays tend to be judicious about their choice of partners. Corporations want to link up with private equity firms with expertise in niche areas. This was seen in Pearson’s acquisition of Simon & Schuster, the United States publisher put up for sale by Viacom in 1998. Leveraged buyout firm Hicks Muse Tate & Furst hooked up with Pearson, the United Kingdom company that owns the Financial Times, to present a joint bid. Pearson agreed to pay $4.6bn to Viacom but as part of its bid, agreed to sell parts of the business on to Hicks Muse for $1bn (Lewis, June 5 1998). This was a significant coup for Pearson and Hicks Muse given the intense competition (the two other bidders were KKR and junk-bond king Michael Milken’s Knowledge Universe). It is not surprising that Pearson linked up with Hicks Muse. Hicks Muse had supplanted KKR as the top LBO financer of 1997 (Hurt III, p.1). As a powerful force in television broadcasting and the owner of the nation’s largest radio station chain, Hicks Muse’s preeminent position pushed it into the fore as Pearson’s choice partner in this media industry acquisition.
However, not all mistakes made by key corporate players in “Barbarians” in the late 1980s have been replicated by other executives during the early part of this century. The nature of the game has changed. While Ted Forstmann was concerned that “the entire LBO industry had become the province of quick-buck artists,” the LBO wave today is now gentler and kinder, as shareholders are unlikely to put up with this kind of slash-and-sell behavior that defined the LBO scene of the 1980s (p.233). In addition, some buyout firms have shifted their focus from quick turnarounds to longer-term endeavors. Most LBO firms in the 1980s leveraged relatively small amounts of capital with large bank loans or junk bond borrowings to buy companies. Hicks Muse, on the other hand, gets its money from pension funds and other institutional investors, and use it to buy controlling stakes in companies. It has a “buy and build” philosophy, “holding on to its acquisitions for at least two to three years and sometimes for as long as seven to 10 years,” until the company has turned around and can be sold for a high return (Hurt III, p.2).
Perhaps, RJR Nabisco epitomized the spate of takeovers and the LBOs of the past, where firms used mountains of debt to buy public companies in hotly contested deals, took them private and then ruthlessly cut costs to make them profitable. These days, hostile takeovers seem to be less prevalent, as more buyouts are management-led. To the extent that “LBO shops are invited guests,” sellers are thrilled to do deals with them and “managers consider the stock market more punishing than going private under a new owner” (Thornton, p.121). Indubitably, many of today’s buy-out opportunities have arisen out of the hangover from the investment boom of the 1990s and the world economic downturn. Firms in a host of distressed industries are looking to dispose of non-core businesses. Last year, for example, saw the biggest LBO since RJR, “the $7 billion purchase in August by two firms of QwestDex, the yellow-pages subsidiary of Qwest, an American telecoms firm in difficulties” (The Economist, July 5 2003).
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