Leveraged Buyouts

A leveraged buyout (LBO) is an acquisition strategy whereby a company is purchased by another company (typically an investment firm) using borrowed money (bonds or loan). LBOs have played an important role in the restructuring of corporate America in the 1980s.

In numerous cases, LBOs have been used by managers to buy out shareholders (a process then called MBO, management buyout) to gain control over the company (both ownership and decision making), which raises ethical problems of conflicts of interest.

Of the many firms associated with LBOs (such as The Carlyle Group, The Blackstone Group, Forstmann Little & Company, Hicks, Muse, Tate & Furst), the New York City–based private equity firm Kohlberg Kravis Roberts & Co (KKR) is the most well known for two reasons: First, KKR pioneered the LBO approach to buyouts, and second, the most famous LBO in American history was the takeover of RJR Nabisco by KKR in 1988 (for the record amount of $25 billion). The story was later chronicled and popularized in a 1990 book by award-winning journalists Bryan Burrough and John Helyar (Barbarians at the Gate: The Fall of RJR Nabisco) and in a 1993 film (starring James Garner), which introduced many readers and viewers to the world of hostile takeovers and financial speculations in corporate America.

Empirical evidence shows that many LBOs, like other types of buyouts, have resulted in significant improvements in firms' performance (using a range of indicators from cash flow to return on investment), which can be explained by a combination of factors including tax benefits, strengthened management, internal reorganization, and change in corporate culture. On the other hand, LBOs, because of the leverage [Page 1284]aspect, are controversial because they may cause disruptions and economic hardship in the company purchased: Its assets serve as collateral for the borrowed money, the purchasing company (often a holding whose only purpose is corporate ownership and control) intending to repay the loan by using the future profits and cash flows from the purchased company or, failing that, by selling its assets (i.e., dismantling the company). Besides, LBOs have represented a moral hazard: In the context of the savings and loan debacle of the 1980s, their investors' gains (through junk bonds) were eventually paid by taxpayers. LBOs also raise further issues of ethics, notably about conflicts of interest between managers or acquirers and shareholders, insider trading, stockholders' welfare, excessive fees to intermediaries, and squeeze-outs of minority shareholders (who may well receive a good price for their shares, an average of 30% to 40% more than the market price, but do not eventually benefit from the massive financial rewards of shrewd postbuyout strategies).

The use of LBOs started to decline in the late 1980s for two reasons: First, companies started to develop preventive strategies and defensive tactics (with “poison pills” meant to deter hostile bids, typically giving current shareholders particular rights to buy additional shares or to sell shares with severe economic penalties on the hostile LBO acquirer); second, changes in the legislation made such takeovers more difficult (e.g., with Delaware's merger moratorium law or Ohio's control share acquisition law). The rise of litigations against leveraged bids (for instance with allegations of violations of antitrust and securities laws) also contributed to the dearth of LBOs. At the start of the 21st century, there have been some LBOs again, especially in the hightechnology sector, with cable and software companies becoming the targets of private equity firms; if some scholars and specialists predict a new wave of LBOs, it is nonetheless unlikely to be accompanied by the greed and aggressiveness of the 1980s.

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