The Leveraged Buyout Boom
It was too perfect a symbol, too convenient a metaphor to slip into the first paragraph of a story about leveraged buyouts, but there it was, sitting on the top of Leonard Shaykin's desk: a croupier's stick -- that long, graceful object with the slightly curved tip that croupiers use to maneuver gambling chips. Lacking a pointer at a speech he had given, Shaykin had improvised with the stick, which he had found in the bottom of a closet. Since then he has kept it in his office.
Now the stick was in his hand, punctuating his remarks about leveraged buyouts, or LBOs The principal purpose of the capital-raising technique, he was saying, was to maximize the number of chips while significantly reducing the risks.
"In a leveraged buyout," Shaykin explains for perhaps the dozenth time that week, "we take a financial risk, but, hopefully, not a business risk." Shaykin, who had set up Citicorp's leveraged buyout unit before joining with venture capitalist Fred Adler to form Adler & Shaykin (a partnership that is raising $100 million to do LBOs), has been talking about leveraged buyouts a lot recently. The LBO has become a phenomenon, a device whose popularity is attested to by everything short of buttons and bumper stickers.
Every other day, it seems, The New York Times or The Wall Street Journal reports on another LBO development -- the bidding war over Norton Simon Inc.; the purchase of the McCulloch Corp. by an investment group headed by McCulloch president Donald V. Marchese; the creation of LBO units by E. F. Hutton Group Inc. and Oppenheimer & Co. The New York Times observed, parenthetically, that in an LBO, "a management group puts up a relatively small amount of money and uses the company and its assets as collateral to borrow a relatively large sum to buy the outstanding equity.
"There's still a need to explain what LBOs are," notes Shaykin, "but that's changing quickly."
Specifically, LBOs are transactions in which buyers borrow against a company's assets at extraordinarily high debt-to-equity ratios, sometimes as high as 12-to-1. LBOs also happen to be one of the hottest items to hit the business and investment communities in nearly a decade W T. Grimm & Co., a Chicago-based merger broker that tracks management buyouts (the purchase of a company by memters of the management team), many of which are highly leveraged, reports that the number of management deals has more than doubled since 1980, while the size of the average deal has shot from $24 million to more than $33 million during the same period. The Merrill Lynch White Weld Capital Markets Group, which has itself invested around $30 million in LBOs, has tracked a 116% increase in LBO activity since 1979, and believes that the volume will be up significantly this year. "As much as 20% of all the acquisitions done this year," claims James J. Burke Jr., of Merrill Lynch's LBO team, "will be financed as leveraged buyouts." Shaykin expects that number to eventually approach 50%.
Shaykin, 39, a tall, trim man who refers to himself as "the better-looking half" of Adler & Shaykin, compares the situation to the one that prevailed in venture capital in the early '70s, when that industry was still finding itself. "I remember having a series of discussions back then," he recalls. "We were all relatively young, and we'd been making investments and doing all of the right things, but we weren't making any money -- and venture capital began to look fragile. If Federal Express, which had tied up $70 million of the total venture capital pool, had failed, it could have seriously affected the shape and direction of the entire venture capital industry. And the question we were asking was, 'Is this really a business, or are we just a group of smart young men making a mistake?' "
In the case of LBOs, that question has already been answered. "It is a business," says Shaykin, who, during his four years at Citicorp, oversaw the investment of $30 million in 12 transactions. During the same period of time, between 1978 and '82, the LBO market has shot to between $4 billion and $5 billion a year, more than twice the size of the venture capital market.
"There's an opportunity now to raise pools of capital and invest in these transactions before it becomes as fashionable as venture capital currently is," says John J. Murphy, a partner at A&S.
If Shaykin's experience is any indication, LBOs are about to explode. A partnership formed in February of this year, A&S attracted more than $50 million in its first eight weeks of fund raising, and transformed Shaykin's normally methodical routine into "one crazy . . . life." "We're being approached by investment bankers who want to bring us transactions," he explains "by lenders, by attorneys, by companies that want to be sold. . ." The croupier's stick taps against the palm of his hand as Shaykin counts off all of the players that want into the LBO game.
Why LBOs? Why LBOs now? The explanations are as numerous as the deals. They were triggered by inflation, with buyers hoping to pay off the debt in ever-cheaper dollars from sales that were inflating at double-digit rates, they were created by the banking community's desire to lend money at above-prime rates; they were sparked by "deconglomerization," the increased spinoff of divisions by U.S. corporations (see INC., February, page 41); they were fueled by changes in Federal Reserve regulations two years ago, which enabled investment banks to arrange financing for the acquisition of stock in public companies. But Shaykin sees something simpler at work. "I don't think it's inflation-driven, or economy-driven, or interest-rate-driven," he says. "I think it's really driven by the American dream -- the desire of management to own a piece of the company they're running, to control their own destinies. . . It has to do with the entrepreneurial spirit."
Adler, best known for his role in the founding of Data General Corp. and Lexidata Corp., agrees. "I really don't even like the phrase 'leveraged buyout,' " he says, "To me, the key phrase is 'management buyout,' because management is what these deals are really all about."
In fact, LBOs are used to achieve a number of ends: to take a public company private, to buy a division shed by a corporation, or to satisfy the needs of a founder who is selling a privately held company and is concerned about liquidity.
In the first case, explains Shaykin, an otherwise solid company may be out of favor in the public market, resulting in low prices and possibly inviting takeovers by "the sharks that swim in the water." Or, the company may feel that it needs to make strategic changes that won't sit well with stockholders. "Does it allow itself to be taken over or to make the wrong decision, or does it say, 'We have to maintain control . . . by going private?' "
An LBO snatched the Signode Corp. from the jaws of financial wheeler-dealer Victor Posner. Another, engineered by Citicorp vice-president David Thomas, resolved a major dilemma for the Devon C roup Inc., a Stamford, Conn.-based company with graphic-arts and wine-distributing interests. "We were traded on the American Stock Exchange and had about 1 million shares outstanding," says Devon president Marne Obernauer Jr., "but no more than 300,000 to 350,000 could have been actively traded." Institutional investors were uninterested, and the research community didn't bother following the stock. As a result, outside shareholders saw few benefits. "We couldn't get up any momentum," Obernauer concedes.
The solution was a $50 million buyout by company management, subordinated debt holders, and Citicorp (which took an equity position) that gave stockholders double the market value -- $28 for stock that had been trading at about $14 one month before the deal was announced -- and freed Devon from its public responsibilities and concerns.
"[The buyout] took care of a very difficult problem for stockholders," notes Obernauer.
The second scenario, involving the purchase of a corporate division, is by far the most common type of LBO. During the past three years, many of the conglomerates that spent the 1960s and early '70s acquiring are now divesting in order to make for a more compatible mix of companies, implement new strategies to address changing markets, or to improve their cash flow. In 1982, W. T. Grimm recorded no less than 875 divestitures (37% the number of acquisitions), 115 of which resulted in management buy outs.
Beatrice Foods Co. and Gould Inc. are among a number of corporations that have recently been busy spinning off. Faced with a sharp decline in profits, Beatrice has put some 50 companies on the auction block; Gould, moving from a diversified manufacturing base to strengthen its electronics group, may divest 75% of the company. And, observes Shaykin, "GE is moving away from middle-tech into higher-tech -- so you could say that GE itself is up for sale."
Among the recently liberated is Universal Electric Co., of Owosso, Mich. Founded in 1942 to manufacture gyro motors for the Norden bomb sight, UE moved into the HVAC (heating/ventilation/air conditioning) market after the war, and was acquired by ESB Inc., of Philadelphia, in 1969. ESB, in turn, was acquired by growth company that served as a cash cow for Inco, UE led a rather autonomous existence until 1980. Then the parent, eager to regroup its resources in Canada and to return to what it did best -- "pulling things out of the ground" -- announced a program of divestiture, beginning with UE.
"I was taken completely unawares," recalls president Bill Lawson, an electrical engineer who had joined UE straight out of college, "and my first thought was, we're going to be sold to somebody else." Later, it occurred to management that it might buy UE itself, but the $11 million to $22 million of up-front cash that would be required for an ordinary purchase was out of reach, and, at the time, Dawson had never heard of an LBO -- a situation that an acquisitions expert at the accounting firm of Coopers & Lybrand corrected.
"He mentioned the LBO as a possibility," says Lawson, "and noted that he had a friend who was gaining quite a reputation in this area, that being Leonard Shaykin." Lawson arranged an "audience" with Shaykin, who was still at Citicorp, and came away "utterly amazed."
"I sat down with Leonard," Lawson recalls, "and he asked me a number of questions -- about our annual sales, rates of return, the market we were in, the growth aspects of that market, our market share, why we were successful, who our key players were. At the end of a 30-minute conversation, he astounded me with his concluding comments. He said, 'Lawson, we want to do the deal. We'll make all the arrangements, we'll take care of everything. We'll handle your equity financing, your debt financing . . . We want to do the deal.' "
Eight members of management applied a total of only $250,000 of their own cash to the $45 million purchase price, but obtained 25% of the equity. In order to ease UE's heavy tax burden, Shaykin suggested a reverse merger. "He said, 'I've got a few companies with NOLs [net operating losses] that I'd like you to talk to . . .,' " Lawson remembers. One such company was First Wall Street Settlement Corp., a clearinghouse for brokerage firms. First Wall Street had run up a $50 million NOL. In a reverse merger, 51% of UE was acquired by First Wall Street.
The complex transaction, some three months in the making, was closed on June 26, 1981. "It took a lot of time, and put quite a strain on my family life," concedes Lawson, "but it was well worth it. This little company was worth any price I could have paid." UE, which employs some 2,000 people, will do more than $80 million in sales this year, clearing 3% to 4% in aftertax profits, and has already retired $9 million of its $34 million debt.
"I can't begin to tell you how excited we are," says Lawson. "The company's performance has improved incredibly, because everybody's working so damn hard . . . And the reason is that they've all got a piece of the action now."
Inco for its part, was so pleased with the way things went that, following the UE sale in 1981, it quickly did three more divestitures as leveraged buyouts.
The third context in which LBOs may make sense are situations involving liquidity. Generally, the owner of a private company, who is growing older, decides that he doesn't want to leave his company's destiny to fate, that he wants to sell during his lifetime. "And it often works out best," says Shaykin, "if he sells to his own management, to the people who have been working for him and been loyal to him for all those years."
The company doesn't have to be shopped, won't be absorbed by a competitor -- a blow to a founder's ego -- and the owner can generally get his price and get it quickly.
Jim N. Brown, president of GP Technologies Inc., in Philadelphia, a manufacturer of typewriter elements and print wheels, notes that founder Calvin Page decided, in 1981, that he wanted to get out of line management; he wanted to devote himself to other interests and, at the same time, effectively convert his ordinary income into capital gains. He also wanted, Brown explains, to protect his company -- "a very healthy firm, with good products, good markets, and good distribution" when Brown joined it in April 1982.
The company was presented to several likely purchasers, among them Gillette Co. and American Brands Inc., without luck, before Page heard about LBOs. Then, during nine months of "dancing," he shaped a deal with Citicorp and individual investors that gave him most of what he wanted. He has reduced his equity position from 100% to 30% of the company and is less active in daily operations, although he serves on the board of directors and remains vice-president of GP's research and development. And he knows that his "baby" is in competent hands.
LBOs have been around in one form or another since the early '70s, but it was only four or five years ago that the theories, language, and mechanisms came together in a cohesive whole. ("The one thing we're lacking at this point," interjects Shaykin, "is a word to describe people who do LBOs".) Since that time, the technique has swept across the U.S. marketplace and has been utilized to move companies as diverse as Tenneco Chemicals Inc. and Expediter Systems Co. The press has often described it as "the salvation of sunset industries," but that definition is being superceded by the LBO's succcss, Adler & Shaykin, for instance, plans to add high-technology prospects to its shopping list.
Even now, LBOs seem omnipresent: The list of deals features Congoleum (flooring), Mid-Atlantic Coca-Cola Bottling (soft drinks), H. G. Parks (sausage), Chris-Craft (cruisers and sportsboats), U.S Repeating Arms (rifles), Hood Sailmakers (sailing equipment), Converse (footwear), Ray-O-Vac (batteries), National Psychiatric (mental hospitals), and A-1 Tool (mold builders).
The insurance companies, banks, and investment firms that pioneered the field -- Prudential Insurance Co. of America, First Boston, Oppenheimer & Co., and Kohlberg, Kravis, Roberts & Co. -- are now part of a greater LBO community that includes Merrill Lynch, Morgan Stanley & Co., Aetna Life & Casualty, Travelers Insurance; Northwestern Mutual Life Insurance, Forstmann Little & Co., Bankers Trust, First National Bank of Chicago; Lehman Bros. Kuhn Loeb, General Electric Credit Corp., and Oregon Public Employees' Retirement System "There's an entire infrastructure for doing LBOs now," says Burke of Merrill Lynch, who notes that investors are increasingly inclined to become equity partners.
For lenders, LBOs are attractive for a variety of reasons. Unlike the venture capital funded company, the typical LBO company is older, established, and has proven products and markets and a seasoned management team, all of which reduce the business risk Because it generally doesn't have the clout or credit rating of a Fortune 500 company, it is willing to pay above-prime rates And, because management is newly invigorated, the deals make for close and rewarding relationships "It gets back to those things bankers wish they still had with major corporations," notes Shaykin. If they take an equity position, lenders may serve in an advisory capacity (Adler intends to share a lot of his high-tech expertise with A&S concerns, showing them how they can use technology to improve profit margins), they get a hedge against inflation, and may see the value of their investment soar.
Although the rags-to-riches multiples that feed venture capital dreams are less likely, some LBOs have yielded imprcssive returns. In January of 1982, an affiliate of Wesray Corp. purchased Gibson Greeting Cards from RCA Corp. for $81 million, all but $1 million of it financed by bank loans and real estate leasebacks, in May, when Gibson went public, the 50% interest held by Wesray's two principals (one is former Treasury Secretary William E. Simon) was worth an estimated $140 million.
Sellers like LBOs because they are easier to arrange, generally produce the desired price, and reward the management team. For the buyers, LBOs represent what Shaykin calls a "Horatio Alger mechanism for the middle-aged manager."
"When he's sitting quietly behind his desk, or heading home on the highway at night, [the managers is] thinking, 'Gee whiz, I wish I were running my own company,' " says Shaykin, sketching the vision that drives him. "Do you realize how many people like that there are? They've got all the corporate marbles, but it simply isn't satisfying."
An LBO gives such individuals an opportunity to buy into a company they otherwise couldn't afford, and it gives them the freedom to run it as they think best -- "not for all sorts of exogenous reasons like quarter-to-quarter earnings," he says, "or emphasis on earnings instead of cash, or to defend some piece of the business that the president finds 'cute' . . . " And, Shaykin continues, "what happens in every case is an unleashing of entrepreneurial spirit . . . A seasoned management team really becomes young again."
He points to cases in which LBO owners have saved a company that might otherwise have faltered. "During the recent recession, Universal Electric suffered a major shortfall in business, Shaykin explains, "but they managed to reduce inventories much faster than the reduction in sales . . . and, throughout the whole sales decline, continued both to make money and to generate cash. . . I'm not so sure that they would have been so diligent if the business wasn't their own.
And, as the company pays off its debt, management's equity position may become quite valuable.
The pitfalls are those that attend any investment phenomenon: namely, that enthusiasm will take precedence over financial considerations, and bad deals will be struck -- a seller will find that he has been underpaid, a company will see that it can't handle the debt load. "There used to be more reservations about huge debt-financed purchases," concedes Shaykin. "There are fewer filters, inhibitions, and restrictions now." A few LBO businesses have failed$--Brentano's Inc. and a food distributor funded by General Electric Credit Corp., among them.
For the moment, though, Shaykin is consumed by the golden outlook: preparing for A&S's first deal this fall. He is putting in 18-hour days back-to-back, week after week. In preparation for the ordeal, he found he had to "structure" a relationship with his wife, Norah, and their two young children, but he has no regrets.
"I think Citicorp is absolutely terrific," he says, "but I left. . .
"I feel very, very lucky because I've come across something that I absolutely love doing and that lends itself to entrepreneurial formation -- to having a fund and doing it in such a way as to control one's own destiny.
Shaykin's vision, that of a frustrated corporate executive sitting in rush-hour traffic considering what might have been, has a personal source. Last year, he was that executive. Now, for the first time in his life, he is an entrepreneur. He has traded a plush office at Citicorp for a spot at the table and a croupier's stick.