A leveraged buyout (LBO) is a financing technique used by a variety of entities, including the management of a corporation, or outside groups, such as other corporations, partnerships, individuals, or investment groups. Specifically, it is the use of debt to purchase the stock of a corporation, and it frequently involves taking a public company private.
The number of large LBOs increased dramatically in the 1980s, but they first began to occur with some frequency in the 1970s as an outgrowth of the 1960s bull market. Many private corporations took advantage of the high stock prices and chose this time to go public, thereby allowing many entrepreneurs to enjoy windfall gains. Even though some of these firms were not high quality, their stock was quickly absorbed by the growing bull market. When the stock market turned down in the 1970s, the prices of some lower quality companies fell dramatically. The bulk of this falloff in prices occurred between 1972 and 1974, when the Dow Jones Industrial Average fell from 1036 in 1972 to 578 in 1974. In 1974 the average price-earnings (P/E) ratio was six, which is considered quite low.
When the opportunity presented itself, managers of some of the companies that went public in the 1960s chose to take their companies private in the 1970s and 1980s. In addition, many conglomerates that had been built up in the 1960s through large-scale acquisitions began to become partially disassembled through selloffs, a process that is called deconglomeration. Part of this process took place through the sale of divisions of conglomerates through LBOs. This process was ongoing through the 1980s and is partially responsible for the rising trend in divestitures that occurred during that period.
The value and number of LBOs increased dramatically starting in the early 1980s and peaking by the end of the decade (Figures 7.1 and 7.2). By the mid-1980s larger companies were starting to become the target of LBOs; the average LBO transaction increased from $39.42 million in 1981 to $137.45 million in 1987. Although LBOs attracted much attention in the 1980s, they were still small in both number and dollar value compared with mergers. For example, in 1987 there were 3,701 mergers but only 259 LBOs. Leveraged buyouts accounted for only 7% of the total number of transactions. In terms of total value, LBOs accounted for a higher percentage of the total value of transactions. In 1987 LBOs made up 21.3% of the total value of transactions, which shows that the typical LBO tends to have a larger dollar value than the typical merger. Figure 7.1 shows that the dollar value of LBOs fell dramatically in 1990 and 1991. This decrease coincided with the decline in