The Effects of Leveraged Buyouts
Smith, Abbie, Business Economics
*Abbie Smith is Professor of Accounting, The Graduate School of Business, The University of Chicago.  See footnotes and references at end of text.
A spectacular rise in the number and size of leveraged buyouts (LBOs) has occurred within the past decade. In an LBO a group of private investors, typically including senior management, borrows against the assets and cash flows of the target firm to buy the public interest in common stock, taking the firm private. The effects of such buyouts are highly controversial. Empirical evidence to date provides some answers about the LBO phenomenon and its effects. This paper summarizes the evidence concerning stockholder gains, bondholder losses, corporate tax savings, and increases in operating efficiency associated with LBOs.
THE RECENT economic expansion has witnessed an explosion of leveraged buyout (LBO) activity. In an LBO a group of private investors, often including senior management, borrows against the firm's assets and cash flows to buy out the public interest in common stock, taking the firm private. Both the number and dollar magnitude of LBOs have increased markedly during the recent decade, from a low of thirteen recorded transactions in 1980 with an average (median) purchase price of $74.4 million ($25.3 million) to a high of 125 transactions in 1988 with an average (median) purchase price of $487.4 million ($79.8 million). (See W.T. Grimm .) The total recorded dollar volume of deals exceeded $60 billion in 1988 alone, with ten deals that year exceeding $1 billion each. In 1989, the largest LBO ever was completed when Kohlberg Kravis Roberts & Co. took RJR Nabisco private via a $25 billion LBO, topping senior management's initial $17 billion bid for the company. To some extent these trends reflect an increase in the number and dollar volume of mergers and acquisitions in general, although the percent of all public takeovers represented by LBOs has increased from 7.5 percent in 1980 to 27 percent in 1988.
To support the unprecedented levels of debt typical of LBOs (typically 75-95 percent of postbuyout capitalization), the ideal LBO candidate is characterized by strong, noncyclical, stable cash flows with significant unused borrowing capacity. The firm's service or product is well established, with minimal requirements for capital expenditures, research and development, or an aggressive marketing campaign. Hence, firms experiencing high growth and/ or rapid technological change are not attractive LBO candidates because of the operating demands on cash and uncertain revenues. Labor relations of the ideal candidate are favorable and the regulatory environment is stable to assure consistent cash flows. Finally, some subset of assets is easily divisible and highly attractive to outside bidders as an additional potential source of cash. Evidence available for LBOs through 1988 is largely consistent with the profile of an attractive LBO candidate, i.e., mature, low-growth firms with strong, consistent, recession-resistant cash flows in "low-tech" industries.
Given the recency of the LBO phenomenon, the long-run consequences of LBOs are unknown. However, experience to date does allow for the evaluation of some aspects of the effects of LBOs.
What does the evidence have to say?
THE EFFECTS OF LBOs
The stockholders of firms that complete an LBO typically receive cash for their shares representing a substantial premium above the market price of stock prior to the LBO announcement. The average LBO stockbolder premia per year ranged from 31 percent to 49 percent over the period 1980-88 (W T Grimm's Mergerstat Review, 1988), comparable to the premia paid in mergers and acquisitions in general.
The large premia paid to the target firm stockholders represent prima facie evidence of immediate stockholder gains associated with leveraged buyouts. The question remains, however, whether equal or even larger gains would have been earned in the future anyway because the buyout is motivated by the private investor group's favorable inside information about the firm's future prospects. …