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November 14, 1988
"Sold American - Are Leveraged Buyouts Good for Business?"
San Jose Mercury News
By Timothy Taylor
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IN his recent book, "The Bonfire of the Vanities," Tom Wolfe refers to the top Wall Street financiers and corporate executives as "Masters of the Universe." At least in popular myth, these people earn thousands of dollars with a phone call; they control the economic future of millions of working Americans; they make major decisions on the basis of personal gain, or personal whim.

The wave of leveraged buyouts is titillating and important for the same reason: It raises the question of what limitations, if any, our market economy puts upon the actions of these Masters of the (Business) Universe.

Most people are familiar with the idea of a corporation owned by its stockholders. The thousands (or even millions) of stockholders vote for a board of directors, who select the chief executive officer and sometimes other top executives. As anyone with a reasonable degree of cynicism would predict, two common complaints have emerged about this system.

The first complaint is that stock market investors care only about the highest possible short-term profits, so they pressure top executives (through the board of directors) to sacrifice the long-run health of the company for the sake of immediate profits.

The second complaint is that the board of directors tends to become a rubber stamp for the top executives. As a result, top executives can pay themselves huge bonuses or try to build themselves a corporate empire, and waste a lot of money with impunity.

Leveraged buyouts certainly have imperfections of their own, but they should be seen as an effort to find a middle ground between over-controlled and uncontrolled executives.

In a leveraged buyout, a small group buys the stock of the company with borrowed money. The buying group may consist of the current management of the company or of outside investors, and the borrowed money may come from banks or from selling high-yield, high-risk bonds, sometimes called "junk bonds." In either case, the top corporate executives are no longer responsible to a board of directors, but to those who loaned them the money. The company is obligated to make the necessary interest payments, which can be quite high, but any profit above that amount can be invested back into the company.

At least in theory, it should be evident how a leveraged buyout might have a positive effect. Michael Jensen, a professor at Harvard Business School, has argued that the leveraged buyouts may be particularly appropriate for companies in stable, slow-growth industries, like the food industry.

Beatrice, for example, was a shareholder-owned food company earning solid profits, but with no especially good place in the slow-growth food industry to reinvest the money. The top executives at Beatrice were thus faced with a temptation to squander the profits on executive perquisites or unproductive investments. But when Beatrice went through a $6.3 billion leveraged buyout, the corporation committed itself to keep costs low and pay out the profits to investors.

Similar logic holds for Safeway, which went through a leveraged buyout, and for RJR Nabisco, a company in the news as the target of what could be a $20 billion buyout.

On the other hand, companies in growing industries with fluctuating profits -- like most high technology companies -- would be bad candidates for leveraged buyouts. Their unpredictable earnings mean they might have trouble making regular interest payments. In addition, the most economically efficient use for money they earn is probably to reinvest it in the company, rather to pay it out to investors.

Leveraged buyouts barely existed 10 years ago; now tens of billions of dollars are being invested in this way. Even if these buyouts are sometimes justified, is the trend going too far?

The most common complaint, perhaps, is that many companies have responded to a leveraged buyout by slashing costs, sometimes by laying off workers, to raise the money to make the interest payments. But this complaint is actually an admission that the company could have cut costs before the buyout, but was being inefficiently run! If this country is serious about global competitiveness, the issue should be how to help workers adjust to economic change, not how to freeze the status quo because some people benefit from industrial sloth and inefficiency.

A second concern cannot be dismissed as easily: Does the increased debt from leveraged buyouts make the financial system more fragile? If a recession hits, and companies can't make their interest payments, what will happen? The optimistic answer is that leveraged buyouts don't make matters any worse than if a company was owned by shareholders. In a recession, investors will lose money either because stock prices will fall or because a company can't make its interest payments.

So far, it does not appear that corporate debt has grown out of proportion to the underlying value of corporations.But even ael Jensen, generally a strong supporter of leveraged buyouts, concedes, "A thorough test of this leveraged buyout organizational form requires the passage of time and recessions."

If the problem is too much borrowing, there are better answers than limiting leveraged buyouts. One obvious way to reduce national borrowing would be to cut the federal budget deficit. And perhaps the best way to reduce corporate debt would be to reform the U.S. tax code, which is slanted in favor of debt.

If a company raises money by selling stock, and then pays dividends to its shareholders, the company's profits are taxed twice: first by the corporate income tax, and then as personal income when people receive them. But if the same company chooses to raise money by borrowing and then paying interest to the lenders, the money is only taxed once, when received as payments by investors. Money used to pay interest is counted as an expense rather than as profit, so it is not touched by the corporate income tax. As finance economists have been pointing out for nearly 30 years, a company can cut its tax bill dramatically by substituting debt for equity.

It seems politically very difficult to alter this feature of the tax code. Individuals are not willing to support a plan to eliminate the corporate profits tax, with all income is taxed only once at the individual level. And just as homeowners are not willing to be taxed on their home mortgage payments, corporate America will fight to the death against being taxed on its interest payments.

As long as the tax code penalizes companies for raising money by selling stock, leveraged buyouts will continue to be attractive.

The final concern about leveraged buyouts is more nebulous than lost jobs or higher debt. It is the deep suspicion that all these deals are just another way for the so-called Masters of the Universe to enrich themselves.

But leveraged buyouts are more than a financial game; they are an attempt to set up new incentives for top business executives. They are an experiment, and the American system of democratic capitalism is based on the presumption that businessmen spending their own money are more likely to try sensible economic experiments than politicians spending other people's money. In five or 10 years, there will be enough evidence to evaluate whether the experiment has worked.

In the meantime, leveraged buyouts can only be judged as they happen, on a company-by-company basis. In the recent flurry of buyouts, it appears that the price paid for stock may have been too high and that borrowing is exceeding reasonable limits. Premiums paid to shareholders of nearly 50 percent are not that uncommon. But even if the buyout results in tax savings and more efficient management, it seems unrealistic to believe that those benefits can make a company increase by 50 percent in value.

The ironic result is that leveraged buyouts, while potentially a positive force for corporate restructuring, seem recently to have lost their anchor in economic reality.

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