u. S.Securities and Exchange CommissionWashington, D.C. 20549 (202) 272-2650

MANAGEMENT BUYOUTS AND LEVERAGED BUYOUTS:ARE THE CRITICS RIGHT?

Prepared forthe Conference on Management Buyouts

New York universityGraduate School of Business Administration

New York, NY

May 20, 1988

Joseph A. GrundfestCommissioner

[M@\YM'~[Ri@~@~~@

This address is scheduled to appear in a forthcomingbook entitled Leveraged Management Buyouts, Y. Amihud, ~(Dow Jones Irwin 1988). The views expressed herein are thoseof Commissioner Grundfest and do not necessarily representthose of the Commission, other Commissioners, or Commissionstaff.

MANAGEMENT BUYOUTS AND LEVERAGED BUYOUTS:ARE THE CRITICS RIGHT?

Joseph A. Grundfest

Management buyouts ("MBOs") and leveraged buyouts("LBOS") have been subject to extensive criticism.1 Theyhave been reviled as unfair to stockholders, threatening toemployees, and inhospitable to long-term corporate planning.The companies involved in these transactions are allegedlydangerous to themselves and others because their high debt-to-equity ratios leave them economically vulnerable, partiCUlarlyif interest rates increase or if the economy suffers arecession.

The bankruptcy of Revco Drugstores, only 18 months afterits management buyout, has recently added fuel to these fears.Further concern has been generated by the rapid growth ofmultibillion dollar leveraged buyout funds. Here, theapprehension is that in order to "do deals" necessary tocommit billions of dollars in available capital, fund managerswill be pressured into paying premium prices that lead tounsustainable leverage, thereby further threatening the

1~, ~, Lowenstein, Management Buyouts, 85 Colum. L.Rev. 730 (1985); Lipton, Corporate Governance in the Age ofFinance Corporatism, 136 U. Pa. L. Rev. 1 (1987); Morrisey,Law, Ethics and the Leveraged Buyout, 65 U. Det. L. Rev. 403(1988). The term "leveraged buyout" refers generally to anacquisition in which the purchase price is financedpredominantly with debt to be repaid by cash flow generated bythe acquired firm. If management of the acquired companyparticipates significantly in the buy-out by holding equity inthe new leveraged firm, the transaction is referred to as amanagement buy-out. Management buyouts are thus a subset ofleveraged buyouts.

2

competitive fabric of an increasingly large number of MBO andLBO companies.2

These concerns are expressed by many respected observersof the economic scene and, as Congressman Markey makes clearin his address, they are shared by influential policymakers inWashington. 3 These concerns are, I believe, quiteunderstandable. The academic and financial communities havean obligation to respond with credible evidence that eithersupports or rejects the factual premises upon which theseconcerns are based.

My review of the evidence leads me to conclusions thatare, however, quite different from those expressed by manycritics of MBO and LBO transactions. Experience to datedemonstrates that some of these transactions are successeswhile others are failures. Among the successes arereinvigorated companies that have regained a sharp

2See, ~, A.C. Wallace, All Dressed Up and No Place toGo?, N.Y. Times, Aug. 6, 1988, at F1, col. 2; J. Lewis,Everybody Into the Pool, Institutional Investor, July 1988, at141.

3Markey, Remarks of the Honorable Edward J. Markey.Chairman. House Subcommittee on Telecommunications andFinance. Before the New York University Conference onManagement Buyouts, [this volume, at p. ]. See alsoLeveraged Buyouts and the Pot of Gold: Trends, Public Policyand Case Studies, A Report Prepared by the Economics Div.Congo Res. Servo for the House Subcomm. on Oversight &Investigations of the Committee on Energy and Commerce, CommaPrint No. 100-R, looth Cong., 2d Sessa (Dec. 1987).

3

competitive edge as a result of a management buyout.4 Amongthe failures are companies that may well have encounter~ddifficulties as a result of the financial pressures imposed byleveraged transactions.5

Public policy cannot, however, be guided solely bysuccesses. Nor should it be dominated by failures. Rationalpublic policy must be guided by the best available evidenceregarding the aggregate consequences of these transactionsmeasured on average and over time. Individual anecdotes, nomatter how compelling when considered in isolation, can easilymislead. Viewed from this perspective, and taking fullaccount of the undeniable risks involved in many of thesetransactions, the preponderance of the evidence stronglysuggests that MBOs and LBOs are beneficial for the companiesinvolved and for the economy as a whole. The successes faroutnumber the failures, and many of the costs associated withthese transactions have been substantially exaggerated.

In order to appreciate the benefits that result fromthese transactions, it is useful to draw an analogy betweenbuyouts. and the operation of the venture capital sector.Venture capital is an undeniably risky business. It is a

4See, ~, When Power Investors Call the Shots, Bus.Wk., June 20, 1988 at 126 (discussing Borg Warner, IglooHoldings, Cortec Industries, spinoffs of ITT Corp., Seven-Up,Dr. Pepper, Beatrice, and Cain chemical).

5~ (discussing Revco, Republic Health, and Dart Drug).

4

trivial matter to identify startup companies that have quicklygone bankrupt costing their backers many millions of dollars--and occasionally making even the most technologically andfinancially sophisticated investors look foolish. If theventure capital industry were jUdged solely by its risks andfailures, that entire sector of the economy would be acandidate to be shut down.

Fortunately, the pUblic policy process has not proved soshort sighted or risk averse. Policymakers are able toappreciate the tremendous successes spawned by the venturecapital industry. They appreciate the extraordinary valuethat can be called forth when entrepreneurs have a substantialequity stake in the businesses they run and when thosebusinesses are overseen by a relatively small group ofknowledgeable, active investors who have a direct andsignificant financial stake in the success or failure of theenterprise. The value added by the entrepreneurial energyassociated with venture capital operations is so wellrecognized that many foreign countries have specificallysought to replicate the United states' venture capital successby providing inducements to entrepreneurs and investorswilling to take venture capital-type risks.6

Buyouts are closely related to venture capitalenterprises. Instead of starting a firm from scratch, a

6see, ~, John W. Wilson, The New Venturers 219-230(1986); Melcher, A continental Spending Spree for VentureCapitalists, Bus. Wk., Aug. 29, 1988, at 41.

5

buyout recreates venture capital-type incentives withinexisting firms by providing management with strong, equity-based incentives combined with aggressive oversight frominvestors who have substantial capital at stake. The economicbenefits that result from reinvigorating large, establishedcorporations that may have grown a bit lazy or sluggish areevery bit as real as the benefits that result from theformation of new firms. Thus, just as society applauds therisk taking inherent in venture capital operations, it makessense, I think, to view buyouts in an equivalent light asrisky but beneficial opportunities for industrial rebirth atfirms that may not be living up to their full potential.

While there is extensive debate over the sources of gainthat result from buyouts, the most significant gains result, Ibelieve, from the reduction in agency costs that occurs whenmanagement is given an opportunity to share a substantialequity stake in the firm they operate.7 Buyouts thusreintegrate management interests with equity incentives andresolve the classic Berle-Means problem that arises whenownership is separated from control.8 Managements are thereby

7See generally Jensen, Agency and Costs of Free CashFlow. Corporate Finance and Takeovers, 76 Am. Econ. Rev. 323(1986).

SA. Berle & G. Means, The Modern Corporation and ErivateProperty (1932).

6

motivated to adopt efficiency-enhancing measures that simplydo not occur in pUblicly traded firms with diffuse owne~ship.9

As the co-head of corporate finance at McKinsey & Companyexplains, these transactions "are so immensely successfulbecause they are better managed."10 Indeed, there is noshortage of war stories describing how a firm taken privatein an MBO or spun off in an LBO increased productivity as adirect result of management improvements that were infeasibleunder prior ownership structures.l1 There is also no shortageof testimonials from business executives who participated inbuyout transactions and say "[i]t's amazing what a littlemotivation does for the bottom line."12

9critics of MBO-LBO transactions occasionally contendthat such management improvements should be forthcomingwithout MBO-LBO transactions, and that shareholders areshortchanged because they must be bought out before theseimprovements take place. The available evidence, however,suggests that the strategies involved in MBO-LBO transactions"increase the risk associated with the managers undiversifiedhuman capital" and that managers will not consent to suchlevels of risk without being offered the opportunity at leastto participate in the larger rewards associated with MBO-LBOtransactions. Gilson, Market Review of InterestedTransactions: The American Law Institute Proposal onManagement Buyout [this volume, at pages 6-7 of themanuscript].

10When Power Investors Call the Shots, supra note 4.11See, ~, Magnet, Restructuring Really Works, Fortune,

March 2, 1987, at 38; Russell, Rebuilding to survive, Time,Feb. 16, 1987, at 44; When