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Leveraged Buyouts
One indication that the people who warn against takeovers might be right is the existence of leveraged buyouts.
In the 1960’s, a big wave of takeovers in the US created conglomerates- collections of unrelated businesses combined into a single corporate structure. It later became clear that many of conglomerates consisted of too many companies and not enoughsynergy. After the recession of the early 1980’s, there were many large companies on the US stock market with good earnings but low stock prices. Their assets were worth more than the companies’ market value.
Such conglomerates were clearly not maximizing stockholder value. The individual companies might have been more efficient if liberated from central management. Consequently, raiders were ableto borrow money, buy badly-managed, inefficient and underpriced corporations, and the restructure them, split them up, and resell them at a profit.
Conventional financial theory argues that stock markets are efficient, meaning that all relevant information about companies is built into their shares prices. Raiders in the 1980’s discovered that this was quite simply untrue. Although the marketcould understand data concerning companies’ earnings, it was highly inefficient in valuing assets, including land, buildings and pension funds. Asset- stripping- selling off the assets of poorly performing or under-valued companies- proved to be highly lucrative.
Theoretically, there was little risk of making a loss with a buyout, as the debts incurred were guaranteed by the companies’ assets.The ideal targets for such buyouts were companies with huge cash reserves that enabled the buyer to pay the interest on the debt, or companies with successful subsidiaries that could be sold to repay the principal, or companies in fields that are not sensitive to a recession, such as food and tobacco.
Takeovers using borrowed money are called “leveraged buyouts” or LBO’s. Leverage means having alarge a proportion of debt compared to equity capital. (Where a company is bought by its existing managers, we talk of a management buyout or MBO). Much of the money for LBO’s was provided by the American investment bank Drexel Burnham Lambert, where Michael Milken was able to convince investors that the high returns on debt issued by risk enterprises more that compensated for their riskiness, asthe rate of default was lower that might be expected. He created a huge and liquid market of up to 300 billion dollars for “junk bonds”. (Milken was later arrested and charged with 98 different felonies, including a lot of insider dealing, and Drexel Burnham Lambert went bankrupt in 1990)
Raiders and their supporters argue that the permanent threat of takeovers is a challenge to companymanagers and directors to do their jobs better, and that well-run businesses that are not undervalued are at little risk. The threat of raids forces companies to put capital to productive use. Fat or lazy companies that fail to do this will be taken over by raiders who will use assets more efficiently, cut costs, and increase shareholder value. On the other hand, the permanent threat of a takeover or abuyout is clearly a disincentive to long-term capital investment, as a company will lose its investment if a raider tries to break it up as soon as its share price falls below expectations.
LBOs, however, seem to be largely an American phenomenon. German and Japanese manager and financiers, for example, seem to consider companies as places where people work, rather that as assets to be boughtand sold. Hostile takeovers and buyouts are almost unknown in these two countries, where business tends to concentrate on long-term goals rather that seek instant stock market profits. Workers in these companies are considered to be at least as important as shareholders. The idea of a Japanese manager restructuring a company, laying off a large number or workers, and getting a huge pay rise (as...
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