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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

JANUARY 1989
NUMBER 17

Chicago Fed Letter
B uyouts and
bondholders
Leveraged buyouts (LBOs) are still
only 7 to 8% of all merger and acqui­
sition (M&A) deals done in the U.S.
Yet, by dollar value they now consti­
tute more than 20% of all M&A ac­
tivity (see Figure 1). The absolute and
relative dollar values of LBOs increased
significantly in 1986 and have contin­
ued at a high pace. Indeed, the recent
RJR Nabisco LBO, at nearly $25
billion, exceeds the annual value of all
LBOs for 1984 and 1985 (see Figure 2).
The large and sometimes astonishing
gains associated with these deals have
put them in the spotlight, making LBO
a newsworthy, market-moving acro­
nym. Substantial profits accrue to
shareholders, investment bankers, fi­
nancial advisors, and attorneys. But
has the lustre of these gains obscured a
darker side of LBOs? Are these pro­
ceeds derived from the creation of
wealth or are they obtained at the ex-

pense of others? Is someone taking a
hit? This issue of Chicago Fed Letter
focuses on the wealth transfer from
target company bondholders to target
company shareholders.
What is an LBO?

In an LBO, an individual or small
group of investors, often company
management in conjunction with an
investment banking firm, uses the
company’s assets as collateral to borrow
funds to take the company private by
purchasing all of its outstanding stock
at a premium.
It is common to sell high-yield, highrisk securities (junk bonds) to accumu­
late the cash necessary for an LBO.
The resulting company is highly lever­
aged, with a significant debt burden.
For 58 LBOs from 1980 to 1984, aver­
age long-term debt increased by 262%
and the average debt-to-equity ratio
jumped to more than 5 to 1. This was
an average increase of more than
1, 000%.
Why LBOs?

Taking a company private may protect
it from hostile suitors. LBOs are often
proposed to shareholders by manage­
ment in an effort to save their company
from a hostile takeover.

SOURCE: M e r g e r s
of selected years.

a n d A q u i s i t i o n s , Almanacs

But even in the absence of a hostile
takeover threat, there are several in­
centives for LBOs. Although the com­
pany is burdened with significant debt
subsequent to the LBO, it is the debt
that generates much of the cost savings
and increased efficiency associated with
the LBO. The debt results in tax
savings in the form of interest de­
ductions. LBOs can also increase
wealth by reducing conflicts of interest
created by the separation of manage­
ment and ownership.

W ho gains?

If an LBO is successful, there are gains
to be made. Shareholders, on the
whole, will not sell out for less than the
market price. Thus, by the nature of
an LBO, the buyout of shares must be
at a premium over the market price.
Research clearly indicates that stock­
holders of firms acquired in M&As (in­
cluding LBOs) gain. They benefit by
receiving returns above those that
would have occurred had the stock fol­
lowed overall market movements. One
researcher conservatively estimates the
gain to target shareholders from take­
overs of publicly traded companies be­
tween 1981 and 1986 to be 47.8%, or
an estimated $134.4 billion.
The same studies find that bidder firm
shareholders have equal probabilities
of gaining or losing and at best receive
modest gains. Yet, recent research
concludes that the average successful
tender offer results in a statistically sig­
nificant positive revaluation of the
2. . . . and more bucks
billions of dollars

50 -----------------------------

Value of LBOs

1984

1985

1986

1987

1988*

*First half of 1988 plus the R JR Nabisco deal.
S O U R C E : M e r g e r s a n d A q u i s i t i o n s , Almanacs
of selected years.

combined firm. Thus, on balance,
takeovers, including LBOs, enhance
shareholder wealth.1
Sources of gain

But, while M&As do enhance wealth,
such wealth may not be derived en­
tirely, or at all, from increased effi­
ciency (e.g., resource reallocation,
removal of inefficient management, or
economies of scale or scope). The cre­
ation of value and gains from efficiency
are even more suspect in LBOs which,
by their nature, lack the usual
synergistic gains of M&As.
Although easily measured, shareholder
gains do not provide an accurate
measure of welfare gains. If, for ex­
ample, takeover and LBO gains are a
result of wealth transfers, then the in­
crease in share prices overstates the ef­
ficiency gains of takeovers and LBOs.
This is because shareholder gains must
be weighed against the losses of others.
Opponents of LBOs argue that gains
from such transactions result primarily
from wealth redistributions: one
stakeholder’s gain—the target
shareholder’s—is at the expense of
another’s economic loss—such as the
target company’s employees or its
bondholders or the U.S. Treasury.
In the extreme, such transactions are
merely costly restructurings of corpo­
rations that provide no social benefits.
Preventing such buyouts would, it is
argued, improve economic welfare.
On the other hand, proponents argue
that LBOs provide net gains to society
by reducing the conflicts of interest be­
tween management and shareholders.
This, in turn, improves resource allo­
cation and efficiency and encourages
value-maximizing behavior. Thus, at­
tempts to prevent such transactions
would have negative effects.
Research has been unclear concerning
the sources of takeover gains. They
may result from redistribution and in­
creased efficiency. But the sources of
gain vary from deal to deal, from in­
dustry to industry, and from year to
year.
Studies have addressed the wealth
transfers to target shareholders from:

government (and, thus, taxpayers) in
the form of tax savings; target labor in
the form of lower wages and higher
unemployment; and target bondholders
in the form of reduced bond values.
Do target bondholders lose?

Corporate bondholders purchase bonds
based on, among other factors, the
bond’s rating, which reflects an assess­
ment of the likelihood that the com­
pany will make timely interest and
principal payments. Purchasers of high
grade bonds assume very little, if any,
risk of corporate default. That is, they
do so in a world without LBOs.
LBOs result in increases in the firm’s
debt burden. If the additional debt
increases the probability or cost of fu­
ture default, then the value of the
target’s bonds will decline.
Among several recent examples of fall­
ing bond values associated with LBOs,
the most notable is RJR Nabisco (see
Figure 3). Indeed, some RJR
bondholders have filed suit against
RJR. They argue that RJR manage­
ment has failed in its duty to
bondholders and that the LBO benefits
others, including management, at the
direct expense of the bondholders.
These highly publicized examples may
be isolated instances of extremely risky
ventures or of poorly written bond
covenants that fail to adequately pro­
tect the bondholder. Or, they may in­
dicate that bondholder losses are
sometimes the price paid for
shareholders’ and others’ gains in
LBOs— more respectably, the price
or
to be paid to obtain efficient manage­
ment and allocation of resources.
Additional evidence

Prior studies have compared the re­
turns on bonds of takeover targets ei­
ther to bonds with similar
characteristics of corporations not sub­
ject to takeover, or to changes in a se­
lected bond index. These studies found
that, on average, target company
bondholders neither gain nor lose by a
(statistically) significant amount in
takeovers. Furthermore, there were no
noticeable wealth transfers between
bondholders and stockholders.2

The following analysis is specific to
LBOs and looks solely at the change in
bond value attributable to the an­
nouncement of the LBO. It does so by
controlling for changes in the bond
price caused by changes in interest
rates on government securities of com­
parable duration.
Our study covered 20 LBOs, including
some of the largest ones, from mid-year
1984 to mid-year 1988. All the organ­
izations had corporate bonds outstand­
ing at the time of the announcement
of the LBO.3
Results for the entire sample are con­
sistent with previous research using
both monthly and daily bond data.
Overall, the probabilities of a gain or
a loss in bond values upon an LBO
announcement are about equal.
Moreover, on average the increases or
decreases in bond values of LBO targets
are not statistically significant. This is
true across all bond grades. So overall,
stockholders are not gaining at the ex­
pense of bondholders in LBOs.
However, this is not very consoling to
the holders of approximately 50 per­
cent of those issues that do lose value.
Although the average change in bond
prices across all issues in the sample is
a statistically insignificant 0.50%, the
difference between the minimum
( —1.84%) and maximum ( —15.39%)
loss is great.

L B O t a r g e t b o n c is turreth n d s :
U

g a m s a n d lo s s e s

( % o f b o n d ’ s fa c e v a lu e )
All
bonds
(n = 2 0 )
Average
- 0 .5 0
Range -1 5 .3 9 -1 7 .0 8

Gainers
( n = 1 2)

Losers
(n = 8 )

5.87
-0 .5 8 -1 7 .0 8

- 7 .5 4
- 1 5 . 3 9 - - 1 .84

The reconciliation of these and previ­
ous results with the highly publicized
negative returns (and less publicized
gains) to bondholders of certain LBO
targets is the recognition of the differ­
ence between individual and average
results. Interestingly, the average data
in this analysis hides the fact that the
two highest-rated bonds (A + ) each
had losses greater than the two lowest
rated bonds (B + ) upon the announce­
ment of their respective LBOs.
The aggregation of data also masks a
major tax-related incentive of LBOs.
The Tax Reform Act of 1986 elimi­
nated the preferential tax treatment of
capital gains. This has increased the
incentives to issue debt. (Interest pay­
ments on debt are deductions from
taxable income, but dividend payments
are taxed at the corporate or personal
tax rate.) Capital restructuring in the
form of an LBO increases the value of
the firm by reducing its tax burden.
A split of our LBO sample into those
effective prior to and after January
1987 provides a suggestive, but not
conclusive, bit of information.
Bondholders of LBOs occurring prior
to the tax law changes effective in 1987
received significant gains averaging
7.36%, while bondholders of LBOs ef­
fective in 1987 and later received sig­
nificant losses averaging 5.10%. The
statistically significant different experi­
ences of the two groups coincides with
the dramatic increase in size of LBOs
and suggests that tax incentives have
changed the nature of LBOs.
The guiding principle for the
bondholder may be to judge each case
individually, taking into account a
firm’s exposure to an LBO. While
changes in bond prices are certainly
important to those buying and selling
bonds, it may be argued that bonds are
usually bought as a long-term invest­
ment to be held to maturity with rela­
tively guaranteed interest payments.

However, the price of a bond today is
affected by the probability and cost of
default in the future. Right or wrong,
a change in bond values today reflects
the market’s best guess about the
LBO’s long-term impact on default
risk.
Assessment

Falling bond values for certain LBO
targets represent the market’s down­
grading of the bond quality prior to or
in absence of an official downgrade.
Several factors may play a role in the
downgrading of individual bonds.
For current and prospective
bondholders relevant factors to con­
sider are: the size of the deal; the level
of existing debt and the relative in­
crease in leverage; expectations of the
corporation’s future credit needs;
whether the LBO group includes cur­
rent management; the protective
covenants of the bond agreement; the
firm’s level of free cash flow; the degree
of increase in stock values; the terms of
the deal including plans to pay down
the debt; the firm’s tax liabilities and
the tax consequences of the deal; and
the corporation’s bond rating history.

1988 (N ew Y ork: S ta n d asrd & P o o r’s
C o rp o ratio n ). I f m ore th a n one issue of
lon g -term d e b t was o u tstan d in g , the one
used was the m ost highly rated issue w ith
the longest term to m a tu rity . S T R IP d a ta
(T re a su ry 0% C A T S p rio r to F eb ru ary
1985) are from S alom on B rothers Inc. Bond
Market Roundup J u ly 1984-N ovem ber 1988.
3 P au l A squith a n d E. H a n K im , “T he
Im p a c t o f M e rg e r Bids on the P a rtic ip a t­
ing F irm s’ S ecurity H o ld ers,” Journal o f
Finance, V ol. 37, No. 5, (D ecem ber 1982),
pp. 1209-1228 covers 50 conglom erate
m ergers from 1960-1978.; D eb ra K.
D ennis a n d J o h n J . M cC onnell, “ C o rp o ­
rate M ergers a n d S ecurity R e tu rn s ,” Jour­
nal o f Financial Economics, Vol. 16, No. 2
(June 1986), pp. 143-187 covers 132
m ergers from 1962-1980.; an d K en n eth
L ehn a n d A n n ette Poulsen, “ L everaged
Buyouts: W ealth C re a te d or W ealth R e ­
d istrib u te d ? ,” in Public Policy Toward Cor­
porate Takeovers, (N ew B runsw ick, N J:
T ra n sa c tio n Books, 1988) covers 13 bonds
o f firms subject to LBOs.

In short, with LBOs an increasing pos­
sibility, the bondholder needs to think
more like a stockholder.
— Diana L. Fortier1
2

1 F o r a review o f the lite ra tu re on gains
a n d sources o f gain in takeovers, see D ian a
L. F o rtier, “ H ostile T akeovers a n d the
M a rk e t for C o rp o ra te C o n tro l,” Economic
Perspectives, F ed eral R eserve Bank o f
C hicago, J a n ./F e b . 1989. F o r evidence on
the gains to shareholders from LBOs see
K h alil M . T o ra b z a d e h a n d W illiam J .
B ertin, “ L everaged Buyouts a n d S h a re ­
ho ld er R e tu rn s ,” The Journal o f Financial
Research, Vol. 10, No. 4, (W in ter 1987), pp.
313-319.
2 LBOs used w ere listed in Mergerstat Review
1984-1987 (C hicago: W . T . G rim m &
Co.) o r in the q u a rte rly R osters o f Mergers
& Acquisitions 1 9 8 5 Q L 1 9 8 8 Q 2 . LBOs o f
subsidiaries o r units o f an o rg an izatio n
w ere excluded. Also excluded w ere lBOs
an n o u n ced aro u n d the tim e o f the O c to b e r
1987 crash. C o rp o ra te bon d d a ta are from
S & P ’s Bond Guide J a n u a r y 1984-N ovem ber

K arl A. Scheld, Senior Vice President and
D irector of R esearch; D avid R. A llardice, Vice
P resident and Assistant D irector of Research;
E dw ard G. N ash, E ditor.
C hicago Fed L etter is published m onthly by the
R esearch D ep artm en t of the F ederal Reserve
Bank of C hicago. T h e views expressed are the
au th o rs’ and are not necessarily those o f the
F ederal Reserve Bank o f C hicago or the Federal
Reserve System. Articles m ay be rep rin ted if the
source is credited and the R esearch D ep artm en t
is provided w ith copies of the reprints.
C hicago Fed L etter is available w ith o u t charge
from the Public Inform ation C enter, F ederal
Reserve Bank o f C hicago, P.O . Box 834, Chicago,
Illinois 60690, or telephone (312) 322-5111.

ISSN 0895-0164

Hopes of a continuation of August’s slowdown in U.S. industrial production that
would ease inflationary pressures were further dampened by solid growth in Oc­
tober. Manufacturing activity in the nation rose 0.5 percent in October, up from
0.4 percent in September. Durable goods, led by business equipment and auto­
motive products, provided the bulk of the growth.
Midwest manufacturing activity was unchanged from its September level, re­
flecting spot weaknesses in business equipment-related industries. While nonelec­
trical equipment continued to expand activity, instruments edged downward and
electrical equipment declined after two strong months of expansion. Also, trans­
portation equipment continued its downward trend as plants closed in Michigan.

Chicago Fed Letter
F E D E R A L R E S E R V E BAN K O F C H IC A G O
P u b lic In fo rm a tio n C en ter
P .O . Box 834
C h ica g o , Illin o is 60690
(312) 322-5111

N O T E : T h e M M I is a com posite index o f 17
m an u factu rin g industries and is constructed from
a weighted com bination o f m onthly hours worked
and kilow att hours d a ta . See “ M idw est M a n u ­
facturing Index: T h e C hicago F ed ’s new regional
econom ic in d icato r,” Economic Perspectives, F ederal
Reserve Bank of Chicago, Vol. X I, No. 5,
S eptem ber/O ctober, 1987. T h e U n ited States
represents the F ederal Reserve B o ard ’s In d ex o f
In d u strial P roduction, M anufacturin g .


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102