Leveraged Buyouts: Inception, Evolution, and Future Trends

Li JIN and Fiona WANG

Perspectives, Vol. 3, No. 6

Abstract: This paper examines the inception and evolution of the leveraged buyout (LBO) business in the United States and analyzes future trends. The factors contributing to the rises and falls of the LBO market in the last two decades are studied. We compare the characteristics of the LBO business in the 80's and 90's. The LBO market in the 90's was more mature and challenging than in the 80's, resulting in a lower mean industry return. The current low public stock valuations and strong investor capital inflows suggest many good opportunities for the buyout funds. However, the skills required for success are different from those in the 80's as the LBO transactions are likely to target companies at earlier stages, require more operational expertise, and expand globally to Europe and Asia.
I. Introduction

Most financial dictionaries define a leveraged buyout (LBO) as a debt-financed transaction, typically via bank loans and bonds, aimed at taking a public corporation private. Because of the large amount of debt relative to equity in the new corporation, these bonds are typically rated below investment-grade, and are properly referred to as high-yield or junk bonds.

Investors can participate in an LBO through either the purchase of the debt (i.e., the purchase of the bonds or participation in the bank loan) or the purchase of equity through an LBO fund that specializes in such investments. Heavy reliance on debt to finance the acquisition magnifies the risk of the transaction; consequently, the potential return to the buyer upon subsequent exit is increased. Possible exit strategies for LBOs include (i) initial public offering, which allows investors to liquidate ownership interest, (ii) re-capitalization which allows equity holders to realize a return by taking a sizable dividend, and (iii) outright or partial sale to another strategic or financial buyer.

The LBO market comprises three major types of transactions: (i) those in which a public company is taken private (this is usually the takeover segment of the LBO market), (ii) divestitures that result from selling off divisions of a public corporation, and (iii) private market transactions involving companies whose stocks are not publicly traded. Exhibit 3 sets forth a breakdown of transaction value in each segment from 1981 to 1997 (Source: M&A Database, Mergers and Acquisitions, 1997)

The LBO market has gone through several cycles: it started quietly in the 1970's and in less than ten years LBO became a topic of heated discussion in Congress and in the news media. The leveraged buyout boom of the late 1980's gave way to the buyout bust of the early 1990's. Beginning in 1991, LBOs began to make a comeback, reaching $24.2 billion in 1996. Then, in the aftermath of the high yield market shutdown in the late 1998 (Exhibit 1), the new LBO wave was pronounced dead. The pronouncement was echoed through 1999 and 2000 when acquisition multiples remained at historic highs in the so-called New Economy and leveraged lenders became increasingly cautious about risk.

However, in the wake of the current dot-com breakdown and stock market corrections, many wonder if LBO markets will resurge yet again. The reasoning is that acquisition multiples have started to decline and sellers finally are willing to realistically accept the resulting lower valuations. The high yield market has not recovered to its 1998 level, but leveraged loan makers are seeing ample liquidity among institutional investors, and several recent transactions suggest that the market is quite receptive to LBO activities.

How does one make sense of the spectacular rise and abrupt fall of the LBO in the 1980's? How has the business changed from its origins in the 80's? What is the outlook for the business? This paper attempts to answer these questions by providing a brief overview of the LBO market and exploring future trends by examining the changes in financial structure and contributing factors over time. As a general theme, the LBO market is a demonstration of the works of the invisible hand of the market trying to eliminate inefficiencies through exploiting arbitrage opportunities. Profitability comes from the financial inefficiency in the 1980s, and shifted more towards operation inefficiency in recent times. The flow of funds into the LBO market is determined by the relative profitability of this market compared to alternative markets, and is therefore affected by the business cycles.

II. The 1980's LBO Boom
Leveraged buyouts are probably one of the most remarkable success stories of the 1980's.
One of the major events that received widespread publicity concerned the substantial profits generated in the Gibson Greeting Cards transaction. The company was first taken private in 1982 and taken public again a year and a half later. A management group led by Wesray Capital bought Gibson from RCA in 1982 for $80 million, contributing only $1 million of its own capital. Without significant changes in the company - although perhaps benefiting from the bull market which began in 1982 - the going public price eighteen months thereafter was $290 million. One of the Wesray principals, former Treasury Secretary William Simon, received $66 million in cash and stock on his investment of $330,000.

Substantial returns on investment turned LBOs into one of the most lucrative investment ideas of the 1980's, attracting many participants, including banks, insurance companies, Wall Street firms, pension funds, and wealthy individuals. From 1981 to 1989 there were over 1,400 "going private" transactions. The traditional LBO deals were small until the first mega deal, the Wometco transaction, which was valued in excess of $1 billion in 1984. Since then, the LBO market had enjoyed explosive growth, with the size of the total leveraged buyout market increasing from $4.5 billion of completed transactions in 1983 to $76.6 billion in 1989. The twenty largest LBO transactions for the period 1983 to 1987 had a total purchase price of $76.5 billion (Source: M&A Database).

1. Financing Structure

The extraordinary increase since the mid 1980's in the size and complexity of LBO deals have been accompanied by a massive influx of innovative financing achieved through a variety of financial intermediaries.

Capital for a leveraged buyout generally consists of the following: (i) senior debt, (ii) senior subordinated debt, (iii) subordinated debt, (iv) mezzanine financing, (v) bridge financing, and (vi) equity layers (see Exhibit 4 for a detailed description of capital structure components). The equity layers in the 80's were usually relatively thin, contributing less than twenty percent of the total capitalization of the new entity. Commercial banks were generally the main source of senior debt, with institutional investors providing mezzanine financing, equity financing, and pools of capital, with or without specified uses. The latter are referred to as blind pools.

2. Sources of Value Created

Over the years there has been much debate regarding the value created by LBO transactions. Skeptics argued that the LBO is simply a means for Wall Street to earn paper profits by arbitraging the valuation differences between public and private markets. Studies by academics and professionals, however, have provided ample evidence of substantial value contributed by leveraged buyouts.

For example, a recent paper examined 90 post-LBO firms that returned to public market through IPOs between 1983 and 1988 (Holthausen and Larcker, 1996). It found numerous points indicating value. In the year before re-entry into public market, the LBO companies had almost doubled the pre-interest, after-tax profits of their competitors, used only half as much working capital, and maintained similar levels of employment. Additionally, the firms had larger marketing budgets. Total capital expenditure was lower, but this was in line with the expectation for the industries with excess capacities. After all, these industries were where most of the LBOs occurred. In addition, for at least four years after the IPOs, these 90 firms continued to outperform their peers both in terms of stock returns and operating returns. Given that the average IPO significantly underperforms market average over a three-year period after going public, such performance improvement by post-LBO firms seems quite impressive (Ibbotson, Ritter, and Sindelar, 1994).

One obvious source of value created is a large reduction in tax burden that a highly leveraged firm obtains through the tax deductibility of interest payments. This was significant because in the 1970's most companies consistently operated at sub-optimal debt-to-capital ratio (see Exhibit 2). In those days the corporations applied financial portfolio theory to strategic design. They strove to increase size and diversity. Continued growth took priority over shareholder value. Consequently debt was used very moderately to minimize the risk of defaulting on interest or principal payments and to allow investments in continued growth. The LBO substituted equity with heavy debt, thus utilizing the previously ignored debt tax shield (at the cost of financial distress, which is discussed later).

Another indirect source of value created is increased clarity in the strategic goals of the enterprise. Diversification, often times empire building, was the main theme in corporate America in the 70's. It was not uncommon to find cheese producers clustering with film producers under the same corporate umbrella. Often overly diversified corporations suffered from disadvantages such as high overhead, slow reaction time, misaligned incentives, politicized decision-making, and a confusing image delivered to investors. The spun-off units after LBO transactions hence were able to operate with more focused strategic goals and achieve better performance.

The most important source of value is the effects on capital and incentive structures, best articulated by the "carrot and stick" mechanism (Jensen, 1986). The mechanism is as follows: First, managerial incentive is through equity participation (the "carrot"). Prior to LBOs, management-owned stock or stock-related compensation was rare. With LBOs, the buyout firms typically owned 80-90% of the target, and operating management owned about 10%. This resulted in an ownership structure that was clearly aligned with the interests of the management and owners, hence reducing agency costs in managing the firm. As manager's ownership significantly increased, it gave them strong incentive to work harder. Second, managerial discipline was tightened through high debt service requirements (the "stick"). Jensen characterizes LBO targets as "firms or divisions of larger firms that have stable business histories and substantial free cash flow (i.e., low growth prospects and high potential for generating cash flows) - situations where agency costs of free cash flow are likely to be high". Managers in such firms have an incentive to spend free cash flow on value-dissipating investments that increase firm size, because a larger firm offers incumbent management greater compensation, greater power, and greater opportunities for advancement. So one benefit of the high level of post-buyout debt is the forced distribution by management of the firm's free cash flow to debt servicing rather than to value-dissipating investments.

Of course, heavy debt can be risky as the expected cost of financial distress increases with the leverage ratio. A firm is said to be in financial distress if (i) the firm's earnings before interest, taxes, depreciation and amortization (EBITDA) is less than its interest expense, (ii) it attempts to restructure its debt, or (iii) it defaults on its debt (Andrade and Kaplan, 1997). In the early 80's, however, most LBO targeted companies were "mature, stable, asset-rich companies with low capital needs." The LBO financing structure was relatively conservative and appropriate for the underlying business risk. Hence the combined benefits of debt outweighed its disadvantages, bringing significant success to a majority of LBO transactions.

3. Market Context

The growth of the high yield bond market undoubtedly contributed to the growth in the LBO activities. Early in the 80's, junk bonds were primarily used as a substitute for bank debt for various firms, such as those that were relatively unknown, those in high-risk, those in start-up industries, or those that for various other reasons didn't have good access to public markets for investment financing. Later in the decade, firms that previously had strong credit ratings also began issuing low-rated but high-yielding bonds to finance acquisitions and buyouts. According to Morgan Stanley, the high yield bond market grew from an average of $7 billion in 1970 to an average of $59 billion in 1985 and an average of $146 billion in 1988. Moreover, data developed by E. Alan Brumberger at Drexel Burnham Lambert Inc. shows that in 1982 only 3% of the high yield bonds issued were in conjunction with LBOs, while by 1985 the amount had increased to 50%.

Although traditional LBOs relied primarily on bank financing, the role of financial participants such as investment bankers greatly facilitated the growth of the LBO market. These investment bankers provided multiple services, such as fair counsel on the terms of the transaction, highly confident letters stating that financing will be available, and bridge financing to provide interim loans to complete the deal. The substantial fees were highly chased after, especially following the elimination of fixed fees in the brokerage industry.

The explosive growth that occurred in assets under management of institutional investors was another important force in LBO activity. According to a report submitted to the U.S. House of Representatives, "Leveraged Buyouts and the Pot of Gold: 1989 Update", these institutions controlled over $4.6 trillion in assets in 1987 compared with $2.1 trillion in 1981. While banks still contributed more than half of LBO debt financing, tax-exempt institutional investors provided a sizeable investment in LBO bonds and up to 50% of LBO equity financing, clearly helping to drive the market.
III. Sharp Decline in the Late 1980's

1. End of the Leveraging Mania

Although the early LBO market created value through significant shareholder gains and increases in operating efficiency, things started to head south by the late 1980's. The first eight months of 1989 saw $4 billion worth of junk bond defaults and debt moratoriums. The first signs of crisis were manifested through the financial difficulties of Canadian entrepreneur Robert Campeau's retail empire in September 1989. Mr. Campeau's failure to meet a scheduled interest payment caused a two percent abnormal return (return adjusted for market movements) in the average stock prices of leveraged firms during the three-day period. Junk bond spreads widened from 500 to 700 basis points and gross inflows into junk bond mutual funds sagged.

The second sign of trouble came just one month later when Citibank and Chase failed to provide the necessary $7.2 billion funds to Stephen Wolf, CEO of United Airlines (UAL), to take UAL private. The news that the loan could not be syndicated shook the stock market, sending risk arbitrageurs rushing to unload their shares in hand.

Bad news gathered pace: many U.S. firms sought Chapter 11 bankruptcy protection. In 1990, the number of corporate bankruptcies that involved more than $100 million in liabilities each reached 24 and amounted to an aggregate of $27 billion in liabilities. The number of such large filings rose in 1991 to 31, while total liabilities stood at $21 billion. In 1992, the number of large bankruptcies declined sharply but the debts involved dropped down only slightly. The LBO market suffered a decline that was so sharp that many people predicted the death of the LBO and junk bond markets.

2. What Went Wrong

According to an article by Kaplan and Stein (1993), of the 41 LBOs between 1980 and 1984 with purchase prices of $100 million or more, only one had defaulted on its debt by the end of 1991. By contrast, at least 26 of 83 large deals done between 1985 and 1989 had defaulted, and 18 had gone into bankruptcy, by the end of 1991. Kaplan and Stein's analysis yields the following "overheated hypothesis:"

Beginning in 1985, junk bond investors poured boatloads of money into the booming buyout market, hoping to imitate the success of early deals. This pushed prices up and fundamentally changed the buyout pricing and financing structure. In particular:

" Buyout prices as multiples of cash flows rose sharply, and multiples were especially high in deals financed with junk bonds.
" As prices rose, buyouts were undertaken in riskier industries, and with higher leverage ratios. High industry risk was positively related to the probability of distress and default. Indeed, buyouts in the riskiest industries, for example, retailing, were 19% more likely to experience distress and 14% more likely to default than the average buyout.
" Recognizing the increased risk inherent in later LBOs, banks made a few "defensive" structural adjustments by taking smaller positions and at the same time accelerating principal repayment schedule. For example, bank debt represented over 70% of total debt in the period 1982 to 1984, but dropped to 42% in 1985. The rapid repayment schedules sharply lowered the ratio of cash flow to total debt servicing obligations, which in turn increased the probability that companies would run into financial distress.
" Beginning in 1985, financing from the public junk bond market displaced not only private subordinated debt, but also to some degree senior bank debt. Another type of widely-held debt, called cram down debt,[1] was also frequently issued. Many junk bond and cram down debt holders agreed to increasing the use of deferred interest in the buyouts, in which much of the bank debt was scheduled to be paid off before deferred interest debt that was predominantly public subordinated debt (either junk or cram down debt). This further juniorized the subordinated debt, potentially transferring value to the senior bank lenders at the expense of the junior creditors. Also declined was the use of strip financing,[2] therefore increased the expected restructuring costs due to increased conflicts of interests between creditors and shareholders.
" Management, investment bankers and other interested deal promoters were able to get more money upfront out of the later deals, reducing the commitments of all related parties to the long-run success of the deals.

Also worth mentioning is the fact that the coverage ratios [3] went so low that the post-LBO firms had to rely on asset sales and the speedy realization of major operation improvement in order to make the first interest payment. So even if the deal was done in the right industry for the right company at the right time, such a financial structure sometimes forced managers into a series of shortsighted value-destroying actions.

Some have argued that politics and not economics stopped the leveraging business. For example, during the late 1980's, banks were forced by regulators, rating agencies and the stock market to reduce their highly leveraged transaction exposures. This in turn reduced banks' willingness and ability to work with highly leveraged post-buyout firms that failed to meet debt service requirements. As a result, it became more difficult to restructure distressed firms out of bankruptcy. However, examination of the legal developments in the late 80's and early 90's by McCauley, Ruud and Lacono (1999) suggests that although there was a political reaction to excessive leveraging LBO market, which spurred significant legal developments, these developments did not kill the LBO market. The legal changes may have been significant but cannot be blamed for the end of the LBO business. The leveraging mania expired when its own excessive risk became apparent and no new creditors were willing to accept additional risks.

It was debt euphoria and greed for profits that sent the leveraging businesses in the 80's to its sad end. According to Brancato (1989), prior to 1983, debt of non-financial corporations fluctuated within a narrow range of 33 to 35 percent of GNP. In 1988, that figure rose to approximately 42 percent of GNP. For the period 1984 to the third quarter of 1988, a total of $793.8 billion of corporate bonds had been added to the credit markets, and a total of $422.3 billion of corporate equities had been withdrawn. The explosive increase in the aggregate debt in the economy exponentially increased the risks and costs of financial distress. As a consequence, the overall quality of outstanding debt deteriorated markedly. In addition, the total volume of deals dropped precipitously from a high of $76.6 billion in 1989 to only $6.9 billion in 1991.

IV. LBOs in the 1990's

As the 1980's yielded to the 1990's, U.S. corporations returned to the equity market at full scale. The reasons for such return included capturing the equity market expansion fresh out of the recession and de-leveraging to ease corporations out of the heavy debt burden. Leveraged buyouts went out of fashion in 1991 and showed only a moderate recovery half a decade later.

Starting in 1996, the buyout market started to gain wide attention again, reaching a total transaction value of $24.2 billion from a $6.5 billion in 1995, according to Mergers & Acquisitions (1997). The transaction volume was not as high as those in the LBO boom of the late 80's, but it was about the same level as those in 1984 and 1985 (see Exhibit 3). The rise can be partially attributed to the buoyant mergers and acquisitions market that was incredibly strong in 1996 as CEOs were focusing on both strategic acquisitions and pruning their non-core-businesses. Overall, 10,000 M&A deals were conducted in 1996, totaling $657.4 billion in transaction value, overshadowing the prior record set the year before of $522.4 billion for just over 9,000 deals.

Another factor in the resurgence of LBOs in the mid-90's was the unprecedented flood of capital that flew into buyout funds from institutional investors, pension funds, and high net-worth investors. Buyout funds raised nearly $15.8 billion in the first nine months of 1996. The third quarter of 1996 took in $8.3 billion in new money, more than the total amount raised in all of 1993, according to Buyouts magazine (1996).

The LBOs funds made a triumphant return in 1996, having received a great deal of new funding from investors and having come back to the market with a new, warm image of supportive capital providers rather than cold hostile raiders. That year LBO shops grew in numbers not seen since the late 80's.

The LBO deals in the 1990's, however, were very different from those in the 1980's. The 1990s' LBOs were done with fewer ideal targets, more intense competition, less leveraged capital structure, different sources of value created, and a sharply reduced mean industry return.

1. Fewer Ideal Targets

First and foremost, there were far fewer good LBO targets available during the 1990's than during the 1980's. During the early 80's, U.S. productivity, as measured by hourly output, grew at only a nearly stagnant 1% annually. Company valuations were extremely low. In addition, the existence of a good number of inefficient conglomerates provided amply room for buyout firms to utilize their financial acumen and artistry to discipline free cash flow and incentives management. All these factors combined to create a perfect environment for LBO transactions.

By comparison, the U.S. productivity growth rate soared to an annual average of 3.1% by the mid 1990's, thanks to technology advances and an entrepreneurial boom. An interesting study by Holmstrom and Kaplan (2001) suggests that U.S. companies were increasingly following the principles pioneered by the LBOs of the 80's. Enhancing shareholder value had become a tenet that was widely accepted by corporate America. Incentive-based compensation was also fairly common. Internal corporate governance mechanisms had become much more effective in the 1990's, thus leaving little room for corporate raiders or buyout firms to optimize performance with their standard toolkits. Holmstrom and Kaplan's study has been confirmed in a recent survey of buyout general partners by Asset Alternatives, a research firm specializing in private equity industry. Furthermore, as Exhibit 5 shows, both large-cap and small-cap valuations as of 2000 are still above historical value investing levels, resulting in fewer bargains being available. This has increased the difficulty for buyout firms to profit upon exits. In addition, the U.S. economy has been shifting from manufacturing industries towards service industries, and the latter are harder to leverage due to the higher intangible asset base. As a consequence of all above factors, ideal buyout targets are much harder to get in the 1990's and 2000's than in the 1980's.

2. More Intense Competition

Second, the competition in the buyout market was much more intense during the 1990's than during the 1980's. One reason for this increased competition was that the successes of buyout firms during the 80's drew many imitators to join the buyout bandwagon. This was the case despite the industry's decline in the late 80's. Such veterans as Henry R. Kravis and Theodore J. Forstmann -- founders in the 1970's of two of the earliest LBO firms -- once had free rein in the 80s; now they faced 850 competitors. In addition, much larger amounts of money had been raised by the industry. According to Asset Alternatives' 2001 research report, aggregate buyout fundraising expanded from 1991 to 2000 at an annual rate of 34%. The expansion could (at least partially) be attributed to the significant growth of large state pension systems. This vast pool of buyout funds tended to concentrate their activities on certain industries at the expense of depressing industry-wide returns. Finally and most importantly, financial buyout firms were finding themselves competing against a wide range of players, including strategic buyers. As the latter generally could provide higher bid prices resulting from business synergies, financial buyers were being forced to focus on smaller businesses and parts of conglomerates.

3. Less Leveraged Capital Structure

Third, the supply of capital to finance the buyout transactions in the 1990's differed greatly from those in the 1980's. The good news was that since the 80's, the high yield market experienced much growth marked by a few ebbs and flows. This supported LBOs from time to time. In addition, the mezzanine market experienced steady growth throughout the last decade with its increasingly important role for buyout deals that were too small to be financed in the high yield market. The bad news, though, was that the senior debt market was lagging behind the growth of buyout equity. Also, the substantial consolidation among financial institutions in the late 90's increased the bargaining power of senior lenders at the expense of buyout firms. In general, because of the extra risk of bankruptcies and low credit ratings, creditors were no longer willing to accept the extremely high leverage ratios prevalent in the 80's and thus forced buyout firms to put in more equity capital and reduced their buyout returns significantly. According to Portfolio Management Data (Exhibit 6) and Asset Alternatives (Exhibit 7), the leverage ratios have dropped from about four times equity in the 80's to only two times equity in the 90's, increasing the equity component from 18% in the 80's to 32% in the 90's.

4. Different Sources of Value Created

As a result of the above factors, fund managers have been trying hard to extract value from a very different set of sources. At their origin, buyouts, especially leveraged buyouts, had been perceived historically as an organizational efficiency tool to streamline organizational processes, reduce workforces, and decrease unit costs. This efficiency approach has been especially useful with mature firms, where the debt structure and limits to managerial spending decrease the downside risk and possible failure of the firm because the decrease in leverage, operating improvement became the primary source of LBO value creation in the 1990s. According to Asset Alternatives, a recent survey of general partners in the buyout business shows that from 1986 to 1990, financial leverage contributed 41% to average buyout returns, followed by operating improvement (34%), multiple expansion (14%),[4] and multiple arbitrage(11%);[5] by contrast, from 1996 to 2000 operating improvement contributed 43% to average buyout returns, followed by financial leverage (24%), multiple expansion (22%), and multiple arbitrage (11%).

5. Sharply Reduced Mean Industry Return

The buyout firms in the 1990's were competing in a much more challenging and different environment than their counterparts in the 1980's. The industry became more mature and specialized. The mean industry return dropped sharply, making the abnormally high returns achieved by the early LBO deals simply impossible for the buyout firms in the 90's (Exhibit 9). According to Business Week, (October 2000), LBO performance has drifted downward from an annualized return of 35% in 1989 to 20% in the first quarter of 2000.

V. Future Outlook and Strategies

Now that the "irrational exuberance" of the new economy has evaporated and valuations have dropped dramatically, many are asking whether the buyout deals will come back. The answer, we think, should be yes. Buyout firms are presented with many good opportunities as sellers in financial difficulties are increasingly willing to accept the more realistic, lower valuations and as investors are trying hard to find investment opportunities to beat the S&P 500 return. But will the new buyout deals be the same as the glamorous ones in the 80s? The answer is probably no. The October 2000 issue of Business Week best states the recent attention that buyout funds get: "it may not be the glory years, but buyout shops are back, raising billions - and heading into unchartered waters." The competitive environment is certainly much more challenging than that of the 80s; yet the drop in returns isn't driving investors away. This is because the top 25% of LBO funds still regularly beat the returns on the S&P 500 Index. Trying to give an estimate of future industry average return is not only difficult but also not very useful in suggesting future trends. Instead, some qualitative characteristics of the future LBO market may be suggested.

1. More Entrepreneurial Focus

One trend is that buyout deals will be more focused on younger companies rather than established ones. While traditional buyouts were likely to occur in established, cash-rich firms within a mature industry, today buyouts have increasingly become a way to unlock the entrepreneurial spirit from rigid corporate structures, with increasing attention paid to technology-related industries. The main driver behind this phenomenon is the tremendous technological advances that the last decade has witnessed. These entrepreneurial buyouts demand different skills from the traditional monitoring skills required in the 1980's buyouts. Financiers need to understand the technology sufficiently to assess the investment and to monitor it.

A recent variation of the leveraged buyout, the leveraged buildup (LBU) has facilitated wealth creation, as mid-market businesses become parts of larger enterprises. These transactions typically work in the following way: the fund buys a small company or a small unit of a big company -- usually one with no more than $ 15 million in revenues -- that serves as a ''platform'' to which smaller companies with industry synergies can be added in subsequent transactions. The screening criteria are based more on long-term productivity of synergistic assets than on simply cheap bargain price tags. The leveraged buildup strategy has demonstrated the ability of LBO or LBU funds to act as a conduit for the transfer of funding and professional skills into the small-to-middle-cap market, which historically has been less efficient and less chased after compared with the large-cap market.

2. Shifts from a Financial Focus to an Operational/Strategic Focus

The second trend is the shift from a financial focus to an operational/strategic focus. According to a 1999 report by McKinsey & Company, the LBO wave in the 80's effectively removed the financial/capital market inefficiencies, while the current wave of buyout investments addresses strategic and operational inefficiencies at both the industry and portfolio company level. One can argue that there are still considerable financial inefficiencies best indicated by the fad of public - private deals as the result of market valuation fluctuations and the many interesting unknowns in the relatively young financial research field of venture capital and private equity. Still, a growing number of buyout firms are realizing the need to incorporate operation expertise into deal process and portfolio management. In many buyout firms operating and financial partners are involved in the investment process from deal origination through due diligence and closing. After the deal is done, the operating partner serves on the board of portfolio companies to oversee important operation decisions of portfolio companies.

The trend is also evident in the increasingly blurred distinctions between different fund vehicles in the private market to which investors can avail themselves: strategic buyers, financial buyers, venture capital firms, and buyout firms, etc. For example, leveraged buildup strategy effectively allows a financial buyer to assume various functions of a strategic buyer by linking separate private equity transactions to a synergetic platform. Instead of just buying out a firm, buyout firms nowadays also invest non-controlling stakes in public companies in the form of convertible preferred or common stock (widely known as PIPE - private investment in public equity). Regardless of what format these private funds take, going forward, a successful private equity fund will have to be able to combine financial acumen with industry knowledge and hands-on management expertise.

3. Global Expansion

Finally, due to increasing competition inside the U.S., there is a trend calling for buyout funds' global expansion to better tap the vast potential of buyout opportunities in Europe and Asia. The vision of managing director David M. Ruberstein at Carlyle Group, according to Asset Alternatives' recent survey, is that "just as there are two or three truly global investment banks, we think there will eventually be two or three global private equity firms with whom partners and investors will have the same level of comfort as when they call Goldman Sachs, Morgan Stanley, or CS First Boston on investment banking business." Whether or not the number will come down to two or three is not really important, but the abundant privatization and de-conglomeration opportunities in Europe and Asia coupled with relatively less developed local capital markets have already stimulated much interest among buyout firms to grow their international business.

For example, European private equity fundraising has grown at 53% compound annual rate from 1995 through 2000, as indicated by data from European Venture Capital and Private Equity Association. In contrast, U.S. buyout fundraising has grown only at a 32% compound rate in the same period. In addition, buyout returns have generally been substantially higher in Europe than in the U.S. during the past three years.

Asia is also experiencing an M&A boom, having recovered from its 1998 financial crisis. The need for restructuring or cash has driven Asian buyout transactions. In addition, U.S. investors are becoming more comfortable with investments in Asia. In order to gain the first mover's advantage, many law firms and buyout funds are launching their Asian acquisitions finance groups to position themselves at the forefront of the burgeoning LBO market.

Given the significant differences in legal, regulatory and accounting environments, it is important for firms that are considering international expansion to absorb more local expertise and knowledge.

VI. Conclusions

The early LBOs in the 1980's created significant value by removing financial inefficiencies and improving corporate governance mechanisms. Massive profits from these early transactions attracted many participants including banks, insurance companies, Wall Street firms, pension funds, and wealthy individuals. The demand push from the public junk bond market that began around 1985 fundamentally changed the pricing and capital structure of later buyouts, leading to a sharp increase in post-LBO failures. The recovery of the market for large LBO deals began in 1991, reaching impressive heights again in 1996 and 1997. However, the financial structure and sources of returns for the 1990's deals have been very different from those for the 1980's deals, reflecting a different macroeconomic environment, more intense competition, and increased industry maturity. Looking forward, buyout deals are likely to exhibit a shift to more entrepreneurial businesses, a need for more operational expertise, and an expansion geographically to tap into vast opportunities in Europe and Asia.

(Li Jin is Assistant Professor of Finance, Harvard Business School, Morgan Hall, Soldiers Field, Boston, MA 02163. Tel: 617-495-5590, Fax: 617-496-5271, ljin@hbs.edu. Fiona Wang is Associate, The Brattle Group. The authors thank Rui Zhao and Charles Wang for helpful comments, and Chris Fang-Yan for editorial assistance.)

Notes:
[1] Cram Down Debt: Debt issued by new buyout firms as part of the payment to the pre-buyout shareholders in order to take the company private. Because the pre-buyout shares are widely held, so is the cram down debt.
[2] Strip Financing: Participation in the long-term debt and equity accounts of an acquired company or buyout. Horizontal strip financing involves each participant's assuming a horizontal layer, i.e., one investor taking senior notes, another senior subordinated notes, another junior notes, and another preferred stock. Vertical strip financing involves the sharing among investors of a portion of each class of debt or equity instruments. The vertical approach was popular because it evenly distributes the risk and liquidation preferences.
[3] Coverage Ratio: Defined as ratio of earnings before payment of interest and income taxes to interest on long-term debt and other contractual long-term obligations.
[4] Multiple Expansion: Industry-wide growth or cyclical expansion.
[5] Multiple Arbitrage: Deal-specific differences between purchase and sale multiples.

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Generally, the financing structure of the 1980' LBOs included the following:

Exhibit 5: U.S. Large-Cap and Small-Cap Valuation Trends, 1990-2001 U.S. Large-Cap Valuation Trend, 1990-2001 (Source: Wilshire Associates) 

U.S. Small-Cap Valuation Trend, 1990-2001 (Source: Wilshire Associates)

Exhibit 6: Average Equity Contributions to Buyouts, 1987-2000 (Source: Portfolio Management Data)

Exhibit 7: Comparative Deal Financing Structures, 1986-1990 vs. 1996-2000 (Source: General Partner Survey, Asset Alternatives, 2001)

 

 

 

 

 

 

  

Exhibit 8: Components of Sources of Return, 1986-1990 vs. 1996-2000 (Source: General Partner Survey, Asset Alternatives, 2001) 

 

 

 

 

 

 

 

 

Exhibit 9: Public Equity vs. Private Equity Returns, 1980-2000 (Source: Venture Economics)