Why do LBOs occur in the first place?
To explain this, I will resort to an analogy.
A car wrecker will often buy a fully functional (but old) vehicle,
and simply junk it, because to the wrecker, the vehicle is worth
more as spare parts than it is as a fully functional car.
This is precisely the way corporate raiders look at a corporation!
(as a conglomerate of companies than can be broken apart and sold
separately as independent companies)
Incidentally, those who take over another corporation forcibly
are known as "corporate raiders". When the takeover
results from the acceptance of a buyout offer, the purchase is
simply referred to as a leveraged buyout. Raiders buy corporations
for the purpose of selling off the component companies separately
for more money than what they paid for the fully functioning corporation.
In other words, the raider attacks corporations whose spare part
value is greater than their stock market share value.
To illustrate the point, let's say that a corporation has 100
million shares that are trading on the stock exchange for $1 each.
Theoretically, the market place puts a value on the corporation
of $100 million dollars. However, if a corporate raider determined
that he could sell the various companies comprising the corporation
separately for $150 million, he could theoretically make a quick
unearned $50 million by buying the stock market shares for $100
million, and then individually selling off the components of the
corporation for $150 million.
In other words, the takeover operators secretly have reason to believe that the one million shares are therefore in reality worth $1.50 a share, so they will approach the corporation and offer to buy enough shares to get controlling interest. Acquiring controlling interest is necessary to be able to initiate the "sell off" of corporate assets. In order to be able to buy enough shares to gain controlling interests, the takeover purchasers might try to lure the shareholders into selling their shares by offering a premium of say 10 cents per share over the going share market price. So in our example, the raiders could offer to pay $1.10 per share, instead of the going rate of $1.00 per share. If enough shareholders agree to sell their shares at this premium, the raiders could assume controlling interest in the corporation. The corporation would effectively be bought out. The new owners would then proceed to sell off whatever of the corporation's companies they wished. Often, just enough companies are sold off to cover the cost of the purchase, while the remainder, which represent the profit of the deal, are kept. Usually the better companies, known as the "cash cows", are kept as sources of positive cash flow to fund further takeovers.
If, as another alternative, they choose to sell off all the companies (i.e. even the cash cows), and succeeded in doing so for $150 million, they could make a relatively instant $40 million profit, involving no productivity whatsoever.
When corporate managers try to prevent corporate raiders from buying up enough stock to hold a controlling interest of their corporations, directors are usually forced to borrow heavily, or to sell off some of their companies' assets, in a desperate move to get cash to purchase their own common stock at the abnormally inflated stock prices offered to their shareholders by the takeover operators.
The other alternative is for the existing directors to virtually pay the corporate raiders what amounts to a ransom to leave the corporation alone. This ransom, which usually involves a "buy back" of whatever shares the raiders have managed to buy up, is known in the industry as "greenmail", a euphemistic term for the technically legal blackmail that takes place, and which the justice system blatantly ignores.
If the corporation gets bought out, or, if it is forced to pay greenmail, the end result is similar; the equity of the corporation gets replaced by debt, which lowers it's tax liability, reduces its cash flow, and makes it increasingly vulnerable to financial problems.
Basically, raiders act as "corporation wreckers", functioning much the same as "car wreckers". If, as a result of selling off the component companies, the corporation's primary product stops getting produced, well tough luck! Raiders are interested only in quick profits.
Stripped bare, corporate takeovers are, in essence, non-productive, economically debilitating real estate flips.
Those wishing to have a clearer appreciation of the debilitating effects suffered by companies which try to fight off takeover bids are encouraged to read the article entitled "Invasion of the company snatchers" in the Dec 12 1988 issue of Forbes. {B53} On the other hand, the article on page 102 of the Sept 4 1989 issue entitled "Don't blame me", details some of the debilitating problems suffered by businesses that have been taken over and reorganized according to the whims of new owner/speculators. {B54} Similarly, the article "One man's poison" on page 38 of the Oct 16 1989 issue leaves little doubt that businesses burdened with LBO debt are, from a competitor's point of view, often less able to compete.
In addition, "tax loss credits" that are generated by LBOs later encourage MERGERS with other profitable companies who use the tax loss credits to avoid paying taxes on their own profits. A brief discussion of this additional tax avoidance rip-off will follow later under the topic: Mergers (Monopolies and Tax Avoidance).
Can those taking part in a corporate raid get rich milking the
economy like this?
To partially answer that question, let me quote from the July
11 1989 edition of Financial World which had an article
on Wall Street's one hundred highest paid earners.
"In general, most of the top 100 earners have two things in common ...they are principles in their firms, and they are deeply involved in takeovers." {B55}
The answer, therefore, is that you most certainly can, and in
two distinct ways. The most profitable way is to be the corporate
raider.
Example: According to Forbes magazine, which does a yearly assessment
of the wealth of the richest 400 Americans, Ronald Owen Perelman,
(a leveraged buyout specialist) increased his personal wealth
by $750,000,000 (Seven hundred and fifty million dollars) in the
period between their 1988 survey, and their 1989 survey. Start
getting concerned!! He was not alone. {B56}
The second most profitable way is to help provide the funding for the corporate raider. For this service, the banks and the junk bond salesmen earn handsome commissions.
How much can a junk bond commissioned salesman make, who assists
the corporate raiders?
Example: Michael Robert Milken. Forbes indicates that Mr. Milken
increased his own personal wealth from 800 million in the 1988
survey, to one billion, two hundred and seventy million in the
1989 survey. His 470 million increase in one year, like Ronald
Perelman's seven hundred and fifty million dollar increase didn't
materialize out of nowhere.
One way or another the cost of his commissions will be passed along to the consumer. {B57} The article "Who's really picking up the tab?" in the Oct 30 1989 issue of Forbes provides enough facts and figures to make anybody steam under the collar. {B58}
LBOs continue at great cost to society, and with far ranging social and economic repercussions, despite the economic elite's rhetoric to the contrary. The numerous social side effects of LBOs are even more ethically scandalous than the flip profits or the drastic reduction to taxes paid. The various component companies which formerly worked together smoothly may now be convulsing under new inexperienced managers. In fact, many managers who spend a lifetime working their way up through the ranks are often let go, suddenly depriving them of well earned pensions, and forcing them quite abruptly into competition with much younger men for a diminishing number of managerial jobs. Management, however, are not usually the only ones who face unemployment hardships as a result of "mergers and acquisitions" (M&As), as they are jointly referred to.
Companies or divisions of companies which manufacture items that can be manufactured more cheaply using 3rd World slave labor, are often shut down and relocated overseas. A recent survey of several thousand American takeovers which took place between 1977 and 1982 has shown that firms which had been taken over employed about 12% fewer staff in 1982 than they had in 1977, while firms which had not been taken over had, on average, increased their staff by about 4%. Overall, wages and benefits fell by about 12% for the staff of firms taken over. {B59} Often a drop in product output, and/or a drop in product quality follows on the heels of cost cutting measures introduced by new profit conscious owners. Effectively, Americans are being fleeced, cheated, and unemployed simultaneously.
Meanwhile, the bulls continue to run as the stock market continues to climb from LBO buying pressure, and consequently the share prices are once again unrealistically high. The LBO frenzy has also driven up the cost of corporate real estate, and in the process, residential real estate as well, to the point that buying a home seems beyond the reach of many hard working productive Americans.
Market speculators will begin 1990 once again nervously poised to dump their stock portfolios at the very first sign of a market sell-out, and that is precisely what the October 1989 crash was all about. The stability of the economy as a whole has already been seriously undermined.
A recession, or worse yet, a depression, could easily cause these leveraged to the hilt corporations to go bankrupt due to a loss of cash flow which could occur during a normal recession. {B60} They could begin defaulting on their enormous bank loans and usher in a catastrophic collapse of the banking system!
So don't let politicians convince you that a corporation based on debt (with no reserves left to survive even minor disruptions to its