What are leveraged buyouts
John W. Kluge (kloo gy), an immigrant from Germany, was for many years a food broker in Washington, D.C. In 1959 he and some friends bought control of the Metropolitan Broadcasting Corporation (MBC) which was a television network (far smaller than NBC, CBS, and ABC) and owned two radio stations. Kluge changed the name to Metromedia and proceeded to build up over 25 years its holdings to seven television stations and 14 radio stations. Metromedia also owned the Ice Capades and the Harlem Globetrotters.
Kluge was always open to new ventures for making a profit. For example, he bought the depreciation rights to the $100 billion of New York's buses and subways. Because of his sometimes unorthodox ventures he felt constrained by having to report to public stockholders even though he held 25 percent of Metromedia. In 1983 he decided to take Metromedia private through a leveraged buyout.
Kluge and his backers had to raise $1.45 billion to purchase 28.6 million shares, refinance Metromedia's existing debt, purchase employee stock options, and provide working capital for the transition. Ten banks led by Manufacturers Hanover Trust provided an eight year loan of $1.3 billion taking Metromedia's assets as collateral. The rate of interest was 1.5 percent above the prime rate and there was a covenant that required Metromedia to maintain a minimum net worth of $100 million.
Kluge made a per share offer to the shareholders of Metromedia of $30 in cash and subordinated debentures having a face value of $22.50. The market value of these fifteen year debentures which would not pay interest until the sixth year was estimated to be $9.50 to $10.00. A threatened stockholder suit brought an increase in the offer by $1 per share. The offer was accepted and Kluge ended up with 93 percent of the voting stock of Metromedia.
Metromedia's ratio of long-term debt to equity was 3.5 and Moody's and Standard & Poors lowered the rating of Metromedia's debentures. In June of 1984 Metromedia went private. Six months later Kluge had Drexel Burnham Lambert sell $1.3 billion of junk bonds to replace his bank loan. It was the biggest junk bond issue up to that point but it sold out within two hours.
In 1985 Kluge sold six of Metromedia's seven television stations to a group headed by Rupert Murdock for $1.5 billion and the remaining station (in Boston) was sold to the Hearst Corporation for $450 million. In 1986 he sold off a billboard operation for $710 million and the Harlem Globetrotters and Ice Capades for $30 million. In 1986 the chain of radio stations was sold for $285 million. This left telecommunications as the main element of Metromedia's operations. But a few months later Kluge sold Metromedia's cellular telephone and paging operations to Southwestern Bell for $1.65 billion. Altogether Kluge sold $4.6 billion of Metromedia's assets.
Gibson Greeting Cards
This company was founded in 1850 and became a corporation in 1895. In 1964 CIT Financial Corporation acquired Gibson Greeting Cards, but in 1980 CIT Financial was acquired by RCA and Gibson became a subsidiary of RCA. Gibson was doing well. In 1984 it was the third largest greeting card company with sales of $304 million. RCA was however implementing a policy of concentrating on its core business of NBC, Hertz, electronics, and communications and decided to sell Gibson Greeting Cards. It was sold to Wesray Corporation, a creation of former Secretary of the Treasury William Simon. The price was $81 million. Wesray gave Gibson management 20 percent of the company. The new Gibson stockholders, including Simon, invested $1 million. The funds came in part from loans from General Electric Credit Corporation ($40 million), Barclays American Business Credit ($13 million). The rest came from Gibson selling and leasing back its three major manufacturing and distribution facilities. Thus the price was actually only $54 million. General Electric Credit Corporation got warrants to
purchase 2.3 million shares at 14 cents per share and additional interest in proportion to any dividends paid by Gibson Greeting Cards. The interest rate in 1982 on Gibson's debt averaged 19 percent. Eighteen months after Wesray bought Gibson it cashed in by a public offering of 10 million shares at $27.50. William Simon realized a payoff of $66 million on an investment of about one third of a million dollars. Later the Gibson stock price fell to $18 but rebounded to $28 when a takeover battle developed between Walt Disney Production and Saul Steinberg.
In 1981 Dart & Craft, a major consumer goods manufacturer, decided to sell off its subsidiary Thatcher Glass. Dart & Craft felt the glass container industry had little growth potential. Thatcher Glass was the third largest bottle manufacturer in the nation and had sales of about $350 million and profits of about $30 million. A new company, Dominick International, was formed to buy Thatcher. This new company included the president of Thatcher Glass. Dominick International offered $120 million in cash and $18 million in subordinated debentures and preferred stock. A group of banks, including Manufacturers Hanover Trust and Chase Manhattan provided $110 million at an interest rate of 22.5 percent. There was $4 million of equity and $3 million of Dominick preferred stock. The rest was raised by other high interest loans. The buyout was completed in 1983 and Thatcher had a debt ratio of 95 percent. This means the debt/equity ratio was about 19. By the end of 1984 Thatcher's sales had dropped sharply due to increased competition from plastic and aluminum containers. Thatcher reacted by cutting prices and laying off 80 percent of its 4,000 employees. In 1985 Thatcher filed for bankruptcy and attempted to reorganize under a new president. Dominick International sold off three of Thatcher's six plants and realized $40 million on the sale. Thus the third largest bottle manufacturer in the U.S. folded as a result of the leveraged buyout.
Federated Department Stores
Federated Department Stores was a company running a collection of relatively high end retailers. The company had lots of stores but did not have a mass marketing strategy. Tthe hostile LBO of Federated Department Stores became the target of a hostile leveraged buyout by Robert Campeau, a Canadian financier. Robert Campeau believed he could realize a major gain in value for the corporation with a change in management. He acquired Federated at a price that was nearly double its pre-acquisition market value. This was risky enough, but he amplified the risk by using debt to cover about 97 percent of the acquisition costs. This was a leverage ratio (debt/equity) of about 32 to 1. Leverage ratios in excess of 9 to 1 have a notably higher rate of failure. The safe levels of the leverage ratio depends upon the nature of the business, the stability of the rate of return on capital. American banks typically operate with leverage ratios of 15 to 1 but this is acceptable because of the predictability and stability of their earnings. Manufacturing corporations in the U.S. operate with leverage ratios which are typically in the range of 0.5 to 1 or 1 to 1.
Robert Campeau acquired Federated in 1989. In 1990 Federated filed for bankruptcy. While financially the LBO of Federated was a failure Campeau was able to bring about some adjustments before the collapse that improved the performance of the company. The improvements were just not enough and not soon enough to cope with the financial burden of high interest payments to cover the high acquisition price.
Baker and Smith cite some very interesting results of Steven Kaplan of the University of Chicago whose research indicated that the reforms carried out did increase the value of the company even though financial distress drove the company into bankruptcy.
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