United States General Accounting Office Report to Congressional Requesters Scpt.cIrrtMtr 1991 LEVERAGED BUYOUTS Case Studies of Selected Leveraged Buyouts IIlll ulllllllN 144824 United States General Accounting Office GAO Washington, D.C. 20648 General Government Division B-244418 September 16,lQQl The Honorable Timothy J. Penny House of Representatives Dear Mr. Penny: This responds to the request from you and, 51 other Members of the House of Representatives (see app. I) for information on the effects of leveraged buyouts (LRO) and hostile business takeovers. This report answers questions you asked concerning (1) what happened to compa- nies that had been taken over through an LBO, (2) how these companies have performed since the takeover, (3) how communities have been affected, and (4) what happened to companies that amassed tremendous debt to avoid being taken over.’ As agreed with your office, we addressed these questions by doing case studies of companies that experienced an LB0 or a takeover attempt during the mid- to late 1980s. Our assessment was based primarily on public documents and financial reports filed by the companies with the Securities and Exchange Commission (SEC). Each company commented on a draft of its case study. The companies’ comments generally involved minor corrections, which we made. (See app. II for details on our scope and methodology.) The case studies included LBOS of Revco D.S. Inc.; Safeway Stores Inc.; and Allied Stores Corporation and Federated Department Stores Inc., both of which were purchased separately by the same acquirer; and a recapitalization to avoid an LB0 by Phillips Petroleum. The case studies are included as appendixes III, IV, V, and VI, respectively. 6 An 1,130is a financing technique in which the takeover purchase of a Background company is transacted mostly with borrowed funds rather than contrib- uted equity. As a result, the acquired company comes out of the 1,130 with a much different capital structure2 than before. Debt replaces equity as the company’s primary source of capital. The proceeds from the debt are used to purchase shares from stockholders, usually at a ‘Information on what happens to company pension plans after an LB0 is provided in Pension Plans: ~(GAReplacementsFollowingHRD-gl-21, Mar. 4, 1991). Other parts of your request are being addressed in ongoing work. ‘A company’s capital structure, or capitalization, is the total value of a corporation’s long-term debt and preferred and common stock accounts. Page 1 GAO/GGD91-107 Leveraged Buyouts B-244418 premium to encourage the sale, leaving control of the company’s stock concentrated within a small group of investors. The assets of the acquired company are generally used as collateral for debt and are often divested to provide funds to repay the increased debt. Debt may be either collateralized by assets or unsecured, using high-yield bonds referred to as “junk bonds.” The much-publicized LB0 binge of the 1980s has resulted in concern about the impacts and efficacy of LROS. Many studies and congressional hearings have been conducted addressing various effects of LBOS. For example, a 1989 study for the Subcommittee on Oversight and Investi- gations, House Committee on Energy and Commerce, identified a variety of issues related to LBOs3 These issues included fairness to parties involved, such as stockholders and bondholders; role of and impact on financial institutions; and economic effects regarding taxes, employ- ment, capital spending, and increased aggregate levels of debt. In the LHOs we studied, the purchasers bought out the target companies’ Results in Brief equity holders with money from loans and bond issues. In Phillips’ recapitalization, the company exchanged debt securities for nearly half of its outstanding common stock in order to avoid an LBO.For all the cases we studied, the equity holders, through selling or exchanging their common stock, earned premiums4 ranging from about 36 percent to about 119 percent. The surviving companies’ capital structures shifted so that debt became the primary source of funding, and debt reduction became one of the companies’ highest priorities. The companies employed such strategies as asset sales, cost savings programs, employee layoffs, and spending restrictions to help pay off debt. Phillips and Safeway are currently operating profitably, but the remaining three companies have declared bankruptcy and are now operating under c bankruptcy court protection. The actions taken to service the increased debt load resulted in many employees losing their jobs. However, the companies we studied had “Dr. Carolyn Kay Hrancato, Leveraged Buyouts and the Pot of Gold: 1989 IJpdate, a report prepared for the use of the Subcommittee on Oversight and Investigations, Committee on Energy and Com- merce, IIouse of Representatives, (Washington, D.C.: IJS. Government Printing Office, 1989). 4Premium is the amount, which we express as a percent, by which a particular price per share exceeds the market price per share on a specific date. The methodology we used for calculating the premiums is described in our objectives, scope, and methodology section in appendix II. Page 2 GAO/GGD-91-107 Leveraged Buyouts ” ,L .I B-244418 locations across the country and were generally a small part of the eco- nomic base of any one community.; In Phillips’ case, however, the com- pany’s headquarters formed a major part of the economic base for the local community, and Chamber of Commerce officials told us that the company’s efforts to reduce costs through employee layoffs adversely affected the overall earning power of the community and resulted in declining real estate values, city sales tax revenues, and volume of retail and service trade. The financial success of the companies after their LBOS depended largely on their ability to meet debt service requirements when due. This is dependent upon the initial price paid; future economic conditions; the value of the company’s assets, especially those to be sold to reduce the LBO debt; and management’s ability to cut costs, reduce debt, and improve profits afterwards. The purchasers and their advisers were pri- marily responsible for making these determinations. However, in these highly leveraged transactions the purchasers had little to lose if they paid too much and a lot to gain if they could make the surviving com- pany a success, while their advisers earned large fees regardless of the price paid or ultimate fate of the surviving company. Thus, both had incentives to complete the deals. For example, the purchasers’ equity investment in the deals was small relative to the total purchase price- in only one case greater than 3 percent-allowing them large potential returns with limited financial risk. In addition, fees earned by the advisers increased if the transaction was completed. Although the reasons varied for doing the buyouts and recapitalization, Why Did These Deals there were some similarities between the cases. As stated in the filings Happen? we reviewed for Revco, Safeway, and Phillips, where management was an active and willing participant in the transaction, the motivation for 6 the deals was related to the existing owners’ desire to retain control of the company. Revco’s management participated in the LBO because they were concerned that the company’s depressed stock price made it sus- ceptible to a takeover. Safeway’s management participated in an I,RO with Kohlberg Kravis Roberts & Co. (KKR), a private investment firm, as a defensive maneuver against a hostile takeover attempt by the Dart Group.” And Phillips’ recapitalization was a defensive tactic against the second hostile takeover attempt of the company in less than 3 months. ‘Dart Group is owned and controlled by the IIaft family, who, despite losing the takeover battle for cont.rol of Safeway, earned about $153 million from selling their stock in Safeway and terminating an agreement made with KKR and Safeway’s management. Page 3 GAO/GGD-91-107 Leveraged Buyouts , “, / B-244418 In contrast, the LBOS of Allied and Federated were not done as part of a defensive strategy but were instead hostile takeovers. The acquirer, Robert Campeau of Campeau Corporation, sought the acquisition of Allied and Federated to expand his commercial real estate operations in the U.S. market and to position his company in retail merchandising. He envisioned that the retail department store chains would provide the anchor stores in shopping centers he planned to develop in the United States, which would attract other stores to rent space. Since the LBOS,Revco, Allied, and Federated have filed for protection What Happened to the from creditors under Chapter I1 of the U.S. Bankruptcy Code and have Companies? been operating as debtors-in-possession6 while developing reorganization plans to submit to the bankruptcy court+ A court-appointed examiner has investigated whether the Revco I& constituted a fraudulent con- veyance7 against the interests of Revco creditors who did not participate in the LBO. Findings by the examiner indicate that viable causes of action do exist against various parties involved in the LRO under both fraudu- lent conveyance and other legal theories. A successful fraudulent con- veyance action could have the effect of changing the priority of creditors’ claims against what remains of Revco’s assets. Safeway sur- vived its LBO and during recent years has, by some measures of perfor- mance such as operating profit margin and gross margin on sales, oper- ated with greater success than before the LBO. In the years following Phillips’ recapitalization, the company’s performance fluctuated, but it was able to reduce debt to a level it considered manageable. Our analysis of company performance focused on measures of changes the companies underwent, including capitalization, asset divestitures, capital expendi- tures, research and development spending, employment levels, stock and bond prices, and bond investment ratings. A company’s capitalization consists of long-term debt and equity.