Rehabilitating the Leveraged Buyout sgervais/Teaching...¢  BW/IP's team of executives were obviously

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  • LBOs are best known as financial plays. As practiced by Clayton, Dubilier e? Rice, they can also promote corporate renewal.

    Rehabilitating the Leveraged Buyout

    by W. Carl Kester and Timothy A. Luehrman

    Once the rage of Western capitalism,..leveraged buyouts have lost their glamour and much oFtheir respectability. Suggest an LBOtoday as a healthy way to create value, and polite company outside of Wall Street will assume you are just trying to stim- ulate lively conversation. Propose it as a means of improving operating performance by restoring strong, constructive relationships among owners, managers, and other corporate stakeholders, and you may be viewed as a refugee of the 1980s, de- luded by the decade of greed.

    It's easy to see why LBOs have developed such a negative image. Even when they were booming.

    critics complained about "paper entrepreneurs." And when the boom faded, a wave of bankruptcies ensued. Since 1987, scores of companies that had been acquired in highly leveraged transactions and that managed more than $65 billion in assets have filed for bankruptcy. The spectacular fall of Drexel

    W. Car] Kester is the M.B.A. Class of 1958 Professor of Business Administration at the Harvard Business School in Boston, Massachusetts. Timothy A. Luehrman is an associate professoT at the Harvard Business School. They are the authors of "The Myth of Japan's Low-Cost Capi- tal" (HBR May-June 1992) and are currently conducting field research on sources of value in leveraged buyouts.

    DRAWING BY CHRISTOPHER BING 119

  • LEVERAGED BUYOUTS

    Burnham Lambert and junk-bond pioneer Michael Milken added to the perception that the LBO wave had been whipped up and sustained by unscrupu- lous financiers who enriched themselves at the ex- pense of others. Harrumphing members of Con- gress held hearings. Soon, a chorus of I-told-you-sos from LBO critics and finger-pointing in the savings- and-loan and banking industries turned leverage into a dirty word. Even the LBOs that "worked" were dismissed as good luck or, more often, the result of deep and painful cuts in employment, in- vestment, and R&D spending. Indeed, it seems as if almost every sales or purchasing manager has a story to tell about a good customer or supplier who was "ruined" hy an LBO.

    Although some leveraged buyouts may have de- served the criticism they have received, we helieve that the overall public perception about them has been distorted. Right now, it is premature to dis- miss LBOs as artifacts of the 1980s and to discuss their impact entirely in the past tense. Leveraged deals are still coming together, including some

    under corporate ownership. Furthermore, the com- panies they managed ultimately thrived.

    CD&R's experience over more than a decade pro- vides insights into what constitutes best practice in tbe ownership and governance of corporate enter- prises. Contrary to what many people think, tem- porary ownership by an LBO firm can provide an important bridge to better long-term management and performance. Moreover, this form of ownership is adaptable to a much wider universe of businesses than commonly assumed-including not only the undcrperforming low-tech companies that have long been associated with LBOs but also neglected divisions and other pieces of corporations with po- tential tor growth and an appetite for investment.

    Challenging Old Assumptions In 1987, CD&R (which was called Clayton & Du-

    bilier until 1992) executed an LBO that transformed Borg-Warner's Industrial Products Division-a pro- ducer of industrial pumps, seals, and fluid-control

    equipment witb revenues of $245 million-into a stand-alone company called BW/IP International. The divi- sion's parent, Borg-Warner Corpora- tion, had shifted its strategic priori-

    Under the right conditions, LBOs are not merely deals. They

    , "̂ , 1 1 r ^^^^ away from industrial machinery

    r e p r e s e n t a n a l t e r n a t i v e m o d e l ot businessesukeBW/IP̂ ,mresponse,

    corporate ownership and control. large ones. More important, LBOs are evolving in ways that we think will establish them as a perma- nent feature of the corporate financial landscape. Under certain circumstances, they offer a useful format for effective governance of corporations. Under the right conditions, LBOs are not merely deals. They represent an alternative model of cor- porate ownership and control just as public owner- ship, venture capital ownership, and franchise arrangements do.

    Our research at one particular LBO firm, Clay- ton, Dubilier & Rice (CD&R), in New York City, re- veals an approach to ownership and governance that challenges the dominant puhlic view about leveraged buyouts and their effect on corporate per- formance. Instead of finding impersonal transac- tions in which the buyers put a lid on investment, growth, and managerial autonomy, we found the opposite. In fact, chief executives with a capacity for strong leadership and sound, independent deci- sion making say they had more freedom to exercise discretion under LBO ownership than they had had

    the division's president, Peter Valli, and a team of executives joined forces with the LBO firm to buy the business for $235 million. More than

    90% of the purchase price was financed with debt. Equity worth $20 million was owned by manage- ment (20%), Clayton a Dubilier (70%), and subor- dinated lenders (10%).

    At first, BW/IP's managers were alarmed by both the price tag and the debt burden. When they were running a suhsidiary of a large, diversified parent, they had had little need to concern themselves with liability management. But once they were on their own, their instincts told them to begin con- serving cash and repaying the debt as quickly as possible. Indeed, that was what they had assumed LBOs were all about: tightening cash management; putting a clamp on new investment and develop- ment expenditures; selling assets as needed and us- ing available cash to reduce leverage; and then sell- ing the business at the first suitable opportunity.

    To their surprise, however, the advice they got from Martin Dubilier, a founding partner of Clay- ton & Dubilier and the firm's lead representative on BW/IP's board of directors, clashed with those assumptions. Instead of pressuring managers to

    120 HARVARD BUSINESS REVIEW Mav-fLine 1995

  • squeeze more cash out of the company and reduce the debt as quickly as possible, Dubilier advised them to search for good new investment opportuni- ties in their industry. Without growth, he argued, the business could survive, but it would not prosper and the returns would not be worth the effort.

    Dubilier's convictions were put to the test a year after the buyout when Valli called him to discuss an opportunity to acquire a small manufacturer of cen- trifugal pumps. The proposed $18.5 million acqui- sition would double BW/IP's installed base of cer- tain types of pumps and strengthen its position in aftermarket parts and services, the fastest-growing segment of its business. But it also would require additional borrowing and getting the banks to waive some covenants on BW/IP's substantial debt.

    At Borg-Warner, such a request would have had to undergo a lengthy bureaucratic process begin- ning with a written proposal analyzing the pump maker's past performance and strategic fit, and forecasting its future performance. Onee headquar- ters had reviewed the proposal, corporate staffers would visit the division and hear a presentation. If they liked what they heard, the proposal would be turned over to Borg-Warner's Corporate Planning Committee, which met monthly. The committee would review the proposal, hear another presenta- tion, and probably ask for further study and analy- sis. At best, it would take the committee several months to come to a decision. Valli and his team had run that gauntlet several times, only to be re- buffed or lose opportunities because of delays.

    In the environment created by Clayton & Du- bilier, things were different. The firm's financial and strategic analyses were every hit as thorough as Borg-Warner's, but the approval process was far more streamlined. Thanks to the relationship that had developed between Dubilier and Valli in their first year of working together, Valli got the firm's approval to make the acquisition in the course of a single telephone conversation. As it turned out, nobody had any regrets: Both the LBO and the acquisition were great successes. By the time BW/IP went public, in 1991, the value of its com- mon stock had grown from $20 mil- lion to $352 million, reflecting a compounded re- turn on equity in excess of 100% per year. The company's revitalized core businesses had im- proved along almost every dimension: higher mar- ket shares, higher operating margins, and better working capital management and asset utilization.

    BW/IP's team of executives were obviously vital to the deal's success, because it was they who did

    the hard day-to-day work. But management credits Clayton &. Duhilier with keeping the company fo- cused outward on growth rather than inward on its debt burden. As one BW/IP executive puts it, "Dubilier helped us see what was good about us, and he got us to invest in it."

    Since its founding in 1976, CD&R has acquired 21 businesses with annual sales ranging from $20 million to $2 billion. Executives at other portfolio companies also report that the firm has given them guidance and support. One CEO says, "CD&R's partners told me, 'Don't think of it as our company; think of it as yours. And run it as though you were going to own it forever."' This approach has pro- duced impressive results: Since the beginning, the eash-on-cash compounded annua