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LBO Firms and the Virtue of Profits

By John E. Tamny - June 6, 2007 12:00 AM

Leveraged buyout (LBO) firms played a very necessary role in the de-conglomeration of U.S. businesses in the '80s. While much is made of allegedly excessive executive compensation today, this was a far more pressing issue back then as evidenced by the most famous deal of that decade: the purchase of RJR Nabisco. When it became apparent that the latter was in play, a frenzied bidding war ensued given the desire of numerous LBO firms to make more efficient a company with a bloated and overpaid executive structure, lavish offices, and perks that included a large fleet of private planes.

The '80s buyout boom was a boon to stocks and the U.S. economy due to the profit motive that drove these highly leveraged deals. LBO firms had to create great efficiencies and returns in order to attract future investors, and the first order result was a far leaner, more vibrant U.S. business climate. The story got even better when the "unseen" was considered; as in all the businesses that aggressively streamlined their operations to avoid being the victims of hostile takeovers. A largely ignored reason for high executive compensation today is the existence of well-capitalized buyout firms, who, by virtue of their impressive buying power, implicitly force CEOs to run their companies as profitably as possible.

While LBO firms continue to drive efficient corporate management around the world, the passage of Sarbanes-Oxley in 2002 made them even more necessary as public companies needed an exit strategy from the climate of fear that plagues many companies today. Rather than let themselves be burdened with the superfluous nature of Sarbox regulations -- rules that reward caution over risk taking -- companies thankfully have been able to access the capital of LBO firms to continue operating free of today's intrusive regulatory culture.

Much of the above was seemingly ignored by Portfolio magazine's Jesse Eisinger in its inaugural issue. In his article, "How Big Is Too Big?" Eisinger looks askance at the private equity/LBO firms who are presently a big news item given the Blackstone Group's plans to float its shares this week with a $40 billion IPO.

Eisinger begins his article by making the good point that for an industry which regularly extols the virtues of companies going private to avoid "death by a thousand S.E.C. filings," it's passing strange that Blackstone is going public, while other giants such as KKR are actively considering doing the same. His skeptical nature is perhaps valid, but at the same time Blackstone's size and capital structure mean that the costs of it being public will be far less onerous than it is for the mostly smaller companies that it takes private. Also, given the huge demand in the market for companies to escape the frustrations of being publicly traded, Blackstone will soon enough have yet another currency of sorts that it will be able to utilize in raising capital for buyouts.

Eisinger makes another interesting point that with LBO firms more and more in the limelight; something that will only grow with public offerings, they're somewhat compromised when it comes to effectively taking companies private. He singles out KKR and Texas Pacific Group's purchase of TXU. That deal that was made possible through major concessions to environmental groups, including plans to cut the utility firm's emissions along with cancelled plans to build eight coal-fired plants in Texas. To get past regulators and politicians, they had to agree to hold the asset for a minimum of five years while agreeing not to add any acquisition-related debt. Eisinger's thinking here is hard to argue with, and the compromises KKR and Texas Pacific made were roundly criticized by business commentators at the time.

It's when Eisinger analyses the health and purpose of LBO firms that he regresses to his former style as cynical judge that he perfected while at the Wall Street Journal. He notes that, "Doing deals for the sake of doing deals has another downside: It's likely to cut into profits, sowing additional seeds of this era's demise." The problem with his thinking is made readily apparent in a graphic featured in the article, which shows how LBO and private equity firms keep launching larger and larger funds. If the industry were simply doing deals for the fun of it, it's pretty certain that investors wouldn't be lined up to put their money in their funds. While overshoot can certainly occur when it comes to investing, the huge demand for the private equity product suggests a very vibrant future for the industry.

He then adds, "Reality has dawned on the buyout czars: Companies can't just be levered up, stripped of assets, and run on bare-bones budgets." On the leverage front, contrary to Eisinger's assumptions, debt can force management to focus on a company's core competencies, rather than unprofitable distractions. Shareholders are the biggest beneficiaries of high debt ratios in that there's less equity at risk. Consider it this way: a company with a capital structure of high equity and small debt is one where management can easily squander the equity with a few bad investments. Conversely, a company with heavy debt loads is one where management has much less leeway to be prodigal in its actions.

Eisinger's assertion that private equity funds strip companies of assets is both naïve and incorrect. In truth, economies perform sub-optimally when assets, be they human or machine, are underutilized. The stripping of assets that he mentions in a pejorative light is in fact private equity investors selling what is underutilized to buyers who see the opportunity to maximize the utility of something the previous owners did not.

Eisinger concludes that there "is no escaping responsible citizenship" for LBO firms. More realistically, companies in the LBO space have but one constituency: their shareholders. Without them, there would be no private equity to speak of, not to mention the economic efficiencies that they regularly enforce through their uncompromising focus on profits. That their greed in the end drives companies to operate more effectively is a virtue in itself, and one that speaks volumes about responsible citizenship.

John Tamny is editor of RealClearMarkets. He can be reached at jtamny@realclearmarkets.com


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