Buying companies on leverage: success has pushed up the stakes

Is success spoiling leveraged buyouts? ''No, but it's making them more difficult,'' says Jeffrey Kenner of Carl Marks & Co. of New York.

He concedes that adverse publicity has made the public question the concept of the leveraged buyout, or LBO. Indeed, Securities and Exchange Commissioner John Shad has recently decried ''the leveraging of America.'' And the increasing numbers of participants in the LBO marketplace have driven prices up. Companies are being bought for higher multiples of earnings than was the case just a few years ago.

But Mr. Kenner and others in the industry insist that the concept is ''sound, as long as the financing meets the needs of the company.'' Moreover, people in the industry insist that LBOs are helping to ''rekindle the entrepreneurial spirit of America.''

An LBO is a way for a company, or a part of a company, to change hands by allowing buyers to obtain financing collateralized against the company's assets.

It's not unlike the way someone buys a house with a small down payment and the rest of the purchase price is obtained from a bank in the form of a mortgage loan, paid off over time out of the purchaser's regular salary. If the purchaser gets in trouble and can't pay off the loan, the bank gets the house.

A typical LBO situation might be, let's say, the Widgets Division of XYZ Conglomerated International Inc. Once a principal business line of XYZ, the Widgets Division has faded from glory as the parent company has pursued new activities in high-technology and service businesses. Nowadays Widgets doesn't even appear in the company's annual report until about Page 47.

But the Widgets management knows the widget market will remain strong for years to come. The people running the division believe implicitly in its product and have some ideas on how to make it better.

So a deal is put together: Managers put in some money, plus equity participation from an LBO company like Carl Marks, along with one or more institutional investors. Banks supply the top layer of financing - loans at a very attractive (for the banks) interest rate.

Once out from under XYZ's corporate thumb, the newly established Widgets Corporation blossoms; sales rise. The bank gets paid off out of operating income , and the loan officer heaves a sigh of relief when it becomes clear the bank won't get stuck having to repossess a lot of widgetmaking equipment.

This is how it goes in theory, at least. In practice, though, ''There is no longer that kind of basis for financing, in a lot of the cases we see,'' says Patricia Riley Merrick, senior vice-president with Charterhouse Group International Inc. in New York. Nowadays it's not just assets, but earnings, that get looked at hard, she adds.

Many observers in the financial world express concern, too, that heavily leveraged businesses could be heading for trouble in the next cyclical downturn, just like a homeowner who gets laid off in a recession and can't make the mortgage payment.

But Ms. Merrick maintains that leveraged buyouts can work even during recession: It's all a question of the basic soundness of the companies being taken private. ''If it's a good company, it will be able to grow, reinvest, and still cover debt service. These are business judgments, and not just financial ones. In the 11 years we've been doing this, we've bought 23 companies, and they've been through periods of 21 or 22 percent interest, and they've all survived.''

She adds, ''A highly cyclical business is not the best candidate for a leveraged buyout - unless it's really growing. If it's really growing on a secular level, there will still be earnings to cover the debt.''

Charterhouse has seen companies taken private ''doing far better than they were under the aegis of a large corporation.'' A Wall Street source echoes, ''It's amazing what happens when people are responsible for turning out the lights - when they go from being hired hands to owners of the company.''

''You don't want to be doing deals at the top of the cycle,'' says Michael R. Dabney, vice-president and general manager of the commercial financial services department of General Electric Credit Corporation, a major source of funding for LBOs. The best time to buy out a division or a company, he says, is at the bottom of the cycle. But as with a stock, he concedes, it is not easy to know whether a rebound will occur or whether it is down to stay.

Mr. Kenner of Carl Marks advises against capital-intensive businesses as candidates for LBOs. ''If you have to invest $40 or $50 million to modernize equipment and that sort of thing, it's not a good time to do a buyout. The time to buy it is after all that.''

Mr. Dabney adds, ''With higher prices and less coverage (of debt), the very, very good (finance) companies are those who spend a lot of time researching the earnings of companies (being considered for LBOs) - not just the amount, but the quality - how sensitive they are to the market.''

Mr. Kenner says the problems with buyouts come when a company decides to put itself - or parts of itself - on the auction block, inviting a variety of competing buyout companies to make bids. ''It's hard to give 'due diligence' in a case like that.'' The best situation is ''if we identify an opportunity; if it's an idea we create.'' Other observers concur that bidding wars do no one any good.

One criticism of LBOs is that once taken private, they ''flip'' - are sold again. The advantages of management ownership are negated, and huge profits are realized - from selling a business, rather than running a business. The case everyone talks about is former Treasury Secretary William Simon's recent 200 -for-1 payoff from the Gibson Greeting Cards deal. But Mr. Dabney says, ''The possibilities for (flipping) are really very slim.''

''It's not a common phenomenon,'' says John Murphy, partner at Adler & Shaykin in New York, ''although it's inevitable that institutional investors will be made liquid at some point.''

Mr. Kenner advises against taking a heavily leveraged firm public. ''When a firm is leveraged, it's good to be private.''

Those financing LBOs insist that for all the publicity, most LBO activity is with smaller companies, those with annual sales of $25 million to $75 million. And of course, some LBOs are buyouts by public companies, and there are private companies bought out by other private companies.

Just how risky are LBOs, especially for banks? One Wall Streeter says, 'We're taught to say everything is risky. But by definition here, we're talking about established, mature businesses, not raw start-ups. This isn't like venture capital.''