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Management shrugged: the case for leveraged buy-outs

More than a decade has passed since corporate raiders, junk bonds and the power of Drexel Burnham dominated the pages of the financial press and the agendas of major corporate boards of directors across the US. Yet, the impulse to improve financial performance through ‘re-engineering' operations, ‘restructuring' portfolios and balance sheets or ‘rethinking' strategy and organisation is still the dominating theme of corporate life. Donald Gogel from Clayton, Dubilier & Rice discusses the case for leveraged buy-outs.

This article is extracted from Private Equity and Venture Capital with the kind permission of Euromoney Books (a division of Euromoney) Email books@euromoneyplc.com for further information about this title

In the rough and tumble world of competitive business, change and adaptation are critical to sustaining success longer than a brief moment in time. Shifts in technology, demographics, culture, fashion and customer needs demand a responsiveness that is difficult to manage for large corporate enterprises built primarily on the logic of economies of scale and functional prowess in engineering, manufacturing, marketing and sales.

Many chief executives today would describe their primary challenge as ‘managing change', by which they mean both the need to build new skills and the effort to overcome the obstacles imposed by current and past practices. By their nature, corporations organise activities around products, customers, markets and functional activities. But the very act of organisation is a compromise with the future. As organisations try to achieve maximum performance on currently defined tasks they ensure a level of inflexibility that makes it difficult to anticipate and make changes to meet new market needs and match new competitive challenges. As they build new skills, they find those skills increasingly inappropriate for performing the tasks of the past.

More than anything else, LBOs are an opportunistic response to the difficulties encountered by current owners and managers to sustain or improve performance of their ‘old' or ‘non-core businesses' while they are building new capabilities for the future. Buyout groups (‘private equity sponsors' in the more polished vernacular of the late 1990s) seek investments where current owners find themselves unwilling to undertake the next generation of changes required to fix businesses and make them more profitable. Often, and with good reason, these businesses are ‘orphans' that have been unable to attract or warrant the management talent or capital needed to continue their growth.

This is no failure on the part of the current corporate owner. On the contrary, it is usually an extremely studied and appropriate response to changed conditions. The decision by the IBM Corporation to sell its Office Products Division in 19' to Clayton, Dubilier & Rice (CD&R) reflected an assessment that IBM had more attractive opportunities than those presented by the low price/low margin typewriter and printer business which was increasingly coming to resemble the consumer electronics market. The decision by Westinghouse in 1994 to sell its Wesco distribution business reflected a strategic assessment that captive distributors were an ineffective channel to customers. The decision by the Gillette Corporation to sell its direct sales cosmetics business, Jafra, in 1998, reflected a judgement that a direct sales channel was never going to be compatible with Gillette's massive investment and franchise in the retail channel. All of these decisions rested on the calculus that concluded that the target business would not contribute to shareholder value.

Why then, if corporate strategists and boards of directors, armed with investment banker opinions, conclude that a business is not worth keeping, should an LBO firm be able to create value?

Of course, buyout firms do not always create value through the acquisition of unwanted corporate divisions. But the fact that they have succeeded often enough to attract more than US$100 billion from investors who believe in the magic of buyouts suggests that they may hold some structural or behavioural advantages that the buyout firms bring to bear in making their investments. I believe that is exactly the case. Buyout firms have at least five relatively simple, key advantages that account for a great deal of their success:

1. The Hawthorne effect;
2. The ‘vision thing';
3. A dream team of management all-stars;
4. Stock ownership and cash incentives; and
5. A sense of urgency.

The Hawthorne effect

In a famous 1930s study of industrial organisation at the Western Electric's Hawthorne plant in Illinois, researchers found that productivity at the factory increased when changes were made in working conditions. A well-known, if obvious, conclusion of the study was that workers like to have people pay attention to them. The Hawthorne effect has since been used to describe changes in behaviour that are induced by management's ‘paying attention'.In many ways, buyout finns and management teams have the benefit of the Hawthorne effect as they negotiate, finance and close a leveraged transaction. First and foremost, a management buyout involves a  change of control, an event that is by definition a transformation. The buyout unleashes a number of powerful forces that enable firms like CD&R to initiate a broad range of changes. The buyout process subjects management plans in every geographic, product and functional area to critical review, not only by the buyer, but also by the buyer's banks, and often by broader capital markets. Such a review typically challenges old ways of conducting business and forces the consideration (and sometimes adoption) of new business practices.

Although not necessarily part of the buyout process, buyouts are also associated with a host of attention-getting changes: a change in corporate name and logo, articles in the local newspapers, a new boss. Everyone is paying attention and, in such a setting, management teams are typically more successful in bringing about change. When CD&R acquired the Allison Engine Company from General Motors Corporation in 1993, many of these factors came into play. Allison, a leading designer and manufacturer of aircraft engines, primarily under military contracts, was facing an uncertain future in face of major budgetary cutbacks. With a large unionised workforce that was assernbled to meet the peak demands of production during the Reagan years, and new series of engines still in development, Allison had lost several hundred million dollars in the early 1990s.

The buyout of Allison was a very public event. National and local union leadership, the or of Indianapolis, bank lenders, lawyers, accountants and many others focused on the stiture. Everyone expected change. Some feared a sale to another aircraft engine rnanufacturer that would, perhaps, close the factory and reduce employment. When the acquisition of Allison by a fund organised by CD&R was finally completed, e than a year after the earliest announcements, the management team was ready to implet a series of changes to transform the military contractor into a leading manufacturer in segments of both the military and commercial aviation markets.

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