CRS RELEASES BRIEF ON LEVERAGED BUYOUTS.

                           CRS ISSUE BRIEF

SUMMARY

A leveraged buyout (LBO) is a corporate acquisition in which a firm's managers and/or an investment group take the firm private in a purchase that relies heavily on loans secured by the firm's assets. The number of LBOs increased from 99 in 1981 to 318 in 1988. The increase in their reported total value has been even more impressive, rising from $3 billion in 1981 to $43 billion in 1988. LBOs have ranged across a number of manufacturing and service industries. Between 1985 and the first half of 1988, the retailing sector was the most active with a total of 89 LBOs.

LBOs are attractive for a variety of reasons. Significant among them is the fact that most LBOs have returned exceptionally high profits to their owners upon their eventual resale. Scattered evidence suggests that many LBOs have become more efficient and profitable firms. However, most LBOs have never experienced a business downturn. There is concern that servicing the LBOs' heavy debt load may cause them extreme financial difficulty in the event of a recession.

LBOs are exceptionally dependent on external financing; banks provide between 50% and 70% of the capital for their purchase, and high-yield (junk bond) debt accounts for 20% to 40%. Buyout funds led by Kohlberg Kravis & Roberts have a reported $25 billion to purchase LBOs. Total bank loans to LBOs are estimated at $175 to $200 billion. Money-center banks such as Bankers Trust, Citicorp, and Manufacturers Hanover dominate in the origination of LBO loans. Most only retain 10% to 25% of the loans, selling the rest to foreign banks, savings and loans, smaller U.S. banks, insurance and pension funds.

Top bank regulators from the Federal Reserve, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have warned about the risks of LBO lending. Concern also exists that LBO loan standards are being compromised, with possibly troublesome implications for the second-tier banks and savings and loans that buy the loans. But, generally, the top banking regulators do not view LBO lending as a major threat to the U.S. financial system. As a result, they have emphasized tighter monitoring of highly leveraged bank lending, but not supported major changes in bank regulation.

The pending $25 billion buyout of RJR Nabisco has stimulated congressional interest in the implications of LBOs. The 101st Congress may consider the following proposals: removing or restricting the interest deductibility on LBO financing; eliminating the double taxation of interest; and taxing the merger-related profits of tax exempt entities, such as pension funds.

ISSUE DEFINITION

The pending $25 billion leveraged buyout of RJR Nabisco has prompted considerable congressional concern over a host of interrelated issues: Are LBOs a generally beneficial form of corporate restructuring? What interests are disadvantaged as a result of LBOs? Does LBO lending pose a risk to the financial markets? What are the Federal revenue consequences of LBOs? Is the growing corporate indebtedness posing an untenable risk to many of the firms involved, as well as to the structural integrity of the U.S. economy?

BACKGROUND AND ANALYSIS

LBOs were not a significant part of the corporate acquisition landscape until the corporate merger wave of the late 1970s and 1980s. Accordingly to data from Mergers & Acquisitions (M&A), a major source of merger data, there were 99 LBOs in 1981. LBOs accounted for 4% of all corporate acquisitions during that year. The number of LBOs peaked at 331 in 1986; falling to 259 in 1987, and rising to 318 in 1988. LBOs constituted 9% of the total number of corporate acquisitions in 1988. As a percentage of total annual acquisitions, LBOs have ranged between 7% and 9% since 1984.

The growth in the overall value of LBOs has been much more rapid. Data from M&A indicates that in 1981, LBOs reported their total value at $3 billion, or 5% of the value of the year's corporate acquisitions. But by 1986, LBOs were valued at $46 billion or 23% of the total value of the acquisitions for the year. In 1988 LBOs totalled $43 billion, and accounted for 19% of the overall value of the year's acquisitions.

The pending $25 billion buyout of RJR Nabisco will exceed the annual value of LBOs for each previous year up until 1986. The record of recent LBO activity is shown in Table 1, below.

Economists commonly distinguish between two broad types of LBOs: (1) LBOs in which a firm is wholly taken private, and (2) divestiture-based LBOs in which a corporate unit is sold to a buyout group, normally containing the unit's incumbent managers. (As a major part of 1980s merger wave, firms have sold off many underperforming units that were bought in the conglomerate wave of the 1960s.)

Although fewer in number, LBOs of entire firms have attracted much more attention. W.T. Grimm & Co., a merger intermediary, reports that in 1987 there were announcements for 47 LBOs of entire firms and 90 divestiture-based LBOs. The notoriety that has attended LBOs of entire firms has several origins: Their size has given them a particularly high public profile. Grimm reports that their average 1987 price was nearly one-half billion dollars. (Divestiture-based LBOs averaged $140 million.) A number of these type of LBOs have been undertaken to avoid the threat of hostile takeover. The LBOs management/buyers are often criticized for their conflicting interests as the fiduciaries of the shareholders that they are simultaneously attempting to purchase the company from. And investors holding bonds in the companies often experience a dramatic devaluation in the worth of their bonds, upon the announcement of a leveraged buyout. (The market is saying in effect that the bonds are riskier because the firm will be taking on considerably more debt to finance the LBO.)

    TABLE 1. LEVERAGED BUYOUTS AS A PERCENTAGE OF COMPLETED MERGERS

MOST ACTIVE LEVERAGED BUYOUT INDUSTRIES

Analysts at the investment banking firm of Salomon Brothers note that every LBO has unique characteristics, yet they have been able to identify those characteristics most frequently found in LBO candidate firms. Those characteristics are: (1) proven historical performance; (2) competent and experienced senior management; (3) prominent market position; (4) established products; (5) divisibility of assets; (8) low capital expenditures; and (7) other factors, including the presence or absence of contingent liabilities, the quality and consistency of the labor force, and the extent of regulation.

Not many firms fit this profile, and in fact some major industry categories would fail to match these characteristics. It is not surprising then that LBO activity tends to be more concentrated in some industries than others, rather than randomly distributed across the whole spectrum of business enterprise.

Mergers & Acquisitions reports that between 1985 and the first half of 1988, the industries in which LBO activity was most concentrated were: (1) retailing (89 LBOs); (2) nonelectrical machinery (64 LBOs); (3) electrical machinery (61 LBOs); (4) food and allied products (41 LBOs); and (5) primary metals (30 LBOs).

SOME OF THE ATTRACTIONS OF LEVERAGED BUYOUTS

Besides the defense against hostile takeovers, a number of other reasons are often used to explain the various attractions of LBOs. These include:

o LBOs can resolve the inherent conflicts between owners and managers that may trouble publicly owned companies.

o Divestiture-based LBOs can provide managers with greater autonomy and freedom that can foster more innovative and efficient management.

o LBOs rely on a large amount of debt financing. Because of the deductibility of interest on debt, an appreciable amount of corporate earnings are thus shielded from taxation.

o Generally within 7 or 8 years, most LBOs are resold or "taken public." Historically, these transactions (sometimes in conjunction with an incremental and selective sale of some of the firm's assets) have earned their owners exceptionally high returns on investment; often exceeding 30% annually.

o Though not as hefty as the profits from taking LBOs public, shareholder premiums from selling stock to LBO groups have generally been quite large.

o LBOs have generated millions of dollars in ancillary fees and contract work for the attorneys and investment banks that facilitate the deals.

LEVERAGED BUYOUTS' PERFORMANCE

A 1987 CRS report, Leveraged Buyouts and the Pot of Gold: Trends, Public Policy, and Case Studies (CRS Report 88-156 E), broached a question that goes to the heart of some of the public policy concern that surrounds the LBOs: Do LBOs result in efficient reallocation of corporate assets or are they simply an asset "shell game"?

Most of the multi-billion dollar LBOs of recent years are still in the relatively early stages of the corporate restructuring process, and it is not yet possible to determine whether or not the typical LBO of the 1980s can be called a success -- characterized by a balance sheet with conventional debt ratios -- or a bankrupt failure. One or two LBOs demonstrate that success is possible; the other extreme is represented by the 1988 bankruptcy filing of Revco D.S., a drug store chain which had gone through a leveraged buyout.

The "wild card" in many discussions over the future performance of LBOs concerns uncertainty regarding their vulnerability to a business downturn. The extensive debt that characterizes LBOs could, in adverse times, amplify the consequences of bad decisions made during the expansion phase of a business cycle. A compounding factor is the considerable inflationary drift in the prices paid for LBOs over the past few years. While surging prices translate into greater levels of debt, those prices may bear decreasing resemblance to the actual financial worth of some recent LBOs. A recession could exacerbate these already troublesome trends.

FINANCING LEVERAGED BUYOUTS

LBOs are primarily financed by debt, with a small amount of equity capital. Most of the financing (40% to 70%) is senior debt provided by institutional lenders such as commercial banks, insurance companies, and pension funds. It is becoming increasing popular [sic] for these funds to be channeled through a special entity -- a buyout fund, similar to a mutual fund -- set up by one of the investment banking firms which facilitate LBOs. The next most significant source of financing is subordinated debt, primarily from issuing high-yield (junk) bonds (10% to 30%) which are usually sold to institutional investers. The small amount of financing remaining is provided by equity investors, the ones most likely to reap spectacular benefits if the leveraged buyout succeeds and is eventually resold to the public.

There are currently about 80 leveraged buyout funds with about $25 billion in capital. The largest fund is under the sponsorship of the pioneering buyout group Kohlberg Kravis & Roberts (KKR). As of fall 1988, the KKR fund was reported to have a $5.5 billion in buyout funds. The other leading funds are Forstmann Little ($2.5 billion), Morgan Stanley ($2 billion), Shearson Lehman Hutton ($1.6 billion), and Merrill Lynch ($1.4 billion).

Large buyout funds generally receive the bulk of their funding from insurance companies, State and corporate pension funds, university endowment funds, and commercial banks. The institutions become limited partners in the investment group and exercise no influence over what firms the buyout fund chooses to buy. The institutional investors are attracted to the buyout funds because, historically, the funds have afforded the investors the opportunity to earn returns (when the LBOs are resold and/or various assets are sold off) that exceeded those from most alternative investments, including high-yield (junk) bonds.

There is widespread concern over bank loans to LBOs, particularly a concern that, in the rush to achieve very lucrative lead bank status, loans standards may be compromised. The principal fear is that regional banks and savings and loans that buy syndicated LBO loans may be especially exposed to unexpected losses. (The Comptroller of the Currency recently noted that a study of 16 multinational and regional banks showed leveraged buyout lending ranged from 2% to 10% of each bank's loan portfolio.)

Salomon Brothers estimates that banks have cumulatively made between $175 and $200 billion in total LBO loans. According to the Loan Pricing Corporation, $80 billion of the loans have been made since mid-1987. Bank LBO financing is generally limited to $50 million per transaction; when large banks initially commit sums of $500 million or more to a particular deal, they generally resell most of the loan to other banks.

Banks find LBO loans profitable because their relative riskiness allows them to charge yields that run 2 to 4 percentage points above the prime rate, the benchmark rate for conventional business loans. Banks that originate the loans, called lead banks, can collect commitment and advisory fees worth several percentage points of the total loan deal.

LBO lending by lead banks is very centralized. The Loan Pricing Corporation estimates that since mid-1987, three money-center lead banks, Bankers Trust, Citicorp, and Manufacturers Hanover, have accounted for roughly 80% of the $70 billion in total LBO bank loans. Lead banks generally retain 10% to 25% of the LBO loans that they originate. Typically, they then syndicate (sell) 40% to 50% of the loans to foreign banks (which are often Japanese). The remaining 10% to 20% of the loans are syndicated to a combination of regional banks, savings and loans, pension funds, and insurance funds. Most LBO loans are for 6 to 8 years, but firms have frequently paid them off in 2 to 3 years.

A report by Standard & Poor's (S&P) credit rating agency, however, claims that a few of the other leading money-center LBO lenders, such as Bankers Trust and Wells Fargo, have retained risky levels of LBO loans that run as high as 40% of their total business lending.

BANK REGULATORS AND LEVERAGED BUYOUTS

The Nation's top bank regulators have generally taken a wary attitude toward imposing dramatic and blanket changes in the regulation of U.S. bank LBO loanmaking.

Fed Chairman Greenspan has suggested that the number of LBOs may fall without congressional tax law changes. Still, Mr. Greenspan has called attention to the particular vulnerability of LBOs in cyclically sensitive industries in the event of a business downturn. And he notes that 40% of LBOs and corporate restructurings appear to take place in so-called cyclically sensitive industries.

Over the long run, Mr. Greenspan sees LBOs as a net asset to the American economy. He has commented that corporate restructuring, including LBOs, appears to have enhanced corporate efficiency and that this should have a salutary long-run impact on the U.S. economy.

However, Mr. Greenspan warns that banks may suffer irreparable losses -- if a large amount of their loans have gone to highly leveraged firms. But the Fed Chairman does not appear to be significantly worried about the perils inherent in the current level of bank LBO exposure.

In late February 1989, the Fed announced that it was tightening guidelines for banks involved in highly leveraged transactions. Loans to borrowers whose debt exceeds three times their equity should not be classified as "highly leveraged financing." Fed officials say that these loans will be given greater scrutiny by bank examiners.

L. William Seidman, head of the Federal Deposit Insurance Corporation (FDIC), has testified that LBOs generally pose no "serious threat" to the banking system and that banks are managing their LBO financing risks "prudently."

While noting that "some regional banks and the vast majority of small banks shouldn't be acquiring positions in LBO loans," he has also observed that the smallest U.S. banks have generally not been engaged in LBO loanmaking.

Comptroller of the Currency (CCC) Robert Clarke has observed that a Spring 1988 CCC survey of 18 of the country's largest money- center and regional banks provided the agency with "reassuring" news that the banks have established limits on both their aggregate highly leveraged loan exposure and on individual highly leveraged loan transactions.

Mr. Clarke is somewhat concerned "that some banks may be financing leveraged transactions without the benefit of proper credit analysis."

CONGRESSIONAL PUBLIC POLICY CONCERNS

The pending $25 billion RJR Nabisco buyout has stimulated congressional interest in examining the implications of leveraged buyouts. The House Energy and Commerce's Subcommittee on Telecommunications and Finance held a hearing on LBOs on Dec. 22, 1988. Other congressional committees which have announced plans to hold LBO related hearings, or have already held them, include the Senate Committees on Finance, Banking, the Judiciary, and the House Committees on Ways and Means, Banking, Energy and Commerce, and Education and Labor. Following are various proposals affecting LBOs that Congress is either currently or may eventually be considering;

o Restrict (or eliminate) the deductibility of interest payments on debt incurred to finance LBOs. The provision could be limited so as to apply only to debt above a threshold level with regard to corporate assets, or only to certain types of LBOs (e.g., hostile takeovers). The counterargument: the proposal would give an unfair advantage to foreign corporations seeking to take over U.S. firms since the effect of the proposal would be to make LBO financing more expensive for domestic corporations.

o Eliminate the double taxation of dividends. At present, tax rules provide corporations with an incentive to use debt rather than equity financing. The cost of financing with debt -- interest payments to creditors -- is deductible as a business expense, while the cost of financing with equity -- dividend payments to shareholders -- is paid out of aftertax earnings, i.e., it is taxed once, and then after the dividend is received by shareholders it is taxed again.

o Tax the merger-related profits of presently tax exempt entities, e.g., pension funds.

Many other merger-related questions either are presently or will probably be considered by the 101st Congress. The following list provides a sampling of these questions; the list is not exhaustive and the order of questions is arbitrary. Comparing the first entry on this list with the tax examples above highlights the shorthand presentation of these questions.

o Should the tax code's fundamental bias toward debt in the structure of corporate finance be altered, either by restricting the deductibility of interest for debt used to finance corporate takeovers, or by liberalizing the double taxation of corporate dividends?

o Should legislation address the apparent conflict of interest which accompanies management-led leveraged buyouts?

o Is there cause for concern when financial institutions -- commercial banks, insurance companies, pension funds, savings and loan associations -- hold increasing amounts of the high- yield, high-risk debt used to finance large corporate takeovers?

o Could -- and should -- legislation or regulation protect holders of outstanding debt issues from a drop in bond prices when a corporation restructures financially, replacing equity capital with junk bonds and other debt?

o Is it possible to distinguish between "productive" and "nonproductive" uses of financial capital?

o Should some (or all) institutional investors be restrained from participating in some (or all) merger related financing? Institutional investors include pension funds, mutual funds, banks, trust funds, etc.

TAX LAW REFORM AND LEVERAGED BUYOUTS

In recent testimony, Treasury Secretary Nicholas Brady has characterized the growth in LBOs as a cause for concern but not alarm. Brady has shunned specific policy proposals in the area of tax law changes to discourage the rapid growth of LBOs, but he has been a major champion of making equity as attractive as debt by reducing the "overtaxation" of equity. To this end, he has advocated ending the double taxation of corporate income by using the revenue obtained from reducing the tax deductibility of corporate income to subsidize tax breaks for payment of taxes on dividends from equity.

However, the Treasury Secretary has expressed skepticism over the "reduce the deductibility of corporate debt" approach to stemming the growth of LBOs, warning that it would increase the aftertax interest cost of American firms that are conducting acquisitions and that it would also disadvantageously increase the cost of capital for American firms vis-a-vis foreign companies.

Meanwhile, estimates by the Joint Committee on Taxation released on Jan. 31, 1989, concluded that if a one-fifth cut in corporate interest deductions went into effect in 1989 it would provide sufficient revenue to eliminate the Federal tax bias of debt over equity. The release stated that the increased tax proceeds from a 20% cut in interest deductions would pay for the tax losses from allowing corporations an 80% deduction on the dividends that they pay.

Sponsors of the report concede that a major shortcoming of the proposal is that companies that use a lot of debt and pay few dividends would be hit very hard.

Representative Gradison of the House Committee on Ways and Means has proposed that the Joint Committee on Taxation's tax proposal be phased in over 5 to 10 years to temper possible shocks to the economy.

Senator Packwood, Chairman of the Senate Committee on Finance during the enactment of the Tax Reform of 1986, has observed that a proposal to provide a partial deduction to a corporation for its dividend payments was stricken from the 1986 tax package because it attracted little support from corporate officials fearful that it would compel them to make more frequent dividend announcements.

SEC Chairman David Ruder has cautioned Congress on reducing the deductibility of corporate interest, warning that proposals put before the House Committee on Ways and Means to restrict corporate interest deductibility contributed to the stock market crash of 1987. Mr. Ruder has given theoretical support, however, to banishing the double taxation of corporate income -- by eliminating the current tax on shareholder dividend payments.

Fed Chairman Greenspan has also given support to equalizing the tax treatment of debt and equity. But Mr. Greenspan has also grimly observed that calls for the elimination of the double taxation on corporate income through some form of tax credit on stock dividends appears to be fiscally impractical.

The Fed Chairman has expressed some concern over "secondary consequences we would not be able to see in advance." He warns that such consequences could have a "disturbing" impact on the economy.

Thus, both Treasury Secretary Brady and SEC Chairman Ruder have endorsed the idea that the double taxation of corporate earnings be eliminated, but they also both concede that the current deficit and budgetary climate would appear to preclude the enactment of such reform.

On Jan. 25, 1989, Senator Bentsen, Chairman of the Senate Committee on Finance, also talked of the constraints imposed by the deficit situation. He observed that Congress would probably not do anything "dramatic" to the tax laws as a response to growing corporate debt and numbers of LBOs. Senator Bentsen also stated his interest in laws that would make equity financing as attractive as debt financing, but noted that for fiscal reasons the lawmakers were constrained in the kinds of tax dispensations that they could employ in the pursuit of that goal.

On Feb. 9, 1989, Representative Rostenkowski, Chairman of the House Committee on Ways and Means, observed that the Committee was split "about 50/50" on whether it would adopt changes in the tax laws as a response to the growth in LBOs. The division within the Committee is reportedly over whether tax changes are necessary and what the best statutory approaches to tilting the laws' bias away from corporate financing might be.

LEGISLATION

H.R. 158 (Dorgan)

Disallows interest deductions for hostile takeovers. Introduced Jan. 3, 1989; referred to Committee on Ways and Means.

H.R. 615 (Bennett)

Amends the Internal Revenue Code to deny the deduction for interest on certain corporate stock acquisition indebtedness. Introduced Jan. 24, 1989; referred to Committee on Ways and Means.

H.R. 954 (Rose)

Amends the Internal Revenue Code to limit the deduction for interest on corporate stock acquisition indebtedness. Introduced Feb. 9, 1989; referred to Committee on Ways and Means.

H.R. 1052 (Dornan)

Amends the Internal Revenue Code to allow a deduction for dividends paid by domestic corporations. Introduced Feb. 22, 1989; referred to Committee on Ways and Means.

S. 325 (Sanford)

Amends the Internal Revenue Code to limit the interest deduction on corporate stock acquisition indebtedness. Introduced Feb. 2, 1989; referred to Committee on Finance.

CONGRESSIONAL HEARINGS, REFORM, AND DOCUMENTS

U.S. Congress. Joint Committee on Taxation. Federal income tax aspects of corporate financial structures. Washington, U.S. Govt. Print. Off., 1989. 124 p. (Joint Committee Print JCS-1-89, Jan. 18, 1989)

Other recent hearings include those held by the House Banking, Finance and Urban Affairs Committee on Jan. 24 and Feb. 7, 1989; those held by the Senate Finance Committee on Jan. 25-27, 1989; those held by the House Committee on Ways and Means on Jan. 31 and Feb. 1- 2, 1989; those held by the House Education and Labor Subcommittee on Labor Management Relations on Feb. 9, 1989; and those held by the House Energy and Commerce Subcommittee on Telecommunications, Consumer Protection, and Finance on Feb. 22 and 28, 1989.

FOR ADDITIONAL READING

U.S. Library of Congress. Congressional Research Service. Leveraged buyouts and the pot of gold: Trends, public policy, and case studies, by Carolyn Kay Brancato and Kevin F. Winch. [Washington] December 1987. 96 p.

CRS Report 88-1

___ Leveraged buyouts: Recent trends, by Gary W. Shorter. [Washington] Feb. 9, 1989. 16 p.

CRS Report 89-101 E