A “leveraged buyout” is when a company’s own assets are used as collateral to support a loan that is then used to purchase that same company. It has been described as the company buying itself. In the 1980s, leveraged buyouts became popular as a way to extract more value for shareholders. The approach was highly successful, with several billionaires created in the process. However, this high-risk approach also has serious ethical and financial consequences. It leaves a company saddled with an enormous pile of debt. Frequently the company is stripped of its brands or dismantled to repay the debt. While shareholders and executives may benefit, creditors, suppliers, or employees are often harmed. With this assignment, you will have the opportunity to evaluate a real-life leveraged buyout of your choice, and to carefully consider the ethical and financial implications of the decisions made by executives and their advisors.
Upon successful completion of this assignment, you will be able to:
The leveraged buyout (LBO) has become a famous, perhaps infamous, approach to corporate finance. Whenever people talk about corporate raiders, they are probably referring to leveraged buyouts. The method has been featured in several movies, including Wall Street and The Boiler Room. The record-breaking 1989 acquisition of RJR Nabisco by famed private-equity firm KKR was even featured in a TV movie Barbarians at the Gate.
While it is easy to disparage such an aggressive and risky maneuver, there are many examples of where a leveraged buyout has resulted in not only great profits but also greatly improved businesses. When a company is purchased through an LBO, it is taken private, meaning its shares are no longer publicly traded. This frequently gives the company the space and discretion it needs to restructure itself.
For example, in 1986 supermarket chain Safeway was purchased by KKR, using only $129 million in cash but over $5 billion in debt. Safeway divested some of its assets and closed many of its unprofitable stores. However, by 1990 the company had greatly improved its profitability and revenue. The company went public again, resulting in $7.2 billion in profits for KKR. Safeway continues to operate successfully to this day, employing some 140,000 people. In 2015, the company was purchased by Albertson’s for $9.4 billion.
In this assignment, you will investigate an example of a real-life leveraged buyout that is of interest to you. You will then have the opportunity to analyze whether the decision to take the company private through an LBO was appropriate, not only in terms of its financial results for the company’s owners but also in consideration of the impact to the firm’s other stakeholders.
In the last workshop, we delved into financial planning, laying the groundwork for bringing a company’s great product and project ideas into being. In this workshop, we are examining a key decision faced by top executives: the manner in which these ideas should be funded. Just like there are many ways to run a business’s operations, there are many alternatives to providing the financing a company needs. The organization’s leaders should understand the implications of these options before making a decision. The company’s approach to financing can have a dramatic effect on its future. With this exercise, you will have an opportunity to explore the features and effects of financing decisions.
Upon successful completion of this assignment, you will be able to:
Every day, businesses fail not because they don’t have great products or because they don’t operate effectively but because they make poor financing decisions. The methods of funding chosen by businesses are part of their infrastructure and can be every bit as important as the design of their products or the quality of their services. Sadly, many top executives are poorly equipped to handle financing decisions. They don’t understand how the company’s financial structure could affect its stability, flexibility, or viability. They fail to see how funding decisions could either create a competitive advantage or serious obstacles that interfere with their ability to serve customers and satisfy shareholders.
With this assignment, you will complete a series of short exercises designed to help you explore the implications of various financing decisions. Hopefully this will leave you better equipped to face such decisions with wisdom and skill.
“Governance” could be defined simply as the mechanisms used to control a corporation and thereby ensure it seeks to maximize the best interests of its stockholders. Stockholders are the ultimate owners of a corporation. They elect representatives, who sit on a Board of Directors, to oversee the company and to hire its top executives. These managers are acting as agents of the stockholders and are legally obligated (they have a fiduciary duty) to pursue the goals set out for them by the Board.
Nevertheless, despite even the best governance processes, there is always a temptation for managers to pursue their own self-interests instead of the interests of their stockholders. This is known as an “agency problem.” Furthermore, it is not always clear what goals managers should pursue. The primary goals of corporations have been a subject of intense debate for nearly 100 years.
Upon successful completion of this discussion, you will be able to:
Agency problems have been an issue with large organizations throughout recorded history. It has been said when God hired Adam and Eve to oversee His creation, it created an agency problem. Today, governance procedures should help align a company’s behavior with the priorities of its owners. However, a single company may have thousands of stockholders. These stockholders generally don’t have the time or inclination to get personally involved in the day-to-day operations of the companies they have invested in. They have little choice but to trust the agents they have hired will act in their best interests. Additionally, there are often disagreements about what a corporation’s priorities should be.
In 1951, a stockholder sued manufacturing company A.P. Smith over alleged misuse of his funds. In an apparent failure of their governance systems, the company’s executives had decided to make a large donation to the engineering school at Princeton University. The stockholder argued if he had desired to make a charitable gift, he would have done so on his own. He did not appreciate the company diverting money he had intended to fund their operations and instead using it for a cause that had no economic benefit (Pierce, 2015).
Despite this stockholder’s protestations, an appellate court ultimately ruled philanthropy was an acceptable use of funds, presuming such a gift might engender goodwill towards the corporation (Pierce, 2015). This ruling encouraged more companies to follow suit. By the 1960s, several “5 percent clubs” (Vogel, p. 20) had emerged in the United States. These groups were made up of companies who had committed to give at least 5% of their pretax earnings to charity.
In 1970, famed economist and Nobel Prize winner Milton Friedman responded to this movement. In an article for New York Times Magazine, he boldly proclaimed, “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits” (p. 126). He went on to say anything else was “collectivist doctrine…and fundamentally subversive” (p. 126). This article became the focus of four decades of scholarly debate.
Friedman, M. (1970, September 13). The social responsibility of business is to increase its profits. The New York Times Magazine, 32–33, 122, 124, 126. http://umich.edu/~thecore/doc/Friedman.pdf
Pierce, J. (2015). The rights of shareholders in authorizing corporate philanthropy. Villanova Law Review, 60(2), 1–32. https://digitalcommons.law.villanova.edu/cgi/viewcontent.cgi?article=3271&context=vlr
Vogel, D. J. (2005). Is there a market for virtue? The business case for corporate social responsibility. California Management Review, 47, 19–45.
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