Now that we've thought a bit about reinvestment in a corporation as opposed to return of earnings and capital to the shareholders, let's look at a Leveraged Buy-Out (LBO) transaction as the consequence of this calculation by the shareholders. Many companies taken private by LBOs seem, groaning under the burden of servicing the debt undertaken in the buy-out, perched on the ``lap of God''. I refer to the process that puts them there as the ``elbow of the invisible hand''.
Imagine a successful company in a stable, easily-analysed industry with pre-tax earnings of 12.3%. If that company has no interest payments or other significant deductions, it will pay about 35% in corporate income tax on its earnings, leaving about 8% net savings. If the corporation pays out 3.8%, the average dividend yield on the Dow Jones Industrials at this writing, about 4.2% is left for reinvestment in the business. If the economy and Fortune shine on the judgement of management, and this reinvestment doubles in a year, the gain in earnings will be 8.4%, a princely sum by the standards of history, but little more than the riskless interest to be earned by the simple expedient of purchasing a Treasury Bill. So consider the plight of an investor in this company. He places his capital at total risk, subject to loss not only from incompetent management and competition, but also from economic shocks, international crises, acts of God, bear markets that reduce the value of all stocks--an endless litany of calamity the Treasury Bill holder dozes through, and for what? A dividend check in the mail that's less than half the income of the T-Bill holder. If the investor accepts the doctrine that earnings are just as good as (and in the face of taxation, better than) dividends, there's still little solace--the Price/Earnings ratio of the Dow Jones 30 Industrials stands at 12.3, the reciprocal of which is almost precisely 8%. Thus for assuming all the risks, trusting the management to optimally deploy retained earnings, and adopting the long-term investment posture which is the only way to ride out the fluctuations of the market, the stock investor receives no more than had he bought a T-Bill. Buy a share of America? Sure...and then let me tellya 'bout this bridge I got.
What's a corporate raider to do? Here's a profligate management, squandering the company's resources on so-called ``reinvestments'' which, despite their self-evident risk, yield less return than riskless short term government debt. Since corporate raiders are instrumentalities of the Efficient Market and Self-Sacrificing Servants of Society, their actions are merely the means through which a tortured economy seeks equilibrium. Let's see how a company looks to its investors after the raider has struck. Before, the company was as we described above-funded by shareholder's equity and retained earnings, paying a return to the shareholders, in today's environment of high interest rates, less than that available from risk-free short-term debt. After the raid is complete, the company's capitalisation has undergone a dramatic change. The previous shareholders' equity has been eliminated; equity is now concentrated in the hands of the raider and his small band of capitalist running dogs. The company has assumed a huge burden of debt--in the purest case of leveraged buy-out the debt equals the entire market capitalisation of the company.
How will that debt be serviced and paid down? By reorienting the corporation from reinvestment in its business to generating cash to repay the holders of its bonds. That this is possible is a product of the tax system and the valuations placed on companies by the stock market. First, the tax gimmick: interest payments on debt are deductible. The same policy that inflated real estate values into the stratosphere is a proximate cause of the takeover boom as well. Consider: if a corporation earns a dollar and pays it out as interest to a bond holder, the creditor receives a full dollar (pre-tax). If the corporation retains the dollar of earnings for its own use, it must pay corporate income tax on it, which shears 33% to 40% from the original dollar. Consequently a corporation can pay out almost 50% more to a bondholder in interest than it could pay a shareholder in dividends, purely as a consequence of the deductibility of interest payments. So, if the corporation uses its entire cash flow to pay the interest on the debt undertaken to buy it out, it can pay the bond holders its before tax profit, 12.3%, a 50% premium over the income to be had from the Treasury bond--enough to pique the interest of even conservative investors.
Second, the acquirer of the taken-over company usually pledges to sell off some of the assets of the original company to retire some of the debt undertaken in the acquisition. That this makes sense is indicative of an inefficiency in the market which has a rational basis in fact. Since, as we've seen, the yield returned by a profitable business to its investors is less than they can obtain without risking their capital at all, the market quite rationally values these investments below their liquidation value to one able to realise all the value inherent in them. If there is another company able to gain market share, earnings on the margin, or other benefits from the acquisition of portions of the original business, it is reasonable to expect that these portions can be sold for more than their beneficial contribution to the sales and earnings of the selling company.
What happens when a leveraged buy-out runs its course? A corporation which previously followed conventional guidelines of reinvestment, dividend payments, and service of modest debt has been transformed into an engine that generates cash flow to service the interest payments due the creditors who financed the acquisition. The result can be viewed as the unbundling of the earnings of the corporation from the possibility of appreciation of its equity--the new owners promise to pay bondholders substantially all the current earnings in the belief that they can restructure the corporation to yield additional earnings which will accrue directly to themselves.
Editor: John Walker