Buyout Binge

Fears about a Wall Street fad

Wall Street can be as slavish in following a financial trend as clothing designers are in copying fashion changes. This year’s financial fad is the leveraged buyout. In these deals, the group of investors buying a company puts up the firm’s assets as collateral. Since the loans needed for a leveraged buyout are thus backed by the company itself, there can be big profits for the investors, who often put up very little of their own cash. In one of the most celebrated leveraged buyouts, former Treasury Secretary William Simon and a group of financiers bought Gibson Greetings in January 1982 for $80 million while putting up only $1 million of their own money. Sixteen months later, Simon’s group took Gibson public in a stock offering worth $290 million. Simon’s profit on the deal: $66 million. Fortnight ago, Simon’s Wesray Corp. launched another buyout: a $71.6 million acquisition of Atlas Van Lines.

Once usually restricted to special situations involving relatively small companies, leveraged buyouts have become both popular and big. Last year there were 36 of them worth $7 billion, compared with only 16 in 1979. In one of the biggest deals this year, executives of Metromedia borrowed money to buy the company from its shareholders for $1 billion. Senior managers at Pittsburgh-based Ryan Homes are also trying to take their company private by paying shareholders for it. Last week they bid $176 million for the big homebuilder. Other companies have been acquired by one of a number of investment firms, including Forstmann Little and Kohlberg Kravis Roberts, that specialize in buyouts. Forstmann Little, for example, bought Dr Pepper for $640 million.

Wall Street has never been famous for its moderation, and now there are growing doubts about the soundness of the deals. John S.R. Shad, chairman of the Securities and Exchange Commission, has issued a surprisingly sharp warning. Said he: “The more leveraged takeovers and buyouts today, the more bankruptcies tomorrow.” Reason: the companies are vulnerable to high interest rates and a down turn in business because of the large loans they have taken on to finance their own purchase. Shad’s views echoed those of Felix Rohatyn, a senior partner in the in vestment banking firm of Lazard Freres, who believes that buyouts are too speculative. Says Rohatyn: “We are turning the financial markets into a huge casino.”

Nonetheless, banks, pension funds and other lenders dazzled by the gains being made in leveraged buyouts have been rushing to assemble billion-dollar cash pools to be used for the deals. That will make more loans available to buyers who actually make the buyouts. Even small investors will soon be able to get into the game. The brokerage house of Dean Witter Reynolds plans to offer a leveraged buyout fund that will allow individuals to participate for as little as $2,000.

But leveraged buyouts can be risky if a company does not earn enough to pay the interest on the huge loans that have been taken out. Debt payments can also divert funds away from investment in new equipment and research and development. A group of managers at Harley-Davidson, the motorcycle manufacturer, bought the company from AMF in a leveraged buyout in 1981, but racked up big losses the following year and had to ask for protection from Japanese competitors.

So far, Washington legislators and regulators have done little besides watch the buyout binge. But pressures are building to curtail the deals. Colorado Democrat Timothy Wirth, chairman of the House Subcommittee on Telecommunications, Consumer Protection and Finance, has announced that he will study the effects of buyouts on the availability of credit as —part of an investigation of takeover tactics. Federal Reserve Board Chairman Paul Volcker, in a letter made public by Wirth, warned that the buyouts may expose companies to financial difficulties. The Federal Reserve, however, has so far declined to restrict lending for buyouts. Volcker says that measures like credit controls “would be very difficult to implement.”

In recent years, no firms that underwent leveraged buyouts have failed. But Wilbur Ross, managing director of Wall Street’s Rothschild Inc., warns: “The real test will come the next time you have a combination of high interest rates and a bad economic environment. When that happens, we’ll see just how prudent some of these deals really were.” As every sensible investor should know, a formula designed to create huge profits in good times can eventually lead to enormous losses in bad times .