The wave of international mergers and acquisitions experienced in both the United States and the UK in the 1980’s and 1990’s is known as the fourth merger and acquisition wave. The fourth wave began just as the U.S. emerged from the recession of 1981-82, which as a result of global competition had laid bare the weaknesses of traditional American center industries. In many cases, changes in markets and technology had resulted in obsolete assets and redundant personnel. The progressive deregulation of airlines, trucking, telecommunications, and banking would also reveal excess capacity in those industries. The conglomerate boom had saddled corporations with unwieldy inefficient/under-managed operations. Massive shifts in investment away from manufacturing to services, along with energy shortages, high inflation, rising interest rates, and falling unemployment had all further contributed to the most serious crisis of confidence in the American business system since the Great Depression. Postwar corporate profits were reaching a low point, and many of the nations biggest companies were suffering from low productivity and a widely perceived loss of managerial competence. Many of these problems were addressed by the merger and acquisition wave of the 1980’s.
Brief History of the Merger Waves
The American economy has experienced four distinct waves of mergers during the twentieth century.
The first wave may be dated approximately as having taken place between 1885 and 1905. This wave consisted predominantly of horizontal mergers. Thus in this period we have an increase in concentration in industrial markets. Mergers were particularly strong in the steel, rubber and tobacco industries.
The second wave may be dated approximately as having occurred during the period 1916-30, with the peak during the late 1920’s. Horizontal mergers continued to be predominant, but vertical ones and conglomerate in particular started being important. Significant merger activity took place in petroleum, primary metals and food products.
The third period started in the 1940’s, after the Second World War. Over that period a striking change in the form of merger took place. Horizontal and vertical mergers have declined in importance while conglomerate mergers have become predominant.
Fourth Wave and the Leveraged Buyout
As the conglomerate wave began to ebb, a new vehicle surfaced for giving dissatisfied shareholders an opportunity to sell their stock in underperforming assets. The tender offer enabled buyers to bypass CEO’s and boards of directors to appeal directly to shareholders. Typically, a tender offer gave shareholders the opportunity to sell their shares at prices substantially above the going market value, when a buyer, seeing the potential for increasing the value of the assets, was willing to pay a premium for them. In many cases, this would spell bad news for underperforming managers, who were likely to be replaced by the new owners. In other cases, buyers might retain managers, but under new restructured agreements or understandings about how the assets would be managed. Most often, the tender offer was associated with a corporate raid, or a hostile takeover attempt, that is, one resisted by the target company’s board of directors.
The fourth wave was different from the previous ones in that both hostile takeovers and leveraged buyouts played a significant role, stimulated by aggressive investment bankers, corporate raiders, and heightened shareholder activism. The fourth wave was also characterized by increasing foreign participation, especially following the relative decline in the value of the dollar and the reduction of federal taxes on capital gains in 1986.
During the merger and acquisition boom of the 1980’s, leveraged buyouts spurred a dual revolution in the American economy- one in corporate finance, another in corporate governance- that profoundly altered the patterns of managerial power and behaviour. They not only substantially improved the worth of specific firms, they also helped to change the ways in which business in general though about debt, governance, and value creation. In order to succeed, they usually required drastic reforms in operations, reallocations of capital, and dislocations of personnel. They aroused the anger of numerous interests- from corporate executives to labor unions, from local communities to bondholders- whose power, status, jobs, and other economic interests were affected by the restructurings. It should be no surprise, then, that the leveraged buyout was denounced in many quarters as just another unproductive, dangerous financial scheme.
A leveraged buyout in its most simplest of terms worked like so. The acquirer would buy a well established company with predictable streams of revenue and cash flow. In financing their acqusition, they borrowed nearly all of the money. By employing high levels of debt, or leverage, minimizing the cost of buying equity, which they shared with the target companies managers. Assuming that the cash flows of the acquired businesses would be more sufficient to repay the borrowing, their success depended on a combination of timely debt reduction and the promotion of longer-term efficiency. If all went well typically within 5 to 7 years, they resold the leveraged equity for substantially higher than average gains.
The wave was stalled by the stock market crash of October 1987, and then rebounded briefly before ebbing and then finally floundering on the shoals of financial scandals, banking and real estate crises, political intervention, and the collapse of the junk bond market. By 1990 the fourth wave was effectively over.
The decline of leveraged buyouts occurred amid circumstances that adversely affected the broader climate for mergers and acquisitions and, in particular, hostile takeovers. There were also specific factors at work that affected the attractiveness of highly leveraged deals. In the macro-economy, problems had been mounting, particularly a fast growing national debt, which deflected savings away from the private sector, and decreased the liquidity in the nations banking system.
Leveraged Buyouts had peaked in numbers (381) in 1998 and in value ($70 billion) in 1989. In the 1990’s, the numbers remained well below those of the mid-80’s. Signs of an economic slow down that would continue into 1993 did not help. In 1996, there were about 150 completed leveraged buyouts valued at about $33.5 billion, in another wise brisk merger and acquisition market of more than 6,000 transactions that generally relied on much lower levels of leverage than had bee common in the 1980’s.
As the millennium approached, it was clear that many of the basic principles of the leveraged management buyout had permeated the corporate economy. In its essence the buyout was a method of creating long-term shareholder value. Value creation was achieved through the creative uses of debt, managerial equity participation, and close monitoring by a dynamic board of directors. Having demonstrated that its basic principle
and practice in buyouts could be applied to large corporations, Investment Bankers showed that shareholders could reassert themselves in the boardroom in highly constructive ways. Most importantly, the buyout regime guaranteed that the interests of owners and managers were kept in alignment. In the late 70’s the idea that shareholders would be or could be restored to power in the governance of corporations was obvious neither to their managers nor to the shareholders, or Wall Street for that matter. But during the 1980’s the mere spector of the corporate takeover was prodding more and more executives to undertake internal reforms – in some cases for no better reason than to defend against unwanted buyers, in others because they had been expired by example. A few big company executives, such as Jack Welsh of General Electric, overhauled their companies and then encouraged ongoing reforms without waiting for external shocks to drive them to change. Some boards of directors grew more active, taking action to replace executives before looming crisis turned into disasters. By 1993, the boards of General Motors, American Express, Kodak, and IBM had done exactly that. As more companies began to link managerial compensation to shareholder value creation, more managers were inspired to respond in kind, increasing corporate productivity, profits, and market values.
Recent developments in management and leveraged buyouts can be seen, to some extent, as interesting resolutions of aspects of the agency problem. Agency theory, which has become one of the most important topics in corporate finance focuses on the relationship between principals, as the owners of an asset, and the agents who operate the asset on the principals behalf. The possible conflicts of interests between a corporations parts (management, employees, shareholders, and bondholders) and how they overcome such conflicts is known as agency theory. The general agreement among agency theorists was that managerial and shareholder interests had become woefully disjointed. What the buyout offered was an opportunity to provide managers the security they needed while at the same time making them substantial equity holders, so that conflicting interests could be brought back into alignment. Among the scholars, Micheal Jensen became an early and consistently forceful advocate of the market for corporate control, and of the leveraged buyout in particular, as the salvation of shareholders from the excesses of managerial capitalism. When economic and legal histories of the 1980’s market for corporate control began to appear, other scholars began to agree with Jensen that the legal and institutional structure of the leveraged buyout represented a new corporate form with the potential to correct long-standing problems in corporate governance.
As the 1990s unfolded, U.S. business enjoyed a financial and managerial renaissance, in no small measure because of what corporations had learned from the leveraged buyout. The managerial corporation did not disappear, but institutional shareholders became more active, and boards of directors more attentive. Executive compensation became more tied to equity performance. Boundaries separating the interests of managers and owners, of shareholders and other stakeholders, began to blur in the outlook of corporate managers. With the apparent success American business was having after some fifteen years of structural reform, even European companies began tying managerial performance more closely to incentives to improve shareholder value.
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