Leveraged buyouts are a favorite and highly controversial business ethics topic, and they have been in the news recently as Dow Chemical fired two senior executives for scheming to buy out the company.
In a typical LBO, company insiders buy out a large public company using private financing, generally borrowing money from large banks or mega-rich private investors. The buyout is called "leveraged" because the new owners put up only a small amount of the actual value of the company. Just as a lever and fulcrum enable a small amount of force to raise a heavy object, a leveraged buy out enables a small amount of equity to acquire a large company. The company stock acquired serves as security for the loan.
LBOs are expensive because in order to acquire a controlling interest, stock prices have to rise considerably. The obvious incentive for such a move is that the new owners believe the company is mismanaged and, therefore, undervalued; typically this incentive is validated as LBOs are followed by a significant shake-up in the company.
The deal makers are viewed as arch-villains by those who lose their jobs - lower-level employees fired as a result of corporate streamlining, as well as senior executives who lose their job because the new owners think they are incompetent. A common complaint is that they increase value at the expense of jobs, or that they create illusory short-term value, drive up the stock price on hype, cash in their chips, and then let the company collapse. For this reason, in periodic LBO feeding frenzies, there are always calls to strengthen business ethics by limiting LBOs.
The same people are viewed as superheroes by a lot of economists and corporate governance devotees. So-called "corporate democracy" is notably sclerotic, and even if it is pretty obvious that management is missing profit opportunities it can be nearly impossible for disaffected shareholders to organize effective action to boot them. Any scheme enabling changed management of struggling companies is viewed as one blessed step in the direction of corporate accountability. Hence, we find parallel calls to bolster business ethics by making LBOs easier, and outlawing various obstacles such as "poison pills" (automatic stock dilutions triggered by buyout offers).
This only summarizes the "boos" and "yays" for the buyout itself; in many cases there is the complicating factor of insider buyouts, like the one the Dow executives are "accused" of engineering. These enable the first camp to add conflict of interest to the litany of complaints - these villains are gutting the company while on its very payroll! Yet LBO fans now praise not only the wisdom of the buyers, but also their courage as they break ranks with an ineffective management team that has failed to represent shareholder interests.
In between these two camps, we find Dr. Pangloss, aka Posner, who defends the position that we live in the best of all possible worlds: Insider LBOs are wonderful because they enable insiders, who have a clear idea of the company\s potential, to take control, but the ability of management to fight off buyouts can also be justified since it enables them to hold out for even better deals.
At first glance, the arguments both in favor and against insider LBOs are plausible, but after years of following this issue I have reached the conclusion that the arguments against are totally unconvincing and the arguments in favor totally convincing. I just can't believe that it is easy to raise a few billion dollars from private investors in order to pay a significant premium for the stock of the company, if there isn't real and proven hidden value in those assets. It's like fooling all of the people all of the time.
The conflict of interest argument also has limited application. Shareholders always benefit from these buyouts. Conflict of interest would be relevant if the insiders were accused of purposely sabotaging their companies to lower their values in order to take advantage of the distressed price afterwards. But, again, I find it hard to believe that investors would entrust billions of leveraged dollars to a manager who has overseen disastrous performance in his or her company or division.
Least of all do I feel sorry for shareholders who cry all the way to the bank, complaining that it's true that the LBO raised the price of the stock 20%, but if the current management had been allowed to continue the stock would have risen even higher.
I have no idea whether the Dow executives did or did not scheme to take over the company (they deny any involvement), but if I were a Dow shareholder I would be saddened that no such scheme has yet materialized.
The writer is research director at the Business Ethics Center of Jerusalem (www.besr.org), an independent institute in the Jerusalem College of Technology.
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