The muddy ethics of buyouts

By Angelo Cataldo

A recent legal ruling could pose a threat to the persistence of leveraged buyouts. Who bears the burden of failure in such a risky practice? And, most importantly, is it possible to promote a remunerative business while preserving an ethical conduct?

PART I: LBOs, a gruesome business

For those who don’t know, a leveraged buyout is essentially an operation in which a company borrows huge amounts of funds to acquire a second company, the target, and take it private. The acquiring company is likely to act either because it has plans for reorganising the target, in the hope that such plans will boost its market value, or because it believes the target company is poorly managed and wants to internally control managerial practices without the sharp-eyed shareholders in the way.

In any case, the acquisition is mainly financed through debt, with an average proportion of 90-to-10% against equity, as reported by Tony Robbins and Investopedia. The acquiring company, usually a Private Equity firm, finances the acquisition of the target by issuing bonds to investors and financial institutions, such as Investment Banks and Hedge Funds, with the twist that the assets that can be pledged as a collateral include the assets of the acquired firm.

This opens a possibly infinite discussion. The main point against LBOs would be that the positions of the target and the acquiring firm in most cases are so disproportionate it seems unfair. In fact, if it is true that the buyout could possibly save a firm from bankruptcy by improving its management and its operations, the acquired company essentially bears the lion’s share of risk. If things turn out good, employees might be saved from unemployment, old shareholders may have their shares bought out above market value and the Private Equity firm will drown in the proceeds generated from the time the company goes private to the time it goes public again even before accounting for the profits of the IPO.

The flip side of the coin, however, is that the acquired firm’s books absorb a large amount of debt compared with the size of the revenues generated by its operations, which could lead to disruptions beyond the possible financial distress the company was experiencing when acquired, namely, bankruptcy. If and when this doomsday scenario occurs (and it certainly does more often than a zombie apocalypse), the acquiring private equity firm could come out almost untouched, given the low amount of equity used to finance acquisition. The only cost of the poorly executed deal would be the equity used by the private company for the buyout. The target firm instead will have its asset liquidated to repay the debt outstanding, experiencing bankruptcy most often than not.

Moreover, the bonds issued to finance the acquisition of the target company will be considered junk bonds because of the high level of risk the whole operation entails. In fact, the frailty of the collateral pledged is most likely to cause lenders to take losses on their positions because the liquidated assets are not enough to repay the debt.

Following the reasoning expressed until now, it is easy to see why a leveraged buyout is considered to be a contentious practice by economic observers in the field and could lead to potentially disruptive consequences for various stakeholders in the companies acquired.

PART II: The blind eyes of justice

Leverage buyouts had boomed in the 80s, when small firms started drawing upon the tainted pond of the newly created and highly fragile junk bond market, an extremely remunerative invention of Mr. Michael Milken and Drexel Burnham Lambert. These small firms were issuing bonds so risky but with yields so beyond standard corporate bonds that investors turned a blind eye to the risk part while carefully examining returns. Thanks to the market created by Milken with the then-giant DBL Investment Bank, these popular issues allowed small firms to raise debt capital to acquire large companies with a leverage ratio that in some surreal instances only barely fell short of 100%.

These cocktails of risk and godly returns have vanished over time, even if the smell of bankruptcy and distress is still quite strong. Even though Milken was forced into a new career as a convicted felon and Burnham Lambert is not here to testify anymore, some early proselytes of Private Equity, such as the founders of Blackstone Group and Apollo Global Management, Mr. Steve Schwarzmann and Mr. Leon Black respectively, were able to build extremely successful and remunerative careers.

These very successful entrepreneurs have prospered through LBOs, deploying the managerial expertise and cross-sector competences of their highly qualified teams to crack the code of success of the acquired companies in various fields, profiting enormously once the recognition of their work by the market translated into substantial capital gains.

However, the well-oiled mechanisms of Private Equity and Leverage Buyouts could take an unsuspected hit by Jed Rakoff, Senior Judge of the Southern District of New York with a history of criticism towards the seldom cruel financial practices of Wall Street.

The story goes as follows:

July 2012: Jones Group, a publicly traded company that sells footwear and apparel with various brands under their umbrella (most notably Nine West, that sells fashionable and affordable fashion), is going through a period of financial troubles. Therefore, the directors of Jones Group hired Investment Bankers to sell the company. Citi Bank, which received the mandate, organized the sale to Sycamore Partners, a Private Equity firm, for $2.2bn, including $1bn of existing debt. The board of directors approved the deal, but before the closing date in April 2014, Sycamore Partners decided to lower the equity share used for the acquisition to $122mln from more than three times that amount and to borrow $350mln more to complete the buyout.

Jones Group directors could have opted out of the deal since Sycamore Partners greatly changed the terms of the contract by lowering their skin in the game while at the same time increasing the exposure for the target even more.

The child that was born from such a toxic marriage, Nine West Holdings, comprising what remained of the Jones Group, was endowed with a debt that was eight times its EBITDA (an astounding $1.55bn) and its skeletal cash flows did not suffice to keep the holding alive.

Sadly enough, the company filed for bankruptcy in 2018, and after settling its claims against Sycamore Partners, the successor trustee of Nine West Holdings (the person in charge of the securities issues of a company when it goes bankrupt) sued former directors at Jones Group for failing to estimate the possible bankruptcy that could be originated by such a leveraged acquisition of such an unprofitable company.

Rakoff (in its legal opinion, In Re Nine West LBO Secs. Litigation) expressed perplexity with regard to the board of director’s assessment of the buyout’s outlook, saying the BoD did not carry out a proper examination of the financial situation in which Sycamore Partners would have put Jones Group. The directors were not able, in a fraudulent manner, to foresee the pile of debt on the group’s balance sheets that would later cause its bankruptcy, nor were they diligent enough to investigate the questionable deals Sycamore Partners put in place to split two of Jones Group most profitable divisions into Sycamore affiliates at a valuation far below their market value. The judge essentially dismissed the validity of the business judgment rule, which usually protects executives who act under rational economic principles when taking important decisions, claiming the directors did not act in good faith and were neglectful and reckless in their judgment.

To sum up, the world of corporate decision-making is being held accountable in a public and vocal way for its careless patterns of behaviour and its unethical profit thirst.

Will this stop questionable business practices? Probably not. Will this be sufficient to at least improve the leverage ratios of such buyouts? Maybe, it will.

But maybe not. In December 2020 BC Partners, a British buyout firm, acquired a Florida based Health Care company providing its balance sheet with a debt nine times the size of its EBITDA.

Given that the business world is very stubborn when it comes to passing on profitable opportunities, the question we should be asking is whether the leverage buyouts should stop, because they clearly won’t.

PART III: The hangover

What’s worse, the pain or the hangover? The hangover, most definitely. But if Rakoff’s judgment was certainly a momentary pain for the industry, doubts persist on its acknowledgment as a relevant judicial precedent for the future.

As reported by Himani Singh in the NYU Journal of Law and Business, LBOs had already taken a serious hit after the glory of the eighties because of newly created corporate defence mechanisms and unfavourable changes in state law, during the nineties. After a phase of near-death, the 21^st century saw a new awakening for these practices.

During the hangover of the court sentence, as the Finance world adjusts the profitable machine of LBOs to bypass the most recent difficulties, questions are again brought up about their ethical implications. The key question is, as always, who bears the burden of the catastrophe if things turn sour. We already discussed this point in detail, and concluded that, apart from a mild co-participation in suffering, Private Equity companies that complete an unsuccessful Leveraged Buyout are far less damaged by its downsides than the acquired companies.

As highlighted by tonyrobbins.com, LBOs can end up transforming the target company for good, thanks to better management, internal reorganization, a new shape imprinted to corporate culture, and tax benefits. This practice can result in value added to the target firms, improvement in their growth prospects and injection of new life into unprofitable and sinking organisms.

A balance must be struck between this bright upside and the obscure helplessness of a target company unable to generate operating cash flows that is drowned in debt. As it usually is the case, this balance rests on the notion of good faith, as opposed to greed.

When a board of directors is confronted with a proposition from a PE firm offering to buy out their company, they shall not ignore the intrinsic risk of an LBO; from the prohibitive leverage ratio, to the firm-specific risk (the target is often in financial distress), such a proposition should be assessed bearing in mind that the ultimate burden of failure rests with the acquired, and not with the acquiring. If an evaluation of the proposal leads to its acceptance, the BoD has to be sure that it has acted under good faith, that it has taken the interest of the company as the primary criteria in the decision-making process, and that greed, or guilt, did not influence this extremely critical decision. The appropriate weight has to be attributes to each scenario, and the board has to retain its right to opt out of poorly conducted deals if the necessity to do so presents itself. A business decision by the board of directors of a listed company is unquestionable if its foundation is oriented towards the protection of the company and its stakeholders, as expressed by Rakoff in its judgment, In Re Nine West LBO Secs. Litigation.

The Jones Group directors proved unable to forecast the incendiary power of a highly risky buyout. Their negligence resulted in a bankruptcy that, although unlikely to redirect Private Equity firms away from the path along LBOs, could at least improve corporate decision making. Holding directors accountable in the case of a catastrophe which could have been foreseen with a little more hindsight is a first step towards that goal.

Profit does not imply guilt. The way in which it is achieved, does.

Authors: Angelo Cataldo

Editor: Jakob Müller