Lbos: Let's Bail Out

By John Greenwald

Like the giant truck-trailers that carry its name across U.S. highways, Fruehauf Corp. was once an American institution. But to escape a corporate raider, Fruehauf in 1986 went private in a leveraged buyout that sent the company into a skid from which it never recovered. After borrowing $1.5 billion to repurchase its stock from shareholders, the Detroit company frantically sold one division after another to lighten its debt burden. To no avail: when it completes the sale of a subsidiary that makes wheels and brakes later this summer, Fruehauf, which had 1986 revenues of $2.7 billion and ranked among the 150 largest U.S. manufacturers, will be an empty shell existing in name only.

The demise of Fruehauf dramatizes the problems that could befall a growing number of leveraged buyouts as the U.S. economy softens. Touted as one of the hottest financial plays of the go-go 1980s, LBOs zoomed in annual volume from about $250 million in 1980 to nearly $45 billion last year. The buyouts included household names like R.H. Macy, Beatrice, TWA and Safeway Stores. In such deals an investor group, often headed by a company's own executives, uses bank loans and high-interest junk bonds to buy a firm and take it private. Almost without exception, the group immediately slashes costs, lays off workers and sells divisions to reduce debt; the managers may eventually reap huge profits by selling the streamlined company back to public investors.

But leveraged buyouts place enormous strains on even the largest corporations. While all debt-laden acquisitions are risky, LBOs replace the stock on corporate balance sheets with loans that must be repaid, leaving executives with little room for error. "Running an LBO is different from running other companies," says Wilbur Ross, a senior managing director of Rothschild Inc., a New York City investment firm. "The reaction time at LBO companies has got to be a lot quicker, because they must generate cash fast enough to beat those interest-payment deadlines."

LBOs invariably lose money at first because heavy debt charges soak up their earnings. RJR Nabisco, which went private last December in a record $25 billion buyout, last week reported a staggering $309 million loss for the second quarter. Reason: $1.05 billion in interest and debt expenses. In announcing the loss, RJR Nabisco said its basic food and tobacco operations, which include Nabisco cookies and Winston cigarettes, performed strongly; the company added that its program to sell assets was ahead of schedule. RJR Nabisco has already sold more than $2.5 billion of businesses, including most of its European food operations.

While no more than 5% of LBOs have so far been failures, an economic downturn could sharply raise the number of casualties. Warned Manuel Johnson, vice chairman of the Federal Reserve Board, in a June speech: "If there were a significant negative shock to the economy, high debt levels could lead to a succession of bankruptcies, causing a crisis of confidence." Johnson estimated that roughly 40% of all leveraged deals are in cyclical industries that are "more likely to run into trouble in the event of a severe slump."

Government reports last week revealed new signs of economic weakness, prompting worries that the current slowdown could turn into a full-fledged recession. Although the Labor Department said on Friday that the U.S. unemployment rate dipped slightly, from 5.3% in June to 5.2% in July, the Government's Index of Leading Economic Indicators, its chief forecasting gauge, showed its fourth drop in five months. Another closely watched barometer, which measures new orders and inventory by the nation's corporate purchasing agents, fell to a six-year low.

Leveraged buyouts could be in trouble during a downturn for many reasons. Investors in some LBOs may simply have paid too high a price or accepted overly rosy projections about their ability to repay debt. Other buyouts might flounder because investment bankers arranged the deals with more concern for the fat fees they produced than for the soundness of the transactions, according to critics of Wall Street. Some studies in LBO failure:

FRUEHAUF. The company's troubles began after takeover artist Asher Edelman launched a $1 billion hostile bid. Following the advice of Merrill Lynch, Fruehauf acquired Edelman's 10% stake at a profit to the raider of $120 million. Some 70 Fruehauf executives then joined forces in a leveraged buyout. But when the trailer division slumped in 1987 as cost-conscious truckers cut back on new orders, Fruehauf had to strain to meet interest payments, which had climbed to $101 million a year. As other divisions faltered, Fruehauf embarked on desperate cost-cutting moves and fire sales that have hollowed out the 71-year-old company. "They paid way too much, and then their markets turned against them," says George Malley, a former head of the trailer division.

Victims of the collapse included Ronald Yoder, 37, who lost his job as a crane operator when Fruehauf shuttered its Fort Wayne, Ind., trailer plant in 1987. Yoder, who is married with a 17-month-old son, now earns about a third less than the $11.47 hourly wage he was paid at Fruehauf and receives no health insurance from his present employer. Says he: "Sure, I got another job, but I can't save a dime. We wanted to have another baby, but we can't afford it. I didn't know what an LBO was until a couple of years ago. They said that a lot of people got rich. Well, I wasn't one of them."

REVCO D.S. Back in 1986 it was the largest U.S. drugstore chain. Revco plunged into an LBO that year after Herbert Haft, chairman of the Dart Group of retailing companies, made a bid for the Twinsburg, Ohio-based firm. With advice from Salomon Brothers, Revco chairman Sidney Dworkin led a $1.3 billion LBO financed largely by junk bonds that paid more than 13% interest. The company then expanded its line of merchandise to include video players and ^ electronic appliances in the hope of boosting business. Bewildered customers began shopping elsewhere, and Revco fell short of its sales and earnings targets. Revco became the largest LBO to seek bankruptcy-court protection last year, after a creditor demanded accelerated payments on $100 million of junk bonds.

SINGER. The defense contractor and former sewing-machine maker had annual sales of nearly $2 billion before raider Paul Bilzerian acquired the company in a $1.1 billion buyout in early 1988. Faced with interest payments of more than $120 million a year, the new owner sold eight of Singer's twelve divisions in an astonishing three-month blitz. Bilzerian, who is appealing a June conviction that found him guilty of violating tax and securities laws in previous takeover attempts, cut the Singer work force from 28,000 to about 3,800. While many of the employees simply switched owners, up to 9,000 may have lost their jobs. "I think what happened is tragic," says Edward Damon, who was vice president for corporate planning. "What's left of Singer is not even a shadow of its former self."

Not all leveraged buyouts have dismal consequences. Steven Kaplan, a finance professor at the University of Chicago business school, argues that the debt burden of an LBO frequently "stops managers from pursuing stupid strategies." In a two-year study of 76 leveraged buyouts that occurred between 1980 and 1986, Kaplan found that most produced handsome returns for investors. But such studies can track only short-term trends because LBOs are a recent development. Says Abbie Smith, a University of Chicago accounting professor: "The real question is, How risky are LBOs? All the research so far has been constrained by the relatively short periods of time involved in buyout studies."

Aside from a brief wave of concern about corporate debt that swept Washington after the RJR Nabisco deal, Congress has paid little attention to LBOs. In order to show the impact of the buyouts, Massachusetts Democrat Edward Markey plans next month to introduce a bill in the House that, among other things, would require companies that go private in LBOs to file public reports for five years.

Such reports may prove unnecessary as the outcomes of many leveraged buyouts -- one of the chief financial legacies of the Roaring 1980s -- become obvious. Says Rothschild's Ross: "1990 and 1991 will be graduation day for many LBOs. Most will graduate, some with honors. Others will be dropouts." More than anything else, the course of the economy over the rest of 1989 could determine how long the list of delinquents will be.

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With reporting by Thomas McCarroll/New York, with other bureaus