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share, about $25 billion in all, for a company that only 33 days previously had been sell-
ing for $56 per share?
KKR and other bidders were betting on two things. First, they expected to generate
billions of additional dollars from interest tax shields, reduced capital expenditures, and
sales of assets not strictly necessary to RJR™s core businesses. Asset sales alone were
projected to generate $5 billion. Second, they expected to make those core businesses
significantly more profitable, mainly by cutting back on expenses and bureaucracy. Ap-
parently there was plenty to cut, including the RJR “Air Force,” which at one point op-
erated 10 corporate jets.
In the year after KKR took over, new management was installed. This group sold as-
sets and cut back operating expenses and capital spending. There were also layoffs. As
expected, high interest charges meant a net loss of $976 million for 1989, but pretax op-
erating income actually increased, despite extensive asset sales, including the sale of
RJR™s European food operations.
While management was cutting costs and selling assets, prices in the junk bond mar-

12 The story of the RJR Nabisco buyout is reconstructed by B. Burrough and J. Helyar in Barbarians at the
Gate: The Fall of RJR Nabisco (New York: Harper & Row, 1990) and is the subject of a movie with the same
Mergers, Acquisitions, and Corporate Control 587

ket were rapidly declining, implying much higher future interest charges for RJR and
stricter terms on any refinancing. In mid-1990 KKR made an additional equity invest-
ment, and later that year the company announced an offer of cash and new shares in ex-
change for $753 million of junk bonds. By 1993 the burden of debt had been reduced
from $26 billion to $14 billion. For RJR, the world™s largest LBO, it seemed that high
debt was a temporary, not permanent, virtue.

The buyout of RJR crystallized views on LBOs, the junk bond market, and the takeover
business. For many it exemplified all that was wrong with finance in the 1980s, espe-
cially the willingness of “raiders” to carve up established companies, leaving them with
enormous debt burdens, basically in order to get rich quick.
There was plenty of confusion, stupidity, and greed in the LBO business. Not all the
people involved were nice. On the other hand, LBOs generated enormous increases in
market value, and most of the gains went to selling stockholders, not raiders. For ex-
ample, the biggest winners in the RJR Nabisco LBO were the company™s stockholders.
We should therefore consider briefly where these gains may have come from before
we try to pass judgment on LBOs. There are several possibilities.

The Junk Bond Markets. LBOs and debt-financed takeovers may have been driven
by artificially cheap funding from the junk bond markets. With hindsight it seems that
investors in junk bonds underestimated the risks of default. Default rates climbed
painfully between 1989 and 1991. At the same time the junk bond market became much
less liquid after the demise of Drexel Burnham Lambert, the chief market maker. Yields
rose dramatically, and new issues dried up. Suddenly junk-financed LBOs seemed to
disappear from the scene.13

Leverage and Taxes. As we explained earlier, borrowing money saves taxes. But
taxes were not the main driving force behind LBOs. The value of interest tax shields
was just not big enough to explain the observed gains in market value.
Of course, if interest tax shields were the main motive for LBOs™ high debt, then
LBO managers would not be so concerned to pay off debt. We saw that this was one of
the first tasks facing RJR Nabisco™s new management.

Other Stakeholders. It is possible that the gain to the selling stockholders is just
someone else™s loss and that no value is generated overall. Therefore, we should look at
the total gain to all investors in an LBO, not just the selling stockholders.
Bondholders are the obvious losers. The debt they thought was well-secured may
turn into junk when the borrower goes through an LBO. We noted how market prices of
RJR Nabisco debt fell sharply when Ross Johnson™s first LBO offer was announced.
But again, the value losses suffered by bondholders in LBOs are not nearly large
enough to explain stockholder gains.

Leverage and Incentives. Managers and employees of LBOs work harder and often
smarter. They have to generate cash to service the extra debt. Moreover, managers™
13 There was a sharp revival of junk bond sales in 1992 and 1993 and 1996 was a banner year. But many of
these issues simply replaced existing bonds. It remains to be seen whether junk bonds will make a lasting re-

personal fortunes are riding on the LBO™s success. They become owners rather than or-
ganization men or women.
It is hard to measure the payoff from better incentives, but there is some evidence of
improved operating efficiency in LBOs. Kaplan, who studied 48 management buyouts
between 1980 and 1986, found average increases in operating income of 24 percent over
the following 3 years. Ratios of operating income and net cash flow to assets and sales
increased dramatically. He observed cutbacks in capital expenditures but not in em-
ployment. Kaplan suggests that these operating changes “are due to improved incen-
tives rather than layoffs or managerial exploitation of shareholders through inside in-

Free Cash Flow. The free-cash-flow theory of takeovers is basically that mature firms
with a surplus of cash will tend to waste it. This contrasts with standard finance theory,
which says that firms with more cash than positive-NPV investment opportunities
should give the cash back to investors through higher dividends or share repurchases.
But we see firms like RJR Nabisco spending on corporate luxuries and questionable
capital investments. One benefit of LBOs is to put such companies on a diet and force
them to pay out cash to service debt.
The free-cash-flow theory predicts that mature, “cash cow” companies will be the
most likely targets of LBOs. We can find many examples that fit the theory, including
RJR Nabisco. The theory says that the gains in market value generated by LBOs are just
the present values of the future cash flows that would otherwise have been frittered
We do not endorse the free-cash-flow theory as the sole explanation for LBOs. We
have mentioned several other plausible rationales, and we suspect that most LBOs are
driven by a mixture of motives. Nor do we say that all LBOs are beneficial. On the con-
trary, there are many mistakes and even soundly motivated LBOs can be dangerous, as
the bankruptcies of Campeau, Revco, National Gypsum, and many other highly lever-
aged companies prove. However, we do take issue with those who portray LBOs simply
as Wall Street barbarians breaking up the traditional strengths of corporate America. In
many cases LBOs have generated true gains.
In the next section we sum up the long-run impact of mergers and acquisitions, in-
cluding LBOs, in the United States economy. We warn you, however, that there are no
neat answers. Our assessment has to be mixed and tentative.

Mergers and the Economy
Mergers come in waves. The first episode of intense merger activity occurred at the turn
of the twentieth century and the second in the 1920s. There was a further boom from
1967 to 1969 and then again in the 1980s and 1990s. Each episode coincided with a pe-
14 S.Kaplan, “The Effects of Management Buyouts on Operating Performance and Value,” Journal of Finan-
cial Economics 24 (October 1989), pp. 217“254.
15 Thefree-cash-flow theory™s chief proponent is Michael Jensen. See M. C. Jensen, “The Eclipse of the Pub-
lic Corporation,” Harvard Business Review 67 (September“October 1989), pp. 61“74, and “The Agency
Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review 76 (May 1986), pp.
Mergers, Acquisitions, and Corporate Control 589

riod of buoyant stock prices, though in each case there were substantial differences in
the types of companies that merged and how they went about it.
We don™t really understand why merger activity is so volatile. If mergers are
prompted by economic motives, at least one of these motives must be “here today, gone
tomorrow,” and it must somehow be associated with high stock prices. But none of the
economic motives that we review in this material has anything to do with the general
level of the stock market. None of the motives burst on the scene in 1967, departed in
1970, reappeared for most of the 1980s, and reappeared again in the mid-1990s.
Some mergers may result from mistakes in valuation on the part of the stock market.
In other words, the buyer may believe that investors have underestimated the value of
the seller or may hope that they will overestimate the value of the combined firm. Why
don™t we see just as many firms hunting for bargain acquisitions when the stock market
is low? It is possible that “suckers are born every minute,” but it™s difficult to believe
that they can be harvested only in bull markets.
During the 1980s merger boom, only the very largest companies were immune from
attack from a rival management team. For example, in 1985 Pantry Pride, a small su-
permarket chain recently emerged from bankruptcy, made a bid for the cosmetics com-
pany Revlon. Revlon™s assets were more than five times those of Pantry Pride. What
made the bid possible (and eventually successful) was the ability of Pantry Pride to fi-
nance the takeover by borrowing $2.1 billion. The growth of leveraged buyouts during
the 1980s depended on the development of a junk bond market that allowed bidders to
place low-grade bonds rapidly and in high volume.
By the end of the decade the merger environment had changed. Many of the obvious
targets had disappeared, and the battle for RJR Nabisco highlighted the increasing cost
of victory. Institutions were reluctant to increase their holdings of junk bonds. More-
over, the market for these bonds had depended to a remarkable extent on one individ-
ual, Michael Milken, of the investment bank Drexel Burnham Lambert. By the late
1980s Milken and his employer were in trouble. Milken was indicted by a grand jury on
98 counts and was subsequently sentenced to jail and ordered to pay $600 million.
Drexel filed for bankruptcy, but by that time the junk bond market was moribund and
the finance for highly leveraged buyouts had largely dried up.16 Finally, in reaction to
the perceived excess of the merger boom, the state legislatures and the courts began to
lean against takeovers.
The decline in merger activity proved temporary; by the mid-1990s stock markets
and mergers were booming again. However, LBOs remained out of fashion, and rela-
tively few mergers were intended simply to replace management. Instead, companies
began to look once more at the possible benefits from combining two businesses.

There are undoubtedly good acquisitions and bad acquisitions, but economists find it
hard to agree on whether acquisitions are beneficial on balance. We do know that merg-
ers generate substantial gains to stockholders of acquired firms.
Since buyers seem roughly to break even and sellers make substantial gains, it seems
that there are positive gains to mergers. But not everybody is convinced. Some believe
that investors analyzing mergers pay too much attention to short-term earnings gains
and don™t notice that these gains are at the expense of long-term prospects.

16 For a history of the role of Milken in the development of the junk bond market, see C. Bruck, The Preda-
tor™s Ball: The Junk Bond Raiders and the Man Who Staked Them (New York: Simon and Schuster, 1988).

Since we can™t observe how companies would have fared in the absence of a merger,
it is difficult to measure the effects on profitability. Studies of recent merger activity
suggest that mergers do seem to improve real productivity. For example, Healy, Palepu,
and Ruback examined 50 large mergers between 1979 and 1983 and found an average
increase in the companies™ pretax returns of 2.4 percentage points.17 They argue that this
gain came from generating a higher level of sales from the same assets. There was no
evidence that the companies were mortgaging their long-term futures by cutting back
on long-term investments; expenditures on capital equipment and research and devel-
opment tracked the industry average.
If you are concerned with public policy toward mergers, you do not want to look only
at their impact on the shareholders of the companies concerned. For instance, we have
already seen that in the case of RJR Nabisco some part of the shareholders™ gain was at
the expense of the bondholders and the Internal Revenue Service (through the enlarged
interest tax shield). The acquirer™s shareholders may also gain at the expense of the tar-
get firm™s employees, who in some cases are laid off or are forced to take pay cuts after
Many people believe that the merger wave of the 1980s led to excessive debt levels
and left many companies ill-equipped to survive a recession. Also, many savings and
loan companies and some large insurance firms invested heavily in junk bonds. De-
faults on these bonds threatened, and in some cases extinguished, their solvency.
Perhaps the most important effect of acquisition is felt by the managers of compa-
nies that are not taken over. For example, one effect of LBOs was that the managers of
even the largest corporations could not feel safe from challenge. Perhaps the threat of
takeover spurs the whole of corporate America to try harder. Unfortunately, we don™t
know whether on balance the threat of merger makes for more active days or sleepless
We do know that merger activity is very costly. For example, in the RJR Nabisco
buyout, the total fees paid to the investment banks, lawyers, and accountants amounted
to over $1 billion.
Even if the gains to the community exceed these costs, one wonders whether the
same benefits could not be achieved more cheaply another way. For example, are lever-
aged buyouts necessary to make managers work harder? Perhaps the problem lies in the
way that many corporations reward and penalize their managers. Perhaps many of the
gains from takeover could be captured by linking management compensation more
closely to performance.

In what ways do companies change the composition of their ownership or man-
If the board of directors fails to replace an inefficient management, there are four ways to
effect a change: (1) shareholders may engage in a proxy contest to replace the board; (2)
the firm may be acquired by another; (3) the firm may be purchased by a private group of
investors in a leveraged buyout, or (4) it may sell off part of its operations to another
Mergers, Acquisitions, and Corporate Control 591

company. There are three ways for one firm to acquire another: (1) it can merge all the
assets and liabilities of the target firm into those of its own company; (2) it can buy the
stock of the target; or (3) it can buy the individual assets of the target. The offer to buy the
stock of the target firm is called a tender offer. The purchase of the stock or assets of
another firm is called an acquisition.

Why may it make sense for companies to merge?
A merger may be undertaken in order to replace an inefficient management. But sometimes
two business may be more valuable together than apart. Gains may stem from economies of
scale, economies of vertical integration, the combination of complementary resources, or
redeployment of surplus funds. We don™t know how frequently these benefits occur, but they
do make economic sense. Sometimes mergers are undertaken to diversify risks or artificially
increase growth of earnings per share. These motives are dubious.

How should the gains and costs of mergers to the acquiring firm be measured?
A merger generates an economic gain if the two firms are worth more together than apart.
The gain is the difference between the value of the merged firm and the value of the two
firms run independently. The cost is the premium that the buyer pays for the selling firm
over its value as a separate entity. When payment is in the form of shares, the value of this
payment naturally depends on what those shares are worth after the merger is complete. You
should go ahead with the merger if the gain exceeds the cost.

What are some takeover defenses?
Mergers are often amicably negotiated between the management and directors of the two
companies; but if the seller is reluctant, the would-be buyer can decide to make a tender
offer for the stock. We sketched some of the offensive and defensive tactics used in takeover
battles. These defenses include shark repellents (changes in the company charter meant to
make a takeover more difficult to achieve), poison pills (measures that make takeover of the
firm more costly), and the search for white knights (the attempt to find a friendly acquirer
before the unfriendly one takes over the firm).

Do mergers increase efficiency and how are the gains from mergers distributed be-
tween shareholders of the acquired and acquiring firms?
We observed that when the target firm is acquired, its shareholders typically win: target
firms™ shareholders earn abnormally large returns. The bidding firm™s shareholders roughly
break even. This suggests that the typical merger appears to generate positive net benefits,
but competition among bidders and active defense by management of the target firm pushes
most of the gains toward selling shareholders.
Mergers seem to generate economic gains, but they are also costly. Investment bankers,
lawyers, and arbitrageurs thrived during the 1980s merger and LBO boom. Many companies
were left with heavy debt burdens and had to sell assets or improve performance to stay
solvent. By the end of 1990, the new-issue junk bond market had dried up, and the
corporate jousting field was strangely quiet. But not for long. As we write this material early


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