Mezzanine financing history is a fascinating journey that goes through some of the most exciting times on Wall Street, as well as bread-and-butter issues of corporate finance. This post presents an overview of the mezzanine financing history based on the research of published articles and interviews with industry participants. As the field of mezzanine finance is vast and its borders are not clearly defined, it is possible that some facts or viewpoints are not reflected here. Therefore, any feedback and comments are welcome.
We walk through the history of developments in the filed of mezzanine financing trying to stick to the chronological order. Occasional digressions and side comments are inevitable, as history of mezzanine capital touches on so many interesting topics and events.
Early days in the mezzanine financing history
The beginning of mezzanine financing story coincides with the rapid growth, boom and later bust of junk bond market that was powering the leveraged buyout (LBO) mania of 1980s. The history of these incredible times has earned quite a lot of coverage in the media and published books, many of which are fascinating and worth checking out. We will mention a couple of these references in the text below, but there is definitely more out there. A word of caution, however, is needed before heading out to read different accounts of LBO history of 1980s. As we mentione in our post on the origin of “mezzanine financing” term, it might appear with different meaning in different documents. While we stick to the definition of mezzanine as privately placed funding, you might find it being used when referring to traded junk bonds.
You have been warned! Now it’s time to dive a bit deeper into the mezzanine financing history of 1980s. We will start off with a more general introduction to LBOs and how people living at that time were looking at recent developments. This is useful not only for the purpose of understanding the history of 1980s, but in general as background knowledge very relevant for mezzanine financing as a specialized financial product. We will then review more closely some examples of mezzanine financing used in the LBO transactions of the days.
LBO fever of 1980s
Wider context and financial climate
The stock market explosion of 1980s has been accompanied by a dramatic upsurge in the number of corporate mergers and acquisitions. One of the reports for Congress described it as the “fourth major merger wave since the turn of the century.” The amount spent on mergers and acquisitions increased by almost 70% from 1983 to 1984, rising from $ 73.1 billion in 1983 to $ 122.2 billion in 1984. One of the most common types of transactions was the leveraged buyout, in which a publicly held corporation is taken private by a group of investors who finance the purchase largely with borrowed money. Typically, a substantial portion of the debt is secured by the assets or the stock of the acquired corporation, and the full amount is to be repaid out of the corporation’s future cash flow. At that point over the past several years, equity investors in these acquisitions, usually including unrelated parties as well as corporate managers, have realized spectacular and widely publicized gains through stock appreciation. Consequently, the number of leveraged buyouts has continued to rise, with the sizes of the target companies increasing to the billions of dollars.
The investment banking firm of Kohlberg, Kravis, Roberts & Co. has been responsible for much of the growth in the leveraged buyout market. Prior to 1979 leveraged buyouts rarely involved more than $ 100 million. In 1979 Kohlberg purchased Houdaille Industries in a leveraged acquisition for $ 355 million, with larger deals to follow. In November 1985 Beatrice accepted an offer from Kohlberg to purchase the company for $ 6.2 billion, a transaction that would be the largest leveraged buyout as of that date. Other leveraged buyouts in the billions of dollars have included the acquisition by Kohlberg of Storer Communications in April 1985 for $ 2.5 billion and Pantry Pride’s buyout of Revlon in November 1985 for $ 1.8 billion.
In addition to the dramatic gains realized by investors, reasons cited to explain the increase in the number and size of leveraged buyouts have included: the rise in divestiture of unprofitable divisions or subsidiaries by large, publicly held companies, significant changes in available financing sources, increasing use as an anti-takeover defense and declining interest rates.
The leveraged buyout market has also changed in other ways over the past few years. The acquisitions now were often initiated by investment bankers rather than by the corporation’s existing management. In addition, the purposes of leveraged buyouts were more varied, with such buyouts now frequently appearing in hostile takeover attempts, both as acquisition techniques and as defenses by management against unwelcome suitors.
The recent popularity of leveraged buyouts has generated controversy within the business community. Some financial analysts have viewed the trend with alarm, and the success of leveraged buyouts has been called a “prelude to disaster.” Expressing concern over the “leveraging-up of American enterprise,” some commentators emphasized the extreme vulnerability of firms with heavy debt to slight downturns in business conditions or the economy. The chairman (between 1981 and 1987) of the Securities and Exchange Commission, John S. R. Shad, expressed this concern, stating that:
“the leveraging-up of American enterprise will magnify the adverse consequences of the next recession or significant rise in interest rates [. . .] The more leveraged takeovers and buyouts today, the more bankruptcies tomorrow.”
Others stressed the additional risks arising from the increased participation of more inexperienced investors, who may evaluate a target less carefully. More investors were then able to participate in leveraged buyouts through “blind pools,” which are equity funds or partnerships formed to provide ready capital for leveraged buyouts. These could fuel bidding of prices up to unrealistic levels and borrowing excessive amounts. Finally, some commentators discuss the lack of fairness to the public shareholders who are eliminated in a leveraged buyout, focusing on the inherent conflict of interest of a corporation’s management that participates on both sides of the transaction.
Although these concerns were widely publicized in the financial press, leveraged buyouts also have strong advocates who argue that the change in corporate ownership improves market allocation of resources and creates shareholder gains through higher productivity and efficiency. These advocates emphasize the increased incentive of managers who typically hold a significant equity interest in the firm as a result of the buyout and the managers’ new commitment to cutting unnecessary costs and eliminating wasteful overhead. Defenders of buyouts also stress the ability of managers of a privately held firm to focus on long-range planning without the pressure imposed by the stock market to show continual rises in earnings per share. The increased reliance on debt financing is seen to be of little concern, with some commentators citing the much higher levels of corporate debt in other countries. It has also been argued that, for some companies, increased debt may serve as an effective control of agency costs, requiring corporate managers to distribute free cash flow instead of investing in unproductive projects.
LBO structures and the use of mezzanine financing
The major consequence of a leveraged buyout occurs when the equity ownership of an operating corporation shifts from the public to a small investor group, accompanied by a significant change in the corporation’s capital structure. (For someone interested in understanding the corporate and financial aspects of leveraged buyouts from the perspective of person living in 1980s, a good reference is “Acquisitions and Mergers, 1987: Tactics, Techniques, and Recent Developments” by Melvin Katz and Ronald M. Loeb.) Before the transaction occurs, the target firm typically has a substantial net worth or shareholder equity, with its assets burdened by relatively little debt. After the buyout, net worth is reduced significantly, although the corporate asset base typically remains unchanged.
If the target’s stock rather than its assets is purchased, with the target then held as a subsidiary of the acquiring corporation, the capital structure of the target itself will not change. Instead, the capital restructuring will be reflected in the balance sheet of the acquiring corporation, whose only asset will be the target stock. The debt of the acquiring company, incurred in order to purchase the target stock, will be secured by the target’s assets and repaid with the target’s cash flow. Accordingly, the financial consequences (and the restructuring of capital) are basically the same whether the buyout is accomplished as a purchase of stock or assets.
The reduction in net worth is caused by two related financial events: the corporation borrows cash, incurring significant amounts of new corporate debt, and the loan proceeds are immediately distributed to shareholders. Corporate liabilities are substantially increased, and shareholder equity is substantially reduced. The recipients of the distribution are the public shareholders, whose stock interests are eliminated in the transaction. The equity interests that remain are held by an investor group, usually including some members of the firm’s management, n31 who obtained or increased their interests with minimal cash contributions.
In the past corporations that went private did so most frequently through the initiative of their management, which was able to acquire a large ownership stake in the company as a result of the transaction. One of the most significant changes in the leveraged buyout market of 1980s has been the entry of investment banking concerns that specialize in such transactions, identifying attractive target firms and then obtaining funds from a variety of outside sources. Typically, neither the investment banker nor the investors will have any interest in changing the operations of the firm after the transaction. Consequently, the uninterrupted continuation of corporate management is considered important, and managers often will be given the opportunity to participate in the equity ownership as an incentive for remaining with the firm. Some commentators have expressed concern over the decreasing equity participation of management in transactions happening during the second half of 1980s, providing less incentive to continue the smooth operations that are essential to the corporation’s repayment of its new debt.
Immediately after the transaction, the corporation’s cash flow, which previously was used to pay dividends or increase shareholder equity, is used to service and repay the debt. After the debt is repaid, the new shareholders anticipate significant gain through appreciation in the value of their stock.
Participants in a leveraged buyout are usually brought together by an investment banker, who benefits from substantial fees and from the opportunity to participate as an equity investor. The profits made by the investment bankers specializing in leveraged buyouts have been widely publicized. According to an article in the Wall Street Journal, the $ 45 million fee that Kohlberg, Kravis, Roberts & Co. received for arranging the leveraged buyout of Beatrice, valued at $ 6.2 billion, was “the largest single investment advisory fee on record.” (Ellis, Leverage Leader, Wall St. J., Apr. 11, 1986.)
The target firm will have been selected by the investment banker on the basis of several different factors. Because of the substantial debt to be incurred, the firm ideally will enjoy those characteristics attractive to lenders: a stable earnings history that is not significantly affected by business cycles, an established position in the market, and modest requirements for future capital investment. A solid asset base, burdened with relatively little debt, is also important, as is a strong management team. An ideal target company would also be substantially discounted on the stock market – at least in the estimation of insiders – with its market value significantly less than both the appraised liquidation value of its assets and a value based on capitalization of future profits. The gap assumed between market value and estimated real value is an important inducement to the new equity investors, who expect that difference to be reflected in future stock appreciation.
The equity investors might also count on realizing gains by increased efficiency in operations after the leveraged buyout, resulting from several factors: increased incentive of management once they have an ownership stake; management’s freedom to concentrate on cash flow rather than earnings per share; and elimination of certain reporting and disclosure requirements applicable to public companies.
A leveraged buyout typically is accomplished through the purchase of the stock or assets of the target firm by a corporation formed solely for the purposes of the acquisition. Although the acquiring entity initially will be capitalized with cash from the equity investors, its ultimate capital structure will be designed with one primary goal: obtaining the maximum amount of debt to finance the acquisition of the target company, with the debt to be serviced and repaid out of the target company’s future cash flow. By maximizing the debt, the new equity investors can minimize the cash they need to obtain 100 percent of the outstanding stock.
To the extent possible, loans will be obtained from banks or commercial lending companies in the form of senior debt, to be secured by the stock or assets of the acquired firm. These loans usually bear interest at a rate that floats several points above prime, with the lenders sometimes also benefiting from large front-end fees. Additional amounts, also loaned at variable rates, may often be obtained from banks based on appraisals of future cash flows.
Even with significant undervaluation by the market, the purchase price for the target firm typically still exceeds its maximum secured loan capacity. This is where mezzanine financing enters the stage. “Mezzanine debt,” unsecured and subordinated, will be obtained to fill in the gap between the senior debt and the minimum equity contributions of the investors. These loans usually bear high rates of interest and frequently are accompanied by an equity interest, such as a stock option or conversion right. Preferred stock, sometimes with mandatory dividend payments and redemption rights, also may be issued. The participants at this level, which include pension funds, insurance companies, and venture capitalists, take greater risks and provide an additional layer of protection for the senior lenders. As compensation, they share with the principals the opportunity to benefit from the discounted market valuation of the target through future equity growth.
As leveraged buyouts increase in number and size, different and often more innovative financing methods are developed. Additional loans sometimes can be obtained if the equity investors agree to sell some of the company’s assets or an entire division or subsidiary after the transaction, with executory sales contracts providing security for these creditors. The possibility of a sale of assets after the acquisition, with the sale proceeds used to reduce the new debt, has made it easier to acquire larger corporations in leveraged buyouts. In 1980s transactions, additional financing has also been obtained with less traditional instruments, referred to as “junk bonds.” These securities, which are high-yield and high-risk, fully subordinated and protected by a minimal equity cushion, may be issued directly to the public shareholders or may be sold by underwriters to provide a source of funding that otherwise would not be available. Employee stock ownership plans, which offered significant tax advantages upon repayment of the debt, may have provided an additional source of financing.
Once the maximum loan capacity is determined and the borrowed funds obtained, the desired capital structure can be put into place in various ways. Often, the transaction will proceed as a merger between the target and the acquiring corporation, with the public shareholders receiving the newly borrowed cash in exchange for their shares. Alternatively, the target firm may transfer its assets to the new entity in exchange for cash and then distribute the cash to its shareholders in redemption of their stock. Sometimes, if a two-tier structure is desired (with the operating firm to be held as a subsidiary of the acquiring corporation), the acquiring entity will make a tender offer for the target stock. Any non-tendering shareholders may be eliminated through a subsequent “clean-up” merger of the target with a transitory subsidiary of the acquiring corporation, giving the acquiring corporation 100 percent ownership of the target.
Whichever form the transaction takes, the public shareholders will terminate their equity interests in exchange for cash, with the distributions to them financed by the new corporate loans. The price paid to the public shareholders for their stock typically will be at a premium over the current market value. The public shareholders will be treated as if they had sold their stock, whether the stock is sold to the acquiring entity directly or is cancelled on the merger or liquidation of the target firm. Accordingly, the shareholders will be taxed only to the extent of their gain, which equals the excess of the amount realized over their investment in the stock.
The financial position of the operating company after the acquisition will depend in large part on the tax provisions, with the company typically paying much less in taxes than it had prior to the acquisition. Cash flow from operations will, of course, be used to service and repay the debt. In the years immediately after the acquisition, the corporation will have substantial tax deductions for interest payments, whereas previously those amounts were used to pay nondeductible dividends or to increase corporate accumulations out of which future nondeductible shareholder distributions could be made. These tax consequences will not change if the target firm is operated as a subsidiary, with its parent, the newly formed corporation, repaying the loans with dividends received from the operating company.
Higher depreciation deductions, resulting from increased bases in assets after the acquisition, may also be available to the target firm after the buyout. If assets are acquired, the bases in the assets will automatically reflect the purchase price. If stock is acquired, an election may be made to reach the same result. In either case, however, the step-up in bases will be obtained only at the cost of recapturing and including in income prior tax benefits, such as previous depreciation deductions.