Leveraged Recapitalizations vs. Leveraged Buyouts

The dispute over the proposed Leveraged buyout (LBO) of Dell has caught my eye and got me to thinking.  One key argument against the Dell LBO is that the proposed price paid to shareholders is too cheap, and the advantages of an LBO can accrue to public shareholders through a leveraged recapitalization rather than an LBO.  The leveraged recap could be done through the company, while remaining public, taking on debt and then doing a massive stock buyback, thus of course shrinking equity.

While pursuing the MBA at Yale I argued the LBO model was the way to eliminate the agency problem in public companies by turning non-owner managers into owners.    I would tweak my argument now to say that while there should be a leveraging up it should be done at lesser multiples of EBITDA so as to make it a “conservative”  leveraging up.  You make a little less, but sleep better. That is in essence the way I run Insight's model portfolio—using margin but not too much of it.  Say you had 10 year long term noncallable debt to fund a public company leveraged recapitalization. Even so your stock price would go down in a 2008 like debacle, but assuming you could service your debt, the company would survive.  LBOs also lost value in the 2008 debacle, it’s just that it’s not public so you don’t see a publicly quoted price decline.  

When seen from this light many good quality public companies  are massively  underleveraged resulting in higher costs of capital, less ROE and lesser returns than are possible through a leveraged recap.  Let’s not forget the rationale of LBOs:  The less equity you put down and the more debt you take on (and can service) the higher the return.  This is why I am so enamored of the work of John Malone, and the public companies he is involved with as a whole currently represent a significant position in Insight's model portfolio. In essence Malone is doing LBOs within public companies.  It’s interesting to contrast the LBO approach to the eminent value investor Martin Whitman’s approach of finding unlevered low ROE, high NAV companies attractive.  In a credit panic or market rout for sure you see this approach’s utility.  It can also be argued that such unleveraged public companies are targets for LBOs and therefore are even more attractive than companies that already have undergone an LBO.  The problem is such LBOs may never happen, or if they do there could be attempts to buy the company cheaply.  In general, I will take a bird in hand, though there is an argument that today’s environment of  Central Bank activism  is fraught with risk.   My overall point is the same I made when I was at Yale:  In general many public companies are underleveraged.  When public non-owner managers run the show, why should they take the risk of leveraging? Since they own little stock there is little upside to them, and much downside in a credit crunch, for example.  

Philip I. Frank, Ph.D.

President and Portfolio Manager,

Insight Asset Management LLC

e-mail: insight-asset@earthlink.net