Usually, on the first day of lectures in your final year Finance course, you’ll get some geeky 30 year old standing up at the front of the lecture hall with a powerpoint list of “must reads” that he got “asked about in all [his] interviews with the big finance houses” (then why are you assistant-lecturing in a university then?). And then he’ll keep mentioning his wife during the lecture – to prove that he has a wife (dammit we KNOW already).

Today, I myself am that geeky near-30-year-old. Although I don’t have a wife (if you think my post on the cost of children was bad…). Also, I kind of hope that my declaring a book to be worth reading doesn’t result in all the cool kids, and wannabe cool kids, avoiding it like it’s a homeless person.

What It’s About

In the late 1980s, Leveraged Buy-Outs (LBOs) were all the rage. And this book is about the drama that surrounded the management-led LBO of RJR Nabisco (a company that made biscuits, of which Oreos are the most famous, and cigarettes: notably, Camels), which was the most expensive ever at the time. RJR Nabisco was the 19th largest company in the US at the time. So it was a bit massive.

Some Background

As I talked about in Stock Up On Protein, companies are basically financed in one of two ways:

  • Debt (also known as “leverage”); and
  • Equity

The great thing about debt, however, is that it’s usually cheaper than equity. Which can make a massive difference to your success.

An example:

  • A company has total financing of $100 million.
  • It makes a profit of $15 million.

If the financing is all from equity, then the company has a return on equity of 15% (that is: your investment is returning you 15% every year).

But let’s say that half the financing comes from company borrowings, which are costing the company 2% per year. The results now look as follows:

  • The company has total financing of $100 million, of which equity of $50 million.
  • It makes a profit before interest of $15 million.
  • The interest cost is $1 million (2% of $50 million).
  • So profit available for the equity shareholders is $14 million.
  • Meaning that the return on their investment of $50 million is 28%.

Of course – it’s a bit riskier. But then, in exchange for that risk, you’re able to build a set of cash flows that is returning you 28% per annum. And the value of the company increases dramatically – just by changing the capital structure.

How it relates to LBOs

So in the 1980s, a lot of the corporate finance teams at the banks were selling this idea to the management teams of these listed companies. Something along the lines of:

“Guys, let’s get you some loans from a bank – you can use the money to buy-out the existing shareholders, and let the company pay back the debt over time. You’ll increase your returns individually (because you guys will all be shareholders), and you won’t have to pay for it – the company’s future cash flows will!”

That is a delicious-looking cherry. Management teams (in theory) have enough inside information to know when their share price in the market is trading too low. They could go in at the cheap price, offer the existing shareholders a small premium, and then let the company itself pay off those loans over time. It’s almost a money-for-free story!

And not surprisingly, this led to especially awesome bidding wars inside boardrooms as various factions of management vied with each other to buy out their companies with borrowed cash.

RJR Nabisco was one of the best (and most dramatic) examples for that: the bidding war started with a proposal of $75 per share, and ended on a settled price of $109 per share – with the original offeree losing, but leaving with a $60 million payout.

And, also, this book gives you an insight into the lives of executives.

So so many private jets.

Why It’s Still Worth Reading

Well, LBOs are a bit back in vogue. If you cast your eyes over at Dell, you’ll notice that there is an LBO bidding war happening over there between the original founder and some private equity funds. Just saying.