ARE SHAREHOLDERS CHEATED BY LBOS? Companies taken private by their own managers a couple of years ago are being sold to the public again, at prices two or three times what the stockholders were paid. The company's executives pocket a lot of the difference. Is something fishy going on here?
By Gary Hector REPORTER ASSOCIATE Margaret A. Elliott

(FORTUNE Magazine) – SECURITY ANALYSTS shuddered when Beatrice Cos. went private early last year. The largest leveraged buyout ever, with a $6.2-billion price tag and $6.1 billion of ulcer-inducing debt, the deal looked like a disaster in the making. Yet in just eight months Beatrice's chief executive, Donald Kelly, has unloaded $6 billion of unwanted businesses and shed nearly $5 billion of debt. Unless the stock market falls apart, Kelly plans to take Beatrice public again in 1987, which could net him more than $400 million personally on an initial investment of $5 million. ''This one,'' says an admiring lender, ''will go down in history.'' It is also fueling a debate about whether an LBO like this one is fair to the shareholders. Sure, they collect a fat premium over the going market price when they sell their shares. But do they really get top dollar? You remember the basic drill on how an LBO works: A group of smart investors, often including the company's management, borrows heaps of money and buys the company. In Beatrice's case, the group included not company insiders but outsiders who used to be insiders. Kelly and friends, a legendarily shrewd group of marketers and dealmakers, had run Esmark before it was acquired by Beatrice in 1985. They teamed up with the LBO firm of Kohlberg Kravis & Roberts, which put the deal together and raised the money. Now comes the punch line: A miraculously short time later the company has more than doubled in value, and the value of management's stake has increased 50-fold. What's going on here? Proponents of management buyouts argue that the discipline imposed by a huge debt and the bliss of being private transform ordinary executives into supermen who work wonders on their organizations. Once a firm goes private, explains Alan Rappaport, a specialist in mergers and acquisitions at Northwestern University's Kellogg School of Management and a consultant, ''You are no longer dealing with the same culture. The economic incentives are much more compelling; there is a much higher energy level, a much greater devotion to efficiency and risk-taking.'' But the evidence emerging from recent LBOs suggests an alternative explanation. What appears to make buyouts successful is the ability of insiders -- or well-informed outsiders like Donald Kelly -- to pay rock-bottom prices to take companies private. Unlike the market for a few hundred shares of common stock, the market for control of public corporations seems to be surprisingly inefficient, at least to judge from the astonishingly different amounts the corporate assets command going into and coming out of a buyout. The critics of LBOs argue that neither the board of directors, the investment bankers helping them out, nor the managers themselves have strong enough incentives to protect shareholders. Indeed, the potential conflicts of interest are so disquieting that a few chief executives are embracing a new financing alternative known as the leveraged cashout. In a cashout the shareholders get not only money up front, but also some stock in the lean-and- mean new company. Some recent cashouts: FMC, Colt Industries, and Holiday Corp. THE CENTRAL ISSUE in the unfolding debate is the proper relationship between management and shareholders. We all know the theory about how this relationship works: Management acts as an agent for the shareholder, making day-to-day decisions in the shareholders' interests. But when the managers begin cobbling together a tender offer for the company they run, they and the shareholders become opposing parties in a negotiation. The guardian angel in this process is the board of directors, whose duty is to ensure that shareholders don't get roughed up by their management. In practice, critics say, the angel has no wings. Sure, the critics concede, interest rates have dropped, and yes, the management is better motivated. But can that explain changes in value like the following: Metromedia Inc., which went private in 1984 for $1.1 billion, is in the midst of a liquidation that has already raised five times that sum. Uniroyal Inc., which went private in April 1985 for $900 million, is in the process of selling off its businesses and seems likely to receive at least $1.4 billion. SFN Inc., a publisher of textbooks taken private for $450 million in early 1985, recently announced plans for a liquidation that will net it close to $1.1 billion. Equally big gains have accrued to owners of smaller companies that have made the round trip, such as Motel 6, Calton Corp., Edgcomb Steel, and Blue Bell Inc. The money that top executives at these companies make on the deals propels them to the outer limits of the known universe for executive compensation. John Kluge, chief executive of Metromedia, made an estimated $3 billion through the liquidation of the company. John Pomerantz, chairman of dressmaker Leslie Fay, which went private in an LBO and then changed hands again in a second LBO, netted $60 million in four years on an initial investment of less than $1 million. Joseph Flannery, chairman of Uniroyal, expects to earn $20 million on an investment of less than $750,000 a year ago. John Purcell, SFN's top executive, made at least $25 million in 18 months on an investment of less than $500,000. IT'S ENOUGH to raise a few eyebrows. Why, the critics ask, does management have to take a company private before it can work up the moxie to do all those things that improve the corporate prospects so dramatically? ''There is something questionable about taking companies private and then, within a relatively short period of time, bringing them public at a substantial increase in value,'' worries A. A. Sommer, a former member of the SEC. ''It would suggest that the public shareholders did not get full value.'' LBOs still have staunch defenders. They argue that buyouts, unlike insider trading, occur in the sunshine. Shareholders are told of the deals weeks in advance, vote on the transactions, and collect a big profit by selling out. Buyers must disclose their intentions in proxy statements, the board of directors must bless the deal, and takeover artists may step in and bid on the company, turning the sale into a public auction. ''The market for buying and selling companies is pretty efficient,'' maintains Fred Eckert, a partner at Goldman Sachs. ''Nobody does leveraged buyouts over a Saturday night anymore. Anybody who has the money can make a bid.'' Critics say that in the real world these protections are meaningless. Once a company is ''in play,'' most shareholders take their money and run. The people who then own the stock, the arbitragers, operate on thin margins and must turn over their inventory rapidly to realize a profit -- in much the same way an efficient supermarket must do. AND CONSIDER the plight of the board. Directors have a fiduciary responsibility to allow shareholders to vote on any bid that substantially exceeds the current market price, even if the board thinks the bid is well below the firm's potential value. Those savvy investment bankers, supposedly so adept at valuing a company, invariably bless their client's bid with a lengthy document explaining why the bid is a ''fair'' market price -- if not indeed egregiously generous. In one bidding war, for Stokely Van Camp, three different investment advisers provided ''fairness'' letters to three different prospective buyers at prices ranging from $50 to $75 a share. When management buys the company, the critics of this movement charge, the bosses know more about the intrinsic value than either the shareholders or the investment bankers. Consider Metromedia. One of the first big leveraged buyouts, Metromedia went private in mid-1984 at the then unprecedented price for an LBO of $1.1 billion. Prospects for its broadcast and cellular radio businesses looked mediocre. The company had been criticized for sloppy accounting practices, which had driven its stock price to a six-year low. John Kluge, Metromedia's chairman and controlling shareholder, decided that the low price left his company vulnerable to raiders, so he took it private, in the process increasing his ownership from around 25% of the company to 93%. In making the deal, he got fairness opinions from Lehman Brothers and Bear Stearns; neither could round up even one competitive bidder. Within months circumstances showed just how risky the deal might prove to be if Kluge was wrong. Metromedia missed a payment on its debt and was forced to refinance. ''I really thought this was going to be the one that hit the fan,'' says a banker who specializes in lending on LBOs. In retrospect, Kluge knew what he was doing. He decided to dismantle his company and dispose of it piece by piece. He sold seven television stations for $2 billion and found buyers for a radio station, the Harlem Globetrotters, the Ice Capades, and finally for the seemingly doggy cellular radio operation, which fetched $1.1 billion. In all, Kluge has made $5.5 billion by dismantling Metromedia -- a fivefold increase in just two years. Everybody admits belatedly that Kluge is some sort of business genius. He sold his TV stations at the peak and nursed along his cellular operations until telephone companies began snapping them up for unheard-of prices. But how much is genius worth? $3 billion? And how much of this prescience did he impart to his shareholders? Or take a smaller example: the management buyout of Fred Meyer Inc., a Portland, Oregon, retailer. Fred Meyer is a regional version of K mart, a blue-collar retailer with an array of large stores throughout the Pacific Northwest. The chain was built almost single-handedly by Fred Meyer and his family and was closely controlled until 1979, when Meyer died at age 92. Two years later a group of the company's executives, together with Kohlberg Kravis & Roberts, took Fred Meyer private in a transaction that Jerome Kohlberg later described as one of the most complicated he'd ever attempted. The price: $420 million, or $55 a share. What made Fred Meyer tantalizing was the company's real estate, carried on the books at cost and rented by the company on long-term sweetheart leases from firms jointly owned by the company and the Meyer family. The value of the property was at least $110 million to $140 million more than the price on the Fred Meyer balance sheet. Pretrial testimony in a suit brought by the Meyer family since the buyout suggests that Fred Meyer's board never understood the transaction they approved. A special committee of the board, composed of three outside directors (two others were appointed but never attended the meetings), met three times, devoting about six hours to reviewing the proposal. The committee never hired its own advisers. It relied on management's law firm and investment bankers, even though management wound up owning a stake of 10% in the private company. At least two other outfits had expressed an interest in buying Fred Meyer, one of which, a French retailer, had proposed a price $2 a share higher than the KKR bid. Yet the committee never sought other bidders or encouraged management to talk with potential buyers from outside. Even worse, despite a motion by Earle A. Chiles, a board member and Fred Meyer's stepson, the board never obtained an independent appraisal of the value of the company's real estate. Minutes of the meeting at which the board accepted the KKR bid show that Martin Siegel, then a Kidder Peabody partner and the buyout group's investment banker, told the board that the offer was fair, but ''at the low end of the range of fairness.'' This qualifying observation was never revealed in any material sent to shareholders.

The actual value of Fred Meyer, according to estimates later done for Chiles by James Reinmuth, dean of the school of business at the University of Oregon, was around $70 a share. Even Reinmuth's estimate may have been low. When Fred Meyer went public again this summer, the company's value had increased to more than $900 million, or over $100 a share. Or consider the more recent leveraged buyout of SFN Inc. of Glenview, Illinois. John Purcell, chairman of SFN, took the company private in 1985. Purcell's bid was opposed by three directors, representing the Scott and Foresman families, which had founded SFN. They hired an outside investment banker, Smith Barney Harris Upham & Co., and argued in board meetings that the directors should solicit other bids for the company to obtain the highest possible price. The board chose instead to consider Purcell's offer, which stipulated that the company could not seek another buyer while negotiating with Purcell. The terms were later amended to allow the board to talk with Hallmark Corp., which had expressed an interest in the company but then chose to join Purcell's investor group, apparently recognizing a good deal when it saw one. SFN's board did a careful job of reviewing the Purcell group's proposal, but by agreeing to consider just one bid, eliminated the chance of an auction. A special committee analyzed the offer with the help of two investment banking firms, which sprinkled the obligatory holy water. But their fairness opinions noted that they never went shopping for other buyers or sought bidders for portions of the company. This oversight occurred despite the fact that Hallmark, Time Inc. (publisher of FORTUNE), and Gulf & Western each had expressed an interest in buying SFN or pieces of it. A YEAR after he got control of the company, Purcell parceled it up and sold off the pieces for twice what the buyout group paid to take it private. The largest piece, Scott Foresman Publishing, was acquired by Time Inc. for $520 million. Members of the Scott and Foresman families refuse to discuss the buyout, hinting that they are still so angry that the things they said might be considered slanderous. One of the other directors who approved the deal publicly rues his decision. ''This is a very sore subject with me,'' says Harve Ferrill, an SFN board member who was on the committee that negotiated a final price with Purcell. ''I thought this was the best transaction that could be done at the time. But I felt the intrinsic value was significantly greater than that.'' As in many other LBOs, events proved the board member right.

CHART: Miraculous Changes in Market Value

COMPANY LBO PRICE VALUE WHEN TAKEN PUBLIC PERCENTAGE DATE OR SOLD INCREASE

BEATRICE $6.2 billion $10 billion (est.) 61% 4/86 Assets sold: Avis for $1.6 billion; Coke bottling unit for $1 billion; 80% of International Playtex for $1.25 billion; other businesses for $2.15 billion BLUE BELL $470 million $792 million 69% 11/84 Sold to VF Corp. for $378 million in cash and stock plus assumption of $414 million in long- term debt DR PEPPER $650 million $866 million 33% 2/84 Assets sold: Canada Dry for $175 million; plants and other businesses sold for $215 million; Dr Pepper sold for $416 million LESLIE FAY $58 million $360 million 521% 4/82 Taken public again 8/86 LILY TULIP $180 million $326 million 81% 3/81 Sold to Owens-Illinois 4/86 METROMEDIA $1.1 billion $6.5 billion (est.) 490% 6/84 Assets sold: seven TV stations for $2 billion; cellular radio business for $1.1 billion; other businesses worth $2.4 billion FRED MEYER $420 million $900 million (est.) 114% 12/81 Retailing operation worth $380 million when taken public 4/86; real estate estimated at over $500 million SFN $450 million $1.1 billion (est.) 144% 2/85 Assets sold: Scott Foresman for $520 million; South-Western Publishing for $270 million; TV and radio stations for $154 million UNIROYAL $900 million $1.4 billion (est.) 55% 9/85 Assets sales pending: chemicals business for $750 million; other businesses for $350 million; estimated net worth of the rest of the company is $422 million

CREDIT: NO CREDIT CAPTION: Since 1981, 260 public companies have gone private. Of those, some 30 or so have been taken public again or broken up and the assets sold off. The average increase in value for the 30 between being bought and being sold again is about 150%. Managers made out like gangbusters. DESCRIPTION: As above.