(FORTUNE Magazine) – YES, there is some reason to be concerned about the pace and size of leveraged buyouts. The trend toward leverage, not only in LBOs but also in takeovers and on the balance sheets of ordinary companies, is big and growing. Says Charles Schultze, former chairman of the Council of Economic Advisers: ''The numbers are beginning to be macroeconomically significant.'' And these highly leveraged companies have yet to be tested by recession. But there is no cause for panic. Much of the alarm triggered by the RJR Nabisco spectacle stems from an instinctive, unexamined fear of debt. The RJR deal could be just one stop on an ever-increasing upward spiral, or it could be a high-water mark. Either way it invites an assessment of LBOs in general. For some companies they work almost like magic. But too many LBOs -- at too high a price -- could end up distorting the economy. The question is whether the efficiencies gained will be greater than the possible problems. Since the LBO era is far from being over, this has to be an interim report. On the following pages, Henry Kravis and Ross Johnson tell their own stories from opposite sides of the fight for the biggest buyout ever. A final article examines why so much money is available for these deals, and whether it will continue to be. Many of the criticisms of LBOs suffer from a singular disregard for what might be called double-entry bookkeeping analysis. This holds that for every seemingly negative financial effect, one can usually find a countervailing positive effect, and vice versa. Nowhere is this clearer than in examining why the kind of breathtaking leverage that typically accompanies an LBO can be the best thing that ever happened to a company. This is not true for every company, certainly. But it is often true for companies with strong cash flow and mature businesses -- like tobacco -- that do not require large capital expenditures or extensive research and development to remain profitable. Simply stated, by putting management under enormous pressure to meet outsize interest payments every quarter, a highly leveraged capital structure can improve a company's productivity dramatically. Michael Jensen, a professor at the Harvard business school, argues that without such pressure, managers often waste money. Says he: ''You have corporations throwing off huge amounts of cash that they plunge back into slow-growth businesses with diminishing rates of return, or spend on ineffective mergers and acquisitions.'' If, however, the shareholders got some of this wherewithal, perhaps through an LBO, they could earn a higher return by investing somewhere else. Typically, in an LBO managers have a greater equity stake in the new private company. This further motivates them to improve earnings. Though more managers of public companies have incentive pay packages these days, they are still compensated mainly with salary and the psychic rewards of running private empires. This mind-set hardly inspires them to sell off divisions or cut staff, even if doing so would boost the price of the company's shares. Another advantage to the LBO structure is the deductibility of interest on the debt assumed. By this means, companies that have gone through an LBO can often eliminate taxes for several years. By contrast, dividends are taxed twice, both as corporate earnings and as income to shareholders. ''LBOs are one of the most productive things to hit the economy in a long time,'' exults Jensen. A number of academic studies support his claim unambiguously. One found that the operating profit margins of LBO companies were 40% higher than their industries' medians two years after the buyout. A CRITICISM frequently heard in the course of the RJR Nabisco saga was that LBOs enable management to steal a company from shareholders by paying too little when it takes the company private. But an increasingly competitive market for corporate control makes that all but impossible. If management puts the company in play, the likelihood is greater than ever that other bids will ensue. Directors have become steadily more aggressive about soliciting such bids. Ross Johnson's initial offer for RJR Nabisco was topped within four days.

Of course, if you are a double-entry thinker, you would expect LBOs to have negative side-effects, and you would not be disappointed. In the drive to cut expenses, employees are sometimes laid off. Still, people get fired even when ownership doesn't change hands, as companies restructure to become more productive. It is hard to argue that society at large loses out in the process. , In most buyouts the businesses sold off wind up in the hands of corporate parents that are better able to wring value out of them. A study by Steven Kaplan of the University of Chicago found that post-LBO employment at 33 buyout companies stayed about the same as before the deals. Those worrisome cuts in research and development? Companies that require lots of R&D -- high- tech outfits, say -- don't attract a lot of buyout bids. Another frequent complaint is that LBOs hurt existing bondholders, and this seems to be true, particularly in some of the most recent deals. The sudden transformation of a corporation with little borrowing into a highly leveraged outfit makes payments on the existing debt less certain. The average price of RJR Nabisco's $5 billion of investment grade bonds fell 20% immediately after Johnson's buyout bid was announced. Significant but less dramatic declines in bond prices were recorded after buyout announcements at other companies, such as American Standard. A number of angry bondholders sued RJR Nabisco for restitution after the announcement of management's buyout plan, including Metropolitan Life, which held $340 million of RJR bonds. But even after such unpleasantness, the bond market does not seem to be significantly discounting investment grade debt, even that issued by companies rumored to be buyout candidates. Issuers worried about the possibility can incorporate in their new offerings covenants and ''poison puts'' that require the company to make good on bonds suddenly devalued by buyouts or other changes in corporate structure.

FAR AND AWAY the biggest potential problem associated with LBOs is the limited flexibility with which management can maneuver in the event of recession, possibly leading to default and bankruptcy. These fears are serious, but often exaggerated. For one thing, when the debt in question provides high, equitylike returns, bondholders are more inclined to exhibit equitylike forbearance, and not press for default as readily as with traditional, lower-paying debt. Says Ronald M. Freeman, a managing director at Salomon Brothers: ''People tend to see equity as a warm, fuzzy pillow and debt as a knife in the back. But if you're paying me an extra three percentage points for the high-yield debt, I'm willing to be understanding if you get into trouble and I think you have a chance to pull through. We can negotiate new terms, maybe defer payments until the slump is over. I'm not doing it gratuitously, but because of the extra interest.'' ;

Even if some companies go bankrupt, the effect on the economy may not be as bad as is often supposed. Says Securities and Exchange Commissioner Joseph Grundfest: ''Bankrupt LBOs are not fire-bombed. Their productive capacity does not disappear from the economy. They continue to do business, often with operating profits, as their capital structures are renegotiated.'' In the case of Revco, a drugstore chain and the largest LBO to go bankrupt so far, not one store was closed or one employee fired as a result. To many critics, bank lending for LBOs represents the real time bomb. A recent Federal Reserve survey found that LBO loans accounted for 9.9% of all commercial loans at large banks. That's less than half big banks' exposure in Third World countries, but many top officials still find the amount troublesome. In October, Federal Reserve Chairman Alan Greenspan cautioned banks to watch their LBO lending more closely, and the Comptroller of the Currency is planning to examine banks' LBO exposure in early 1989. That may prompt banks to think twice before getting into many more of these deals. Spurred by disgust at the RJR Nabisco shootout, a lot of people in Washington are offering other solutions even before they have a firm grasp on the problems. An example: the proposal to eliminate the tax deductibility of interest on corporate debt. That presumably would discourage LBOs by making them more expensive. It would also get rid of what the critics see as a big loss of tax revenue. But it would make debt more expensive for young, growing companies that really need it. It would give acquisitive foreign investors an advantage since they would still have the deduction back home. Also, as FORTUNE reported (December 5), the tax losses from interest deductions may well be exceeded by revenues from capital gains and other taxes paid in connection with LBOs. REPRESENTATIVE Edward Markey of Massachusetts, chairman of the House finance subcommittee, is talking about legislation that would distinguish between ''productive debt'' and ''nonproductive debt.'' This seems a classic bad idea that would put the government in the role of deciding how much companies should borrow and why. A more sensible approach would be to find a revenue-neutral way to eliminate the double taxation of dividends. Says Alan J. Auerbach, chairman of the economics department at the University of Pennsylvania: ''There's a role for debt and a role for equity, but there's no reason that the tax system should discriminate against either one.'' Apart from tax changes, control of the growth of debt is better left to the market. This is not without its perils. There is a huge pool of pension assets looking for a home and more than $20 billion in committed money waiting to do LBOs. Given the stock market doldrums, LBOs and leveraged takeovers are the only game in town. And LBO firms earn big fees for managing deals whether they pan out or not. Still, some market forces making for moderation are already at work. Competition is reducing rewards. New provisions on bond issues make buyouts more expensive. As the risks and rewards for leveraged buyouts become better known, lenders and investors may well exert more caution out of concern for their own position. In the end, the best antidote to excessive greed may be enlightened self-interest.

BOX: RISKS AND REWARDS OF LBOs

1. Shareholders in leveraged deals score big. Competing buyout groups are boosting premiums. 2. Existing bondholders get the shaft. Bond prices can plummet in the face of new debt. 3. Profit margins rise after most LBOs. Managers become owners and are more careful not to squander corporate resources. 4. Recession could trigger LBO defaults. But even bankrupt companies keep on producing. 5. Deals reflect the tax code's debt bias. If equity were treated more equitably, market forces should keep a cap on leverage.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: HOW SOME PAST LBOs PLAYED OUT Leveraged buyouts are like snowflakes: Each is different. Since its buyout, Macy issued more debt and bought some new stores. It loses money. The other companies all shrank by selling off assets and then used the proceeds to reduce debt. Despite having to pay a lot more interest than before, these companies posted higher earnings, largely because they were able to achieve productivity gains.