Bernard Axelrad Scholarship Fund

Definition: Alchemy — An early form of chemistry with magical associations studied in the Middle Ages; its chief aim was to change baser metals into gold; the process of transforming something common into something precious.

For those who cannot or choose not to follow the maze of the latest financial craze making headlines, I offer this short course on the Leveraged Buy-Out (LBO):

The two basic earmarks of a leveraged buy-out are avarice and a large supply of borrowed money.

The foremost practitioner of the LBO is the investment firm of Kohlberg, Kravis, Roberts & Co. KKR is now in the process of buying RJR Nabisco. The group is paying $25 billion, of which only $15 million (or far less than 1/10 of 1%) is KKR's own funds.

KKR and a handful of lawyers, investment banks and investment advisers stand to earn hundreds of millions of dollars in fees. As one take-over speculator said in the jargon of the '80s, "The fees are humongous."

They manufacture nothing but money for selves, cohorts

In the creation of these monstrous fees they certainly qualify as modern age alchemists. They create no product, no plant, no jobs by their machinations. They manufacture nothing for themselves and their cohorts.

To do that, the promoters of LBOs break up operating companies to achieve higher values, on the presumption that the sum of the parts (when sold off) is worth more than the whole. In the RJR Nabisco case, the company itself is a combination of the former R.J. Reynolds Tobacco Co. (Camel, Winston, Salem, Vantage cigarettes) and the former Nabisco Food Co. (Blue Bonnet Margarine, Del Monte canned fruits and vegetables, Planters Peanuts, Orco cookies, Ritz Crackers, Baby Ruth and Butterfinger candy bars, Cream of Wheat, A-1 steak sauce, Ortega Mexican food).

All these well advertised and well accepted brand items can be readily sold separately to eager buyers and the proceeds used to pay down the large indebtedness incurred in the LBO.

The LBO is a short term deal — a quick in and out by its promoters with no attention to long range planning and growth. It's a matter of selling-off some parts and then cutting back drastically on labor and other costs with respect to the rest of the company.

It is like hocking your gold teeth for money and then being unable to chew solid food.

Since these take-over artists do not have the capital and are not prepared to risk their own funds, a gold mine of borrowed money is needed to turn a $25 billion "megadeal." And, for attractive up-front fees and high interest on so-called "junk bonds," money is available from many sources.

"Leverage" is the operative word in LBOs. To maximize their profit, promoters structure the deal at a ratio 10% equity to 90% but debt. Accordingly, there is slim money margin for error, and any rise in interest rates or downturn in business can spell disaster in repaying that debt.

Yet, banks and savings and loans, usually staid and conservative, risk money on these deals with the knowledge that their depositors are safeguarded by Uncle Sam's guarantee to make good any losses. Then there are the insurance companies with coffers bloated from all those premiums paid in advance; and, the opulent college endowment funds of universities like Harvard, Cornell and Yale — as well as affluent charitable foundations like Getty.

Gamblers: banks S&Ls, colleges, pension funds, charities

Another major supplier of loans for LBOs are the government retirement and pension funds of states such as California, Michigan and Oregon.

Greed is the sine qua non — the fundamental element — in all these loans.

All those august institutions are aware of the risks of making unsecured loans to LBO promoters, but the fees and above-average interest rates dull their sense of caution. In many instances the compensation of the people who manage the institution's investments is directly related to the income earned — and bounteous up-front fees and interest income can seduce prudence and caution.

What I find so ironic is that the funds to effectuate an LBO are supplied by the staunchest defenders of the entrepreneurial system and yet their money is used to dismember the most prestigious exemplars of capitalism like RJR Nabisco.

Sadly, LBOs, besides doing nothing productive, also leave a trail of disruption in their wake. Long term employees arc out of jobs as divisions are sold off, their retirement funds placed in jeopardy. Communities which relied on the stable presence of venerable corporations like RJR are bereft of their benefaction, and the art and cultural activities of the area are curtailed for lack of funding.

Even stockholders who get a higher price for their shares are not entirely happy. They are forced to sell at a time not of their own choosing and denied the dividends and long term appreciation that they may have sought. They are required to pay taxes on the proceeds at a time not propitious for them and they are faced with the daunting prospect of suitably reinvesting the proceeds as reduced by those taxes.

`System' no excuse: This affects each of us personally

"So what?" you might say to all this. "This is the entrepreneurial way of our capitalistic system and it does notI affect me personally." But it does affect you and me personally. It does in many ways, albeit some subtle and indirect.

To rapidly pay down the massive debt incurred in the LBO, the takeover people need to increase operating income. That entails both pruning expenses and raising prices. Inevitably consumers of Nabisco foods will be paying higher prices and receiving less for their money.

Since there are no "free lunches" in the real world, the hundreds of millions of LBO fees have to come from someone — and the consumer/taxpayer is (as usual) a handy fall guy. Since KKR will borrow over $20 billion "on speculation" to effectuate the buy-out, it will have to pay above-market interest rates commensurate with the risk. That high interest influences all other interest rates, exerting upward pressure in general on the interest that you and I and Joe Public pay for homes, cars, refrigerators, clothes and credit cards.

All of the massive interest paid on the newly incurred indebtedness created by the LBO is deductible from corporate taxes, so the company will not pay any income taxes on its earnings for quite awhile. And, since much of the interest is paid to not-for-profit state retirement funds and college endowment funds, the interest income they earn is not taxed either.

Any shortfall in revenue collections by the Treasury becomes the problem of all taxpayers, adding to the budget deficits that already threaten our economic vitality.

Still, the general public is both apathetic and helpless in the face of the depredations by these fast-buck artists.

However there is a more formidable adversary to the LBOs beginning to awaken to the danger — namely, the chief executives of the largest American corporations. If KKR can "do" a $25 billion deal with so little of its own money, then no corporation however large is safe.

Those Fortune 500 guys do have clout and know how to lobby Congress and the Administration effectively. I predict it will be those pillars of American capitalism who will eventually arrange to harness the free-wheeling LBOs.

Until such time, we can all watch enviously the modern day alchemists at work as they manufacture money for themselves out of a trail of paper concocted by the lawyers, investment bankers and advisers — and paid for by us.