gao case studies of selected lbos, 1991

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United States General Accounting OfficeReport to Congressional Requesters

Scpt.cIrrtMtr 1991 LEVERAGEDBUYOUTSCase Studies ofSelected LeveragedBuyouts

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GAO United StatesGeneral Accounting OfficeWashington, D.C. 20648General Government DivisionB-244418September 16,lQQlThe Honorable Timothy J. PennyHouse of RepresentativesDear Mr. Penny:This responds to the request from you and, 51 other Members of theHouse of Representatives (see app. I) for information on the effects ofleveraged buyouts (LRO) and hostile business takeovers. This reportanswers questions you asked concerning (1) what happened to compa-nies that had been taken over through an LBO, (2) how these companieshave performed since the takeover, (3) how communities have beenaffected, and (4) what happened to companies that amassed tremendousdebt to avoid being taken over.As agreed with your office, we addressed these questions by doing casestudies of companies that experienced an LB0 or a takeover attemptduring the mid- to late 1980s. Our assessment was based primarily onpublic documents and financial reports filed by the companies with theSecurities and Exchange Commission (SEC). Each company commentedon a draft of its case study. The companies comments generallyinvolved minor corrections, which we made. (See app. II for details onour scope and methodology.)The case studies included LBOS of Revco D.S. Inc.; Safeway Stores Inc.;and Allied Stores Corporation and Federated Department Stores Inc.,both of which were purchased separately by the same acquirer; and arecapitalization to avoid an LB0 by Phillips Petroleum. The case studiesare included as appendixes III, IV, V, and VI, respectively.

Background An 1,130s a financing technique in which the takeover purchase of acompany is transacted mostly with borrowed funds rather than contrib-uted equity. As a result, the acquired company comes out of the 1,130with a much different capital structure2 than before. Debt replacesequity as the companys primary source of capital. The proceeds fromthe debt are used to purchase shares from stockholders, usually at aInformation on what happens to company pension plans after an LB0 is provided in Pension Plans:~(GAReplacementsFollowingHRD-gl-21,Mar. 4, 1991). Other parts of your request are being addressed in ongoing work.A companys capital structure, or capitalization, is the total value of a corporations long-term debtand preferred and common stock accounts.

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Results in Brief

premium to encourage the sale, leaving control of the companys stockconcentrated within a small group of investors. The assets of theacquired company are generally used as collateral for debt and are oftendivested to provide funds to repay the increased debt. Debt may beeither col lateralized by assets or unsecured, using high-yield bondsreferred to as junk bonds.The much-publicized LB0 binge of the 1980s has resulted in concernabout the impacts and efficacy of LROS. Many studies and congressionalhearings have been conducted addressing various effects of LBOS. Forexample, a 1989 study for the Subcommittee on Oversight and Investi-gations, House Committee on Energy and Commerce, identified a varietyof issues related to LBOs3 These issues included fairness to partiesinvolved, such as stockholders and bondholders; role of and impact onfinancial institutions; and economic effects regarding taxes, employ-ment, capital spending, and increased aggregate levels of debt.

In the LHOs we studied, the purchasers bought out the target companiesequity holders with money from loans and bond issues. In Phillipsrecapitalization, the company exchanged debt securities for nearly halfof its outstanding common stock in order to avoid an LBO.For all thecases we studied, the equity holders, through selli ng or exchanging theircommon stock, earned premiums4 ranging from about 36 percent toabout 119 percent. The surviving companies capital structures shiftedso that debt became the primary source of funding, and debt reductionbecame one of the companies highest priorities. The companiesemployed such strategies as asset sales, cost savings programs,employee layoffs, and spending restrictions to help pay off debt. Phillipsand Safeway are currently operating profitably, but the remaining threecompanies have declared bankruptcy and are now operating underbankruptcy court protection.The actions taken to service the increased debt load resulted in manyemployees losing their jobs. However, the companies we studied had

Dr. Carolyn Kay Hrancato, Leveraged Buyouts and the Pot of Gold: 1989 IJpdate, a report preparedfor the use of the Subcommittee on Oversight and Investigations, Committee on Energy and Com-merce, IIouse of Representatives, (Washington, D.C.: IJS. Government Printing Office, 1989).4Premiu m is the amount, which we express as a percent, by which a particular price per shareexceeds he market price per share on a specific date. The methodology we used for calculating thepremiums is described in our objecti ves, scope, and methodol ogy section in appendix II.

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locations across the country and were generally a small part of the eco-nomic base of any one community.; In Phillips case, however, the com-panys headquarters formed a major part of the economic base for thelocal community, and Chamber of Commerce officials told us that thecompanys efforts to reduce costs through employee layoffs adverselyaffected the overall earning power of the community and resulted indeclining real estate values, city sales tax revenues, and volume of retailand service trade.The financial success of the companies after their LBOS depended largelyon their ability to meet debt service requirements when due. This isdependent upon the initial price paid; future economic conditions; thevalue of the companys assets, especially those to be sold to reduce theLBO debt; and managements ability to cut costs, reduce debt, andimprove profits afterwards. The purchasers and their advisers were pri-marily responsible for making these determinations. However, in thesehighly leveraged transactions the purchasers had little to lose if theypaid too much and a lot to gain if they could make the surviving com-pany a success, while their advisers earned large fees regardless of theprice paid or ultimate fate of the surviving company. Thus, both hadincentives to complete the deals. For example, the purchasers equityinvestment in the deals was small relative to the total purchase price-in only one case greater than 3 percent-allowing them large potentialreturns with limited financial risk. In addition, fees earned by theadvisers increased if the transaction was completed.

Why Did These Deals Although the reasons varied for doing the buyouts and recapitalization,Happen? there were some similarities between the cases. As stated in the filingswe reviewed for Revco, Safeway, and Phillips, where management wasan active and willing participant in the transaction, the motivation forthe deals was related to the existing owners desire to retain control ofthe company. Revcos management participated in the LBO because theywere concerned that the companys depressed stock price made it sus-ceptible to a takeover. Safeways management participated in an I,ROwith Kohlberg Kravis Roberts & Co. (KKR), a private investment firm, asa defensive maneuver against a hostile takeover attempt by the DartGroup. And Phillips recapitalization was a defensive tactic against thesecond hostile takeover attempt of the company in less than 3 months.Dart Group is owned and controlled by the IIaft family, who, despite losing the takeover battle forcont.rol of Safeway, earned about $153 million from selling their stock in Safeway and terminating anagreement made with KKR and Safeways management.


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In contrast, the LBOS of Allied and Federated were not done as part of adefensive strategy but were instead hostile takeovers. The acquirer,Robert Campeau of Campeau Corporation, sought the acquisition ofAllied and Federated to expand his commercial real estate operations inthe U.S. market and to position his company in retail merchandising. Heenvisi oned that the retail depar tment store chains would provide theanchor stores in shopping centers he planned to develop in the UnitedStates, which would attract other stores to rent space.

What Happened to the Since the LBOS,Revco, Allied, and Federated have filed for protect ionCompanies?

from creditors under Chapter I1 of the U.S. Bankruptcy Code and havebeen operating as debtors-in-possession6 while developing reorganizationplans to submit to the bankruptcy court+ A court-appointed examinerhas investigated whether the Revco I& constituted a fraudulent con-veyance7 against the interests of Revco creditors who did not participatein the LBO. Findings by the examiner indicate that viable causes of actiondo exist against various parties involved in the LRO under both fraudu-lent conveyance and other legal theories. A successful fraudulent con-veyance action could have the effect of changing the priority ofcreditors claims against what remains of Revcos assets. Safeway sur-vived its LBO and during recent years has, by some measures of perfor-mance such as operating profit margin and gross margin on sales, oper-ated with greater success than before the LBO. In the years followingPhillips recapitalization, the company s performance fluctuated, but itwas able to reduce debt to a level it considered manageable. Our analysisof company performance focused on measures of changes the companiesunderwent, including capitali zation, asset divestitures, capital expendi-tures, research and development spending, employment levels, stock andbond prices, and bond investment ratings.A companys capitalization consists of long-term debt and equity. Thecapitalization of all the companies we studied changed from primarilyequity to primarily long-term debt after the LBOS or recapitalization.Revcos long-term debt nearly quadrupled while its stockholders equitybecame negative within 5 months of the LBO. Safeways long-term debtOperating as a debtor-in-possessiqn means the companies cannot engag e n transactions outside theordinary course of business without first c omplying with the bankruptcy code and, when necessary,obtaining bankruptcy court approval.7A fraudulent, conveyance is essentially a transaction in which a debtor transfers an interest in itsproperty (i.e., grants a lender a security interest in the property) either (1) with the intent to defraudits creditors or (2) regardless of the debtors intent, if the debtor did not receive fair consideration forthe transfer made, causing it to be either i nsolvent or have insufficient capital to conduct its business.

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increased from 46.5 percent of its capitalization 1 year before the LRO o99.1 percent immediately after. Al lieds long-term debt as a percentageof its capitalization more than doubled, from 34 percent before the LB0to 78 percent after, while Federateds increased from 24 percent to 53percent after its LBO. Phillips long-term debt increased from about 30percent of its capitalization to about 81 percent immediately after i tsrecapitalization.Asset divestitures were significant for all the companies. By the end ofits 1990 fiscal year, Revco had divested all of its subsidiary operationsthat were not retail drugstores and almost 11 percent of the nearly2,100 retail drugstores it owned at the time of the LBO. Allied divested18 of its 24 divisions and Federated divested over half of its 15 divi-sions. Safeway divested over half of its nearly 2,400 food outlets, andPhillips sold off $2 billion worth of assets, including several oil and gasproperties, a crude oil tanker, a fertilizer business, and certain mineraloperations. At the time of its recapitalization Phillips valued its totalassets at about $15.8 billion.Capital expenditures and research and development expenditures can beimportant to maintaining a competitive position. Capital spending atRevco, Allied, and Federated declined after the LBOS and was reducedafter Phillips recapitalization. Safeways capital spending was reducedfor 3 years after its LBO, then increased in 1990, and Safeway expects itto be restored to pre-r,no levels in 1991. After the recapitalization, Phil-lips research and development expenditures initially declined, thenrose, but they were refocused on the companys core businesses. Theother companies did not report research and development expendituresin their consoli dated financial statements.Employment at the companies declined after the LBOS and the recapitali-zation as a result of asset divestitures and cost reduction efforts. Exceptfor Phillips, the bulk of the reductions were probably due to asset dives-titures. Employment at Revco fell by more than 2,000, or about 8 per-cent; Safeway laid off over 54,000 employees, or almost one-third of itsworkforce; combined employment at Allied and Federated fell by morethan 108,000, or about 54 percent; and at Phillips, employment wasreduced by 7,500, or about 26 percent. We did not determine how manyof these companies workers lost their jobs. However, the LROS no doubtcreated significant hardships for many laid-off employees-some ofwhom had spent years with the companies before the reorganization.Not only were the income streams of these employees interrupted but, in



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all likelihood, the health and pension benefits associated with their lostjobs were either temporarily or permanently destroyed.Stock and bond prices and bond investment ratings indicate financialgains for stockholders and financial losses for some bondholders. Stock-holders earned premiums on the shares they sold. Revco stockholdersreceived a premium of 36 percent. Allied stockholders received a pre-mium of 79 percent, while Federated stockholders earned a 1 19-percentpremium. Safeway stockholders received about a 49-percent premium.In Phillips recapitalization, stockholders earned a premium of about 48percent. According to data from W.T. Grimm & Co., a recognized pub-lisher of financial data, premiums tended to range between about 31 to49 percent on corporate takeovers from 1980 to 1986.8On the basis of the record of bond prices and investment ratings, bond-holders either lost or were unaffected by the 1~~0s and recapitalization.After the Revco LBO, prices and investment ratings of its outstandingbonds diminished. Investment ratings of Safeways bonds diminishedafter its I.HO but gradually improved as the companys debt was reducedwhile its bond prices remained relatively stable. The prices and invest-ment ratings of Allieds and Federateds bonds fell after their respectivemos. While the prices of Phillips bonds were generally stable during thecompanys takeover fights and following its recapitalization, its invest-ment ratings were downgraded. However, as Phillips reduced its debtand improved its financial strength and flexibility, its bond pricesincreased and its investment ratings were upgraded.

How Did the The companies financial performance after the LBOS and recapitaliza-Companies Perform? tion varied. The overall performance of Revco, Allied, and Federateddiminished; Safeways initially was mixed but then improved; and Phil-lips fluctuated. In any event, the highly leveraged environment inwhich the companies operated after the transactions magnified theimportance of managements operating decisions and increased the com-panies vulnerability to economic downturns.As indicated, the I&OS and Phillips recapitalization resulted in the com-panies amassing tremendous amounts of debt. For example, the totaldebt-to-equity ratio for Allied increased from 1.2 before the LBO tonearly 21 for the first full year after the LBO. For the companies thatwere taken over, the acquiring company borrowed funds or sold bonds%mragcd ISuyouts and the Pot of Gold: 1989 I Jpdate, p. 78.

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to finance the buyout. Then, after the takeover, these bank loans andbond issues were transferred to the balance sheet of the companyformed with the acquired company. To recapitalize, Phill ips exchangedalmost half of its outstanding common stock for the debt securities itissued.Interest expenses after the LBOS tended to be so high at Revco, Allied,and Federated that the companies could not consistently generate suffi-cient cash flow to cover the interest expenses and remain solvent. Thi swas the case even after they divested assets and used the proceeds toreduce debt. Before the LESOS,each of these companies had generatedsufficient cash flow from operations to cover interest expenses by atleast four times. For example, at Revco the year before the LBO, cashflow from operations before interest expense was over five times theinterest expense. The year after the LBO, Revco could not cover itsinterest expense with cash flow from operations. In contrast, Safewayand Phillips generated sufficient cash flow from operations to coverinterest expenses.The profitability of Revco, Allied, and Federated diminished after theLBOS mainly because of their high debt servicing costs, while Safewaysprofitability showed mixed results after the LBO but later improved.Revco has reported only net losses since its LBO and consequently hasnot generated a return on stockholders equity since before the buyout.Allied and Federated, which had profit margins that were higher thanaverage for department stores before their LBOS, fell below average orgenerated losses afterwards, Phillips profitability initially fell after itsrecapitalization, then fluctuated as a result of internal managementactions and uncontrollable external events.

How HaveCommunities BeenAffected?Many individual employees lost jobs or at least had their lives disruptedby having to change jobs or employers after the LBOS and recapitaliza-tion we reviewed. Although this obviously created hardships for theseindividuals, because the companies we reviewed had stores or facilitiesin widely dispersed geographic locations, it was not feasible to deter-mine the overall effects of the LBOS or attempted takeovers on the com-munities. However, we did identify some communi ty effects.For example, according to officials of Bartlesville, Oklahoma, wherePhillips is headquartered, the community was affected by the attempted



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takeovers and subsequent recapitalization of that company . The Bartles-ville Area Chamber of Commerce said that the economy of the commu-nity depends significantly on Phillips because of the large number ofpeople in the community the company employs. The Chamber statedthat Phillips reductions in employment adversely affected the overallearning power of the community and, in particular, reduced real estatevalues, city sales tax revenues, and the volume of retail and servicetrade.After the Safeway LBO, employees who had been discharged filed suitand were awarded a settlement against Safeway. In addition, a SafewayWorkers Assistance Program funded by two grants using Job TrainingPartnership Act money provided job training and placement assistancefor 738 displaced Safeway employees in the Dallas/Fort Worth area. Ofthose served, 685 completed the program. The grantee determined that83 percent of those obtained employment after about 24 weeks in theprogram. However, the grantee also determined that the average hourlywage at placement was below the wages previously earned at Safeway.Opportunities for employment with new owners of Safeway stores werelimited, and where such employment was found, employee benefits andwages were also reduced.Although Revco divested a number of its drugstores, we did not attemptto identify any community impact from the closings or sales because thesmall number of personnel typically employed at a single drugstore com-bined with the many different communities in which the stores werelocated, in our view, decreased the potential for any significant, adverseeconomic impact on a local community. Community effects of theCampeau LBOS could not be determined because of the departmentstores numerous locations in highly diverse urban economies.

Other Observations The small number of cases we reviewed does not allow us to commentabout 1,130sn general. However, in the cases we reviewed it is clear thefinancial success of the companies after the LRO depended largely ontheir ability to meet debt service requirements when due. This dependedon judgments made by the purchasers and their advisers regarding theinitial price paid; future economic conditions; the value of the compa-nies assets; and managements ability to cut costs, reduce debt, andimprove profits after the buyout. In these highly leveraged transactions,however, the purchasers had little to lose if they paid too much and a lotto gain if they could make the surviving company a success, while theiradvisers earned large fees regardless of the price paid or the ultimate


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success of the surviving company and thus had an incentive to completethe deals.The purchasers in the transactions we reviewed had relatively little tolose because their equity investments were very small compared to thetotal purchase price. Specifically, in the Revco LBO the purchaser con-tributed only about 2.0 percent of the aggregate purchase price throughequity contributions. In the acquisition of Federated, the portion of theacquirers equity investment that was not borrowed was only 2.9 per-cent of the total purchase price, and that money came from the sale ofAllieds Brooks Brothers chain. Similarly, in the Allied and SafewayLISOS, the purchasers equity investments were only 8.5 percent and 2.7percent of the total purchase price, respectively. This provided the pur-chasers the opportunity to earn tremendous returns if the survivingcompany were to prosper while at the same time limiting the financialrisk they were taking.The investment bankers acting as advisers and financial managers forthe 1~30s arned fees ranging from about $49 million to about $127 mil-lion for these and other services, including providing temporarybridge loans in the Allied, Federated, and Safeway deals and under-writing issues of securities to finance the Allied, Federated, and Revcodeals. Similarly, other participants-primarily banks, but also attor-neys, accountants, and others- received fees from these transactionsthat ranged from about $38 million to about $166 million. Total fees forthe deals as a percentage of the purchase price ranged from nearly 4.5to 7.5 percent. Many of these fees, such as those for bridge loans orunderwriting services, would not have been earned unless the dealswere completed. As a result, while the dealmakers and their adviserswere tasked with assessing the price to be paid and the ability of thecompany to survive, they had financial incentives to simply see that thedeals were completed.



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We are sending copies of this report to the other congressional reques-ters, the Securities and Exchange Commission, other interested Membersof Congress, and appropriate committees. We will also make copiesavailable to the public.The major contributors to this report are listed in appendix VII. If thereare any questions concern ing the contents of this report, please call meat (202) 275-8678.Sincerely yours,

0 Craig A. SimmonsDirector, Financial Institutionsand Markets Issues



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Contents

LetterAppendix ICongressionalRequesters

116

Appendix II 18Objectives, Scope, andMethodologyAppendix III 22Case Study: LB0 of The LB0 Transaction 22Revco D.S., Inc. Impact of LB0 on Revco 28Financial Indicators of Revcos Performance After the 39LB0Impact of LB0 on Communities 43Current Status of Revco 44Appendix IV 47Case Study: LB0 of The LB0 Transaction 48Safeway Stores, Inc. Financing the LB0 54Safeway After the LBO: Increased Debt Required Massive 57Asset DivestituresImpact of LB0 on Employees and Communities 62Safeways Performance Since the LB0 65Current Status of Safeway 71Appendix VCase Study:Campeaus LBOs ofAllied StoresCorporation andFederated DepartmentStoires, nc.

Allied: The Target CompanyCampeaus LB0 of AlliedFederated: Another Campeau TargetCampeaus LB0 of FederatedImpact of LBOs on Allied and FederatedFinancial Indicators Show Decline in CompanyPerformance After the LBOsEvents Since the Bankruptcy Filings

74747580818597107



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Contents

Appendix VICase Study:Recapitalization ofPhillips PetroleumRecapitalization of PhillipsImpact of Recapitalizat ion on PhillipsFinancial Indicators of Phillips Performance After theExchange OfferImpact of Exchange Offer on Phillips Employees andCommunityCurrent Status of Phillips

108109113123128130

Appendix VIIMajor Contributors toThis ReportTables Table III. 1: Summary Statistics of Revco LB0Table 111.2: inancing Sources for Revco LB0Table 111.3: nvestment Ratings for Revco BondsTable 111.4:Revcos Bond PricesTable 111.5: nterest CoverageTable 111.6: iquidity RatiosTable 111.7: ndicators of Revcos Declining ProfitabilityTable IV. 1: Estimated Financing Sources and Applicationof Funds for Safeways LB0

Table IV.2: LB0 Investment Bankers-Services and FeesTable IV.3: Remaining Estimated Fees, Expenses, andCosts Related to Safeways LB0Table IV.4: Safeways Year-End Bond RatingsTable IV.5: Safeways Year-End Bond PricesTable IV.6: Interest CoverageTable IV.7: Current RatioTable IV.8: Quick RatioTable IV.9: InventoryTable IV. 10: Safeway and Industry Profitability MeasuresTable V. 1: Allied Stores Corporation Selected Pre-LB0Financial StatisticsTable V.2: Sources and Uses of Funds for Financing theCampeau-Allied MergerTable V.3: Allied Stores Corporation Prices per Share ofCommon Stock on Selected DatesTable V.4: Federated Department Stores, Inc., SelectedPre-LB0 Financial Statistics

131

2426373841424355565761626668 68697075777981



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Contenta

Table V.6: Sources and Uses of Funds for FinancingCampeaus Acquisition of FederatedTable V.6: Federated Department Stores, Inc., Prices perShare of Common Stock on Selected DatesTable V.7: Allied Stores Corporation Divisions Retainedand Sold After the LB0Table V.8: Federated Department Stores, Inc., DivisionsRetained and Sold After the LB0Table V-9: Allied Stores Corporation Bond Prices forSelected Months/YearsTable V.10: Allied Stores Corporation Bond Ratings forSelected Months/YearsTable V. 11: Federated Department Stores, Inc., BondPrices for Selected Months/YearsTable V. 12: Federated Department Stores, Inc., BondRatings for Selected Months/YearsTable V.13: Number of Allied and Federated Employeeson Selected DatesTable V. 14: Allied Stores Corporation and Industry Debtper Dollar of Equity Before and After the LB0Table V. 15: Federated Department Stores, Inc., andIndustry Debt per Dollar of Equity Before and Afterthe LB0

8384878993949596979899

Table V. 16: Allied Stores Corporation and IndustryAbility to Service DebtTable V.17: Federated Department Stores, Inc., andIndustry Ability to Service DebtTable V.18: Allied Stores Corporation and IndustryLiquidity Ratios

101102104

Table V. 19: Federated Department Stores, Inc., andIndustry Liquidity RatiosTable V.20: Allied Stores Corporation and IndustryProfitability Measures

104106

Table V-21: Federated Department Stores, Inc., andIndustry Profitability MeasuresTable VI. 1: Phillips Gross Payroll, Including EmployeeBenefits

106116

Table VI.2: Changes in Capital Expenditures 118Table VI.3: Investment Ratings for Phillips Bonds 121Table VI.4: Phillips Bond Prices 122Table VI.& Debt per Dollar of Total Common 124Stockholders EquityTable VI.6: Phillips Interest Coverage 125



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Table VI.7: Liquidity Ratios 126Table VI.8: Indicators of Phillips Profitability 127Table VI.9: Phillips Bartlesville Work Force 129

Abbreviations

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chief executive officerbarrelsKohlberg Kravis Roberts & Co.leveraged buyoutNew York Stock ExchangeOffice of Technology Assessmentresearch and developmentSecurities and Exchange CommissionStandard Industrial Classification

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Appendix ICongressionalRequesters

The Honorable Timothy J. PennyThe Honorable Byron L. DorganThe Honorable Lawrence J. SmithThe Honorable Cass BallengerThe Honorable Gerald D. KleczkaThe Honorable Thomas M. FogliettaThe Honorable Gerry E. StuddsThe Honorable Robert J. MrazekThe Honorable Barbara BoxerThe Honorable Harris W. FawellThe Honorable Lane EvansThe Honorable Bruce A. Morrison*The Honorable James W. BilbrayThe Honorable Gerry SikorskiThe Honorable Terry L. BruceThe Honorable Richard RayThe Honorable Robin TallonThe Honorable John LewisThe Honorable Chester G. AtkinsThe Honorable Tim JohnsonThe Honorable Wil liam 0. LipinskiThe Honorable Jim JontzThe Honorable Lynn Martin*The Honorable Albert G. BustamanteThe Honorable Amo HoughtonThe Honorable Christopher ShaysThe Honorable Richard H. StallingsThe Honorable Harry JohnstonThe Honorable Helen Delich BentleyThe Honorable Elizabeth J. PattersonThe Honorable David E. SkaggsThe Honorable Thomas J. RidgeThe Honorable Mervyn M. DymallyThe Honorable Charles E. BennettThe Honorable Martin Olav SaboThe Honorable James L. OberstarThe Honorable Robert A. RoeThe Honorable Cardiss CollinsThe Honorable Silvio 0. Conte**The Honorable Bruce F. VentoThe Honorable Clarence E. MillerThe Honorable Donald J. PeaseThe Honorable Dennis M. Hertel

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Appendix IChgressioual Requesters

The Honorable Joseph M. GaydosThe Honorable Ben Nighthorse CampbellThe Honorable H. Martin LancasterThe Honorable Bob TraxlerThe Honorable Jim OlinThe Honorable James A. Traficant, Jr.The Honorable Marcy KapturThe Honorable Robert W. Kastenmeier*The Honorable Julian C. Dixon

No longer a Member of Congress.



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Annendix IIObjectives, Scope,and Methodology

Our objective was to prepare case studies that provide informationabout companies that had experienced a leveraged buyout (LBO) or hadsurvived an attempted takeover. As requested, the case studies addressthe following questions:l What has happened to companies as a result of an LRO or attempted LBo?l How have those companies performed since the LB0 or attempted LBO?l How were communities affected?l What has happened to companies that have amassed tremendous debt inorder to avoid being taken over?

We did four case studies of companies that experienced an LB0 or a take-over attempt during the mid- to late 1980s. We selected three LBOS and arecapitalization that occurred in 1985 or 1986 so that there would be asufficient period of time after the LBO or recapitalization to assess subse-quent performance of the company. Within this time frame, weattempted to select cases that would il lustrate various features. Weselected Revco because it appeared from press reports to be experi-encing difficulties after its LBO and Safeway because it appeared to besuccessfully emerging from its buyout. We selected the Campeau buyoutof Allied Stores Corporation and the subsequent buyout of FederatedDepartment Stores, Inc., because of the bidding wars that took placebetween Campeau and the Edward J. DeBartolo Corporation for Alliedand between Campeau and Macys for Federated and the declining per-formance of both Allied and Federated after the Federated LBO. Finally,we selected Phillips Petroleum because it had received considerable pub-licity about its efforts to avoid being taken over by amassing tremen-dous debt.In developing our approach for the case studies we interviewed officialsof SIX and reviewed literature on case studies done by SEC nd otherorganizations and individual researchers. The case studies address theabove questions to the extent that they apply to the case or wereanswerable. For example, the Campeau case study did not address thecommunity effect questi on because of the large number and diversity ofcommunities where Allied and Federated had stores. The last questionon amassing debt to avoid being taken over applied only in the Phillipscase, in which we also addressed the other three questions and followeda methodology similar to the other case studies.

Campcaus :wquisition of Allied occurred in 1986; it acquired Federated in 1988, and we includedthis buyout. as well in t,tw cast study.



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Appendix IIObjectives, Scope, and Methodology

Our information on how the LBOS were done, what happened to the com-panies, and the companies post&no performance is largely based onpublic documents and financial reports filed by the companies with SEC.We obtained information on particular industries from various industryand trade reports, We also obtained selected information through tele-phone interviews with individuals knowledgeable about the LBOs, suchas an attorney involved with one of the bankruptcies, ratings agencyofficials, and company officials, Officials of Revco, Allied, and Feder-ated declined to meet with us or to provide information that was notalready available through public sources because of their bankruptcystatus and their concern about possible litigation. Phillips provided uswith employment data by year for its Bartlesville headquarters.Safeway provided answers to questions we submitted regarding thebuyout. All of the companies commented on a draft of their respectivecase studies, and we made changes as appropriate.Our analysis of the effects of the LBOS and the recapitalization focusedon several items. These include (1) capitalization, which reflects changesin the long-term debt and equity in a companys financial structure toindicate the increased demands placed on a company to service the LBO-induced debt and its subsequent increased vulnerability to economicdownturns; (2) asset divestitures to illustrate how the companies down-sized to reduce debt using the proceeds of asset sales; (3) changes incapital expenditures and, where applicable, research and developmentexpenditures to show how the companies diverted funds from theseactivities, which are vital to maintaining a competitive position2 to ser-vice and reduce debt; (4) employment levels to indicate how the workforce at the companies was affected by efforts to service and reducedebt; and (5) stock and bond prices and bond investment ratings to indi-cate financial gains or losses experienced by stockholders andbondholders.Our calculations of the premiums received by stockholders as a result ofthe LBOS and Phillips recapitalization were calculated as the percentagedifference between the buyout price and closing common stock marketprices 1 month before the initial buyout or tender offers.3 Stock pricesSome analysts have argued that forced reductions in capital spending after an LB0 promote a com-panys efficiency because only the investments with the highest return will be made.:ln Campeaus 1~130f Allied, we calculated premiums from April 1986, when Campeau beganpurchasing Allied shares, The actual tender offer did not begin until September. In Safeways LB0 wecalculated premiums from 1 day before the June 11, 1986, disclosure by the Ilafts that they ownedabout 6 percent of Safeways common stock and might acquire the company. The Kohlberg KravisRoberts & Co. tender offer did not begin until August 1, 1986.



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are from The Wall Street Journal and The Daily Stock Price Record, NewYork Stock Exchange.Our assessment of the effect of the LBOS on bondholders was based onchanges in bond prices and investment ratings after the LBOS. Althoughchanges in bond prices also reflect other factors, such as interest rates,issue terms, and rumors of potential takeovers, we generally associatedtrends in bond prices after the LBOS with the effects of the LBOS. Changesin bond investment ratings generally reflect changing investment risksassociated with the bonds pursuant to changing conditions at the com-panies, The bond prices and investment ratings are from Moodys BondRecord, which publishes current bond prices and investment ratingsas of the last trading day 1 month before the publication month.To evaluate the companies performance after the LBOS, we applied com-monly known principles of financial analysis, Our primary tools forjudging per formance were ratios that compared the relationships amongkey financial statistics for a particular performance period, usually thecompanies fiscal year, We calculated ratios for the last full year beforethe LBOS and for subsequent years through 1989. The statistics weredrawn from the companies consolidated financial statements-balancesheet, statement of operations, and statement of cash flows-andaccompanying notes. The ratios used in our analysis are the following:

. The debt-to-equity ratio shows the relationship between financingsources-primarily loans and various debt instruments that requireinterest payments as opposed to stocks, which convey ownership and ashare of profits, We used two ratios of debt to equity-long-term debt tototal common stockholders equity and total debt (defined as total liabil-ities) to total common stockholders equity.. Interest coverage ratios indicate a companys ability to service debt bycomparing measures of cash flow to interest expenses. We used cashflow from operations before interest expense divided by total interestexpense. Another interest coverage ratio that we used for the Campeaustudy to compare with department store industry data is earningsbefore interest and taxes divided by interest expense.l Liquidity ratios measure a companys ability to meet short-term obliga-tions by comparing current assets to current liabilities. We used the cur-rent ratio-current assets divided by current liabilities-and the quickratio-cash plus marketable securities plus receivables divided by cur-rent liabilities, The quick ratio, by excluding inventories and pre-paidexpenses, provides a more immediate measure of a companys short-term debt paying ability.



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l Profitability ratios indicate how well an enterprise has operated. Weused profit margin-net income as a percentage of net sales-to indi-cate how effectively the companys operations and finances were man-aged. For Safeway, we also used operating profit margin-operatingprofits as a percentage of gross sales to indicate how effectively oper-ating profits were managed. And, for both Campeau and Safeway, wealso calculated gross margin- net sales less the cost of goods sold as apercentage of sales-to obtain an indication of these companies oper-ating efficiency, pricing policies, and ability to compete. For cases inwhich the company had a positive net worth position, we calculatedreturn on average common stockholders equity-net income divided bythe average of beginning- and end-of-year common stockholdersequity-to indicate the returns available to the companies owners.We did our work between January 1990 and March 1991 in accordancewith generally accepted government auditing standards.



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Appendix IIICaseStudy: LB0 of Reveo D.S., nc.

On December 29, 1986, Revco D.S., Inc., was acquired in an LBO by aninvestor group that included both private investors and management fora total cost of about $1.45 billion. As a result of the buyout, the com-panys long-term debt nearly quadrupled from $309 million at the end ofthe fiscal year before the buyout to about $1.3 billion after. Revco haddifficulty meeting its increased debt requirements and, after unsuc-cessful attempts to restructure its debt, defaulted on a $46.5 millioninterest payment due bondholders June 15, 1988. Revco subsequentlyfiled for Chapter 11 bankruptcy protection on July 28, 1988, 19 monthsafter the buyout.The company has since been trying to develop a reorganization plan thatis acceptable to all of its constituencies. However, after waiting morethan 2 years for Revco to devise a plan, some of the companys creditorsformulated their own and filed it with the bankruptcy court onNovember 15, 1990. In addition, a court-appointed examiner has investi-gated whether the LHO onstituted a fraudulent conveyance against theinterest of Revco creditors who did not participate in the I,ISO. Findingsby the examiner indicate that viable causes of action do exist againstvarious parties involved in the LRO nder both fraudulent conveyanceand other legal theories. A successful fraudulent conveyance actioncould have the effect of changing the priority of creditors claimsagainst what remains of Revcos assets.This case study is based on public documents filed by Revco with SEC;interviews with representatives of Revcos vendors and bondholders;the Revco examiners final report; Moodys Bond Record, MoodysIndustrial Manual, and Moodys Industrial News Reports; Standard &Poors Industry Surveys; and stock price listings in The Wall StreetJournal. Officials at Revco reviewed and provided technical commentson a draft of our study.

The LB0 Transaction Revco is a retail drugstore chain that sells prescriptions and proprietarydrugs, health and beauty aids, vitamins, tobacco products, sundries, andA fraudulent convcyanc(> s essentially a transaction in which a debtor transfers an interest in itsproptrty (i.e., grants a kbndor a securit,y interest in the property) either (1) with the intent to defraudits creditors or (2) rcagardlcss f the dcbtors intent, if the debtor did not receive fair consideration forthcb ransfer made, c,ausing t t,o be either insolvent or have insufficient capital to conduct its business.1h(*United States 13ankruptcy Court for the Northern District of Ohio approved the appointment ofan c~xaminc~ro invcstigat,r potential causes of act,ion and other remedies arising from the Kevco LHOand to analyzc~ he benefits and detriments of pursuing any available claims. The examiner filed apreliminary report dated July 16, 1990, with his initial findings, and a final report dated December17, 1990, with his final conclusions.

Page 22 GAO/GGD-91-1 07 Leveraged Buyouts


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Appendix IIICase Study: LB0 of Revco D.S., Inc.

close-out merchandise. Its corporate fiscal year, which we refer tothroughout this report, ends on the Saturday closest to May 31. Thus,the December 29, 1986, LBO occurred during the third quarter of Revcosfiscal year 1987.Before the buyout, Revco was one of the nations largest discount drug-store chains with 2,031 drugstores in 30 states at the end of fiscal year1986. Although Revco had diversified into nondrug businesses, themajority of its sales originated from its core drugstore business. About90 percent of fiscal year 1986 net sales was attributable to the drugstoredivision. Of the remaining 10 percent, 5 percent was from Odd LotTrading Co., a wholesaler and retailer of close-out merchandise thatRevco had acquired in 1984, and the other 5 percent from Revcos man-ufacturing and other nonretail divisions.

Investor Group Revco was purchased by an investor group through a holding company.The investor group consisted of three parties:(1) Management investors-composed of 33 officers and key employeesof the company, including Revcos top two executives, Sidney Dworkin,Chief Executive Officer and Chairman of the Board, and William B.Edwards, Chief Operating Officer and President.(2) Transcontinental Services Group N.V.-a Netherlands Antilles cor-poration formed in 1982 and an investment holding company that isgenerally engaged in making special situation investments, principally inthe United States.(3) Golenberg & Co. an Ohio corporation, formed in 1978, engaged inthe investment banking business.Anac Holding Corporation is the holding company formed in 1986 bycertain members of the management investors, through which the acqui-sition of Revco was effected. Because the investor group included mem-bers of Revcos existing management, the LB0 is also referred to as amanagement buyout.

Summary Statistics ofRevcos LB0 According to the examiners final report, management was motivated toparticipate in an LHO of Revco because of fears that the company sdepressed stock price made it susceptible to a takeover. Summary infor-mation about the Revco LBO is included in table III. 1.Page 23 GAO/GGD-91-107 Leveraged Buyouts

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Table 111.1:Summary Statistics of RevcoLB0 Purchase price:OwwwWOutcome:

Investment advisers:

$1 .45 billionInitial offer, submitted March 11 , 1986, equivalent to $36 ashare of cash and equity, rejected. Subsequent mergeragreement accepted August 15, 1986, equal to $38.50 a share,all cash; LB0 effective December 29, 1986.Revco-Goldman, Sachs & Co.Anac-Salomon Brothers, Inc.; Golenberg & Co.;TSG Holdings Inca

aTSG Holdings Inc. is a wholly owned subsidiary of Transconfinental, a member of the investor group.TSG provides ma nagement services to Transcontinental and those businesses in which Transconti-nental or its affiliates have a direct or indirect i nterest.Source: GAO analysis based on company dat a filed wtth SEC.

Stockholder Premium During fiscal years 1984 and 1985, Revcos common stock tradedbetween $24.00 and $37.50, and $22.50 and $32.88, respectively. Duringthe first three quarters of fiscal year 1986, before delivery of the initialproposal in the fourth quarter, the market price of Revcos commonstock ranged between $23.13 and $29.50. The final purchase price of$38.60 per share provided Revcos stockholders a premium3 of 36 per-cent-almost 9 percent higher than what stockholders would havereceived if the initial offer had been accepted. To reflect the stock valuebefore the LB0 may have influenced it, the premium was based on thedifference from the closing stock price of $28.25 per share on February11, 1986, 1 month before the delivery date of the initial offer.

Financing The financing of Revcos LB0 was composed of senior debt,4 subordinateddebt, and equity investment. The senior debt, provided by a syndicateof 11 banks, was secured by the companys assets. The subordinateddebt consisted of 13.125-percent senior subordinated notes due in 1994,13.30-percent subordinated notes due in 1996, and 13.30-percent juniorPremium is the amount, which we express as a percent, by which the offered price per shareexceeds the market price per share on a specific date.4Senior debt is generally provi ded by commercial banks. The amount available is influcnccd by pro-jected cash flow and, if secured, by the collateral value of the acquired businesss assets. It is consid-ered senior because t has higher priority with respect to repayment than other types of outstandingdebt.Subordinated debt instruments require that, in the event of liquidation, repayment of principal maynot be made until another debt instrument senior to it has been repaid in full.FCuity represents the ownership interest in a company of holders of its common and preferredstock.


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subordinated notes due in 2001 that were issued in a public offeringunderwritten by Salomon Brothers. The notes were unsecured obliga-tions, and interest on all three was due semiannually-June 15 andDecember 15, with the first payment due on June 16, 1987, about 6months after the effective date of the buyout.The third part of the financing, the equity investment, was made up ofthree types of redeemable preferred stock- convertible,g exchange-able,1 and junior, of which the exchangeable was issued publicly-andcommon stock, which the investor group and Salomon Brothers pur-chased.12The cash generated from these sources and applied to theaggregate purchase price of $1.45 billion is shown in table 111.2

7The unior subordinated notes were issued as part of 93,750 units-each consisting of one 13.3-percent junior subordinated note in the principal amount of $1,000,4 shares of Anac common stock,and 4 common stock puts. Each put emitles the owner to tender to Anac one share of common stockfor mandatory purchase by Anac at the fair market value of the common stock on December 15,1993.After the LBO, Revcos common stock was owned entirely by Anac. The equity portion of thefinancing refers to preferred and common stock issued by Anac. Ownership of Anacs equity providesthe holder an indirect equity interest in Revco.The convertible preferred stock entitles holders to convert their preferred stock into common stockin connection with any merger of Anac with or sale of its property and assets to any entity. Theconvertible preferred stock is convertible into an aggregate of 29 percent, on a fully diluted basis, ofAnac common stock and contains antidilution provisions.The exchangeable preferred stock entitles holders to exchange their shares of preferred stock, atAnacs option, into subordinated notes of Anac at any time on or after December 15, 1988. The junior preferred stock has no conversion or exchange features. In the event of liquidation,holders have a claim on the assets available for distribution after payments to creditors and holdersof convertible and exchangeable preferred stock.Common stock was also sold publicly as part of the units in which the junior subordinated noteswere issued-see footnote 7.



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Table 111.2:Financing Sources for RevcoLB0 (Dollars in Millions)Proceeds from public offering of subordinated debt($703,750) and exchangeable preferred stock($130,020)

Amount Percent

$033,770 58Term loan from bank syndicatea----Issuance of Anac common stock ($29,538 invested byinvestor arouo)

455,000 31---.______34,361 2

Issuance of convertible preferred stock 85,000 6__--Issuance of junior preferred stock 30,098 2--Revco cash 10,655 1Total $1,448,904 100aAn aggregate amount of $567 million was borrowed from the bank syndicate, of which $455 million wasapplied toward the purchase price The remaining $112 million was pl aced into a revolving credit facilityintended to finance any direct loans or letters of credit Revco needed In its ongoing operations after theLEO.Source: GAO analysis based on company d ata filed with SECThe amount invested by the investor group, through purchasing Anaccommon stock, was very small in relation to the purchase price-onlyabout 2 percent. Similarly, the management investors investment wasonly about 1 percent of the total purchase price. The majority of thepurchase price, about 80 percent, was composed of the senior debt termloan (about 3 1 percent) and subordinated debt (49 percent), with equityinvestment providing about 19 percent and Revcos cash about 1percent.

Fees and Costs Paid in According to Revcos proxy, dated November 14, 1986, an estimated $78Connection With the LB0 million in fees and costs were anticipated in connection with Revcos LROand were to be paid by either Anac or Revco. However, based on theexaminers final report, approximately $86.9 million of fees andexpenses related to the LRO were actually paid by Anac or Revco-$8.9million more t,han that estimated before the LBO. These fees were about6.0 percent of the aggregate purchase price.Fees for financial advisory services provided by the four advisersinvolved in the LROwere payable upon consummation of the merger. Theinvestment bank representing pre-Lno Revco received a $1 million fee upfront. Anacs three advisers provided additional services, including



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Appendk IIICam Study: LBQ of Revco D.S., Inc.

underwriting,l: private placement of debt,14and management and finan-cial consulting. Based on the examiners report, fees paid for variousservices are$3.0 million to Goldman, Sachs & Co. for f inancial advisory services pro-vided to Revcos Board of Directors and Special Independent Committeeand for preparing fairness opinion (includes $1 million fee paid upfront).$38.8 million to Salomon Brothers, Inc., for financial advisory servicesprovided to Anac, for underwriting publicly issued subordinated debtand exchangeable preferred stock, and for private placement of convert-ible preferred stock.$6.0 million to Golenberg & Co. for financial advisory services providedto Anac.$0.6 million to TSG Holdings Inc. for assisting Anac in structuring themerger and related transactions. TSG was also contracted to providepost-IJlsoRevco management, consulting, and financial services for anannual fee of $300,000.$7.8 million for legal and accounting services.$28.0 million for bank commitment and other fees. ($20.4 million, orabout 73 percent, was paid to the agent banks, Wells Fargo Bank andMarine Midland Bank.)$0.8 million for other professional services.$1.7 million for miscellaneous expenses.In addition to the services listed here, Salomon Brothers, Inc., andGolenberg & Co. also participated in the IBO as merchant bankers byattaining an indirect equity stake in post-I&o Revco through purchasingequity of Anac. Salomon Brothers purchased about $11 million worth ofAnac common stock and junior preferred stock giving the investmentbank 9.3 percent of Anac common stock, assuming conversion of con-vertible preferred stock. Golenberg & Co. purchased about $520,950 ofAnac common stock giving it a l-percent equity stake in Anacs commonstock, assuming conversion of convertible preferred stock.

An undcrwritc~r acts as a middleman bctwcen a corporation issuing new securities and the public byllurcbasing thus c~c~uriticsrom the issuer and reselling them in a public offering.Irivatc~ placrmcmt. s the distribution of securities that have not been registered with SEC. Hcgula-tions rclstrict the distribution of such unregistered securities to a limited number of purchasers whoall hirvc it dcmonstratcbdability to evaluate the merits and risks of the security.In merchant banki ng, investment bankers assume an equity st ake in the surviving corporation of anacquisition through dircWy or indirectly purchasing preferred or common stock.



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Impact of LB0 onRevco Various factors contributed to Revco declaring bankruptcy after thebuyout, the most important being Revcos failure to (1) successfullyreduce its increased debt through internally generated cash flow, assetdivestitures, and inventory reduction and (2) achieve projected oper-ating results. Management turnover and eroding trade credit placed fur-ther strain on the company, and capital expenditures were restricted. AsRevcos performance deteriorated, bondholders also suffered as thevalue of their holdings decreased. On July 28, 1988, 19 months after theLBO, Revco filed for protection from its creditors under Chapter 11 of thebankruptcy code.

Revcos CapitalizaBecame PrimarilyAfter LHOkionDebt The LB0 had a significant impact on Revcos capitalization. Specifically,Revcos long-term debt, including the portion currently due, nearly qua-drupled from $309 million at the end of fiscal year 1986 to about $1.3billion at the end of fiscal year 1987, and its total common stockholdersequity went f rom $393 million at the end of fiscal year 1986 to a deficitof about $20 million at the end of fiscal year 1987. The deficit, whichrepresents the period of time since the Lso-December 30,1986,through May 30, 1987-was due to the net loss and dividend obligationsRevco had at the end of fiscal year 1987.

According to the prospectus, although management did not project thedeficit in common stockholders equity, they had expected the most sig-nificant effect of the buyout to be on Revcos capitalization. Specifically,on August 23, 1986, before the LBO, Revco had a ratio of long-term debt(including the current portion) to total capitalization of 44 percent,which means that more than half of Revcos capitalization came frominvested capital. Assuming that the buyout and the financing hadoccurred on August 23, 1986,*7management projected the ratio of long-term debt (including the current portion) to total capitalization toincrease to 83 percent, making borrowed funds the largest source ofcapital.

Capitalization is the total value of a corporations long-term debt and preferred and common stockaccounts.17Basedon pro forma fi nancial statements which are projected financial s tatements embodying a setof assumptions about a companys future performance and funding requirements. The statements,included in the December 18, 1986, prospectus, were prepared as if the buyout had occurred onAugust 23, 1986.



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Cash Flow FromOperations DeterioratedAfter LB0Cash flow from operations represents the net inflow or outflow of cashduring a period resulting from the operating activities of a company. Itfocuses on the liquidity aspect of operations and when related to debtservice can provide an indication of a companys ability to service itsdebt through internally generated cash. Despite finding, on a pro formalbasis for fiscal year 1986, that Anacs earnings before income taxes andfixed chargeW were inadequate to cover fixed charges resulting fromthe debt incurred in financing the IBO, management expected Revcoscash flow from operations to be sufficient on an annual basis to meetpost-I,130 ebt obligations. According to the prospectus, managementbased its expectation on the revenues and operating profits it projectedRevco would generate after taking into account the divestiture programand the expected continued growth in the drugstore divisions sales.However, after the I&O, Revcos cash flow situation deteriorated.According to the Revco examiners final report, concerns about cashflow existed immediately after the LRO as evidenced in a January 2,1987, memorandum from Revcos treasurer, which stated:I am very concerned about cash flow since the sales for the past six weeks havebeen poor resulting in approximately $30 million less cash flow. It will be very diffi-cult to make up this loss of funds. In fact, we have no excess cash going forward.Furthermore, because of higher interest costs and reduced profitabilityof operations, Revcos cash flow from operations declined significantlyduring fiscal year 1988, the first full year after the buyout, to a netoutflow of $57.3 million. As a result of its bankruptcy filing, Revcosliquidity position during fiscal year 1989 improved dramaticallybecause of the deferral of about $309.9 million in operating cashrequirements. Excluding these cash requirements, Revcos cash flowfrom operations provided a net inflow of about $15.2 million at the endof fiscal year 1989. If Revco had not filed for Chapter 11 protection, itwould have had a net outflow of cash used in operations of about $294.7million at the end of fiscal year 1989. The decline in operating cash flowcontributed to Revcos inability to service its debt.

The pro forma results of operations are based on the assumption that the acquisition and mergerand related financing occurred at the beginning of the fiscal year presented.Fixed charges consist of inkrest expense, amortization of deferred financing costs, amortization ofdiscount on junior subordinated notes, and a portion of operating lease rental expense reprcscntativcof the: ntorcst factor.



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Proceeds From Asset Management established an asset divestiture program that initiallyDivestiture Program Below included about 100 drugstores and substantially all of Revcos nonretailExpectations drugstore subsidiaries, except its close-out subsidiary, Odd Lot TradingCo. The proceeds from the asset sales were to reduce the senior debtterm loan. The provisions of the term loan required the program to gen-erate $265 million in proceeds by the second quarter of fiscal year 1989(November 1988), all of which would be applied to reducing the loan.According to the examiners final report, sales under the asset divesti-ture program did not proceed as originally projected. For example, twosubsidiaries were to be sold before the LBO with part of the proceedsbeing used to pay the merger consideration due stockholders. Neithersale was closed before the LBO was effected. Furthermore, as early asMarch 31, 1987,3 months after the LBO, the examiner reported thatmanagement was having doubts as to whether asset sales would be ableto generate enough proceeds to make a prepayment on the term loan duein May.During fiscal year 1988, management revised its expectations of the pro-grams total proceeds and projected they would fall short of the targeted$256 million. By the end of fiscal year 1988, before Revco filed forChapter 11 protection, the program was substantially complete and thetotal amount of funds generated and applied toward reducing the termloan was $197 million-$68 million short of the amount required. Atthat point, the assets remaining to be divested consisted primarily ofcertain drugstores and Odd Lot. Management had initially excluded OddLot from the program on the condition that it continue to pass variousfinancial tests and earnings levels. The divestiture of Revcos subsidiaryoperations was completed n the second quarter of fiscal year 1990,more than a year after Revco declared bankrugtcy, According to theexaminers final report, total proceeds generated from Revcos assetdivestitures were $231 million-$23.8 million short of what wasrequired by the term loan agreement.

InventoryCreated UProblemsReductionnanticipated

Management ran an inventory reduction program from March 1987through July 1987 called Operation Clean Sweep. It was intended topermanently reduce drugstore inventory levels and eliminate unwanted,outdated, slower selling merchandise that was not part of Revcos coredrugstore business. According to the examiners final report, the inven-tory targeted for elimination included television sets, video cassetterecorders, microwave ovens, gas grills, and knockdown furniture. Revcohad begun stocking these items in 1985 and 1986, before the LBO, hoping



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Appendix IIICase Study: LB0 of Revcu D.S., Inc.

they would generate high margins. However, the examiner reported thatover a Z-year period the items had not been selling.According to Revcos fiscal year 1988 annual report, the inventoryreduction program accomplished its goal of reducing inventory but cre-ated two major unanticipated problems during fiscal year 1988. First,although it reduced inventory levels, Revco failed to restock with appro-priate amounts of normal selling merchandise. As a result, the companyhad to undertake a significant replenishment of inventories during thefirst quarter of fiscal year 1988. According to the companys annualreport, the inventory purchased caused significant imbalances betweenproduct categories,Second, the inventory reduction program triggered a covenant inRevcos term loan agreement regarding the application of excess cashflow. As a result, Revco had to pay $39.2 million toward the bank loanshortly after the end of fiscal year 1987. According to the Revco exam-iners final report, the payment left Revco with depleted inventory andinsufficient cash to replenish its inventory.Revcos inventory problems continued to snowball during fiscal year1988. Revco needed to generate enough funds not only to deal with itsinventory imbalances but also to meet both inventory requirements forthe 1987 Christmas season and an interest payment on its subordinateddebt due December 15, 1987. The companys cash and short-term bor-rowing ability were insufficient to satisfy all its obligations, and in spiteof securing a $30 million overline on its revolving bank credit, i ts 1987Christmas inventory suffered. Inadequate inventory levels of someproduct lines existed, while others had to be marked down to be sold.Because we did not talk wi th Revco officials, we could not determinewhy the adverse effects of Operation Clean Sweep were unanticipated.However, according to the examiners final report, several parties ininterest cited improper implementation by senior management, includinginadequate monitoring or supervising of store managers, and insuffi-cient training of store managers with respect to inventory control as twofactors contributing to Revcos post&no inventory reduction efforts.



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Projections Were NotAchieved Before the LBO, certain members of Revcos management-includedamong the management investors-prepared projections of Revcosfuture operations and provided them to the investor group and prospec-tive lenders interested in participating in the acquisition of Revco. Man-agements projections assumed an annual increase in net sales of 12percent and operating profit before depreciation as a percentage of salesof 7.7 percent for fi scal years 1988 through 1991. Underlying the pro-jected sales increases was an assumption that existing stores wouldincrease their sales and new stores would be added at a rate that wouldadd about 10 percent additional retail space each year.According to the examiners final report, the projections were based onmanagements expectations that substantial improvements in Revcossales and margins would be achieved. Specifically, despite poor oper-ating results for fiscal years 1985 and 1986, according to the prospectus,management expected Revco to perform at the same levels it did duringthe 10 fiscal years before fiscal year 1985, when net sales grew at acompound annual rate of 19 percent and net earnings grew 23 percent ayear. Management did not think Revcos poor performance in fiscalyears 1986 and 1986 was indicative of the results it would achieve in1987 and beyond but instead attributed the results to various extraordi-nary events that were considered to be nonrecurring.Even before the LBO was closed, Revco was unable to meet its own finan-cial projections. For example, after receiving disappointing first quarterresults for fiscal year 1987, management revised its initial projectionsdownward. However, the examiners final report poin ted out that man-agement adjusted projections downward for only the first half of1987-projecti ons for the latter half of 1987 and the growth assump-tions underlying those projections remained unchanged. Furthermore,although Revcos second quarter results for fiscal year 1987 also fellshort of managements original projections, no further revisions in theprojections or growth assumptions were made, even though the resultswere announced more than 2 weeks before the buyout was closed.After the LBO, Revco did not achieve its projections for fiscal year 1987or the growth assumptions management made for fiscal years 1988through 1991. Specifically, the examiner reported that Revcos fiscalyear 1987 operating income was almost 30 percent below its revisedprojections, and, on the basis of the companys annual reports for fiscalyears 1988 through 1990, we calculated that annual increases in Revcosnet sales were 4 percent or less, operating profit before depreciation as apercentage of sales was below 7.7 percent each year, and gross retail



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-Appendix IIICaee Study: LB0 of Revco D.S., Inc.

footage declined each yearSZOccording to Revcos fiscal year 1989annual report, the companys inability to achieve projected operatingresults was a major factor in its Chapter 11 filing.

Corporate ControlChanged After LB0 After the LBO, corporate control at Revco underwent many changes,including an increased equity stake by the management investors andheavy turnover among executive officers. As of October 3 1, 1986, beforethe LDO, the management investors owned about 3.1 percent of Revcosoutstanding common stock. After purchasing about $10.2 million inAnac c ommon stock in the buyout, 21 he management investors ownedabout 19.5 percent of the total voting capital stock of Anac, on a fullydiluted basis.According to the examiners final report, significant concerns about theability of Revcos pre-r,Bo management to successfull y run the companyin a highly leveraged environment were developing before the closing ofthe deal. For example, the banks that organized the senior debtexpressed doubt as to whether Revcos pre-Lso chief executive officer(CEO) was capable of operating the company on a daily basis when it hadsuch a heavy debt burden. The examiner reported that Anacs financialadviser indicated to the banks that the daily management responsibili-ties of the pre-1,noCEO would be significantly diminished after the LBO. nfact, 3 months after the deal was closed, a new CEOwas named.During fiscal year 1988, the first full year after t he buyout, Revcosmanagement team changed significantly due, in part, to the boards elec-tion of another CEO in October 1987,7 months after the initial change inChanges in t he accounting method used and the exclusion of operating results of units to bedivested make Revcos post-LB0 datd incomparable to its historical results of operations. To enhancecomparability of pre- and post-LB0 data, Revco prepared unaudited pro forma statcmcnts, whichassumed the merger and divestiture program were completed at the beginning of fiscal year 1987.Subsequent to fiscal yt:ar IRRR-after the Chapter 11 filing-management changed the drugstores tobe divested. In order for prc- and post-filing data to be comparable, Revco made unaudited pro f ormaadjustments to fiscal years 1987 and 1988. During fiscal year 1990, management announced it wouldbe selling over 700 drugstores. Operating results of t hese stores were excluded from the companysfourth quarter operating results for fiscal year 1990. Thus, to enhance compdtabihty between fiscalytyar 1990 and previous years, Rcvco prepared pro forma financial statements for fiscal years 1988l.hrough 1990. We used pro f orma data when comparing changes between years.The management investors purchased Anac common stock for $6.946 a share, the Sameprice paidby other investors. According to the Revco examiners final report, the management investors paid anaggregate n cash of about $756,000, issued promissory notes of about $200,000, and transferred238,867 shares of old Rcvco common stock.sFully diluted basis assumes conversion of convertible preferred stock into Anac common stock butdoes not. assume the grant or exercise of any employee stock options to purchase Anac common stock



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this position. Attempting to improve Revcos performance, the new CEOessentially installed a new management team: only 7 of the 22 fiscalyear 1987 officers remained at the end of fiscal year 1988 and 12 newofficers were hired. As a result of the high turnover, the number ofexecutive officers that had been employed with the company for over 5years was significantly less than before the buyout-about one-third offiscal year 1988 officers had been with Revco for over 5 years comparedwith 90 percent of the officers during fiscal year 1986, before the LRO.Because we did not talk with Revco officials, we could not determine theeffect that the high turnover in management had on Revcos operationsand the business decisions being made.

Vendor ConfidenceDeclined, Leading toErosion of Trade CreditDuring fiscal year 1988, as Revcos financial situation and ability to ser-vice its debt worsened, vendors confidence in Revcos ability to meet itsobligations began to decline. It became increasingly difficult for the com-pany to buy on credit from some of its vendors, who began demandingcash-on-delivery. The erosion of trade credit placed additional strain onRevcos ability to deal with its inventory problems because it furtherexacerbated Revcos lack of funds for restocking shelves with needed,saleable merchandise. Revco subsequently filed for Chapter 11protection.According to the Chairman of the Trade Creditors Committee-the com-mittee that represents Revcos vendors in the Chapter 11 proceedings-almost all of Revcos vendors interrupted shipments of merchandisefrom the date of the filing, July 28, 1988, until August 24, 1988, whenRevcos debtor-in-possession (D-I-P) financingz3 was approved. TheChairman explained that this time frame had been critical becauseRevco had no financing in place, and consequently vendors had no confi-dence that they would be paid. The combination of eroding credit andvendors refusal to ship merchandise created significant out-of-stockconditions that led to a deterioration in customer confidence.According to the Chairman, the D-I-P financing was instrumental inrestoring vendor confidence because of its unique terms. The termsgranted more security to vendors than is usual under the bankruptcycode, in which vendors are generally unsecured lenders. Specifically,vendors who extended customary payment terms to Revco after thefiling date were given a super-priority lien, which gave them the same3The D-I-P financing was a $145 million line of credit provided by a syndicate of banks for Hevcosuse in continuing its operations while in bankruptcy.



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Appendix IIICase Study; LB0 of Revco D.S., Inc.

level of security as the banks providing the funds. Thus, if Revco couldnot make post-filing payments, those vendors had the same claim onRevcos assets as the banks. Revcos fiscal year 1990 annual reportcredits the D-I-P financing with enabling the company to begin restoringvendor support, improving its out-of-stock condition, and restoring cus-tomer confidence.

Capital SpendingRestricted After LB0 After the LBO, Revcos capital expenditures were reduced because ofrestrictions in the senior debt credit agreement. Specifically, capitalexpenditures were limited to $37.5 million in fiscal year 1987 and to amaximum of $30 million annually thereafter. This was much less thanbefore the buyout when, from fiscal year 1981 to fiscal year 1986,Revcos capital expenditures had been about $48 million, $45 million,$32 million, $58 million, $90 million, and $96 million, respectively. Man-agement did not anticipate that the restrictions would adversely affectRevcos efforts to maintain and modernize its drugstore division,because significant levels of expenditures and improvements had beenmade since 1981. For example, at the end of fiscal year 1986, manage-ment estimated that approximately 75 percent of all Revcos pre-Lsodrugstores were either new or had been remodeled within the past 5years.Because we did not talk with Revco officials, it is difficult to determinewhether the restrictions impeded the companys modernization efforts.However, it appears that Revco was unable to complete its moderniza-tion program during 1988 as it had indicated it would in its 1987 annualreport. The program, which included remodeling existing stores to adoptmajor aspects of a new store prototype, was still ongoing at the end of1988 but had become subject to the companys overall reorganizationprocess. Furthermore, contrary to Revcos pre-LB0 goal of expandingdrugstore operations through opening or acquiring 100 drugstores ayear for the next 5 years, 24 here was a net decline of 91 drugstores atthe end of fiscal year 1988,2 months before Revco filed for Chapter 11protection.

a41roxy (Nov. 14, 1986), p. 44.



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Bond Values Declined asRevcos PerformanceDeterioratedRevco has five bond issues outstanding, two of which were issued beforethe LBO. Under the provisions of the two pre-LBo bonds, Revco could notsecure the senior debt financing without equally and ratably securing26these bonds. To satisfy the provisions, Revco modified the terms of oneof the bond series-after obtaining consent from at least two-thirds ofthe bondholders-so that in lieu of receiving equal and ratable security,holders of the bond received a flat payment and a l-percent increase inthe bonds interest rate. Holders of the other pre-LBo bond were grantedequal and ratable security in the collateral with the banks: a lien andsecurity interest in substantially all of Revcos assets. The other threebonds were issued as part of the LB0 financing and were unsecured obli-gations of Revco. As Revcos performance deteriorated after the LRO, hevalue of its bonds similarly declined as evidenced by Moodys InvestorsService downgradingz6 in their investment ratings and their diminishedprices.Before the LBO, Moodys downgraded the investment ratings on Revcospre-r,l%o onds from A3 to Bl, indicating that the bonds investment riskhad increased and that they now provided less assurance that interestand principal payments would be paid in the future. The downgradingof these ratings before the LHO illustrates the adverse effects pre-1,130bondholders may have when a buyout is pending that will add riskierlevels of high-interest, low-rated debt.After the buyout, investment ratings on all five bonds were downgradedtoward the end of fiscal year 1988, as indicated in table 111.3.

%Zually and ratably secured means that after securing the new debt, already existing debt mustcontinue t,o have the same proportion of collateral it had bef ore the new debt was secured.The purpose of Moodys ratings is to provide the investors with a simple system of gradation bywhich the relative investment qualities of bonds may be noted. Gradations of investment quality arcindicated by rating symbols, each symbol representing a group in which the quality characteristicsare broadly the same. There are nine symbols as shown below, from that used to designate leastinvestment risk (highest investment quality) to that denoting greatest investment risk (lowest invest-mc:nt quality): (1) Aaa, Aa, A; (2) Baa, Ba, B; and (3) Caa, Ca, C.Moodys applies numerical modifiers, 1, 2, and 3, in each generic rating classification from Aathrough 13 n its corporate bond rating system. The modifier 1 indicates that the security ranks in thehigher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modi-fier 3 indicates that the issue ranks in the lower end of its generic rating category.



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Table 111.3: nvestment Ratings for RevcoBonds Datelo/88 1 /86 04166 OS/86 07188--.- --Pre-LB0-_. --1 i;Z$ercent sinking fund debentures due in A3 I31 83 Caa Ca

iTl225-percent notes due in 1995a A3 Bl 83 Ca Ca-----Post-LB0 ~----____ __-- ___- ___-13~;L$$rcent senior subordinated notes due b B2c Caa Ca Ca_-- ---. __-13.30.percent subordinated notes due in 1996 b B2c Caa Ca Ca13/;0;80ecent junior subordinated notes due b B3C Caa Ca CaNote: Dates selected reflect all rating changes by Moodys from January 1986 to December 1990%terest rate increased to 12.125 percent after the LB0 as part of modificati ons made to the bondsterms to allow the senior debt f inancing to be secured.bRattngs were not yet asstgned for post-LB0 bonds.CPer examtners final report, rating assign ed by Moodys Speculati ve Grade Service on November 20,1986.Source: Moodys Bond Record

Moodys revised Revcos bond ratings at times that generally corre-sponded to periods of stress within the company and where Revcoscredit became more questionable. For example, ratings were down-graded for all five bonds in both April and June 1988, when Revco washaving difficulty servicing its debt. Revco announced in April that itmight not make its June 15th interest payment, then was unsuccessfulin attempts to restructure its debt, and finally failed to make the June15th interest payment. As of July 1988, the month Revco filed forChapter 11 protection, all of its bonds had been downgraded to Ca.Moodys generally assigns this rating to bonds that are in default orhave marked shortcomings indicating they are speculative to a highdegree. As of June 1991, the Ca rating had not been revised and stillrepresented Moodys assessment of the investment quality of Revcosbonds.All five bonds were originally sold at par? except for one pre-Lno bond,which was sold slightly below. As Revcos performance deterioratedafter the 1,130,the prices of its bonds-especially those issued to financethe r>no-also declined. Table III.4 illustrates the price changes.

71Jar is the redemption value of a bond that appears on the face of the bond certificate, unless thatvaluc~ s othcrwisc specified. The 93,750 units through which t he junior subordinated notes wereissued were sold for $1,000 each.



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Table 111.4:Rwcoa Bond Prices (PricesAre Rounded) Date12187 04188 06188 12188 12189 12190-- --Pm-LB0 bonds11.7dpercent sinking funddebentures due in 2015 $850 a a a $850 $600Il. 125percent notes due in 1995b 870 $790 $790 $650 700 710Post-LB0 bonds13.125-percent senior subordinatednotes due in 1994 c 590 530 500 420 110~__ .-13.30-percent subordinated notesdue in 1996 c a a a a -d13.30-percent junior subordinatednotes due in 2001 c 440 320 160 80 30Note, Except for the period of time right before filing for Chapter 11 protection, when Revc o was havingdrffrculty servic ing its debt, dates selected reflect year-end bond prices. All bonds have a $1,000 facevalue.aNo prrce was listed in Moodys Bond Record.blnterest rate increased to 12.125 percent after the LB0 as part of modifications made to the bondsterms to allow the senior debt f inancing to be secured.?3ubordinated bonds were not listed in Moodys Bond Record at thus pornt.dAccording to Moodys offrcrals, - rndrcates that erther no data were available or the bond was nottrading.Source: Moodys Bond Record.

Unable to Service Its Debt, Inadequate proceeds from the asset divestiture program, continuingRevco Filed for Chapter 11 inventory problems, eroding trade credit, and inability to borrow fundsProtection from the revolving credit facility or to achieve projected operatingresults led Revco to announce in April 1988 that it might not be able tomeet pending debt obligations. The company hired Drexel BurnhamLambert Inc. to help restructure its debt through a debt-for-equity swap.Their efforts were not successful, and as discussed, Revco was unable tomake its June 15th interest payment of $46.5 million on its subordinateddebt. Afterwards, holders of more than 25 percent of the senior subordi-nated notes informed the company of their intention to accelerate thematurity date on the principal amount of $400 million. The percentageof notes involved was high enough that the entire issue would have beenaccelerated. This, combined with the existing problems listed above,caused Revco to file for Chapter 11 protection under the bankruptcycode on July 28, 1988.As of the date Revco filed for Chapter 11 protection, substantially all ofits pre-filing secured and unsecured debt was deferred while the com-pany continued to operate its business as a D-I-P. Operating as a D-I-P



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Appendix IIICaee Study! LB0 of Revco D.S., Inc.

means the company cannot engage in transactions outside the ordinarycourse of business without first complying with the bankruptcy codeand, when necessary, obtaining bankruptcy court approval. Until thebankruptcy court approves a plan of reorganization, Revco does nothave to meet scheduled principal payments on senior debt or payinterest expense on unsecured debt after the filing date.By May 19,1989, Revco had received about 7,800 proofs of claims fromcreditors. Although numerous claims did not specify the amountclaimed, those that did totalled approximately $9.3 billion. According toits 1989 annual report, the company thought this overstated its liabili-ties and was an unreliable estimate because creditors had filed duplicateand unrealistic claims. Revco is now reconciling claims that differ fromits records and is evaluating them to determine which are likely to beallowed by the bankruptcy court. At the end of June 1990, Revco hadpaid about $11.6 million of allowed claims, pursuant to an order of thebankruptcy court dated August 13, 1989.2s

Financial Indicators of After the LBO, Revcos performance deteriorated rapidly until the com-Revcos Performance pany was forced to file for Chapter 11 protection from its creditors.Revcos changing financial position is reflected by changes in the com-After the LB0 panys debt-to-equity ratios, ability to service debt, and profitability.Revcos Debt BurdenIncreased SignificantlyAfter LB0

Changes in a companys debt burden are reflected by ratios of its debt tototal common stockholders equity (hereafter we refer to total commonstockholders equi ty as equity). After the LBO, Revcos debt increasedsignificantly with respect to its equity, which actually was negative only5 months after the buyout due to a net loss and dividend obligations onredeemable preferred stock. As Revco continued to report losses and itsdividend obligations accumulated, the deficit in equity increased eachfiscal year after the buyout.Because Revcos equity was negative after the buyout, calculating ratiosof debt to equity is meaningless. However, Revco had prepared debt-to-equity ratios before the buyout reflecting how it expected the debtburden to change. Specifically, on August 23, 1986, Revcos total debt-

sThe order authorized

gao case studies of selected lbos, 1991

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