Tuesday, May 14, 2013

Two Botched Leveraged Buyouts and the First Modern Philanthropist

On this day in economic and business history...

The leveraged-buyout industry (also known as private equity) gained a particular notoriety during the 2012 presidential campaign. However, the history of that industry is not particularly lengthy. In fact, it begins right around the time that losing candidate Mitt Romney began his career at Bain Capital. The very first time a leveraged buyout took a major public company private was on May 14, 1979, when Kohlberg Kravis Roberts (NYSE: KKR  ) paid $355 million for struggling manufacturer Houdaille Industries.

The deal, $300 million of which was debt-financed by multiple banking and insurance companies, took nearly a year to put together and firmly established KKR as an investment fund to follow. Ultimately, KKR kicked in a microscopic $1 million toward the buyout. Houdaille shareholders, who held $15 shares before the offer, walked away with $40 per share -- more than anyone reasonably expected to get for a weak manufacturing concern at the tail end of the stagflation-addled '70s. KKR promised a "pot of gold" for investors on a proposed 1984 public offering, but economic forces would not be kind to Houdaille.

Max Holland, writing for Washington Decoded decades later, laid bare the details behind this unprecedented buyout and the glaring flaws it revealed years later:

Wall Street immediately recognized that the financial rules were no longer the same. "The public documents on that deal were grabbed up by every firm on Wall Street," one buyout artist, Frank Richardson, recalled several years later. "We all said, 'Holy mackerel, look at this!'" ...

Normally ... a corporation the size of Houdaille has a comfortable cushion -- its own equity -- to fall back on. It can suspend dividend payments if need be, or borrow against its equity if new investment is needed. But a leveraged company has only one option: service the debt, even if it means breaking up the company.

The unexpected came in the form of a recession and foreign competition. Nothing like the deep 1981-1982 recession had been forecast when Houdaille underwent its LBO in 1979. As if that wasn't enough, seemingly overnight Houdaille was also facing the specter of fierce competition in a business segment that was supposed to be a safe niche: machine tools. The Japanese were making startling inroads into the American market, long the almost exclusive preserve of U.S. builders like Houdaille.

The market conditions of 1979 offered a rare bright spot in over a decade of weak market returns, but there were many headwinds against the deal's success. The grinding early-'80s recession was worse from an inflation-adjusted viewpoint, as it occurred during Fed Chairman Paul Volcker's efforts to counteract high levels of inflation. The Dow Jones Industrial Average (DJINDICES: ^DJI  ) fell to its final low point in a decade-plus secular bear market that had given investors negative real returns since the late 1960s. As Holland notes, Japanese competition would also threaten American manufacturing in many industries beyond Houdaille's niche.

Houdaille was gone from the American corporate landscape by 1987. This did not slow the leveraged-buyout industry down; indeed, its greatest triumphs occurred after Houdaille vanished. KKR wasn't set back much by Houdaille's failure, and it has remained on the leveraged-buyout vanguard ever since, completing a record-setting buyout of RJR Nabisco in 1989. More recently, KKR joined forces with other private-equity firms to complete a $45 billion buyout of Texan utility TXU. This deal, unfortunately, now more closely resembles KKR's early failure. The renamed utility is drowning under $52 billion in debt, and the failed bet on high natural-gas prices has meant that KKR and its compatriots may eventually have to write off the deal at a significant loss.

The foundation of modern philanthropy
John D. Rockefeller and his son, John D. Rockefeller, Jr., established the nonprofit Rockefeller Foundation on May 14, 1913. With an initial contribution of $35 million and another $65 million added the following year, the Rockefeller Foundation immediately leapt to the fore of American charitable organizations, which it in fact helped to pioneer -- only the nonprofit Carnegie Corporation is older. Guided by "Junior" during its early years, the foundation soon established a model of charitable giving that has since been emulated by many of the world's wealthiest people, incorporating its wealthy founders' goals into a broader, results-driven approach learned from the business world. Its guiding mission, "to promote the well-being of mankind throughout the world," was channeled primarily into education and health initiatives -- similar to the philanthropic efforts of that latter-day Rockefeller, Bill Gates.

The Rockefeller Foundation had its glaring flaws, most notably in its support of German eugenics programs leading up to World War II. This stain on the Foundation's integrity didn't stop it from pursuing nobler goals after the depth of Nazi depravity was revealed, and today the Foundation remains one of the most influential nongovernmental organizations in the world, with a multibillion-dollar war chest and a century of experience to draw on.

Are you cured yet?
The first known vaccination took place on May 14, 1796, when English physician Edward Jenner used fluid from a cowpox-infected cow's udder (ew, gross) to purposely infect an 8-year-old boy. Luckily for Jenner, people then were far less likely to sue for medical malpractice, and he was able to test a smallpox sample on the boy several weeks later. When no smallpox developed, Jenner knew that he had successfully vaccinated his subject against the terrible disease.

Today, most major pharmaceutical companies have large vaccine-manufacturing operations. Thanks to this capacity, several diseases (including smallpox) have been virtually eradicated, and vaccination rates for formerly dangerous communicable ailments approach or exceed 90% in many parts of the world. Vaccination has been one of the great drivers of life-expectancy gain in the centuries following Jenner's discovery, and although medical science is far from curing everything, we're a lot closer to a disease-free humanity than we were when infected udders were the best way to stave off sickness.

Apple v. Apple
John, Paul, George, and Ringo of the Beatles founded Apple Corps on May 14, 1968. At the height of their "more-popular-than-Jesus" global music dominance, the Beatles had the enviable problem of simply making too much darn money. Individually, the Beatles would be taxed out the "Hey Jude" by the British government. Collectively, as business owners, they could save enough money to buy Abbey Road, and then some.

However, the Beatles were far better musicians than businessmen. Subsidiaries to make electronics, produce films, and sell retail products were all terrible failures, and outside of the Beatles catalogue (later bought by Michael Jackson), there wasn't much that anyone wanted to buy. Apple Corps eventually became known primarily as the launchpad for numerous lawsuits, many of which were aimed squarely at Steve Jobs' Apple (NASDAQ: AAPL  ) .

Apple v. Apple is now legal shorthand for a long-running series of lawsuits between the two parties, beginning in Apple's (the computer maker) second year of existence and plodding on until 2007. For a while, this meant that Beatlemania never came to iTunes, but after a final agreement in the year of the iPhone's debut, the two parties patched things up over a reported $100 million settlement from the big Apple to the smaller, British Apple.

There's no doubt that Apple is at the center of technology's largest revolution ever and that longtime shareholders have been handsomely rewarded. However, there is a debate raging as to whether Apple remains a buy. The Motley Fool's senior technology analyst and managing bureau chief, Eric Bleeker, is prepared to fill you in on reasons both to buy and to sell Apple, as well as what opportunities remain for the company (and your portfolio) going forward. To get instant access to his latest thoughts on Apple, simply click here now.

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