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Overview

When we think of the 1980s, one of the first images that comes to mind is that of a yuppie. A yuppie was someone who spent money on luxury items and other extravagances. The yuppies were thought to represent an excess in spending during the decade. In this story about Ross Johnson and RJR Nabisco, you’ll learn more about how leveraged buyouts came into being; how Ross Johnson rose through the ranks at RJR Nabisco; why he became so successful there; and why it made such an attractive target for hostile takeovers.

Big Idea #1: Wall Street’s modern-day modus operandi started out as a work-around to avoid estate taxes.

Leveraged buyouts, or LBOs, are a way to preserve family wealth. They were devised by clever lawyers in the 1980’s who wanted to help wealthy business owners pass their money onto their heirs. These transactions came about at the same time that many of those business owners were getting ready to retire from running their companies.

Because of the estate tax, business owners would have to pay a lot in taxes if they wanted to retire and pass their companies on to heirs.

People who owned a company were faced with three options. First, they could pass the business onto their child and pay the taxes in full. Second, they could sell it to someone else, giving up control of the business. Thirdly, they could go public by selling shares of stock in their companies on an exchange like Wall Street and let people buy and sell those shares as if they were stocks in other companies.

There are three choices for punishment: death, life in prison and the chair. However, none of these options was appealing. Therefore, a lawyer named Jerry Kohlberg came up with an alternative solution that involves long-term imprisonment.

If someone is retiring, they can just form a shell company with other people and get them to buy their business for a much lower price than what it would be if the business was purchased in an open bidding war.

To acquire a company, investors would use bank loans and insurance bonds to pay for the acquisition. In other words, they would only put in ten percent of the money while getting back thirty percent from insurance bonds and sixty percent from bank loans. This means that they acquired the target company for almost nothing while putting a massive amount of debt on it.

Big Idea #2: In the 1980s, LBOs were turned into money-making machines, prompting both impassioned praise and critique.

In 1982, a company called Gibson Greetings was sold for $80 million to an investment group that had paid just $1 million of the cost themselves. A year and half later, the firm went public and was resold for $290 million. The primary individual investor put down $330,000 and turned it into $66 million; in other words, the LBO craze took off by 1983.

The frenzy was caused by the US Internal Revenue Code, which allowed interest tax deductions but not dividends. This encouraged companies to go into debt and pay their debts instead of making a profit.

Second, the appearance of junk bonds made it possible to raise a massive amount of money in a short period. Junk bonds enable an LBO (leveraged buyout) to happen quickly and aggressively as opposed to slowly over time. This raised concern about whether or not this was a good thing since companies were being taken over more quickly than ever before, but proponents said that this made firms leaner and increased their value which is true because debt can be used by investors to streamline the business without mercy, cutting costs wherever possible.

LBOs were criticized because they increased the debt of companies. This meant that many employees lost their jobs when a company went bankrupt.