Journal of Applied Corporate Finance

S P R I N G 19 9 3 V O L U M E 6. 1

The Evolution of Buyout Pricing and Financial Structure

(Or, What Went Wrong) in the 1980s
by Steven N. Kaplan,
University of Chicago, and
Jeremy C. Stein,
Massachusetts Institute of Technology
THE EVOLUTION OF by Steven N. Kaplan,
University of Chicago, and
BUYOUT PRICING AND Jeremy C. Stein,
FINANCIAL STRUCTURE Massachusetts Institute of Technology*

(OR, WHAT WENT

WRONG) IN THE 1980s

he leveraged buyout boom of the late

T 1980s has given way to the buyout bust
of the early 1990s. After rising from less
than $1 billion in 1980 to a peak of more
than $60 billion in 1988, buyout volume fell dramati-
cally, to less than $4 billion in 1990 and to under $1
billion in 1991.
How does one make sense of this enormous
rise and abrupt fall? According to a wide range of
observers, from financiers to journalists, the story is
a straightforward one, albeit one that does not fit
comfortably with traditional notions of efficient
markets. Simply put, the buyout market over-
heated—the success of early deals attracted a large
inflow of new money and, by the late 1980s, too
much financing was chasing too few good deals.
The end result was that many transactions were
overpriced, recklessly structured, or both. In this
view, the decline in buyout volume since 1989
represents a warranted market correction.
Many statements of the “overheated buyout
market hypothesis” point directly to the widespread
use in later deals of publicly issued, subordinated
debt—that is, “junk bonds”—as an important factor.
Forbes quoted one buyout specialist as saying: “It
was so much easier to go to the public markets. It
was cheaper, and there were very few covenants...
It was fantasy.” The Forbes article went on to say, “As
long as the junk bond market existed, smart money
was able to raise dumb money from passive inves-
tors—money that would accept high risks for skimpy
rewards.”1

*This is a shorter, less technical version of an article originally published in

Quarterly Journal of Economics (May, 1993).
1. R. Smith, “The Takeover Game Isn’t Dead, It’s Just Gone Private,” Forbes,
October 1, 1990, 63.

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APPLIED CORPORATE
CORPORATE FINANCE
FINANCE
 With the benefit of hindsight, there appears to
be some support for this “overheating” hypothesis.
We recently completed a study of 124 large manage-
ment buyouts (MBOs) executed between 1980 and
1989. Of the 41 deals in our sample put together
between 1980 and 1984, only one defaulted on its
debt—a default rate of just over two percent. In stark
contrast, 22 of 83 deals completed between 1985 and
1989 had defaulted as of August 1991—a rate of
almost 27%. Nine of these defaulted transactions had
landed in bankruptcy court by that time. (Since
August 1991, four more of the later buyouts have
defaulted and nine more have filed for bankruptcy.)
Of course, hindsight is always 20/20, and the
poor outcomes in the later deals may have been at
least partly the product of subsequent develop-
ments, rather than poor deal pricing or structuring.
Such developments could have included adverse
macroeconomic conditions as well as regulatory
actions that made it more difficult and costly to
restructure troubled buyouts.2 The primary aim of
our study of MBOs was to determine whether there
were indeed important differences ex ante between
the deals done in the latter part of the decade and
those done earlier. In other words, are there reasons
to believe the later deals were the product of an
overheated market and, thus, more likely to run into
difficulties, or should any such difficulties instead be
attributed largely to bad luck?
Our study focused on three broad categories of
data that bear on the overheating hypothesis. The
first relates to the overall prices paid to take
companies private. Regardless of the details of the
capital structure, or the extent to which there are
costs of financial distress, it is clear that investors will
earn lower returns as the prices paid increase
relative to the fundamental value of company assets.
The second category of data we examined
pertains to buyout capital structure. Even if the price
paid to take a company private is a reasonable
multiple of cash flow, a poorly designed capital
structure raises the probability and costs of financial
distress, thereby lowering the prospective returns to
some classes of investors. In evaluating this possibil-
ity, we went beyond relying just on aggregate
measures of leverage such as interest coverage and
debt-to-capital ratios. While these measures can
2. See Michael Jensen, “Corporate Control and the Politics of Finance, Journal
of Applied Corporate Finance, Vol. 4 No. 2 (Summer 1991). Jensen subscribes to
the view of an overheated buyout market, but then goes to argue that the costs of
73
VOLUME 6 NUMBER 1
provide useful information about the likelihood that
a company will fail to meet its contractual obliga-
tions, they have less to say about the attendant costs
of default. In principle, very low coverage need not
impose large costs as long as the debt is structured
in such a way as to lead to speedy, low-cost
renegotiation. For this reason, we focus not just on
the absolute magnitude of the debt burden, but also
on the contractual features of the debt—seniority,
maturity, and the division between public and
private lenders.
The third and final category of data we looked
at concerns the incentives of buyout investors. One
of the supposed spurs to improved performance in
buyouts is the increased equity stake of manage-
ment; managers who own a large percentage of
post-buyout equity might be expected to do a better
job. On the other hand, managers who “cash out” a
large fraction of their pre-buyout equity holdings at
the time of the deal may have more of an incentive
to take part in an overpriced or poorly structured
transaction. A similar argument can be made when
large upfront fees are paid to other interested
parties. We examined whether these types of incen-
tives changed over time.
Our study documented a large number of
changes in the buyouts of the late 1980s relative to
those done earlier:
Buyout price to cashflow ratios rose, though not
more sharply than market- or industry-wide ratios;
Prices were particularly high in deals financed
with junk bonds;
As prices rose, buyouts were undertaken in
riskier industries, and with somewhat higher le-
verage ratios;
Banks took smaller positions in later deals and, at
the same time, accelerated required principal repay-
ments, leading to sharply lower ratios of cash flow
to total debt obligations;
Public junk debt displaced both private subordi-
nated debt and the associated practice of “strip”
financing (in which subordinated debtholders also
receive equity stakes), thereby raising the expected
costs of financial reorganization;
Finally, management and other interested parties
such as investment bankers and deal promoters took
out more money up front in the later deals.
such overheating were greatly exacerbated by regulatory obstacles to financial
reorganization.
SPRING 1993
TABLE 1 (3) (4) (5)
PRICING (1) (2) Net Cash Flow EBITDA Market (6)
Number Capital to Capital to Capital E/P ratio Premium
Year of MBOs ($ Millions) (as %) (as %) (as %) (as %)

1980-81 6 397.3 8.85 16.30 11.25 51.1

1982 8 164.2 13.27 17.18 13.24 64.8
1983 10 392.3 7.10 13.54 8.07 34.4
1984 17 383.4 7.85 14.34 9.86 40.8
1985 12 923.3 8.39 12.98 8.53 25.7
1986 15 371.1 7.54 13.48 6.01 38.7
1987 20 439.0 4.48 10.81 5.03 41.2
1988 31 476.7 7.27 11.48 6.93 48.1
1989 5 315.5 9.16 13.32 7.86 56.7

Total 124 395.4 7.56 12.75 7.65 43.0

N Obs. 124 120 124 124 122

Time Trend
(+) (–)** (–)*** (–)*** (+)
1980-82 vs. 1983-85
(+)* (–)** (–)*** (–)*** (–)***
1983-85 vs. 1986-89
(+) (–)** (–)*** (–)*** (+)**

*** Medians significantly different over time or in comparison periods at 1 percent level; ** at 5 percent level; and * at 10 percent
level.

THE SAMPLE
Our sample of buyouts was taken from compa-
nies listed either as leveraged buyouts or as acqui-
sitions by private companies in Securities Data
Corporation’s merger database, Morgan Stanley’s
merger database, and W.T. Grimm’s Mergerstat
Review from 1980 to 1989. We restricted this sample
to large management buyouts (those with transac-
tion value greater than $100 million) in which at least
one member of the incumbent management team
obtained an equity interest in the new private firm.
We focused on MBOs because pre-transaction data
for these transactions are generally more readily
available and more complete.
We found 124 buyouts completed between
1980 and 1989 that satisfied these criteria. As shown
in Column 1 of Table 1, the number of such large
MBOs increased steadily (with the exception of
1985) throughout the ’80s, and then fell off sharply
after 1988. The median buyout in our sample had
total capital of $395 million; and although there is a
trend toward increasing size over time (see Column
2), that trend was not statistically significant over the
entire period.
For each MBO in our sample, we gathered
information describing the transactions from proxy,
10-K, 13-E and 14-D statements, and the Wall Street
Journal, and collected post-transaction data from
the COMPUSTAT Tapes. We also attempted to
determine the extent of post-buyout financial dis-
tress by searching the NEXIS database for the buyout
companies and by reading post-buyout financial
statements. Post-buyout financial statements and
other data were available for 89 of the 124 MBOs.
BUYOUT PRICING
The first question we asked was, How did
buyout prices vary over time relative to fundamen-
tals? We measured the buyout price (which we also
refer to as “total capital”) as the sum of (1) the market
value paid for the firm’s equity; (2) the value of the
firm’s outstanding debt; and (3) the fees paid in the
transaction; minus (4) any cash removed from the
firm to finance the buyout.

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 Of the 41 deals in our sample put together between 1980 and 1984, only one
defaulted on its debt—a default rate of just over two percent. In stark contrast, 22 of
83 deals completed between 1985 and 1989 had defaulted as of August 1991—a rate
of almost 27%.
Cash Flow to Price Ratios Over Time
We considered buyout prices in relation to two
primary measures of operating cash flow. The first
was earnings before interest, depreciation, amorti-
zation, and taxes (EBITDA). EBITDA is a measure of
gross cash generated from operations, and thus
represents an upper bound on the cash available to
pay investors. The second measure, net cash flow,
equals EBITDA less capital expenditures.
The ratios of both net cash flow and EBITDA to
capital declined significantly over time, exhibiting a
pattern (see Columns 3 and 4) broadly consistent
with the popular notion that buyout prices rose
relative to fundamentals in the 1980s. Furthermore,
both ratios were significantly lower for late-1980s
buyouts than for mid-1980s buyouts, and signifi-
cantly lower for mid-1980s buyouts than for early
1980s buyouts.3
The decline in buyout cash flow to price ratios
over time was not, however, a phenomenon that
distinguished the LBO market from other U.S. capital
markets. As shown in column 5, the earnings to price
ratio of the entire S&P 500 also fell during the 1980s,
as the general level of the stock market rose.4
The fact that buyout prices seemed to move
largely in line with the rest of the stock market can
be interpreted in two ways. On the one hand, if we
maintain the assumption that the stock market as a
whole is efficient, then the absence of a buyout-
market-specific pattern in prices casts a measure of
doubt on the overheating hypothesis. On the other
hand, it could be argued that if we are going to
entertain the possibility of overheating at all, it may
be unnatural to expect it to be completely confined
to just the buyout market.
Another way to gauge the extent of a buyout-
specific trend in prices is to examine the “premiums”
paid in buyout transactions. We measured such
premiums as the percentage difference between the
price paid for a firm’s equity and the price two
months before the first announcement of buyout or
takeover activity. Here again, as shown in Column 6,
the data provided little support for a buyout-specific
3. In much of the analysis in this study, we used two different methods to
quantify the statistical significance of the temporal patterns in the data. First, we
measured the non-parametric or rank correlation between (all individual observa-
tions of) our variables and a simple annual time trend over the entire period 1980
to 1989. Second, as in the results just cited, we also used non-parametric rank tests
to compare the values of the variables in three distinct periods: 1980 to 1982 (or
the “early 1980s”); 1983 to 1985 (or the “mid-1980s”); and 1986 to 1989 (or the “late
1980s”).
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VOLUME 6 NUMBER 1
pricing phenomenon. Premiums showed no signifi-
cant trend during the 1980s.
In sum, the time series data presented in this
section provide somewhat mixed support for the
overheating hypothesis. Although buyout prices
increased over the decade, this increase was not
specific to the buyout market; it was evident in the
broader stock market as well. This is not, how-
ever, our final word on buyout pricing. We later
discuss how such pricing was affected by other
variables in the buyouts, especially the use of junk
bond financing.
AGGREGATE DEBT BURDENS AND THE
RISKINESS OF BUYOUT COMPANIES
Pricing is only one of several factors that can
affect the ultimate success of a buyout. Even if a
buyout is completed at the “right” price, it may be
structured in a way that leads to higher expected
costs of financial distress. We now examine whether
capital structures in later deals changed in a way that
might have increased the ex ante likelihood and
costs of financial distress.
Changes in Buyout Company Risk
One cannot, of course, look at debt and
coverage ratios in a vacuum. The extent to which
a company’s debt ratio is deemed “high” or its
coverage is deemed “tight” should depend in part
on the underlying riskiness of its assets. Thus, we
started by analyzing changes in company risk over
time.
Our findings are summarized in Table 2, which
presents two measures of total risk. Column 1
presents a measure of total risk calculated using
financial data for the individual buyout compa-
nies—specifically, the standard deviation of the
growth rate of operating margins (where operating
margin equals the ratio of EBITDA to sales) over
the ten-year period leading up the the buyout. This
measure trends upward throughout the 1980s
(though not significantly). The late 1980s buyouts,
4. In our original study, we also provided crude market-adjusted measures of
buyout pricing by subtracting the earnings to price ratio of the S&P 500 (for the
quarter in which the deal was priced) from the buyout ratios of net cash flow and
EBITDA to capital. These market-adjusted measures did not exhibit a significant
downward trend; in fact, the trend for the net cash flow to capital ratio was even
slightly positive.
SPRING 1993
TABLE 2 Risk measures
RISKa
(1) (2)
Std. Deviation Fractional Change Brookings Study Estimated
Year in Operating Margin Std. Deviation Industry Earnings

1980-81 0.18 [6] 0.213 [6]

1982 0.19 [8] 0.249 [7]
1983 0.17 [10] 0.074 [9]
1984 0.13 [16] 0.249 [16]
1985 0.13 [11] 0.249 [12]
1986 0.19 [12] 0.348 [13]
1987 0.20 [17] 0.249 [18]
1988 0.18 [24] 0.249 [28]
1989 0.18 [3] 0.262 [5]
Total 0.17 [108] 0.249 [114]
Time Trend (+) (+)**
1980-82 vs. 1983-85 (–) (–)
1983-85 vs. 1986-89 (+)** (+)*

a. The two columns under each Risk Factor are the median and number of observations, respectively.
*** Medians significantly different over time or in comparison periods at 1 percent level; ** at 5 percent level; and * at 10 percent
level.

however, have significantly more risk than those in
the mid-1980s.
Column 2 presents a measure of industry total
risk used by a 1990 Brookings Institute Study
(hereafter referred to as “the Brookings Study”)5—
namely, the standard deviation of the growth rate of
industry real earnings. The pattern of changes in this
industry measure throughout the ’80s was similar to
that of our firm-specific measure. The risk was
significantly higher for buyouts of the late 1980s than
for those of the mid-1980s.
In sum, our measures of total risk suggest that
buyout companies in the late 1980s were somewhat
riskier than those in earlier years. Other things equal,
this would seem to dictate a more conservative
capital structure. With this observation in mind, we
now turn to the aggregate capital structure data.
Aggregate Debt Burdens
For each of the 124 companies in our sample,
we calculated the ratio of total post-buyout debt to
total capital, where total post-buyout debt equals the
sum of (the market value of) new debt issued to
finance the buyout and (the book value of) pre-
buyout debt retained. As shown in Column 1 of
Table 3, the median debt to total capital ratios
increased over time. The time trend was positive and
significant, and the ratios in 1986 to 1989 (with a
median of 90.3%) were significantly larger than
those in 1983 to 1985 (median 86.5%).
Moreover, our measure of total debt may have
understated the amount of debt in the capital
structure because it excluded preferred stock with
fixed commitments. In several cases, such preferred
stock was exchangeable into subordinated debt.
Accordingly, we calculated yearly medians of post-
buyout common stock to total capital, where post-
buyout common stock included preferred stock
convertible into common stock (but not straight
preferred stock or preferred stock convertible into
debt). As shown in Column 2, these common stock
ratios fell significantly over the ’80s, with the lowest
ratios (median of 5.56%) from 1986 to 1989.6

5. See B. Bernanke, J. Campbell, and T. Whited, “U.S. Corporate Leverage:
Developments in 1987 and 1988,” Brookings Papers on Economic Activity, I (1990),
255-286.
6. As was true of buyout pricing multiples, and will be shown to be true of
coverage ratios later, the equity ratios became more conservative in 1989, thus
suggesting a turning point. Arguably, the 1989 deals do not belong in our
classification of the late 1980s. These buyouts took place as the public junk bond
market began to falter and, thus, do not necessarily fit with the overheating
hypothesis. Indeed, the few observations we have suggest that the 1989 buyouts
were different from those of the preceding three years. Nevertheless, eliminating
1989 buyouts from the late 1980s sample has no effect on our statistical results.

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 Consistent with the lower cash flow to price ratios and rising leverage ratios, we
found a negative time trend for both interest coverage measures, with both net cash
flow and EBITDA to interest reaching a minimum in 1987 and 1988.

TABLE 3
AGGREGATE DEBT AND COVERAGE RATIOSa

(1) (7) (8) (9)

Post- (2) (5) Req’d Debt Net Cash EBITDA to
Buyout Common (3) (4) Net Cash (6) Repay in 2 Flow to [Cash [Cash
Debt to Stock to Net Cash EBITDA Flow EBITDA Years to Interest + Interest +
Capital Capital Flow to to to Cash to Cash EBITDA (Repay in 2 (Repay in 2
Year (as %) (as %) Interest Interest Interest Interest (as %) Yrs)/2] Yrs)/2]

1980-81 88.3 10.53 0.56 1.15 0.56 1.15 0.0 0.56 1.15
6 6 6 6 6 6 6 5 6
1982 87.3 6.67 0.90 1.28 0.90 1.28 0.0 0.75 1.16
8 8 8 8 8 8 6 5 6
1983 87.2 11.54 0.67 1.26 0.67 1.2 22.3 0.69 1.18
10 10 10 10 10 10 7 7 7
1984 88.7 7.91 0.74 1.29 0.74 1.29 32.3 0.66 1.12
17 17 17 17 17 17 11 11 11
1985 86.0 7.03 0.75 1.22 0.82 1.30 59.2 0.59 1.09
12 12 12 12 12 12 11 11 11
1986 90.7 5.60 0.73 1.50 0.73 1.75 160.0 0.36 0.72
15 15 13 15 13 15 10 8 10
1987 88.9 4.04 0.43 1.12 0.52 1.27 103.5 0.21 0.76
20 20 19 20 19 20 14 14 14
1988 90.5 6.13 0.60 1.11 0.70 1.16 103.5 0.41 0.66
31 31 30 31 30 31 21 20 21
1989 83.2 13.20 0.83 1.27 0.83 1.27 43.3 0.62 0.89
5 5 5 5 5 5 4 4 4
Total 89.1 6.52 0.68 1.20 0.74 1.27 60.0 0.46 0.89
124 124 120 124 120 124 90 85 90
Time Trend
(+)** (–)* (–) (–)* (–) (–) (+)*** (–)** (–)***
1980-82 v. 1983-85
(–) (+) (–) (–) (+) (+) (+)*** (–) (–)
1983-85 v. 1986-89
(+)*** (–)*** (–) (–) (–) (–) (+)*** (–)*** (–)***

a. The two rows in each cell are the median and number of observations, respectively.
*** Medians significantly different over time or in comparison periods at 1 percent level; ** at 5 percent level; and * at 10 percent level.

The increase in debt ratios and the decline in
equity ratios are interesting and somewhat puzzling
aspects of buyout financial structures. The higher
prices paid relative to cash flows in late 1980s
buyouts, even if perfectly rational, would appear to
suggest that these buyouts were associated with
more optimistic growth expectations than earlier
ones. But if the later deals were associated with
expected cash flows that were more “back-loaded”
in time (as well as somewhat riskier), one might have
expected them to be structured with less debt
relative to total value.
To explore this issue further, the remaining
columns of Table 3 present several measures of the
adequacy of current cash flows relative to contrac-
tual obligations. These measures use net cash flow
and EBITDA in the last full year before the buyout.
We calculated expected interest payments based on
the interest rates and debt amounts projected in the
proxy or 14D statements describing the buyouts.
Columns 3 and 4 compare net cash flow and
EBITDA to expected total interest payments in the
first post-buyout year. Consistent with the lower
cash flow to price ratios and rising leverage ratios,
we found a negative time trend for both interest
coverage measures, with both net cash flow and
EBITDA to interest reaching a minimum in 1987
and 1988.

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VOLUME 6 NUMBER 1 SPRING 1993
 The ratios in Columns 3 and 4 use total interest
obligations, which include both cash and non-cash
interest. Non-cash interest is associated with de-
ferred interest debt, which includes zero-coupon
and pay-in-kind (PIK) bonds. Including non-cash
interest payments may present a misleading picture
because the use of such payments (as we point out
later) increased significantly in the second half of the
1980s. In fact, they may have been introduced
precisely to allow firms with more “back-loaded”
cash flows to support high levels of debt.
To test for this possibility we repeated our
coverage calculations using cash interest payments
that excluded interest payments on deferred interest
debt. As expected, this adjustment improved the
relative standing of the coverage ratios of the later
deals (see Columns 5 and 6).
Although interest coverage is an often-used
measure of financial soundness, it does not fully
capture a firm’s ability to meet all its debt-related
obligations. Cash flow must also be devoted to
making principal repayments. Ninety of the 124
transactions in our sample reported a principal
repayment schedule for their bank debt. As shown
in Column 7, the ratio of required debt payments
(including principal repayments) for these 90 buyouts
rose sharply over time, with an pronounced break
between 1985 and 1986, when principal repayments
increased by a factor of more than 2.7.
We next repeated our coverage calculations,
this time considering how net cash flow and EBITDA
compared to total cash debt obligations (including
principal). As shown in Columns 8 and 9, these
coverages were substantially lower for 1986-1989
buyouts than for earlier deals. For example, the
median ratio of EBITDA to cash obligations was
always above one before 1986, but fell to between
0.76 and 0.66 for the 1986-88 period before recov-
ering somewhat to 0.89 in 1989. Similarly, the
median ratio of net cash flow to cash obligations,
which was always above 0.56 before 1986, did not
exceed 0.41 from 1986 to 1988. Again, the ratio
recovered in 1989, rising to 0.62.
This change in the coverage ratios after 1985
implies a sharp deterioration in the ability of buyout
firms to meet their total debt-related obligations out
7. Given that Kaplan’s study found a roughly 40% increase in net cash flow
for a sample of management buyouts announced between 1979 and 1985, it is hard
to see how operating cash flows could be expected to meet required debt service
payments. See S. Kaplan, “The Effects of Management Buyouts on Operations and
Value,” Journal of Financial Economics, XXIV (1989), 217-254.
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JOURNAL OF APPLIED CORPORATE FINANCE
of operating cash flows. For example, a buyout with
the 1988 median ratio of 0.41—the highest median
of the 1986 to 1988 period—would have needed to
increase net cash flow by 144% (0.59/0.41) in its first
year to meet its debt obligations.7
These coverage numbers, however, present
only part of the overall picture on financial sound-
ness. In many of the later buyouts, asset sales may
have represented an alternative means of generating
the cash to make debt-related payments.8 And even
if planned asset sales failed to materialize, and
required payments could not be met, this would not
necessarily have meant disaster. The costs at this
point would have depended critically on the ability
of creditors to restructure their claims efficiently.
In sum, then, the data in this section strongly
suggest that the buyouts of the late 1980s had a
higher ex ante probability of winding up in a
restructuring situation, particularly if planned asset
sales were subject to some uncertainty. The data
have thus far had less to say about the possible costs
of such restructurings.
SENIOR BANK DEBT AND
THE ROLE OF ASSET SALES
We now focus our attention on specific compo-
nents of buyout capital structures. The most senior
part of the capital structure for most of our MBOs
was a term loan (and, often, an accompanying
revolving credit loan) arranged by one or more
commercial banks. As we already have seen, banks
accelerated required principal payments over time.
As shown in the Column 1 of Table 4, the ratio
of bank debt to total debt declined significantly over
time, with a distinct break in 1985. Bank debt
represented over 70% of total debt in the period 1982
to 1984. In 1985, it dropped to 42% of all debt. After
that, the ratio stabilized, ranging between 52% and
57% from 1986 to 1989. As we discuss in more detail
later, this decline in bank debt ratios coincided with
increasing use of public bonds in the subordinated
debt tier of the capital structure.
We next examined the interest rate terms of the
bank loans, in part to provide a measure of banks’
assessments of the riskiness of buyouts. In most of
8. See A. Shleifer and R. Vishny, “Asset Sales and Debt Capacity,” Journal of
Finance, XLVII (1992).
 The ratio of bank debt to total debt declined significantly over time, with a distinct
break in 1985. Bank debt represented over 70% of total debt in the period 1982 to
1984, but dropped to 42% in 1985. This decline in bank debt ratios coincided with
increasing use of public bonds in the subordinated debt tier of the capital structure.

TABLE 4 (1) (2) (4) (5) (6)

BANK DEBTa Bank Bank (3) Fee-adjusted Asset Asset Sale
Debt Interest Bank Fees Bank Interest Sales Amount as %
to Total Rate versus to Bank Rate versus (% of of Capital (if
Year Debt Prime Debt Prime Deals) Asset Sale)

1980-81 39.0 0.75 0.21 N/A 50.0 15.5

6 5 1 0 6 3
1982 72.9 1.25 1.28 1.31 0.0 N/A
8 7 5 5 8 0
1983 75.7 1.38 0.40 1.44 33.3 21.1
10 8 8 8 9 3
1984 72.0 1.44 0.79 1.59 18.8 23.2
17 16 14 13 16 3
1985 42.0 1.50 1.94 2.13 33.3 14.2
12 11 7 7 12 4
1986 52.0 1.50 2.06 2.21 60.0 19.3
15 13 13 12 15 8
1987 54.3 1.50 2.06 2.13 40.0 22.4
19 17 15 15 20 8
1988 55.3 1.50 2.49 2.24 32.3 14.8
29 27 22 22 31 10
1989 57.1 1.50 2.38 1.98 20.0 11.4
5 5 4 3 5 1
Total 56.4 1.50 1.93 2.12 33.6 18.1
121 109 89 85 122 40
Time Trend
(–)** (+)*** (+)*** (+)*** (+) (–)
1980-82 vs. 1983-85
(–) (+) (–) (+) (+) (–)
1983-85 vs. 1986-89
(–)* (+)*** (+)*** (+)*** (+) (–)

a. The two rows in each cell are the median and number of observations, respectively.
*** Medians significantly different over time or in comparison periods at 1 percent level; ** at 5 percent level; and * at 10 percent
level.

the deals, the interest rate on the bank debt was set
as the minimum of a spread over the prime rate or
a spread over LIBOR. As shown in Column 2,
although the spreads over prime trended slightly
upward over time (the median values of the prime-
based spreads were 1.125%, 1.50%, and 1.50% in the
early, middle, and late 1980s), they nevertheless
seem to have been remarkably stable.
The relative lack of variation in spreads showed
up in other tests we ran as well. For example, when
we pooled all deals between 1984 and 1989, we
found that 58 of 89 buyouts had prime-based
spreads of 1.50%. The highest spread was 2%, the
lowest 1%. This uniformity in loan pricing seems
puzzling. If we take a heterogeneous group of
companies and impose a similar highly leveraged
capital structure on all of them, one might expect a
great deal of variation in the riskiness of the debt
and, hence, a good deal of variation in its pricing.
One explanation for the lack of variation in
loan pricing is that banks adjusted their fees over
time. As shown in Column 3, the median fee was
0.78% through 1984, and rose thereafter to a peak
of 2.49% in 1988. Since the increased fee income
may have been viewed as the economic equiva-
lent of higher interest rates, we calculated a fee-
adjusted interest rate and a corresponding fee-
adjusted spread to the reference rate. As reported
in Column 4, the fee-adjusted spreads over prime
rate jumped from 1.59% in 1984 to 2.13% in 1985,
and remained between 1.98% and 2.24% from
1985 to 1989. This finding is consistent with banks’

79
VOLUME 6 NUMBER 1 SPRING 1993
expectations that later buyouts were more likely
to get into financial trouble.9
Focusing on interest rate spreads also ignores
a potentially important set of “non-price terms of
credit,” such as collateral and covenants, that bank-
ers can use to adjust their risk-return tradeoff. Non-
price credit terms are particularly relevant because
banks are the senior lenders in the buyout transac-
tions. Given that bank debt typically equals only 50%
of total capital, it may have been possible for banks
to structure their loans to largely eliminate default
losses. If so, it would have made sense to lend at the
same interest rate in all deals.
We were not able to get comprehensive data on
collateral or covenants for the bank loans in our
sample. As we reported earlier, however, banks
both reduced the amount they loaned and required
more rapid principal repayments in later deals. Both
of these reactions are consistent with banks protect-
ing themselves in reaction to lower overall buyout
quality.
As noted earlier, the acceleration of repayment
schedules may have reflected an increased reliance
on asset sales. In fact, these schedules (and the
correspondingly tighter coverages) might have been
a mechanism for forcing buyout companies to sell
assets in order to raise cash. We attempted to
determine the expected role of asset sales by
examining statements of the intent to sell assets that
appeared in the buyout proxy and 14D statements.
As shown in Column 5, asset sales were ex-
pected in 21% of the pre-1983 MBOs, 27% of the
1983-1985 MBOs, and 39% of the 1986-1989 MBOs.
For those companies that planned to make major
asset sales, the assets to be sold represented a
roughly constant fraction of total capital (see Col-
umn 6)—at medians of 15.5, 19.8, and 18.5%—
during the three different periods.
“Cross-Sectional” Tests. Although we do not
report the results here, we also analyzed the strength
of the correlation between low coverage ratios, high
buyout prices, and asset sales by running a series of
regressions. The results of the first two regressions
suggested, in effect, that buyouts with expected
9. There are, however, two reasons it may be misleading to treat fees and
interest income as economically equivalent. First, the fees bank lenders receive are
not always proportional to the size of their loans. Conversations with bankers
indicate that the originating bank retains some fee income even when it sells most
of the loan. If so, the fee-adjusted spreads reported in Table 4 overstate the returns
to banks that actually fund the loan and bear the risk. Second, banks also might
plausibly prefer fee income because of capital regulations and compensation
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JOURNAL OF APPLIED CORPORATE FINANCE
asset sales were associated with ratios of net cash
flow and EBITDA to debt obligations that were
roughly 0.25 lower than buyouts without expected
asset sales (that is, coverages were substantially
tighter in buyouts with expected asset sales). A third
regression suggested that buyouts with asset sales had
net cash flow to buyout price ratios that were a full
2% lower than buyouts without asset sales. For
example, a typical 1987 buyout without asset sales
had a net cash flow to price ratio of 5.7%, whereas one
with expected asset sales had a ratio of only 3.7%.
This last finding seems especially interesting
because it is not obvious why plans to sell assets
should make companies more valuable in the
aggregate. The first-order effect of asset sales would
seem to be to transfer value from junior to senior
creditors, not to create new value. To see this,
consider the extreme case where an asset sale would
generate enough cash to repay all the senior debt.
In this case, the use of asset sales would make the
senior debt riskless, thereby increasing its value
while shifting more risk onto the junior debt. Given
this possibility, it is understandable why senior bank
lenders would be willing to lend to more aggres-
sively priced deals only if they could force asset
sales. It is not at all clear, however, why junior
lenders would be willing to participate in such deals.
To summarize the results of this section: senior
bank lenders appear to have placed a relatively small
emphasis on interest rate spreads in their structuring
of buyout loans. Rather it seems that, over time, they
(1) increased fees, (2) reduced the fraction of the total
debt they provided; and (3) imposed more rapid
repayment schedules. Such repayment schedules
likely could be met only by firms selling assets and
repaying banks with the proceeds. Asset sales look to
have played a somewhat more prominent role in the
more aggressively priced deals.
The overall picture that emerges is one of the
banks making “defensive” structuring adjustments
in the later, higher priced buyouts. While these
adjustments may have made sense from the banks’
senior perspective, they raise several questions:
Who and why were the junior lenders agreeing to
practices. Fee income shows up in earnings in the first year of the buyout. Because
this increases both book net worth and any compensation based on earnings, it can
have a higher shadow value to banks and bankers than an economically equivalent
interest rate. The greater fee income in the late 1980s buyouts may thus have
tempted bankers to make buyout loans that offered a less favorable risk-return
tradeoff.
 Banks both reduced the amount they loaned and required more rapid principal
repayments in later deals. Both of these reactions are consistent with banks
protecting themselves in reaction to lower overall buyout quality.

TABLE 5
SUBORDINATED DEBT

(4) (6)
(1) (2) (3) Average Junk (5) Average PIK (7) (8)
Number % of Deals % of Deals and Cram % of Deals or Discount Strips Average
of with Public with Cram Down to with PIK or Debt to (% of Strip Debt to
Year MBOs Junk Debt Down Debt Capital (%) Discount Debt Capital (%) Deals) Capital (%)

1980-81 6 0.0 0.0 0.0 0.0 0.0 83.3 36.6

1982 8 0.0 12.5 1.2 25.0 3.0 75.0 24.5
1983 10 0.0 10.0 1.1 10.0 1.1 70.0 27.5
1984 17 5.9 23.5 5.7 11.8 2.1 47.1 17.3
1985 12 58.3 58.3 25.9 50.0 7.6 50.0 19.7
1986 15 40.0 26.7 17.5 26.7 5.6 33.3 7.4
1987 20 50.0 45.0 24.9 50.0 9.7 10.0 4.4
1988 31 61.3 38.7 22.5 61.3 8.5 29.0 12.0
1989 5 60.0 40.0 21.5 60.0 10.6 20.0 9.4
Total 124 37.1 32.3 16.1 37.9 6.1 39.5 14.8
Time Trend
(+)*** (+)** (+)*** (+)*** (+)*** (–)** (–)***
1980-82 vs. 1983-85
(+)* (+)* (+)** (+) (+) (–) (–)
1983-85 vs. 1986-89
(+)*** (+) (+)*** (+)*** (+)*** (–)*** (–)***

*** Medians significantly different over time or in comparison periods at 1 percent level; ** at 5 percent level; and * at 10 percent level.

these structuring changes? And what are the impli-
cations of these changes for the likelihood and costs
of financial distress?
SUBORDINATED DEBT
We now turn to an examination of the subor-
dinated debt in our sample transactions. In what
follows, we focus on non-price attributes of this
debt—private placement versus public issuance, the
use of deferred interest securities, and the use of
“strip” financing techniques.
As shown in Column 2 of Table 5, the financing
of buyouts with publicly issued low-grade, or junk,
bonds effectively began in 1985. Only one buyout
prior to 1985 used public junk bonds. In contrast,
over 54% of the subsequent buyouts used them.
Many buyouts also issued a second type of
widely-held debt as part of the buyout financing—
commonly called “cram down” debt. Cram down is
debt issued by the new buyout firm as part of the
payment to the pre-buyout shareholders to take the
company private. Because the pre-buyout shares are
widely-held, so is the cram down debt. Column 3
also shows an increased reliance on the use of “cram
down” debt, particularly after 1984.
Moreover, the ratio of new public buyout
debt—that is, combined junk and cram down
debt—to total capital also rises sharply over time
starting in 1985. Before 1985, new public debt
was a small fraction of total capital; from 1985
and beyond, it always exceeded 17% of total
capital (see Column 4).10
As we noted earlier, the trend toward increased
use of public subordinated debt coincided with the
adjustment by banks to reduce the size of their loans.
To provide a more direct test of the argument that
public debt effectively displaced bank debt in later
buyouts, we ran several regressions. Although not
reported here, the results of these tests suggest that

10. Note that these are unconditional averages, including buyouts both with
and without widely-held debt. These averages, therefore, understate the impor-
tance of public debt in those transactions which actually use it.

81
VOLUME 6 NUMBER 1 SPRING 1993
the ratio of bank debt to total debt was from 11% to
15% lower in buyouts that relied on junk bonds than
in buyouts that did not. This pronounced “crowding
out” of the bank debt by junk bonds is consistent
with the notion that overheated junk-bond investors
were willing to bid more aggressively for buyout
loans than were the relatively defensive bankers.
We also found strong evidence of two addi-
tional trends in subordinated debt financing. First,
the use of deferred interest debt increased sharply
after 1984. As shown in Column 5, such debt was
used in only 12% of pre-1985 buyouts, but in more
than 50% of the buyouts after 1984. Similarly,
deferred interest debt as a percentage of total capital
increased as well (see Column 6), exceeding 8.5% in
all years after 1986.
The increase in deferred interest on the subor-
dinated debt likely had an effect similar to that of
accelerating senior debt repayment. That is, it
further “juniorized” the subordinated debt, poten-
tially transferring value to the senior bank lenders.
In buyouts that used deferred interest debt, much of
the bank debt was scheduled to be paid off before
the buyout firm began cash payments on the
deferred interest debt. Interestingly, the deferred
interest debt was disproportionately public subordi-
nated debt—either junk or cram down. Of the 59
buyouts that did not use junk or cram down debt,
only three issued deferred interest debt. In contrast,
deferred interest securities were present in 44 of 65
buyouts that used public debt.
The use of public subordinated debt also
appeared to be related to the overall pricing of
transactions. We ran a series of regressions (the
detailed results of which, again, are not reported
here) that showed the use of junk debt was associ-
ated with a decline in both net cash flow and
EBITDA to total capital ratios of 1.6%. To illustrate
the import of this finding, our regression coefficients
imply that 1988 buyouts financed without junk
bonds had an EBITDA to total capital ratio of 12.4%,
thus representing a multiple of roughly 8X operating
cash flow. By contrast, for those buyouts financed
with junk bonds, the implied ratio was 10.8%, or
about 9.25X. This finding also fits with the notion
that junk bond investors were particularly aggres-
sive bidders for buyout loans.
Finally, at the same time that the use of deferred
interest and public subordinated debt increased, the
use of strip financing declined. Strip financing is
present when lenders invest in post-buyout equity.
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JOURNAL OF APPLIED CORPORATE FINANCE
In most cases of strip financing, it is the subordinated
debtholders who hold the equity. However, we also
found several cases in which the senior lender or
lenders purchased equity.
As shown in Columns 7 and 8, both the
percentage of transactions using some form of strip
financing and strip debt as a fraction of total capital
declined over the ’80s. Over 70% of the buyouts
before 1984 used some form of strip financing. Also,
the debt owned by stripholders amounted to roughly
25% of the total capital in these buyouts. In contrast,
fewer than 25% of the post-1985 buyouts used strip
financing, with strip debt worth at most 12% of total
capital in those deals.
As in the case of deferred interest debt, the use
of strip financing was related to the use of public
debt, although in this case the relation went the
opposite way. Over 59% (35 out of 59) of the
buyouts that did not use public debt used strip
financing, compared to fewer than 22% (14 of 65) of
the buyouts that did use public debt.
In sum, the results in this section indicate that
beginning in 1985, financing from the public junk
bond market displaced not only private subordinated
debt, but also to some degree senior bank debt. Junk
bond financing was more likely to involve deferred
interest securities, less likely to involve strips, and was
associated with higher buyout prices.
INCENTIVES
The third and final category of data we exam-
ined concerns the incentives of buyout investors.
Conventional economic wisdom holds that signifi-
cant increases in managers’ percentage equity stakes
should lead to improvements in operating perfor-
mance and more successful buyouts generally. But,
as we shall show, the conventional wisdom failed to
take into account another important change in
incentives also taking place during the 1980s.
Columns 1 and 2 of Table 6 report the median
percentages of pre-buyout and post-buyout equity
(fully diluted to account for stock options) owned
by the post-buyout management team. Before the
buyout, the new management team owned a me-
dian 5% of the equity. This percentage increased
significantly during the ’80s, peaking at more than
8% in both 1987 and 1988. After the buyout, the
median management equity ownership of the post-
buyout company was 22.3%, a figure that also
increased significantly over time.
 The larger the capital gain they are able to “cash out” relative to their new
investment, the more managers may be tempted to go along with (or even
encourage) a buyout they know to be overpriced or poorly structured.

TABLE 6 (1) (2) (3) (4) (5)

INCENTIVESa Old Mgmt. New Mgmt. New % / Old % New $ / Old $ Total Fees
Year Equity (%) Equity (%) Mgmt. Equity Mgmt. Equity to Capital

1980-81 1.5 10.1 7.58 0.707 2.05

6 6 6 6 6
1982 2.0 23.1 6.79 0.958 2.66
8 8 8 8 8
1983 5.2 15.5 3.42 0.524 2.58
10 9 9 9 9
1984 4.4 27.5 3.81 0.670 2.21
17 17 17 17 17
1985 3.5 22.5 4.51 0.334 3.69
12 11 11 11 12
1986 5.1 20.8 6.28 0.314 5.06
12 13 11 11 15
1987 8.1 19.0 3.54 0.410 4.32
17 14 14 14 20
1988 8.4 28.5 2.86 0.349 5.97
25 24 22 22 31
1989 6.2 15.3 2.93 0.542 5.73
4 4 4 4 5
Total 5.0 22.3 4.14 0.460 3.81
111 106 102 102 123
Time Trend
(+)** (+)* (–) (–)* (+)***
1980-82 vs. 1983-85
(+)** (+)** (–) (–) (+)
1983-85 vs. 1986-88
(+) (+) (–) (–)* (+)***

a. The two rows in each cell are the median and number of observations, respectively.
*** Medians significantly different over time or in comparison periods at 1 percent level; ** at 5 percent level; and * at 10 percent
level.

Column 3 combines the information in Col-
umns 1 and 2 by calculating the ratio of the
percentage of post- to pre-buyout equity owned by
the management team. This ratio provides a mea-
sure of the change in the intensity of the relationship
between managerial effort and compensation. The
median ratio for the 102 buyouts with both pre- and
post-buyout information was 4.14. (The ratio trended
downward over time, but not significantly.)
While their large percentage stakes in post-
buyout equity suggest that managers will work hard
to maximize shareholder value once the buyout has
been completed, the large post-buyout stakes alone
do not ensure they will enter only into well-priced
and -structured transactions. It is important to recog-
nize that managers typically “cash out” in dollar terms
at the time of a buyout. Although their percent-age
ownership of the now-levered equity increases sharply,
the dollar amount invested tends to fall.
This cashing out could have important and
potentially adverse incentive effects on the choice,
pricing, and structuring of deals. In particular, the
larger the capital gain they are able to realize at the
time of the deal, the more managers may be tempted
to go along with (or even encourage) a buyout that
they know to be overpriced or poorly structured. At
the extreme, a manager offered a significant owner-
ship stake in post-buyout equity at no cost may find
it hard to turn down what is, in effect, a free option,
even if the buyout has only a small chance of success.
As shown in Column 4, the median ratio of the
dollar value of post- to pre-buyout equity owned by
the management team was 0.46. This means that the
management team typically invested less than half as
much in post-buyout equity as in pre-buyout equity.
Even more telling, however, the time trend of this
variable over the 1980s was significantly negative,
with a particularly sharp drop between 1984 and

83
VOLUME 6 NUMBER 1 SPRING 1993
1985. Before 1984, the median ratio was 0.57. From
1985 to 1989, the median ratio was 0.35. Thus, the
temptation for management to cash out appears to
have been far greater in the buyouts of the later
1980s than in earlier ones.
Management investors are not the only par-
ties driven by incentives. So are buyout promot-
ers, investment banks, and lenders. Most buyout
participants were compensated with both long-
term security interests and upfront fees. As we
noted earlier, banks required higher upfront fees
in the later 1980s than they did before. And, as
shown in Column 5, the same pattern was true of
total buyout-related fees. The largest portion of
these fees was paid to buyout promoters, invest-
ment banks, and commercial banks. The ratio of
total fees to total capital made its biggest jump in
the late 1980s. It ranged from 2.05% to 2.66%
before 1985, rose to 3.69% in 1985, and peaked at
5.97% in 1988.
INTERPRETING THE EVIDENCE
The evidence we have presented thus far can
be used to tell a detailed story of overheating in the
buyout market, one which centers largely on the
role of publicly issued junk bonds.
Junk Bonds and
The Overheated Buyout Market
The story goes as follows: Beginning in 1985,
junk bond investors, attracted by the success of
earlier deals, poured large amounts of money into
the buyout market. This pushed up prices in general,
and especially prices in those deals in which junk
bonds were actually used. Other, less aggressive
classes of lenders such as banks and private subor-
dinated lenders reacted defensively to the “demand
push” from the junk bond market. They reduced
their participation in deals, and the banks in particu-
lar took steps such as accelerating principal repay-
ments and forcing asset sales that would effectively
enhance their senior status. The junk bond investors
did not prevent themselves from being “juniorized”
in this way. Indeed, by accepting large quantities of
deferred interest securities, they further encouraged
the process.
11. See M. Jensen, “The Eclipse of the Public Corporation,” Harvard Business
Review, No. 5 (1989), 61-74.
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JOURNAL OF APPLIED CORPORATE FINANCE
Even more so than the bankers, other interested
parties were also successful in extracting upfront
money from the deals. Ostensibly well-informed
players such as management, buyout promoters and
investment bankers were increasingly able to earn
compensation simply for completing a transaction,
rather than having their fortunes ride on its eventual
success or failure. Thus, instead of providing a
system of checks and balances, these “smart money”
participants may have been quite eager to partici-
pate, even in deals they viewed as overpriced or
poorly structured.
If this junk bond/“demand push” story is cor-
rect, it implies two channels through which inves-
tor returns in later deals could have been reduced.
The first, and more obvious, channel was pricing;
all else equal, higher prices relative to fundamen-
tals would mean lower returns for some categories
of investors. The second channel related to costs of
financial distress. Although expected costs of finan-
cial distress are hard to assess, many of the capital
structure changes that accompanied the inflow of
junk bond financing could be viewed as increasing
such costs.
First was the dramatic shift from privately-
placed to widely-held subordinated debt that began
in 1985. With widely dispersed creditors, free-rider
problems were more likely to interfere with efficient
financial reorganizations. By “free-rider,” we mean
that even though it can be in the collective interest
of subordinated debtholders to contribute new
funds for investment, any single holder may find it
individually rational not to do so. Adding further to
this “free rider” problem was the growing bank
practice of selling off senior bank buyout loans.
A second change that may have increased the
potential for costly financial distress was the decline
of the strip financing technique common in earlier
buyouts. When a firm is highly leveraged, conflicts
of interest between lenders and equityholders can
lead to distorted corporate behavior such as “risk-
shifting” and underinvestment that reduces overall
firm value. By reducing such conflicts, strip financ-
ing arguably limits these distortions.11 If this logic is
correct, the decline of strip financing in the late
1980s is puzzling, to say the least.
In addition to the movement towards public
debt and away from strip financing, other changes
 A rapidly growing asset sales market could help explain rising buyout prices in
general, to the extent some buyouts created significant portions of their value
added by relocating assets to different owners. To the extent this was so, we would
expect to see a strong correlation between buyouts premised on large asset sales
and the use of junk bonds.

in buyout debt structure may also have increased the some buyouts created significant portions of their
expected costs of financial distress. One such change value added by relocating assets to different owners.
was the “juniorizing” of the public subordinated To the extent this was so, we would expect
debt that resulted from both faster principal repay- to see a strong correlation between buyouts pre-
ments on the senior bank debt and the trend toward mised on large asset sales and the use of junk
deferred interest junk bonds. bonds. Although junk bonds would clearly have
How did these changes raise the costs of made it more difficult for a distressed firm to
reorganizing troubled companies? First of all, as recast its capital structure, the possibility of asset
with conflicts between lenders and stockholders, sales could have been viewed by the planners of
conflicts between senior bank creditors and junior the buyout as a potential, low-cost alternative to
public debtholders can also reduce the ability of financial reorganization.13
distressed companies to secure new funds. The Such a correlation between asset sales and junk
logic is as follows: Suppose a firm is in financial bonds would help explain the more aggressive
difficulty and needs an infusion of funds to make a pricing of buyouts involving junk bonds. That is, the
positive net present value investment. On the one use of junk bonds may simply be an indicator that
hand, bank lenders would seem to be the best the firm in question had a lot of easily detachable
hope for putting up the new money, since they do and marketable assets. If the potential for asset sales
not face as severe a free-rider problem as the was in itself value-increasing, this “detachability” of
widely-dispersed junior lenders. On the other hand, assets may have legitimately commanded a higher
the banks’ senior status probably reduces their buyout price. Also, to the extent junk bonds were a
incentive to invest; the banks may already be well- reliable indicator of detachable assets, it would be
protected, and may not have much upside to gain wrong to conclude that deals with junk bonds had
from further investment.12 higher expected costs of financial distress.
Now consider what happens if the bank’s It should be noted that this alternative story
principal repayments are moved forward in time. does not explain all of our empirical findings. For
This has two negative effects. First, the higher debt example, increased liquidity in the asset sales mar-
service burden raises the probability that the firm ket would not appear to offer much insight into the
will be unable to meet its contractual obligations. trend toward more front-loaded compensation for
Second, the fact that the banks extract value more managers and other interested parties.
rapidly effectively enhances their senior status rela-
tive to the subordinated debt. This further protects EX POST EVIDENCE
the banks, and may correspondingly further reduce
their incentives to contribute new money. For this While it may be impossible to resolve fully the
reason, accelerated repayment schedules may well ambiguities raised above, we made an effort in this
increase the expected costs of financial distress. direction by examining post-buyout data. The over-
heating hypothesis holds that buyouts in the later
An Alternative Interpretation 1980s were less soundly structured than earlier
deals. This suggests that later deals, even with
A different reading of our evidence—one more significant operating improvements, would run into
consistent with investor rationality—might focus on difficulty more often. The alternative interpreta-
external changes in regulation, capital markets, and tion—that the deals were rationally priced and
the general economy. One likely candidate—though structured, but simply ran into unforeseeable exter-
by no means the only one—may have been fluctua- nal problems—would suggest that expected operat-
tions in the liquidity of the asset sales market. A ing improvements failed to materialize.
rapidly growing asset sales market could help Furthermore, the overheating hypothesis would
explain rising buyout prices in general, to the extent seem to imply that “poorly structured” deals—in

12. See R. Gertner and D. Scharfstein, “A Theory of Workouts and the Effects
of Reorganization Law,” Journal of Finance, XLVI (1991), 1189-1222.
13. Shleifer and Vishny [1992], cited earlier in note 9, argue that it was precisely
this increase in asset liquidity in the early and mid-1980s that made the large growth
of the public junk bond market possible.

85
VOLUME 6 NUMBER 1 SPRING 1993
terms of pricing, capital structure, or incentives—
should become financially distressed more often.
This should be especially true of deals financed with
junk bonds because these deals tended to have both
higher prices as well as capital structures that were
less easily renegotiated.
The alternative interpretation does not make the
same predictions about ex-post outcomes. Because
variations in price, capital structure, and incentives
may reflect legitimate differences in unobserved
fundamentals, they should not necessarily be corre-
lated with ex-post difficulties. For example, if junk
bonds were (sensibly) used only in deals where asset
sales provide an alternative means of averting dis-
tress, we should not see a disproportionate number
of junk-bond financed deals become distressed.
We now present evidence on (1) the extent to
which management buyouts experienced financial
distress; (2) post-buyout operating performance;
and (3) the degree of correlation between financial
distress and various measures of pricing, capital
structure, and incentives. Such evidence is inevita-
bly preliminary, especially for those buyouts com-
pleted in the last years of the ’80s.
Frequency of Distress
We used three different indicators of financial
distress. We considered a buyout to have encoun-
tered distress if, by August 1991, the firm had
(1) attempted to restructure its debt because of
difficulty in making debt payments, (2) defaulted on
a debt payment, or (3) filed for Chapter 11. Before
reporting our evidence on these three kinds of
distress, we should emphasize that they do not
necessarily have the same import. For example,
encountering distress probably means that some
class of investors has lost money (and, hence, may
suggest a deal was overpriced), but may well have
little to say about the deadweight costs of financial
distress. In other words, a buyout that encounters
distress may be able to restructure at low cost.
As shown in Column 1 of Table 7, over 25% of
the 124 buyouts in our sample firms had experi-
enced at least one of these three forms of financial
distress by August 1991. The incidence of financial
14. Only the changes in net cash flow margin in the second year trend
downward significantly over time. And this is driven by the poor performance of
only the 1986 buyouts.
15. In a study of 40 large leveraged buyouts completed between 1985-1989,
for example, Tim Opler finds that nominal and industry-adjusted increases in
86
JOURNAL OF APPLIED CORPORATE FINANCE
distress increased significantly over time, with 1985
as the apparent breakpoint. Before 1985, only 1 of
41 buyouts experienced distress; from 1985 and
onward, 30 of 83 did. As shown in Column 2, the
percentage of defaults among buyouts also in-
creased significantly, again with 1985 appearing to
be the year of change.
The time trend for Chapter 11 filings, however,
although positive (see Column 3), was not significant.
Fewer than one-half of the companies that have
defaulted on debt payments have also filed for
Chapter 11. However, because defaults usually pre-
cede a Chapter 11 filing, this trend could (and has)
become more pronounced with the passage of time.
Post-buyout Operating Performance
The increase in defaults may have been caused,
of course, by a combination of ex ante changes in
pricing and structuring as well as ex post surprises in
performance. Columns 4 and 5 present the annual
medians of changes in EBITDA and net cash flow to
sales in the first post-buyout year relative to the last
pre-buyout year. For the entire sample, the ratios
increased by 9% and 43%, respectively, in the first
year of operations. Over a two-year period follow-
ing the buyouts, the operating improvements are
roughly the same; as shown in Columns 6 and 7,
EBITDA operating margins increased by 12% and
net cash flow margins by almost 42%.14
These patterns of operating changes, therefore,
do not offer much support for the view that
economic conditions and performance surprises led
to the increase in financial distress over time. Many
of the buyouts of 1985, 1987, and 1988 experienced
financial distress despite improvements in operating
performance.15 Thus, the results overall seem con-
sistent with changes in buyout pricing and financial
structure having played an important role in in-
creased financial distress.
Correlation Between Distress and Ex Ante
Variables
Our final test was to determine the extent to
which the three varieties of financial distress were
operating margins and cash flow margins were, if anything, larger for later buyouts
than for earlier ones. See “Operating Performance in Leveraged Buyouts: Evidence
from 1985-1989,” Financial Management, XXI, No. 1 (1992), 27-34.
 Many of the later buyouts experienced financial distress despite significant
improvements in operating performance. Thus, the results overall seem consistent
with changes in buyout pricing and financial structure having played the major a
role in increased financial distress.

TABLE 7 (4) (5) (6) (7)

POST-BUYOUT Actual Actual Actual Actual
(1) (2) Growth Growth Growth Growth
PERFORMANCEa Experience Default (3) Operating Cash Flow Operating Cash Flow
Financial on Debt Chapter Margins Margins Margins Margins
Year Distress Payment 11 t-1 to t+1 t-1 to t+1 t-1 to t+2 t-1 to t+2

1980-81 0.0 0.0 0.0 2.5 22.7 8.9 132.6

6 6 6 3 2 3 3
1982 0.0 0.0 0.0 1.6 29.4 26.6 48.5
8 8 8 5 4 5 4
1983 0.0 0.0 0.0 9.2 55.7 26.3 60.1
10 10 10 8 7 7 7
1984 5.9 5.9 5.9 –1.3 28.4 –1.5 40.0
17 17 17 12 12 11 11
1985 33.3 25.0 16.7 14.3 30.2 21.9 31.4
12 12 12 11 11 9 9
1986 46.7 46.7 26.7 –7.9 17.7 –32.6 –45.5
15 15 15 9 8 9 8
1987 45.0 30.0 15.0 15.6 67.0 22.5 30.8
20 20 20 17 16 15 14
1988 29.0 16.1 0.0 14.2 48.4 12.3 22.8
31 31 31 20 19 7 7
1989 20.0 20.0 0.0 25.2 40.7 N/A N/A
5 5 5 2 2
Total 25.0 18.5 8.1 9.1 43.0 12.1 41.8
124 124 124 87 81 66 63
Time Trend
(+)*** (+)* (+) (+) (+) (–) (–)*
1980-82 vs. 1983-85
(+) (+) (+) (+) (+) (–) (–)
1983-85 vs. 1986-89
(+)*** (+)** (+) (+) (+) (–) (–)**

a. Number of observations on second line.

*** Medians significantly different over time or in comparison periods at 1 percent level; ** at 5 percent level; and * at 10 percent
level.

correlated with measures of pricing, capital struc-
ture, and incentives that we found to have changed
significantly during the ’80s. To measure the strength
of such correlations, we ran several series of (mul-
tivariate as well as univariate) regressions. Although
detailed results are presented in the original study,
we simply summarize our findings below:
The lower the ratio of EBITDA to capital (or,
alternatively, the higher the price paid as a multiple
of cash flow), the greater the probability that a
buyout encountered financial distress in any of its
three forms.
High industry risk had a positive relation to the
likelihood of distress and default. (Indeed, buyouts
in the highest industry risk quartile—for example,
MBOs in retailing—were 19% more likely to en-
counter distress and 14% more likely to default than
the average buyout.)
A high degree of cashing-out on the part of
management was associated with a significant in-
crease—roughly 15%—in the probability of default.
The use of junk bonds was associated with
statistically and economically significant increases in
the probability of distress, default, and Chapter 11
of, respectively, 21%, 10%, and 11%.
Because we viewed this last correlation to be
the most interesting, we investigated its “robustness”
to several multivariate specifications. When the four
other independent variables cited above were added
both individually and as a group to the junk bond
variable in a series of regressions, the estimated
coefficients on the junk bond variable were signifi-

87
VOLUME 6 NUMBER 1 SPRING 1993
cant in all cases (as well as statistically similar to their
values in the univariate regressions summarized
above).
We interpret this relatively strong and robust
ability of junk bonds to predict future distress as
supportive of the overheating hypothesis. According
to the story sketched above, one would expect the
presence of junk bonds to be an especially useful
summary statistic, as it captures a tendency towards
both higher prices and more fragile capital structures.
CONCLUSIONS
We now come back to the question we asked
at the outset: Were there differences in the pricing
and capital structure of buyouts in the late 1980s that
might have led one to expect disappointing investor
returns relative to those in earlier deals? In brief, our
analysis of 124 large MBOs completed between 1980
and 1989 yields the following conclusions:
Buyout price to cashflow ratios rose (although not
more sharply than market- or industry-wide P/E
ratios).
Prices were particularly high in deals financed
with junk bonds.
As prices rose, buyouts were undertaken in riskier
industries, and with somewhat higher leverage
ratios.
Banks took smaller positions in later deals, and at
the same time accelerated required principal repay-
ments, leading to sharply lower ratios of cash flow
to total debt obligations.
The public junk bond financing that largely re-
placed private subordinated debt beginning in 1985
was much more likely to include deferred interest
securities, and less likely to involve equity “strips.”
Finally, management and other interested parties
such as investment bankers and deal promoters
were able to take more money upfront out of the
later deals.
On balance, our evidence, while not unambigu-
ous, fits well with a version of the overheated buyout
market hypothesis. According to this version of the
story, the demand push from the junk bond market
STEVEN KAPLAN
is Associate Professor, Graduate School of Business, University
of Chicago, and a Research Fellow at the NBER.
88
JOURNAL OF APPLIED CORPORATE FINANCE
that began around 1985 fundamentally altered both
the pricing and capital structure of later buyouts. We
view the changes in capital structure as particularly
important. In an apparently defensive reaction,
senior bank lenders participated less in the later,
junk-bond financed deals and tried to extract their
money more rapidly. While this reaction may have
made good sense from the narrow perspective of the
senior lenders, it arguably increased the expected
costs of financial distress by exacerbating conflicts
of interest between junior and senior claimants.
Further support for this junk bond/demand
push interpretation comes from our analysis of the
ex post data, which finds the presence of junk bonds
in a buyout to be a good predictor of various types
of financial distress. Presumably, this is because the
presence of junk bonds captures a tendency toward
both higher prices and more fragile capital structures.
If this interpretation is correct, the question
arises as to how the junk bond investors made the
mistakes they did. Although such a question is
inevitably difficult to answer satisfactorily, our data
do provide some hints. To the extent that junk
bond investors miscalculated, they probably did so
by focusing too much on stated coupon yields and
past buyout successes, and too little on the subtle
capital structure details of the deals they were
investing in. Holding everything else constant, there
is a big difference between owning a debenture
that does not begin to receive any cash payout until
after the senior debt has been largely repaid, and
one that gets repaid along roughly the same sched-
ule as the senior debt.
Whether or not one accepts the overheating
interpretation, our data provide a useful post-
mortem of the buyout boom. At least with the benefit
of hindsight, it seems clear that some of the changes
in capital structure and incentives seen in the deals of
the later 1980s were bad ideas. Thus, one might
expect future buyouts to look more like those of the
earlier 1980s: with less stringent principal repayment
schedules, more closely-held subordinated debt and
strip financing, and less front-loaded compensation
for management and other interested parties.
JEREMY STEIN
is Associate Professor of Finance at the Sloan School of
Management, Massachusetts Institute of Technology, and an
Associate at the NBER.
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