Remaking the Public Corporation from Within

An emerging synthesis of financial strategies organizational structures, and operating philosophies, is revitalizing the publicly held corporation by addressing deep-seated structural weaknesses. This synthesis reflects three critical insights. The first is the power of entrepreneurial motivation. Managers and employees respond best to precise financial incentives that offer amplified and unlimited rewards for outstanding performance and genuine penalties for poor performance. These incentives should be driven by the factors that contribute directly to economic value, and they should be tailored to the particular strategic challenges facing different business units. Ultimately, managers make the best decisions when they think as owners—which puts a premium on policies that turn managers into significant equity holders in their enterprise. The second is the impact of balance sheet restructuring and strict financial discipline. Many public companies fail to maximize value because they succumb to common sources of value destruction: the almost irresistible temptation to use surplus cash flow to overinvest in undeserving core businesses or make overpriced acquisitions; headquarters’ tendency to force strong operations to support weak ones to the detriment of overall corporate performance; and the reluctance to dispose of profitable core businesses that are worth more in other hands. The best way to avoid these value-destroying mistakes (as well as create positive incentives for value maximization) is to use leverage aggressively, but at the business unit level. Through a transaction I call internal LBOs, surplus-generating business units can distribute substantial amounts of cash to their parent, concentrate a significant equity stake in the hands of operating management, and instill a sense of urgency by setting up a demanding repayment schedule. Internal LBOs transform the balance of power between headquarters and operating managers and thereby enhance the intrinsic value of a company’s business units. The third insight is the benefits of decentralizing authority and ownership. Large corporate bureaucracies slow down the flow of information, bog down decision making, diffuse accountability, impose homogeneous policies on heterogeneous businesses, and cost tens of millions of dollars to maintain. Headquarters should instead operate with a skeletal staff whose primary role is to negotiate demanding performance objectives with individual business units and to hold those business units accountable. Moreover, companies should not confuse strategic control of a business with 100 % ownership. Outside parties (merchant bankers, business partners, public shareholders) should be encouraged to acquire equity positions in business units so as to diversify financial risk, reinforce entrepreneurial incentives, and enhance accountability to the capital markets. Most publicly held companies have exceptionally talented and dedicated managers and employees. Yet the capital markets continue to value them at substantial discounts from what aggressive investors are willing to pay or what managers themselves believe their companies are worth. Many managers still react to these value gaps by blaming the capital markets. Forward-looking managers seek answers elsewhere. They devise corporate structures and policies that encourage superior business performance rather than obstruct it. They embrace the most powerful organizational trend of the past ten years—the failure of centralized bureaucratic enterprise and the ascendancy of decentralized enterprise. In short, they manage by motivation rather than mandate, by empowerment rather than punishment. Motivation: The Ownership Imperative The core principle of effective motivation is simple yet powerful: managers deliver outstanding performance when they think as owners. The opportunity to create personal wealth through equity is almost always a more compelling incentive than what even the most ingenious salary and bonus systems can provide. Thus perhaps the single most important reform an organization can make is to transform its managers into significant owners of the business—or better still, significant owners of the business units in which they work. Making managers into owners is not just a matter of stock certificates and financial rewards. The ownership imperative should engage executives and employees at an emotional level. Pride in work, prudent risk taking, and above all, a deep sense of responsibility for the success or failure of the enterprise are critical attitudes that separate owners from hired hands. But words like “pride” and “responsibility” sound like little more than platitudes unless they are backed up with monetary rewards. Which raises an obvious question: How is it possible for senior managers to own a significant share of corporate equity, particularly in companies whose market values run into the billions of dollars? One especially effective initiative that a few companies have tried involves what I call a leveraged equity purchase plan (LEPP). In a LEPP, senior managers acquire a substantial amount of corporate equity through stock purchases. These plans have three major features: Most of the purchase price for the shares (say, 90 % ) is financed through a loan from the company. The loan is secured solely by a pledge of the stock and has no recourse to individual managers’ personal assets. The rest of the purchase price (say, 10 % ) comes out of the managers’ personal net worth and is put “at risk.” The managers’ investments should be sizable enough to matter but not so large that they cannot afford to lose it—because they might. The loan from the company accrues interest at a rate equal to the company’s cost of capital (less a discount to compensate managers for bearing market risk). Thus managers benefit financially only by generating a spread between the return earned on the funds used to buy the stock and the company’s cost of capital (as reflected by the interest on the loan). Consider a publicly traded company with a market value of $ 1 billion whose directors want to put a meaningful percentage of the company’s equity, say, 10 % , in the hands of senior management. The $ 100 million purchase price could be financed through a $ 90 million loan from the company and $ 10 million invested by the executive group from each member’s personal resources. The loan would accrue interest, and at designated intervals, managers would face a repayment decision. If the company’s market value fell beneath the face value of the loan, management could cancel its financial obligation by tendering an appropriate portion of the shares back to the company. It would lose “only” its initial investment. (Of course, preventing that $ 10 million loss would likely be a top priority—and an effective spur to outstanding performance.) But if the share-price increase outstripped the interest rate, management would retain the shares and the interest would continue to accrue. Managers would be required to pay the accrued interest if and when they choose to sell their shares. A leveraged equity purchase plan achieves several important goals simultaneously. First, it is a financially realistic way to get significant equity into the hands of senior managers without diluting the interests of shareholders—a big problem with the aggressive use of traditional stock options or restricted stock. Few executive groups, no matter what their annual salary and bonus, can accumulate enough financial resources to purchase more than a trivial fraction of their company’s outstanding shares. Second, it creates demanding managerial incentives aligned with the interests of shareholders. Because the loan used to purchase the stock accrues interest, management is not rewarded for just any increase in value. Management comes out ahead only if the company’s value grows at a rate faster than the interest accrues. Indeed, if the loan bears interest at a rate equal to the company’s cost of capital, the LEPP rewards management for generating a spread between the cost of the capital and the rate of return earned on the funds used to buy the stock—and that is the heart of effective capital budgeting. These are valuable protections for investors. But what the plan offers management is even more important for corporate value. First, there is a direct and visible payoff for generating superior performance. The value of the shares management acquires will discount to the present value all the projected payoffs from subsequent management actions. These gains are then amplified because of the ten-to-one leverage factor. A mere 10 % increase in the market value of the company’s equity (above the loan’s interest rate) will generate a 100 % increase in the value of management’s investment. Of course, a 10 % decline in market value will wipe out management’s stake completely. Faced with a stark choice between high rewards for success and severe penalties for failure, most people choose success. In essence, a LEPP duplicates the pressures to perform associated with an LBO without requiring shareholders to sell their equity. A LEPP shrinks the typical leverage and ownership structure of a buyout to a size that fits just management—and without the corporate debt burden or the “taint” of an LBO. Shareholders reap the benefits of continuing to own stock in a healthy, publicly traded company while management feels the pressures of a buyout. Michael Dingman implemented such a plan soon after he formed the Henley Group, a collection of 35 poorly performing businesses spun off from Allied-Signal in 1986. The new company floated to an initial market value of $ 1.8 billion, a remarkable valuation considering that as a group the businesses that comprised Henley lost $ 27 million in the year before the spin-off. Investors were banking on Dingman’s track record as well as his reputation for giving his most talented managers tremendous personal incentives to create value for shareholders. Wall Street anticipated that Dingman would introduce a powerful and creative incentive scheme, and he did. Under the Henley plan, 20 of the company’s executives agreed to purchase freshly issued shares that would give them a 5 % stake in the company. Of the $ 108 million purchase price, 90 % , or $ 97 million, was financed with a loan from the company that had no recourse to management. (The loan was secured solely by a pledge of the shares.) Management contributed the 10 % balance, or $ 11 million, which was put “at risk.” The loans bore interest at an annual rate of 6.5 % (much lower than the company’s cost of capital), and the interest was accrued and not actually paid. Instead, at designated intervals over the next five years, installments of the loan (including accrued interest) came due against a comparable proportion of the shares. At each of the intervals, management had to decide whether to forfeit or retain a chunk of shares. The Henley plan received much attention when it was announced, and Wall Street received it warmly. Henley’s share value rose nearly 10 % versus the Standard & Poor’s “500”—testimony to investors’ confidence in the plan’s potential as an incentive tool. But few public companies have implemented similar plans or even embraced its core elements. Why not? Largely because such programs strike hard at deep-seated boardroom traditions. Directors have few qualms about granting managers restricted stock or options. But they resist financing open-market purchases of shares, in part because of public perceptions. Many journalists and opinion leaders remain convinced that any subsidized purchase of equity by managers represents a transfer of wealth from shareholders rather than an effective way to align the interests of the two groups. Indeed, the Henley plan has been the target of several lawsuits and much press criticism. There are legal obstacles as well; many states limit or forbid such programs altogether. Yet what matters for corporate performance are the incentives associated with consequences of giving managers equity while simultaneously putting managers’ personal wealth at risk. It is possible to replicate a LEPP through a new type of stock option program that directors may find more palatable. This nonqualified stock option has three parts: The exercise price for the options is set at a 10 % discount from the current market price. Management purchases the options at a price equal to the 10 % in-the-money discount. The exercise price increases by a predetermined rate of growth, thereby preserving a minimum acceptable return for shareholders before management participates. Consider a company whose common shares trade for $ 30. A LEPP option would set the initial exercise price at $ 27, and managers would buy the options for $ 3 each. The exercise price would increase at a rate equal to the company’s projected cost of equity capital, less any dividends paid on the common shares (and perhaps a discount to compensate managers for risk). If, for example, the cost of equity is 15 % and common dividend yield is 5 % , the exercise price would rise by 10 % per year and become $ 29.50 after the first year, $ 32.45 the year after, and so on. All too often, traditional option plans (or worse yet, grants of restricted stock) are little more than additional compensation rather than effective incentive tools. LEPP options create real incentives to perform—or else. The options are bought, not granted. At the time of issuance, they are in-the-money not at-the-money, and management must commit its personal wealth to participate in the plan. Indexing the exercise price (rather than allowing it to stand still) imposes on managers a demanding moving target. Finally, unlike ordinary options, they do not dilute common equity value unless and until the shareholders realize a return that exceeds the rate at which the exercise price grows. Directors can feel comfortable about selling a small cadre of senior managers a very large number of LEPP options and using them aggressively as a tool to reshape corporate incentives. Internal LBOs and the Power of Leverage Organizations that address the ownership imperative at the level of the corporate parent face a second challenge: to push the incentives of ownership down into the individual business units and to hold those units accountable for performance. This is where leverage can make a powerful contribution to increased value—especially in slow growth businesses where the chances for unproductive reinvestment are greatest. Most companies borrow at the consolidated level. The parent raises cash from commercial banks or the public debt markets and distributes the cash to its business units. A new model, the internal LBO, turns this relationship on its head. Companies leverage themselves aggressively at the business unit level and repatriate the funds to the parent. This debt has no recourse to the parent company; the subsidiary alone is responsible for repayment. Think of a boat whose hull is divided into separate chambers. Compartmentalizing debt into separate business unit chambers ensures that a leak in any one unit does not sink the equity in the remaining units. Decentralizing debt also transforms the nature of the relationship between business units and the parent. It limits cross-business exposure to risk, holds down the cost of equity, and enhances financial flexibility for the parent. It prevents wasteful cross-subsidization among business units; cash generated in one operation cannot be passed freely to another. It also ensures that surplus cash flow is dedicated to debt service and repatriated to equity investors, thereby reining in the natural temptation to reinvest in businesses that lack potential for real growth. The substitution of debt for equity on the balance sheet also makes it easier to provide operating managers with a significant share of equity in their unit at a realistic cost to them. Consider how such an internal LBO might work in a business unit that, as a result of discounting its likely future cash flows, contributes an estimated $ 100 million to its parent’s market value. The corporate parent could simultaneously sell and buy the unit at a price reflecting a typical LBO premium (say, 30 % ) over its current value. The $ 130 million transaction could be financed as a typical LBO: 50 % of the price, or $ 65 million, could be obtained from commercial banks at a rate of, say, prime plus 1.5 % ; 30 % of the price (roughly $ 40 million) could be financed with subordinated debentures paying a rate close to the normal cost of equity (say, 15 % ); the remaining 20 % , or $ 25 million, would be common equity, of which 80 % could be retained by the corporate parent and 20 % purchased by the unit’s management for $ 5 million. To further amplify the incentive structure, management’s $ 5 million investment could be financed with a LEPP option program. In other words, management would invest $ 1 million to acquire an option on $ 5 million worth of shares, with a $ 4 million exercise price scheduled to increase at the business unit’s borrowing rate. (The illustration, “Anatomy of an Internal LBO,” provides an overview of this hypothetical transaction.) Anatomy of an Internal LBO (in millions of dollars) The internal LBO generates benefits for nearly all the company’s constituencies. The proceeds of the senior and subordinated debt financing bring the parent company $ 105 million in tax-free cash out of a business unit with an apparent value of $ 100 million. Furthermore, because the debt raised by the business unit has no recourse, the parent’s overall debt capacity is increased and its financing flexibility preserved. Yet even with these immediate benefits, the parent still retains 80 % of the potential upside equity rewards in the business unit while the lenders bear the brunt of the downside risk. Lenders are reassured about bearing this risk because managers of the unit (and often managers of the parent) are willing to stake a large part of their own net worths to buy equity whose value will increase only if the debt is substantially repaid. Managers find the transaction appealing because for a total investment of $ 1 million (or just 1 % of the original $ 100 million appraised value), they receive 20 % of the value created in the unit after the 30 % buyout premium is surpassed. Of course, their investment will be wiped out completely if they fail to create enough value to cover the buyout premium. This all-or-nothing payoff profile is a proven motivator. This model has been put into practice across a range of industries. In April 1985, Allied Chemical Corporation (now Allied-Signal) performed a classic internal LBO of Union Texas Petroleum, its wholly owned subsidiary engaged in oil and gas exploration and production, natural-gas processing, and petrochemicals manufacturing. The internal LBO increased UTP’s intrinsic value by 30 % —a benefit that showed up as an immediate gain in the market value of Allied’s common shares. The transaction subsequently yielded a compound annual return of 30 % , an increase in value that rewarded UTP’s managers, the third-party investors who participated in the deal, and Allied Chemical. UTP’s recapitalization was 80 % financed with new debt and preferred stock and 20 % with common equity. The debt that UTP raised was supported by UTP alone and had no recourse to Allied. Thus Allied was able to pump more value out of UTP while still preserving its own financial flexibility. The specifics of the financing unfolded this way: UTP paid Allied a cash dividend of $ 2 billion, which UTP financed by raising $ 1.7 billion in senior bank debt and $ 300 million in subordinated debentures. UTP gave Allied a $ 300 million redeemable preferred stock. For $ 3 million, UTP management purchased new common shares representing a 0.6 % interest in UTP. UTP managers also were granted options to buy additional common shares representing an approximate 2.5 % interest in the company. New common shares representing a 49.7 % interest in the recapitalized unit were sold for $ 250 million to Kohlberg Kravis Roberts, the leveraged buyout sponsor. UTP’s senior management purchased its shares at the same price KKR paid, and the options it obtained were exercisable at the same price (about $ 7.50 per share). The investment community reacted swiftly and strongly. Allied’s stock rose $ 7.59 per share versus the Standard & Poor’s “500,” for an increase in total market value of approximately $ 630 million. Assuming that this increase was entirely attributable to the UTP recapitalization, it can be inferred that UTP had an intrinsic value to Allied of $ 2.17 billion before the deal (by subtracting the $ 630 million in improvement in the parent company’s value from UTP’s $ 2.8 billion transaction value). The increase in UTP’s value, from $ 2.17 billion to $ 2.8 billion, is almost precisely a 30 % premium to the benefit of UTP’s parent—the traditional premium associated with public-company LBOs. UTP went public in September 1987. The $ 14 per share offering price indicates that the value of the equity held by Allied, UTP management, and KKR had risen from $ 503 million to $ 953 million over the 30 months, a compound annual rate of return of 30 % . All told, Allied generated $ 2 billion in cash, retained a preferred takeout of $ 300 million in value above that, raised $ 253 million for UTP to invest by selling stock to management and to KKR, and still realized a 30 % compounded annual rate of return on the $ 250 million common equity stake kept in the recapitalized unit—all from a business unit that had an apparent value of only $ 2.2 billion. How do internal LBOs create such value? Much of the answer lies with the powerful incentives already discussed—putting a significant equity stake into the hands of management, using leverage to create pressures to cut costs and use assets more creatively. These transactions also create value because they transform the power relation between headquarters and the business unit. A debt repayment schedule takes over for the inadequate budget-setting processes that afflict so many companies. Business unit managers often hold the upper hand in negotiating easily achievable budget targets with their corporate parent. Indeed, many companies simply institutionalize poor performance year after year through undemanding budgets that the parent feels powerless to change. What’s worse, by setting targets for profits but only rarely for cash flow, most budgets fail to find the truly exceptional balance sheet opportunities to create value that raiders unearth. The larger and more diverse the company, the more aggravated these budgetary problems are likely to be. As an adviser to a huge, integrated oil company, I was shocked to learn that my request for financial data on one of the company’s major operating units could not be fulfilled by my contacts at the head office. The unit’s senior executives had secured a right to control the release of detailed information to the parent, and they certainly were not about to share it with an outside consultant. The corporate officers conceded that this policy put them at a disadvantage around the time of budget negotiations, but it was the agreement they had struck. An internal LBO repeals this disadvantage. The LBO debt’s repayment schedule spells out a challenging, multiyear, cash-flow budget in which there is no chance for hedging or renegotiation. The bankers’ earnest intent to lend no more money to the LBO than can be repaid and the competitive pressures they feel to lend enough money to win the bid are opposing forces that negotiate a debt repayment schedule likely to be neither too aggressive nor too timid. The notion of “management by exception” takes on real meaning. So long as the business unit is meeting its debt repayment schedule, there is no need for the parent to get deeply involved in the details of the business since the “budget” is being achieved. In effect, an internal LBO is a way for headquarters to extract superior performance from business units by “externalizing” the budgeting and bonus systems. It engages sophisticated outside parties to set a cash-flow budget that is highly demanding but still realistic and that arises from the full value of the unit. It converts those lofty performance expectations into an unyielding debt repayment schedule that provides precise and unforgiving targets. Finally, it offers unit managers exceptional rewards for beating the budget and extracts real penalties for falling short. Internal LBOs create value because they make unit managers “dividend” their budget to the parent and capitalize that commitment into a bond they must repay. Internal LBOs are different from leveraged recapitalizations of the sort performed by FMC, Holiday, and Kroger. Many of these transactions (which take place at the consolidated level) have been one-time responses to takeover rumors or unsolicited tender offers. I am advocating the use of internal LBOs (which take place at the business unit level) as a systematic and voluntary part of a company’s strategy—as applicable to healthy, core businesses as to underperforming, peripheral ones. Indeed, they can become the basis of a new organizational architecture that overcomes many of the weaknesses of the public company structure identified by Michael C. Jensen in his controversial HBR article.1 Internal LBOs need not be limited to easily separable business units. USX Corporation’s December 1988 recapitalization of its transportation division involved a business unit that was (and remains) highly integrated with the parent company’s other operations. The transportation operation consisted of seven railroads, a barge line, a dock company, and a lake fleet. It generates a significant portion of its revenues from carrying raw materials (coal and ore) to USX’s steel mills and transporting finished products from the mills to customers—a classic, no-growth business that was forgotten in a company of the size and diversity of USX. So USX sold the transportation unit to a new company formed for the purpose of conducting an internal LBO. The senior management of the transportation unit acquired 5 % of the new company’s common equity shares, and a third-party investor (the Blackstone Group) purchased a 51 % interest, leaving USX a 44 % owner after pulling out the $ 500 million in proceeds from the new, nonrecourse debt the unit took on. The critical operating challenge was to negotiate contracts (spelling out the ongoing relationship between the parent and its refinanced subsidiary) before the transaction. Stone Container has taken this logic even further by recapitalizing a business unit at the level of an individual mill. In December 1988, Stone transferred its Port Wentworth, Georgia linerboard plant to a new company called Stone Savannah River. Then, instead of leveraging to distribute cash to its parent, the new company borrowed $ 335 million in nonrecourse senior and subordinated debt to finance a major expansion and capital-improvement project. Since Stone agreed to take all of the mill’s production for at least 12 years, Savannah River has a guaranteed captive customer to generate funds to pay down its debt. In the final step of the restructuring, outside investors paid $ 115 million in cash to acquire a 50 % stake in the new company. Stone reinvested $ 35 million of the proceeds into Savannah River preferred stock, leaving it with $ 80 million to reduce its own debt and improve its balance sheet. At this level, an internal LBO turns into the familiar and time-tested method of project finance. To be sure, much of corporate America remains worried about the financial risks associated with leverage—especially in light of recent turmoil in the junk bond market and a few high-visibility corporate bankruptcies. Companies unwilling to assume the risks of leverage might be able to derive many of the benefits of an internal LBO without actually completing the transaction. For example, the parent could take back subordinated debt (or a preferred stock issue) from the operating unit in addition to retaining an 80 % common equity stake. In such a “partial” internal LBO, only the commercial bank debt will actually be raised and proceeds repatriated to the parent. The parent is still guaranteed a preferred takeout of profits before the unit’s managers participate, but if the unit’s cash flows do not meet debt-service schedules, the parent, and not some third party, will negotiate to convert some or all of the subordinated debt (or preferred stock) into equity. Unit managers will be penalized to the extent that their equity stake is diluted as a result of the exchange. But unless the unit’s performance deteriorates severely, it will still be possible to repay the senior bank debt, thereby keeping the outside creditors at bay. The corporate parent could even provide the senior debt financing. Such a “simulated” internal LBO is performed just on paper and is truly internal, bypassing the need to bring in outside parties for financing. Essentially, operating managers would purchase phantom stock in their unit whose price reflected the buyout premium. They would earn out the stock as they repaid a hypothetical senior and subordinated debt burden with cash flows generated by their unit. The obvious advantage of a simulated internal LBO is that there is no external creditor to threaten bankruptcy. The parent remains the one and only true investor in the business unit. Moreover, the details of the scheme can be kept from unwanted public scrutiny. These apparent advantages are also potential shortcomings. Without involving external investors, it may be difficult for the parent to know the true debt capacity and value of the unit. Will corporate headquarters be any better at negotiating the price and structure of an internal LBO with unit managers than it is at negotiating a budget? There is also a risk that without the threat of intervention by external creditors and without a clear mechanism to capitalize the value it creates, unit management will not take the plan as seriously. No matter how realistic, war games are not war. Decentralizing Authority and Ownership Each of the internal LBOs I’ve described involved seasoned and stable business units that were generating more cash then they could productively reinvest. For such cash-generating businesses, decentralizing debt and equity enhances rather than jeopardizes value. Bairnco, a diversified manufacturer based in New York City, has embraced the internal LBO model more aggressively than any other company I know. Its remarkable long-term performance testifies to the power of the technique and its value-creating promise.2 (See the insert, “Bairnco: A Case Study in Value Creation.”) Bairnco: A Case Study in Value Creation One company that captures the emerging synthesis of financial strategies, organizational structures, and operating philosophies is Bairnco, a diversified manufacturer based in New York City. On the surface, Bairnco looks like an uninspiring conglomerate hardly worth a second glance from business strategists. It consists of four completely unrelated operations that together generated 1988 revenues of nearly $ 230 million. Keene Corporation manufactures advanced composite materials for aerospace, defense, and commercial markets. Kasco supplies meat-cutting products and services to retail butchers. Arlon builds specialty laminated and adhesive-coated products for a range of high-technology customers. SSC makes shielding and radar-absorbing products for the defense sector. Yet beneath the surface, Bairnco emerges as an intriguing model of corporate growth and value maximization. The top officers have a meaningful interest in the parent company’s common equity. (By himself, founder Glenn Bailey owns nearly 10 % of Bairnco’s stock.) The company lets its people share materially in the financial success of their operations and measures performance based on variables that contribute directly to corporate value. Its headquarters bureaucracy is skeletal because Bairnco delegates responsibility to perform to its operating units. The company systematically decentralizes debt and equity in its individual business units and follows these transactions with equity spin-offs. Bairnco’s articulated strategy is to acquire a family of separate companies with single or focused product lines, nurture them to the point where they may stand successfully on their own, and then spin them off to its shareholders—that is, to buy, build, and harvest. The strategy unfolds in a two-stage process. First, the business unit leverages itself aggressively and distributes the proceeds to the parent, allowing Bairnco to recover its prior investment. Meanwhile, Bairnco sells up to 20 % of the stock in the unit to the managers and then distributes the remaining equity to its shareholders in a tax-free spin-off. The best testimony to the power of the company’s strategy is the exceptional returns Bairnco has generated over the long term. An investor who held $ 1,000 worth of Bairnco shares on December 31, 1978, and who maintained the holdings in Bairnco plus its spin-off companies, would have held shares worth $ 14,551 ten years later—a 31 % compound annual return, almost double the return from a similar investment in the Standard & Poor’s “500.” This value creation involves much more than “financial engineering” or the tax deductibility of interest. Consider the experience of Kaydon Corporation, the first business unit to be decentralized according to the Bairnco model. Kaydon left the corporate fold in April 1984 through a one-for-one stock dividend to Bairnco stockholders. Just before the spin-off, Kay-don performed an internal LBO. Kaydon paid Bairnco a special $ 56 million cash dividend by borrowing $ 53 million and selling new Kaydon shares to management for $ 3 million. Of the $ 53 million worth of leverage, $ 6 million was a subordinated debt issue placed with Bairnco itself, making this transaction a “partial” internal LBO. While Bairnco did forgo some cash as a result, the subordinated debt gave it a claim to future cash flow and value that is senior to Kaydon’s common stockholders, including the Kaydon managers. Furthermore, should Kaydon’s cash flow be insufficient to service the subordinated debt, the former parent will be responsible for stepping in and negotiating a financial restructuring of Kaydon—an important assurance for lenders. But the senior debt, the bulk of the transaction’s financing, has no recourse to Bairnco, in keeping with one of the main principles of financial decentralization. The internal LBO dramatically reshaped Kaydon’s balance sheet—and allowed management to acquire a significant share of the company with a realistic (but meaningful) personal investment. Shareholder equity dropped to $ 10 million, and debt increased to 87 % of capital employed (debt plus equity). By investing $ 3 million, Kaydon’s managers acquired 18.7 % of their unit. Certain officers of Bairnco and its other subsidiaries invested $ 100,000 to buy 0.6 % of Kay-don’s shares at the same price. Without the internal LBO, the personal funds that managers invested would have bought less than 4 % of the company. With the Kaydon spin-off, Bairnco in effect launched a publicly traded LBO. This transaction predated by more than two years the much-publicized leveraged recapitalization of FMC, which appears to be the first such deal ever. Like FMC, Kaydon has performed exceptionally well since its re-capitalization. From an initial value of $ 5, Kaydon’s shares have skyrocketed to over $ 31 a share, a 500 % increase that directly benefits Bairnco shareholders who held on to their Kaydon shares—as well as the managers and employees who made the increase possible. Kaydon Since the Spin-Off This dramatic creation of value was the result of savvy strategic moves and major operating improvements. (The table gives an overview of Kaydon’s performance since the spinoff.) Although Kaydon operates in competitive, limited-growth markets, revenues grew from $ 86 million in 1984 to $ 135 million in 1988—in part through two significant acquisitions completed after the spin-off. The company’s leverage, which started at classic leveraged buyout proportions, has been substantially paid down. Debt dropped from more than $ 70 million to $ 22.5 million at the end of 1988, while common equity rose from $ 16 million to nearly $ 70 million. What made this rapid deleveraging possible? First, by emphasizing higher-value-added product lines, Kaydon’s operating margins widened from 20 % in 1984 to more than 26 % in 1989, a trend that increased cash from operations to service debt. Second, Kaydon managed to hold down capital spending while still supporting its product demands. The ratio of sales to net property, plant, and equipment rose from 1.8 in 1984 to 2.8 in 1989, a great improvement in the use of equipment. Third, Kaydon did not pay dividends until three years after the recapitalization, and even then the payout was immaterial. By not paying dividends, Kaydon’s shareholders’ equity increased by the entire amount earned, and more cash was available to repay debt. Kaydon, like the UTP transaction described in the article, has been a fabulously successful internal LBO. Both generated substantial amounts of cash for their parent companies while preserving their parent’s financial flexibility. Both created powerful incentives for managers and employees to deliver outstanding performance. Both kept the parent company’s shareholders as investors in the LBO (either directly or indirectly), and both subsequently generated handsome rewards for investors. But there are also important differences. Kaydon’s LBO proceeded in full public view while UTP’s was submerged in private hands. Making managers perform in the goldfish bowl of public disclosure may accentuate the pain of failure and the satisfactions of success. Moreover, Bairnco decentralized equity by putting Kaydon’s shares into the hands of the company’s own shareholders. They, not some third party such as KKR, benefited from the successful aftermath of the transaction. Finally, the transactions had some important tax differences. Spin-offs to shareholders can be tax-free to the parent company and to the shareholders on the receiving end. Third-party sales to a firm such as KKR can trigger an up-front tax on part or all of the gain implicit in the transaction. What’s more, should Allied decide to sell its UTP shares to harvest its gain, it will face a corporate capital gains tax. But when a Bairnco investor chooses to harvest the gain in Kaydon’s value by selling shares in the market, only that investor will have a tax to pay on the capital gain. Bairnco will escape tax at the corporate level, an important advantage. Bairnco continues to push its model of aggressive decentralization in a series of divestitures that reflect corporate success rather than failure. In August 1988, Bairnco said it would spin off the Genlyte Group, a lighting products concern it acquired 1981. In January 1990, Bairnco said it would spin off its Keene Corporation subsidiary to shareholders. No details on that transaction are yet available, but the Genlyte formula resembled the Kaydon transaction. Before the spin-off, Bairnco aggressively leveraged Genlyte to recover its investment (the newly independent unit had an initial debt-to-capital ratio of 77 % ) and sold Genlyte management 16 % of the shares in the recapitalized operation. Bairnco could take its model even further. Why, for example, does the parent company wait until just before it spins off a business unit before it leverages it up and allows operating management to acquire a significant equity stake? It is possible to adopt internal LBOs without selling or distributing equity—to engage in private, self-contained recapitalizations between the parent company and unit management—as a way to motivate improved performance in the business units. Loading debt on the shoulders of promising new ventures or technology-intensive businesses, however, can snuff out flexibility and limit growth prospects. Businesses whose risk profiles or growth potential preclude internal LBOs can benefit from the decentralization of equity alone. Equity decentralization can take a number of forms: a partial or complete distribution of the unit’s shares to shareholders in the parent company (a nonqualifying “stock dividend” or a qualifying “spin-off” for tax purposes), a partial or full sale of common stock in the unit to the public, or an issuance of the unit’s stock to facilitate a tax-free merger or joint-venture combination. The common objective is to work ownership into the hands of entrepreneurial managers and, ultimately, employees. Tactically speaking, the best equity decentralization route depends on the business facts and circumstances at hand. But the end result is to redefine the relationship between headquarters and the business unit so as to reinforce entrepreneurial energies while maintaining the protective umbrella of a business infrastructure. Powerful corporate parents have much to offer fledgling business units: borrowing capacity, administrative economies of scale, marketing clout, and so on. The key is for the relationship between the business unit and the parent to be well-defined and flexible enough to allow operating managers to understand the “price” of the benefits they are receiving and to opt out of certain parts of the relationship if it is in their interest to do so. Decentralizing equity is an important tool to advance this goal. Thermo Electron Corporation, a diversified technology company based in Waltham, Massachusetts, provides a model for thinking about aggressive equity decentralization. The company generates revenues of nearly $ 580 million through the sale of products such as cogeneration power plants, medical instruments, and pollution-control devices. But the company is better thought of as a publicly traded venture capital group. Most of its commercial offerings trace their origins to its advanced research laboratories in Waltham and San Diego, California. As a new technology approaches commercial application, Thermo Electron deposits it into a separate subsidiary and sells a minority equity stake to public investors. This process began in 1983 and by the end of 1989 had spawned five partially public business units in which the parent company controls a majority stake. (The chart, “Thermo Electron’s Decentralized Structure,” shows how the company is organized and the parent’s stake in each of its subsidiaries.) Thermo Electron’s Decentralized Structure (all dollars in millions) Combined revenues for the five subsidiaries reached $ 273 million in 1989—double the level of just three years earlier and nearly half of Thermo Electron’s total corporate revenues. Operating income for the group increased over the same period from $ 17.7 million to more than $ 30 million. The entrepreneurs who are concentrating on developing new technologies and building their businesses derive real benefits from the parent company’s managerial, financial, and production support. Yet the benefits—as well as the costs associated with those benefits—are more precisely identifiable and negotiable than in a typical diversified conglomerate. Likewise, financial rewards are targeted to the objectives and performances of the diverse business units rather than the company as a whole. Thermo Electron’s structure offers a range of benefits. The financial structure enhances flexibility for the business units and the parent. Obviously, the subsidiaries benefit from Thermo Electron’s size and financial staying power. But their independence gives them access to capital beyond what’s available through the parent company’s capital-budgeting process. The units used similar financing strategies. Their initial public offerings (IPOs) were small, raising from less than $ 4 million to just over $ 10 million. At the time of their IPOs, most of the units had revenues on the order of $ 10 million to $ 20 million and were barely profitable (Thermo Instruments is the exception). Since the IPOs, several of the new units have returned to the capital markets on their own for additional funds—floating convertible subordinated debentures in Europe, for example, and issuing new shares to acquire competitors or buy ventures from Thermo Electron. All told, the subsidiaries have raised nearly $ 60 million worth of common stock through public offerings and $ 110 million of convertible subordinated debentures. For its part, Thermo Electron gets to syndicate what it considers to be excessive business risks, thereby allowing it to fund a wider range of risky but promising new ventures. For example, the parent has agreed to reimburse up to $ 4 million of Thermedics’s costs for developing and commercializing its drug-detection and explosive-detection products. (Thermedics will raise whatever additional capital it needs on its own.) The business unit will have the exclusive right to obtain a license from Thermo Electron to produce and market the products that result from the research and development effort, in exchange for the payment of royalties to Thermo Electron on the sales of such products. Financial independence helps the business units attract, retain, and motivate key employees. Thermo Electron’s structure makes incentives for management and employees more precise and powerful. Stock options and other equity-based compensation devices are linked closely to areas over which business unit managers have control. The managers of the public subsidiary units participate in stock option plans that give them between 1 % and 7 % of the upside value in the unit. In general, the degree of managerial ownership increases with the length of time that the subsidiary has been public. Note that stock options in these startup ventures are more valuable than they are for more mature companies because the ventures pay no dividends and have great upside potential in terms of capital appreciation. Thermo Electron also marries incentives for individual performance with the benefits of corporatewide risk diversification. Employees of the subsidiary companies are eligible to participate in both their own unit’s stock purchase plan and Thermo Electron’s defined contribution retirement and employee stock ownership plan. Certain officers and key employees of the subsidiaries participate in Thermo Electron’s incentive and nonqualified stock option plans as well as their own. The corporate parent provides a range of services whose costs are explicit and negotiable. For example, cash management is centralized under the Thermo Electron umbrella; the parent credits its subsidiaries with a return on their funds based on prevailing interest rates. Administrative overhead is also centralized—but negotiable. Thermo Electron’s corporate staff provides certain services to the subsidiaries in exchange for a fee that amounts to 1 % of each unit’s gross revenues. For identifiable overhead costs, Thermo Electron charges back to the units based on the costs directly attributable to each company. These service agreements can be canceled by the subsidiary companies with four months notice. The parent company even manufactures certain products for its subsidiaries under cost-plus contracts. For example, Tecogen’s small-scale cogeneration units are manufactured by Thermo Electron’s Crusader Engine Division, a leading supplier of inboard boat engines. The contract is cancelable upon one year’s notice to Thermo Electron. The subsidiaries provide investors with higher quality information about the prospects and risks of individual activities in a diversified company. They also create “pure plays” in distinct industry categories that hold a unique appeal to different types of investors, and they assure investors that new funds raised will be devoted to an identifiable and particularly promising purpose instead of being spread unaccountably throughout the consolidated company. The structure also gives unit managers a “market feedback” for their past performance and a “market test” for critical new investment decisions. Thermo Electron’s model of equity decentralization recently cascaded to an even deeper level. Thermo Cardiosystems, a wholly owned subsidiary of Thermedics (which is 62 % owned by Thermo Electron), was formed to develop a permanently implantable heart-assist device. It was taken public in January 1989, leaving Thermedics a 55 % owner (and Thermo Electron with 39 % of the company). Such a practice puts pressure on Thermo Cardiosystems to perform and challenges Thermedic’s management to come up with yet another winner instead of resting on its laurels. Few would argue with the proposition that a company’s organizational structure should complement and support its business strategy. Companies likewise benefit from ownership structures and financial policies that match their growth rates and levels of risk. For the publicly held corporation, one financial size does not fit all. But the experiences of organizations as diverse as the Henley Group, Allied Chemical, Bairnco, and Thermo Electron do point in similar directions. Companies become engines of exceptional value creation when they replicate internally the disciplinary and incentive forces offered by the capital markets. 1. Michael C. Jensen, “Eclipse of the Public Corporation,” HBR September-October 1989, p. 61. 2. In April 1990, Bairnco disclosed that the insurance coverage that had protected its Keene subsidiary from asbestos-related litigation was in doubt. Bairnco shares immediately plummeted, losing 50 % of their value in one week. This development should not detract from the substance of the company’s achievements under Glenn Bailey—particularly since the asbestos-related events took place long before Bairnco acquired Keene.

Remaking the Public Corporation from Within

Partner Center