6
December 1986: The Leveraged Buyout of Revco Drug Stores
Revco was in trouble from the day it went private. Sales and earnings projections were strictly from dreamland.1
Revco Drug Stores was taken private on December 29, 1986, at a 48 percent premium to the firm’s stock price 12 months earlier. Nineteen months later, it filed for bankruptcy. The means by which the firm had been “taken private,” a leveraged buyout, was a hall-mark of the 1980s and 1990s.2 In this transaction, management and a group of investors, acquired from public shareholders Revco’s common stock with a cash payment that was financed substantially by debt. At closing in December 1986, Revco’s leveraged buyout (LBO) was one of the largest ever ($1.4 billion) and certainly one of the most complex, featuring nine discrete layers of financing.
A counterpoint to the story of Revco is the leveraged buyout of its direct competitor in the retail pharmacy industry, Jack Eckerd Corporation. Eckerd was taken private in May 1986, also in response to a threatened hostile bid. As was typical of most LBOs, Eckerd reported losses but positive cash flows, sufficient to purchase 220 of Revco’s stores in 1990. Subsequently, Eckerd submitted an unsolicited bid to purchase the entire company. Revco’s management and creditors resisted. In 1993, Eckerd went public again, netting its equity investors a hefty return. Why Eckerd prospered and Revco didn’t offers lessons about governance, deal design, and financial leverage.
THE DEMISE OF REVCO
The buyout consummated a long episode of anxiety for Sidney Dworkin, the CEO of Revco, about possible takeover threats, internal fighting over control of the firm,3 and declining financial performance.4 The performance of Revco’s common stock over the period 1984-1986 provides a clear picture of how poorly the company performed prior to the 1986 LBO.
An analysis of the market-adjusted returns and cumulative market-adjusted returns (CMARs) to shareholders during the period 1984 to 1986 paints a dismal picture of Revco before the leveraged buyout. Shareholders suffered a -40 percent CMAR in 1984-1985. This performance reflected several events. In April 1984 the U.S. Food and Drug Administration (FDA) announced a possible link between E-Ferol, a vitamin E supplement produced by a Revco subsidiary, and infant deaths. Analysts estimated that Revco’s liability could mount to $75 million; yet the drop in market value associated with this event was $160 million. Further deterioration in returns later in 1984 is associated with the announcements of worse-than-expected financial performance. In 1985, the declines in CMAR in February-March are associated with management changes and the removal of dissident directors; later in 1985, additional declines are associated with worsening financial performance and the downgrading of Revco’s debt ratings by the major rating agencies.5 Generally, Revco underperformed its peer group over the 1984-1986 period, reporting lower annual sales growth and earnings before interest and taxes (EBIT) margins (EBIT/Sales).
An independent investment banker first proposed the idea of an LBO to Sidney Dworkin on September 17, 1985. Shortly thereafter, Revco retained Salomon Brothers Inc. to advise on the feasibility of an LBO. Salomon rationalized Revco’s poor recent financial results as being due to “temporary problems”6 and solicited Wells Fargo to develop a syndicate of banks to provide senior debt in the transaction. Wells Fargo provided a commitment letter in early March 1986; and on March 11, 1986, Sidney Dworkin presented a proposal for an LBO to the Revco directors. The proposal called for shareholders to receive $33 per share in cash, and $3.00 per share in exchangeable preferred, a 17.6 percent premium to the previous day’s price per share on the New York Stock Exchange.
The LBO announcement produced a two-day market-adjusted return of 8.4 percent for Revco shareholders. However, Dworkin’s announcement generated a vigorous debate within the financial community regarding the adequacy of the bid. Two securities analysts, issuing separate reports, believed the offering price to be “fair.”7 Other analysts believed the bid to be too low: William Blair & Company issued a report8 saying, “$38-40 is more equitable.” Also, the Dart Group, operator of a chain of discount drug stores, approached the directors about a possible acquisition of Revco. Later Dart asked to join the LBO group, and threatened to mount a hostile tender offer if excluded. Jamie Securities, a risk arbitrage boutique, expressed an interest in raising its holding of shares to more than the 9 percent it already owned.
On June 2, 1986, Dworkin presented a revised offer to the board for $38.50 in cash. The directors accepted the offer on August 15. Revco stockholders voted to approve the acquisition on December 17.The LBO closed on December 29.
Notable about this deal was its complex financial structure. It featured nine layers of financing and included exotic forms of securities rarely seen on Wall Street.These included the following:
• Preferred stock, like common stock, serves to “cushion” the creditors.
The amount of cushion the firm needs is probably dictated by expectations about the firm’s cash flows, particularly its strength and stability. The capital structure is like a serving line, with the senior creditors at the front, and the equityholders at the back. If the food is likely to run out, the cooks would rather have customers at the end of the line who will not boycott the cafeteria. Preferred holders cannot initiate a bankruptcy proceeding in the event a dividend is passed. At the same time, preferred stock is probably cheaper than common stock; dividends on preferred stock are not tax deductible, although corporate investors do enjoy an 80 percent preferred-dividend exclusion that creates a tax savings, which investors and issuers frequently share (via a lower dividend).
• Bundling the subordinated notes into units with common stock shares and common stock puts essentially “kicks” the expected return on the notes upward (if one is optimistic). The natural question is why Revco did not simply issue the notes with a coupon of 15 percent or 20 percent? The answer must be that the financial engineers did not anticipate sufficient strength of cash flow. The strategic role of the equity kick is also applicable to the convertible preferred stock.
• The exchangeable preferred was perhaps the most interesting layer in the deal structure. In essence, it was a “pay-in-kind” (PIK) preferred for the first five years, thereafter reverting to an ordinary current-cash-dividend preferred. In addition, the company retained the option to exchange the preferred for subordinated debt carrying the same yield, 15.25 percent. Upon exchange, investors would lose the 80 percent dividend exclusion but would gain modestly higher seniority in the event of liquidation.The company, on the other hand, would gain a new tax deduction with which to shelter its cash flow.
Was the exchangeable preferred issue really debt or equity? The answer must be found in the anticipated economic behavior of management, and in the economic role this issue plays. One should anticipate that Revco will exercise its right of exchange as soon as the firm gets a whiff of tax expense in 1992. Over the 1987-1989 period, this issue could just as easily have been carried as a debt issue; either way, additions to retained earnings would have been the same. It is a preferred stock in name only, so named in order to exploit a curious feature of the tax code.
• The junior preferred was to be purchased entirely by Salomon Brothers, and Transcontinental Services Group (TSG), another investor group.These investors could just as easily have committed the capital in the form of common equity; they probably chose to take a portion of their return in the form of PIK preferred to exploit the dividend exclusion. Economically speaking, one could view the junior preferred as common equity.
Revco’s ornate capital structure could be explained as a sophisticated solution to a complex financial problem: (1) Raise a lot of money to pay the buyout premium; (2) get as much as possible from the senior lenders (it’s the cheapest capital); (3) get as little as possible from the equity investors (they want to maximize returns); (4) tailor the terms of the capital in the “mezzanine” to be serviceable by the expected flow of cash and yet to be attractive to the providers of that capital (i.e., where necessary use contingent forms of payment).
Through the summer and fall of 1986, management watched the performance of the firm fall short of budget, which management attributed to the entry of new discounters into the discount-drug retailing industry. Net income for the year ended May 31, 1986 was down 17.6 percent versus the prior year. During the first quarter of fiscal 1987 (i.e., May-August 1986), operating income was 21.8 percent lower than plan. In October 1986 the operating budget was revised to provide a forecast for use in the prospectus. However Revco’s actual performance failed even to meet the revised budget. Nonetheless, during 1986, shareholders had realized a CMAR of 27 percent.
An internal memo written by Revco’s treasurer and dated January 2, 1987—four days after the LBO closed—expressed serious concerns about the firm’s worsening cash flows:
I am very concerned about cash flow since the sales for the past six weeks have been poor resulting in approximately $30 million less cash flow. It will be very difficult to make up this loss of funds. In fact, we have no excess cash going forward.9
The reports for the 4- and 32-week periods ending January 10, 1987 showed an extremely disappointing Christmas season.
What followed was progressive financial asphyxia. Anxious bankers met with Revco in February and March. On March 31 the banks were informed that Sidney Dworkin would step down as CEO, though he would remain board chairman, a move that reflected the sentiments of the banks and Salomon that Dworkin “was more entrepreneurial and not experienced or capable of running the operations on a day-to-day basis in a highly leveraged environment.10 Daily operating control would be shifted to President William B. Edwards. At this same meeting, the banks were informed that progress on asset sales was delayed, operating income was running below budget, and inventories were higher than plan. In May 1987, Revco’s operating profits for the fiscal year were 12.5 percent below plan, and its chief financial officer believed that the firm “was in serious danger of not being able to make debt service payments.”11
The changing of the guard brought with it a change in Revco’s strategy. Management abandoned Revco’s strategy of “everyday low prices” and adopted a strategy that included weekly sales and promotions. In addition, the product mix was broadened to include TVs, knockdown furniture, and VCRs. Store layouts were changed in an effort to increase pharmacy sales. These changes complicated operations and confused customers.
The internal power struggles split staff loyalty and caused infighting among management. Management struggles were taking precedence over running the company in the efficient manner necessary to make the LBO work. In September 1987, a new management team was installed at Revco, including Boake A. Sells, a former president of Dayton Hudson. Following this change in senior management, Dworkin sold his stake in the Revco venture for $8 million in cash and assets (the amount of his original investment in the LBO), and after 30 years of service, left the company he had so badly wanted to control.
Following the departure of Dworkin, asset sales stalled and cash became scarce. Due to the cash shortage, the company was unable to stock adequate inventory in the fall of 1987 and the Christmas season was a disaster. More generally, the stock market crash of October 1987 dampened consumer demand for the kind of goods toward which Revco was shifting its merchandising strategy. Revco was in serious trouble.
The extent of the problems became known when Revco filed its 10-Q for the quarter ended February 6, 1988. The disclosures indicated that asset sales to date had not been adequate to meet interest payments and the company had drawn down all but $15 million of its revolving line of credit. Furthermore, Revco was in violation of certain financial and nonfinancial debt covenants.
On March 10, 1988, Salomon’s high-yield bond sales force stopped making a market for Revco’s debt securities. Twelve days later, Salomon deleted Revco from its monthly report, The Safest of High Yields. At the same time, Boake Sells met with Salomon and expressed his displeasure with the level and quality of Salomon’s advisory services. On April 13, Salomon presented a restructuring proposal to Revco; Sells virtually rejected it, soliciting restructuring proposals two days later from Drexel Burnham, First Boston, and Goldman Sachs. Revco retained Drexel on April 19 to devise a restructuring plan.The hiring of outside advisors was triggered by internal projections, which indicated that Revco would not be able to meet a $46 million interest payment on its publicly held subordinated debt. Management planned to miss the debt payment so that working capital could be increased, that vendors could be paid, and that store operations could be improved.
On June 16 1988, Revco missed its first interest payment and omitted a quarterly preferred stock dividend. Drexel appealed to the firm’s investors to grant Revco “breathing room.” When these appeals were rejected, the firm filed for bankruptcy on July 28, 1988.
Drexel’s attempts to restructure were fruitless for several reasons. As management had suggested might happen, Revco missed a $46 million interest payment in June 1988. Transcontinental Services Group (TSG), which controlled 60 percent of Revco’s common equity, refused to give up a controlling interest in the firm in exchange for $703 million in concessions from bondholders. When a major bondholder refused to consent to a standstill agreement until January 15, 1989, the fate of the highly leveraged company was sealed. On July 28, 1988, 19 months after going private, Revco filed for court protection under Chapter 11 of the bankruptcy code.
Revco’s bankruptcy sent tremors through the financial community. From the buyout to July 1988, investors in these securities lost about 80 percent of their capital. The Revco LBO was one of the most prominent highly leveraged transactions in the late 1980s. The rapidity of its demise raised questions about the safety of these transactions and the ability of financial engineers to mitigate the foreseeable risks.This realization strained the junk bond market. The bankruptcy announcement coincided with a rise in junk bond risk premiums.
Revco was Salomon Brothers’ first foray into the field of large merchant banking deals: Salomon largely designed the transaction, placed the securities, and invested its own capital as a principal. The failure of Revco and other deals temporarily impaired Salomon’s franchise in merchant banking.
In 1990, while in bankruptcy, Revco divested almost one-half of its stores to Jack Eckerd Corporation, Reliable Drugs, Perry Drugs, and Harco, among others. Revco successfully fended off takeover threats by Rite Aid and Eckerd during almost four years of bankruptcy proceedings. Management, creditors, and competitors between November 1990 and February 1992 submitted at least 10 reorganization plans. In early 1992 both Rite Aid and Eckerd withdrew their bids for Revco. Revco ultimately paid Eckerd to go away, covering $7.5 million in expenses associated with Eckerd’s yearlong pursuit of Revco. The company finally emerged from bankruptcy protection in June 1992.
COUNTERPOINT: THE LBO OF JACK ECKERD CORPORATION
Based in Clearwater, Florida, Eckerd had 1,547 drugstores in 15 states. It was second to Revco in the number of outlets and behind both Revco and Walgreen in annual income. Drugstore chains accounted for 59 percent of the $43.2 billion in drugstore sales in 1984 (up from 57 percent in 1983), and their rapid growth over the past 10 years gave them excess cash to invest in other unrelated ventures . . . some of which went sour. Drugstores in general were considered an attractive takeover target in the early to mid-1980s because of the high profitability of the pharmacy end of the business, even though increased competition from supermarkets had cut profitability of health and beauty product sales. Besides Eckerd, other recent acquisitions in the industry had included Kroger’s purchase of Hook Drugs for $159.1 million in February 1985, K Mart’s $500 million purchase of Pay Less Drug Stores one month later, and the $325 million acquisition of Peoples Drug Stores by Imasco Ltd in April 1984. However, the larger drugstore chains such as Walgreen and Rite Aid were more immune to takeovers because of their high P/E multiples. Eckerd faced increasing competition in the Sunbelt region of the United States and saw a new threat from “deep-discount” chains, which operated on thinner profit margins than the typical drugstore chain. Eckerd, a Fortune 500 company, had sales of $2.5 billion in FY 1985 (ended August 3), but posted a loss of $8.3 million (compared with earnings of $85.4 million in 1984). Poor financial performance made it a prime takeover target.
In June 1985, Dart Group Corporation disclosed that it owned five percent of the shares of Jack Eckerd Corporation. Eckerd stock fell 68.5 cents to $26.25 after weeks of rising prices on takeover rumors. Dart’s purchase came weeks after an announcement by Eckerd that third-quarter earnings were expected to be only one-half that of the prior year’s period of $17.9 million. Eckerd responded by filing a lawsuit to stall Dart Group, and by selling divisions that were ancillary to the core business. On July 15, 1985, Eckerd announced the repurchase of Dart’s stake for $29.50 a share ($55.6 million total). News of the agreement sent Eckerd stock down $3.125 a share to $26.375.
In August Eckerd announced that it was considering a possible “sale, merger or business combination.” Analysts viewed the announcement as intended to increase the stock price (Eckerd was nine percent owned by management, including its chairman, president, and chief executive, Stewart Turley) as well as fend off any further hostile takeovers. The company also announced that it expected a 30 percent drop in earnings for the year to between $56-61 million, attributing the decline to unusually heavy mark-downs on merchandise and write-offs associated with the sales of divisions.
On October 10, 1985, Jack Eckerd Corporation announced that it had entered into a definitive merger agreement providing for the acquisition of the company by a new corporation to be owned by its employees and management, in addition to a group of investors organized and led by Merrill Lynch Capital Partners Inc. The LBO was seen by analysts as a move to discourage further takeover attempts (Dart Group Corporation had made a play for the company earlier in the year). The LBO also enabled Eckerd to concentrate on getting its business back in order without having to worry about short-term stockholder earnings. Initially, analysts viewed the LBO deal as good, but not great, thinking the company might be worth somewhat more than the buyout offer.The offer consisted of an all-cash bid valued at $33 per share for a total $1.2 billion.
On April 30, 1986, the acquisition was consummated following shareholder approval at the company’s annual meeting. Stewart Turley, chairman and chief executive officer of the new private company, said that going private would not affect the way he and his team would run the drugstores and that the change would be invisible to customers. Jack Eckerd, the founder of the firm, announced that he would sell all of his stock (1.1 million shares) and would not hold any position in the new company. He further noted that a person who had invested $1,000 in the original issue of Eckerd stock in 1961 would receive $158,000 as a result of the LBO.
Jack Eckerd Corporation had a negative net worth of about $252 million at the end of fiscal 1990, and payments on debt contributed to a net loss of $32.6 million. But Eckerd also paid down its $785 million in senior debt to $460 million from 1986-1990, as sales rose from $2.6 billion to $3.5 billion (despite the fact that the number of stores rose by only about 100). In June 1990, Revco agreed to sell 220 of its drugstores to Eckerd for an undisclosed price (later estimated to be about $60 million).
A year later, Eckerd announced an unsolicited offer to buy Revco out of bankruptcy. The offer was resisted by management and the creditors’ committee as being insufficient. Eckerd revised the offer upward again. But management countered with an offer of a greenmail payment in 1992, which Eckerd accepted.
The decision to go public again in 1992 was widely anticipated because of low interest rates. The company was able to refinance its debt inexpensively and buy back preferred stock that was getting 14.5 percent yields, thus saving money and improving the balance sheet. Meanwhile, high stock prices meant that investors would be willing to pay more for shares of Eckerd than before.
Although Eckerd had lost money annually since the buyout, the company maintained sufficient cash flow to pay off its debt and was considered one of the more successful companies to have undergone an LBO. By paying down and refinancing the outstanding debt at a lower rate, the IPO was expected to make Eckerd profitable again. Moreover, improved cash flow would enable the company to channel more resources into store construction /renovation and other capital improvements.
Eckerd tested investor interest with a small issue of stock in 1993, rather than dive in with a larger issue and have it not be well received.The proceeds from the IPO were used to pay down the nearly $1 billion in debt still outstanding from the 1986 LBO. Even though sales growth had been respectable, annual debt service payments approaching $150 million were eroding profits. In 2004, CVS Pharmacy acquired Eckerd.
THE PROBLEM OF CAPITAL ADEQUACY
The bankruptcy of Revco spawned a flurry of litigation centered on the question of whether, as a result of the LBO, the firm was (1) left insolvent, or (2) left with “unreasonably small capital.” If so, penalties for fraudulent conveyance could be invoked.
The test of insolvency considers whether the sum of liabilities at the date of the LBO was greater than the value of the firm’s assets. The bankruptcy examiner retained Alex. Brown & Sons to perform a solvency analysis comparing the par value of liabilities to the market value of assets—where market value was determined under three different approaches, comparable market multiples, comparable merger multiples, and discounted cash flow. Notwithstanding the numerous difficulties of applying these approaches, the examiner concluded, “it appears that under most tests Revco would have been solvent, although not in all cases.”12 The difficulties included scientifically estimating a discount rate, and accounting for the uncertainty about forecast assumptions.
The alternative explanation is that the structure of Revco’s deal was too aggressive, that it left the firm with too little financial slack with which to withstand the ordinary risks of business. “Financial slack” is conventionally thought of as excess cash and unused debt capacity, the cushion for adversities. Of course, there are two measures for slack, both of which are linked. One looks at the amount of equity relative to debt, and asks how large an erosion of enterprise value could be sustained before the value of debt exceeded the value of the enterprise. The other view would be to compare the projection of cash flows to the annual debt service obligations of the firm. One view looks at stocks of value; the other looks at flows. These two perspectives are linked if the market value of the enterprise and its securities is simply the present value of expected future cash flows.
In choosing how to finance the firm, managers choose the mix of equity and debt. Ordinarily, the higher the proportion of debt in the capital structure, the greater is the expected return, and the risk of default. The higher return derives from exploitation of debt tax shields, a phenomenon understood since the early work of Nobel prize winners, Franco Modigliani and Merton H. Miller. The higher risk derives from the lower margin for error that high debt service obligations create: As leverage rises, it takes relatively smaller surprises to bring the firm to ruin. The Examiner’s report cites evidence testing these hypotheses.
From analysis by Alex. Brown using a base case scenario assuming 12 percent revenue growth and 7.7 percent EBITDA margins, the Examiner concluded that Revco “appears to have adequate capital.”13 But testing another scenario, which relied on assumptions drawn from a Marine Midland Bank projection, 14 the Examiner found that Revco would be unable to meet its cash requirements starting in 1989. Further scenario analysis by Alex. Brown projected financial difficulty in 1988, 1989, and 1990. The Examiner offers other evidence to suggest that the deal was economically unattractive.
• There was no stampede of lenders trying to get into the deal: Of 33 banks invited to participate in the syndicate, only 11 actually did; the initial round of commitments was insufficient to finance the deal. Increases in fees to the banks were necessary to induce them to increase their lending commitments.
• The appraised values of Revco were less than the purchase amount.
• Although other bidders were rumored to be preparing offers, in fact none appeared to top Dworkin’s bid.
• The rating agencies, Moody’s and S&P, plainly declared Revco’s LBO to have a “negative outlook” more than a month before the deal was consummated.
• Internal bank memoranda acknowledged that the firm would survive only with aggressive asset sales.
• The performance of the firm had been declining for years and was so significant in the fall of 1986 as to necessitate a rebudgeting of fiscal year 1987.
The Examiner concluded, “A strong case can be made that Revco was left with unreasonably small capital as a result of the Revco LBO.”15
The quantitative tests of insolvency and inadequate capital are driven by point estimates of forecast assumptions.Yet given the crucial role of uncertainty about the future in this case, it is the probability of failure rather than a point estimate in a scenario that should be the governing economic test. Kenneth Eades and I16 used Monte Carlo simulation to test the ability of Revco to cover its annual cash obligations, and in particular, to yield an estimate of the probability of failure to cover. At issue is the sensitivity of the coverage of cash interest and preferred dividend payments to variations in operating assumptions: those used by Revco and Salomon, versus assumptions consistent with the performance of comparable companies and Revco’s own historical performance.
The simulation model forecast two ratios, EBIT coverage and Cash Flow coverage from May 31, 1986 to May 31, 1989. One could look at a longer forecast period, but the first three years feature the maximum risk exposure for Revco and thus warrant the most scrutiny.We considered two different debt service coverage ratios for these years. The first ratio was Earnings Before Interest and Taxes (EBIT) divided by projected interest and principal payments on long-term debt and cash dividends on convertible preferred stock. We call this the “EBIT Coverage Ratio.” The second ratio was EBIT plus proceeds from asset sales divided by interest, principal, and cash dividends.We call this second ratio the “Cash Flow Coverage Ratio.”
The Examiner’s report reveals strongly contrasting views about Revco’s future performance among insiders and outsiders. Salomon and Revco advocated operating assumptions that others deemed aggressive in light of the performance of comparable companies and of Revco’s own operating history. The Examiner noted that the lowest sales growth rate contemplated by Salomon was 8 percent, while the lowest EBIT margin used was 6.5 percent.17 However, the investor group provided its banks with forecasts assuming 12 percent sales growth—Wells Fargo ran a “worst case” scenario assuming 8 percent sales growth.18 Goldman Sachs, the advisor to Revco’s outside directors, determined that a 12 percent growth rate assumption was “too aggressive” (a more reasonable assumption was 8 percent), and the assumption of a 7.7 percent gross margin was “a bit aggressive.” 19 Ironically, Goldman ultimately opined that the investor group’s projections were “realistically attainable.”20
To some extent, Revco’s sales growth rate depended on the rate at which it planned to open new stores: The company planned to open 100 new stores per year for the next five years, to discourage new entry by competitors into Revco’s own market areas.21 The wisdom of the aggressive expansion strategy, however, is questionable in light of the resulting drag on operating performance: the Examiner noted that 70 percent of Revco’s stores that had been open less than one year lost money; the figure dropped to 48 percent for stores open between one and two years.22 In short, a case could easily be made for using much more conservative forecast assumptions than were used by principals in evaluating the Revco LBO.We modeled the impact of both sets of assumptions.23
The analysis suggests that Revco had a probability of between 5 percent and 30 percent of successfully servicing its financial obligations in the first three years after going private.These survival possibilities are so low as to suggest that Revco was undercapitalized in the sense that the new debt obligations exceeded its expected cash flow and the buyout was doomed to fail from the start. It is only when Revco’s earning power is assumed at almost double that of its recent past that the survival probability (assuming independence of cash flows) approaches 50 percent.The survival probabilities are relatively insensitive to assumptions concerning asset sales and growth of sales, suggesting that it was the structure of the deal, rather than flawed execution of the strategy by management that drove Revco down. The results for optimistic and pessimistic forecast assumptions are summarized in Table 6.1 and Figure 6.1. Figure 6.1 gives a representation of the probability distribution of Revco’s cash flow coverage ratio for the entire three-year period, 1987-1989. The graph reveals that only about 30 percent of the outcomes are higher than a coverage ratio of 1.0. The average coverage ratio is about 0.91, well below the minimum coverage of 1.0.
In comparison we applied the same assumptions (though different base year sales and debt service figures) to the Jack Eckerd Corporation, one of Revco’s competitors in discount drugstore retailing and itself the subject of a leveraged buyout in 1986. Eckerd’s base year financial figures differed from Revco’s. Perhaps most importantly, its annual interest and principal payments had a substantially deferred payment schedule as compared to Revco. The simulations for Eckerd reveal annual coverage ratios well in excess of 1.0 for the first three years and a cumulative probability of survival of 95 percent. We concluded from this comparison that the low coverage ratios for Revco revealed in the simulation analyses were a feature of Revco’s projected schedule of debt service rather than a result of the functioning of the model or reasonableness of the growth and margin assumptions. Moreover, it seems clear that the Revco LBO had a very high likelihood of failing within the near term and that our probabilistic analysis is qualitatively consistent with the opinions of the rating agencies at the time.
TABLE 6.1 SENSITIVITY ANALYSIS OF MONTE CARLO SIMULATION RESULTS
Source: Bruner and Eades, 1992. Reprinted from Financial Management (Spring, 1992) with permission from the Financial Management Association International, College of Business Administration #3331, University of South Florida,Tampa, FL 33620 (813) 974-2084.
Figure 6.1 Probability Distribution of Revco’s Cash Flow Coverage Ratio for the Three Years 1987-1989 Cumulatively
Source: Bruner and Eades, 1992. Reprinted from Financial Management (Spring, 1992) with permission from the Financial Management Association International, College of Business Administration #3331, University of South Florida,Tampa, FL 33620 (813) 974-2084.
CONCLUSION: WHAT WENT WRONG
Revco collapsed merely 19 months after going private, a lifespan astonishing for its brevity. Jack Eckerd Corporation survived and prospered. Common to both stories was a turbulent product market in drug retailing (specifically, the rise of the discount chains), the threat of hostile raiders, and the stock market crash of 1987 that produced a depressed holiday selling season that year. Clearly, business was not as usual. The retail chain of more than 1,400 stores was complex to supply and manage. Relatively high acquisition premiums left little room for error at Revco. Its financial performance was tightly coupled to its operating performance. Eckerd, on the other hand, had a little more slack with which to absorb shocks. The operating team was hampered by divided staff loyalties, infighting, executive turnover, and an inexperienced financial sponsor. It was working in crisis mode from the date of going private. Finally, overoptimism as a cognitive bias is strongly apparent in the aggressive financing terms designed into the deal. Fundamentally, however, the Revco case illustrates the forceful effect of bad management choices during and after the transaction.This is apparent in three areas.
1. Aggressive strategic change. A typical LBO candidate would have most of the following features:
• Strong cash flow.
• Low level of capital expenditures.
• Strong market position.
• Stable industry.
• Low rate of technological change (and low R&D expense).
• Proven management with no anticipated changes.
• No major change in strategy.
Revco departed from this profile in a number of ways.
Management intended to sustain the firm’s aggressive rate of new-store openings, about 100 per year. This strategy would demand approximately $10 million per year in capital expenditures, assuming costs of $100,000 each. At the rate of 100 stores per year, however, Revco might be on the verge of exhausting the desirable opportunities for new stores in small towns. Expansion into larger cities might bring higher setup and operating costs. Aside from the possible financial and marketing instability induced by this growth strategy, it also promised to divert the attention of senior management, and to strain the capabilities of middle- and junior-level managers. It made little sense simultaneously to impose on the firm huge financial risks, and market expansion demands. The change in merchandising strategy contradicts the profile of stability. Rearranging store layouts and introducing a range of bigger-ticket consumer goods risks confusing and driving away the customer, and increasing Revco’s inventory risk.
2. Aggressive transaction structure.The comparison of Revco and Eckerd revealed dramatically different probabilities of financial survival, as summarized in Table 6.2. In comparison to Eckerd, Revco’s deal displayed a materially higher acquisition premium, much smaller percentage of equity capital, lower cash flow coverage of interest—so low, in fact, that it would need to be supplemented by an aggressive program of asset sales, and a net withdrawal of cash by managers and key institutional investors in equity. Revco’s operating cash flow was simply insufficient to satisfy the demands for principal repayment in 1987-1988. For instance, timely service of the term loan assumed that Revco could sell its nonretail assets (about $230
million) by the end of fiscal year 1988. Thereafter, the operating cash flow was expected to be sufficient to service the debt. In short, the first 18 months after the buyout were to be a dangerous, “bet-the-ranch” time for the firm.
TABLE 6.2 COMPARATIVE SUMMARY: LBO OF REVCO DRUG STORES VERSUS LBO OF JACK ECKERD CORPORATION
Arguably, Sidney Dworkin and his financial advisers were credit abusers. To compensate in part for a high purchase price, they exploited the credit bonanza prevailing in 1986 for LBO investments.
• They borrowed quite a lot relative to their equity base (only 2.4 percent of the total purchase price was financed by common equity).
• They borrowed too much relative to Revco’s expected operating cash flow (the probability of survival in the first three years based on reasonable historical performance was quite low).
• They structured their borrowings in ways that would make it difficult to negotiate breathing room if Revco should encounter difficulty (nine layers of debt financing, all sold to different lenders or investors).
• They predicated the payment of principal in early years on asset sales rather than on operating cash flow, thus betting the survival of the firm on the buoyancy of the M&A market.
The case of Revco Drug Stores offers an important lesson for sound practice in M&A. Deal designers must preserve some financial slack in the structuring of their transactions. Bad things can happen to good companies. It is through the maintenance of slack that buyers can withstand the vicissitudes of business life. Intuitively, one knows that slack can be valuable. Slack is like an insurance policy, to be drawn upon in times of adversity.
3. Failure of governance. The appeal of the leveraged buyout has been that it proves the wisdom of governance that is up close and personal. Michael Jensen and others24 have properly argued that the LBO invokes closer scrutiny (from banks, managers, and the LBO sponsor), aligns managerial incentive payments much more closely to the success or failure of the firm, binds managers to deliver cash to investors, rationalizes internal organization, and reduces costs—all this produces material improvements in the efficiency of firms taken private. Revco’s proxy statement cited these and other virtues as motives for the LBO. It offered several reasons why the buying group regarded the purchase of Revco as “an attractive investment opportunity”:
• Favorable business prospects.
• Being private would permit Revco to have a higher debt-to-equity ratio and thus realize higher return on equity and higher growth in net worth
• The value of Revco depended on long-term expansion of the business, rather than on quarterly results to which the public investors give undue attention.
Indeed, the examiner’s report suggests that some progress was made toward these ends.
The case of Revco Drug Stores illuminates what can happen when the systems of governance and control fail to function. Karen Wruck (1991, 90) wrote:
Stating that too much leverage was the fundamental cause of Revco’s problems does not offer much insight into what went wrong. Management disarray, a weak and inexperienced LBO sponsor, a fee structure almost guaranteed to produce overpayment, and a disastrous midstream shift in strategy all conspired with the use of debt financing to put Revco into Chapter 11.
She reminds us of the fatal effects of managerial choices that elevate risk and failures of the operational team—these are two of the six factors highlighted in Chapter 4.
NOTES
1 Phillips (1988), 46.
2 This chapter draws on collaborative research with my colleague, Ken Eades, who deserves special recognition as a co-developer of the perspective offered here. In addition, the study refers throughout to the historical data given in the bankruptcy examiner’s report on Revco (Zaretsky (1990)). This chapter derives from court records, public news reports, and data analysis developed with the help of Ty Eggemeyer, Greg Graves, and David Eichler, all research assistants. Thanks also go to the Financial Management Association International, publisher of Financial Management, for permission to republish tables and findings from the Bruner-Eades (1992) article.
3 CEO Dworkin had been concerned about possible takeover threats (Zaretsky (1990), 30) since April 1984 when the firm’s stock price was battered by the sudden announcement by the Food and Drug Administration of a possible link between E-Ferol, a vitamin product, and infant deaths. In the week of the FDA announcement, Revco’s market value of equity fell by $160 million, more than twice the $75 million liability, which analysts estimated (see Kully (1984)). Dworkin, who owned 2.3 percent of the firm’s common shares, had hoped to pass the reins of senior management to his two sons, both of whom were senior vice presidents of Revco. Within six days of the FDA announcement, Revco announced an agreement to acquire Odd Lot Trading, Inc., a retailer of close-out goods, in an exchange of shares—the transaction would put 12 percent of Revco’s new total shares in the hands of two of Dworkin’s closest friends, Isaac Perlmutter and Bernard Marden, who were the owners of Revco, and who would become officers of Revco.
The peace of mind acquired with Odd Lot was short-lived: In less than three months from joining the firm, Perlmutter and Marden found evidence of purchasing irregularities in the firm, centering on Elliott Dworkin, Sidney’s son. A week later, Perlmutter and Marden announced that they might make a hostile tender offer for the firm, that they wanted 6 of 12 seats on the board of directors, and that they had retained Drexel Burnham Lambert to advise them. Shortly thereafter, the board largely exonerated the purchasing department; Perlmutter and Marden were fired in February 1985; Revco repurchased their shares in July 1985.
4 For the five years up to 1984, Revco’s sales had grown at a compounded annual rate of 19 percent; earnings per share had grown at about 18 percent. Its stock price had risen 60 percent, as compared to a 49 percent increase in the S&P 500 index. Revco’s stock price never recovered from the E-Ferol controversy, the purchase of Odd Lot Inc., and from the ensuing management infighting. Nor was the stock price helped along by a decline in the firm’s financial performance in 1985 and 1986—though revenues grew at a comparatively slow rate, operating profits declined, blamed in large part on losses at the new Odd Lot subsidiary.
5 Performance deteriorated in 1985 because of unsuccessful price discounting programs, significant store relocating and remodeling expenses, turmoil in the purchasing department arising from the departure of the dissident directors, legal fees associated with the dissidents, and losses associated with an unsuccessful division.
6 Zaretsky (1990), 36.
7 The two analysts’ reports were mentioned in Winter (1986).
8 See Kully (1986).
9 Zaretsky (1990), 199.
10 Zaretsky (1990), 133.
11 Zaretsky (1990), 137.
12 Zaretsky (1990), 177.
13 Zaretsky (1990), 177.
14 Marine’s “Reasonable Case” assumptions were sales growth varying from 7 percent to 6.5 percent over five years, and EBDIT margin ranging from 5 percent to 7.5 percent. See Zaretsky (1990), 178.
15 Zaretsky (1990), 196.
16 Bruner and Eades (1992).
17 Zaretsky (1990), 34.
18 Zaretsky (1990), 42.
19 Zaretsky (1990), 52-53.
20 Zaretsky (1990), 54.
21 Revco D. S. Proxy Statement, November 14, 1986, 11.
22 Zaretsky (1990), 42.
23 Detailed assumptions for the simulation analysis may be reviewed in Bruner and Eades (1992).
24 See, for instance, Baker and Wruck (1989); Bull (1989); DeAngelo, DeAngelo, and Rice (1984); Jensen (1989); Kaplan (1989a and 1989b); and Schleifer and Vishny (1988).
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