The Players

Byron C. Radaker arrived at Congoleum in 1975, became COO in 1976, President and CEO in 1977, and then Chairman in 1980. Byron had previously resigned from Certain Teed Corporation (a building products firm) after allegations of insider self-dealing, which were never proven.

Eddy G. Nicholson had worked as the second in command with J. P. Fuqua (after whom the Duke University business school is named) building conglomerates. Mr. Nicholson joined Congoleum in 1975, became COO at the end of 1978, and then President in 1980.

James Harpel was a Harvard MBA who identified Congoleum as an LBO candidate. And what did Harpel do when he determined Congoleum was a good LBO target? Did he buy the company? Yes and no. He had Century Capital Associates (where he was a managing partner) buy 124,000 shares of Congoleum at just under $13 a share (or a total of about $1.6 million). He then took his idea of turning publicly traded Congoleum into a private firm through a leveraged buyout to the investment banking firm First Boston. Isn’t that insider trading, which is illegal? No, not at all. Jim had an idea and thought it was a good one. He felt he had identified a potential LBO candidate before anyone else. He then bought shares. He was not an insider and was not using any inside, non-public information. Many years later, after becoming quite wealthy, Mr. Harpel endowed a chair at Harvard’s Kennedy School of Government. Why not the business school that gave him the knowledge to become wealthy? Ah, we will discuss that a little later.

First Boston approached the Prudential Insurance Company and some other institutional investors to finance the LBO.³ Why would the firm conducting the LBO approach an insurance firm as a possible investor? Wait and we’ll get there as well.

In early 1980, the various players (First Boston, Mr. Harpel’s Century Capital Associates, various financial institutions including Prudential, and the Congoleum executives Byron C. Radaker and Eddy G. Nicholson) created Fibic Corp., a holding company. Fibic Corp. purchased all the outstanding shares of Congoleum for $445 million (or $38 per share, which represented a premium of more than 50% above the price at which Congoleum was trading at the time).

How Was the Deal Financed?

What was the actual funding for the deal (i.e., where did the $379.6 million come from)? Fibic borrowed $125 million in new bank debt. Prudential and other institutional investors purchased $246.1 million of securities through strip financing. First Boston and Century Capital purchased a combined $4.5 million of common stock in the new firm. Management (principally Radaker and Nicholson)¹¹ also purchased a combined $4 million of common stock. The total financing for the deal was therefore $379.6 million from all parties combined.

Strip financing is a technique where the investor buys a “strip” of several different securities simultaneously. The strip is sold as a single security. In this case, the $246.1 million of strips consisted of four different pieces: $113.6 million of senior notes, $89.8 million of subordinated notes, $26.2 of preferred stock, and $16.5 million of common stock. Strips can either be separable or nonseparable. In a separable strip, the various securities can be separated and sold later as individual instruments. In a nonseparable strip, the different securities must remain combined in the same proportion. Congoleum’s strips were nonseparable

The Balance Sheet view of Fibic’s new financing is shown in Table 17.4.

Where did the investment bankers (Century Capital and First Boston) get the $4.5 million they invested? Most of it came from the fees they collected for doing the deal. As noted, total fees were $10 million, which included the money to First Boston and Century Capital as well as a $3 million fee to Lazard Frères & Co. (another investment bank who provided a “fairness” opinion on the deal) and the fees to accountants and attorneys.¹² Where did management get the $4 million they invested? They were paid $10.1 million for their stock options in the old firm and invested $4 million of that into the deal.

So when the smoke clears, what did the new Congoleum’s Balance Sheet look like? Table 17.5 shows the restated 1978 debt and equity after the LBO. The new firm still retained old Congoleum’s debt of $15.4 million (1978 year-end) plus the new debt of $328.4 million described above for total debt of $343.8 million. Comparing this with the preferred and common equity of $51.2 million, the firm increased its debt ratio (debt/(debt + equity)) from 7.6% ($15.4 million/($15.4 million + $187.5 million)) to 87.0% ($343.8 million/($343.8 million + $51.2 million))—this ignores for the moment the excess cash available on old Congoleum’s Balance Sheet. We discuss all of this in more detail in Appendix 17A for those who want it.

Wow! This is a huge increase in leverage. Given our discussion on capital structure earlier in this book, it also should represent a huge increase in financial risk. But is this right? Was the new debt (and risk level) really this high? No. Why not? Look closely again at the debt and equity components in Table 17.4. Let’s consider Congoleum’s common stock. There was a total $25.0 million of common stock. It was split between the $16.5 million owned by Prudential, $4.5 million by First Boston and Century Capital, and $4 million by management (Byron and Eddy). In other words, Prudential owned 66% of the common stock, with First Boston and Century Capital owning 18% while Bryon, Eddy, and a few others owned 16%.

Next, let’s consider Congoleum’s bank debt. What happens if post-LBO Congoleum fails to pay its pre-LBO debt or any new bank debt incurred? The firm risks being forced into bankruptcy.

But what would happen if Congoleum fails to pay the senior or subordinated notes? Remember, Prudential’s senior notes and subordinated notes were tied in with its preferred and common equity and sold as nonseparable strips. This is a critical detail. Would Prudential really have sued Congoleum and put the firm into bankruptcy? If Prudential had been willing to do this, who would it have hurt? The equity holders would have been hurt; however, Prudential was one of the equity holders and owned 66% of Congoleum’s equity after the LBO! Essentially, the senior notes and the subordinated notes were not debt in the traditional sense because this debt was held by the equity holders and couldn’t be separated from the equity. In a very important sense (that of the risk of being forced into bankruptcy), it is not debt. In effect, if Prudential forces bankruptcy, it is harming itself.

The bank debt and old debt were therefore the only “true” debt that added financial risk to Congoleum in the way we discussed in Chapter 6. This meant the new post-LBO firm’s “true” debt was really only 35.5% of total financing (($15.4 million of old debt + $125 million of bank debt) / $395 million of debt plus equity). A 35.5% “true” debt level with cash flows as stable as Congoleum’s was relatively safe with a low risk of bankruptcy.

Thus, the debt ratio may appear to have been 87% (total debt of $343.8 million/$395 million in total debt and equity), but in reality it was not. Prudential owned 59.2% of the debt and 66% of the common stock in strips. The “true” debt level was actually 35.5% as previously noted.

Let’s consider this situation again using a simple example. Imagine you start your own firm in your garage and lend yourself money. You own all the stock. If you can’t pay yourself back the money you lent yourself, are you going to take yourself to court and force yourself into bankruptcy? No. Similarly, as long as Congoleum paid the old debt and the bank debt, it was safe from bankruptcy. Congoleum did not face a substantial risk of bankruptcy if it failed to repay Prudential because the insurance company owned the senior debt, the subordinated debt, the preferred stock, and most of the common stock. So the strip was not really debt in the traditional sense that we talked about earlier in the book (i.e., in the sense of adding to the risk of being forced into bankruptcy in the event of being unable to repay debt).

So, how risky were the old debt and bank debt? The interest on the old debt was about $1.2 million, and the interest on the bank debt was about $17.5 million. This means Congoleum needed to earn $18.7 million to cover the interest on the old debt and bank debt. Table 17.1 showed that in 1978, Congoleum had EBIT of $85.6 million. This was a coverage ratio of 4.6 times. Note that Congoleum’s $17.2 million of royalties alone in 1978 were enough to cover 92% of the interest charges. This shows that Congoleum could easily pay the interest on its old debt and bank debt, and that its risk was not high.

Now, let’s explain the Congoleum LBO another way, using what we know about capital structure theory. Remember that in a pure M&M world with no taxes, capital structure doesn’t matter. By contrast, in an M&M world with taxes and no costs of financial distress, the desired amount of debt is 100%. However, in the real world, as we add debt, we usually add costs of financial distress, so the optimal capital structure depends on the trade-off between the benefit of tax shields and the costs of financial distress. Thus, in determining target capital structure for an LBO, we need to understand the amount of financial distress the LBO has.

To restate our earlier question: Is there any financial distress associated with the strips used to finance the LBO of Congoleum? Not really. By using these nondetachable strips to finance the LBO, First Boston created an M&M world with taxes and very little costs of financial distress. So the optimal amount of debt in this case was much higher than if the firm had to consider the usual higher costs of financial distress.

We should have convinced you by now that the strips used in the Congoleum LBO were not really debt since they didn’t increase the financial risk of the firm. However, let’s add more evidence.

As can be seen from Table 17.4, where the strip is broken down into its various components, the interest rate on the senior notes was 11.25%. The interest rate on the subordinated notes was 12.25%. The preferred stock was paying a dividend of $11 per share, or about 13.5% ($11/$81.25 issue price per share). And the ratings on these three instruments were B+, B–, and CCC respectively.

What was the rate on the new bank debt at the time? About 14%. Let this sink in. What was the most senior debt in this firm? The bank debt was the most senior.¹³ Who had to get paid first? The holders of the most senior debt, which in this case were the banks. What was the rate on this senior debt? About 14%. Who came after the banks? The holders of the senior notes (otherwise known as senior debentures). What was the rate on the senior notes? 11.25%. And the subordinated notes only received 12.25%.

Note, the yield curve was flat for 1978 and slightly rising in 1979. (One-year government rates were 9.28% and 30-year rates were 10.65%.) This means the rate difference between Congoleum’s senior debt and junior debt is not due to different lengths to maturity.

Does the interest rate on senior debt make sense? If the senior debt was getting 14%, what rate should the junior debt have gotten? Typically higher than the senior debt, because it has more risk. So why did Prudential, which owned the junior debt, accept a lower interest rate than the bank, which owned the senior debt? Because the debt that Prudential owned was not really debt. Prudential was going to get the remainder of its return on the equity it owned. It was therefore willing to accept a lower rate on the senior and subordinated notes. Furthermore, Prudential kept the interest rates on the notes low enough so that Congoleum’s cash flows could pay off the debt without technically defaulting. Thus, the fact that the senior debt (the bank debt) got 14% and the junior debt got at most 12.25% also tells us that the junior debt was not really debt in the traditional sense.

The strips more closely represented equity, since the majority equity holder (Prudential) also owned the strips. So why use strips, why not just use equity? Because if the firm called the strips equity and paid dividends, then the firm would have had to pay taxes before it paid the dividends. But if the firm called the strips debt and paid interest, the firm got to deduct the interest and reduce the amount it owed in taxes.

What was the key result of the LBO? Congoleum basically swapped out one stockholder for another: the firm swapped out the public stockholders for the private ones. To do this, it used a brilliant financing structure. By using strip financing, Congoleum was able to increase its nominal debt level and reduce taxes without a corresponding increase in financial distress.

This was the very first LBO with this structure (i.e., with strip financing). It was also five times larger than any LBO ever done before. The Congoleum LBO became the blueprint for future LBOs, and it started the LBO—and now, private equity—boom. We will discuss below how the equity return compensated Prudential and made up for the low rate it got on the debt it owned.

Risk of the LBO

Let us now revisit: What was the basic business risk (BBR) of Congoleum? Since Congoleum had three distinct product lines, another way of asking this is: How much risk was there in each of the three businesses? Not very much. As previously noted, this was why the firm was such a good LBO candidate. Home furnishing had a very low basic business risk with Congoleum’s patents and brand name (Congoleum flooring is still in the market today, 35 years later). Shipbuilding had a very low BBR because they were a government contractor with a multiyear backlog. The auto part business had low risk because it also had numerous patents, plus it sold in the maintenance market (less risky than the original equipment market). Furthermore, if cash flows turned out to be lower than forecasted, Congoleum could have easily divested one of these divisions for funds because none were critical to any other.

So let’s ask: What are the expected cash flows? Later in this chapter, we will calculate pro formas for the LBO; we find there is very strong cash flows and very little risk to the debt holders.¹⁴ The coverage ratio (EBIT/interest) we project is strong and improves over time (from 1.38 to 5.74, as shown in Table 17.9), and the cash flows are stable. Importantly, the royalties to Congoleum from its patents remain equal to half the projected total interest payments. The combination of low BBR with stable cash flows, the ability to sell off a division, improving coverage ratios, and a “real” debt level of only 35.5% provided great comfort to the lenders.

What about the management of Congoleum? Was it good management? Would investors have been worried that management might leave? We know the management at the time was able to run the company because they had done a good job in the past. In addition, with the LBO, management would now own a substantial portion of the equity in Congoleum, providing them with added incentive and thus making them unlikely to leave.

So what was the risk from the bank’s point of view? Low to moderate. This was a stable company with good cash flows, good collateral, good management, and a low-to-moderate “actual” debt level. The bank owned $125 million of debt, which was 32% of total capital and was all senior debt.

How about the risk from Prudential’s point of view? Congoleum’s total debt level with all debt included—regardless of its being “actual” or not—was 87% ($343 million/$395 million). Of this total debt, Prudential had 59% ($203.4 million/$343 million), all of which was junior. Without the equity component, this would have made Prudential’s position quite risky, even given the stable cash flows and low business risk. However, Prudential also owned 66% of Congoleum’s equity. This means its position should be viewed as that of an equity holder, not a debt holder. And while this equity position was riskier than the bank’s position, Prudential (like any equity holder) also had a potential upside. Furthermore, unlike a typical equity holder in a firm with 87% debt, Prudential also owned much of the debt. As such, the risk of financial distress from the junior debt is not that high. Prudential, as the majority equity holder, would not have forced Congoleum (mostly owned by itself) into bankruptcy.

Value Creation

We stated earlier that the LBO structure used in Congoleum created value. How much value did the LBO create? Well, on July 15, 1979, Congoleum’s share price was $25 a share. Since there were 11.783 million shares outstanding, this means Congoleum’s market capitalization (market cap) was $299 million. This was the market value of the equity. On July 16, 1979, the consortium of Prudential, First Boston, Century Capital, and Congoleum’s management made a tender offer to the current shareholders at $38 a share. This means the bid for all of the 11.783 million shares was for a total of $447.7 million. The market value of equity went up by $148.7 million ($447.7 million – $299.0 million) in one day, a 50% premium. How did the market value of equity go up by so much with the tender offer?

Through the miracle of modern finance!

The operations of Congoleum did not change in any way as a result of the LBO, nor were they expected to.

Congoleum went from being a public firm worth $299 million to being a private firm worth $467.8 million (the price paid). Where did the additional value come? Let’s take a look.

Congoleum’s Pro Formas

Let’s put ourselves in July 1979 as the present and generate pro formas for Congoleum with and without the LBO. Since this chapter is not about pro formas (which we explained earlier in the book), the pro formas can be found in Appendix 17A. Note that there are two significant changes we want to focus on in the projections with the LBO as compared to the projections without the LBO: First, interest expense increases (from $1.2 million in 1978 to $41.6 million in 1980) due to the additional debt. Second, depreciation and amortization expense increases due to the write-up of the assets to their purchase price by the LBO. Table 17.6 provides the projected Income Statements with and without the LBO, taken from Appendix 17A (Tables 17A.1 and 17A.4).

Explaining the Miracle: LBOs and Taxes

Table 17.6 shows that Congoleum’s pro forma net income without an LBO is $51.6 million compared to a pro forma net income with an LBO of $8.2 million. Why such a huge difference? The reasons are that with the LBO:

1. Income before tax is reduced by the $42.0 million increase in depreciation and amortization caused by the higher asset values after the LBO.
2. Income before tax is reduced by the $41.6 million additional financing charges from the debt incurred to fund the LBO.

Together these two changes cause the income tax to be reduced by $40.2 million. In finance, these tax savings are often referred to as depreciation tax shields and interest tax shields. Explaining these two tax shields one more time: The pro forma in Table 17.6 shows that the LBO has additional depreciation and amortization expenses of $42 million in 1980 (thus increasing SG&A). At a corporate tax rate of 48%, this translates to a tax savings of $20.2 million.

Similarly, the additional interest expense in 1980 is $41.6 million. At a corporate tax rate of 48%, this translates to a tax savings of $20.0 million.

Taken together, the additional tax shield on depreciation and amortization of $20.2 million and the tax shield on interest of $20.0 million combine to the $40.2 million shown in Table 17.7 for 1980.

Looking forward five years, the savings in taxes with the LBO is projected to be roughly $35.3 million per year (a high of $40.2 in 1980 to a low of $29.3 in 1984), as shown in Table 17.7.

A Theoretical Explanation of Our “Miracle of Modern Finance”

Let us return to capital structure theory for a moment. If you recall, M&M (1958) showed us that the “pie” is fixed and that capital structure determines how we cut the slices and who gets them. M&M (1963) showed us that with taxes, the government also gets a slice of the pie and that therefore taxes reduce the size of the slices available to other stakeholders. By increasing debt, we reduce the size of the slice to the government. Keeping with this analogy, the LBO, by increasing interest and depreciation expense, reduces the size of slice going to the government and increases the slices to the other parties. In Congoleum, the government’s share of the pie is reduced by $40.2 million in 1980, according to our pro formas.

However, and this is key, who gets the $40.2 million that used to go to the government in taxes? It now goes to the debt holders in the form of interest and principal repayment. And who are the debt holders? The banks (partially) and Prudential (principally). But remember, Prudential is also the largest equity holder (owning 66% of the equity). By leveraging up the firm to 87% debt, we have reduced the payments to the government and increased the payments to the debt holders. However, unlike our discussion of capital structure, where the cost of increasing the debt increased the risk,¹⁵ the strip financing means that debt holders and equity holders are the same parties, and thus the risk of distress has not increased with the increase in debt.

So, what has the firm accomplished by doing the LBO? For one thing, the firm has created a situation where it will pay roughly $40.2 million less in taxes in 1980. In essence, Congoleum borrowed money from Prudential to buy its stock and is now using the tax savings it gets from having debt to pay Prudential back.

To return to our tongue-in-cheek question above, why did Harpel (the Harvard MBA who started all this) give a chair to Harvard’s Kennedy School of Government instead of Harvard’s Business School, from which he graduated? Perhaps it was in honor of the government tax code, which allowed this modern miracle of finance. (This is pure unsupported speculation on your authors’ part.)

Going Forward

Appendix 17A shows the Pro Forma Income Statements and Balance Sheets for 1980–1984 and how they were generated. (Again, we recommend that the reader take time out at this point to skim Appendix 17A.) From Table 17A.4, we are able to generate Congoleum’s pro forma excess cash flows as shown in Table 17.8.

Note that we assume that Congoleum is depreciating the patents and other assets for tax purposes but does not require new CAPEX to maintain those patents and other assets. (As noted in Appendix 17A, CAPEX is assumed to equal the depreciation on the pre-LBO assets, so these don’t change over time and the LBO write- ups decrease over time.) Prior to the LBO, additions to PP&E were $12.7 million in 1978 and $6.7 million in 1977.

Table 17.9, which is derived from Table 17A.5 in Appendix 17A, shows that over the first five years after the LBO, the amount of debt decreases substantially. This assumes the excess cash shown in Table 17.8 is used to pay down debt. In fact, even if the excess cash is held by the firm (i.e., not used to pay down debt), we know that the “actual” debt level is debt minus excess cash.

Thus, Congoleum is projected to go from being a firm with 86.5% of debt immediately after the LBO to being a firm with 37.5% debt just five years later. The bottom line is that tax payments that used to go to the government are now going to the capital providers of Congoleum, which are largely the debt holders (i.e., Prudential) but also include the equity holders. After the debt is paid down, the firm looks as though it has the same capital structure as before the LBO, but the ownership has changed to Prudential, the investment banks, and management.

In addition to the dramatic drop in debt, Congoleum’s equity also increases substantially, as shown in Table 17.9. The preferred stock remains at $26.2 million. The common equity increases from the initial $25 million investment to $137.9 million (the cumulative net income minus the cumulative preferred dividends).

LBOs appear to be very complicated (different types of debt, preferred stock, etc.). The underlying reality is not that complicated, but it needs to look very complex. Why? So that it qualifies as debt for tax purposes even though the risk level is quite low. The reality of the financing is that the strips are technically debt, but are really more like equity. This is why the deal is structured with senior debt, subordinated debt, junior debt, preferred stock, and so on. Has the government figured this out and changed regulations to prevent companies from avoiding tax payments in this way? Yes and no. Some rules have been changed; others have not. However, this method was allowed in the Congoleum transaction and many others.

Equity Returns

How much equity did First Boston, Century Capital, and Congoleum’s management invest in Congoleum? They invested a total of $8.5 million in 1979. Prudential invested another $16.5 million of common equity. This is a total common equity investment of $25.0 million. What is this equity expected to be worth at the end of 1984? As seen in the pro forma in Appendix 17A, Table 17A.4, in 1984 the firm is projected to have $46.7 million of net income. In addition, the firm is expected to have paid off almost all its debt, as shown in Table 17A.5, with debt (short-term plus long-term) falling from $306.7 million at the end of 1980 to $98.5 million in 1984.

Assume the current equity holders of Congoleum now decide to go public. How much should they expect to receive for their equity? Let us first consider a P/E multiple. Selling the earnings at a multiple of 1.0 would mean the current common equity holders would almost double their money (going from the $25.0 million invested to $46.7 million). A multiple of 1.0 times earnings is clearly way too low. Using Congoleum’s pre-LBO earnings multiple of 7.3, the firm’s market capitalization (sale price) would be $340.91 million. This is a return of over 1,363%, or an average annual return of 68.5% per year. Now you know why we call this the miracle of modern finance. If the current equity holders (Prudential, Century Capital, etc.) were able to sell Congoleum at the average market multiple of 15.0, the returns would be even more spectacular: a market capitalization of $700.5 million, meaning a total return of over 2,800% or an average annual return of 94.5% per year.

How would Byron and Eddy do? Remember they initially put $4 million (of the $10.1 million they received for the stock options, pocketing the remaining $6 million for other uses) into the firm for a 16% equity share. At an earnings multiple of 7.3, management would receive $54.5 million ($340.9 * 16%) on their $4 million investment, plus the salary and perks they earn from running the firm. How does this compare to the salary of $370,000 Mr. Radaker was getting before the LBO? This is the difference between being rich and sincerely rich. Now we are talking sincerely. We can now also recognize the attraction that LBOs might have to management.

Prudential invested a total of $246.1 million in the strips, of which $16.5 million represented a 66% share of Congoleum’s common equity. In our pro formas, five years later the debt and preferred stock of $229.6 million are repaid in full, and the equity is estimated to be worth $225.0 million ($340.9 * 66%) at a multiple of 7.3, or a total of $454.6 million ($229.6 + $225.0). Thus, Prudential earns 84.7%, or an average annual return of 13.1% on its strip investment, in addition to the annual interest and preferred dividend payments.

A quick summary to this point: Congoleum was the first modern LBO. The key to understanding the value creation in this case is that modern LBOs represent an M&M world with little or no financial distress. In M&M’s theoretical world, if there are taxes but no costs of financial distress, you should maximize the amount of debt. Typically, we don’t want to maximize the amount of debt because of the costs of financial distress. In the Congoleum case, however, the participants figured out a way to finance the firm with equity while calling it debt. They then took the money they would have paid to the government and instead paid themselves (as the debt holders).

Price Paid to Old Stockholders

So now we have to ask: Was $38 a share (the LBO price) a fair price to pay? Remember, it was a 50% premium on the market price at the time. But at $38 a share, Congoleum’s management, the investment bankers, Century Capital, and Prudential all made an enormous amount of money. Did they do this at the expense of the old stockholders? Should they have paid the old stockholders more? Well, the old stockholders got 50% more than the market price at the time.

If the management of a public company buys it from the stockholders, is this self-dealing? Furthermore, can management later be held liable? To prevent liability (or at least defend themselves from the charge of self-dealing), what must management do? They must hire an investment bank. Why? To obtain a fairness opinion.¹⁶ Management will be sued regardless (if the LBO works well), but a fairness opinion helps protect management from accusations of self-dealing. To the authors’ knowledge, there has never been a successful lawsuit against management, a board of directors, or investment banks where a fairness opinion was obtained before an LBO.

So where did the Congoleum consortium get the fairness opinion? Lazard Frères, an independent investment bank (independent of First Boston, Prudential, Century Capital, and Congoleum’s management). A summary of Lazard’s fairness opinion is presented in Appendix 17B. What did Lazard use to justify its opinion that the price was fair? Lazard used a variety of multiples to value Congoleum’s three separate divisions. Could you have valued Congoleum’s three separate divisions? By this point in the book, your authors hope your answer is, “Absolutely!” Now, Lazard also had people sitting by the phone waiting to see if another bidder came in with a higher offer.

How much would you charge to provide a fairness opinion? What would your hourly rate be? We’re guessing it is substantially below what Lazard charged, which was $3 million. (Your authors would like to point out at this time that they and other academics are perfectly capable of performing the same analysis as the investment banks, and for less money.)

Now, some people might think that Lazard is being compensated for the liability it assumes and for putting its reputation on the line when providing fairness opinions. However, when an investment bank gives a fairness opinion, it typically requires the firm that requested the opinion to indemnify the investment bank from any liability. This means that if there is a lawsuit against the investment bank and the investment bank loses, it does not have to pay. So much for any liability. What about the value of an investment bank’s reputation? We will leave it to the reader to determine the value of an investment bank’s reputation, but we do not believe that reputational risk is what determines their fees.

Furthermore, contingency fees are common for investment bankers in acquisitions. In this case, per page 12 of the proxy statement, Lazard gets a flat fee of $1 million regardless of whether the deal is consummated or not. Lazard also gets a contingency fee of $2 million if the deal goes through. So if Lazard finds that the deal is not fair, it gets the $1 million flat fee. If Lazard says the deal is fair and then the deal is successful, Lazard gets $3 million. Incentive effects are clearly possible.

An old joke is that if the world really wanted peace in the Middle East, then it should have Goldman Sachs represent one side and Morgan Stanley the other side, with the signing of a peace agreement on a contingency fee basis. The punch line is that the world would have peace by the end of the month.

What Happened Next?

So what actually happened to Congoleum? Congoleum did very well after the LBO. The company continued to operate effectively and took the forecast interest tax-shield and depreciation tax-shield. The firm was profitable, well above the forecast, and debt was paid down rapidly. After five years, the tax shields were greatly reduced because the assets were depreciated and the interest tax shield decreased as the debt was reduced. For many LBOs, this is often the time the firm goes public again. Why? The tax advantages of the LBO have been realized and are no longer as large. Furthermore, as we discussed earlier, even at modest earnings multiples, the returns to the LBO investors are significant.

Congoleum did not go public again. Rather, it did a second LBO in 1984. In the second case, the management team brought in new partners, and Byron and Eddy ended up owning 70% of the equity. Prudential, First Boston, and Century Capital all earned a healthy premium of three times earnings for their participation in the first LBO.

Then what happened? In 1986, the management team decided to sell Congoleum. According to the Wall Street Journal:¹⁷

Congoleum Corp. has completed the job of dismantling itself with the sale of Bath Iron Works, but the job now is to figure out what to do with the $850 million in cash. Pondering the problem last week was Eddy G. Nicholson, 48, and Byron C. Radaker, 52, formerly the chiefs of Congoleum. They say they owned or controlled 70% of Congoleum’s common stock.

Basically, Byron and Eddy sold off the company to others in pieces¹⁸ and netted $595 million ($850 million * 70%) for themselves.

Performance Incentives of LBOs

The above analysis is not meant to imply that the only advantage to LBOs is the increase in tax shields. Importantly, when the managers are also the stockholders, there is evidence that they do a better job in managing the firm. An academic study by Steve Kaplan shows that performance measures (i.e., increases in operating income, decreases in capital expenditures, and increases in net cash flow) all substantially improve after an LBO.²⁰

Thus LBOs, if properly structured, not only return us to an M&M world with no costs of financial distress, they also return us to a world where the managers are the owners so there are no agency costs.

Coming Attractions

Our next case involves the acquisition of Family Dollar by Dollar Tree. This case covers strategy, valuation, and execution, which we will do in four consecutive chapters.

Assumptions for Congoleum’s Pro Formas without the LBO (Tables 17A.1 and 17A.2)

• Sales growth of 11% (the average growth from 1974 to 1978).
• Cost of sales at 67% (the 1978 level).
• SG&A at 19% (the 1978 level).
• Interest expense for 1979 is set slightly below the 1978 amount (reflecting the debt being paid off each year) and is zero in 1979 (as the debt is fully paid off).
• Tax is 48% of the profit before tax amount.
• Earnings per share (EPS) is net income divided by 11.783 million shares.
• Dividends paid are 25% of net income (and dividends per share are total dividends divided by 11.783 million shares).
• The year-end stock price is 7.3 times EPS.
• Cash is the plug figure, the amount required to make the Balance Sheet balance.
• Accounts receivable is set at 11% (the 1978 level).
• Inventory is set at 13% (the 1978 level).
• Other current assets, PP&E, and Goodwill are all held constant (at the 1978 amount).
• Debt is paid off (given the large cash balance).
• Accounts payable is set at 7% of sales (the 1978 level).
• Other current liabilities are held constant (at the 1978 level).
• Other long-term liabilities and contributed capital are held constant (at the 1978 level).
• Retained earnings are the ending balance from 1978 plus the pro forma net income computed in Table 17A.1, less an assumed dividend of 25% of net income.

Congoleum’s Pro Formas with the LBO

Table 17A.3 (which shows how Congoleum’s Balance Sheet might have appeared in 1979 with the LBO) is generated using the pro forma 1979 Balance Sheet in Table 17A.2 (which shows how Congoleum might have appeared in 1979 without the LBO). Table 17A.3 is then adjusted for the changes due to the LBO (e.g., with changes in value due to the LBO). Note that there is no change in the 1979 Income Statement as the LBO occurs after year-end and thereby has no effect on income until 1980. The key changes are:

1. The assets are written up after the LBO by $245.8 million, with $174.0 million allocated to patents and the remaining $71.8 million allocated to PP&E. How do we get the $245.8 million amount? It is the difference between the $467.8 million paid to purchase Congoleum (the $447.7 million paid to stockholders plus the $10 million in fees and the $10.1 million paid to the executives) and the $222.0 million net book value of the firm without the LBO in Table 17A.3 (assets of $345.3 million less liabilities of $123.3 million) at the time of the LBO. The $174 million allocated to the patents is based on an estimate provided in Congoleum’s proxy statement.²¹ For simplicity, PP&E is increased by the remaining $71.8 million. In reality, each individual asset and liability would be adjusted to its market value, with the remainder allocated to goodwill.²²

2. The short-term debt is increased by $125 million, the amount of the new bank debt.
3. The long-term debt increases, as stated earlier, by the $113.6 million of senior notes plus the $89.8 million in junior notes, or a total of $203.4 million.

   To restate the preceding paragraph:		(millions)
   Cash paid for Congoleum (Table 17.3)		$467.8
   Pro forma total assets 12/31/1979	$345.3
   Pro forma total liabilities 12/31/1979	$123.3
   Net book value 12/31/1979		$222.0
   Purchase price discrepancy		$245.8
   Allocated to patents (appraisal)	$174.0
   Allocated to PP&E	$ 71.8	$245.8

4. The contributed capital is reset, as stated above, to reflect the preferred stock of $26.2 million plus the common stock of $25 million, or a total of $51.2 million.
5. The retained earnings are reset to $0 after the purchase, as the assets and liabilities have been reset to their purchase price.

Congoleum’s Post LBO Pro Formas 1980–1984 (Tables 17A.4 and 17A.5)

We are now able to generate Congoleum’s pro forma Income Statements and Balance Sheets with the LBO. We will use many of the assumptions in Tables 17A.1 and 17A.2 as well as the changes noted in Table 17A.3.

The pro forma Income Statements (Table 17A.4) are generated using the following assumptions:

• Sales growth of 11% (the average growth from 1974 to 1978).
• Cost of sales at 67% (the 1978 level).
• SG&A at 19% of sales (the 1978 level) plus $41.98 million for the additional depreciation and amortization. For simplicity, PP&E is depreciated evenly over ten years and the patents over five years. Thus:
• Depreciation and amortization is estimated as follows:

• Interest expense is 14% of the prior year-end bank debt (for 1980 this would be 14% * $125 million = $17.5 million) plus 11.25% on the senior debt (for 1980 this would be 11.25% * $113.6 million = $12.8 million) plus 12.25% on the junior notes (for 1980 this would be $113.6 million at 11.25%) plus $11.0 million on the junior notes (for 1980 this would be 12.25% * $89.8 = $11 million).

• For simplicity, each year’s interest expense is based on the amount of outstanding debt at the end of the prior year. Excess cash is assumed to be used to pay off debt on the last day of the year. The bank debt is assumed to be paid off first. This is both because it has a higher rate and also because senior debt (in this case, the bank debt) normally has covenants that prevent paying off junior debt first. Once the bank debt is fully paid off, the senior debt is paid off next and the and junior notes are paid off last.²⁴

• An income tax rate of 48% is used, as it was the corporate tax rate at the time of the LBO. (Students today would use a tax rate closer to the current maximum corporate tax rate of 35%. Students reading this book 30 years in the future . . . you get the idea.)

The pro forma Balance Sheets (Table 17A.5) are generated using the following assumptions:

• Congoleum maintains a minimum cash balance of 1.5% of sales. Any balance above this amount is considered excess cash and used to pay down debt.
• Accounts receivable is set at 11% of sales (the 1978 level).
• Inventory is set at 13% of sales (the 1978 level).
• Other current assets are held constant (at the 1978 level).
• PP&E and Intangibles, after being increased by the LBO (as per Table 17A.3), are reduced evenly over 10 years ($7.18 million) and 5 years ($34.8 million) respectively. CAPEX is assumed to match the depreciation on the prior balances (i.e., the change in PP&E and Intangibles is the additional depreciation and amortization on the LBO write-ups only).
• The bank debt is paid down, as noted above.
• Accounts payable is set at 7% of sales (the 1978 level).
• Other current liabilities are held constant (at the 1978 level).
• The long-term debt is paid down, as noted above.
• Other long-term liabilities are held constant (at the 1978 level).
• Contributed capital is assumed to remain constant.
• Retained earnings are increased by the pro forma net profit and reduced by the preferred stock dividend of $3.542 million (322,000 shares @ $11/share). No other dividends are paid since all excess cash is assumed to pay down debt.

Thus, Tables 17A.1 through 17A.2 help generate Tables 17A.4 and 17A.5. These in turn generate Table 17.8 in the chapter.