And no wonder: Leverage transfers cash from a company’s pockets to that of shareholders and creditors, while raising the risk of default for rank-and-file employees and all other stakeholders. So distasteful is leverage that even many buyout pros refer to it by the ominous-sounding term “financial engineering.” Has anyone ever tried to seriously argue that leverage—and even too much leverage—can be a good thing for company performance? Well yes, of course someone has. Nearly twenty-five years ago, after a big wave of LBOs in the mid-1980s had led to some high-profile setbacks for the industry.
In 1989 Michael C. Jensen, now 74 and an emeritus professor of business administration at Harvard Business School, published an influential paper in the Harvard Business Review, “Eclipse of the Public Corporation.” In the paper, which today reads like “A Modest Proposal” in its unblinking advocacy for LBOs as a superior form of corporate ownership, Jensen observed that leverage had already become an industry bugaboo. It was, he wrote, “perhaps the central source of anxiety among defenders of the public corporation and critics of the new organizational forms.”
And yet Jensen found that “most critics” of leverage overlooked three things:
- First, pointing to the 1980s bull market, Jensen noted that corporations had to borrow more money simply to avoid deleveraging.
- Second, Jensen argued that corporations that borrow money without retaining proceeds—typical in LBOs—are less likely to waste free cash flow. Sure, corporations can issue dividends if they have no better use of the cash. But dividends are discretionary. Debt has to be repaid to creditors to avoid bankruptcy. Wrote Jensen: “Debt is in effect a substitute for dividends—a mechanism to force managers to disgorge cash rather than spend on empire-building projects with low or negative returns, bloated staffs, indulgent perquisites, and organizational inefficiencies.”
- And third, Jensen wrote that “debt is a powerful agent for change.” Indeed, he argued that even too much leverage could lead to positive developments. “Companies that assume so much debt they cannot meet the debt service payments out of operating cash flow force themselves to rethink their entire strategy and structure,” Jensen wrote. “Overleveraging creates the crisis atmosphere managers require to slash unsound investment programs, shrink overhead, and dispose of assets that are more valuable outside the company.”
Gasp! Just imagine the partner of a buyout shop today explaining to a public pension board how his firm plans to use leverage to create a “crisis atmosphere” at companies to compel a much-needed bust-up. Chairs would be flipping backwards left and right.
But here’s the problem. Leverage has gotten such a bad name that investors and legislators have lost sight of some of the reasons private ownership can make so much more sense than public ownership in the first place. In Jensen’s masterful phrasing: “By resolving the central weakness of the large public corporation—the conflict between owners and managers over the control and use of corporate resources—these new organizations are making remarkable gains in operating efficiency, employee productivity, and shareholder value.”
Jensen added, presciently, “Over the long term, they will enhance U.S. economic performance relative to our most formidable international competitor, Japan, whose companies are moving in the opposite direction. The governance and financial structures of Japan’s public companies increasingly resemble U.S. corporations of the mid-1960s and early 1970s—an era of gross corporate waste and mismanagement that triggered the organizational transformation now under way in the United States.”
Reached by phone late last month for an interview, Jensen said that in fact he has become disenchanted with some aspects of the buyout industry, including the move by a handful of the largest firms to go public themselves. Nevertheless, while noting he hasn’t been following the industry closely for several years, Jensen said he stands by most of his conclusions in the paper, including the positive effects of leverage. He pointed to the downfall of Eastman Kodak, which filed for bankruptcy protection early last year, as having been avoidable if the company had been sufficiently levered in the 1980s. “They were fat, dumb and happy,” Jensen said. “They didn’t have to make any changes. Leverage is one of the things that forces that.” A spokesperson for Eastman Kodak responded in an email: “We are entirely focused on completing our emergence as a profitable, sustainable company, so are not spending any time looking back at the distant past.”
Every few years it is worth re-reading “Eclipse of the Public Corporation.” Just don’t send it to your congressman.