Harvard: Making a Profit

Ever abreast of trends in the financial world, Harvard's in-house investment company is on the cutting edge of the latest Wall Street rage: leveraged buyouts.

The LBOs--as they are called by the traders, economists and politicians who are busy debating the ethical implications of such mammoth takeover deals--have become a staple of the University's investment in the past few years, currently taking up $162 million of Harvard's endowment.

And Harvard Management Company, the wholly-owned subsidiary of the University that maintains its $4.2 billion endowment, has built up a team of LBO experts that other university financiers say is the envy of the higher education investment circle.

Scott M. Sperling heads the University's three member LOB team. Michael Eisenson and Michael G. Thonis are two relatively new additions to Harvard Management brought in to strengthen the University's buyout investments, according to a Wall Street investment banker who has worked with Harvard.

"By adding Eisenson and Thonis, they're now trying to put the burden of deal review on [their own] people" rather than the managers of limited partnerships, who traditionally put together such deals, says the investment banker.

Sperling's buyout team has geared up for action over the past year, increasing by $20 million the amount Harvard has invested in LBOs since 1987. And Harvard has also moved a step beyond, using its resources and expertise to manage its own LBO funds, rather than relying on outside limited parternships to carry off the deals.

As one Wall Street investment banker, speaking on the condition of anonymity, says, "Harvard has some real smart guys." The University, he adds, has built an LBO team with top-notch "in-house expertise."

And Rod Adams, Stanford's treasurer, says, "We don't have a shop like Scott Sperling's." Adams says his university hasn't jumped on the LBO bandwagon in the same way that Harvard has--as he puts it, Stanford "has taken a somewhat different view of LBOs" than Harvard.

Stanford's attitude is not surprising, considering the controversy surrounding the ethics of leveraged buyout deals. Headlines splashed across the business pages of The New York Times and The Wall Street Journal have made LBOs into one of the touchiest investment issues of the day.

Leveraged buyouts are an increasingly popular, though controversial, method of taking over companies. The deals--which included the recent, largest-ever takeover of RJR-Nabisco by a limited partnership in which Harvard invested--buy out stockholders in a company using borrowed funds worth up to 80 percent of the buyout price. Only about 20 percent of the investment generally comes in the form of cash up front, which means the company ends up assuming a large debt once the sale is completed.

In the past few months, Congress has held numerous hearings on the economic and ethical implications of LBOs. And this month, the House Ways and Means Committee is scheduled to hear testimony that may move Congress to consider bills to curb the recent rash of buyouts.

But in the meantime, Harvard continues to increase its presence in the burgeoning LBO market. According to Wall Street sources and Eisenson, the University has been choosing its own buyout deals for about the past five years. And each year, as the endowment has increased, so has the amount of Harvard capital invested in those buyouts.

The reason for Harvard's interest in controlling its own deals? Most experts say the decision has been a strategic financial one--ethical principles, they contend, are secondary.

"I can tell you without any equivocation that Harvard's decision was economically and not politically driven," the Wall Street broker said recently. "In a typical fund," he explained, "20 percent of the profits go to the fund."

And an administrator in a Wall Street investment banking firm says, "There will be a higher return because [Harvard has] eliminated the middleman."

Eisenson agrees, saying that while limited partnership gave Harvard "access to bigger deals," the new direct investments avoid the "cost attached to limited partnerships," a cost he says amounts to about a 20 percent cut of the profits.

But while most agree the lure of increased profits has drawn the Harvard Management Company's attention, Harvard officials say they are also considering the ethical issues involved.

Vice President for Finance Robert H. Scott has said that "the Corporation is focusing in on the issue [of LBOs]." He added that there has been "quite a bit of discussion on the appropriateness of a variety of investments."

Harvard's seven-member chief governing body "is still looking at the issue" of LBOs because, Scott says, the University does not want to participate in any deals "where the fees are more important than the economics."

But while the finance administrator says he thinks "there is nothing inherently wrong with leveraged buyouts," many economists and politicians say the deals are economically questionable and ethically dubious.

"The problem you have with leveraged buyouts is there are a lot of people making zillions of dollars on them...and no one likes to see these people making all this money," a Wall Street money manager says.

One expert, Kennedy School lecturer Robert B. Reich, says "I doubt that this is the most socially productive way to use that money." The economist, who has taken his dispute with LBOs to the op-ed page of The New York Times and the front cover of The New Republic, argues that "the only clear winners [in leveraged buyouts] are investment bankers and lawyers."

Objections to LBOs center on three main ethical issues. First, many say that the deals force companies to go private and thus lose any chance of public scrutiny. Second, they say that if management initiates the takeover there is a conflict of interest between their responsibilities to stockholders and their position as investors.

And finally, critics contend that the deals produce socially unacceptable results by concentrating profits in the hands of a few investors. "LBOs create a structure where a few individuals are owners and derive profits from the work of several thousands of individuals," says Robert K. Massie, Jr., a former fellow in the program on ethics and a Ph.D candidate at the Business School.

Many critics of LBOs also say that while they make money for the shareholders, they often put employees out of work.

"One of the objections to LBOs is that companies have to operate with a very narrow attitude towards expenses," says Converse Professor of Finance and Banking Warren A. Law. Recently bought-out companies "tend to fire a lot of people," he adds.

But advocates of leveraged buyouts say that the transactions produce more streamlined companies with higher profit margins and more efficient managements. "A fat, dumb and happy management is bad for the employees," says the Wall Street administrator.

And LBOs have been lucrative for Harvard, Sperling says. For example, Harvard's investment in the Kohlberg, Kravis, Roberts and Company (KKR) limited partnership that recently took over RJR-Nabisco "has generated significant returns for Harvard's account."

Of the $162 million the University currently has invested in LBOs, Sperling says "somewhere in the low tens of millions of dollars" of that money was in the KKR deal, which was finalized last month.

In making its LBO investments, the University is looking for companies "with a stable predictable cash flow, assets and no debt," says the Wall Street investment banker. "You want non-sexy businesses--bricks rather than toys or fashion," he adds.

And although some investors participate in `unfriendly' LBOs in which the takeover is made without the backing of management, Harvard is "not going to be involved in unfriendly deals because they'll loathe the publicity," says the investment banker.

But, as Scott says, in the leveraged buyout business "what's unfriendly is a little hard to tell."

That uncertainty about unfriendly takeovers is mirrored in the long-term prognosis for the leveraged buyout trend. While Harvard and other investors may be raking in the profits from LBOs today, economists say they think the buyout market will falter if the economy weakens.

"Generally speaking, LBOs are quite lucrative for investors," says Reich. But, he adds, "when the market turns sour, it may not be quite so lucrative."

Doug Henwood, publisher of the Left Business Observer,says "LBOs sort of made economic sense in the early '70s and '80s when they were small [transactions]." But "they no longer make sense because I don't see how we can finance the debt," he adds.

Henwood says he thinks that if the economy went into a recession, those economic conditions combined with rising interest rates would throw as many as 10 percent of U.S. companies out of business if the LBOs continued.

And he says if a recession was anything like the one in the early 1980s, "people like Harvard would find their investments going bad."

Law says he also thinks there may be a recession in the near future, giving a "one-in-five chance" for a recession in the next year.

But the economic verdict is not clear. Steven P. Galante, managing director of buyout information at Venture Economics--a Boston-based business analysis firm--says, "there were a lot of LBOs in 1980 and 1981 and they went through that recession without any defaults."

"Generally," Galante says, "you don't structure a deal based on the best-case scenario."

All those economic debates, however, may eventually be moot if Congress passes laws hampering the leveraged buyout deals.

Since LBOs rely on the tax deductibility of loan interest, some takeover critics have suggested that this allowance be discontinued or decreased, thereby making LBOs less attractive, a Capitol Hill source says.

Other critics who are mainly concerned with the level of debt incurred in the LBO process have suggested that the tax deductibility be shifted towards cash expenditures rather than debt, thus encouraging LBO initiators to use money instead of loans.

But the congressional source says he "wouldn't be surprised if nothing is done [about LBOs] on the Senate side" because people have drawn a negative connection between the 1987 stock market crash and a House resolution, passed five days before the crash, that halted LBO deductions over $5 million.

And Galante says, "Congress has been historically reluctant to pass legislation to regulate the markets." Law agrees with this analysis, asserting that any action Congress takes "has as many problems as solutions."

But the Capitol Hill source says many government officials are concerned about the rise in LBOs because "debt is not as productive as research and development." And, he adds, there is an "undercurrent" of feeling in Congress that there are ethical problems with LBOs.

But, as Massie says, "Congress responds to major events." And, "in the absence of a major event, like another RJR, they probably won't do anything," he adds.