You might know Joel Greenblatt (Trades, Portfolio) best as the founder of Gotham Asset Management, or perhaps as the author of the well-known book on stock investing, "The Little Book That Beats The Market." However, in addition to these pursuits, Greenblatt is also an active teacher: he is an adjunct professor at the Graduate School of Business at Columbia University. In a 2005 talk with his students, he explained why he doesn't like to get involved with leveraged buyouts.
Be careful who you do business with
A leveraged buyout is an acquisition that is financed primarily with borrowed capital, with the assets of the purchased company being used as collateral for the loan itself. This is a strategy that works extremely well if the value of the business rises, but doesn't work at all if the value declines. As with all leveraged strategies, losses are magnified just as much as gains.
LBOs were particularly popular in the 1980s, with many investors being levered as much as 9 to 1. Anyone who has researched any amount of financial history will know that with this amount of borrowed money, something tends to give sooner or later. But that doesn't mean that it isn't possible to make a lot of money in the short term, and Greenblatt thought that he could get in on the trend.
Greenblatt was offered financing by the investment bank Drexel Burnham Lambert (best known as the bank brought down by Michael Milken's illegal activities in the junk bond market) on what seemed like pretty favorable terms. As equity holders, Greenblatt and his partners needed to put up just $1 million, while Drexel Burnham was willing to extend $26 million in debt financing.
Unfortunately, not everything went as smoothly as Greenblatt had hoped, as he said:
"One warning sign that we should have seen was that the seller was a leveraged buyout shop that had obviously goosed the numbers the year before they sold. [The business] made baking pans for Twinkies and Wonderbread and that kind of thing. And it was interesting to see something around for so long - if you went to the factory in Chicago, the little office outside the factor had a typing pool of about 20 manual typewriters from like 1928. So those were the little tip-offs about this business that we should have seen! Anyway, it went bankrupt within about six or nine months of when we purchased it, being the shrewd, due diligence types that we were at the time."
Luckily for Greenblatt, he and his partners were able to sell off different parts of the business such that the reorganized company ended up actually being worth more than they paid at the start. This is a great example of how bankruptcy can be a source of opportunity for value investors - even if a business seems unsalvageable, that doesn't mean that it is completely worthless. However, it goes without saying that this was not the outcome that Greenblatt was expecting, and it was this stressful experience that made me sour on the LBO strategy as a whole.
Read more here:
- The Value Investor's Handbook: Identifying Fraud
- Warren Buffett: The Advantages of Investing in Small Companies​
- Market Indicators Off of the Beaten Path
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
