Back in the early 1980s, leveraged buyout (LBO) firms, armed with money from speculative investors, made fortunes buying companies, chopping them up and selling off the pieces. In 1988, LBO firm Hyde Park Holdings acquired High Voltage Engineering, a Wakefield, Mass.-based manufacturer of diversified energy controls, and sold off its divisions, liquidated its real estate and fired over a third of its workforce. Meanwhile, the LBO investors saw none of the spilled guts but plenty of the glory-returns on junk-bond investments often averaged 20 per cent yearly.
Today that kind of take, while not exactly chump change, pales in comparison to the dough filtering down to investors from the ridiculously high valuations of barely born companies. Is FreeMarkets, the Pittsburgh-based business-to-business online auction site, worth $US10 billion in equity on $7.8 million in sales? I don't know, but I do think it classifies as a new form of very risky equity-what I call junk equity.
Junk equity has the friendly face that junk bonds and LBOs never had. Crazy Internet startup valuations don't tear companies apart; they build something from nothing and slap a fantasy value on it that makes young workaholics fulfilled and investors rich. Rumor has it that venture firm Kleiner Perkins Caufield & Byers' partners each took home $1 billion last year.
Strangely, all of this frenzied activity seems to have had little impact on the Fortune 500. But junk equity may turn out to be the tinder for as much predatory behavior as junk bonds were in the '80s. No large-scale financial activity occurs in a vacuum, and the tremendous equity war chests being built from investments in Internet startups make traditional companies-which now look undervalued by comparison-tremendously vulnerable to takeovers. Just look at Time Warner, which is about to be swallowed up by 15-year-old AOL-an Internet service provider!
LBOs were relatively quiet in the '90s, mostly because the Fortune 500 got religion and cut costs, making the traditional LBO slice-and-dice game more challenging. But LBOs haven't gone away-they've simply made their own set of adjustments. These days, a new breed of LBO, the transformational operator, has emerged. These firms, such as Clayton Dublier & Rice (CD&R) and Forstmann Little, don't just chop up companies and resell the pieces; they transform the companies before they sell. With everyone playing the equity game so loosely these days, LBOs stand to make huge gains by buying old companies, taking them private, getting them ready to do business on the Internet and then offering them up as fresh IPOs. The junk equity gained by selling these companies could make the junk-bond days seem dull by comparison.
For example, CD&R purchased Wesco Distribution for $800 million in 1994 and sold it for $1.1 billion after making significant operational improvements. How do they perform this magic? They buy the company, bring in new, strong operating management, give equity to management and employees, and aim for clear operating goals. If necessary, the transformational operators are willing to make huge investments to fix the company, improve cash flow and market share. Then they bring the company out on the public market-transformed-and make all involved rich.
These LBOs have not yet even begun to tap the possibilities for making a traditional business ready for the online world. For example, if an operationally oriented LBO firm like CD&R bought Toys "R" Us, took it private for a few years and invested in the changes necessary to transform it into a combination marketplace and "marketspace" company-that is, you could shop in the store or online-Toys "R" Us would surely be valued at the same level as its online competitor eToys, which despite a mere $30 million in sales has a market cap 10 times that of $11.2-billion-in-sales Toys "R" Us.
If Toys "R" Us could transform itself, it wouldn't just match eToys, it would crush it. Can't fit junior's toy into the SUV? The checkout clerk could log on to the Web site and have it delivered to your door. Worried about online return hassles? Just bring it back to any Toys "R" Us store. The possibilities for "bricks and clicks" services are endless, and Toys "R" Us has stores in every part of the country to test them out cheaply. Rope off a few hundred square feet of a store and experiment with willing customers. Give them scanners to choose the toys they want, then go to an ATM-style kiosk linked to Toys "R" Us's Web site to confirm the order and select fulfillment options-pickup in the store or home delivery.
Toys "R" Us could be an example of seamless integration of place and space while rewarding its investors with a windfall. Why doesn't Toys "R" Us do it now? I'd argue that management is afraid. They speculate that if they simply maintain a web presence, the market might reward them in four years when all this Internet hysteria calms down. No wonder Toys "R" Us decided to spin off its dotcom effort, robbing itself of the possible synergies of bricks and clicks. The two organisations remain separate, and the people who run the brick-and-mortar business have no incentive to help the dotcom business and vice versa.
Companies can save themselves the pain and humiliation of being snapped up by LBOs if they change themselves first. Yet the wonderful world of organisational transformation is like sausage making-better done in private and never shown to the person eating the sausage. Worse, if companies invest to transform their businesses, they will take an earnings hit because of higher expenses, and Wall Street is likely to severely punish their stock price. At the same time, if they do not invest to maximise the effective use of Internet technology, they will continue to see dotcom startups grab cheap capital while they grind out hard-won earnings with little stock appreciation.
To protect their companies, progressive management teams must be willing to do three things: Invest in transforming the business; reward employees equally for both online and brick-and-mortar successes; and bring in outside management and pay systems to attract the best talent available. If the capital markets will not give management the equity necessary to transform the business, company leaders must consider a management buyout or sell themselves to an LBO firm.
CIOs play an important role in making these transformations. They must clearly articulate the power of Internet technologies to radically lower the cost of customer service, logistics, marketing communications and other key functions. The CIO is best positioned because he or she has the knowledge of what it takes to play in the information economy.
Now is the time to take action before barbarians are once again at the gate, armed and hungry for blood.
John J Sviokla, a former Harvard Business School professor, leads the digital strategy practice at US-based Diamond Technology Partners
Join the CIO Australia group on LinkedIn. The group is open to CIOs, IT Directors, COOs, CTOs and senior IT managers.