The Simple Mechanics of Legalized Theft:

Or how corporate kleptocrats are robbing the U.S. blind

A lot of economic theory has been accepted like religion, "by faith," instead of like science, by withstanding critical examination. I think parts of economic theory are like parts of psychological theory: severely under-evaluated. Don't get me wrong, both psychology and economics have many serious scholars who are very rigorous. But both fields seem to attract greater-than-normal numbers of ideologues in scientist's trappings; probably because it is harder to disprove their whacky theories in these two disciplines than it is in the so-called hard sciences.

One of the widely acclamimed but spurious economic theories is that corporate takeovers are good for our economy because they weed out the inefficient and promote the efficient. Well, let's take a look at how it usually works, and you decide if the theory holds up to actual practice or not.

Here's how it usually works:

Company A is sound financially, has a great future, employees 1,000 workers who are happy with their careers, has no debt, and great income. It is valued, by the worth of the stock it has issued, at $100 Million. The kleptocrats -- er, Corporate Raiders, see Company A as a company that is "Worth more than the value of its stock." This is code for "Can be hyped and sold to the gullible for more than it is worth." But we'll get to that soon.

The Corporate Raiders prepare for a takeover of Company A. Their first step is to borrow 75 percent of the money they need for the takeover, and use 25 percent of their own money. That's right, they use borrowed money to buy it, often at a leverage ratio of 3 to 1 or higher. They offer above-market stock buyouts and pay somewhere around $60 Million to gain control of the company. Recall that once they have 51 percent of the stock, they have voting control. So they don't even have to buy the company, just a bit over half of it.

Let's do the math so far. The fair market value of the company, as determined by its stock is $100 Million. The Corporate Raiders gain 51 percent control of it; for some price around $60 Million, perhaps a bit less. They bought control using one-quarter their own money and three-quarters debt, so they got control of the company for about $15 Million of their own money! How would you like to fully control a $100 Million company for a measly $15 Million, or buy controlling interest of Microsoft for 25 cents on the dollar? Do you smell the rat yet?

Raiders, once successful, now have control of a company that was worth $100 Million and had no debt. But now it is worth $100 Million and has debt of $45 Million. That's right, once they have control, the company assumes the debt with which they gained control of it. In effect, the law allows the raiders to force the company to pay for most of its own buyout. Its all perfectly legal. But is it good for the nation? We'll soon see.

The Raiders are looking to raise the value of the stock. They do this by cutting the number of employees to the bone. Lower payroll costs are reflected -- in the short term -- as much greater profits. The stock value rises 50 percent, on the hype of a more efficient company with higher profits. But it isn't more efficient, it just seems so because the balance sheet has far less labor expenses. So the company is now valued at $150 million. But the company is in trouble because most of its skilled workers and middle management have been fired. It is just a shell game, not a good investment. Nonetheless, the Raiders sell Company A for $150 Million to a competitor company who is all too glad to take over their competition. (Yes, dear reader, takeovers are anti-competetive, and tend towards monopolies.)

Now, the Raiders have their half (51 percent) of a $50 Million profit from the sale. For their original personal investment of $15 Million, they now have their investment back, and a tidy $25 Million profit -- and they leave the $45 Million of debt with the company. How would you like to be able to offload your personal debt this way, and while putting your debt on the back of someone else also make 156 percent profit in 18 months to 2 years? Neat huh? (Warning: If you did this in your personal or business affairs, they'd jail you. But it is perfectly legal for the corporate raiders.)

What is Company A's position now? It has $45 Million of debt that has to be serviced, deeply cutting profits, a destroyed talent infrastructure -- because so many talented workers and experienced middle managers were fired to make the profits look good, and a new owner who is interested in little more than ridding itself of pesky competition. To make matters worse, investors soon learn that the company is not able to maintian the high level of profit it showed for the short while when labor expenses were way down, and inventory was being depleated. So, the stock value tumbles, and the total company value is recalculated to about $75 Million; its old value minus the stolen $25 Million. In short order, Company A goes bankrupt. It simply could not make a profit after it serviced the debt that was foisted on it during the takeover. Neat how the Raiders, offloaded their personal debt to the Company. Wouldn't you like to be able to do that too?

And what about the workers? All 1,000 of them are looking for new jobs. They take a terrible economic hit. And our government (which means you and me as taxpayers) picks up the tab for their unemployment and for retraining them. And the government loses all the tax income from this company and these 1,000 employee. The tax income from the company is gone forever, and from the 1,000 employees for a period of about 3 years, and most of them never again make as much as they did before.

And our government pretends that this is good business practice, and perfectly good for the nation, when it really is a matter of government authorized theft and government authorized destruction of perfectly viable companies. Makes one wonder who is buying our leaders' silence?

And some economists continue to praise corporate takeovers. To me, they are either shills, knowingly lying; or they are ideologues who believe their errors despite what the data shows. As for me, I don't really care if they are dishonest or just stupid. All that matters to a scientist is whether something is fact or error. And they make grevious errors. So let our politicians and our news media debate their dishonesty or stupidity. For me, they are just wrong.

Can this disastrous destruction of American companies be stopped? Sure. 1.) Simply forbid the use of borrowed money (leverage) for corporate takeovers. 2.) Insist that no debt of the Corporate Raiders can be assigned to the company's books. Whatever debt they incur in a takeover must remain on their own books. If the Raiders have to spend their own money, the profit incentive goes way down, by factors, not simple percentages. 3.) Third, no reselling of the company for 10 years. You do a takeover, you're in it for a decade. These are reasonable protections of people's jobs and of good companies from the kleptocrats of our society.

-- mof, 1-21-2010


1. I wrote this article in January of 2010, well before Mitt Romney ran for President, so I cannot be accused of tayloring it to him. More to the point, his avocation is taylored to this article.

2. In March of 2018 The Week carried an article written by Jeff Spross, titled "How vulture capitalists ate Toys 'R' Us". This article mirrors almost exactly what I wrote 8 years earlier. Congress knows what is going on, and is still doing nothing -- as per usual. Big money talks.

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