Intra-Industry Effects of Buyouts
The modern private equity business is not so old, as the first leveraged buyout took place in 1955. This was when McLean Industries, run by Malcolm McLean, acquired the Pan-American Steamship Company and the Waterman Steamship Company. He financed these acquisitions with the proceeds of the sale of his trucking company, McLean Trucking. He also did this through bank debt and the issuance of preferred stock. Since then, dealmakers started forming their own investment firms to do similar types of buyouts. The high-profile ones included Warren Buffet and Victor Posner. They were followed by Boone Pickens and Saul Steinberg. A few bankers at Bear Stearns also did leveraged deals. Their success attracted many competitors and led to a segment of the financial services industry we know today as the private equity business.
Effects of Buyouts
There are various impacts of horizontal mergers on the stock prices of competitors. A study by Slovin, Sushka, and Bendeck investigated 128 buyout bids from 1980-1988. 78 of the buyout bids were from managers, while 50 were from outsiders. They found that while target returns were significantly higher when the bids came from buyout firms, this had no impact on rivals. The authors concluded that bids led to positive valuation effects for rivals and that these effects were not that different in outsiders or management bids. These positive valuation effects were due to new information about the industry and firms in it were being created by the buyout, and the price paid to target shareholders.
In another study by Harford, Stanfield, and Zhang, a large sample of 586 LBOs over the years 1991-2006 were studied, and they found that these provide a signal to other firms about M&As and LBO opportunities in the industry. They also concluded that LBOs have the possibility to lead other M&As. one way to interpret this is that potential bidders might believe that other companies in the industry might present good profit opportunities if the firm that underwent the LBO had so much “slack” that it could afford to take on significant debt service obligations.
Leveraged Capitalizations
On the other hand, research conducted by Brown, Fee, and Thomas analyzed a sample of 355 LBOs and 43 leveraged recapitalizations from 1980-2001. Results have shown significant negative returns for suppliers of the LBO firms. Those with significant supply relationships with the LBO firms were more negatively affected. This can be analyzed as maybe, post-deal, the firms that went through a buyout would have more bargaining power. It can also be interpreted as the post-LBO companies being forced to pressure suppliers to handle the higher debt service. The authors also concluded that the companies which supplied companies that went through leveraged recapitalizations have no significant response to the deal. These recapitalization firms, which are larger than LBO companies, might have enjoyed buying power over suppliers.
Private Equity Market
Private equity companies gave a substantial part of the fuel for the M&A boom from 2003 to 2007. It then declined with the fallout from the subprime crisis but bounced back as the recovery took hold.
The private equity market refers to a collection of funds that have raised capital by soliciting investments from different investors where the funds will be invested in equity positions in companies. A going-private transaction then occurs when these investments acquire 100% of the outstanding equity of a public company. When the equity is accumulated through an investment capital of the private equity fund but mainly borrowed funds, this is called a leveraged buyout or an LBO. Many refer to the funds as LBO funds since these deals are such common investments for private equity funds.
These funds may make other investments, such as providing venture capital to nascent businesses. Funds established for this purpose are sometimes called venture capital funds. These kinds of investments may use the fund’s capital exclusively without using borrowed funds. But with this equity investment, the target company may enable itself to have more access to debt markets. This may happen after securing the equity investment from the private equity fund. It is possible for the fund to take a minority or a majority position in the company. Usually, venture capital investments contain incentives, such as stock options. These enable the investor who assumes the risk to enjoy greater profits if the business becomes successful. However, a lot of dissimilarities between private equity funds and venture capital funds happens.
Private Equity Funds vs. Venture Capital Funds
It is necessary to know the difference between private equity funds and venture capital funds since both are users of private equity. equity. Both are organized as limited partnerships, with the general partner making the investment decisions. However, there are plenty of very significant dissimilarities between the two.
Private equity funds look for undervalued investments like whole companies that are not trading at values commensurate with what the fund managers think is possible. These could also be divisions of companies that want to sell the units due to a change in strategy or a need for cash. One example was in 2002 when the international liquor conglomerate Diageo realized that there was not a lot of synergy between its liquor brands and the burgers and fries in its Burger King division. The Texas Pacific Group and Goldman Sachs Group purchased Burger King from Diageo in 2002 for $1.5 billion.
Generally, private equity fund managers raise capital from various institutional investors. Usually, they charge their investors “2 and 20”. This means 2% of invested capital and 20% of profits. 20% of profits is referred to as carried interest.
On the other hand, venture funds often make investments in new companies that may have limited revenues. The companies they invest in are often startups. Private equity firms seek out more established companies that have lengthy revenue, if not a profit, history. They usually invest together in a syndicated manner and undergo have several rounds of funding as a company goes through stages in its development.
Venture funds also go through shorter investment horizons and additional capital is only given if the company meets its milestones.
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Types of LBO Risk
LBOs have many risks that can be broken down into two main types. These include business risk and interest rate risk. The first one is defined as the risk that the firm going private will not generate sufficient earnings to meet the interest payments and other current obligations of the firm.
This category considers factors like competitive factors within the industry. This includes greater price and nonprice competition. This category also considers cyclical downturns in the economy. Companies with very cyclical sales or companies that are in very competitive industries tend not to be good LBO candidates.
The other type of LBO risk, which is interest rate risk, is the risk that interest rates will rise, thus increasing the firm’s current obligations. This is important to firms that have more variable-rate debt. Interest rate increases could force a firm to bankruptcy even when it experienced greater than anticipated demand and held nonfinancial costs within reasonable bounds.
The interest rates’ level at the time of the LBO is a guide to the probability that rates will rise in the future. For instance, interest rate increases are more likely if interest rates are low at the time compared to the interest rates at peak levels.
Return to Stockholders from LBOS
Studies regarding returns to stockholders from LBOS usually highlight the abnormal returns to pre-buyout shareholders. They also focus on premiums as measured by the difference between firm values derived from the final takeover stock price as compared to the preannouncement stock price. The premium analysis can be complex depending on how the preannouncement price is determined and the extent to which the study allows for the preannouncement price runup.
Researchers handle this by using a preannouncement price that involves an anticipation window like two months before the announcement. There is interestingly a difference between the results from the abnormal returns and the premiums studies, but it is justifiable. Research with the use of cumulative abnormal returns already incorporates an expectation of a firm’s return which, in turn, reflects how the market values post-buyout profitability.
A popular study by DeAngelo, DeAngelo, and Rice analyzed the gains to both stockholders and management from MBOs. The sample was a total of 72 companies that attempted to go private between 1973 and 1980. As mentioned, the premium paid for their sample was 56%, which was higher than the premium data presented for more recent years. Results show that managers are willing to offer a premium.
Private Companies Dominated the Buyout Market
In the 200s, private equity companies dominated the buyout market. They are popular for being more careful buyers. The same study found that an average change in shareholder wealth around the announcement of the deal was 22%. Over a longer time period around the announcement, the total shareholder wealth change was approximately 30%. It is consistent with the results for various studies about M&As. Moreover, the announcement of the bid being withdrawn results in the decline of shareholder wealth by 9%.
In another research, Travlos and Cornett showed the statistical significance and negative correlation between abnormal returns to shareholders and the P/E ratio of the firm relative to the Industry. To interpret, the lower the P/E ratio, compared with similar firms, the greater probability that the firm is poorly managed.
The researchers analyzed the low P/E ratios as reflecting greater room for improvement through changes such as the reduction of agency costs. Some of these gains in efficiency may be accumulated by privatization. Then, these gains become the source of the buyout premium..
Return to Stockholders from Divisional Buyouts
Again, MBOs are deals where a group of management purchases apart from the parent company. Most of these purchases are criticized because they are not “arm’s length” deals. Parent company’s managers are usually accused of giving special treatment to a management bid.
The parent company may spurn the closeout process and acknowledge the executives’ proposal without requesting other higher offers. One way to check whether these exchanges are really to investors’ greatest advantage is to take a gander at their investor riches impacts.
In 1989, researchers Hite and Vetsuypens tried to show if divisional buyouts had adverse effects on the wealth of parent stockholders. Most researchers believe that divisional buyouts may present opportunities for efficiency-related gains as the division becomes removed from the parent company’s layers of bureaucracy. This is likely to be valuable to the managers of the buying group but does not deny the often-cited possibility that a fair price was not paid for the division. A fair price is may the one which is derived from an auction.
Divisional Buyouts
The scholars were not able to find evidence of a reduction in shareholder wealth following divisional buyouts by management. In their analysis, these indicated that division buyouts result in a more efficient allocation of assets. The existence of small wealth gains indicates that shareholders in the parent company shared in some of these gains.
Briston, Saadouni, Mallin, and Coutts did not support the positive view of a management buyout from the lens of parent company shareholders. In their study, a sample of 65 MBOs in Great Britain over the period 1984–1989 was used. The results showed that parent company stakeholders experienced negative returns following MBO announcements. This result contradicts the other types of selloff announcements. Implying that this may be parent company managers giving their former colleagues a better deal than they offer non-affiliated buyers
Post-LBO Firm Performance
Several studies showed substantial operating performance improvements when management buyouts occurred in the 80s. Some of the early studies tackled Kaplan and Lichtenberg and Siegel’s study. Both found improvements in financial performance following the management buyouts. The same results were also presented by later researchers, like Guo, Hotchkiss, and Song. Who analyzed 192 leveraged buyouts that were completed during the period 1990–2006. Aside from concluding that the deals were less levered than their 1980s predecessors. They also found that the operating performance of the firms that were taken private was at least as good as matched industry companies. They consider this performance to gain a result of large positive returns that yielded their investors.
For instance, Gao et al. found an 11% increase in EBITDA/sales relative to comparable firms. The positive outcomes on LBO execution were not simply limited to U.S. LBOs.
Research Discoveries for LBOs
Different research has shown up at comparable discoveries for LBOs in various European nations. For example, Great Britain, France, and Sweden, this result raised debates in some scholars. Who questioned whether the companies that were studied were the only ones that had publicly available financial statements made them a biased sample. The companies that have financial statements published could have sold public debt or go through a subsequent transaction like an IPO.
In a study conducted by Cohn, Mills, and Towery, a subsample of 71 companies that underwent an LBO that had both tax returns and financial statements available were used. The results were coherent with the prior research. It showed that the following forms did show substantial improvements in financial performance.
For example, they found a 9% improvement in mean return on sales over a two-year period after the buyouts. Then, they focused on a broader sample of 317 companies taken private in an LBO. Including the previous 81 with both tax return and financial statements available. And others that had only tax return data available.
They concluded that there was no evidence of meaningful performance improvements for this larger sample. This may mean that the companies whose financial statements were public have been performing better. This let them issue public debt or even go public again. Others may not have performed as well and may not have been able to pursue such transactions.
All in all, Cohn, et al. found that the positive view of LBOs that has prevailed in the world of M&A research for many years may have been overly sanguine. LBOs may strengthen dealmakers and investors of private equity and managers of these private equity firms. But they may not have any positive impact on the companies themselves.
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The Financing for Leveraged Buyouts
There are two general categories of debt used in Leveraged Buyouts. The secured and unsecured debt are the two general categories. Both of these are often used collectively. In this article, we will talk about financing for leveraged buyouts and how these two categories play a part.
Two General Categories of Debt
Secured Debt
Secured Debt, or also known as asset-based lending, may also contain two subcategories of debt. These are the intermediate-term debt and senior debt.
These two categories may also be considered as one in some smaller buyouts. However, when it comes to larger deals, secured debt may have several layers. These layers vary according to the term of the debt and the types of assets used as security.
Unsecured Debt
We also have unsecured debt. This is also referred to as subordinated debt and junior subordinated debt. From the name itself, unsecured debt lacks the protection a secured debt has.
However, unsecured debts generally carry a higher return, this offset the additional risk for some. To the debt financing is added an equity investment.
Depending on the market condition, the percentage of the total financing that the equity component constitutes may also vary. However, it usually is between 20% to 40% range.
Sponsors or the dealmaker will usually work with providers of financing or investment banks in every leveraged buyout. It is the investment bank’s job to conduct due diligence and the proposed deal. Once they are finished doing their due diligence, the bank will decide if the deal meets the criteria, and they will present the deal to the banks they work with.
High-yield Bond
Additionally, the lead investment bank may also decide to conduct a presentation for the different prospective lenders. The presentation will show the bank’s analysis and the reasons why they think the lenders should feel secure providing capital to finance the deal.
Moreover, to develop more interest in an offering of high-yield bonds, a similar process may also be conducted. This is often done for high-yield bonds that may be part of the overall deal financing structure.
Oftentimes, these presentations are preceded by the distribution of a preliminary offering memorandum. The memorandum must be related to the bond offering. SEC approval is usually needed before the memorandum can be finalized. Otherwise, the bonds are forbidden to be offered publicly.
Banks will often provide a commitment letter first if they agree to provide debt capital to the deal. The commitment letter will put forward the stipulation of the loans.
There are also instances where banks choose to hold some of the debt in their own portfolio. Usually, this is done when the banks are still seeking commitments from different financing sources. The banks will then syndicate the rest of the debt.
Where Does Debt Capital Come From?
Most of the time, debt capital comes from two different main sources. On one hand, we have banker lenders who may choose to provide different types of loans or amortizing term loans.
These banks vary from commercial banks, finance companies, savings and loan associations, and more. On the other hand, debt commitments with longer-term usually come from institutional investors. These include insurance companies, hedge funds, pension funds, and more.
There will be times when one group can be seen providing different types of capital in different deals. Moreover, some parts of debt capital may even come from bond issuance.
A bond issuance may require the investment bank to provide a bridge loan. This is done so it can close the time gap between when all the funds are needed to close a deal and when the bonds can be sold in the market.
LBO Debt Financing
Moving on to leveraged buyouts debt financing, there are also two broad categories. One is the senior debt, and the other is the intermediate-term debt.
Loans that are secured by liens on particular assets of the company are what senior debts consist of. The collateral includes physical assets which maybe land, plants, and other equipment. This collateral provides the downside risk protection required by lenders.
Senior debt can have five or more years of terms. It also comes in various forms. Of course, it varies according to the nature of the target’s business and the type of collateral it can provide.
A senior debt may also constitute between 25% and up to 50% of the total financing of a leveraged buyout. The interest rates are usually between the 2% to 3% prime plus. Commercial banks, investments, and other institutional investors like insurance companies, finance companies, and mutual funds are the typical sources of this. The term is usually between 5 to 10 years.
Keep in mind that even though bank debt is the least costly form of debt, it also comes with maintenance covenants most of the time. These maintenance covenants often impose financial restrictions on the life of the loan.
Usually, bank debt is priced above some variable base market rate. A great example of this would be LIBOR or the prime rate. How much higher usually depends on the borrower’s creditworthiness.
Other Senior Debt Revolving Credit
Additionally, the company may also have access to a revolving credit in a leveraged buyout. The revolving credit may be secured by short-term assets. These short term assets may include but not limited to inventory and accounts receivable.
The company may also need to pay a variable rate that is pegged to some base rate. For instance, the crime rate in the prime plus a certain percentage. Additionally, revolving credit can also be repaid. It can also be reborrowed depending on the company’s agreement with the lender.
Usually, this form of credit is used to deal with seasonal credit needs. Its relevance often is contingent on the nature of the business. It is the sponsor’s choice to arrange a revolving credit line with a bank. This, in turn, may syndicate it with other banks.
Usually, the borrower is required to pay a commitment fee when it comes to these types of credit lines. This fee will give the borrower access to the credit even if it is unused.
However, if the credit is used, then the borrower is also required to pay the interest rate. Usually, the revolving credit line is secured by some specific assets. Oftentimes, it has a term of five years.
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Conflicts of Interest in Management Buyouts
It is common for conflicts of interest to occur when it comes to management buyouts. Managers have the job to maximize the value of investment of stockholders and give them the highest return possible. They also have the job to present an offer to stockholders to buy the company. This is the case when the management of RJR Nabisco gave an offer to stockholders to take Nabisco private in a management buyout.
This offer was quickly supplanted by a contending offer made by KKR and other responding offers from management. Why did the management choose to advocate an offer that it knew was not in the interests of their stockholders if their actual goal is to maximize their investments? Researchers hypothesize that managers cannot serve in these dual and conflicting roles as agents for buyers and sellers.
MBOs can be more successful than LBOs because better access to information about the profitability of the company is given than an outside buying group has. When managers decide to pursue a management buyout, they can opt to secure the financing themselves. With the aid of their investment bank, or they can work with a private equity firm that offers to finance.
Earnings Management
“Earnings management” is another important issue and potential conflict before a management buyout occurs. It typically involves a meticulous process of changing financial reports. This is done to mislead shareholders about the organization’s elemental performance. Sometimes. It is also done to prompt contractual results that usually depend on reported accounting numbers.
If the managers are interested in buying a company from the shareholders, they could have an incentive. That will lower their reported profitability to pay less for the acquisition. In Perry and Williams’ analysis of 175 management buyouts between the years 1981-1988. They found evidence that discretionary accruals were manipulated. These were done in the predicted direction in the year prior to the public announcement of the MBO.
The researchers also developed a control sample where matched firms for each bought-out company were chosen. There is an association between accruals like increases in depreciation expenses or decreases in noncash working capital with a reduction in income in the MBO group. These results show a cause for concern and extra carefulness.
One proposed answer for these contentions is neutralized casting a ballot. Whereby the defenders of an arrangement don’t take part in the endorsement procedure. If the defenders or proponents are stockholders, then their votes will not be counted in the approval process. They might be allowed to participate in the voting because it goes by the law.
Important Steps to Reduce Conflict
The next step is usually the appointment of an independent financial advisor to render a fairness opinion. This helps reduce contentions in terms of interests. Regardless of whether these precautionary steps are embraced, specific practical considerations may restrict their viability. And even if the members of the board of directors who may profit from the LBO may not vote for its approval. Other members of the board with close relationships to them may consider themselves required to support the deal.
Stockholders’ lawsuits for suing directors for breach of fiduciary duty have placed limits on this tendency. The investment bankers who have put fairness opinions forward may also have much business with management. Or may have a financial interest in the deal, leaving them of questionable value.
Even if these steps are important in trying to reduce the conflicts inherent in the management buyout process. One solution that has been proposed is to have mandated auctions of corporations presented with an MBO.
US Court on LB Conflicts
Current case law states that directors are not permitted to favor their own bid over another once the bidding has started. This prohibition was set forth by different court decisions, such as in Revlon, Inc. versus MacAndrews & Forbes Holdings, etc. In this case, the Delaware Supreme Court ruled that the directors of Revlon breached their fiduciary duty in granting a lockup option to white knight Forstmann Little & Co. The court ruled that this constituted an unfair bidding process that favored Forstmann Little & Co. over hostile bidder Pantry Pride.
In another example of Hanson Trust PLC v. SCM Corporation, the Second Circuit Court had the same position regarding the use of lockup options to favor an LBO made by Meryll Lynch instead of a hostile bid by Hanson Trust PLC. Hanson Trust had initially made a tender offer for SCM at $60 per share. In response to Merrill Lynch’s LBO offer at $70 per share, Hanson Trust upped its bid to $72.
According to the Court, SCM gave preferential treatment to Merrill Lynch by granting lockup options on two SCM divisions to Merrill Lynch. The board of directors will usually respond by creating a special committee of independent when they are faced with a management proposal to take the firm private.
Meanwhile, nonmanagement directors have the job to ensure that shareholders receive fair, if not maximal, value for their investment. The committee may then choose to have its own valuation produced, hire an independent counsel, and conduct an auction.
Post-Buyout Managerial Ownership
It should be noted that even when the management is the buyer of the business, outsiders still provide other equity. So they cannot be in full control of the post-buyout business. This is dependent on the amount of equity capital needed and how much capital the managers have and are willing to invest in the deal.
In a study by Kaplan, he used a sample of 76 management buyouts over the period of 1980–1986 and compared the median pre-buyout and post-buyout share ownership percentages of the CEOs and all management. The results of the study show that these percentages rose from 1.4% and 5.9% to 6.4% and 22.6%, respectively.
Management ownership more than tripled after the buyout. In theory, the managers are required to be better motivated considering their much higher ownership interest. This will help ensure that the company moves closer to efficiency levels that can help them maximize their profit.
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Leveraged Buyouts
In the corporate world, there are plenty of techniques you can use as a part of your merger and acquisition tactic. One of the most well-known financing techniques is a Leveraged Buyout of an LBO.
So, what exactly is a leveraged buyout? This refers to a financing technique that a variety of entities uses. Many, including corporations, individuals, investment groups, management of corporations, partnerships, and so on use LBOs as a tactic.
About Leveraged Buyouts
Leveraged Buyout is the process of using debt to purchase the stock of a corporation. Most of the time, this involves taking a public company private. The level of interest rates and the availability of debt financing are some of the few factors that affect an LBO’s popularity.
In the years between 2004 and 2007, there were plenty of low-interest rates that prevailed. These helped explain why there are a lot of large LBOs that happened in that same period.
Additionally, from 2008 to 2009, we have seen a lack when it comes to debt financing at a time when interest rates were low. These occurrences help explain the big falloff in numerous deals during those years.
When the economy recovered from 2010 to 2017, there was an increase in debt financing availability. This was mainly due to the fact that there were large amounts of liquidity that were provided by expansionary monetary policy. However, lenders were also cautious at this time. So they weren’t ready nor willing to fund all types of deals that they did before the subprime crisis happened.
Leveraged Buyout Terminologies
Usually, there is a lot of overlap when it comes to LBOs and going-private transactions. What does a going-private deal mean? This refers to a public company that goes private. There are also times where it is referred to as a public-to-private transaction or PTP.
Transactions like PTP are financed with some equity and some debt. It is also important to remember that a debt-financed buyout can be done of a non-listed, that is, not-public firm.
LBO Deal
Now, this deal can also be called an LBO when, and only when, the bulk of the financing comes from debt. These deals are also referred to as bootstrap transactions back in the 1960s and 1970s.
Additionally, there are also deals that are called institutional buyouts. Institutional buyouts are when the owner of the formerly public company is a private firm or other financial institution.
On the other hand, there are also deals that are referred to as management buyout or MBO. MBO happens when a company sells a business unit, or sometimes even the entirety of a company to a management group.
The majority of these transactions involve a public company divesting a division. In doing so, the public company sells it to the unit’s management as opposed to an outside party. These types of deals are usually referred to as unit management buyouts.
Lastly, deals may also be referred to as a leveraged buyout when managers rely heavily on borrowed capital to finance the deal. You see, this is where the significant overlap in the terms come in. There are so many gray areas between the terminologies used to describe these transactions.
Leveraged Buyouts Early Origins
So, how did leveraged buyouts came to be? Well, this terminology became popular in the 1980s. However, long before that, the concept of a debt-financed transaction where a public company goes private was already around.
Take the Ford Motor Company as a great example of an LBO. In 1919, Henry Ford and his son Edsel grew tired of having to answer to shareholders. The main reason was that the founder of the auto company and the shareholders have different opinions regarding important matters such as dividends policy.
Henry Ford’s solution was to borrow what was considered to be an astronomical sum of money at the time to take the company private. Keep in mind that this is the world’s largest automobile company. Henry and Edsel purchased the company’s shares from the shareholders for $106 million. This roughly converts to $1.76 billion dollars today.
$75 million of those $106 million was borrowed from a collection of East Coast banks including Old Colony Trust, Bond & Goodwin, and Chase Securities of New York. Additionally, Ford also wanted to be free to manufacture and sell their Model Ts ever-decreasing prices.
This means that they would have to reinvest the profits they make back to the company instead of distributing them to shareholders. The shareholders have a mixed reaction to this.
Ford Strategic Plan
Some shareholders, such as the Dodge brothers were happy to cash out their shares. They were planning on using their capital to expand their own auto company that will clash with Ford later.
There were also some investors who wanted higher profits. But of course, this means that Ford needed to sell their automobiles at higher price points. That wasn’t part of Henry Ford’s plans at the time.
He was focused on making Ford automobiles that were affordable and attainable for the average American. To do this, he needed to continually lower his prices. Hence, he decided to take his public company private.
Ford Downhill Solutions
Interestingly enough, there were also problems that befell the LBOs of the fourth merger wave (which we will discuss in the next article) that affected Ford. Years after Ford went private, the United States economy experienced a downhill which affected Ford.
During 1920-1921, the automobile company incurred a cash crunch. This worried a lot of people that the company may no longer be able to service the huge debt load it had taken on in the buyout.
However, Henry Ford responded with a smart strategy by temporarily halting production. This was followed by layoffs and measures to cut their costs.
Not only that, but Ford also had other alternatives at his disposal. He exercised his rights in his agreements with Ford dealers and sent them the mounting inventory of cars, even though they didn’t necessarily have a need for them.
In return, this required the dealers to pay for the cars and dealers from all over the United States headed out for financing. At the end of the day, this gave Ford Motor Company the cash infusion it needed to resume production.
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