The Crash of the Revco Leveraged Buyout: The Hypothesis of Inadequate Capital

The bankruptcy of Revco Drug Stores is one of the most notable in the history of highly leveraged transactions. This study considers the allegation that the leveraged buyout of Revco left it without adequate capital to survive. We use Monte Carlo simulation to determine Revco's financial coverage ratios and the expected probability of financial survival. The simulation finds a very low probability that Revco would survive the heavy debt and preferred stock obligations during the first three years following the buyout. The simulation approach provides a useful perspective on the efficacy of the insolvency and capitalization tests as evaluated by the courts. We argue that capital adequacy on the day of going private is extremely difficult to prove using a point-estimate valuation; a simulation-based test provides the more appropriate statistic -- i.e., a probabilistic assessment of survival.