August 2009 Do Buyouts (Still) Create Value? Shourun Guo, Edith S. Hotchkiss, and Weihong Song ∗ Abstract We examine whether, and how, leveraged buyouts from the most recent wave of public to private transactions created value. For a sample of 192 buyouts completed between 1990 and 2006, we show that these deals are somewhat more conservatively priced and less levered than theirpredecessors from the 1980s. For the subsample of deals with post-buyout data available, median market and risk adjust ed returns to pre- (post-) buyout capital invested are 72.5% (40.9%). In contrast, gains in operating performance are either comparable to or slightly exceed those observed for benchmark fir ms. Increases in industry valuation multiples and realized tax benefits from increasing leverage while private are each economically as important as operating gains in explaining realized returns. Forthcoming, Journal of Finance∗ Guo is at Duke Energy Corporatio n. Hotchkiss is at the Carrol l School of Management, Boston College. Song is at the College of Business, University of Cinc innati. The authors thank Francesca Cornell i, Ken Doyle, Mike Ferguson, John Graham (the co-editor), Campbell Harvey (the editor), Steve Kaplan, Darren Kisgen, Kai Li, John Morris, Jun Qian, Laura Resnikoff, Steve Slezak, Jeremy Stein, Per Strömberg, Wei Wang, an anonymous referee, and seminarparticipants at Babson College, Boston College, the 7 th China International Conference in Finance (Guangzhou), University of Connecticut, Drexel University, the NBER New World of Private Equity conference, the Swedish Institute for Financial Research, and Università Ca'Foscari di Venezia for helpful comments and suggestions.
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Shourun Guo, Edith S. Hotchkiss, and Weihong Song∗
Abstract
We examine whether, and how, leveraged buyouts from the most recent wave of public toprivate transactions created value. For a sample of 192 buyouts completed between 1990 and 2006,we show that these deals are somewhat more conservatively priced and less levered than their predecessors from the 1980s. For the subsample of deals with post-buyout data available, medianmarket and risk adjusted returns to pre- (post-) buyout capital invested are 72.5% (40.9%). Incontrast, gains in operating performance are either comparable to or slightly exceed those observedfor benchmark firms. Increases in industry valuation multiples and realized tax benefits fromincreasing leverage while private are each economically as important as operating gains inexplaining realized returns.
Forthcoming, Journal of Finance
∗ Guo is at Duke Energy Corporation. Hotchkiss is at the Carroll School of Management, Boston College. Song is atthe College of Business, University of Cincinnati. The authors thank Francesca Cornelli, Ken Doyle, Mike Ferguson,John Graham (the co-editor), Campbell Harvey (the editor), Steve Kaplan, Darren Kisgen, Kai Li, John Morris, JunQian, Laura Resnikoff, Steve Slezak, Jeremy Stein, Per Strömberg, Wei Wang, an anonymous referee, and seminar participants at Babson College, Boston College, the 7th China International Conference in Finance (Guangzhou),University of Connecticut, Drexel University, the NBER New World of Private Equity conference, the SwedishInstitute for Financial Research, and Università Ca'Foscari di Venezia for helpful comments and suggestions.
The leveraged buyout (LBO) wave of the 1980s was an important phenomenon well studied by
academics and practitioners. The recession of the early 1990s, however, brought most of that
activity to an end, as many of the deals from later in that period defaulted. Nearly fifteen years
later, however, the pace of LBO activity reached new record levels, renewing questions about
whether and how these deals create value.1
A substantial body of empirical work based on leveraged buyout transactions from the 1980s
supports the notion that leveraged transactions create value. Several studies show large gains in
operating performance following the buyout; theories attribute these gains to reduced agency costs
through the disciplining effects of leverage and better governance (monitoring by the financial
sponsor, concentrated ownership, etc).2
Other studies show that firm values increase from the time
of the buyout to a subsequent change in ownership or restructuring, producing large returns to
invested capital.3
Given the rise of the private equity industry, changes in the characteristics of firms targeted
for buyouts, and changes in the structure of the transactions themselves, the mechanisms through
which buyouts can create value have likely changed. Notably, there is little (or no) evidence from
the more recent wave of buyouts which documents whether and how these transactions create
value.4
This paper attempts to fill this gap, studying a sample of 192 LBOs completed between
1990 and 2006.
1 Dealogic reports that global financial sponsor M&A buyouts reached record highs of $352.3 billion in 2005, $737.4billion in 2006, and $796.1 billion in 2007 despite the abrupt fall off in the second half of that year, and representedapproximately 17% of total announced M&A volume in those years.2 These papers largely study management buyouts (MBOs). See Kaplan (1989a), Lichtenberg and Siegel (1990), Smith(1990), Cotter and Peck (2001), and papers summarized in Renneboog and Simons (2005).3 Kaplan (1989c), Kaplan (1994), and Andrade and Kaplan (1998).4 Axelson, Jenkinson, Strömberg, and Weisbach (2009), and a series of papers written for the World Economic Forum(2008), provide analysis of the pricing and structure of recent buyouts. Kaplan and Strömberg (2008) describe recenttrends in the leveraged buyout / private equity industry.
the time of the buyout. We also find that improvements in cash flows, net of tax benefits, are
greater for sample firms with larger increases in debt as a result of the buyout. This evidence is
consistent with theories suggesting the benefits of debt in reducing agency costs.5
Although
operating gains are small on average, the substantial variation within our sample suggests that
operating performance may still be an important factor in explaining returns.
To examine the relative importance of the three potential determinants of realized returns,
we directly quantify the impact on returns of changes in operating cash flows, changes in valuation
multiples, and realized tax benefits from increasing debt while private. Comparing the realized
returns to what they hypothetically would have been if profitability (relative to firms matched on
industry and pre-buyout characteristics) had remained at its pre-buyout level, for the full sample we
show that improvements in performance account for 23% (18.5%) of the pre- (post-) buyout return.
Changes in industry valuations also have a large effect on returns; changes in the industry total
capital/EBITDA ratio account for 18% of the return to pre-buyout capital for the full sample, and
26% of the return for firms exiting through an IPO. The magnitude of the impact of increasing tax
shields depends on our assumptions as to whether leverage will be maintained after the exit from
the private equity firm’s portfolio; for firms sold in a secondary LBO, the increased tax benefits
account for 29% of the return to pre-buyout capital.6
We also use cross sectional regressions to provide further evidence on the relative
importance of the factors explaining returns. These regressions account for the fact that there may
be some overlap in the sources of these gains; for example, an increase in leverage may affect the
firm both through increasing cash flows as a result of the discipline of debt, as well as through the
cash flow benefits of reducing taxes. Consistent with our prior results, the regressions show that the
5 Jensen (1986), Jensen (1989b), Wruck (1990).6 A summary of the return results for classroom use as teaching slides is provided in the Internet Appendix as TablesIA.TS1 and IA.TS2.
impact of changes in industry valuation multiples and realized tax benefits from increased leverage
are each as important as operating gains in explaining returns. The regressions also show that in
addition to our cash flow measures of operating changes, firms which restructure via asset sales
while private are associated with significantly lower returns.
Our regressions explaining returns also allow us to consider the impact of deal pricing on
post-buyout returns. Holding constant the pre-buyout announcement firm value, a lower price paid
at the time of the buyout will leave the total return to pre-buyout capital unaffected, but will lower
the premium to pre-buyout shareholders and therefore increase the return to post-buyout capital.
However, the regressions show that neither returns to pre- or post-buyout capital are significantly
related to either the premium paid or the industry adjusted EBITDA/capital ratio at the time of the
buyout. Our paper also provides evidence useful in the debate over potential collusive bidding in
“club” deals involving more than one private equity firm.7 Both pre- and post-buyout returns are
higher for club deals, and returns are not significantly related to measures of the competition in
bidding. A likely explanation for our findings is that deals with better ex-ante prospects attract
participation by multiple private equity firms.
An additional contribution of our paper is to document the pricing and other characteristics
of the most recent wave of buyouts. These statistics provide a comparison to earlier research that
aids our understanding of how deals have recently changed, and also enables us to address concerns
about the potential impact of sample selection on our interpretation of the post-buyout performance
results (specifically, the availability of post-buyout financial data). Relative to the buyouts of the
1980s, deals are somewhat less highly levered (median total debt/capital of approximately 70%),
but still impose very high default risk on the firms. Premiums paid to pre-buyout shareholders, as
7 Officer et. al. (2009); Boone and Mulherin (2009). See also: “Private Equity Slugfest; Investors and regulators fear there isn't enough competition among private equity firms for deals. Business Week , 13 February 2007.
atypical characteristics.8 This produces a final sample of 192 LBOs from 1990 to 2006. In contrast
to deals from the 1980s, relatively more firms come from service industries (28% of our sample)
and fewer from manufacturing (36% of our sample). A total of 120 different private equity (PE)
firms are involved in the buyouts, but no single PE firm invests in more than 14 sample companies. 9
In order to study the performance of buyouts, as well as events that occur after the firm is
private, we further restrict the sample to buyouts completed by December 2005 which have some
amount of post-buyout data available from 10Ks or other SEC filings. The 94 firms in this
subsample either have widely held public debt outstanding, or provide historical financial
statements at the time of a subsequent IPO, acquisition, or public debt financing. Comparing the
subsample of 94 firms to the full sample of 192 buyouts allows us to address the impact of sample
selection on observed post-buyout performance. Our description of the evolution of buyout pricing
and financial structure for our sample period (1990-2006) also provides a useful comparison to the
results of Kaplan and Stein (1993) for deals of the 1980s.
Table I describes the buyout sample and deal pricing. The buyout price, referred to as “post-
buyout total capital” or simply “capital”, is measured as the sum of the market value paid for the
firm’s equity, the value of outstanding debt, and the fees paid in the transaction, minus cash
removed to finance the buyout. For the full sample of 192 buyouts, the median deal size (capital) is
$463.7 million, but there is a trend towards larger deals in later years. For the period 1990 to 2005,
the median deal size for the 94 buyouts with post-buyout data is significantly larger ($509.3
million) than for the 72 remaining buyouts (median $336.9 million). This is due to the fact firms
with public debt financing, therefore reporting 10Ks post-buyout, are typically larger.
(INSERT TABLE I ABOUT HERE)
8 These include cases where the target firm is intended to be merged with another operating company, or where a privateequity firm acquires the target using the stock of another portfolio company.9 The largest concentrations of PE firms are Blackstone (14 deals), Texas Pacific Group (13 deals) and KKR (11 deals).
We describe the price paid relative to fundamentals using the firms’ earnings before interest,
taxes, depreciation, and amortization (EBITDA) in the last full year prior to the buyout completion,
as a percentage of capital. This measure is not significantly different between firms with and
without post-buyout data completed by 2005. We also report a market adjusted measure which
subtracts the same ratio for firms in the S&P 500 at the time of the buyout. The market adjusted
measure is greater for the deals with post-buyout data available, suggesting they are less
aggressively priced, but the difference is not economically or statistically significant. The ratio
declines in recent years, reaching a low of 0.86 for the full sample in 2006.10
As an additional measure of deal pricing, Table I reports the premium paid, calculated as the
percentage difference between the price paid for a firm’s equity and the price one month before the
buyout announcement. The median premium does not increase over our sample period, and for the
full time period is relatively low (median of 29.2% for 1990 to 2006) compared to Kaplan and
Stein’s median of 43% for the 1980s.11
Although the premium paid for deals completed in 2006
does not indicate these deals are more aggressively priced, the decline in EBITDA/capital for the
2006 deals suggests that the cash flow characteristics of 2006 buyout targets may be different from
those completed in earlier years. Overall, the sample deals do not appear highly priced relative to
the transactions of the 1980s, and importantly for our study, do not appear substantially different for
firms depending on whether post-buyout data are available.
Tables II and III describe the financing structure of the deals. Table II reports the aggregate
debt levels and coverage ratios, based on data from SEC filings, Dealscan, and Dealogic. Overall
leverage is measured by the ratio of pre- or post-buyout debt to capital or to EBITDA. Post-buyout
10 To provide a more direct comparison to Kaplan and Stein (1993), a market adjusted ratio based on the S&P 500 P/Eratio reaches a low of 3.23 in 2006, which is lower than for any year reported for their sample.11 There are two cases of negative premiums in 2003 where 1) the stock price of the target firm declined significantlyfrom one month prior to the day before the buyout announcement, and 2) the purchase price was lower than the marketprice, but agreement with shareholders was reached (following shareholder lawsuits).
debt is equal to the sum of new debt issued to finance the buyout and pre-buyout debt retained. We
use book values of debt, as most new debt is issued at a price close to its face value, and relatively
little long term pre-buyout debt is retained. Prior to the buyout, firms have a leverage ratio of
approximately 23.7% (pre-buyout debt/capital) for the full sample. However, leverage is
significantly increased with these transactions, to a sample median of nearly 70% post-buyout
debt/capital (and a median percentage increase in leverage of 45.7%). Thus, a potentially large
source of value for the sample firms is an increase in interest tax shields. The high level of post-
buyout debt may also serve as a disciplining mechanism, as firms take on substantial default risk in
these transactions. Similarly, debt as a multiple of EBITDA increases from 1.8 to 6.0 (full sample,
total). This leverage corresponds to a ratio of total equity to capital of approximately 30% (versus a
sample average of 6.52% from Kaplan and Stein). Although they are very highly levered, the deals
in our sample are more conservatively financed than deals of the late 1980s, where leverage ratios
approached 90%.
(INSERT TABLE II ABOUT HERE)
Interest coverage ratios (EBITDA/interest ) have a median of 1.87 for the full sample. These
coverage ratios are based on expected interest payments at the time of the buyout, using EBITDA
for the last full fiscal year prior to the buyout.12 Where data are available, we also report the
coverage of interest plus required principal repayments. Using the average projected principal
payments for the first two post-buyout years, this coverage ratio also well exceeds 1.0. One reason
for the strong coverage ratios at the time of the buyouts is that few transactions rely on expected
asset sales subsequent to the buyout (see Section III), and so rely only on the firm’s operating cash
flows to repay debt.
12 Expected interest payments are based on stated interest rates or on stated spreads over LIBOR. We use the 3-monthLIBOR rate at the end of the announcement month for this calculation.
at the fiscal quarter end prior to the buyout (for computing returns to pre-buyout capital), or as the
buyout price (for computing returns to post-buyout capital). We also report “market and risk
adjusted” returns by discounting the interim payments and terminal value by an unlevered return.14
This is equivalent to the realized net present value of the transaction, scaled by the pre- or post-
buyout capital invested. The return measures the gain over the entire period the firm is private.
Calculating the terminal value requires that we identify the “outcome” for the transaction
(for firms with financial sponsors, this is sometimes referred to as the “exit” date from the private
equity firm’s portfolio). We search SEC filings, news sources, Lexis/Nexis, and Dealogic to
identify outcomes which include a subsequent IPO, acquisition by another company, acquisition by
another private equity firm (known as a secondary LBO), or Chapter 11 or distressed restructuring.
Remaining firms are still private or the outcome is unknown. A summary of these outcomes is
provided in Table IV, both for the initial sample of 192 buyouts and the 94 deals completed by 2005
which have post-buyout data available (90 of these have sufficient data for our return calculations).
(INSERT TABLE IV ABOUT HERE)
Table IV shows that 23 firms enter Chapter 11 or a distressed restructuring, which is 12% of
the full sample of 192 firms, but 22.5% of firms which have reached an outcome (groups 1 through
4 in Table IV). For comparison, Andrade and Kaplan (1998) report that 29% of their initial sample
of 136 MBOs and leveraged recaps fail by 1995, most of which are deals completed between 1985
14 Since the cash flows include payments to all providers of capital (both debt and equity), we use a discount rate based
on an unlevered return. From the CAPM, our discount rate is equal to r f *(1-βu) + βu*r m, where r f is the one month T-billreturn (Ibbotson) and r m is the realized return on the S&P 500 from the pre- or post-buyout date to the date of the cash
flow. βu is the asset beta calculated using stock returns for up to 60 months prior to the buyout and the pre-buyoutdebt/equity ratio (see Gilson, Hotchkiss and Ruback (2000) and references therein for detailed explanation of the assetbeta calculation). Our return calculations differ from the “market adjusted” returns calculated by Andrade and Kaplan(1998) who discount cash flows by the value weighted S&P 500 equity return, which is equivalent to assuming the assetbeta of the buyout firm is equal to one. Since the median asset beta of firms in our sample is 0.67, this would producean overly conservative estimate of returns for our sample. See also Groh and Gottschalg (2009) for discussion of risk adjusted discount rates for buyouts.
and 1989.15 In the Chapter 11 cases in our sample, there is typically almost no recovery to equity
holders, and control of the firm is given to senior lenders. Interestingly, we identify only two out of
court distressed restructurings, and a large portion of the Chapter 11 restructurings are
“prepackaged” bankruptcies. This is consistent with the idea that the resolution of distress via
Chapter 11 may not be costly for these firms. Table IV also shows the proportion of firms for
which there is no observed outcome – for all but 5 of these firms (all of which are deals prior to
2000), we are able to verify from Lexis/Nexis that the firm is still private.
Using this information, the terminal value at the outcome date is determined from the
observed value at exit from Chapter 11, sale of the firm, the time of an IPO, or the last available
year if still private. When a terminal value cannot be directly observed (cases where information on
final distributions is not available, or the firm is still private), we estimate it as a multiple of
EBITDA. EBITDA multiples are calculated as the industry median ratio of market value of debt
plus equity to EBITDA of all firms on Compustat with the same four-digit SIC code.16
Similar
results are obtained using multiples of revenues rather than EBITDA.
The realized returns to pre- and post-buyout capital are reported in Table V. As expected,
the nominal and the market and risk adjusted returns are negative for the Chapter 11 group. Four
Chapter 11 firms still produce positive nominal returns to pre-buyout capital, a lower proportion
than reported by Andrade and Kaplan (1998) (whose study largely includes financially but not
economically distressed firms). Overall, Table V demonstrates the mean and median returns are
positive. For example, the median market and risk adjusted return to pre-buyout capital for the full
15 Given our shorter post-buyout horizon relative to Andrade and Kaplan (1998), some of our sample deals which are“still private” may ultimately fail, particularly given the economic downturn starting at the end of our sample period.The 6% failure rate reported by Strömberg (2008) for financial sponsor buyouts from 1970 to 2007 may also ultimatelybe higher.16 When the buyout firm is still private, industry multiples are measured at fiscal year end 2007.
III. Sources of value creation: changes in operating performance
The large positive returns to invested capital suggest that, at least on average, value is
created for those investors. We expect a primary determinant of the returns to be the changes in
operating performance of the firm after it is taken private. In this section, we first document the
post-buyout operating performance for the 94 deals completed by 2005 with post-buyout financial
data. We then relate observed operating performance gains to variables which proxy for sources of
these gains, such as improved management incentives, discipline of higher debt levels, better
monitoring by buyout sponsors, and other pre-buyout characteristics.
III.A. Changes in operating cash flows.
In order to evaluate the economic and statistical significance of pre- to post-buyout changes
in operating performance, cash flow changes must be adjusted by some benchmark. Empirical
literature suggests several approaches for determining the matching firms used for this benchmark.
We report results for three measures: 1) unadjusted changes, 2) using the industry median as the
benchmark, 3) matching on industry, pre-buyout level of performance, change in performance pre-
buyout, and market to book ratio of assets. The industry median adjusted performance provides the
most direct comparison to prior research (Kaplan (1989a)), using firms in the same four-digit SIC
code. Our alternative performance-adjusted benchmark is based on Lie (2001), who shows that this
benchmark yields more powerful test statistics, especially for samples with extreme pre-event
performance. We select up to 5 matching firms that have the smallest sum of absolute differences
from the sample firm in the year -1 level of performance, change in performance, and market-to-
book ratio of assets, and use the median as our benchmark.17
17 We follow Lie (2001) and Grullon and Michaely (2004) with some small modifications. The comparison groupincludes firms that have the following characteristics: (1) the same two-digit SIC code as the buyout firm, (2) a level of
operating performance between 80%-120% or within ±0.01 of the level of the sample firm’s performance in year –1, (3)
a change in operating performance between 80%-120% or within ±0.01 of the sample firm’s change in operating
Table VI reports the percentage changes in operating performance for the last full year prior
to completion of the buyout (year -2 to -1), from year -1 to up to three years after the year in which
the buyout is completed (year 0), and from the last full pre-buyout year to the year prior to the deal
outcome or the last available year if still private (year -1 to last year). We also report this last
measure for the subset of deals with outcomes as of July 2008 (an IPO, sale, secondary buyout, or
bankruptcy of the firm).
(INSERT TABLE VI ABOUT HERE)
Panel A.1 of Table VI reports measures of firm profitability (return on sales, calculated as
the ratio of EBITDA or net cash flow to sales). Other than the change in net cash flow/sales for year
-1 to +1, the unadjusted changes in EBITDA/sales and net cash flow/sales are negative for the
changes to each post-buyout year. The industry adjusted changes are most comparable to prior
research for buyouts, but do not show any significant gains. However, using the industry-
performance-market/book adjusted change, there is a significant increase from year -1 to year +1 or
+2 for both EBITDA/sales and net cash flow/sales. Still, even in these cases, the magnitudes are
substantially smaller than reported by Kaplan (1989a). For example, Kaplan reports percentage
gains in industry adjusted net cash flow/sales (relative to year -1) of 45.5%, 72.5%, and 28.3%, for
the first three years following the buyout, respectively. At best, we find a median percentage gain
in net cash flow of 14.3% using the performance adjusted benchmark. The smaller magnitude of
the cash flow gains in comparison to buyouts of the early 1980s may be due to the fact that many of
the buyouts from the earlier period involved firms with relatively poor pre-buyout performance.18
performance in year –1, (4) a market-to-book ratio between 80%-120% or within ±0.1 of the sample firm’s market-to-book ratio in year –1, and (5) financial data available in the first full year after the buyout.18 Bharath and Dittmar (2009) and Mehran and Peristiani (2008) show that factors driving firms to go private havechanged since the 1980s. Our results are consistent with Kang et al. (2007) who show that the probability of an LBOoccurring increases with the total funds raised by the private equity industry, and with Ljungqvist et al. (2008) whoshow that buyout funds accelerate their investments when credit market conditions loosen.
our evidence that operating gains are not large for U.S. public to private buyouts is qualitatively
similar to some recent studies of buyouts in Europe and the U.K., suggesting this behavior may not
be unique to the U.S. market.20
III.B. Explanations for post-buyout operating performance.
While operating performance gains are small on average, the variation in performance (as
seen across deal outcomes in Table VI.B) is quite large. We examine the relationship between
operating performance and factors expected to be related to operating gains, using the proxy
variables summarized in Table VII for the 94 firms with post-buyout data:
(INSERT TABLE VII ABOUT HERE)
19 We also consider that PE firms may exit in favorable market conditions before the benefits of operational changesappear in realized cash flows. For the subsample of firms exiting via an IPO, the cash flow improvements from pre-buyout to the first or second year post -IPO are not substantially greater than those reported in Table VI.20 For example, Weir et al. (2008) and Vinten (2007) show declines in profitability following buyouts in the U.K. andDenmark. However, studies that include many smaller divisional buyouts and buyouts of private firms in Europe showthat profitability increases more than benchmark firms (Cressy et al. (2007), Acharya et al. (2009), Boucly et al (2009)).
4) Other pre-buyout characteristics and activities while private. The ability to improve operating
performance may be greatest for firms which are underperforming pre-buyout, which we measure
by return on sales (EBITDA/sales) in year -1. The firms in our sample are also active in buying
and/or selling assets while private, even when these activities are not described at the time of the
buyout. Financial sponsors of the buyout may serve as advisors for these transactions (often
collecting a transactions fee), perhaps reducing the likelihood of poorly devised acquisition
strategies or helping firms to restructure by divesting certain divisions. We use information from
the statement of cash flows to identify acquisitions and asset sales. Over half of the sample firms
are involved in asset purchases or sales of at least $10 million in any of the first three years
following the buyout. Subsequent acquisitions can be large relative to capital at the time of the
buyout, with a mean of 40.2% of capital for the 47 (out of 94) firms reporting acquisitions.23
The cross sectional regressions for post-buyout operating performance are reported in Table
VIII, first for deals which have reached an outcome (regressions 1-3) and then for the full sample
(regressions 4-6). The dependent variables are the level of post-buyout cash flows in the final year
prior to the deal outcome (ROS at last year) or the change in cash flows from the year prior to the
buyout to the last post-buyout year (change in ROS or ROA adjusted for performance of firms
matched on industry, pre-buyout performance and market to book ratio). All regressions control for
the deal size (ln (capital)). Each regression also controls for performance at year -1 (ROS or ROA
relative to the matching firm), and for regressions (1) and (4), the matching firm’s level of ROS at
the last year. Results are similar for regressions explaining the level of ROA, and for the subset of
deals with post-buyout public debt which continue to file 10Ks regardless of the deal outcome (see
Internet Appendix Table IA.VIII). Year dummies are not significant.
23 Some sample firms make a substantial number of large acquisitions once private. For example, SunGard DataSystems, which was taken private in 2005, has so far disclosed 19 acquisitions of firms in related businesses whileprivate.
The regressions in Table VIII do not show that deals with higher management equity
contributions (management equity/total equity) perform better. Firms with greater increases in
leverage as a result of the buyout consistently show better cash flow performance. These results are
consistent with the disciplining effect of higher debt for the post-buyout firm.24 The coefficients for
the fraction of debt from senior bank lenders or the change in net working capital/sales are not
significant (Internet Appendix Table IA.VIII).
For the variables related to monitoring by the PE firm, we find that the management change
variable is positively related to cash flow performance. We control for whether the CEO is also
Chairman (positive and significant), and find that the positive effect of a management change on
profitability (ROS) is reduced when the CEO is also Chairman. Controlling for board size, the
fraction of board seats held by the PE firm (sponsor director ratio) is negative. This does not
necessarily imply a negative role for the PE firm in the governance process; an alternative
explanation is that firms with more problematic operations require more direct intervention by the
PE firm.25 Lastly, the regressions show that only the change in adjusted return on assets (ROA) is
significantly greater for “club” deals involving more than one PE firm (further discussion of club
deals is provided in Section IV below). Cash flow performance appears unrelated to the asset sale
and acquisition behavior of companies while private.
Overall, the leverage changes and governance activities appear important in explaining
operating gains. Differences across sample firms in their ability to improve operating performance
are likely to explain some of the variation in the value created by these deals, i.e. the returns to
24 It is also possible that PE firms use greater leverage for firms with better prospects. Consistent with Axelson et al(2009), the post-buyout leverage ratios for our sample firms are strongly related to current lending rates. However,current lending rates are not expected to be related to firm prospects. We therefore use the inflation adjusted leveraged-loan interest rate at the time of the buyout as an instrument for leverage, and find results similar to those reported inTable VIII. This suggests our result is not driven by the use of higher leverage for deals with ex ante better prospects.25 See also Cornelli and Karakas (2008) for discussion of PE firm involvement in firm governance.
We perform a similar analysis to quantify the impact of realized tax benefits on returns. For
each year the firm is private, we perform a hypothetical tax calculation, estimating the taxes that
would have been paid if the firm had not increased its leverage. We assume the firm has interest
payments such that it maintains its pre-buyout interest coverage ratio, or pays interest at the pre-
buyout level in unprofitable years.26
Hypothetical taxes are calculated each year using the actual
EBIT and tax loss carryforwards, and the hypothetical interest payments. We then calculate the
difference between these tax payments and those based on the actual interest deductions realized by
the firm. The sum of these differences, discounted back to the pre- or post-buyout date, provides an
estimate of the realized tax benefits of increasing leverage while private. The results summarized in
Table IX (Panel C) show that for the overall sample, the realized annual tax benefits account for a
median of 3.4% (4.8%) of the returns to pre- (post-) buyout capital (details of the calculations are
shown in Internet Appendix Table IA.IX.3).
If the firm maintains its increase in leverage beyond the time when the firm is private, the
terminal value used to calculate realized returns will also reflect an ongoing tax benefit. For firms
undergoing a secondary LBO, this is a reasonable assumption. Firms undergoing an IPO typically
reduce leverage with some portion of the proceeds from going public, so that a smaller amount of
ongoing tax benefits is likely. In contrast, firms undergoing a Chapter 11 restructuring must
substantially delever. Therefore, we calculate the impact of ongoing tax benefits on the terminal
value separately from those realized while the firm is private, and report this component of tax
benefits separately depending on the outcome. The “TV tax benefit ” in Table IX assumes the final
year’s tax benefit (calculated as above) continues in perpetuity. The potential impact on returns
from the terminal value of tax benefits is large; for firms sold in a secondary LBO, this component
26 These assumptions are similar to those used by Graham (2000) and Graham (2001). We use each firm’s marginalstate and federal tax rate, and discount estimated tax benefits at the sample median interest rate on debt.
of the tax benefit explains 24.2% (29.4%) of returns to pre- (post-) buyout capital. The “total tax
benefit ” in Panel C is the median of the sum of each firm’s annual and TV tax benefit .
Comparing the magnitude of the impact of each factor on returns in Table IX, for the full
sample returns to pre-buyout capital, we can attribute 22.9% of the return to changes in operating
performance, 17.7% to changes in industry valuation multiples, and 33.8% to tax benefits from
increasing leverage. However, as noted above, the magnitude of the tax benefits is likely overstated
for certain outcome groups, such as distressed restructurings, where it is not likely the firm remains
as highly levered after exit from the PE firm’s portfolio.
IV.D. Cross-sectional analysis of determinants of returns.
Table XI reports cross sectional regressions explaining returns to capital, which provide
further comparison of the relative importance of the determinants of returns. The dependent
variable is the market and risk adjusted return to pre- or post-buyout capital. The independent
variables include measures of the changes in operating performance, industry valuation multiple,
and tax benefits from increased leverage. We also include variables that measure the extent of asset
restructuring, since increased distributions to capital from the sale of non-productive assets will
impact returns but may not be reflected in our measures of changes in operating performance. 27 We
report results both for the subsample of deals which have reached an outcome and for the full
sample of firms where returns could be estimated.
(INSERT TABLE XI ABOUT HERE)
In order to compare magnitudes of effects across coefficients, we report [in brackets]
standardized regression coefficients. As expected, operating performance changes, measured as the
change in adjusted return on sales from year -1 to the last year available, or as the change in ROA,
are strongly related to the returns to either pre- or post-buyout capital. For example, from
27 Regression coefficients are unaffected when we include a variable for the change in the sales to working capital ratioof the buyout firm, which is not significant.
regression (1), a one standard deviation increase in the change in operating performance is
associated with a 0.340 standard deviation increase in the return to pre-buyout capital. The
magnitudes of the effects of changes in industry multiples or tax benefits are not dissimilar to that of
the operating performance changes, which helps us to understand why operating gains alone are not
sufficient to explain the positive average returns. The regressions also show that firms engaging in
more asset sales while private have lower returns to pre- or post-buyout capital.
We also report regressions in Panel B of Table XI that further allow us to consider the
impact of deal pricing on returns. A lower price paid in the buyout is expected to be associated with
a higher return to post-buyout capital, but not to pre-buyout capital. Our measure of deal pricing,
industry adjusted EBITDA/capital is not significant for any regressions (similar results are obtained
using an unadjusted pricing measure or the premium paid).
The variable indicating “club” deals is positive and consistently significant for the
specifications using ROS as the measure of operating performance. One possible explanation for
this result is that there is less competitive bidding for club deals.28
If the impact of the club PE
variable is simply to lower the price paid to selling shareholders, this would increase the return to
post-buyout capital but should be unrelated to pre-buyout capital’s return. However, the club PE
variable is significant in regressions for returns to both pre- and post-buyout capital. Our results for
the club PE variable are robust to other non-linear specifications of our control variable for deal
size.
We address this issue further by directly measuring whether there is competition in bidding
for the firm, using a measure of competition based on Boone and Mulherin (2007).29 To
28 Officer et al. (2009) find that target shareholders receive less in club deals than in sole-sponsored LBOs. Using adifferent sample, Boone and Mulherin (2009) fail to find any negative effect of club deals on either takeover competition or target returns.29 We obtain information from the background section of 14A and S-4 filings (for mergers) and 14D filings (for tender offers).
characterize the bidding process, we identify the number of potential buyers making written private
bids before the merger announcement, and the number of potential buyers making public bids. We
define the variable “competition” as a dummy variable that equals 1 if there are multiple bidders
making either private or public bids. This measure of competition, however, is insignificant in all
regressions, as is the interaction of club PE and competition. Our evidence appears more consistent
with an alternative explanation; deals which are particularly attractive ex-ante based on their
prospects at the time of the buyout are more likely to be shared by more than one PE firms.30
Overall, the regressions show that the changes in valuation multiples and tax benefits of
increasing debt are economically as important as firm specific changes such as gains in operating
performance in explaining the realized returns to capital.31
Returns are also higher for deals with
multiple PE firms.
The ability of private equity firms to purchase firms and later exit at a higher valuation
multiple, producing substantial returns, also may be explained in part by credit market conditions
during our sample period. By taking on large amounts of cheaply priced debt, firms can lower their
WACC and therefore increase their valuation multiple.32 While growth in the junk bond market
may have fueled the buyout boom of the 1980s, the impact of collateralized debt obligation (CDO)
packaging of senior bank debt on credit spreads may have served that role more recently. We do
not find that Year Dummies (either for the year of the buyout or the year of exit) are helpful in
explaining returns, however.
30 If certain firm characteristics determine whether there are multiple PEs, the error term of the model that gives rise tothis choice may be correlated with the error term in the return regression. If so, the OLS estimate is not a consistentestimate of the marginal effect of club PE on the return. To account for the bias, we fit a two-step treatment effectmodel (see Inter Appendix Table IA.XI). These results support our interpretation of the OLS regressions.31 Besides comparing the standardized regression coefficients, we can also compare the marginal effects of our keyvariables on returns. Using regression specification (1), a one standard deviation increase in the adjusted change in ROS increases the return by 57%, a one standard deviation increase in the industry multiple increases the return by 51%, anda one standard deviation increase in the tax benefits/pre-buyout capital increases the return by 65%.32 Demiroglu and James (2009) also discuss the relationship between credit spreads and LBO valuations.
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Sample consists of 192 leveraged buyouts completed between 1990 and July 2006 with deal values of at least $100 million.94 deals completed by 2005 have post-buyout data available from 10Ks or other SEC filings. Capital is defined as the sumof the market value paid for the firm’s equity, the amount paid for outstanding debt, the book value of debt retained, andfees paid in the transaction, minus cash removed to finance the buyout. Market EBITDA to Capital ratio is based on thevalue-weighted S&P500 component firms in the month before the buyout is announced. The buyout premium is defined asthe percentage difference between the price per share paid for the firm’s equity and the price one month before the buyoutannouncement. The significance of difference in medians is based on two-sample Wilcoxon rank-sum (Mann-Whitney)test. ***, **, and * indicate significance at the 1, 5, and 10 percent level, respectively.
Characteristics of debt financing used to finance the buyout are identified from Dealscan, Dealogic, and SEC filings. Public Debt inis defined as cases where a lender also provides equity financing for the transaction.
The table reports post-buyout outcomes as of March 2009 for the full sample of 192 buyouts as well as the 94 deals completedby 2005 with post-buyout data available. The number of observations is reported, followed in parentheses by the number of those observations having post-buyout data.
Outcome: (1) (2) (3) (4) (5)
LBO Announcement Year IPO Sold 2nd LBO Chapter 11still private
Table VII – Summary statistics for deal characteristics
Panel AManagement equity participation is a dummy variable that equals 1 if management of the target contributes equity.Management change indicates there is a CEO change at or within a year of LBO completion. Post-LBO CEO is the chairman of the Board indicates the post-LBO CEO is also chairman. Club PE indicates there are two or more PE sponsors for the deal.Sells significant assets indicates the firm sells assets of more than $10 million in any year during the 3-year post-buyout period.
Makes significant acquisitions indicates the firm makes an acquisition with a value of at least $10 million in any year during the3-year post-buyout period. The percentage of deals is based on the 94 deals with post-buyout data available.
# of deals % of deals
Management equity participation 58 61.7%
Club PE participation 26 27.7%
Management Change 35 37.2%
Post-LBO CEO is the chairman of the Board 48 51.1%
Sells significant assets while private 34 36.2%
Makes significant acquisitions while private 47 50.0%
Panel BPre-buyout leverage is measured at year -1. Leverage change is the difference between total debt at the buyout and total debt atyear -1, divided by EBITDA at year -1. Bank loans/ total debt, board size, and capital are measured at the time of the buyout.Sponsor director ratio is defined as the number of directors from sponsors divided by total number of directors on board. Assetsales/capital is the total value of asset sales during the 3-year period after completion of buyouts divided by post-buyout capital.Acquisition/capital is the total value of acquisitions made during the 3-year period after completion of buyouts divided bycapital. Duration measures the number of fiscal years from the completion of buyout to exit if the deal reaches an outcome orthe number of fiscal years to the last post-buyout year if the firm is still private.
Table VIII – Regressions for post-buyout performanceThe table reports the multivariate regression results for post-buyout performance for subsample of deals that have reachedan outcome and for the full sample. Adjusted ROS and ROA subtract the performance of firms matched on industry, pre-buyout performance, and market/book ratio. The dependant variable in models 1 and 4 is return on sales (ROS),measured as (EBITDA/sales) at the last post-buyout year. The dependent variable in models 2 and 5 (3 and 6) is thechange in adjusted ROS (ROA) from year -1 to the last post-buyout year. Capital is the buyout purchase price.CEO_chair indicates the CEO is also Chairman. Other independent variables are as defined in Table VII. P-values are inparentheses. All regressions are OLS with heteroskedasticity adjusted standard errors. a, b, and c indicate significancelevel at 1%, 5%, and 10%, respectively.
Median Capital/EBITDA multiples and changes in multiples are reported for the buyout firm, industry, and market (S&P). Pre-buyout announcement. Post-buyout date is the buyout effective date. Terminal value (TV) date is the month end at which the terminmultiple is calculated using non-buyout firms in the same SIC industry group with at least 5 firms. S&P multiple is the median capa, b, and c denote the median is significantly different from zero at the 1%, 5%, or 10%, respectively.
Table XI – continuedPanel B reports the OLS estimation results for return to capital for subsample with outcome and full sample with post-buyout data availabequals 1 if there are multiple bidders for the company, otherwise 0. P-values are reported under the coefficients in parentheses. a, b, and c i10%, respectively.
Panel B Subsample with outcome
(1) (2) (3) (4) (5) (6)
Return to: Pre-buyoutcapital
Pre-buyoutcapital
Post-buyoutcapital
Post-buyoutcapital
Pre-buyoutcapital
Pre-buycapit
Ind&perf.&M/B adj. Chg in ROS (-1, last) 4.731a 3.318a 4.878a
(0.001) (0.002) (0.000)
Ind&perf.&M/B adj. Chg in ROA (-1, last) 4.419a 3.115b 4.437
(0.016) (0.018) (0.00
Change in industry multiple 0.090a 0.081a 0.075a 0.069b 0.082a 0.074(0.000) (0.001) (0.002) (0.010) (0.000) (0.00
Table IA.TS1 – Median realized returns to pre- and post-buyout capita
“Market & risk adjusted” return discounts interim payments and terminal value to the pre- or post-buyout capital date. The
βu*rm, where rf is the one month T-bill return (Ibbotson) and rm is the realized return on the S&P 500 from the pre- or postflow. βu is the asset beta calculated using stock returns for up to 60 months prior to the buyout and the pre-buyout debt/e
based on Wilcoxon signed-ranks test. a, b, and c indicate significance level at 1%, 5%, and 10%, respectively.
Regressions for operating performance – robustness checks
Change in sales/NWC is defined as change in sales-to-working capital ratio from pre-buyout year tolast post-buyout year prior to deal outcome. All other variables are as defined in Tables VII and VIII.
Table IA.IX.3 – Impact of realized tax benefits on returns
The table reports the effect of realized tax benefits from increasing debt on the return to pre- or post-buyout capital. For each y
payments are calculated assuming the firm maintains its pre-buyout interest coverage level, or pays interest at the pre-buyout level in
each year using the actual EBIT, tax loss carryforwards, and the hypothetical interest payments, and the firm’s actual marginal feder
of tax benefits while private is calculated as the sum of the differences between the tax hypothetical payments and those based on th
the firm, discounted to the pre-or post-buyout capital date at sample median interest rate (LIBOR plus spread) of 8.35%. Hypothetic
the present value of tax benefits while private (divided by pre- or post-buyout capital) from the realized return. The terminal value (T
– Ihypothetical*t/r) using the final year’s hypothetical interest payments. The proportion of return due to tax benefits is defined as thewithout the tax benefits, divided by the absolute value of the return.
Regressions for return to capital: treatment effects model
Table reports two-step treatment effect model (estimators are derived in Maddala (1983) and Green (1999)). The first step (treatmentequation) estimates a probit model for the Club PE indicator variable, using the subset of observations where management projections areprovided at the time of the buyout. From the probit estimates, the hazard rate for each observation is computed following Maddala (1983,pp.120-122). The hazard rate is used in the second step regression in addition ot he variables used for the OLS model (Table XI),
yielding an unbiased and consistent estimator for the Club PE variable. Competition is a dummy variable that equals 1 if there aremultiple bidders for the company, otherwise 0. Projected Growth in Sales is the average projected sales growth rate by management atthe buyout in the Proxy statement, 13E3, or 14D1. ln(# of projected years) is the number of years of projections provided.). P-values arereported under the coefficients in parentheses. a, b, and c indicate significance level at 1%, 5%, and 10%, respectively.
Step 2:
: Treatment equation
Step 1:
Club PE
Return to pre-buyout capital Return to post-buyout capital