Buyout Activity and Asset Prices

Abstract

We develop a model in which leveraged buyout (LBO) transactions are sensitive to variation in pricing conditions. The privatization of the firm generates value by eliminating agency costs that impede the firm’s growth; however, LBO investors require compensation to commit their capital to a single, undiversified project. These quantities are derived in an economy with long-run risk and recursive preferences. We conclude that more buyouts should occur when risk-free rates are high and the risk premium is low. In a panel dataset of public companies from 1980 to 2009, we document that LBO activity is positively related to the risk-free rate and negatively related to expected excess returns. We find the aggregate discount rate, rather than credit specific factors, is an important determinant of LBO activity. We also predict firms with higher exposure to systematic shocks and higher idiosyncratic risk are less likely to LBO. In the data, we find firms are less likely to privatize if they have a high market beta, residual variance, or cash flow volatility.