Debt Structure, Private Equity Reputation, and Performance in Leveraged Buyouts

Abstract

This paper provides a comprehensive study of deal characteristics and participants’ involvement in leveraged buyouts (LBOs) and their impact on target firms’ performance. Using a sample of 501 U.S. LBOs completed between 1986 and 2011, I find that higher industry-adjusted changes in return on assets and return on sales are associated with larger amount of leverage added during the buyout process, tighter LBO loan covenants, and equity contribution of target firms’ management. LBOs are more likely to exit through an IPO or a sale if they use more bank debt with tighter covenants and are sponsored by private equity firms of high reputation. These relations are robust to credit market conditions and aggregated LBO activities. The evidence suggests that the main source of value creation in LBOs is the reduced agency costs through the disciplining effect of debt, closer monitoring by lenders, and the better aligned management incentives. Private equity firms’ reputation is also important in ensuring successful deal outcomes. My findings also suggest that the poor performance observed in recent LBOs is a result of less leverage, fewer bank loans, and less restrictive covenants used in these deals.