Abstract
The focus of this paper is to assess the long-term common stock performance of the parent firms that underwent divisional buyout (DBO) and had event risk covenant (ERC) bonds outstanding at the announcement of the DBO. The final sample of 46 parent firms exhibit a common characteristic where all the ERC bonds were redeemed (either called above par or put on the firm at par) or restructured at a higher cost to the firm around DBO announcement date due to the presence of ERCs. ERCs are triggered since the parent firms that divest their assets through a DBO reveal future cash flow volatility, which has potential to lower the value of existing bonds. This refunding of the bonds leads to costly refinancing for the parent firms, which has long-term implications. I find significantly negative cumulative abnormal returns at the issue date of the ERC bonds for these firms due to potential managerial entrenchment and foregone transfer of wealth from bondholders to stockholders. Consistent with the finance literature, I find significantly positive cumulative abnormal returns for parent firms at the announcement of the DBO. These positive short-term returns at the announcement do not translate into long-term positive returns. The common stock of these parent firms significantly underperforms the market over the periods three, four, and five years after the DBO date. This dichotomy can be attributed to the security market overreaction to the announcement of DBO. The long-term underperformance can be attributed to the costly refinancing of the ERC bonds.
Highlights
Leveraged buyouts (LBOs) have been widely explored in the finance literature
The parent firm stays public after the divisional buyout (DBO), the firm’s common stock can be observed to evaluate the firm’s long-term performance
The prime focus of this paper is to study the long-term market performance of the parent firms, with event risk covenant (ERC) bonds outstanding at the DBO announcement, over the periods three, four, and five years after the DBO
Summary
In an LBO the investors buyout the entire publicly traded firm and take it private primarily with debt financing. Smith (1990) finds that firm’s operating performance considerably and significantly increased after the LBO. In a divisional buyout transaction (DBO hereafter), firm’s mangers and/or investor(s) buyout a division of a publicly traded firm primarily with debt financing and is typically taken private. The DBOs are motivated by an opportunity to increase the efficient use of assets for the division at the same time improving the effectiveness and efficiency of decision making for the slimmer parent firm (Hite & Vetsuypens, 1989). The long-term performance of parent firms after the DBO has remained unexplored in the literature. The parent firm stays public after the DBO, the firm’s common stock can be observed to evaluate the firm’s long-term performance
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