Leveraged Buyouts Research Articles

Business Aggression, Institutional Loans, and Credit Crisis: Evidence from Lending Practices in Leveraged Buyouts

This paper investigates the lending practices related to leverage buyouts (LBOs) market between high and low write-down institutions. The write-downs, which are a proxy for business aggression of institutions, are mainly related to credit crisis from the beginning of 2007 to August 10, 2008. We find that high (low) write-down institutions increase (decrease) loan market share dramatically during the period of 2001-2006. The increase is mainly driven by the segment of loans sold to institutional investors, such as collateralized loan obligations vehicle, hedge fund, and insurance companies. Institutional loans originated by high write-down institutions carry significantly fewer covenants and higher interest spread than those by low write-down institutions during 2001-2006. However, there are no such differences during 1995-2000. The aggressive lending practice by high write-down institutions to lower quality borrowers during 2001-2006 appeared to be mitigated by reputable private equity (PE) investors. High write-down institutions arranged loans with more covenants and lower interest spread for borrowers with investments from more reputable private equity investors. We contribute to extant literature in the area of financial crisis by providing empirical evidence that both business aggression of some institutions and the increase demand for institutional loans drive the peculiar lending practice during the easy credit period, which subsequently leads to declines in values of assets associated with these loans. Our focus on the role of PE reputation in mitigating aggressive lending practice complements recent studies in the area of LBO loans market and PE reputation, such as Demiroglu and James (2008) and Ivashina and Kovner (2008). The findings of demand pressure (credit supply) from institutional loans add to the analyses of Ivashina and Sun (2008) and Wang (2008). We provide additional evidence that such increase in institutional loans demand is filled by some aggressive financial institutions, which ex post incur high write-downs during the credit crisis. Many such institutions pay horrendous prices for their business aggression and have ceased to exist in the market.

Club deals in leveraged buyouts

We analyze the pricing and characteristics of club deal leveraged buyouts (LBOs)—those in which two or more private equity partnerships jointly conduct an LBO. Using a comprehensive sample of completed LBOs of U.S. publicly traded targets conducted by prominent private equity firms, we find that target shareholders receive approximately 10% less of pre-bid firm equity value, or roughly 40% lower premiums, in club deals compared to sole-sponsored LBOs. This result is concentrated before 2006 and in target firms with low institutional ownership. These results are robust to controls for target and deal characteristics, including size, Q, measures of risk, and time and industry fixed effects. We find little support for benign motivations for club deals based on capital constraints, diversification motives, or the ability of clubs to obtain favorable debt amounts or prices, but it is possible that the lower pricing of club deals is an inadvertent byproduct of an unobserved benign motivation for club formation.

Leveraged buyouts, private equity and jobs

Using a unique data set of 533 leveraged buyouts (LBOs) observed over the 1993–2004 period, covering all size ranges, the study conducts a systematic analysis to determine and quantify: (1) the effect of private equity (PE) and LBO governance on employment and (2) whether the size of the target firm impacts on post-buyout employment effects. After accounting for endogeneity, we find that LBOs, whether PE financed or not, do not have significantly different employment levels compared with a control sample of firms. Additionally, there are no employment effects contingent on the size of the target firm. The findings contrast with anecdotal claims of job destruction. The study therefore makes an important contribution to the debate on the impact of LBOs and PE.

Industry Effects of LBO Events

We explore the effects of leveraged buyouts (LBOs) on industry rivals of the firm undergoing the LBO. In particular, we seek to explain why certain firms experience strong positive market reactions and other firms experience strong negative market reactions. We find evidence that an industry effect exists that helps to explain why LBO targets cluster by industry such that there is persistence in LBO activity within an industry. This persistence does not appear to be connected to future shocks to the industry. This indicates that the rival wealth response may be related to future expected LBO offers within the industry, and not due to some expected future shock. We explore this hypothesis further by examining firm-level data. We find further evidence in favor of a pure acquisition hypothesis: that an LBO in an industry indicates that more LBOs will be attempted in the same industry. Our investigation then brings us to explore changes made by rival firms in response to the LBO activity. We document changes in capital expenditure and leverage among rivals. However, such changes appear to be transitive. Finally, we note that industry-level return variance increases following LBOs, but that rival firms’ industry betas decrease. We examine any effect this has on executive compensation packages but find little evidence of any large changes. In sum, our results indicate that the pure acquisition hypothesis is the most sensible hypothesis in explaining rival firms’ abnormal returns around LBO announcements.

The role of private equity group reputation in LBO financing

This paper investigates whether the reputation of acquiring private equity groups (PEGs) is related to the financing structure of leveraged buyouts (LBOs). Using a sample of 180 public-to-private LBOs in the US between January 1, 1997 and August 15, 2007, we find that reputable PEGs are more active in the LBO market when credit risk spreads are low and lending standards in the credit markets are lax. We also find that reputable PEGs pay narrower bank and institutional loan spreads, have longer loan maturities, and rely more on institutional loans. In addition, while we find that PEG reputation is positively related to buyout leverage (i.e., LBO debt divided by pre-LBO earnings before interest, taxes, and amortization (EBITDA) of the target), and leverage is significantly positively related to buyout pricing, we do not find any direct relation between PEG reputation and buyout valuations. The evidence suggests that PEG reputation is related to LBO financing structure not only because reputable PEGs are more likely to take advantage of market timing in credit markets and but also because PEG reputation reduces agency costs of LBO debt.

Home Bias in Leveraged Buyouts*

AbstractIn this paper, we examine cross‐border investments in 2,260 portfolio companies by 102 buyout funds raised between 1995 and 2004. Using proprietary data compiled by AlpInvest Partners, we calculate the aggregate home bias of these funds as well as their home bias at the fund level. We find significant variation across funds. While UK‐based funds are on average least home‐biased, they show a high degree of intra‐European bias. In comparison, US funds are found to be least home‐biased in terms of inter‐regional acquisitions, with Europe being the most important destination for US buyout capital. Furthermore, we find that buyout funds tend to be less home‐biased than portfolio investors and, more specifically, mutual funds. This finding is consistent with the optimal ownership theory of the home bias, which predicts that foreign direct investment – as opposed to portfolio investment – represents the preferred choice of entry in countries where the quality of governance is perceived to be inferior, promoting insider ownership.

The effect of change-in-control covenants on takeovers: Evidence from leveraged buyouts

Change-in-control covenants first became commonplace towards the end of the takeover wave in the 1980s. We examine merger and acquisition activity from 1991 to 2006 to see how such covenant protection influences the wealth effects and probability of takeovers. Examining a sample of leveraged buyouts (LBOs) we find bondholders with such covenant protection experience average wealth effects of 2.30% while unprotected bonds experience − 6.76% upon the announcement of an LBO. Furthermore, we document that the existence of bondholder change-in-control covenants cuts the firm's probability of being targeted in an LBO in half. We also find that change-in-control covenants reduce the probability of being targeted in non-LBO takeovers, but the effect appears less dramatic.

Do Cross-border Leveraged Buyouts Sponsored by Private Equity Firms Increase the Globalization of the Banking Industry?

This paper investigates empirically the effects of cross-border leveraged buyouts (LBOs) sponsored by private equity firms on the globalization of the banking industry from two perspectives. First, I examine the impact of cross-border LBOs on cross-border borrowing and lending. I find that cross-border LBOs have positive and significant effects on cross-border borrowing and lending. In particular, I find that LBOs sponsored by foreign private equity firms are more likely to include a foreign lead bank in the syndicated loans. Second, I examine the impact of cross-border LBOs on the integration of syndicated loan pricing in the LBO market. I find that the cross-border borrowing and lending brought by cross-border LBOs do not help to bring about the integration of syndicated loan pricing in the LBO market. Further, I find that loans arranged by domestic lead banks are on average associated with lower spreads, indicating that domestic banks have some advantage in syndicating loans in their domestic markets and thus charge a lower price for the loan.

Illegal buyouts

This study empirically examines the effects of a regulation change on the structure and governance of leveraged buyouts (LBOs) within the Italian private equity market, whose transactions were only recently legalized. With a new data set covering approximately 85% of the buyout funds active in Italy during the period of 1999–2006, we find that a regulation that prohibits LBOs can reduce their frequency, but does not exclude them altogether. Rather, it inhibits efficient governance and distorts decision making. Overall, the data are consistent with the view that laws prohibiting LBOs result in less efficient LBO arrangements.

Reverse‐LBOs, re‐LBOs and informational asymmetry hypothesis of LBO transactions

PurposeThe purpose of this paper is to examine the informational asymmetry (informational advantage of managers) in leveraged buyout (LBO) transactions.Design/methodology/approachUnlike previous studies of informational asymmetry in LBOs, this research uses a set of reverse‐LBO and re‐LBO firms. The paper proposes and empirically tests three hypotheses that draw on the informational advantage of managers in LBOs. Specifically, the value gain (VG) realized by the reverse‐LBO firms is compared with that realized by a control sample of firms; the wealth distribution between managers and pre‐buyout shareholders is studied; and, finally, the performance of re‐LBO firms relative to reverse‐LBO firms is evaluated.FindingsThe results do not support the view that managers use buyouts to exploit their informational advantage. Specifically; the performance of LBO firms under the private ownership is comparable to those of matching public firms; the management team's return in a LBO deal is not significantly more than pre‐buyout shareholders’ return; and repeating reverse‐LBO firms (re‐LBOs) do not necessarily perform better than the non‐repeating reverse‐LBO firms.Originality/valueWhile reverse‐LBOs have been investigated to some extent in the prior literature, studies on re‐LBOs are quite scant – although these transactions offer a new and interesting avenue to examine the motivations behind LBOs in general. The use of the entire LBO − reverse‐LBO − re‐LBO cycle in testing the informational advantage of managers is a novelty. It is hoped that re‐LBOs will attract the amount of attention they deserve as these firms may offer interesting means to reinvestigate commonly debated theories of corporate finance.

Investing in Sponsor-Backed IPOs: The Case of Hertz

This case and its companion, UVA-F-1560, were awarded the 2012 Wachovia Award for Excellence in Teaching Materials - Innovative Case. In November 2006, Alec Berg, a successful hedge fund manager, must decide whether to invest in the initial public offering (IPO) of the Hertz Corporation. The IPO followed a leveraged buyout (LBO) of Hertz that was completed in December 2005 by three prominent private equity firms that had combined to purchase Hertz from the Ford Motor Company for $14.9 billion. The LBO sponsors had borrowed an additional $1 billion on top of the buyout financing to pay themselves a special dividend in June 2006. This loan would be repaid with the IPO proceeds and any remaining proceeds from the IPO would go to the sponsors. The IPO generated widespread criticism with respect to the speed with which the IPO was conducted and the payment of special dividends. In the face of this criticism, the demand for the Hertz IPO weakened, and the offer price was reduced from the initial file price range of $16–$18 to just $15. Berg must assess whether at $15 per share, Hertz offers an attractive investment for this fund. The case provides the necessary information for students to analyze the sponsors' returns on their investment in Hertz and the attractiveness of the $15 offer price to public shareholders. The case also offers an opportunity for students to discuss the controversy surrounding the payment of special dividends and the claim that private equity sponsors invest with a long-term perspective that creates value for the company.

Private Equity Syndication: Agency Costs, Reputation and Collaboration

Abstract: Syndicates are a form of inter‐firm alliance in which two or more private equity firms invest together in an investee firm and share a joint pay‐off, and are an enduring feature of the leveraged buyout (LBO) and private equity industry. This study examines the relationship between syndication and agency costs at the investor‐investee level, and the extent to which the reputation and the network position of the lead investor mediate this relationship. We examine this relationship using a sample of 1,122 buyout investments by 80 private equity companies in the UK between 1993 and 2006. Our findings show that where agency costs are highest, and hence ex‐post monitoring by the lead investor is more important, syndication is less likely to occur. The negative relationship between agency costs and syndication, however, is alleviated by the reputation and network position of the lead investor firm.

Financial Visibility and the Decision to Go Private

This paper documents that a large fraction of the companies going private from 1990 to 2004 were fairly young IPO firms that chose to revert back to their original organizational form, and therefore to a more concentrated ownership structure. Consistent with the findings of the earlier literature examining leverage buyouts (LBOs), we find strong support for Jensen’s free cash flow hypothesis, suggesting that one key reason for firms deciding to go private is to mitigate agency problems between insiders and outside shareholders. However, our evidence also reveals that firms with small growth in analyst coverage and institutional ownership, and low stock turnover were more likely to go private and opted to do so sooner. Thus, another potential reason for restructuring by these IPO firms may be their inability to enjoy the benefits of public ownership that come from financial visibility because of their failure to attract a critical mass of security analyst coverage and investor interest.

What Drives Leverage in Leveraged Buyouts? An Analysis of European LBOs' Capital Structure

This paper examines leverage in European private equity led LBOs. We use a unique, self-constructed sample of 126 European private equity sponsored buyouts completed between June 2000 and June 2007. We find that leverage determinants derived from classical capital structure theories do not explain leverage in LBOs, while these determinants do drive leverage in a control group of comparable public firms. Rather, we document that leverage levels in LBOs are related to the prevailing conditions in the debt market. In addition, our results support the hypothesis that the reputation of the private equity sponsor involved in the buyout is positively related to LBO leverage. Finally, also the type of buyout (primary versus secondary) is related to the amount of leverage used.

Will the Fraud Act 2006 'Get the Law Right?': A Study of the Effectiveness of Applying Criminal Sanctions to Penalise Fraud in the 'Commercial Sphere'

Fraud in the UK jumped 50 percent in the first half of the year, compared with the previous six months, and is likely to worsen... As many as 128 fraud cases went to courts, involving 630 million pounds - with banks suffering an all-time high of over 350 million pounds - said a report by accountancy firm KPMG... Fraud against banks totalled more in six months than in any whole year in the 20 year history of KPMG's Fraud Barometer, the accountancy firm said. Fraud remains extremely prevalent in the UK..., said Hitesh Patel, partner at KPMG Forensic unit. ...The most bizarre case to come to court in the first half of the year involved someone who allegedly conned an investor into believing that he was acting on behalf of the Barclay brothers to sell the Ritz hotel in London for 250 million pounds - less than a reported market price of about 600 million. The investor paid a deposit of 1 million, quickly spent by the fraudster. This caption and other scandals arising from recently exposed enormous frauds, for instance Enron, WorldCom, Barlow Clowes and Barings Bank to mention but a few, is an indication that financial crime is a greater threat to humankind today than any time in history. Our planet is more fragile than ever and more at risk from the predations of environmental criminals. Economies are more internationalised and therefore more vulnerable to sophisticated criminals who use corporations to avoid regulation and run international law evasion schemes. The situation is worsened by the way markets are receptive to radical new business ideas such as leverage buyouts, junk bonds and poison pills which can sweep through capitalist markets overnight with disastrous consequences. These dynamics have challenged criminal laws, rendered them ineffective and society seems to have run out of control strategies. It is important that laws stipulating responsibility for financial crime are sanitised. The new Fraud Act (2006) (hereinafter 'the Act') has redesigned criminal law so as to cast the net of responsibility further around the actors that violate the law. However, the law is relatively new and only time will tell whether it will be effective in its pursuit of holding perpetrators of financial crime to account for their transgressions. This paper shall delve into conventional theories that have evolved over the years regarding white-collar crime, and the general principles and methods employed in detection, investigation, prosecution and punishment of financial crime. The study shall focus on the effectiveness or lack of it, of the use of criminal sanctions to proscribe misconduct in the 'commercial sphere.' The paper shall seek to gauge how society may perceive the new Act and whether the Act will be an effective tool to combat financial crime. This article shall also attempt to accomplish the task of suggesting ways of alleviating relevant concerns in the use of criminal sanctions beyond the goal of enforcing specific regulatory norms. The study does not seek to be a treatise on penal law however it is an attempt to conclude the difficult task of suggesting an effective way of decisively curbing financial crime in the UK.

Secondary buyouts, private equity and firms’ corporate governance

During last years numerous studies have focused attention on determinants of leverage buyouts (LBOs), finding strong evidence about the capability of those operations to improve firms’ productivity and operating performance. Nonetheless, there is a lack of research concerning the performance realized by secondary buyouts (SBOs), which are operations where a LBO is refinanced with a new ownership structure that includes a new set of private equity financiers and a new debt structure. By the analysis of a initial dataset of 164 transactions occurred in Italy during the period from 2000 to 2008, we find evidence of SBOs’ rationales of corporate governance, with significant firms’ performance improvements.

Elephant Bar Restaurant: Mezzanine Financing

In November 2003, John Fruehwirth, a principal at Allied Capital was considering a $20 million mezzanine investment in growth capital for the Elephant Bar Restaurant, a restaurant chain. Elephant Bar had had some initial success in but now Allied’s investment committee had to wrestle with the question of whether the restaurant concept was strong enough to travel and become a national brand or whether it was mainly a California Concept. And if the concept was strong enough to travel, would Allied Capital be able to meet its underwriting standards? Because Elephant Bar is a company with aggressive growth plans, it is significantly riskier than traditional mezzanine investments. The case can be used in courses on venture investing, to illustrate another funding source available to young companies. Traditional mezzanine financing is often used to provide a portion of the funding for late stage investments, such as leverage buyouts. The case can also be used in courses on private equity, to illustrate the perspective, risk mitigation strategies, and return expectations of mezzanine investors.

Bidding for Hertz: Leveraged Buyout

In August 2005, The Carlyle Group and its partners (Clayton, Dubilier & Rice, and Merrill Lynch Global Private Equity) must finalize the terms of a bid to purchase the Corporation. The Ford Motor Company had put Hertz, a wholly owned subsidiary, up for sale in April 2005, and in June 2005, entered a dual-track process, which would result in its sale or an initial public offering (IPO). The case provides detailed pro forma projections for the transaction that allow students to examine the synergies of the deal and estimate a value and bid for Hertz. Students must consider whether their bid provides an adequate return to the sponsors, can produce in a higher value for than an IPO, and can best that of a rival bidding group. The case is appropriate for use in courses on corporate finance, private equity, or deal valuation. Because of the rich range of issues that can be considered, the case also works well as a capstone case or in a case competition. For instructors wishing to provide students an overview of the role and practices of private equity, we recommend combining the LBO case with its companion case, Investing in Sponsor-Backed IPOs: The Case of Hertz (UVA-F-1561). The IPO was announced in July 2006 just seven months after the LBO was completed. The two cases cover a wide range of issues that arise over the course of entry and exit of private equity investments.

Investing in Sponsor-Backed Ipos: The Case of Hertz

In November 2006, Alec Berg, a successful hedge fund manager, must decide whether to invest in the initial public offering (IPO) of the Hertz Corporation. The IPO followed a leveraged buyout (LBO) of Hertz that was completed in December 2005 by three prominent private equity firms that had combined to purchase Hertz from the Ford Motor Company for $14.9 billion. The LBO sponsors had borrowed an additional $1 billion on top of the buyout financing to pay themselves a special dividend in June 2006. This loan would be repaid with the IPO proceeds and any remaining proceeds from the IPO would go to the sponsors. The IPO generated widespread criticism with respect to the speed with which the IPO was conducted and the payment of special dividends. In the face of this criticism, the demand for the Hertz IPO weakened, and the offer price was reduced from the initial file price range of $16-$18 to just $15. Berg must assess whether at $15 per share, Hertz offers an attractive investment for this fund. The case provides the necessary information for students to analyze the sponsors’ returns on their investment in Hertz and the attractiveness of the $15 offer price to public shareholders. The case also offers an opportunity for students to discuss the controversy surrounding the payment of special dividends and the claim that private equity sponsors invest with a long-term perspective that creates value for the company.

Financial leverage and bargaining power with suppliers: Evidence from leveraged buyouts

This paper investigates whether leveraged buyouts (LBOs) increase the bargaining power of firms with their suppliers. We find that suppliers to LBO firms experience significantly negative abnormal returns at the announcements of downstream LBOs. We also find that suppliers who have likely made substantial relationship-specific investments are more negatively affected, both in terms of abnormal stock returns and reduced profit margins, than suppliers of commodity products or transitory suppliers. Interestingly, leveraged recapitalization announcements are not associated with negative returns to suppliers, suggesting that increased leverage without an accompanying change in organizational form does not, on average, lead to price concessions from suppliers.