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| Leveraged Buyouts |
A leveraged buyout (LBO), also known as a highly leveraged transaction (HLT), is a financial transaction where a firm’s assets are acquired using a high level of debt. This results in a very high leverage for the firm after the transaction.
Using a sample of 76 management buyout (MBO) transactions— a special case of an LBO undertaken by a firm’s management—Kaplan (1989) reports that the book value of debt to equity ratio increased from 21% before the buyout to 86% after the transaction.
LBOs along with venture capital investments are the two primary investment vehicles for private equity funds. Using a sample of 746 private equity funds that are largely liquidated, Kaplan and Schoar (2005) report that about 41% of the private equity capital was invested in these funds. The mean size of an LBO fund in their sample is about U.S. $416 million.
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To compare the performance of the LBO funds, the authors discount the cashflows for these funds with the return on S&P 500 index. Net of fees and on equal-weighted basis, the median LBO fund underperformed S&P 500 by a factor of 0.80 while the fund at the 75th percentile outperformed the index by a factor of 1.13.
On value-weighted basis, where value is proxied by the amount of capital committed to the fund, the respective performance numbers are 0.83 and 1.03. They also find evidence of persistent performance.
Given LBO specialists such as KKR closely monitor a portfolio of firms after these transactions, LBOs should be thought of as a new form of organization similar in structure to that of a diversified conglomerate, according to Jensen (1989).
Kaplan (1991), however, argues that LBOs are neither permanent nor short-lived organization form. this conclusion is based on his observation that the median firm in a sample of 183 large LBO transactions between 1979 and 1986 remained private for 6.8 years after the transaction.
But why do LBOs exist? theoretically, in a Modigliani–Miller (1958) ideal world where taxes, transaction cost, and agency problems do not exist, capital structure is irrelevant and LBOs do not add any value. In reality, however, the tax shield of debt is valuable to a firm’s equity holders.
Hence, LBOs are expected to increase firm value. A counterargument is presented in Miller (1977) where an investor holds both debt and equity, and any benefit from the tax deduction for the equity gets completely offset by the tax paid on the interest income from the debt.
Empirically, Kaplan (1989) provides evidence that value of the tax shield in a sample of MBOs between 1979 and 1985 ranged from 21 to 143% of the premium paid to pre-buyout shareholders.
A second source of value in an LBO may come from the reduced agency problem of the free cashflow. Free cashflow is the cash flow in excess of what is required to finance all the positive NPV project opportunities for a firm.
Jensen and Meckling (1976) suggest that agency problem arises when a firm’s manager is not a 100% owner of the equity, he/she has incentives to invest in negative NPV projects, including consumption of excessive perks. This happens because the manager accrues 100% of the benefit from such wasteful expenditures but bears less than 100% of the cost.
Jensen (1986) argues that LBOs can mitigate the agency problem of free cashflow. Increasing a firm’s leverage increases managerial equity ownership. This assumes that the manager does not sell his/her equity interest at the LBO.
This provides the manager with powerful incentives to improve the operating performance of the firm and reduce investments in negative NPV projects.
In addition, with the interest payment of debt hanging over the manager’s head as a sword and close monitoring by the buyout specialist, he/she becomes disciplined and does not have the opportunity to waste resources.
A third source of value in LBOs could be from the strategic sale of a firm’s underperforming asset after the transaction. Strategic buyers can use these assets more efi ciently and hence may be willing to pay a premium.
Kaplan (1991) documents that about one-third of a firm’s assets are sold to strategic buyers following an LBO and argues that this is much lower compared to 72% of the asset sale in case of a hostile takeover.
A third source of value in LBOs could be from the strategic sale of a firm’s underperforming asset after the transaction. Strategic buyers can use these assets more efficiently and hence may be willing to pay a premium.
Kaplan (1991) documents that about one-third of a firm’s assets are sold to strategic buyers following an LBO and argues that this is much lower compared to 72% of the asset sale in case of a hostile takeover.
Critiques of LBOs may argue that such transactions transfer wealth from a firm’s employees to its equity holders. Improved operating performance may come from the reduced wages and benefits of the employees who have little equity ownership and hence stand to gain little from such transactions.
Based on empirical evidence, Kaplan (1989) concludes that the gain from the buyouts comes from better alignment of managerial incentive to those of the shareholders and from the reduced agency cost rather than wealth transfer from the employees.
Another critique against LBOs may be that such transactions transfer wealth from pre-LBO debt holders to equity holders. Increasing leverage also increases the probability of a bankruptcy.
As the new debt used to finance an LBO is often senior to the preexisting debt, original bondholders are likely to recover less in case of a bankruptcy.
Thus the original bondholders bear most of the increased cost of financial distress brought on by the LBO but almost none of its gains such as the benefit of the tax shield or the reduced agency cost.
LBOs may also create an asset substitution problem where a firm has to forego positive NPV projects because it is unable to finance those projects due to a high level of debt.
The evidence is mixed on whether a firm’s cost of financial distress increases after an LBO. Andrade and Kaplan (1998) examine 31 LBOs that became financially distressed subsequent to the transaction.
They provide evidence that although some firms are forced to reduce capital expenditure and a few engage in asset fire sale, these firms still had superior operating performance than the median firm in the industry.
In addition, they argue that the leveraged transaction generated a positive, albeit small, value even after subtracting the cost of financial distress. They did not find any evidence of asset substitution in their sample.
In contrast to these results, Zingales (1998) finds that highly leveraged firms have lower ability to make capital investments. Using data from trucking industry he finds that this was particularly pronounced in firms that were eventually forced to exit the industry.
Following a buyout, a firm may also face predatory threat from its deeper pocket competitors that do not have a high level of debt or interest payment. In the same study, Zingales analyzes the effect of high leverage on a firm’s ability to react to and survive competitive pressures in the product market following deregulation.
The author found that transportation firms with high leverage were forced to charge lower prices during the price war. In the end, the more efficient firms with superior operating performance were forced to exit partly due to high leverage, leaving the playing field for their inefficient, underleveraged, and deep pocket competitors.
