essays in private equity

1995, Dennis, 1994, Magowan, 1989, Chevalier, 1995, Aslan and Kumar, 2009.3One potential explanation for the motivations of the leveraged buyouts of private firms is that private equity

Essays in Private Equity

DISSERTATION

Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy

in the Graduate School of The Ohio State University

By Ji-Woong Chung Graduate Program in Business Administration

The Ohio State University

2010

Dissertation Committee:

Professor Isil Erel Professor Berk A Sensoy Professor Michael S Weisbach, Advisor

Copyright by Ji-Woong Chung

2010

Abstract

This first essay, “Leveraged Buyouts of Private Companies,” studies the motivations and the consequences of leveraged buyouts of privately held companies Over the last two decades, the number (enterprise value) of leveraged buyout transactions involving

privately held targets totals 10,013 ($855 billion), accounting for 46% (21%) of the worldwide leveraged buyout market Yet the vast majority of academic studies focus on the buyouts of publicly held targets This chapter investigates the effects of leveraged buyouts on privately held targets I find that, unlike the corporate restructuring process of public firms after the buyouts, private targets sponsored by private equity firms grow substantially after the buyouts The overall evidence suggests that private equity firms, through leveraged buyouts, facilitate private targets’ growth by alleviating targets’

investment constraints

In the second essay, “Incentives of Private Equity General Partners from Future

Fundraising” which is co-authored with Berk Sensoy, Lea Stern, and Mike Weisbach, we model and estimate the total incentives facing private equity general partners Incentives from the explicit fee structure (“two and twenty”) of private equity funds understate the actual incentives facing private equity general partners because they ignore the rewards stemming from the effect of current performance on the ability to raise larger funds in the future We evaluate the importance of these implicit incentives in the context of a

iii

learning model in which investors use current performance to update their assessments of

a general partner’s ability, and, in turn, decide how much capital to allocate to the

partners’ next fund Our estimates suggest that implicit incentives from expected future fundraising are about as large as explicit incentives from carried interest in the current fund This implies that the performance-sensitive component of revenue is about twice as large as suggested by previous estimates based only on explicit fees Consistent with the model, we find that these implicit incentives are stronger when abilities are more scalable and weaker when current performance is less informative about ability Overall, the results suggest that implicit incentives from future fundraising have a substantial impact

on general partners’ welfare and are likely to be an important factor in the success of private equity firms

In the last chapter, I study performance persistence in the private equity industry

Contrary to what has been known in the literature, I find that performance persistence in private equity is short-living Current fund performance is positively and significantly associated with the first follow-on fund performance, but not with the second or third follow-on funds Even the statistically significant association between two consecutive funds’ performance is not economically large The returns of the best performing quartile portfolio drops by about half, and those of the worst performing portfolio improve

substantially from one fund to the next fund There is no difference in the performance of the second (and after) follow-on funds of current top and bottom performing quartile portfolios Performance converges in the long run The commonality of relevant market

conditions between two consecutive funds largely explains performance persistence Also, excessive fund growth conditional on past performance erodes performance and reduces persistence

v Dedication

To my parents, Dong-Jo Chung and Wol-Sun Kim

Table of Contents

Abstract ii

Dedication v

Acknowledgments vi

Vita vii

Fields of Study vii

Table of Contents viii

List of Tables xii

List of Figures xiv

Chapter 1: Leveraged Buyouts of Private Companies 1

1.1 Introduction 1

1.2 Hypothesis development 7

1.3 Data and summary statistics 9

1.3.1 Data sources and some institutional background 9

1.3.2 Sample selection 13

1.3.3 Construction of control sample 14

ix

1.3.4 Ownership structure of private targets 16

1.4 Post-buyout growth of target firms 18

1.5 Analysis of Deal rationales 21

1.6 Pre-buyout investment constraints and post-buyout growth 23

1.7 Operating performance after buyouts 25

1.8 Conclusion 27

Chapter 2: Incentives of Private Equity General Partners from Future Fundraising 29

2.1 Introduction 29

2.2 Model 36

2.2.1 Setup 37

2.2.2 Cross-sectional implications 38

2.2.3 Lifetime compensation of GPs 42

2.3 Data 47

2.4 The Empirical Relation between today’s Returns and Future Fundraising 52

2.4.1 Calculating indirect incentives for different types of funds 52

2.4.2 Indirect incentives of older and younger partnerships 55

2.4.3 Indirect incentives and fund size 56

2.5 General Partner Incentives Implied by the Regression Estimates 56

2.5.1 Basic results 56

2.5.2 Indirect incentives over the partnership’s life 60

2.5 Discussion and Conclusion 62

Chapter 3: Performance Persistence in Private Equity Funds 65

3.1 Introduction 65

3.2 Data 70

3.3 Testing Performance Persistence 72

3.3.1 Transitional Probabilities 74

3.3.2 Correlation between current fund performance and follow-on fund performance 76

3.3.3 Multivariate regression 77

3.3.4 Subsequent performance of initial performance quartile 80

3.3.5 Robustness of the results 83

3.4 Why (Not) Performance Persists? 84

3.4.1 Fund flows and fund performance 84

3.4.2 The effect of fund flows on performance persistence 87

3.4.3 The effect of time gap on performance persistence 89

3.4.4 Common market conditions 91

3.5 Conclusion 95

References 97

xi

Appendix A: Tables for Chapter 1 110Appendix B: Tables for Chapter 2 124Appendix C: Tables for Chapter 3 141

List of Tables

Table A.1 Distribution of leveraged buyout transactions in the U.K 111

Table A.2 Distribution of final sample of leveraged buyouts 113

Table A.4 Logistic regression to predict the likelihood of being a leveraged buyout target 115

Table A.5 Ownership characteristics of privately held targets 116

Table A.6 Changes in firm growth after leveraged buyouts of public targets 117

Table A.7 Changes in firm growth after leveraged buyouts of private targets with private equity 118

Table A.8 Acquisitions and disposals of businesses and operations after leveraged buyouts 119

Table A.9 Pre-buyout investment constraints and post-buyout growth 120

Table A.10 Operating performance after a buyout: Private equity sponsored targets 121

Table B.1 Descriptive Statistics 125

Table B.2 Committed Capital by Type of Fund and Fund Sequence 126

Table B.3 Fund Growth 128

Table B.4 Fund Performance and Time between Successive Funds 129

Table B.5 Future Fundraising and Current Performance 130

Table B.6 Future Fundraising, Current Performance, and Fund Sequence 132

Table B.7 Future Fundraising, Current Performance, and Fund Size 133

xiii

Table B.8 Future Revenue and Current Performance 134

Table B.9 Future Revenue, Current Performance and Fund Sequence 137

Table C.1 Private equity fund performance and fund raising by vintage year 142

Table C.2 Transition probabilities from current funds’ performance quartiles to follow-on funds’ performance quartiles 144

Table C.3 Pearson and Spearman correlations between current fund performance and follow-on fund performance 145

Table C.4 Cross sectional regression of current performance on past performance 146

Table C.5 Subsequent fund performance (unadjusted IRRs) by quartile portfolios based on current fund performance 147

Table C.6 Current fund performance and follow-on fund growth 150

Table C.7 Fund growth and follow-on fund performance 151

Table C.8 The effects of fund growth and time gap on performance persistence 152

Table C.9 The effects of similar market conditions on performance persistence 153

List of Figures

Figure A.1 Typical corporate structure after a buyout .122 Figure B.1 Importance of incentives from future fundraising over the partnership's life 140 Figure C.1 Private equity fund performance and fund raising by vintage year .161 Figure C.2 Performance of quartile portfolios ranked on current fund performance 162 Figure C.3 Cash flows of a private equity fund over its life .163

1

Chapter 1: Leveraged Buyouts of Private Companies

1.1 Introduction This paper examines the effects of leveraged buyouts on the investment and performance

of privately held targets The leveraged buyout market for privately held firms is large Over the last two decades there have been more than 10,000 acquisitions of private firms through leveraged buyouts, for an aggregate deal value exceeding $850 billion

(Strömberg, 2007).1 Despite the importance of these transactions in terms of the

frequency and the size, academic studies have devoted little attention to private-to-private transactions.2

Importantly, the economic forces driving these private-to-private leveraged buyouts are likely to be distinctively different from those driving public-to-private buyouts In the existing academic literature, agency theory of free cash flows (Jensen, 1986, 1989, 1993) has been the important theoretical grounds to understand the motivations and the effects

of leveraged buyouts of public firms Previous studies document that firms with abundant free cash flows and low investment opportunities are more likely to engage in leveraged buyouts (Lehn and Poulsen, 1989, Opler and Titman, 1991, Long and Ravenscraft, 1993, Dittmar and Bharath, 2009), and that target firms reduce capital expenditures and actively

sell assets or divisions after buyouts (Kaplan, 1988, Smith, 1989, Wiersema et al 1995, Dennis, 1994, Magowan, 1989, Chevalier, 1995, Aslan and Kumar, 2009).3

One potential explanation for the motivations of the leveraged buyouts of private firms is that private equity firms may be able to improve a target’s value by mitigating

inefficiencies coming from various investment constraints facing small private firms In fact, unlike the image reflected in the media as “asset-strippers,” private equity firms often claim that they take this growth strategy to help the target firms grow and increase firm value This paper finds evidence supporting this view I find that privately held targets substantially grow after the buyouts led by private equity firms: assets, sales, capital expenditures, and the number of employees all increase This finding stands in stark contrast to what the academic literature has documented regarding corporate

restructuring process after leveraged buyouts

These findings are typically interpreted as being consistent with the view that buyouts reduce free cash flow problems by reversing previously made inefficient investments or

acquisitions However, the agency view cannot explain the leveraged buyouts of private firms (Wright et al 2000) because it is less likely that private firms suffer from agency problems due to their concentrated ownership structure

I investigate a sample of 1,009 buyouts in the U.K between 1997 and 2006, 887 of which involve privately held targets The U.K market provides two advantages: first, the

stringent disclosure and financial reporting environment in the U.K allow observation of

3 Also managerial compensation is restructured to align the interests of managers with owners, and high leverage and close monitoring by investors reduce inefficient resource wastes (Baker 1992, Baker and Wruck, 1989) As a result, after leveraged buyouts, operating performance and plant productivity improve (Kaplan, 1988, Smith, 1989, Litchenberg and Siegel, 1989, Muscarella and Vetsuypens, 1990, among

3

the characteristics of privately held targets and what these companies actually “do” in the post-buyout period under private ownership.4

In the sample of privately held targets, I first document that the average (median)

ownership of the largest owner prior to buyout is 87% (100%) and the vast majority (95%) of these owners are also managers of the companies Therefore, it is unlikely that private targets suffer from the same kinds of agency problems as public companies

Second, the U.K leveraged buyout market

is, after the U.S., the second largest in the world, making it possible to examine a large sample of buyouts

I also find that, after buyouts led by private equity firms, privately held targets, unlike publicly traded targets, increase assets, sales, employment, and capital expenditures For example, from one year prior to the third year after the buyout, the industry adjusted total assets increase by 94% for private targets of private equity firms and the value decreases

by 25% for public targets Similarly, the median value of industry-adjusted capital

expenditures to sales ratio increases by 18% for private targets.In contrast, the adjusted capital expenditures to sales ratio decreases by 5% for public targets over the same period Private targets also make substantial acquisitions under private equity ownership: The cash outflows (inflows) associated with acquisitions (disposals) to

industry-tangible fixed assets ratio is 0.644 (0.000) in private targets and 0.039 (0.026) in public targets

However, these findings can be driven by selection bias In other words, private equity firms may be acquiring private firms which could have grown even without private

4

U.K company laws require all limited liability companies (both private and public) to file periodic reports with the Companies House See the U.K Companies House for the Companies Act

equity led leveraged buyouts Indeed, I find that targets of private equity sponsored buyouts are more profitable and experience faster growth prior to buyout than industry peer private firms, which suggests that private equity firms do select particular types of private firms

To examine whether a target’s growth is more of a selection effect or a treatment effect

by private equity firms, I compare the investment and growth of the target firms of private equity with the carefully selected three sets of control sample firms First set of control firms is private firms which underwent leveraged buyouts without private equity firms’ involvement This is a natural set of benchmark because these private firms were actually put up for sale, experienced similar ownership changes, and could have been targets of private equity Second, I construct non-LBO target private firms which have similar characteristics as private equity led LBO target firms using propensity score matching Lastly, I compare targets’ growth with industry median growth, following previous studies (Kaplan, 1989, Smith, 1990) Comparing with industry median will give

a general idea about how the target firms are different from other industry peer firms I find that the targets’ growth is substantially larger than the growth of other benchmark private firms Overall, the evidence suggests that even though private equity firms select targets with growth potential, they do help target firms grow and expand post-buyout

To further understand whether private equity firms through leveraged buyouts mitigate investment constraints facing small private targets, I examine the relationship between pre-buyout investment constraints and post-buyout growth First, I test whether more financially constrained targets in terms of size, age, and leverage experience larger post-

5

buyout growth Second, I investigate whether owner-managers’ risk aversion measured

by ownership concentration and age is associated with post-buyout growth Lastly, I examine whether lack of operational expertise is related to larger post-buyout growth I assume that if a private firm is managed by owner-managers, the firm does not have access to outside professional management skills Though I find that more constrained firms tend to experience larger post-buyout growth, the statistically significance of the relationship is not strong, making it harder to draw a strong implication from this

analysis

Finally, I examine the operating performance of private targets post-buyout to see how private equity firms’ growth strategy is associated with post-buyout performance I find that private targets with private equity sponsors experience an increase in operating performance: industry-adjusted EBITDA increases by 12% during the first three years post-buyout Not surprisingly, the industry-adjusted ratio of operating income to sales drops by 35% The reason is because the rate of sales growth exceeds that of EBITDA after buyouts This pattern implies that buyouts with private equity sponsors result in growth but not improved margins This deterioration of operating efficiency could be the result of worse investments on the part of private equity firms However, it could also be that private equity firms are increasing, i.e., optimizing, investments by taking positive NPV but less profitable projects which were not previously exploited prior to buyouts due to investment constraints Therefore, we observe the decrease in the average

profitability of private targets over time after the buyouts Though the evidence in this paper cannot distinguish between these two hypotheses, it is unlikely that private equity

firms are making unprofitable and inefficient investments in light of previous studies For example, Sheen (2008) finds that private firms which underwent private equity led

leveraged buyouts are more likely than public firms to make an efficient investment in response to the expected demand shock in chemical industry Also, Bargeron et al (2008) finds that private equity firms tend to pay less acquisition premium than public firms when acquiring a similar target firm, which suggests that private equity firms tend to make investments in a most cost saving way

To my knowledge, this is the first academic study to examine the effects of leveraged buyouts of private firms, transactions which account for a large fraction of the leveraged buyout market Importantly, I show the importance of private equity sponsors and

leveraged buyouts in alleviating the investment constraints facing private firms With the existing findings on the buyouts of public firms, the overall evidence suggests that private equity firms attempt to reorganize target firms in a way which reduces inherent the

targets’ inefficiencies—agency problems in public targets and investment constraints in private ones

A closely related study to this paper is Boucly et al (2009) From the examination of French leveraged buyouts transactions, they document substantial growth in assets, sales, and employment They interpret that private equity and leveraged buyouts can provide

“niche” financing for credit-constrained firms in countries with under-developed capital market Though similar in spirit, the evidence in this paper suggests that, even in the U.K with relatively well developed financial market, private equity firms take growth strategy

to improve firm value by alleviating investment constraints of small private targets

1.2 Hypothesis development

In private companies, entrepreneurs or owners usually serve as the managers of their company, or the ownership structure is highly concentrated in the hands of a few, such as founders, angel investors, and venture capitalists These owners perform close monitoring

on the management and managerial incentive mechanisms are tightly structured to protect owner wealth from manager expropriation (e.g Sahlman, 1990, Kaplan and Strömberg, 2003) Therefore, the agency problems associated with incentive misalignment between owners and managers are unlikely to be found in private companies Consequently, the elimination of agency costs of free cash flows (Jensen, 1986, 1993) is less likely to be an important reason for leveraged buyouts for a private company as it is for a public firm Private firms, however, tend to have limited or costly access to public resources imposed

by concentrated ownership structure and information asymmetry All else equal, when facing an investment opportunity, managers of private companies are less able or willing

to implement the investment Owners with substantially undiversified wealth tied up in

the firm may not want the extra risks associated with the new investment Further, the existing managers may not possess the intimate knowledge and expertise necessary to execute the new investment, and the firm may not have the financial resources to take advantage of new investment opportunities Often owners of private firms tend to have different goals, such as preserving wealth, keeping the business stable, maintaining stable income flows, and providing employment opportunities for their descendants

Private equity firms, through leveraged buyouts, can alleviate these investment

constraints by providing the owners with a whole or partial exit (thereby lowering the ownership of and reducing the risk exposure to the owners) Private equity firms

sponsoring these transactions reduce information uncertainty of target firms through due diligence and their reputation in the capital markets Private equity firms also import advanced management skills (e.g operational knowledge and expertise on the corporate control market) and industry and regional networks into the target companies.In addition, private equity firms, being professional investment firms which manage several portfolio companies, are more risk-tolerant than the individual owners and better positioned to take risky investments

In contrast, a public company taken private through a leveraged buyout is less likely to be resource constrained One of the main reasons that a firm goes public is to tap the public capital market and to exploit current and future investment opportunities (e.g Kim and Weisbach, 2007) Hence, a public company may pursue a leveraged buyout and go

private because it no longer needs public resources Public status also provides an

opportunity to engage in mergers and acquisitions (which is a major investment for a

9

company), either by creating shares that serve as a currency for acquisitions (Brau,

Francis, and Kohers, 2005, Brau and Fawcett, 2006) or by establishing a market value for the firm (Zingales, 1995, Mello and Parsons, 2000, Brau and Fawcett, 2006) These theories suggest that a firm without large growth investment opportunities, without a need for large amount of capital, and with no demand for corporate control activities will

be more likely to go private

In sum, consistent with the traditional argument in support of leveraged buyouts, publicly held targets will try to increase firm value by eliminating inefficiencies arising from agency problems after a leveraged buyout In contrast, financial buyers of private targets will try to alleviate investment constraints and capitalize on growth opportunities through

a leveraged buyout

1.3 Data and summary statistics

1.3.1 Data sources and some institutional background

Leveraged buyout transactions are collected from Zephyr;5

5

Zephyr, which is published by Bureau van Dijk, provides information on mergers and acquisitions, IPOs, and private equity deals worldwide since 1997 As of January 2009, it contains information on 703,327 deals Zephyr does not cover deals “involving equity stakes of less than 2 percent, unless the consideration for the stake is greater than GBP 15 million (i.e where the market capitalization of the target is over GBP

300 million) When the bidder is an investment trust or pension fund, then the threshold is raised to 5 percent If the purchase is considered to be significant, then it is entered regardless of the deal value.”

deal information (deal date, deal type – public-to-private or private-to-private, etc.) is cross-checked using SDC Platinum and Capital IQ I select completed management buyout, management buy-in, and institutional buyout deals with an acquired stake of at least 50% and target companies that are located in the U.K The total number of such deals is 4,652 As a comparison,

during the same period, the number of completed leveraged buyout deals where the targets are located in the U.K and the stake owned after buyout is at least 50% is 4,386 in the SDC database; Capital IQ contains 3,322 such deals from 1997 to June 2007

Therefore, Zephyr’s deal coverage appears to be most comprehensive than other

databases typically employed in academic research

Table 1 provides summary statistics on leveraged buyout transactions Panel A presents the distribution of the number of buyouts by transaction year and target status The

buyouts of independent private firms (“Private”) account for about 40% of the U.K leveraged buyout market, after divisional buyouts (“Divisional,” 41%) The buyout of

public firms represents only a small fraction, 4.9% However, the median deal value of private targets is £10 million whereas that of public targets is £74.6 million Therefore, while public firm buyouts are small in number, they account for 29% of the market in value Private firm buyouts make up 11.2%, less than half the size of public firm buyouts However, note that only 37.8% of private buyouts report deal values, whereas all public buyouts do so If we assume that the size of unreported deals of private buyouts is the same as for reported deals, the total deal value of private firm buyouts is about £69

billion, approximately the same as the total deal value of public firm buyouts

Although I do not attempt to explain the difference in deal pricing across target status in this study, I briefly present the information on deal value multiple.6

Deal value multiple

on EBITDA is highest among secondary buyout deals, 10.61, and lowest among

11

distressed buyouts, 6.11 Deal value multiples are slightly lower in private buyouts than public buyouts: 7.87 vs 7.92 for private and public targets, respectively

Panel B reports the distribution of leveraged buyout transactions by transaction type The

most frequent form of buyout (66.5%) is a “management buyout” (MBO) where the

existing managers of a target company purchase a controlling interest from existing

owners The next most popular form of buyout (22%) is an “institutional buyout” (IBO),

in which private equity firms acquire a target company from previous owners and, often, the target's management takes a relatively small stake In a management buy-out, the incumbent managers, as a bidding group, take an equity stake In the case of an

institutional buy-out, managers receive equity ownership as part of their compensation

packages (Renneboog and Simons, 2005) A “management buy-in” (MBI), where an

outside management team takes a majority stake in the target company and often replaces existing managers, accounts for 9.4% of the buyout market Finally, a “buy-in

management buyout” (BIMBO) indicates that an existing management team, along with

outside managers, buys out a company; this type of deal represents about 2% of the market About half of all buyouts are sponsored by private equity funds In terms of deal value, institutional buyouts dominate, accounting for 81% of the market Management buyouts follow at 17% The median deal value of institutional buyouts is £62 million which is substantially larger than that of transactions led by incumbent or outside

management teams This pattern is not unexpected since large public firms usually

complete buyouts with private equity partners

Pre- and post-buyout financial information on target companies is from three sources: Amadeus, Worldscope (for public targets), and from the annual accounts filed with the Companies House This process is complicated by substantial changes in corporate

structure that occur after buyouts Figure 1 depicts a typical leveraged buyout transaction Usually one or more acquisition vehicles (e.g NewCo and TopCo) are established one on top of each other to complete the transaction After NewCo is incorporated by

management and/or private equity firms, it acquires Target and its subsidiaries TopCo is also concurrently created to acquire NewCo After the buyout, these acquisition vehicles continue to serve as holding companies of Target and its subsidiaries.7

In the U.K when one company becomes a wholly owned subsidiary of another, the

subsidiary does not have to prepare consolidated financial statements (in accordance with Section 228 of the Companies Act in 1985) In a leveraged buyout, when a target

company has significant subsidiaries and becomes, again, a subsidiary of an acquisition vehicle, the target’s financial statements do not usually include its subsidiaries’ financial information Therefore, a target’s pre-buyout financial statements and its post-buyout financial statements can be significantly different, even though the entity is materially unchanged throughout the process Hence, for each buyout transaction, I trace and

identify the target’s parent company Because their annual accounts consolidate the target and its subsidiaries’ financial information, I use the parent company’s annual

account as a comparison against the pre-buyout target’s annual account

7 There are several reasons for the establishment of multiple acquisition vehicles “When there are several layers of financing, a number of acquisition vehicles are formed into which corresponding financial instruments are invested Senior lenders take comfort by having subordinated or equity invested into vehicles further away from cash generating target group Effectively, this structure establishes ‘structural

2007 Finally, I exclude target firms which do not provide consolidated financial

statements (651).8

The distribution of the final 1,009 leveraged buyouts from 1997 to 2006 by calendar year

is reported in Table 2 Public-to-private transactions account for 12% and private deals make up the rest The number of transactions is more concentrated towards the end of the sample period, peaking in 2006 The median deal values involving private and public companies are ₤10.00 and ₤74.64 million, respectively The leveraged buyouts transactions are concentrated in manufacturing and services industry This could be

The final sample of target firms consists of 886 independent private target firms and 122 public target firms

8 Not all companies provide detailed annual accounts: public companies disclose a substantially greater amount of information than private companies Small or medium-sized private companies can provide abbreviated accounts which contain only minimal company and financial information (in accordance with Section 248 of the 1985 Companies Act) Also cash flow statements are not filed if the company is a wholly owned subsidiary of another company (Financial Reporting Standards 1)

because there are more number of firms in this industry or because firms in these

industries tend to have greater amount of fixed assets which can be used as collateral for debt financing

1.3.3 Construction of control sample

To examine the effect of leveraged buyouts led by private equity firms on private targets,

I compare the investment and growth of the target firms of private equity with the

carefully selected three sets of control sample firms First, I compare targets’ growth with industry median growth, following previous studies (Kaplan, 1989, Smith, 1990) The second set of control firms is private firms which underwent leveraged buyouts without private equity firms’ involvement This is a natural set of benchmark because these private firms were actually put up for sale, experienced similar ownership changes, and could have been targets of private equity In addition, to a certain extent, unobservable economic forces leading to leveraged buyout decision can be controlled by using this sample

Second, I construct non-LBO target private firms which have similar characteristics as private equity led LBO target firms using propensity score matching From all U.K companies in Amadeus, I first exclude private firms which have engaged in leveraged buyouts Then I select firms that provide consolidated financial statements I exclude firms where only unconsolidated statements are available because such statements do not provide a complete view of the business Among these private firms, I randomly choose 3,000 firms to generate reasonable estimates of the following discrete choice regression

15

model With 3,000 non-LBO target firms and my sample of private equity led LBO target firms, I estimate a logistic regression to predict the likelihood of being a target In this regression, I include a list of typical determinants of a firm being a target of leveraged buyout such as firm size, sales growth, profitability, cash holding, and leverage The predicted value from this logistic regression is called propensity score, which implies the probability of being a target of leveraged buyout Then for each target firm, I choose a control firm with the closes propensity score.9

One purpose of the first two control sample is to mitigate sample selection bias As shown in Table 3, it turns out the targets of leveraged buyouts led by private equity have different characteristics than other industry peer firms Therefore, to examine whether private equity firms do affect the target firms’ behavior after the buyouts, I need to

carefully construct control sample of firms which could have been targets of private equity but decided not to be acquired by private equity Comparing the targets’ post-buyout behavior with the control sample of firms will tell, though not perfect, whether private equity firms are simply selecting particular types of private firms or private equity firms do affect the targets’ post-buyout restructuring process

Table 3 provides the summary statistics of financial characteristics for private target firms

of private equity prior to buyout and compare with three control samples Compared with industry peer firms, the target firms are smaller, older, more profitable, growing faster, and less leveraged Relative to private targets which underwent leveraged buyouts

without private equity sponsors, the target firms are larger, more profitable, and growing

9 For a detailed description of the methodology, see Li and Prabhala (2007)

faster There are not much significant differences between the target firms and the

matched control firms

In Table 4, I also report the estimates of the logistic regression to predict the likelihood of being a target of private equity led leveraged buyout of the following specification:

The dependent variable is a binary variable equal to 1 for target firms and 0 for control sample firms Since targets of leveraged buyouts should take substantial leverage, targets’ profitability, measured by EBITDA, and leverage may be important determinants of leveraged buyouts

The results show that private firms with higher profitability are more likely to targets of private equity led leveraged buyouts Also, private targets of leveraged buyouts have larger sales growth than peer non-target private firms In addition, private targets are under-utilizing debt capacity (negative coefficient of total debt to sales), which implies that leveraged buyouts are more attractive for under-leveraged private firms To the extent that sales growth proxy for growth potential of private firms, the results suggest that private firms with larger growth opportunities are more likely to be targets of private equity led leveraged buyouts

1.3.4 Ownership structure of private targets

In this section, I document the ownership structure of privately held targets to see

whether and the degree to which ownership is concentrated Table 5 details the ownership

As expected, ownership is highly concentrated among a few shareholders The average (median) number of shareholders of private targets is 3.6 (2) Thirty-one percent of private targets are entirely owned by a single owner The average (median) ownership of the largest owner is 87% (100%) 95% of the largest owners are also directors (chairman or

managing director) of their firms Therefore, the majority of private target firms qualify

as zero-agency cost firms of Jensen-Meckling (1976)

Though I cannot directly observe why the owner-managers would want to exit the business, a modest fraction (23.5%) of the owner-managers is above 65 years of age, which is suggestive of retirement In the transactions, ownership is transferred to a larger number of shareholders, including existing managers and private equity firms This change in the ownership structure is distinctively different from the change in public firms undergoing leveraged buyouts, where, not surprisingly, ownership becomes more concentrated

10 All companies in the U.K must submit this annual return form (Form 363a prior to October 2009) to Companies House each year: It provides a snapshot of general information about the company, including the details of key personnel, the registered office, share capital and shareholdings

1.4 Post-buyout growth of target firms

If private firms face investment constraints which can be alleviated by a leveraged buyout led by private equity firms, we expect to observe increases in firm size and investment post-buyout

Measuring firm size surrounding the time of a leveraged buyout is complicated due to the fair-value adjustment to the book value of assets Current assets including stocks

(inventories) and creditors (account payable) are fair-value adjusted upon completion of the buyout Also, typically, positive goodwill is generated to reflect the purchase price paid for the target’s assets (as a result, intangible fixed asset size increases) and,

subsequently, these write-ups are depreciated or amortized over the ensuing years Therefore, to make a fair comparison between assets in the pre-buyout period and those post-buyout, I adjust the book value of total assets by subtracting write-ups and goodwill generated at the time of the buyout transaction One limitation of this approach is that the size of the assets after buyout may be understated Since write-ups and goodwill are depreciated or amortized after buyouts, subtracting write-ups and goodwill generated at the time of the transaction from the book value of assets at each fiscal year-end will lead

to an underestimation of the book value of assets Re-adding depreciation and

amortization to the book value of assets in each year will not alleviate this concern, because depreciation and amortization also include assets not associated with write-ups and goodwill due to the buyouts Hence, to give as fair a view as possible, I also provide other measures of firm size, such as tangible fixed assets (PPE), sales and the number of employees

19

Before I proceed to examine post-buyout growth of target firms of private equity led leveraged buyouts, I examine post-buyout growth of public targets in Table 6 I find a substantial reduction in firm size among public targets of leveraged buyouts This finding

is consistent with those in previous studies (Kaplan 1989, Smith, 1990, Aslan and Kumar, 2009) For example, Kaplan (1989), with a sample of 48 public targets, documents that the control-adjusted capital expenditures to sales ratio decreases by 16.7%, 16.8%, and 25.6% respectively for years +1, +2, and +3 compared with year -1 He interprets this finding as being consistent with reduced agency costs of free cash flow

Table 7 provides summary statistics for changes in firm growth of the private targets of private equity from the two years preceding the buyout to three years afterwards for private and public targets All measures of firm growth are benchmarked again three control samples: Industry median, private LBO targets without private equity sponsors, and matched sample using propensity score matching

Private targets substantially increase in total assets, sales, and tangible fixed assets For example, from year -1 to year +3, the control-adjusted sales and tangible fixed assets of private targets increase by 34% and 23%, respectively Capital expenditures are the net cash flows from the purchases and sales of fixed assets Private targets significantly increase capital expenditures, especially during the first year post-buyout During the first year post-buyout, the control-adjusted capital expenditures of private targets increase by 62% The control-adjusted capital expenditures to sales ratio, however, does not increase This is mostly because the growth rate of sales (denominator) exceeds that of capital expenditures (numerator)

Many studies examine whether leveraged buyouts benefit investors at the cost of

employees (Shleifer and Summers, 1988, Kaplan, 1989, Lichtenberg and Siegel, 1990, Davis et al., 2008) In general, researchers find that employment grows less than other peer firms (Kaplan and Strömberg, 2008) This is partially true in my sample of leveraged buyouts The industry-adjusted number of employees in public targets at year +3 is 35% lower than it is at year -1 In contrast, private targets undergo substantial increase in employment The control-adjusted employment grows by 37% from year -1 to year +3 Though prior studies on the effect of leveraged buyouts on employment generate

somewhat mixed results, it appears the buyouts substantially increase employment for private targets However, I find that, in an unreported table, the industry-adjusted wage per employee decreases post-buyout

The difference in post-buyout investment behavior between private and public targets suggests that private firm buyouts occur for very different reasons than those of public firms: leveraged buyouts reduce inefficiencies of private targets arising from investment constraints and those of public targets stemming from free cash flow problems

Finally, to see the extent of the acquisitions and disposals activities of target companies, I compute the sum of all cash outflows (inflows) associated with acquisitions (disposals) from the time of a leveraged buyout to the exit (when the firm exited private equity ownership) or to the most recent fiscal year, and divide this sum by PPE at the end of the fiscal year prior to buyouts I exclude cash outflows associated with the leveraged

buyouts The intensities of acquisitions and disposals activities are estimated by the following measures:

The overall evidence in this section shows that private targets grow substantially buyout through larger investments and acquisitions This finding is distinctively different from the post-buyout restructuring and value creation process involving publicly held targets (Kaplan, 1988, Smith, 1989, Wiersema and Liebeckind, 1995, among others), and supports the view that leveraged buyouts alleviate the investment constraints of privately held targets and facilitate the targets’ growth after the buyouts

In addition, the median disposal-related cash inflows

to PPE ratios are 0.00 and 0.017 for private and public targets, respectively Therefore, private targets engage in active add-on acquisition activities after the buyout while public targets do not

1.5 Analysis of Deal rationales For a subsample of 113 deals which involve privately held targets, I collect deal rationale information though Zephyr and the Lexis-Nexis News Search These deal rationales are

11 I have not yet examined acquisition and disposals activities of target firms prior to buyouts

comments made by managers of targets, acquirers, or equity sponsors on the completion

of transactions Typically, these comments contain information about the motives for and goals in completing the deals and the future prospects of the target companies Therefore, from this information we can infer deal participants’ motivations for the leveraged

buyout Of course, these comments tend to be optimistic about targets’ future

performance since deals would not have otherwise been completed Also the motivation for the deal and the future plan expressed in deal rationales may not coincide with the actual restructuring process after buyouts Despite these caveats, it is worthwhile to analyze what deal participants have to say about why they sell and buy target companies and what the buyers intend for the target companies This analysis will complement the earlier quantitative analysis

The comments on deal rationales are qualitative information where some subjective judgment is called for in interpreting the comments’ implicit meaning In 26 cases, deal rationales do not provide clear ideas about the grounds and future plans for target

companies Examples of this kind include: “We firmly believe that the company will now benefit from this buy-out,” (Rite-Vent Ltd.) “It is pleasing to have worked with local professionals to complete the transaction,” (MWL Print Group Ltd.) and “We believe the deal which has been completed provides an excellent platform for … future

development” (SHG Opportunity Management Ltd.)

In 61 cases (61/87≈70%), managers (of the target company or sponsors) specifically mention that they will expand or grow the target companies through geographical

expansion plans (14%), new investments plans (19%), and acquisitions plans (11%) The

23

remainder simply state that managers intend to expand and grow the target businesses See Appendix I for examples of deal rationales listed according to different future plans Overall the evidence suggests that the buyers of private targets seem to have a clear intention to grow and expand the business post-buyout

1.6 Pre-buyout investment constraints and post-buyout growth

To further understand whether private equity firms, through leveraged buyouts, mitigate investment constraints facing small private targets, I examine the relationship between pre-buyout investment constraints and post-buyout growth When facing a similar growth opportunities, a more investment constrained target firm before the buyouts will benefit more from private equity sponsors and leveraged buyouts, and will experience larger growth after the buyouts

I use several proxy variables to measure the degree of investment constraints facing private targets First, as a measure of financial constraint, I use firm size, firm age, and leverage Second, to proxy for owner-managers’ risk aversion, I use the Herfindahl index

of ownership concentration and owner-managers’ age Lastly, I examine whether a target

is managed by a professional manager under the assumption that if a private firm is managed by owner-managers, the firm is less likely to have access to outside professional management skills Specifically, I estimate the following median regression (4) Median regression, which is a form of quintile regression, estimates the change in the medians of the dependent variables produced by one unit of change in the predictor variables;

therefore the estimates are less affected by extreme outliers (Koenker and Hallock, 2001)

This specification is also consistent with previous univariate statistical tests where

median values are used

where

Growth = Growth rate of firm size (assets, sales, employment, and capital expenditures)

from one year prior to buyout to three year post-buyout,

SG = Sales growth from year -2 to year -1 (proxy for growth opportunities),

FirmSize = The book value of assets at year -1,

FirmAge = The number of years from incorporation to the year of leveraged buyouts,

Leverage = The total debt to total assets ratio at year -1,

Concentration = The Herfindahl index of ownership concentration at year -1,

OwnerAge = Owners’ age,

= One if a owner is also the manager and zero otherwise at year -1

I interact each measure of investment constraints with sales growth to condition on

different amount of growth opportunities each target firm faces Table 9 reports the median regression estimates of targets’ growth on pre-buyout investment constraints variables Though I find that more constrained firms tend to experience larger post-

25

buyout growth, the statistically significance of the relationship is not strong, making it harder to draw a strong implication from this analysis

1.7 Operating performance after buyouts

In this section, I examine the post-buyout operating performance to see whether the different investment behaviors of private and public targets have different implications for operating performance in the post-buyout period My sample of buyout firms does not suffer from sample selection bias as the performance of targets can be observed

irrespective of whether they exit leveraged buyout ownership

The main variable of interest is EBITDA I exclude the year when the leveraged buyout occurred from the analysis for two reasons: first, buyout-related expenses can understate operating performance in year 0 Second, the first annual account after the buyout

provides information on the business from the time of the buyout to the new fiscal end, which, typically due to fiscal year-end changes, is shorter than twelve months This makes a pre- and post-buyout comparison difficult

year-Table 10 reports the results Among private targets, the level of EBITDA increases after the buyout From year -1 to year 3, the control-adjusted EBITDA increases by 12% I also examine the EBITDA to operating assets (the average of fiscal year-beginning and -end current and tangible fixed assets), EBITDA to sales, and EBITDA to the number of employees The reason I normalize EBITDA by sales or the number of employees is to mitigate the bias due to write-ups in operating assets As firm size significantly increases