Abnormal returns associated with selected financial profiles of leveraged buyouts, an empirical analysis

... ABNORMAL RETURNS ASSOCIATED WITH SELECTED FINANCIAL PROFILES OF LEVERAGED BUYOUTS: AN EMPIRICAL ANALYSIS A dissertation submitted in partial fulfillment of the requirements for the degree of. .. date? 2) the financial profiles of these LBOs provide ex ante identification of this event? and 3) is it possible to invest in companies with similar financial profiles and also earn abnormal re... rod uction prohibited w ith o u t perm ission ABNORMAL RETURNS ASSOCIATED WITH SELECTED FINANCIAL PROFILES OF LEVERAGED BUYOUTS: AN EMPIRICAL ANALYSIS R eproduced w ith perm ission o f the cop

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ABNORMAL RETURNS ASSOCIATED WITH SELECTED FINANCIAL PROFILES OF LEVERAGED BUYOUTS:

AN EMPIRICAL ANALYSIS

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ABNORMAL RETURNS ASSOCIATED WITH SELECTED FINANCIAL PROFILES OF LEVERAGED BUYOUTS:

AN EMPIRICAL ANALYSIS

A dissertation submitted in partial fulfillment

of the requirements for the degree of

Doctor of Philosophy

By

LINDA L RICHARDSON, B.A., M.S

Connecticut College, 1970 Montana State University, 1974

December 1989 University of Arkansas

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This dissertation is approved for recommendation to the Graduate Council

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I have many people to thank My first debt of gratitude is to W Clint Johnson, who encouraged me to en

ter the field of finance after many years in economics

Next, to Jonathan Willard, my highest regards, respect, and many thanks for making this possible Without technical

support from Wayne Persons, Wayne Barber, Tom MacDonald,

Bruce Andrews and Carl Helms, life would have been even

more difficult My official unofficial editors were Marie

Dickson, Alice Persons, and Gary Lombardo, who spent many

sleep-filled nights reading my copy Thanks also to Lynne

Cote and Anne LaLime for their typing assistance and to Jim Brady and Casandra Fitzherbert for library assistance And literally in my hour of need, Tom Sanders graciously filled

in for me Thank-you Dr Hardin for persevering and giving

me the hope and encouragement needed to complete the task

I dedicate this endeavor to Bob and Jeremiah They both make everything and anything possible in my life

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TABLE OF CONTENTS

ACKNOWLEDGMENTS iii

LIST OF TABLES vii

Chapter I Introduction 1

Definition of a Leveraged Buyout 6

Abnormal Returns 8

Potential Candidates 10

History 12

A Hybrid in Theory 15

Summary 17

II Literature Review 19

Studies Testing for Abnormal Returns 19

Motivations for Going Private 21

Potential Gains for Shareholders 23

Gains are Transitory 27

Gains Measurements May Be Inappropriate 31

Impetus For This Study 32

Possible Profiles for Management buyouts 34

Summary 35

III Methodology 36

Definition of the Population and Sample 36

Financial Ratio Analysis 41

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Possible Predictors 42

Data Collection 47

Testing for Any Industry Effect 48

Factor Analysis to Eliminate Multicollinearity 49

Classification and Multiple Discriminant Analysis 50

Intertemporal Effects 55

Probit and Logit 56

Selection of Likely Candidates 59

Efficient Markets and Event Studies 60

Models Used for Residual Analysis 63

The Test 64

Summary of Methodology 66

IV Empirical Analysis and Findings 68

Initial Empirical Question 68

Multivariate Analysis of Variance 68

Reasons for Factor Analysis 70

Results of Factor Analysis 76

Stepwise Procedures 94

Results of Logistic Regression (LOGIST) 101

Abnormal Returns From the LBO Sample 104

Abnormal Returns for Predicted LBOs 110

Summary of Results 112

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V Summary and Conclusions 113

Research Methodology 113

Empirical Findings 116

Conclusions and Implications 120

Limitations of This Study 121

Contributions of This Study 122

ENDNOTES 124

WORKS CITED 128

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LIST OF TABLES

1 25 LEVERAGED BUYOUTS OF ALL TIME

BY DOLLAR VALUE 2

2 TOP 10 DIVESTITURE LBOs OF ALL TIME BY DOLLAR VALUE 3

3 THE LEVERAGED BUYOUT MARKET 1981-1988 4

4 FORMS OF RESTRUCTURING BUSINESS FIRMS 7

5 TEN-YEAR MERGER COMPLETION RECORD 1978-1988 30

6 SAMPLE OF LEVERAGED BUYOUTS BY ANNOUNCEMENT DATE 38

7 INDUSTRY REPRESENTATION OF LEVERAGED BUYOUT ACTIVITY 40

8 DESCRIPTIVE STATISTICS for 1983 71

12 DESCRIPTIVE STATISTICS FOR ALL LBOs USING FISCAL YEAR PRIOR TO ANNOUNCEMENT DATE 75

13 FACTOR PATTERN for the INITIAL UNROTATED SOLUTION for 1983 80

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17 VARIANCE EXPLAINED BY EACH F A C T O R 84

18 FACTOR PATTERN FOR VARIMAX ROTATED SOLUTION FOR 1983 85

22 INTERCORRELATIONS FOR FINANCIAL RATIOS FOR 1983 89 23 INTERCORRELATIONS FOR FINANCIAL RATIOS FOR 1984 90 24 INTERCORRELATIONS FOR FINANCIAL RATIOS FOR 1985 91 25 INTERCORRELATIONS FOR FINANCIAL RATIOS FOR 1986 92 26 VARIABLES SUBMITTED TO STEPWISE DISCRIMINANT ANALYSIS BASED UPON FACTOR ANALYSIS RESULTS 93

27 SUMMARY OF PREDICTOR VARIABLES 96

28 1983 MDA RESULTS 97

32 AVERAGE RESIDUALS FOR LBO SAMPLES 107

33 CUMULATIVE RESIDUALS FOR LBO SAMPLES 108

34 PREDICTED LBO SAMPLE 109

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Chapter I Introduction

After its completion, the Kohlberg Kravis Roberts &

Co acquisition of RJR Nabisco Inc will represent a record book entry as the largest leveraged buyout (LBO) in history

at $24.7 billion.1 Leveraged buyouts were among the most

lucrative financial deals of the past decade Previously

topping the list of companies taken private through a le

veraged transaction was Beatrice Co Inc., taken private by Kohlberg Kravis Roberts & Co for an estimated $6.25 bil

lion in 1986 (see Table 1) Allied-Signal Inc headed the

list of divestiture type leveraged buyouts in the sale of

50% of Union Texas Petroleum Holdings Inc for $1.7 billion

in 1985 (see Table 2).a

Motivated by high yields, favorable tax treatment

of debt, and a period of unprecedented economic growth, the number and dollar value of deals increased for the period

beginning in 1984 (see Table 3) Falling interest rates

provided an environment well suited to deals made possible

by significant amounts of debt

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TABLE 1

25 LEVERAGED BUYOUTS OF ALL TIME

BY DOLLAR VALUE

Acquiring CompanyKohlberg Kravis

Roberts & Co

Kiewit-Murdock Investment Corp

SCI Holdings Incorporated

Inc

Private investor group led by

Kohlberg Kravis & Roberts

L Acquisition Corp

Aancor Holdings Inc

Eckerd Holdings Inc

HHF Corp

Anac Holding Corp

Griffith Acquisition Corp

Reliance Acquisition Corp

PACE Group Holdings Inc

Playtex Holdings Inc

ARA Holding Co

Occidental Petroleum and

Drexel Burnham Lambert Inc

Company Taken PrivateBeatrice Cos Inc

Safeway Stores Inc

Borg-Warner Corp (90%) Owens-Illinois Inc

R.H Macy & Co., Inc

Continental Group Inc

Storer CommunicationsUnion Texas Petroleum Holdings (50%)Lear Siegler Inc

National Gypsum Jack Eckerd Corp

Levi Strauss & Co

Revco D S Inc

National Car Rental System Inc

Reliance Electric Co

Three units of City Investing Co

International Playtex Inc

Container Corp of America

Fruehauf Corp

Northwest Industries Metromedia Inc

MGIC Investment Corp

Wometco Enterprises ARA Services Inc

Diamond Shamrock Chemicals Co

Sources Mergers and Acquisitions

1987), 48

(November/December

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TABLE 2

TOP 10 DIVESTITURE LBOs OF ALL TIME

BY DOLLAR VALUE

Kohlberg Kravis Roberts & Co

Household International Inc Griffith Acquisition Corp

Northwestern Mutual Ins

Drexel Burnham Lambert

Source: Mergers and Acquisitions (November/December

1987), 52

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Source: Mergers and Acquisitions (May/June 1989), 64.

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These lucrative deals have provided returns to in

vestors, as well as facilitators, which have been

unobtainable elsewhere The classic benchmark of promised riches is William Simon's 20,000% profit on his $330,000

personal investment in the leveraged buyout of Gibson

Greeting Cards in 1983.3

This study answers three empirical questions: 1) do abnormal returns accrue to actual LBOs for a trading period surrounding their announcement date? 2) do the financial

profiles of these LBOs provide ex ante identification of

this event? and 3) is it possible to invest in companies

with similar financial profiles and also earn abnormal re

turns ?

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Definition of a Leveraged Buyout

A leveraged buyout involves the purchase of the assets or stock of either a privately or publicly owned com

pany, subsidiary or division Its distinguishing charac

teristic is the amount of debt used in the acquisition Up

to ninety-five percent of the purchase price is financed by layers of loans secured by the target company's assets and

is to be repaid with the target company's operating cash

flow

These transactions represent restructuring which could be categorized as either a sell-off or change in ownership activity (see Table 4) Both types of activity,

when facilitated through the use of debt financing in ex

cess of ninety percent, have been referred to as a lever

aged buyout

With divestitures, the purchase of a portion of a firm by an outside third party does not create a new legal entity However, in a going-private transaction, a pub

licly owned company is taken private by a group of inves

tors which often includes existing management This is referred to as a management buyout, or pure going-private

transaction

The focus of this study is leveraged management buyouts, going-private transactions financed by significant amounts of debt

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C Going-Private Transactions/Mgmt Buyouts

D Leveraged Buyouts/Leveraged Mgmt Buyouts

Source: J Fred Weston and Thomas E Copeland, Managerial

Finance 8th ed (Chicago: Dryden Press 1986), 901

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Abnormal Returns The technique used to assess the impact of an

nouncement type news is the event study methodology The

normal relationship between a particular stock's return and the "market" is established for a period unaffected by this news With these predicted returns estimated, actual re

turns surrounding the announcement date are compared, and

the difference is a measure of abnormal or excess returns

Halpern reviewed event studies applied to corporate acquisitions in his 1983 paper.4 He concluded that studies conducted to identify acquisition specific influences in

merger activities using accounting data and stock price

data were flawed because: 1) accounting data do not provide information on the expected long-run impacts; 2) serious

problems exist in defining comparable control groups; and

3) the comparison group does not provide information on how specific firms would have performed without an acquisition

Of particular interest in this study is the ex

amination of stock price movements for the targeted LBO

prior to the announcement Capital markets react to rumors

of possible takeovers by driving up the stock price of target companies in anticipation of premiums that must be paid

to existing shareholders in order to buy out their equity

position It has been estimated that in a management

buyout, this premium may average approximately 56% relative

to the open market share price for up to 40 trading days

prior to the proposal.3

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After an announcement is made, the ability to earn this premium dissipates In order to earn these returns in full, an investor would have to possess information about these events in advance of their announcement or be able to predict their occurrence If an investor could predict these events based upon the existence of a unique financial profile, then direct knowledge of the event would not be necessary.

Merger and acquisition related research took this hypothesis one more step by testing for abnormal returns for firms with similar financial profiles Would firms with similar financial profiles, which never were acquired, also produce abnormal returns? Are these firms subject to

a "spillover effect" because investors consider them to be potential candidates?

Studies conducted by Stevens,6 Simkowitz and Monroe,7 and Wansley, Roenfeldt and Cooley,0 concluded that this was possible Specifically, Wansley, Roenfeldt and Cooley found that abnormal returns of up to 29.1 percent

accrued in the seven months prior to the actual takeover

This represents a return which is 29.1 percent above its risk-adjusted expected rate of return However, the port

folios of the potential candidates also earned abnormal returns of 17.1 percent for a 21 month test period They

concluded that abnormal returns could be earned by inves

tors under both scenarios

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These studies testing for abnormal returns for economic events such as mergers and acquisitions, as well as

pure going-private transactions, have limited applications for leveraged buyout transactions

The motivation for leveraged management buyouts is similar to a pure going-private transaction But debt has significant tax benefits, and therefore has greater poten

tial gains for equity participants In a recent working

paper on management buyouts, Kaplan noted that the largest positive returns accrued to those buyouts financed with at least 70% debt He estimated that the tax benefits gener

ated by debt financing were worth between 30% and 130% of

the premium paid to the pre-buyout shareholders.9

Potential Candidates The establishment of a statistically significant LBO profile could serve as a basis for predicting potential candidates Practitioners have proposed different

characteristics which would produce an ideal LBO candidate Some suggested criteria include (1) a steady, reliable cash flow with a solid base for projecting its continuance; (2)

a proven, reliable product; (3) a low to medium technology field; (4) key managers with proven track records; (5) key managers who will have their own money at stake after the

buyout; (6) an up to date physical plant; (7) an ability to avoid higher than normal capital expenditures during the

payback period; (8) a low level of pre-existing debt;10 (9)

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substantial dividends; (10) operating in a noncyclical in

dustry; and (11) general financial strength.11

Those companies which held the most allure prior to the Tax Reform Act of 1986 were those operating in basic

industries which had lackluster appeal in the stock market

or had fallen into disfavor with investors.12 These established industrial firms were often found to be undervalued

A great deal of emphasis has been placed upon screens designed to find undervalued assets A 1984 ar

ticle in Forbes suggested choosing companies with (1) sales

of 20 million to 5 billion; (2) a long-term debt to equity ratio of 35% or less; (3) a cash flow to debt ratio of 30

or greater; (4) a 12 month return on equity of 7% or more;

(5) a positive 4 year average annual growth in earnings;

(6) a current ratio of 1.43 or more; and (7) a

price-earnings ratio of less than ten.13

Although LBOs have managed to survive and flourish

in various economic climates, the new tax code has changed the complexion of the potential candidate Since the ability to write off those assets which were sold in order to

service the debt was eliminated, bust-up LBOs have become

less popular The asset rich firm, once an attractive candidate, has been replaced by a profile whose emphasis is on internally generated cash flows.1*1

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activity, or the combination of a number of companies in

the same industry to form a large, single enterprise, pro

duced such giants as U.S Steel, E.I DuPont and American

Tobacco From 1925 to 1931 the direction of merger activ

ity changed from horizontal to vertical with the combina

tion of manufacturers, suppliers and distributors into

single economic entities, an example being General Foods

The third wave, beginning after World War II and ending in the late 1960s, was characterized by the combination of unrelated businesses, the era of conglomeration which pro

duced Litton Industries and Textron.13

Leveraged buyout activity emerged in the early 1960s as a form of interim financing, and was frequently

used by the owners of small, privately held businesses to

attract competent owner-managers Financing was confined

to a select group of investment bankers and venture capital firms During the era of deconglomeration, which began in

the early 1970s, divestiture of marginally acceptable businesses acquired in the merger and acquisition era was made viable using significant amounts of debt financing

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In 1976, LBO activity was institutionalized with the establishment of the first commingled fund solely dedicated to financing leveraged buyouts The fund, established by Kohlberg Kravis Roberts & Co., was used in 1978

to finance the going-private transaction of Houdaille In

dustries With a newly established trend in place, commercial banks began in 1982 to look to available and projected cash flows for securing credit This accelerated LBO ac

tivity with banks adding credibility and credit.16

LBOs have, in general, been financed by layers of debt and equity Senior debt held by commercial banks has represented approximately 40%-65% of total financing needs Approximately 15%-30% has been subordinated debt held by

insurance companies and 5%-15% held as equity by various participants

The list of participants has included Wall Street firms, pension funds, wealthy individuals, venture capital firms and incumbent management Venture capital firms in

creased their commitment to LBOs beginning in 1984 by put

ting up $481.46 million, an increase over the previous year

of 71.9%.17 Wall Street firms such as Drexel Burnham &

Lambert Inc., First Boston Corp., Shearson Lehman Bros.,

Merrill Lynch, and Bear Stearns and Co., have returned to

merchant banking functions by putting their own money into these deals Interest in these deals has spread to

thrifts, as well as regional banks.10

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Senior debt held by banks earned, on the average, one percent over the prime rate without any additional risk beyond that of commercial loans• Returns on subordinated

debt averaged above 20% and equity returns ranged from

35%-70% Investment banking firms have charged a commis

sion of approximately 1 percent on setting up these deals, with Kohlberg Kravis Roberts & Co earning $45 million as

advisory fees for the Beatrice buyout Attractive second

ary markets make debt liquid and encourage investors to

participate, with an average holding period of less than

five years after having gone private The restructuring,

accomplished by management in a private setting, made this new entity more competitive and cost effective The com

pany emerged as one more highly valued by the marketplace

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A Hybrid in TheoryThe theory which describes the combining and recombining of real assets differs from the theory which de

scribes rearranging ownership and maintaining corporate

control Leveraged buyouts represent a hybrid in theory in the sense that the activity results in both restructuring

and rearranging

Restructuring may be defined as any activity that

is motivated by the desire to expand, as in the case of

mergers, acquisitions, and joint ventures, or by the desire

to sell off a subsidiary or division, as in the case of divestitures

The theory of mergers, acquisitions, tender offers, and joint ventures places an emphasis on the benefits to

shareholders that result from restructuring activity

These activities may be driven by the increased efficiency resulting from synergy, the benefits from the information

or signalling of the event itself, a minimization of agency costs, increased market power, or possible tax benefits A divestiture represents the transfer of assets to a higher

valued use or to a more efficient user, a type of reverse

merger, with synergistic benefits resulting from streamlining efforts.20

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The theory of maintaining corporate control seeks

to explain different methods used to maintain the status

quo ownership by preventing possible takeovers and dilu

tion Repurchase agreements, antitakeover amendments, and ways to deal with "greenmail" are included in corporate

control theory or behavior.ax

Changes in ownership affect the capitalization of the firm In this context, theory must deal with changes

in financial risk and expected changes in shareholder

wealth The purchase of a previously publicly held company through the use of debt, and little or no equity, consti

tutes a change in ownership structure Pure going-private transactions restructure corporate ownership by replacing

the entire public stock interest with full equity ownership

by an incumbent management group With LBO type management buyouts, management proposes to share equity ownership in

the subsequent private firm with third-party investors

Leveraged buyouts can be divestiture type transac

tions or going-private transactions With divestitures,

the sell-off is accomplished by debt financing; the motivation is to eliminate inefficiencies Going-private trans

actions represent a different motivation Presumably, management is motivated to arrange these deals because the

potential exists for substantial gains to accrue to a pri

vate company These gains may be realized as management

eventually takes the company public again

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Therefore, LBO activity can be motivated by either synergy, as in the case of divestitures, or by potential wealth gains resulting from going-private transactions.

It is important to distinguish between the two types of LBO activity since the term has taken on a generic context as applied to two entirely different economic events

SummaryLeveraged buyouts represent a dominant financial trend over the last decade They have been a significant force in financial markets Past empirical studies have been confined to management buyouts without examining le

verage driven deals The available literature on mergers and acquisitions does not address the issues of go

ing-private and impacts of debt on agency costs or changes

in shareholder wealth LBOs remain, in theory, a hybrid lacking empirical investigation Practitioners, always interested in creating more efficient markets, have suggested characteristics and conditions necessary for LBOs to flourish However, these remain speculative due to the lack of scholarly activity in the area

This study investigates those characteristics con

sidered to be significant in differentiating firms which have changed to private ownership through a leveraged man

agement buyout from those which remain publicly owned A multivariate framework, using both multiple discriminant analysis and logistic regression, was developed to deter-

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mine which attributes best distinguished these leveraged

management buyouts from similar firms not going private

A test for abnormal returns for the actual LBO sample indicated that abnormal returns of up to 21.48 per

cent accrued in the eighty day period surrounding the an

nouncement date For those firms predicted to be LBOs be

cause of their statistically similar profile, abnormal

returns of 32.68 percent were reported using 1986 as the

test period

These findings imply that financial characteristics can provide a means by which firms going private through a leveraged buyout can be separated from others In addi

tion, they argue that an investor would have been able to

earn abnormal profits by investing in both the actual LBOs,

as well as those predicted to be LBOs

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Chapter IX Literature Review

A review of the literature revealed an absence of any empirical studies dealing specifically with leveraged

buyout events Most journal citations dealt with mergers,

acquisitions, tender offers and pure going-private transactions LBO specific literature was confined to business

periodicals whose readers are practitioners rather than research oriented academicians However, they have been in

cluded in the bibliography and will be summarized in this

chapter in an attempt to serve a broader based need

Studies Testing for Abnormal ReturnsThe fundamental assumption of the existing lit

erature is that capital markets are efficient with respect

to publicly available information such as a merger, acqui

sition, or going-private announcement By efficient, it is meant that stock prices will instantaneously and fully re

flect the information or signal that an announcement of

this type will initiate The difficulty is in separating

the effect of these signals on security prices from the underlying motivation of the event itself

Merger and acquisition studies related to pre-buyout shareholder gains for the owners of target firms

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indicate that it is possible to earn abnormal returns for

the period preceding the announcement Mandelker reported abnormal returns of 14% for a period of 7 months before the merger.22 Elgers and Clark found cumulative average re

siduals of 43% for 2 years prior to the acquisition.23

Torabzadeh and Bertin, in a 1987 study of 48 leveraged buyouts occurring between 1983 and 1985, found excess returns of 23.26% accruing from 12 months prior to 4 months after the announcement date.2,4

With mergers and acquisitions, the motivation for increased value may be attributed to such synergistic ben

efits as increased market power, economies of scale in production, financial economies of scale, replacement of inefficient management, and a change in systematic or

unsystematic risk These studies suggest that pre-buyout

returns to the owners of the target firm represent a shar

ing of these potential post-buyout gains by the acquiring

firm

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Motivations for Going Private These synergistic benefits may not be present with

a leveraged buyout In a leveraged buyout, a public firm

is reorganized into a private concern This going-private transaction represents a change in both the ownership and

capitalization of the firm These transactions reduce the often conflicting interests of management and owners, as

ownership and control emerge as the right and

responsibility of management, the new majority interest

This stronger link between managerial performance and reward results in greater managerial incentives which

are now internalized In addition, the need to monitor

management for owner related interests is all but

eliminated In a leveraged buyout, management increases

its residual claim and establishes a stronger monitoring

link with third-party investors These third-party inves

tors, who specialize in arranging these debt driven deals, are better at monitoring managerial decisions than public

shareholders The reduction of these costs, referred to as agency costs, provides a dimension to these activities that merger related theory does not possess

DeAngelo, DeAngelo, and Rice considered the capital structure effect of increased leverage to be a complemen

tary monitoring effect Additional leverage reduces the

firm's cost of capital because of the tax advantage of

debt An optimal capital structure would substitute debt

for equity financing in an attempt to minimize the cost of

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capital Because of existing long-term institutidhal ties with lenders, these s a w y third party equity investors are encouraged to borrow directly from these sources Optimal borrowing strategies result in the complementary effect of minimizing the cost of capital.25

The resurgence of management stock, with the in

creased level of LBO activity in the mid 1980s, provided evidence that agency costs can be reduced when management

perceives their own best interest to be more closely

aligned with those of existing shareholders This class of stock is similar to an option, as management buys the right

to trade this class of stock for voting privileged common

stock This option may be exercised provided certain goals are achieved, and management remains with the company It

is often referred to as a "golden handcuff" because it ne

cessitates management's continued participation

The value of this class of stock is a direct func

tion of management's ability to increase sales, cut costs,

acquire assets, build up market share, increase profits,

and most importantly, pay off the newly acquired debt

Lenders are receptive to this idea since rewards are distributed only after the debt is repaid The only

drawback is the potential dilution to existing shareholders upon issuance of the new common stock

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Potential Gains to ShareholdersJensen hypothesized that the benefits that accrue with a leveraged takeover will exceed those accomplished by

an exchange of stock.as

The assumption is that debt is an effective substitute for dividends Dividends are paid out when the internal rate of return on existing projects is less th=n o>:

equal to the cost of capital Shareholder wealth would be reduced if earnings were reinvested at a rate less than the cost of capital, and would remain unchanged if they were equal

If all projects that had a positive net present value could be funded, and excess cash was available,

Jensen argued that this "free cash flow" could be used to

service debt instead of paying dividends This would re

duce the amount of discretionary income available to managers

If agency costs measure the costs of conflict be

tween managers and owners, these costs could be reduced

when managers were forced to disburse the cash rather than investing it at a rate below the cost of capital.27

This control function of debt is most important in organizations that have low growth prospects but generate

large cash flows Therefore, desirable LBO candidates will

be those that exhibit these characteristics The benefits that accrue to the remaining shareholders after a leveraged takeover are a direct result of the role of debt in the re-

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duction of agency costB The necessity to use future cash

flows to pay down the existing debt eliminates the need to

monitor these funds and their use

DeAngelo, DeAngelo, and Rice investigated the motivation and source of gains in going-private transactions.28 They hypothesized that "pure ownership structure changes

can create significant productive gains."29 They gave recognition to a fundamental premise of this study — corpo

rate combinations differ fundamentally from going-private

transactions which simply restructure ownership of a single existing entity

DeAngelo et al argued that the potential gains from going private can be passed on or shared with current owners The purpose of their study was to test for changes

in shareholder wealth at the time of the initial proposal, and to test for a net wealth effect in the event that a

proposal was withdrawn

In estimating the wealth effects of going-private transactions, DeAngelo et al approached the empirical

question as an event study They measured the announcement effect over a two day trading period, since it was not

clear whether the announcement occurred during the day's

trade or after the close of trade Using the Wall Street

Journal to be the primary source of announcement dates for these events between 197 3 and 1980, the full sample in

cluded 72 firms, twenty-eight of which had undergone a le

veraged buyout

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