As we enter 2012 and as the U.S. economy continues to stabilize, there appears to be a growing sense of optimism about further recovery in the M&A market. During the first half of 2011, the M&A market continued a resurgence that began in the latter part of 2010, with higher aggregate deal value than had been seen since before the financial crisis. Though worldwide M&A activity declined in the second half of 2011, reflecting uncertainties regarding the volatile global financial climate, it has continued at a relatively strong pace, and a number of significant transactions have recently been announced, including Kinder Morgan’s $38 billion acquisition of El Paso, United Technologies’ $18 billion acquisition of Goodrich, and Gilead’s $11 billion acquisition of Pharmasset.

…continue reading: Mergers and Acquisitions in 2012

In the paper, Deviation from the Target Capital Structure and Acquisition Choices, forthcoming in the Journal of Financial Economics, I explore the effects of a firm’s leverage deficit on its acquisition choices. In particular, I examine the extent to which a firm’s leverage deficit affects the likelihood of the firm making an acquisition as well as the effect of its leverage deficit on the payment method and on the premiums paid for the target firm. Because managers are likely to anticipate the constraints of overleverage on acquisition choices, I also analyze managerial decisions on capital structure in the light of potential acquisitions. Specifically, I test whether managers of overleveraged firms reduce their leverage deficits when they foresee a high likelihood of making acquisitions. Finally, I examine how capital markets react to the acquisition announcements of firms that deviate from their capital structures. Managers of overleveraged firms will face constraints on the form and level of financing and are more likely to be selective in their acquisition choices if they fail to decrease their leverage deficits substantially. Therefore, I hypothesize that managers of overleveraged firms will pursue only the most value-enhancing acquisitions, which, in turn, will foster favorable market reactions to the news of their acquisitions.

…continue reading: Deviation from the Target Capital Structure and Acquisition Choices

In our paper, The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts: Evidence from U.S. Corporate Tax Returns, which was recently made publicly available on SSRN, we study post-LBO financial performance and behavior for approximately the universe of U.S. LBO firms taking place between 1995 and 2007.  We overcome the lack of public financial data for most LBOs firms that has limited prior research by instead analyzing confidential federal corporate tax return data. Since all U.S. corporations, including those that are privately-held, must file tax returns, we can observe post-LBO income and balance sheet information for nearly all U.S. LBO firms.

We use our large, representative sample to test a number of long-standing hypotheses regarding the motivation for LBOs and their role in the economy. Arguably the most influential view on LBOs is that of Jensen (1989), who regards the LBO structure as superior to the structure of the publicly-traded firm. He argues that the concentration of ownership and high level of debt in the LBO structure disciplines managers. The high level of debt eliminates free cash flow that managers might otherwise waste on “empire-building” activities. Indeed, levering up the firm more than would be optimal from a long-term perspective puts pressure on management to earn its way out of the firm’s debt load.

…continue reading: The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts

In our paper, Corporate Governance of LBOs: The Role of Boards, which was recently made publicly available on SSRN, we study whether the success of private equity-backed firms is due to their superior corporate governance or instead due to financial engineering. We focus in particular on the role of boards in LBOs and look at changes in the board when a public company is taken private by a private equity group.

We construct a new data set, which follows the board composition and financial figures of all public to private transactions that took place in the UK between 1998 and 2003. Out of these 142 transactions, 88 have private equity sponsors and are thus identified as LBOs. The remaining transactions are either pure MBOs or other types, and are used as benchmarks. We track each company two or three years before the announcement of the buyout until the exit of private equity investors or until 2010, whichever is earlier.

We find that when a company goes private, fundamental shifts in board size and composition take place. The board size decreases on average by 15% and the presence of outside directors is drastically reduced, as they are replaced by individuals employed by the private equity sponsors. We also find evidence that the board size and presence of LBO sponsors on the board depend on the “style” or preferences of the private equity firm. Overall, the boards become more in line with the type of boards that the corporate governance literature would identify as exhibiting better corporate governance. We then set to find out what role these boards play.

…continue reading: Corporate Governance of LBOs

The extent of agency problems in publicly traded firms and the need for reform of executive compensation remain the subject of active debate. In the paper, Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts, recently made available on SSRN, I bring new evidence to this debate by measuring a particular kind of firm behavior where there is potential for managerial abuse—the use of corporate jets.

Motivated by a large literature that finds improvements in efficiency and performance when firms are purchased by a private equity (PE) fund in a leveraged buyout (LBO), I use novel data to compare the fleets of jets operated by publicly traded and privately held firms. In the cross-section of firms from 2008, I find that PE-owned firms average about 40% smaller jet fleets than publicly traded firms, even after controlling for firm size, industry, and location in a variety of flexible ways. One could still worry, however, that these cross-sectional differences do not represent a causal effect of PE ownership due to omitted variables or other factors. Thus, I also measure changes in jet fleets within firms that are taken from public to private by a PE fund in an LBO between 1992 and 2007, and I find fleet reductions of a similar magnitude. Of course, the selection of firms into PE-ownership is not random, and I discuss assumptions under which these comparisons across and within firms provide estimates of lower and upper bounds on the average treatment effect of taking a firm from public to private in an LBO.

…continue reading: Agency Problems in Public Firms

In our forthcoming Journal of Finance paper, Did Structured Credit Fuel the LBO Boom? we study how large shifts in the availability of credit affected the corporate use of leverage by examining LBO transactions that rely heavily on debt financing. We argue that developments that led to the growth of structured credit contributed to increased credit supply that at least partially fueled the recent LBO boom. Our evidence highlights important linkages between structured credit, the dual role of banks in the structured credit markets as loan originators and underwriters, and the corporate use of leverage.

…continue reading: Did Structured Credit Fuel the LBO Boom?

The Delaware Court of Chancery yesterday enjoined both the shareholder vote on a premium LBO transaction and the buyers’ “deal protection” devices.  In re Del Monte Foods Co. S’holders Litig., C.A. No. 6027-VCL (Del. Ch. Feb. 14, 2011).  The Court held that the advice the target’s board received from its financial advisor was so conflicted as to give rise to a likelihood of a breach of fiduciary duty and indicated that the bidding buyout firm may face monetary damages as an “aider and abettor” of the potential breach.

On a preliminary record, the Court found that after the Del Monte board called off a process of exploring a potential sale in early 2010, its investment bankers continued to meet with several of the bidders — without the approval or knowledge of Del Monte — ultimately yielding a new joint bid from two buyout firms late in 2010.  While still representing the board and before the parties had reached agreement on price, Del Monte’s bankers sought and received permission to provide buy-side financing, which required the company to retain another investment advisor to render an unconflicted fairness opinion.  Del Monte reached a high-premium deal with a “go-shop” provision and deal protection devices including a termination fee and matching rights.  The original bankers were then tasked with running Del Monte’s go-shop process (which yielded no further offers), although the Court noted they stood to earn a substantial fee from financing the pending acquisition.

…continue reading: Buyout and Deal Protections Enjoined due to Conflicted Advisor

By now dealmakers are no doubt familiar with the “go-shop” which gained popularity during the 2006-2008 LBO boom as an alternative formulation to the traditional “no-shop” in sale agreements for public company targets. In a number of recent strategic deals an interesting hybrid formulation has been used under which the traditional no-shop prohibitions on post-announcement active solicitation of competing offers apply but the bifurcated termination fee structure feature of the go-shop is used, with a lower break-up fee applying in the event the topping bid surfaces during a defined initial period after the deal signing.

…continue reading: Test-Driving a Hybrid Go-Shop

In the paper Private Equity and Long-Run Investment: The Case of Innovation, forthcoming in the Journal of Finance, we examine the changes in patenting behavior of 495 firms with at least one successful patent application filed in the period from three years before to five years after being part of a private equity transaction. A long-standing controversy is whether LBOs relieve managers from short-term pressures from public shareholders, or whether LBO funds themselves are driven by short-term profit motives and sacrifice long-term growth to boost short-term performance.

…continue reading: Private Equity and Long-Run Investment

(Editor’s Note: This post comes to us from Shourun Guo of Duke Energy Corporation, Edith S. Hotchkiss at Boston College, and Weihong Song at the University of Cincinnati.)

The leveraged buyout (LBO) wave of the 1980s was an important phenomenon well studied by academics and practitioners. However, given the rise of the private equity industry, changes in the characteristics of firms targeted for buyouts, and changes in the structure of the transactions themselves, the mechanisms through which buyouts can create value have likely changed. Despite this, there is little (or no) evidence from the more recent wave of buyouts which documents whether and how these transactions create value. In our forthcoming Journal of Finance paper, Do Buyouts (Still) Create Value?, we seek to fill this gap by studying a sample of 192 LBOs completed between 1990 and 2006.

We first show that the firms in our sample on average experience large increases in total value from the time of the buyout to their subsequent exit from a private equity firm’s portfolio, producing large returns to invested debt and equity capital. We find that returns to either pre- or post-buyout capital are positive and significant for all outcome groups except deals ending in a distressed restructuring. Median market and risk adjusted returns to pre- (post-) buyout capital are estimated at 72.5% (40.9%), even including the cases of distress.

There are three potential explanations for the realized returns we document. First, firm value will increase if there are firm specific improvements in operating performance. Second, even if there are no changes in the cash flows of the firm subsequent to the buyout, firm values may benefit from rising market or industry sector valuation multiples while the firm is private. Third, substantial increases in leverage produce larger tax shields, boosting returns by increasing the cash flows available to the providers of capital. We directly quantify the impact on returns of changes on each of these explanations.

Comparing the realized returns to what they hypothetically would have been if profitability (relative to firms matched on industry and pre-buyout characteristics) had remained at its pre-buyout level, for the full sample we show that improvements in performance account for 23% (18.5%) of the pre- (post-) buyout return. Changes in industry valuations also have a large effect on returns; changes in the industry total capital/EBITDA ratio account for 18% of the return to pre-buyout capital for the full sample, and 26% of the return for firms exiting through an IPO. The magnitude of the impact of increasing tax shields depends on our assumptions as to whether leverage will be maintained after the exit from the private equity firm’s portfolio; for firms sold in a secondary LBO, the increased tax benefits account for 29% of the return to pre-buyout capital.

We also use cross sectional regressions to provide further evidence on the relative importance of the factors explaining returns. These regressions account for the fact that there may be some overlap in the sources of these gains; for example, an increase in leverage may affect the firm both through increasing cash flows as a result of the discipline of debt, as well as through the cash flow benefits of reducing taxes. Consistent with our prior results, the regressions show that the impact of changes in industry valuation multiples and realized tax benefits from increased leverage are each as important as operating gains in explaining returns. The regressions also show that in addition to our cash flow measures of operating changes, firms which restructure via asset sales while private are associated with significantly lower returns.

The full paper is available for download here.