Who’s to blame when a signed deal falls through? This question is especially relevant with respect to LBO buyers these days. Deals negotiated when times were good and credit was easy look much less appealing if not disastrous now that the short term economic outlook is bleak and the credit environment has soured. In particular, banks are weary of lending into LBOs when their ability to securitize and sell off the loans has waned. Private equity buyers may want to extricate themselves from signed deals, or be forced to do so because debt financing is not forthcoming. What contractual rights do sellers, buyers, and financiers have against one another in such a situation? What reputational effects, if any, constrain them from exercising those rights? And how should a seller’s board trade off deal certainty against price when choosing between competing transactions? Isaac Corré of Eton Park, Steven Davidoff a/k/a The Deal Professor, John Finley of Simpson Thacher, and Jim Morphy of Sullivan & Cromwell debated these questions with Vice Chancellor Leo Strine, Jr. and Professor Robert C. Clark in their Mergers, Acquisitions, and Split-Ups class here at Harvard Law School last week.

The video of the event is available here.

I recently presented my paper Leverage and Pricing in Buyouts: An Empirical Analysis, which is co-written with Ulf Axelson, Tim Jenkinson and Per Strömberg, at the Law, Economics and Organizations seminar, here at Harvard Law School.

This paper provides an empirical analysis of the financial structure of large recent buyouts. We collect detailed information of the financings of 153 large buyouts (averaging over $1 billion in enterprise value). We document the manner in which these important transactions are financed. In addition, we compare the firms acquired by private equity funds to comparable firms that are publicly traded. Buyouts are executed by knowledgeable professionals (the general partners (GPs) of the private equity funds) with strong incentives, who utilize sophisticated financial structures designed to maximize value by optimizing on a number of margins.

If we presume that GPs optimize capital structure at the time of the acquisition, then this capital structure provides a benchmark for understanding optimal capital structure in public firms. Lastly, we consider the relation between leverage and transaction multiples, and try to estimate the extent to which the ability of debt markets to provide financing impacts the pricing of deals.

The financial structure that private equity firms choose for their portfolio companies is radically different from that observed for comparably firms quoted on public equity markets. Indeed, a reasonably summary of the differences we observe would be to view them as the inverse of each other. We find that buyout leverage is cross-sectionally unrelated to the leverage of matched public firms, whether we measure leverage as the ratio of debt to enterprise value or by debt as a multiple of cash flow – as proxied by earnings before interest, taxes, depreciation and amortization (EBITDA).

Leverage appears to be largely driven by other factors than what explains leverage in public firms. In particular, the economy-wide cost of borrowing seems to drive leverage. Prices paid in buyouts are related to the prices observed for matched firms in the public market, but are also strongly affected by the economy-wide cost of borrowing. These results are consistent with a view in which the availability of financing impacts booms and busts in the private equity market.

The full paper is available for download here.

Per Stromberg and I have just completed Leveraged Buyouts and Private Equity. In the paper, we describe and present empirical evidence on the leveraged buyout and private equity industry, both firms and transactions.

We start the paper by describing how the private equity industry works. We describe private equity organizations such as Blackstone, Carlyle, and KKR, and the components of a typical leveraged buyout transaction, such as the buyout of RJR Nabisco or SunGard Data Systems. We present evidence on how private equity fundraising, activity and transaction characteristics have varied over time. The article then considers the effects of private equity. We look at evidence concerning how private equity affects capital structure, management incentives, and corporate governance. This evidence suggests that private equity activity creates economic value on average. At the same time, there is also evidence consistent with private equity investors taking advantage of market timing (and market mispricing) between debt and equity markets particularly in the public-to-private transactions of the last fifteen years.

We also review the empirical evidence on the economics and returns to private equity at the fund level. Private equity activity appears to experience recurring boom and bust cycles that are related to past returns and to the level of interest rates relative to earnings. Given that the unprecedented boom of 2005 to 2007 has just ended, it seems likely that there will be a decline in private equity investment and fundraising in the next several years. While the recent market boom may eventually lead to some defaults and investor losses, the magnitude is likely to be less severe than after the 1980s boom because capital structures are less fragile and private equity firms are more sophisticated. Accordingly, we expect that a significant part of the growth in private equity activity and institutions is permanent.

The full paper is available for download here.

Over the past year, the areas of corporation law impacting how transaction attorneys guide their clients developed at a significant pace. This trend emerged with Vice Chancellor Strine’s Netsmart, Topps, and Lear opinions, issued during the height of the private equity-led LBO boom and continued through Chancellor Chandler’s United Rentals opinion, in which the Court addressed issues associated with the break up of a transaction entered into during that boom. In between the Court addressed a number of issues, including permissible board actions in the context of seeking stockholder approval; when a company must include management projections in its proxy solicitation materials; and how to value a company in an appraisal proceeding.

In this article, we discuss these developments in the order that a transaction attorney would likely need to consider them-starting with the exploration of strategic alternatives and ending with litigating a busted deal. We do not intend to conduct an exhaustive analysis on any particular topic or any particular case. Instead, we intend to raise awareness of certain guidelines that these cases suggest.

What our experience has taught us over the past year, and what we hope becomes clear, is that although each opinion issued by the Delaware courts provide guidelines to transaction planners, each opinion is decided based on a particular set of facts. Thus, the opinions issued by the Delaware courts should be taken for what they are–guidelines for shaping a transaction–and not bright-line rules to be followed in all instances.

The article is available here.

Ulf Axelson, Tim Jenkinson, Per Stromberg, and I have released Leverage and Pricing in Buyouts: An Empirical Analysis, a study of the financings of 153 large buyouts.  The Article gathers a sample of large recent buyouts and considers the impact of a number of factors on their pricing and structure.  The paper presents our findings with respect to the factors that drive buyout dynamics.

We find, for example, that the availability of leverage seems to be an important determinant of prices in buyouts.  In other words, as financial markets have become more lax, historical prices of buyouts have gone up, potentially leading to the boom in buyouts of the last 2 or 3 years.  This finding suggests that, given the crash in the bond market last month, there would be fewer buyouts–and those that do occur will be at lower prices than before.  All of those predictions are consistent with what we are seeing in financial markets now.

Another finding of interest is that “club” deals occur, if anything, at higher prices than otherwise-similar deals that are sponsored by a single private-equity house.  This finding is in contrast to allegations that a reason for “club” deals is to collude on prices.

The full Article is available for download here.