Leveraged Buyouts Revisited
Private equity and the resolution of financial distress
BY Per Strömberg, Edith S. Hotchkiss, David C. Smith | March 22, 2011
Here is a new working paper on SSRN puts the LBO boom in perspective. The authors make a few interesting conclusions on the use of leverage and the role of private equity firms in the outcome of restructurings…
Leveraged buyouts (LBOs) by private equity funds have played a dominant role in corporate finance for more than two decades, especially during the LBO “boom” years of the late 1980s and mid-2000s. By the end of 2006, private equity sponsors were engaging in transactions totaling more than $800 billion per year and concurrently raising new capital equivalent to 1.5% of the total value of the U.S. stock market. Academic studies of LBO behavior have mirrored the growth in the private equity market. Jensen (1989), who wrote his seminal paper in the wake of the 1980’s LBO boom, argued that the LBO organizational form, which combined high leverage levels, concentrated ownership, and high-powered incentives, was a superior way to deal with corporate governance problems in firms. This hypothesis was supported in the empirical work studying the 1980’s buyouts, such as Kaplan (1989, 1991), Smith (1990), and Lichtenberger and Siegel (1987), which documented significant gains in profitability, productivity, and financial performance for firms after being acquired in LBOs. As the private equity market continued to grow in the late 1990’s and 2000’s, subsequent work (such as Acharya and Kehoe (2008), Davis et al (2008, 2009), and Lerner et al (forthcoming)) by and large corroborated the positive view of the earlier studies, finding that LBOs have a positive effect on firm performance.
There is one area, however, where the LBO model has been put into question, namely in its use of leverage. In his original work, Jensen (1989) emphasized the positive effect of high leverage, which served as an important corporate governance mechanism disciplining management and making firms more efficient. The experience from the bust in the LBO market in the early 1990’s, where a large fraction of LBOs ended up in financial distress and bankruptcy, suggested that the use of leverage in LBOs could be excessive and costly for firms. Kaplan and Stein (1993) showed that the LBO market became overheated in the late 1980’s due to the cheap access to junk bond financing, which in turn lead to excessive leverage levels and LBO deal pricing. Using LBO data from 1980 to 2008, Axelson et al (2010) show that leverage and pricing levels in buyouts are driven by debt market conditions, where environments where credit is “cheap” lead to LBOs using more leverage, involve higher pricing multiples, and subsequently leading to lower returns to private equity funds. Axelson et al (2009) provide a model arguing that this pattern is driven by agency conflicts between the private equity fund and its investors, where the compensation contract of private equity fund partners give them an incentive to overinvest in LBO deals. When credit markets are “hot” and credit is easily available, the overinvestment problem will be exacerbated, leading to boom-bust patterns in the LBO market.
This raises the important issue of whether the costs of financial distress due to the overlevering of LBOs offset the economic gains due to active ownership and governance. So far, the literature has been largely silent on how private equity sponsors manage financial distress in the companies they own. The lack of emphasis on financial distress is notable given that LBO takeovers are by definition heavily leveraged transactions that increase the chance that an acquired company will default on its debt. Indeed, following the recent downturn in credit markets, 190 companies with significant private equity backing defaulted on their debt during 2008 and 263 in 2009.While private equity-backed defaults declined substantially in 2010, many analysts expect a potential large bulge of defaults again by the mid-2010s as large amounts of PE-backed debt comes due.
This paper attempts to fill the gap in the literature by studying the defaults and restructurings of private equity-backed (PE-backed) firms that become financially distressed during the period January 1997 to April 2010. Our main goal is to discern how the involvement of private equity firms (PE sponsors) influences the outcome of these restructurings. (read the full paper).