The operational performance of buyout targets under private equity ownership:

Evidence from the US, 1990-2007

by Fernando R. Chaddad

Kenan-Flagler Business School at the University of North Carolina

Fernando_Chaddad@unc.edu

Free cash flow theorists argue that opportunistic managers will invest in value-destroying projects, and not return excess cash to shareholders. Jensen (1986) argues that the solution to this problem is to increase debt to levels high enough to preclude wasteful investments. The leveraged buyout (LBO) wave that swept the US in the 1980's was in line with this reasoning. Jensen (1989) then predicted the eclipse of the public corporation and its replacement by superior governance forms such as buyouts.

Buyouts were the focus of intense study following the 1980's LBO wave in the US (e.g. Kaplan, 1989; Long and Ravenscraft, 1993; Wieserma and Liebeskind, 1995). Yet, questions remain open. First, it is unclear whether buyouts lead to improved operations (e.g. the operational engineering mentioned by Kaplan, 2007), or whether post-buyout firms operate at essentially the same pre-buyout levels of efficiency - but with more financial leverage and therefore risk. If post-buyout improvements are purely financial, then the economic logic of buyouts must be questioned. Second, empirical studies measuring performance beyond the immediate short-term are rare. Yet, management in buyout targets may artificially depress performance in the year before the buyout in order to set a lower bar for post-buyout improvements (and compensation). A third, open question goes beyond post-buyout performance at an aggregate level and refers to the circumstances under which specific buyouts are expected to over (under) perform. Finally, whereas scholars have studied 1980's LBOs, present-era private equity (PE) buyouts have yet to be examined with the same degree of intensity. The present research aims to address these four questions, adding to the corporate governance literature in general and the strand dedicated to buyouts in specific.

In order to answer these questions, I will link two large datasets. The first dataset produces a list of whole-company PE buyouts performed in the US from 1990 to 2007, sourced from Thomson Financial's Securities Data Company (SDC). A key challenge in the study of buyouts is the need to source pre and post-buyout financials, despite the going-private advent. The second dataset includes firm-level financials from a confidential database by the US Census Bureau (the Quarterly Financial Report). The methodological approach draws from Long and Ravenscraft (1993) and includes t-tests for direct effects, as well as fixed-effects regressions testing moderating relationships. This is necessary given the need to account for industry factors, time factors, and non-buyout (control) firms. A matched-sample analysis may be applied as a robustness check (e.g. Wiersema and Liebeskind, 1995).

Several implications are expected. These include: thoughts on the relationship between risk and return (e.g. Bowman, 1980); the possibility that bounded rationality (e.g. Simon, 1997) may offer an alternative explanation for overinvestment in publicly-traded firms; the potential evidence of agency problems in PE firms themselves, despite the claim that PE is supposed to lower agency costs in buyout targets; the potential finding that PE buyouts are difficult to reconcile with an important component of a firm's strategy, which must include the economic logic of management actions (e.g. Hambrick and Frederickson, 2005); and the possibility that insiders may take advantage of information asymmetries to underprice buyouts in MBO (management buyout) deals.

REFERENCES

Bowman, E. 1980. A risk-return paradox for strategic management. Sloan Management Review, 21:17-31.

Hambrick, D. and Fredrickson, J. 2005. Are you sure you have a strategy? The Academy of Management Executive, 19:51-62.

Kaplan, S. 1989. The effects of management buyouts on operating performance and value. Journal of Financial Economics, 24:217-254.

Kaplan, S. 2007. Private equity: past, present and future. Journal of Applied Corporate Finance, 19:8-16.

Long, W. and Ravenscraft, D. 1993. The financial performance of whole company LBO's. Center for Economic Studies discussion paper, 93-16.

Jensen, M. 1986. Agency costs of free cash flow, corporate finance and takeovers. American Economic Review, 76:323-329.

Jensen, M. 1989. Eclipse of the public corporation. Harvard Business Review, 67:61-74.

Simon, H. 1997. Models of bounded rationality. Cambridge, MA: MIT Press.

Wiersema, M. and Liebeskind, J. 1995. The effects of leveraged buyouts on corporate growth and diversification in large firms.  Strategic Management Journal, 16:447-460.