Private Equity and Long‐Run Investment: The Case of Innovation

A long‐standing controversy is whether leveraged buyouts (LBOs) relieve managers from short‐term pressures from public shareholders, or whether LBO funds themselves sacrifice long‐term growth to boost short‐term performance. We examine one form of long‐run activity, namely, investments in innovation as measured by patenting activity. Based on 472 LBO transactions, we find no evidence that LBOs sacrifice long‐term investments. LBO firm patents are more cited (a proxy for economic importance), show no shifts in the fundamental nature of the research, and become more concentrated in important areas of companies' innovative portfolios.     

Predicting the duration and reversal probability of leveraged buyouts

We examine the probability that a firm will return to public status following a leveraged buyout (LBO) transaction and for those LBOs that will eventually reverse, we examine the factors that impact the timing of the reversal. These two dimensions of the reversal decision are studied by estimating standard and split population hazard models for a sample of 343 LBO transactions. Our results indicate that not all LBO firms eventually will reverse, i.e. the net benefits of private status for some firms appear to be permanent. For those LBOs that will reverse, reversal probabilities are found to increase over the first seven or eight years following a typical LBO, then to decline thereafter.     

Active Investors, LBOs, and the Privatization of Bankruptcy

In this testimony to the House Ways and Means Committee on February 1, 1989 (when LBOs and other highly leveraged transactions were under fierce attack by politicians and the media), the author identified “LBO associations” such as KKR and Forstmann Little as a valuable innovation in organizational form—a new model of management and governance that was competing directly with the headquarters of large public corporations, especially conglomerates. In the author's words, LBOs “substitute incentives provided by compensation and ownership plans for the direct monitoring and often centralized decision-making in the typical corporate bureaucracy.” In illustrating his point, the author noted that whereas the CEOs of U.S. companies during the '70s and '80s saw their personal wealth go up by only about $3 for every $1,000 increase in firm value, the average CEO in an LBO experienced a change of $64 per $1,000—and for the partners of the LBO firm, the closest equivalent to a conglomerate CEO, the change was about $200 per $1,000. Based on the performance of the first wave of LBOs to return to public ownership, such dramatic concentrations of equity ownership appear to have produced large gains in operating efficiency. (And since the author's testimony, these findings have been confirmed by subsequent studies of later periods and in other countries.) The heavy debt loads in these transactions, besides making possible the concentration of equity ownership, also perform an important control function, intensifying the search for efficiencies and discouraging reinvestment in low-return projects. For those LBOs that have trouble servicing their debt loads, the author argues that the costs of insolvency should turn out to be significantly lower than for traditional public companies because LBOs provide strong incentives to keep the process of reorganizing troubled companies out of the bankruptcy court (a prediction that, although proving wrong in the early‘90s, has turned out to be true of the most recent wave of private equity deals).     

The effect of change-in-control covenants on takeovers: Evidence from leveraged buyouts

Change-in-control covenants first became commonplace towards the end of the takeover wave in the 1980s. We examine merger and acquisition activity from 1991 to 2006 to see how such covenant protection influences the wealth effects and probability of takeovers. Examining a sample of leveraged buyouts (LBOs) we find bondholders with such covenant protection experience average wealth effects of 2.30% while unprotected bonds experience ? 6.76% upon the announcement of an LBO. Furthermore, we document that the existence of bondholder change-in-control covenants cuts the firm's probability of being targeted in an LBO in half. We also find that change-in-control covenants reduce the probability of being targeted in non-LBO takeovers, but the effect appears less dramatic.     

Are Trade Size‐Based Inferences About Traders Reliable? Evidence from Institutional Earnings‐Related Trading

The use of observed transaction sizes to differentiate between “small” and “large” investor trading patterns is widespread. A significant concern in such studies is spurious effects attributable to misclassification of transactions, particularly those originating from large investors. Such effects can arise unintentionally, strategically, or endogenously. We examine comprehensive records of a sample of institutional investors (i.e., “large” traders), including their order sizes and overall position changes, to assess the degree to which such misclassifications give rise to spurious inferences about “small” and “large” investor trading activities. Our analysis shows that these institutions are heavily involved in small transaction activity. It also shows that they increase their order sizes substantially in announcement periods relative to nonannouncement periods, presumably as an endogenous response to earnings news. In the immediate earnings announcement period, transaction size‐based inferences about directional trading are quite misleading—producing spurious “small trader” effects and, more surprisingly, erroneous inferences about “large trader” activity.     

The evolution of capital structure and operating performance after leveraged buyouts: Evidence from U.S. corporate tax returns

This study uses corporate tax return data to examine the evolution of firms' financial structure and performance after leveraged buyouts (LBOs) for a comprehensive sample of 317 LBOs taking place between 1995 and 2007. We find little evidence of operating improvements subsequent to an LBO, although consistent with prior studies, we do observe operating improvements in the set of LBO firms that have public financial statements. We also find that firms do not reduce leverage after LBOs, even if they generate excess cash flow. Our results suggest that effecting a sustained change in capital structure is a conscious objective of the LBO structure.     

Illegal buyouts

This study empirically examines the effects of a regulation change on the structure and governance of leveraged buyouts (LBOs) within the Italian private equity market, whose transactions were only recently legalized. With a new data set covering approximately 85% of the buyout funds active in Italy during the period of 1999–2006, we find that a regulation that prohibits LBOs can reduce their frequency, but does not exclude them altogether. Rather, it inhibits efficient governance and distorts decision making. Overall, the data are consistent with the view that laws prohibiting LBOs result in less efficient LBO arrangements.     

All Guts,No Glory: Trading and Diversification among Online Investors

I explore cross‐sectional portfolio performance in a sample containing 324,736 transactions conducted by 16,831 Swedish investors at an Internet discount brokerage firm during the period May 1999 to March 2002. On average, investors hold undiversified portfolios, show a strong preference for risk, and trade aggressively. I measure performance using a panel data model, and explain the cross‐sectional variation using investors' turnover, portfolio size and degree of diversification. I find that turnover is harmful to performance due to fees, and is therefore more predominant among investors with small portfolios. I argue that the degree of diversification is a proxy for investor skill, and it has a separate and distinct positive effect on performance. Investors underperform the market by about 8.5% per year on average, of which half can be attributed to trading costs.     

A Comparison of Reverse Leveraged Buyouts and Original Initial Public Offers: Factors Impacting their Issuance in the IPO Market

The purpose of this paper is to assess the factors that affect the returns earned by investors in early trading of reverse LBOs and compare those results to factors affecting original IPOs which are matched by size, industry, and issue date. A mean excess return of 7.64% is observed for the sample of reverse LBOs during the period 1987 to 1998. This return is uniformly lower than returns earned by investing in original IPOs. These results support the information asymmetry hypothesis. The results also show that factors such as number of months the LBO was privately held, the over‐allotment, or greenshoe option, the size of the issue, insider ownership, and gross spread impact the returns earned by investors in reverse LBOs. Other factors which are known to affect returns on original IPOs, such as lead underwriter, whether the deal was syndicated, the number of managers, the listing exchange, lockup agreements, and auditor, are shown to have no impact on the returns in reverse LBOs for the sample in question. We find that the level of insider participation and the over‐allotment option are more important to original IPOs than to reverse LBOs in explaining the excess returns earned by shareholders in early trading. We find, however, that the size of the offering has more impact on excess returns for reverse LBOs than for original IPOs.     

Leveraged buyouts and bond credit spreads

Recent decades have witnessed several waves of buyout activity. We find leveraged buyouts (LBOs) to be a significant concern for bondholders by showing that a) intra-industry credit spreads increase upon an LBO announcement, b) yields on bonds without event risk covenants are, on average, 21 basis points higher than those on same-firm bonds with such covenants, and c) structural models calibrated to historical LBO events imply an impact of 18–21 basis points on 10-year credit spreads. The impact is strongest in expansion periods and for bonds with maturities of 10–20 years.     

Investor protection and firm value: Evidence from PIPE offerings

We find that PIPE issues that do not provide any protections to investors convey positive information about the firm and result in positive announcement period returns. However, PIPE issues that provide protections do not convey any new information about the firm and hence do not result in significant positive or negative announcement period returns. PIPE issuers that offer no protections to investors outperform their matched portfolios for up to 9 months after the issue. PIPE issuers that offer protections underperform their matched portfolios for 18 to 36 months after the issue.     

Club deals in leveraged buyouts

We analyze the pricing and characteristics of club deal leveraged buyouts (LBOs)—those in which two or more private equity partnerships jointly conduct an LBO. Using a comprehensive sample of completed LBOs of U.S. publicly traded targets conducted by prominent private equity firms, we find that target shareholders receive approximately 10% less of pre-bid firm equity value, or roughly 40% lower premiums, in club deals compared to sole-sponsored LBOs. This result is concentrated before 2006 and in target firms with low institutional ownership. These results are robust to controls for target and deal characteristics, including size, Q, measures of risk, and time and industry fixed effects. We find little support for benign motivations for club deals based on capital constraints, diversification motives, or the ability of clubs to obtain favorable debt amounts or prices, but it is possible that the lower pricing of club deals is an inadvertent byproduct of an unobserved benign motivation for club formation.     

The role of private equity group reputation in LBO financing

This paper investigates whether the reputation of acquiring private equity groups (PEGs) is related to the financing structure of leveraged buyouts (LBOs). Using a sample of 180 public-to-private LBOs in the US between January 1, 1997 and August 15, 2007, we find that reputable PEGs are more active in the LBO market when credit risk spreads are low and lending standards in the credit markets are lax. We also find that reputable PEGs pay narrower bank and institutional loan spreads, have longer loan maturities, and rely more on institutional loans. In addition, while we find that PEG reputation is positively related to buyout leverage (i.e., LBO debt divided by pre-LBO earnings before interest, taxes, and amortization (EBITDA) of the target), and leverage is significantly positively related to buyout pricing, we do not find any direct relation between PEG reputation and buyout valuations. The evidence suggests that PEG reputation is related to LBO financing structure not only because reputable PEGs are more likely to take advantage of market timing in credit markets and but also because PEG reputation reduces agency costs of LBO debt.     

The Interim Trading Skills of Institutional Investors

Using a large proprietary database of institutional trades, this paper examines the interim (intraquarter) trading skills of institutional investors. We find strong evidence that institutional investors earn significant abnormal returns on their trades within the trading quarter and that interim trading performance is persistent. After transactions costs, our estimates suggest that interim trading skills contribute between 20 and 26 basis points per year to the average fund's abnormal performance. Our findings also indicate that any trading skills documented by previous studies that use quarterly data are biased downwards because of their inability to account for interim trades.     

Do LBO Supermarkets Charge More? An Empirical Analysis of the Effects of LBOs on Supermarket Pricing

This article examines changes in supermarket prices in local markets following supermarket leveraged buyouts (LBOs). I find that prices rise following LBOs in local markets in which the LBO firm's rivals are also highly leveraged and that LBO firms have higher prices than their less leveraged rivals, suggesting that LBOs create incentives to raise prices. However, I also find that prices fall following LBOs in local markets in which rival firms have low leverage and are concentrated. These price drops are associated with LBO firms exiting the local market, suggesting that rivals attempt to “prey” on LBO chains.     

REIT Institutional Ownership Dynamics and the Financial Crisis

Collectively, institutional investors hold large ownership stakes in REITs. The traditional view is that institutions are both long-term and passive investors. The financial crisis beginning in 2007 provides an opportunity to analyze the investment choices of institutional investors before, during, and after the crisis. Our results indicate that institutional ownership increased prior to the financial crisis, declined significantly during the period of market stress, but rebounded after. These results hold for four institutional investor subtypes: mutual funds/investment advisors, bank trusts, insurance companies, and other institutions, with mutual funds/investment advisors and bank trusts most clearly exhibiting this pattern. We also find evidence that institutions actively manage their REIT portfolios, displaying a “flight to quality” after the market downturn by reducing beta and individual risk exposure, and by increasing ownership in larger REITs.     

PERFORMANCE LEVERAGE, AND OWNERSHIP STRUCTURE IN REVERSE LBOs

Previous studies have provided convincing evidence of improvements in the performance of companies that undergo leveraged buyouts (LBOs). This article presents evidence from the authors' recent study of the performance of 90 "reverse LBOs–LBO firms that go public again in an IPO—after they return to public ownership. The aim of the study was to track the performance of reverse LBOs and to reveal any association between operating performance and changes in leverage and equity ownership.
Among the principal findings of the study were the following: Despite a substantial decline in leverage ratios and equity ownership by insiders at the time of the IPOs, equity ownership of reverse LBOs remained more concentrated and leverage higher than that of public companies in the same industries.
The operating performance of reverse LBOs was significantly better than that of the median firm in their industries in the year prior to and in the year of the IPO. Although there is some evidence of a deterioration in the performance of the reverse-LBO firms, they continue to outperform their industry competitors for at least four full fiscal years after the IPO.
Greater reductions in the percentage equity owned by managers and other insiders at the time of the reverse LBO are associated with larger declines in operating performance.
The stock price performance of reverse LBOs after going public appears more "rational" than that of other IPOs—that is, there is less initial under pricing and no sign of the negative, longer-term abnormal returns reported by recent studies of IPOs.     

Did Structured Credit Fuel the LBO Boom?

The leveraged buyout (LBO) boom of 2004 to 2007 was fueled by growth in collateralized debt obligations (CDOs) and other forms of securitization. Banks active in structured credit underwriting lent more for LBOs, indicating that bank lending policies linked LBO and CDO markets. LBO loans originated by large CDO underwriters were associated with lower spreads, weaker covenants, and greater use of bank debt in deal financing. Loans financed through structured credit markets did not lead to worse LBOs, overpayment, or riskier deal structures. Securitization markets altered banks' access to capital, affected their lending policies, and fueled the recent LBO boom.     

Institutional trading and share returns

Using a unique database of daily transactions from Australian equity managers, we investigate the relation between institutional trading and share returns. The 34 institutional investors included in our sample exhibit a statistically and economically significant ability to predict large capitalization share returns for the ten days following their trades. Detailed analysis indicates that investment manager style is important in understanding the link between institutional trading and stock returns. The contemporaneous relation between institutional trading and returns depends on trade size, broker use, and investment style. We find growth-oriented managers are momentum traders, while style-neutral and value managers are contrarian.     

The staying power of the public corporation

Has the publicly held corporation out-lived its usefulness? In HBR's September-October 1989 issue, Michael C. Jensen of the Harvard Business School said "yes." The institutional shortcomings of the public corporation are so grave, he argued, that it must be considered fatally flawed. He described the emergence of a new form of enterprise-the LBO Association-that releases much of the untapped value and corrects many of the inefficiencies of large public companies. Alfred Rappaport, a professor and consultant who advises large public companies, joins the debate with a rebuttal to Jensen. Rappaport shares many of Jensen's criticisms of current strategic and financial practices among public companies. But he does not believe leveraged buyouts and other going-private transactions can replace the public corporation. This is so, he asserts, for two reasons: LBOs have a limited demand and a limited life. Rappaport argues that the publicly held corporation is worth saving. It is inherently flexible and self-renewing-properties that are fundamental to stability and progress in a market-driven economy and that transitory organizations like LBOs cannot replicate. Rappaport advances a four-point program to overhaul strategic planning, compensation, and governance to maximize shareholder value in public companies: 1. Find the highest valued use for all assets. 2. Limit investment to opportunities with credible potential to create value. 3. Return cash to shareholders when such value-creating investments are not available. 4. Establish incentives for managers and employees to focus on the critical business drivers that create value.