Do Buyouts (Still) Create Value?

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.