The Determinants of Leverage and Pricing in Buyouts

In the paper, Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts, which was recently made publicly available on SSRN, my co-authors (Ulf Axelson at the London School of Economics; Tim Jenkinson at the University of Oxford, and Per Strömberg at the Stockholm School of Economics) and I empirically investigate the determinants of capital structure in LBOs, highlighting the crucial importance of debt markets in providing capital for the financing of buyouts.

Understanding the financial structure of private equity firms is important not only in and of itself, but also for understanding the role that capital structure plays for corporations in general. In 1989, Michael Jensen famously predicted that the leveraged buyout would eclipse the public corporation and become the dominant corporate form. His argument was based on the thesis that the governance and financing of leveraged buyouts was superior in dealing with agency problems and restructuring. Together with active boards, high-powered management compensation, and concentrated ownership, he considered leverage to be an essential part of this superior governance model. Unlike public firms, Jensen argued, private equity funds optimized the capital structure in companies they acquired, to take full advantage of the tax and incentive benefits of leverage (trading these benefits off against the costs of financial distress).

As luck would have it, shortly after Michael Jensen’s prediction, buyouts virtually disappeared in the wake of the collapse of the junk bond market in 1989. The dependence of buyout activity on credit market conditions has been evident ever since. Although buyout activity was very low in the early 1990’s, it recovered in the later part of the 1990’s and reached record volume during the credit boom in 2006-2007, only to come to an abrupt end with the credit crisis in late 2007. This boom and bust pattern underscores the importance of leverage to the private equity model. It is also consistent with a somewhat different view of buyouts from Jensen’s: Instead of tailoring the capital structure optimally to the needs of the company, LBOs could simply be relying on cheap debt to take levered bets on firms. Indeed, critics of LBOs have argued that the high leverage used in buyouts could jeopardize the health of otherwise sound firms.

We collect detailed information on the financing of 1157 worldwide private equity deals from 1980 to 2008. We find that buyout leverage is cross-sectionally unrelated to the leverage of matched public firms, and is largely driven by factors other than what explains leverage in public firms. In particular, we find that the economy-wide cost of borrowing is the main driver of both the quantity and the composition of debt in these buyouts. Credit conditions also have a strong effect on prices paid in buyouts, even after controlling for prices of equivalent public market companies. Finally, the use of high leverage in transactions negatively affects fund performance, controlling for fund vintage and other relevant characteristics. The results are consistent with the view that the availability of financing impacts booms and busts in the private equity market, and that agency problems between private equity funds and their investors can affect buyout capital structures.

The full paper is available for download here.