Corporate Governance of LBOs

In our paper, Corporate Governance of LBOs: The Role of Boards, which was recently made publicly available on SSRN, we study whether the success of private equity-backed firms is due to their superior corporate governance or instead due to financial engineering. We focus in particular on the role of boards in LBOs and look at changes in the board when a public company is taken private by a private equity group.

We construct a new data set, which follows the board composition and financial figures of all public to private transactions that took place in the UK between 1998 and 2003. Out of these 142 transactions, 88 have private equity sponsors and are thus identified as LBOs. The remaining transactions are either pure MBOs or other types, and are used as benchmarks. We track each company two or three years before the announcement of the buyout until the exit of private equity investors or until 2010, whichever is earlier.

We find that when a company goes private, fundamental shifts in board size and composition take place. The board size decreases on average by 15% and the presence of outside directors is drastically reduced, as they are replaced by individuals employed by the private equity sponsors. We also find evidence that the board size and presence of LBO sponsors on the board depend on the “style” or preferences of the private equity firm. Overall, the boards become more in line with the type of boards that the corporate governance literature would identify as exhibiting better corporate governance. We then set to find out what role these boards play.

Central to our analysis is the examination of the private equity representatives’ presence on the board. We find that private equity sponsors are more present on the boards of the more difficult deals, presumably because these deals need more expertise, monitoring and advice. One way in which we identify more difficult cases is by looking at LBOs where the CEO is changed when the company is taken private. These may be the forced CEO change cases where a large overhaul of the company has been necessary due to unsatisfactory performance of the management, or the voluntary CEO change cases where losing the CEO who is very familiar with the business constitutes a significant challenge to a successful restructuring of the company.

We then turn to study the effects of the private equity firms’ involvement in the boards. We focus on CEO turnover after the company is taken private, as CEO turnover is an indication of how active and attentive a board is in the corporate governance literature. We find that CEO turnover is significantly lower when the company becomes private, and significantly lower than turnover in similar (matched) public companies. In particular, turnover is lower in LBOs where the CEO of the public company remains in charge after the LBO. We show that more difficult deals have higher CEO turnover, however greater involvement of private equity sponsors reduces, rather than increases, the CEO turnover. This is consistent with the claim often made by private equity groups that their involvement lengthens the temporal horizon of the CEO, since they are not concerned with short term figures. This finding also raises questions about whether it is appropriate to look at the CEO turnover in general as a sign of good corporate governance.

Finally, we look at the operating performance of these LBOs. Despite the difficulty in obtaining reliable information, we find some evidence that deals where the CEO is changed during the transition to private have a higher operating performance and that more significant private equity presence on the board leads to higher operating performance. This evidence is consistent with the idea that greater private equity sponsor involvement ultimately leads to better performance. It is also somewhat consistent with the idea that the cases where the CEO is not changed during transition are not the easiest restructuring deals, but rather the ones where private equity backer intends to rely mainly on financial engineering.

The full paper is available for download here.