The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts

The following post comes to us from Jonathan Cohn of the Department of Finance at the University of Texas at Austin; Lillian Mills, Professor of Accounting at the University of Texas at Austin; and Erin Towery of the Department of Accounting at the University of Texas at Austin.

In our paper, The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts: Evidence from U.S. Corporate Tax Returns, which was recently made publicly available on SSRN, we study post-LBO financial performance and behavior for approximately the universe of U.S. LBO firms taking place between 1995 and 2007.  We overcome the lack of public financial data for most LBOs firms that has limited prior research by instead analyzing confidential federal corporate tax return data. Since all U.S. corporations, including those that are privately-held, must file tax returns, we can observe post-LBO income and balance sheet information for nearly all U.S. LBO firms.

We use our large, representative sample to test a number of long-standing hypotheses regarding the motivation for LBOs and their role in the economy. Arguably the most influential view on LBOs is that of Jensen (1989), who regards the LBO structure as superior to the structure of the publicly-traded firm. He argues that the concentration of ownership and high level of debt in the LBO structure disciplines managers. The high level of debt eliminates free cash flow that managers might otherwise waste on “empire-building” activities. Indeed, levering up the firm more than would be optimal from a long-term perspective puts pressure on management to earn its way out of the firm’s debt load.

If Jensen’s argument is correct, then we should observe significant improvements in operating performance post-LBO in the 2000s, as firms curtail negative NPV investments. The reduction in the free cash flow problem should also result in less investment. Our operating performance and growth results for the full sample are not consistent with Jensen’s argument. If anything, operating performance declines after LBOs for the average LBO firm, though this decline appears to be at least partially attributable to broader performance trends that also affect peer firms. However, there is weak evidence of a small increase in pre-interest return on sales. The picture regarding investment is less clear. Not only do total assets increase from the year before the buyout to the year of the buyout, they also increase the year after the buyout, though they begin to decline after this point. Our capital structure results fail to support the argument that acquirers lever LBO firms up beyond the long-run optimal level to provide managers incentives to generate cash flow in order to pay down debt. As the results in our paper show, leverage and debt levels, if anything, increase after LBOs.

Perhaps Jensen’s argument only explains the primary motivation for some LBOs. For example, loss LBO firms do experience an improvement in operating performance after LBOs. The fact that these firms were unprofitable before the LBO might suggest that they were poorly-managed and could therefore benefit more than the average firm from an increase in discipline. However, these firms experience a modest drop in assets, which suggests disinvestment, before they undergo LBOs. This would be consistent with these firms being in financial distress and therefore needing to raise capital by selling off assets or disinvesting. They tend to experience asset growth both during and after the LBO. It is therefore unclear whether Jensen’s argument is the rationale for these LBOs. In short, our evidence indicates that Jensen’s argument is not an important motive for LBOs in the 2000s.

Another explanation for LBOs is that some publicly-traded firms are underlevered, and that the LBO allows the firm to move towards its optimal capital structure. This would create value for investors by, for example, allowing the firm to generate more interest tax shields. Our results do appear to support this argument. Consistent with the increased tax shields afforded by debt, the number of firms paying tax drops dramatically in the year of the LBO and remains low even up to five years after the LBO. Thus, to the extent the IRS uses decreases in net income as an indicator of compliance risk, they should also consider how dramatic increases in leverage would explain reductions in income. The change in debt levels and leverage ratios accompanying an LBO are long-lived, and if anything debt tends to continue to increase after a buyout. Moreover, even those firms that generate excess cash flow post-LBO, and therefore have the capacity to pay down debt, do not do so. Of course, this explanation leaves unanswered the question of why publicly-traded firms cannot or will not increase leverage on their own if doing so creates shareholder value.

Finally, arguments that LBOs represent private equity firms opportunistically “stripping” otherwise healthy firms do not find support in our data. The primary evidence against this argument is the lack of dividend payments by firms in the first few years after an LBO. We also do not find that firms tend to shrink after LBOs. In fact, the healthiest firms—those that were operationally profitable pre-LBO—actually grow post-LBO, even after the initial asset revaluation that likely occurs for financial reporting purposes.

The full paper is available for download here.

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One Comment

  1. John Doe
    Posted Thursday, September 8, 2011 at 1:24 am | Permalink

    Interesting but time frame skews results.

    “[T]he universe of U.S. LBO firms taking place between 1995 and 2007” should say it all

    Why not address the psychology behind why investors decide to lever targets beyond an “optimal” capital structure? Lack of discipline in debt markets during bull markets should be another focus of this article

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