Interesting Paper on Leveraged Buyouts and Private Equity

Christmas is fast approaching and I thought that instead of writing up Alpha.Sources' pendant to the flurry of 2010 market outlooks (it will come at some point over the Christmas), I would point you to a recent paper I read on leveraged buyouts and private equity industry. The paper is written by Steven N. Kaplan and Per Strömberg at the Institute for Financial Research in Stockholm and offers a nice overview of industry which has grown in importance since it was conceptualized in the roaring 1980s and spawned stories such as Wallstreet as well as it was of course an integral part of the story of Milken and the junk bond market's rapid ascend and subsequent fall from grace. 

Normally, leveraged buyouts and private equity are not topics that fill the pages here at Alpha.Sources and I am not about to start a tradition. However, during my first year in grad school at Copenhagen Business School I co-authored a paper on the topic of leveraged buyouts and specifically how the spreads on Mezzanine debt is determined. So, I am a little bit predisposed to take an interest in this even if I am the only one out of the quintet working on the paper that has not yet joined the PE or M&A industry in some form or the other. I don't plan to either although the section on fees and compensation suggest that I should clearly consider this a career path. 

Messieurs Strömberg and Kaplan essentially present us with an overview article that knits together a nice picture of how scholarly financial research has investigated and dealt with the private equity industry LBOs drawing naturally heavily on the seminal work of Michael Jensen. The original contribution in the form of the empirical analysis is less ground breaking even if its conclusions are quite interesting as they support the idea that the LBO/PE industry is subject to notable boom and bust cycles often (and naturally) centered around the cost of debt relative to equity. Needless to say that the "Great Moderation" and the subsequent low interest rates it brought with it represented a major driver of the large amount of deals struck in an 2003/04 to 2007 context. 

Private equity funds first emerged in the early 1980s. Nominal dollars committed each year to U.S. private equity funds have increased exponentially since then, from $0.2 billion in 1980 to over $200 billion in 2007. Given the large increase in firm market values over this period, it is more appropriate to measure committed capital as a percentage of the total value of the U.S. stock market. The deflated
series, presented in Figure 1, suggests that private equity commitments are cyclical. They increased in the 1980s, peaked in 1988, declined in the early 1990s, increased through the late 1990s, peaked in 1998, declined again in the early 2000s, and then began climbing in 2003. By 2006 and 2007, private equity commitments appeared extremely high by historical standards, exceeding 1 percent of the U.S. stock market’s value.

Clearly, 1% of the public market at its peak suggest that it remains a niche industry (and product), as the authors argue and as you will learn from reading up on private equity, it is an industry which has been the source of much inspiration in terms of especially corporate governance.

Having said this, private equity and LBOs ares still riddled with myths particularly concerning the potential downsides. I am not saying this because I unequivocally think that private equity (and especially LBOs) have no downsides, but because the discussion is often framed so as to make private equity and LBOs the prime example of the illness which is (Anglo-Saxon/Short term) capitalism.

Proponents of leveraged buyouts, like Jensen (1989), argue that private equity firms apply financial, governance, and operational engineering to their portfolio companies, and, in so doing, improve firm operations and create economic value. In contrast, some argue that private equity firms take advantage of tax breaks and superior information, but do not create any operational value. Moreover, critics sometimes argue that private equity activity is influenced by market timing (and market mispricing) between debt and equity markets. In this section, we consider the proponents’ views and the first set of criticisms about whether private equity creates operational value.

The criticism against market timing and mispricing is difficult to sustain in my opinion. In short, mispricing and to some extent market timing refer to the idea that private equity and LBO activity take advantage of the relative price of debt (i.e. the interest rate) vs the price of equity and thus this is also in part what gives the industry its boom/bust nature. However, I have difficulties seeing how this can be a source of criticism as such. Also on the perennial question of employment and short termism the critiques fall short. Consequently, the evidence that private equity should be characterised by asset strippers who simply cut employment to increase productivity and employ ultra short term horizons is simply not there I think.

Also, many of the big ticket LBO deals who tend to get a lot of attention are also of public companies (utilities) where rather aggressive cost cutting is a natural part of the process. On the short term behavior, it is equally not borne out in the data except of course as a pure (and important) operational aspect in the sense that an increase in debt financing reduces free cash flow and thus forces companies to make plans on how they can continue servicing the debt (the free cash flow problem). But this is supposed to be good no?

Well, perhaps not all good and I would certainly not disregard the connection between a cyclical boom/bust industry driven by the cost and supply of debt and the fact that companies may be moved into a leverage ratio which is not optimal.

The mispricing theory implies that relatively more deals will be undertaken when debt markets are unusually favorable. Kaplan and Stein (1993) present evidence consistent with a role for overly favorable terms from high-yield bond investors in the 1980s buyout wave. The credit market turmoil in late 2007 and early 2008 suggests that overly favorable terms from debt investors may have helped fuel
the buyout wave from 2005 through mid-2007.”


”These patterns suggest that the debt used in a given leveraged buyout may be driven more by credit market conditions than by the relative benefits of leverage for the firm.”

But then again, the evidence on default rates does not suggest that LBOs are more likely to default although this may change radically once we get the data from 2007+ parsed by researchers.

The big issue in the context of the pros and cons of private equity and LBOs is really performance. Especially, it is important to distinguish between two performance measures. One is the extent to which private equity leads to higher value creation and a more efficient operational and governance structure at the level of the acquired company. And another is whether it leads to excess returns for the investors.

Without going too much into detail the existing evidence seems to support the claim that private equity (often in connection with LBOs) tend to increase firm value and efficiency whereas the question of returns is more fickle (my emphasis and ordering of quotes).

Overall, we interpret the empirical evidence as largely consistent with the existence of operating and productivity improvements after leveraged buyouts. Most of these results are based on leveraged buyouts completed before the latest private equity wave. Accordingly, the performance of leveraged buyouts completed in the latest private equity wave is clearly a desirable topic for future research


Given that so many leveraged buyouts occurred recently, it is not surprising that 54 percent of the 17,171 sample transactions (going back to 1970) had not yet been exited by November 2007. This
raises two important issues. First, any conclusions about the long-run economic impact of leveraged buyouts may be premature. Second, empirical analyses of the performance of leveraged buyouts will likely suffer from selection bias to the extent they only consider realized investments.

Could this mean that with a financial crisis lingering since 2007, the post mortem on a large part of yet to be exited will turn into sour grapes? I am inclined to think so although we need to factor in that the industry itself has grown more complex and diverse. Essentially, funds may have the opportunity to extent the period in which they manage their portfolio and thus increase result as a sole function of market timing or they may choose to offload to other private equity funds which is a fast growing exit strategy (in relative terms). However, most private equity funds are closed ended and thus the butcher's bill will have to settled at some point with potential subpar returns to follow. However, let me be clear. Regardless of the return offered to the partners is an unequivocal force of good if the discipline and governance enforced by private equity ownership creates operational value through increased productivity and other efficiency gains.

Yet, it is in the context of private equity as a financial asset that I think the criticism (if any) should be levied. In particular it is very important to point out that the return from private equity that may potentially accrue to you and me as retail investors is zip, nada and nothing. We simply don't have access to this and in this sense, the idea of private equity as a surpreme alternative to a public market is rather daft. Quite simply after the managers, partners and the pension fund has had its fees the retail investor in the bottom of the pile will enjoy none of the return created at the firm level. In fact, evidence seem to suggest that even the pension fund who enters as a limited parter may not even experience excess return over the market.

In any case, as you can see, it made me think a little bit. Over to you then ...