Analysis Of Buyout Specialists Participating In MBOs And LBOs

Private equity (PE) firms set up private equity funds to buyout companies from current shareholders, often in partnership with the current management team (Cumming, Siegel, & Wright, 2007). They typically engage in public to private transactions, acquisitions of multi business firms’ divisions or acquire privately-held companies through leveraged buyouts (LBOs) or management buyouts (MBOs) (Gilligan & Wright, 2014). Venture capital firms that engage in early stage investments are technically also PE firms (Klein, Chapman, & Mondelli, 2013) however, in this article I will use the term PE firm to de-scribe buyout specialists participating in MBOs and LBOs. In a typical LBO, a control-ling stake of a firm is purchased by using a small portion of equity and high percentage of outside debt financing (Hoskisson, Shi, Yi, & Jin, 2013; Kaplan & Strömberg, 2009).

In an MBO transaction, a controlling stake of a firm is acquired by its own managers, usual-ly cooperating with PE firms to finance the deal (Wood & Wright, 2009). One important characteristic is that post-buyout, most of the companies are taken private (Kaplan & Strömberg, 2009; Strömberg, 2008). Due to the fixed time horizon of usually 10 years (Kaplan & Schoar, 2005; Metrick & Yasuda, 2010) of the PE fund, buyouts have to be exited quite fast by listing the acquired company in initial public offerings (IPO), selling the company to a strategic investor or through a sponsor-to-sponsor1 deal. Unsuccessful companies are either written off or file for bankruptcy (Kaplan & Strömberg, 2009; Strömberg, 2008). From an economic perspective, LBOs and MBOs are a new organisational form that reduces agency cost and drives efficiency (DeAngelo & DeAngelo, 1987; DeAngelo, DeAngelo, & Rice, 1984; Jensen, 1986a).

Agency theory predicts that within public com-panies the divergent goals of managers and shareholders lead to conflicts (Berle & Means, 1933; Fama, 1980; Jensen & Meckling, 1976). Taking this argument further, Jen-sen (1986a) argued that the investment of free cash flow is a serious root cause of these conflicts. Given that free cash flow cannot be invested with a positive net present value, Jensen (1986a) reasoned that free cash should be redistributed to the company’s share-holders. However, managers may object to this proposition and instead use the excess cash to finance projects that increase growth since they are more concerned about the size of the firm, their own power, status and wealth (Baumol, 1967; Hill & Snell, 1988; Wil-liamson, 1964). Thus, according to agency theory, these projects are undertaken to max-imise managers’ own utility (Aoki, 1984; Jensen & Meckling, 1976; Marris, 1964; Wil-liamson, 1964). Following agency theory, several governance mechanisms can limit the conflict be-tween shareholders and managers. Examples of these limiting mechanisms are boards of directors, the market for corporate control and management talents, concentrated owner-ship and executive long-term compensation (Demsetz, 1983; Fama, 1980; Jensen, 1986b). Still, Jensen (1986a) proposed that in firms with undistributed free cash flow, these gov-ernance mechanism are sometimes not sufficient to mediate the conflict between man-agement and shareholders over the distribution of free cash. Following Jensen (1986a), in the described situation a buyout would be convenient.

Therefore, the free cash flow hy-pothesis suggest that if free cash flow in relation to the firm’s assets increases (Linkage 1 in Figure 1), the likelihood of the firm engaging in a buyout also increases (Fox & Mar-cus, 1992; Lehn & Poulsen, 1989). Through the high leverage of the buyout company (Cumming et al. , 2007; Kaplan & Stein, 1993), managers are forced to effectively invest and increase efficiency which in the end reduces managers’ discretion over free cash. Additionally, the enhanced equity stakes of the management in the post-buyout company (Garvey, 1992; Kaplan & Stein, 1993; Kaplan & Strömberg, 2009; Singh, 1990) lead to an alignment of the firm’s and managers’ interests, thereby putting the managements’ attention on findings ways to pay off debt whilst increasing firm value. The concentrated ownership in the hands of the PE firm facilitates closer monitoring of the post-buyout firm which improves the firm’s gov-ernance. Following this hypothesis of reduced agency cost and new incentives, increases in profitability and operating efficiency will be achieved (Jensen, 1986a; Jensen, 1989; Smith, 1990). Lowenstein (1985) further argues that managers have insider information about the company, e. g. knowing that cash flows will be higher than anticipated by the market. Due to this information advantage, managers are able to acquire the company at a discount.

This under-pricing hypothesis forecasts that operating performance is enhanced post-buyout (Linkage 2 in Figure 1). Management scholars are specially interested in finding out how increases in efficien-cy and profitability can be achieved post-buyout. Economists argue (Easterwood, Seth, & Singer, 1989; Hoskisson & Turk, 1990) that after the buyout, managers have to critically decide in which industries they want to compete since they cannot compete in businesses that have a low probability of success. Especially the high levels of debt of the post-buyout company should drive refocusing of the post-buyout company to be able to cover their debt obligations (Jensen, 1989). If a company does not possess a parenting ad-vantage for any their businesses (see Campbell, Goold, & Alexander, 1995), then these businesses should be divested. Additionally, managers would only undertake projects that are vital for the maintenance or extension of the firm’s competitive advantage (Linkage 3 in Figure 1). Finally leading to the hypothesis that unrelated diversification will diminish post-buyout (Fox & Marcus, 1992).