LBOs have many risks that can be broken down into two main types. These include business risk and interest rate risk. The first one is defined as the risk that the firm going private will not generate sufficient earnings to meet the interest payments and other current obligations of the firm.
This category considers factors like competitive factors within the industry. This includes greater price and nonprice competition. This category also considers cyclical downturns in the economy. Companies with very cyclical sales or companies that are in very competitive industries tend not to be good LBO candidates.
The other type of LBO risk, which is interest rate risk, is the risk that interest rates will rise, thus increasing the firm’s current obligations. This is important to firms that have more variable-rate debt. Interest rate increases could force a firm to bankruptcy even when it experienced greater than anticipated demand and held nonfinancial costs within reasonable bounds.
The interest rates’ level at the time of the LBO is a guide to the probability that rates will rise in the future. For instance, interest rate increases are more likely if interest rates are low at the time compared to the interest rates at peak levels.
Return to Stockholders from LBOS
Studies regarding returns to stockholders from LBOS usually highlight the abnormal returns to pre-buyout shareholders. They also focus on premiums as measured by the difference between firm values derived from the final takeover stock price as compared to the preannouncement stock price. The premium analysis can be complex depending on how the preannouncement price is determined and the extent to which the study allows for the preannouncement price runup.
Researchers handle this by using a preannouncement price that involves an anticipation window like two months before the announcement. There is interestingly a difference between the results from the abnormal returns and the premiums studies, but it is justifiable. Research with the use of cumulative abnormal returns already incorporates an expectation of a firm’s return which, in turn, reflects how the market values post-buyout profitability.
A popular study by DeAngelo, DeAngelo, and Rice analyzed the gains to both stockholders and management from MBOs. The sample was a total of 72 companies that attempted to go private between 1973 and 1980. As mentioned, the premium paid for their sample was 56%, which was higher than the premium data presented for more recent years. Results show that managers are willing to offer a premium.
Private Companies Dominated the Buyout Market
In the 200s, private equity companies dominated the buyout market. They are popular for being more careful buyers. The same study found that an average change in shareholder wealth around the announcement of the deal was 22%. Over a longer time period around the announcement, the total shareholder wealth change was approximately 30%. It is consistent with the results for various studies about M&As. Moreover, the announcement of the bid being withdrawn results in the decline of shareholder wealth by 9%.
In another research, Travlos and Cornett showed the statistical significance and negative correlation between abnormal returns to shareholders and the P/E ratio of the firm relative to the Industry. To interpret, the lower the P/E ratio, compared with similar firms, the greater probability that the firm is poorly managed.
The researchers analyzed the low P/E ratios as reflecting greater room for improvement through changes such as the reduction of agency costs. Some of these gains in efficiency may be accumulated by privatization. Then, these gains become the source of the buyout premium..
Return to Stockholders from Divisional Buyouts
Again, MBOs are deals where a group of management purchases apart from the parent company. Most of these purchases are criticized because they are not “arm’s length” deals. Parent company’s managers are usually accused of giving special treatment to a management bid.
The parent company may spurn the closeout process and acknowledge the executives’ proposal without requesting other higher offers. One way to check whether these exchanges are really to investors’ greatest advantage is to take a gander at their investor riches impacts.
In 1989, researchers Hite and Vetsuypens tried to show if divisional buyouts had adverse effects on the wealth of parent stockholders. Most researchers believe that divisional buyouts may present opportunities for efficiency-related gains as the division becomes removed from the parent company’s layers of bureaucracy. This is likely to be valuable to the managers of the buying group but does not deny the often-cited possibility that a fair price was not paid for the division. A fair price is may the one which is derived from an auction.
Divisional Buyouts
The scholars were not able to find evidence of a reduction in shareholder wealth following divisional buyouts by management. In their analysis, these indicated that division buyouts result in a more efficient allocation of assets. The existence of small wealth gains indicates that shareholders in the parent company shared in some of these gains.
Briston, Saadouni, Mallin, and Coutts did not support the positive view of a management buyout from the lens of parent company shareholders. In their study, a sample of 65 MBOs in Great Britain over the period 1984–1989 was used. The results showed that parent company stakeholders experienced negative returns following MBO announcements. This result contradicts the other types of selloff announcements. Implying that this may be parent company managers giving their former colleagues a better deal than they offer non-affiliated buyers
Post-LBO Firm Performance
Several studies showed substantial operating performance improvements when management buyouts occurred in the 80s. Some of the early studies tackled Kaplan and Lichtenberg and Siegel’s study. Both found improvements in financial performance following the management buyouts. The same results were also presented by later researchers, like Guo, Hotchkiss, and Song. Who analyzed 192 leveraged buyouts that were completed during the period 1990–2006. Aside from concluding that the deals were less levered than their 1980s predecessors. They also found that the operating performance of the firms that were taken private was at least as good as matched industry companies. They consider this performance to gain a result of large positive returns that yielded their investors.
For instance, Gao et al. found an 11% increase in EBITDA/sales relative to comparable firms. The positive outcomes on LBO execution were not simply limited to U.S. LBOs.
Research Discoveries for LBOs
Different research has shown up at comparable discoveries for LBOs in various European nations. For example, Great Britain, France, and Sweden, this result raised debates in some scholars. Who questioned whether the companies that were studied were the only ones that had publicly available financial statements made them a biased sample. The companies that have financial statements published could have sold public debt or go through a subsequent transaction like an IPO.
In a study conducted by Cohn, Mills, and Towery, a subsample of 71 companies that underwent an LBO that had both tax returns and financial statements available were used. The results were coherent with the prior research. It showed that the following forms did show substantial improvements in financial performance.
For example, they found a 9% improvement in mean return on sales over a two-year period after the buyouts. Then, they focused on a broader sample of 317 companies taken private in an LBO. Including the previous 81 with both tax return and financial statements available. And others that had only tax return data available.
They concluded that there was no evidence of meaningful performance improvements for this larger sample. This may mean that the companies whose financial statements were public have been performing better. This let them issue public debt or even go public again. Others may not have performed as well and may not have been able to pursue such transactions.
All in all, Cohn, et al. found that the positive view of LBOs that has prevailed in the world of M&A research for many years may have been overly sanguine. LBOs may strengthen dealmakers and investors of private equity and managers of these private equity firms. But they may not have any positive impact on the companies themselves.
© Image credits to Anni Roenkae