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Going Private

Understanding Leveraged Buyouts and Private Equity

Research by Steven N. Kaplan

Steven N. Kaplan is Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business.

 
 

Booms and busts are part of private equity's history. But industry firms have been consistently successful at making valuable changes to the companies they buy.

There are many reasons why private equity firms— particularly leveraged buyout (LBO) transactions—have been so controversial. Private equity is often associated with job losses when private equity investors take over companies; large amounts of debt used to finance these deals; large sums that partners seem to make; and a veil of secrecy that surrounds running their portfolio of companies. The crucial question is whether private equity firms indeed leave the businesses they buy and sell better off in the long-run.

Given the criticisms, many people might be surprised that academic research has found that the answer is largely yes, suggesting that there is a lot about private equity that is not well understood. To separate facts from opinions, University of Chicago Booth School of Business professor Steven N. Kaplan and Per Strömberg of the Stockholm School of Economics were asked by the Journal of Economic Perspectives to write a paper to shed light on this somewhat mysterious business. “We wanted to summarize what we know about leveraged buyouts and private equity in a logical, systematic, and balanced way, which you rarely get in the popular press,” Kaplan says.

In their study, Kaplan and Strömberg demystify private equity by describing how the industry works, how fundraising and transaction characteristics have varied over time, the changes that private equity investors make to a company, and the effects of these changes on operating performance, employment, and fund returns.

Kaplan and Strömberg also explain the factors that drive the recurring boom and bust cycles of the industry. This feast and famine aspect of private equity suggests that the industry will undoubtedly contract after a phenomenal run just a few years ago. At the same time, they conclude that reports that the private equity industry is dead are exaggerated. Just like the previous waves of the late 1980s and 1990s, the industry will come back. Moreover, Kaplan and Strömberg believe that a substantial part of private equity’s growth is unrelated to cyclical factors, but rather to the techniques that firms have refined over so many deals which add value to the companies they buy.

What Is Private Equity?

A private equity firm invests in companies using money raised through a fund. The fund’s limited partners, which can include corporate and public pension funds, endowments, insurance companies, and wealthy individuals, provide most of the capital. The private equity firm, also called the general partner, usually puts in at least one percent of the total capital. The fund typically has a fixed life of about 10 to 13 years. General partners manage the fund’s investments on behalf of the limited partners. They are compensated by charging management fees usually equal to two percent of the committed capital and a “carried interest” or profit shares that is usually 20 percent of the fund’s profits.

In a typical buyout, the private equity firm agrees to buy a company with 60 to 90 percent debt—hence the term “leveraged buyout.” The fund covers the remaining 10 to 40 percent, with the managers of the purchased company contributing an additional small fraction of the equity.

LBOs of large public companies in such mature industries as manufacturing and retail dominated the first buyout wave of the mid- to late 1980s. However, public-to-private deals dropped significantly following the fall of the junk bond market in the late 1980s. Instead, in the 1990s, “middle-market” buyouts of private rather than public companies became the most common type of LBO transaction. Buyout activity also spread to such new industries as information technology, financial services, and health care.

The private equity landscape changed again in the most recent wave when public-to-private deals surged in 2005 to mid-2007, accounting for about one-third of LBO transaction value during this period. With the return of public-to- private transactions, the size of the average deal almost tripled between 2001 and 2006.

Private equity firms restructure the companies they buy and hope to sell them or “exit” at a much higher price, either by selling the business to another company or private equity firm, or through an initial public offering. The median holding period is roughly six years, but has varied over time.

A common criticism is that private equity funds increasingly “flip” their investments quickly rather than hold on to them long enough to make valuable changes. But Kaplan and Strömberg see no evidence that “quick flips” have become more common. Of the deals that were sold since 1970, only 12 percent were exited within 24 months of the LBO acquisition date. Moreover, because of the popularity in recent years of secondary buyouts, which are buyouts of companies owned by other private equity groups, LBOs actually stay longer in the hands of private equity firms.

Is Private Equity a Better Organizational Form?

As LBO activity increased in the 1980s, Harvard University professor Michael Jensen predicted that LBO organizations would eventually become the dominant organizational form. Ownership stakes of portfolio companies are much more concentrated compared to a public company’s dispersed shareholders, and the private equity firm itself is an efficiently run organization that gives strong financial incentives to its investment professionals.

Moreover, private equity firms typically give the management team of a portfolio company a large equity upside through stocks and options—a practice that was unusual among public firms in the early 1980s. Private equity firms also require management to make a meaningful investment in the company so that it participates in the downside as well. Managers cannot sell equity or exercise options until the company exits, thus reducing the incentive to manipulate short-term performance. Even though stocks and options have become more widely used in public corporations, Kaplan and Strömberg say that management’s ownership percentages are still greater in LBO companies than in public companies.

Another important tool is the firms’ significant use of leverage when they buy a company. Leverage creates pressure on managers to make regular interest and principal payments on debt. Without it, managers may be reluctant to distribute extra cash to shareholders and may be tempted to use that money on wasteful projects. Thus, borrowing imposes discipline on managers. Leverage may also increase firm value because interest tax deductions are valuable. However, the probability of costly financial distress goes up if leverage is too high.

Private equity investors control the boards of their portfolio companies and are more actively involved than public company boards. A portfolio company board also is typically smaller and its members meet more frequently. Moreover, private equity firms do not hesitate to replace poorly performing managers of portfolio companies. According to previous research, one-third of chief executive officers are replaced during the first 100 days after firms take over.

In addition to financial and governance engineering, most large private equity firms today have added what Kaplan and Strömberg call “operational engineering” to their toolbox. This involves using industry and operating expertise to identify attractive investments, and then develop and implement an operating plan that includes cost-cutting and productivity improvements, strategic changes or repositioning, acquisition opportunities, as well as management changes and upgrades. Private equity firms hire consulting groups or professionals with operating expertise and considerable knowledge of a certain industry, such as former CEOs Lou Gerstner of IBM and Jack Welch of General Electric.

Have all these changes paid off? Empirical evidence suggests that on the whole, LBOs have indeed led to operating improvements and greater cash flow. In an early study, Kaplan found substantial increases in operating and cash flow margins for U.S. public-to-private deals in the 1980s. Subsequent studies that focus on buyouts in Europe in the 1990s and 2000s likewise have found significant operating and productivity improvements. Finally, studies on public-to-private LBOs in the late 1990s and early 2000s find positive but modest operating gains, perhaps because management practices at public companies have come closer to practices at companies owned by private equity firms.

Critics say, however, that buyouts benefit private equity firms at the expense of company employees who suffer job and wage cuts. Private equity firms counter that they grow their companies. A recent large sample study finds that employment growth at U.S. LBO firms is lower than at other businesses in the same industry after a buyout. At the same time, however, LBO companies create more new jobs at new establishments than other similar firms. Overall, Kaplan and Strömberg view the empirical evidence on employment as largely consistent with the view that portfolio companies add economic value by operating more efficiently.

A good test of whether private equity firms create value is if they are able to sell their investments at a good price. Comparing private equity fund returns with the returns from investing in the S&P 500 index, a study by Kaplan and Massachusetts Institute of Technology professor Antoinette Schoar found that private equity funds outperform the S&P 500 index gross of fees, which is consistent with private equity investors making portfolio companies more valuable. However, fund investors earn slightly less than the S&P 500 index net of fees paid to the private equity firm.

Feast, Famine, and the Future

Kaplan and Strömberg observed that the boom and bust cycles of private equity are related to the level of company earnings compared to the level of interest rates. In particular, private equity activity tends to be higher when the typical public company generates more cash flow than it would have to pay in interest if high-yield bonds were to finance the purchase of the entire company. Indeed, private equity transactions slowed down substantially since the debt markets tightened, interest rates increased, and earnings began to decline in the fall of 2007.

Past returns also drive the ups and downs of the market, according to Kaplan and Strömberg. Investors’ money flows into private equity when returns are high. As more capital is committed to the asset class, subsequent returns tend to decline. Eventually, capital commitments decline as realized returns fall, leading to better returns and starting the cycle anew. Thus, the returns on investments from the extraordinary amounts raised in 2005 to 2008 will likely be disappointing. With returns down, less money will go into private equity in the following years. “At some point, if history repeats itself, that will lead to better returns and then the cycle will start all over again,” says Kaplan.

Some companies may default on their debts and some may even go bankrupt, but Kaplan and Strömberg think that the magnitude of defaults and failed deals is likely to be lower than after the 1980s boom because buyout companies today have higher interest coverage ratios and looser debt covenants.

Beyond the near term, private equity seems to be in a better position relative to other asset classes because the duration of capital matches the duration of assets—that is, long-term capital making long-term investments in companies. Moreover, CEOs and executives of public companies have recently become more receptive to private equity than in the past. Private equity is increasingly seen as a partner rather than a raider, and CEOs of buyout companies are typically paid better and worry less about regulation, litigation, media, and activist shareholders. Private equity is becoming more sophisticated too, as it expands its operational engineering capabilities to create more value for portfolio companies.

"Leveraged Buyouts and Private Equity." Steven N. Kaplan and Per Stromberg. Journal of Economic Perspectives, 2009.