Do LBOs Sustain Efficiency Gains?

Article excerpt

Do LBOs Sustain Efficiency Gains?

The occurence of leveraged buyouts has become a commonplace event in the financial community. Only the size of the LBO, such as the recent $24.9 billion bid for RJR-Nabisco, continues to dazzle the investment public. The acceptance of the phenomenon is due to the wealth it creates. Indeed, there appears to be an overwhelming source of wealth creation in that remarkable returns are received by practically all parties involved. Public shareholders receive large take-out premiums. Participating managements earn enviable returns.(1) Specialists and investment funds (the investment pools that provide equity funding for the specialist-backed deals) receive over 30 percent, compounded annually.(2)

Conventional wisdom perceives an LBO as a method to allocate resources more productively. This line of reasoning provides an explanation for the wealth creation. Theoretically, a private company should be operated in a more efficient manner upon elimination of the absentee owner, the public shareholder. In fact, though, very little evidence exists to support such claims. This study provides some additional evidence on the efficiency hypothesis by investigating the financial performance of LBOs returning to public status. It accomplishes this goal by determining industry-adjusted performance measures for the first two years after the LBO goes public.

BACKGROUND

In essence, a company subjected to a leveraged buyout goes on a rigorous diet - a quick reduction plan. The goal of this plan is to shed unwanted fat and cut down on wasteful consumption. An LBO company accomplishes this goal by reducing unnecessary overhead and selling unrelated business units, thus cutting the company down to a productive core. Anecdotal evidence of such behavior abounds. Consider, for example, the large conglomerate Beatrice Foods, Inc. Soon after going out as an LBO, this company was split up and repackaged as several distinct companies. The same break-up strategy was applied to the following LBOs: Uniroyal, Dr. Pepper, and Metromedia. And, within months of closing the RJR leveraged buyout, several billion dollars of RJR assets have been sold. Presumably, these LBO companies are repackaged because the individual units are more valuable and run more efficiently if separated from the original company.

Such behavior comes as no surprise. Researchers expect to see managerial behavior consistent with increased efficiency as a result of an LBO. The rationale exists on both theoretical and practical lines. Theoretically, agency theory predicts increased efficiency and heightened risk-taking by management when a company is private [8]. By eliminating the public shareholder and increasing management ownership, the LBO process strengthens the managerial incentives to maximize cash flow and the theoretical present value of the cash flows. On a practical level, management is forced to shape the company as a cash producing machine to survive the debt-ridden capital structure the LBO created. Unlike equity, debt requires service payments. And, the higher the debt load, the higher the cash service requirement. Jensen [6] has labeled this phenomenon the control hypothesis of debt. Recently, Lehn and Poulsen [12] provided evidence supporting the control hypothesis of debt by finding a "significant relationship between undistributed cash flow and a firm's decision to go private."

However, little empirical evidence exists supporting this increased efficiency hypothesis. Company information is almost nonexistent due to the nature of an LBO (the company becomes private and is no longer obligated to submit to SEC reporting requirements). Yet, there has been a study by Kaplan [9] that provides some scholarly evidence of increased efficiency. Kaplan studied a sample of LBOs for which data are available. These are companies that issued public debt or reentered the public equity market (IPO). …