On the Capital Structure of Leveraged Buyouts
Arzac, Enrique R., Financial Management
* In a leveraged buyout (LBO) transaction, a group of investors finance the acquisition of a corporation or division mainly by borrowing against the target's future cash flows. While not new, LBOs have grown in frequency and size in recent years and have been the object of academic research and public policy debate. The effect of LBO transactions on production efficiency and security-holder wealth are examined in a number of recent empirical studies.(1) In 1989, both Houses of Congress conducted hearings on the effects of LBOs on the U.S. economy . The present paper develops a formal rationale for the choice of capital structure made by the organizers of the buyout, including the use of such arrangements as strip financing and equity kickers. This analysis seems a necessary complement to recent empirical studies and will hopefully contribute to the debate on the causes and consequences of LBOs. This paper uses signalling equilibrium concepts first applied to the capital structure question by Ross  and Leland and Pyle . In Section II, the role of debt service as a signal of the level of future free cash flow(2) is examined. The signalling role assigned to leverage is consistent with Jensen's  view that the use of debt to finance the buyout of companies with substantial free cash flow reduces agency costs. the incentive to organize a buyout also follows from Jensen's argument since, when managers can spend cash flow at their discretion rather than in the interest of the owners of the firm, investors are likely to value equity at less than its attainable value and an opportunity to close the value gap via restructuring exists. The signalling model is also consistent with cases in which management expects free cash flow to increase above the level expected by the market, even though it was not misallocated in the past, and cases in which managers buy business units in order to develop their full potential, free from the constraints imposed by headquarters.
The organizers of a buyout will be referred to as "the promoters." They effectively control the corporation and usually include active equity investors and management. For example, the general partners of LBO equity funds together with the top management of the LBO firms were the promoters of many of the LBOs undertaken in recent years. On the other hand, limited partners of LBO equity funds and lenders receiving equity participations are usually not members of the promotions group and are more appropriately considered outside investors. No distinction is made in this paper between leveraged buyouts (LBOs) undertaken by outsiders and management buyouts (MBOs) in which the existing management is part of the promotion group.
The model rationale is as follows: Promoters would want to organize an LBO only if they expect to reap a significant gain from the transaction. Such a gain would result from a disposition of free cash flow that produces value in excess of the buyout price. The promoters get the net present value of the transaction via their equity participation, which is an increasing function of the value placed on future cash flows by other investors. Hence the importance of a credible signal which unambiguously conveys the promoter's commitment to generate and distribute free cash flow to investors. Interest payments are one such signal. Together with a loss suffered by the promoters in the event of default, they produce the desired unambiguous signal that communicates the cash flows attainable by the buyout and induces a valuation of equity consistent with the promoters' expectations.
The model is expanded in Sections III and IV in order to allow for a positive probability of default in equilibrium and to examine the role of strip financing and equity kickers. This is done by adding states of nature which result in low cash flows. Strip financing is the practice of requiring bondholders to buy a share of the equity in order to reduce conflict among classes of security holders in low cash flow states. …