Does an Industry Effect Exist for Leveraged Buyouts?
Ambrose, Brent W., Winters, Drew B., Financial Management
* The process of taking a firm private (called "going private" or "leveraged buyout") has received much attention in the financial literature. In a leveraged buyout (LBO), shareholders earn a substantial premium for their shares over recent trading prices. Several studies have attempted to explain these returns to shareholders and the motivations behind leveraged buyouts by concentrating on both firm-specific and industry factors to explain why LBOs occur.(1)
Theoretical factors for explaining the motivations for taking a firm private can be grouped under two competing hypotheses. The first, the firm effects hypotheses, states that firm-specific characteristics, such as management or operating inefficiency, are the primary motivation for taking a firm through a leveraged buyout. The second, called the industry effect hypothesis, states that factors in common to the firm's industry are the primary motivation for taking a firm private.
The purpose of this study is to examine the industry effect hypothesis. In Section I, we present a discussion of the theories and evidence for why leveraged buyouts occur. Section II describes the data used to test the industry effect hypothesis and Section III discusses both the methodology and the results. Finally, Section IV discusses the conclusions.
I. Theories for LBO Activity
Past research has attempted to explain the common factors that might support the industry effect hypothesis of leveraged buyout activity. One proposed factor is the potential leverage-induced tax savings involved in LBOs. Other factors are related to potential agency problems.
The tax-savings hypothesis has received considerable attention. It follows from the tax shield of interest payments on the increased debt in an LBO. Marais, Schipper, and Smith  present evidence that tax savings are correlated with the LBO premium. Kaplan  also finds that the tax benefits are a large source of wealth in leveraged buyouts.
The agency relationship between managers and shareholders has also received considerable attention. Jensen  proposes that leveraged buyouts reduce a special type of agency problem associated with free cash flow, i.e., "cash flow in excess of that required to fund all projects that have positive net present values" [5, p. 323]. Lehn and Poulsen  test the free cash flow hypothesis and find evidence consistent with shareholder gains resulting from reducing the agency costs associated with free cash flow.
The industry effect hypothesis suggests that certain industries are more likely to have LBO activity. Also, other industries, for example, those that are regulated, are less likely to have LBO activity. For there to be a concentration of LBOs in an industry, most firms within it must generate enough cash flow above their current needs to service the debt used in the LBO and have the potential to benefit from reducing agency costs. Jensen  points out that "some of the best examples of this have occurred in the oil, tire, and tobacco industries -- all industries that have been forced to shrink their operations in the last decade" [4, p. 44]. Lehn, Netter, and Poulsen  support the industry effect hypothesis. They report that LOBs occur for firms in industries that are faced with slower growth prospects and lower research and development (R&D) expenses.
To test the industry effect hypothesis, this paper examines the correlation between the number of leveraged buyouts and industries. We test the hypothesis using the general nonparametric statistics comparing the frequency distribution of LBOs and non-LBOs across industries. We examine the free cash flow, the growth rate and the debt capacity of each industry identified as having significant LBO activity.(2) Finally, we examine the cumulative excess returns occurring for each industry portfolio identified as having significant LBO activity. In general, our results provide only limited, weak support for the industry effect hypothesis. …