American Economic Association
American Economic Association Leveraged Buyouts and Private Equity Author(s): Steven N. Kaplan and Per Strömberg Source: The Journal of Economic Perspectives, Vol. 23, No. 1 (Winter, 2009), pp. 121-146 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/27648297 Accessed: 18-08-2015 18:29 UTC
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Journal ofEconomie Perspectives?Volume
23, Number 1?Winter 2009?Pages
121-146
Buyouts and Private Equity
Leveraged
Steven N. Kaplan
and Per Str?mberg
a leveraged buyout, a company is acquired by a specialized investment firm a relatively large portion of using a relatively small portion of equity and outside debt financing. The leveraged buyout investment firms today refer to
In
(and are generally referred to) as private equity firms. In a typical an leveraged buyout transaction, the private equity firm buys majority control of existing or mature firm. This arrangement isdistinct from venture capital firms that themselves
or emerging companies, and typically do not obtain typically invest in young In this control. paper, we focus specifically on private equity firms and the majority in which they invest, and we will use the terms private equity and leveraged buyouts leveraged buyout
interchangeably. buyouts first emerged
Leveraged 1980s. As leveraged predicted dominant
as an
activity increased
important phenomenon in that decade, Jensen
in the
(1989) buyout that the leveraged buyout organizations would eventually become the form. He argued that the private equity firm corporate organizational
itself combined
stakes in its portfolio companies, ownership for the private equity firm professionals, and a lean, with minimal overhead costs. The private equity firm then
concentrated incentives
high-powered efficient organization
managerial compensation, highly leveraged capital applied performance-based to the structures (often relying on junk bond financing), and active governance
isNeubauer Family Professor ofEntrepreneurship and Finance, Uni Steven N. Kaplan School ofBusiness, Chicago, Illinois. Per Str?mberg isProfessor Graduate versityof Chicago
ofFinance at theStockholm School ofEconomics and Director of theInstitutefor Financial Research (SIFR), both in Stockholm, Sweden. Both authors are also Research Associates, National
are
Bureau
of
Economic
([email protected])
Research,
Cambridge,
Massachusetts.
Their
e-mail
and ([email protected]).
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addresses
122
Journal ofEconomie Perspectives
in which
companies
invested.
and
leverage,
weak
to
According
to those of the typical public
superior low
it
A
governance.
corporate
with dispersed
corporation
few
shareholders, this
later,
years
were
structures
these
Jensen,
prediction
junk bond market crashed; a large number of high profile leveraged buyouts resulted in default and bankruptcy; and leveraged (so called public-to-private transactions) virtually buyouts of public companies by the early 1990s. disappeared seemed
The
premature.
But the leveraged buyout market had not died?it was only in hiding. While leveraged buyouts of public companies were relatively scarce during the 1990s to purchase private companies and early 2000s, private equity firms continued In
divisions.
and
the United buyout
the mid-2000s,
States
transactions
public-to-private
the rest of the world)
(and
when
reappeared
a second
experienced
leveraged
boom.
In 2006 and 2007, a record amount of capital was committed terms
in nominal
both
and
commitments
as
and
a fraction
of
rivaled,
if not
transactions
the overall
stock
overtook
the
to private equity,
market.
Private
equity
the first wave
of
activity
in the late 1980s that reached
its peak with the buyout of RJR Nabisco in 1988. in in with the turmoil the debt However, 2008, markets, private equity appears to have declined again. start the paper by describing
We describe the
equity
private
fundraising,
equity
typical
or SunGard
RJR Nabisco
leveraged
and
as
such
characteristics
and
KKR,
the
of
buyout
on how private
evidence
present
transaction
and
Carlyle,
transaction,
buyout
Systems. We
Data
activity,
as Blackstone,
such
organizations
of a
components
how the private equity industry works. We
have
over
varied
time.
The
article in
changes that
private
then considers structures,
capital
investors
equity
on
value
economic
and
This
then
evidence At
average.
equity. We and
incentives,
management introduce,
the effects of these changes. creates
the effects of private review
describe governance
corporate
the
the
evidence
empirical
on
suggests that private equity activity same
the
there
time,
is also
evidence
consistent with private equity investors taking advantage of market timing (and market mispricing) between debt and equity markets particularly in the public-to private
transactions also
We equity boom
at and
of
review
the
fund
bust
the
the
15 years.
that
on
evidence
empirical
level.
cycles
last
Private
equity
are
returns
past
returns
and to
appears
activity to
related
the economics
and
to
experience to
the
level
private
recurring of
interest
rates relative to earnings. Given that the unprecedented boom of 2005 to 2007 it seems likely that there will be a decline in private equity
has just ended, investment boom
may
and
in
fundraising
eventually
lead
to
the
some
next
several
defaults
and
years.
While
investor
the losses,
recent the
market
magnitude
is likely to be less severe than after the 1980s boom because capital structures are less fragile and private equity firms are more sophisticated. Accordingly, we expect that a significant part of the growth in private equity activity and institutions
is permanent.
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StevenN. Kaplan
Private
Firms,
Equity
Blackstone,
and
Carlyle,
with
organizations
as a
are
KKR
equity firms. In the late 1980s, Jensen decentralized
123
and Transactions
Funds,
Private Equity Firms The typical private equity firm is organized corporation.
and Per Str?mberg
few
relatively
the most
prominent
private
these firms as
described
(1989)
or limited liability
partnership of
three
investment
lean, em
and
professionals
ployees. In his survey of seven large leveraged buyout partnerships, Jensen found an 13
of
average
investment
who
professionals,
tended
to come
an
from
investment
banking background. Today, the large private equity firms are substantially larger, are still small relative to the firms in which they invest. KKR's S-l (a although they in preparation for KKR's form filed with the Securities and Exchange Commission initial public offering) reported 139 investment professionals
other
large
firms
equity
private
to have
appear
more
sionals. In addition, private equity firms now appear wider
of
variety
and
skills
was
than
experience
true
than
in 2007. At least four
100
investment
profes
to employ professionals with a 20
years
ago.
Private Equity Funds A private equity firm raises equity capital through a private equity fund. Most private a
equity
are
funds
amount
certain
"closed-end"
of money
vehicles
to pay
for
in which
investors in
investments
to
commit as well
companies
provide as man
agement fees to the private equity firm.1 Legally, private equity funds are organized as limited partnerships in which the general partners manage the fund and the limited partners provide most of the capital. The limited partners typically include institutional and
insurance as
serves
such
investors,
the
companies, fund's
as
as
public
is customary
funds,
pension
individuals.
wealthy It
partner.
general
and
corporate
as well
The for
the
endowments,
private
firm
equity
to
partner
general
provide at least 1 percent of the total capital. The fund typicallyhas a fixed life,usually ten years, but can be extended forup to three additional years. The private equity firm normally has up to five years to invest the fund's capital committed into companies, and then has an additional five to eight years to return the capital to its investors.After committing their capital, the limited partners have little say in how the general partner deploys the investment funds, as long as the
basic
covenants
of
the
fund
agreement
are
followed.
Common
covenants
include
fund capital can be invested in one company, on types of securities a fund can invest in, and on debt at the fund level (as opposed to debt at the portfolio company level,which isunrestricted). Sahlman (1990), Gompers and Lerner restrictions on how much
(1996), and Axelson,
rationale
for
The the
1
equity
private
partner
general
In a "closed-end"
Str?mberg, and Weisbach
fund
these
fund,
(forthcoming) discuss the economic
structures. firm
earns
or an
is
general
partner
annual
management
investors cannot
withdraw
in three
compensated fee,
their funds until
usually
the fund
a
(2005)
of
is terminated.
funds, for example, where investors can withdraw their funds whenever for an economic funds. analysis of closed- vs. open-end
contrasts with mutual See Stein
First,
ways.
percentage
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This
they like.
124
Journal ofEconomie Perspectives
and
committed,
capital
the
Second,
employed.
to as
referred
"carried
as
then,
are
investments earns
partner
general
that
interest,"
almost
on
evidence
empirical
For
assume
example,
those a
that
share
always
general partners charge deal and monitoring invest. Metrick and Yasuda (2007) describe provide
a
a
realized, of
of
percentage
the
of
profits
20 percent.
equals
capital
the
fund, some
Finally,
fees to the companies inwhich the structure of fees in detail
they and
fees.
private
equity
firm, ABC
Partners,
a
raises
private
equity fund, ABC I, with $2 billion of capital commitments from limited partners. At a 2 percent management fee, ABC Partners would receive $40 million per year for the five-year investment period. This would decline over the following five years as ABC exited or sold its investments. The management fees typically end after ten years, although the fund can be extended thereafter. ABC would invest the differ ence between the $2 billion and the cumulative management fees into companies. IfABC's investments turned out to be successful and ABC was able to realize
would be entitled to a $6 billion from its investments?a profit of $4 billion?ABC carried interest or profit share of $800 million (or 20 percent of the $4 billion tomanagement fees of $300 to $400 million, ABC partners would profit). Added
have received a total of up to $1.2 billion over the fund's life. In addition,
sometimes
partners
general
are paid
deal
charge
and
fees
monitoring
that
to the general partner by the portfolio companies not by the limited partner. The extent to which these fees are shared with the limited partners is a issue
contentious
somewhat
in
fundraising
These
negotiations.
fees
are
commonly
split 50-50 between general and limited partners. The Private Equity Analyst (2008) lists 33 global private equity firms (22 U.S. at the end of 2007. based) with more than $10 billion of assets under management The same publication lists the top 25 investors in private equity. Those investors are (California Public Employees' by public pension funds, with CalPERS CalSTERS State Teachers' Retirement System), (California System), Public School Retirement System), and theWash (Pennsylvania Employees'
dominated
Retirement PSERS
ington State Investment Board
the top four slots.
occupying
Private Equity Transactions In a typical private equity transaction, the private equity firm agrees to buy a company. If the company is public, the private equity firm typically pays a premium
of 15 to 50 percent over the current stock price (Kaplan, 1989b; Bargeron, Schlingemann, Stulz, and Zutter, 2007). The buyout is typically financed with 60 to the term, leveraged buyout. The debt almost always 90 percent debt?hence includes
a
loan
portion
that
is senior
and
secured,
and
is
arranged
by
a bank
or
an
investment bank. In the 1980s and 1990s, banks were also the primary investors in these
loans.
More
recently,
fraction of the senior and investors
and
"collateralized
however,
institutional
secured
loans. Those
loan
obligation"
managers,
investors
a
purchased
investors include hedge who
combine
a number
large
fund of
term loans into a pool and then carve the pool into different pieces (with different seniority) to sell to institutional investors. The debt in leveraged buyouts also often includes a junior, unsecured portion that is financed by either high-yield
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Leveraged Buyouts and Private Equity
Figure 1 U.S. Private Equity Fundraising and Transaction U.S. Stock Market Value from 1985 to 2007
Values
as a Percentage
125
of Total
,_,
3.50%n
Sources: Private Equity Analyst, CapitallQ,
bonds or "mezzanine
Str?mberg
(2008),
authors'
calculations.
(that is, debt that is subordinated to the senior debt). (2007) and Standard and Poor's (2008) provide more
debt"
and James Demiroglu detailed descriptions.
The private equity firm invests funds from its investors as equity to cover the team of remaining 10 to 40 percent of the purchase price. The new management the purchased
(which may or may not be identical to the pre-buyout typically also contributes to the new equity, although the
company
team) management amount is usually a small fraction of the equity dollars contributed. 2005 buyout of Sun (2005) describes a large leveraged buyout?the Kaplan Gard Data Systems?in detail. Axelson, Jenkinson, Str?mberg, and Weisbach (2008) provide a detailed
description
of capital structures in these kinds of lever
aged buyouts. to Private Equity Funds Private equity funds first emerged in the early 1980s. Nominal dollars committed each year to U.S. private equity funds have increased exponentially since then, from
Commitments
$0.2 billion in 1980 to over $200 billion in 2007. Given the large increase in firmmarket values over this period, it ismore appropriate to measure committed capital as a
percentage of the total value of theU.S. stockmarket. The deflated series, presented in Figure 1, suggests thatprivate equity commitments are cyclical. They increased in the 1980s, peaked in 1988, declined in the early 1990s, increased through the late 1990s,
peaked in 1998, declined again in the early 2000s, and then began climbing in 2003. By 2006 and 2007, private equity commitments appeared extremely high by historical standards, exceeding 1 percent of the U.S. stock market's value One caveat to this observation
is that many of the large U.S. private equity firms have only recently global in scope. Foreign investments by U.S. private equity firms were much smaller 20 years ago, so the comparisons are not exacdy apples to apples.
become
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126
Journal ofEconomie Perspectives
Figure 2 Global Private Equity Transaction
Volume,
1985-2006
information on capital commitments to Although we do not have comparable non-U.S. funds, it is clear that they also have grown substantially. In 2007, the Private Equity Analyst lists three non-U.S. private equity firms among the twelve largest in the world
in assets
under
management.
Private Equity Transactions Figure 2 shows the number
and
combined
transaction value
of worldwide
leveraged buyout transactions backed by a private equity fund sponsor based on In total, 17,171 private equity-sponsored buyout transactions data from CapitallQ. occurred from January 1, 1970, to June 30, 2007. (This excludes transactions
but not completed by November 1, 2007.) Transaction values equal the enterprise value (market value of equity plus book value of debt minus cash) of the transaction values are not acquired firms, converted into 2007 U.S. dollars. When announced
(generally smaller, private-to-private deals), we impute values as a func tion of various deal and sponsor characteristics. Figure 1 also uses the CapitallQ data to report the combined transaction value of U.S. leveraged buyouts backed by a private equity fund sponsor as a fraction of total U.S. stock market value. recorded
and discusses potential Str?mberg (2008) describes the sampling methodology biases. The most important qualification is that CapitallQ may underreport private equity transactions before the mid-1990s, particularly smaller transactions. Overall
buyout transaction activitymirrors the patterns in private equity fund Transaction and fundraising volumes exhibit a similar cyclicality. Transac raising. tion values peaked in 1988; dropped during the early 1990s, rose and peaked in the later 1990s, dropped in the early 2000s; and increased dramatically from 2004 to
2006. A huge fraction of historic buyout activity has taken place within the last few recorded 5,188 buyout transactions years. From 2005 through June 2007, CapitallQ
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StevenN. Kaplan
and Per Str?mberg
127
Table 1 Global
1985-1989
LBOs
1990-1994
$257,214 642
enterprise value of transactions
Combined Number
across Time
Characteristics
Buyout Transaction
Leveraged
2000-2004
1995-1999
,614
$553,852
1,123
L,055,070
4,348
2005-6/
1970-6/
30/2007
30/2007
1,563,250
$3,616,787
5,188
5,673
17,171
by type: (% of combined
enterprise value) Public to private
49% 31% 17% 2% 0%
private
Independent Divisional Secondary Distressed
54% 31% 6% 1%
15% 44% 27% 13% 1%
18% 19% 41% 20%
34% 14% 25% 26% 1%
27% 23% 30% 20%
72% 13% 13%
60% 16% 20%
44% 17% 32%
47% 15% 30%
52% 15% 26%
4%
6%
4% 3%
by target location: (% of combined
LBOs
enterprise value) United States and Canada United Western
7%
Kingdom
UK)
Europe
(except
1% 2%
3%
Asia and Australia Rest ofWorld
3%
for 17,171 worldwide table reports transaction characteristics leveraged buyout transactions database announced between every transaction with a financial sponsor in the CapitallQ sum is net the of to pay for the value and and 6/30/2007. debt used 1/1/1970 Enterprise equity of 2007 U.S. dollars. For the transactions where in millions transaction value was not enterprise
Note: The
that include
recorded,
these have been
imputed using
in Str?mberg
the methodology
(2008).
estimated enterprise value of over $1.6 trillion (in 2007 dollars), with those 2*/2years accounting for 30 percent of the transactions from 1984 to 2007 and
at a combined 43
of
percent
total
the
real
transaction
value,
respectively.
2006 Although Figure 2 only includes deals announced through December 2007), the number of announced (and closed by November leveraged buyouts continued to increase until June 2007 when a record number of 322 deals were
After that, deal activity decreased substantially in the wake of the new buyouts were announced. In in markets. 133 turmoil credit January 2008, only
announced. As
the
private
market
equity
evolved, as summarized The
analysis. some
extent
first, a U.K.,
late
has
in Table 1980s
buyout
grown,
wave From
phenomenon.
transaction
1; Str?mberg was
(2008)
presents a U.S.,
primarily
1985-89,
these
also
characteristics
three
a more
and
Canadian, countries
have
detailed to
accounted
for 89 percent of worldwide leveraged buyout transactions and 93 percent of transaction value. The leveraged buyout business was dominated by worldwide relatively
large
transactions,
in mature
industries
(such
as
manufacturing
and
retail); public-to-private deals accounted for almost half of the value of the trans actions. These transactions in the first buyout wave helped form the perception of private equity that persisted formany years: leveraged buyouts equal going-private transactions
of
large
firms
in mature
industries.
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128
Journal ofEconomie Perspectives
Following the fall of the junk bond market in the late 1980s, public-to-private activity declined significantly, dropping to less than 10 percent of transaction value, while the average enterprise value of companies acquired dropped from $401 million to $132 million (both in 2007 dollars). Instead, "middle-market" buyouts of traded firms?either independent companies or divisions of larger non-publicly for the bulk of private equity significantly and accounted new as information to industries such activity. Buyout activity spread technology/ corporations?grew
financial
media/telecommunications,
ing and retail firms became value
transaction
as
twice
fell,
and
services,
were
deals
many
care
health
as buyout
less dominant
while
manufactur
targets. Although in
undertaken
aggregate versus
1990-94
1985-89. As private equity activity experienced steady growth over the following period a in for the market continued to evolve. from 1995-2004 2000-2001), dip (except
Public
company
accounted
An
transactions.
increased,
buyouts
for over
80
of
percent
transaction
fraction
increasing
buyouts of private companies
although of
buyouts
more
value
and
were
so-called
than
90
still of
percent
secondary
buyouts?
private equity funds exiting their old investments and selling portfolio companies to other private equity firms. By the early 2000-2004 period, secondary buyouts comprised over 20 percent of total transaction value. The largest sources of deals in this
were
however,
period,
large
corporations
off divisions.
selling
theWestern Euro Buyouts also spread rapidly to Europe. From 2000-2004, market the United had 48.9 percent of pean private equity (including Kingdom) worldwide leveraged buyout transaction value, compared with 43.7 percent in the States. The scope of the industry also continued to broaden, with compa nies in services and infrastructure becoming increasingly popular buyout targets. The private equity boom from 2005 to mid-2007 magnified many of these
United
trends.
Public-to-private
together accounting
over
value
transaction
and
formore this
secondary
grew
buyouts
in numbers
rapidly
and
size,
than 60 percent of the $1.6 trillion leveraged buyout
time.
in
Buyouts
industries
nonmanufacturing
contin
to grow in relative importance, and private equity activity spread to new parts of the world, particularly Asia (although levels were modest compared toWestern
ued
and
Europe
As
America).
(deflated) deal
average
large
transactions
public-to-private
sizes almost tripled between
returned,
2001 and 2006.
and Timing of Exit
Manner
Because ment
North
exits
most are
an
private important
equity aspect
funds of
have the
a
private
limited
contractual
equity
process.
lifetime, Table
invest
2 presents
statistics on private equity investment exits using the CapitallQ buyout sample. The top panel shows the frequency of various exits. Given that so many leveraged
buyouts occurred recently, it is not surprising that 54 percent of the 17,171 sample transactions (going back to 1970) had not yet been exited by November 2007. This raises
two
important
issues.
First,
any
conclusions
about
the
long-run
economic
impact of leveraged buyouts may be premature. Second, empirical analyses of the performance of leveraged buyouts will likely suffer from selection bias to the extent they
only
consider
realized
investments.
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129
Leveraged Buyouts and Private Equity
Table 2 of Leveraged
Exit Characteristics
1970-
across Time
1990-
1985-
1984
Year oforiginal LBO Type
Buyouts
1995-
2000-
2003-
2006-
Whole
1989
1994
1999
2002
2005
2007
period
6% 25%
5% 23%
8% 11%
6% 9%
3% 6% 11%
3% 1%
14%
35%
38%
40%
37%
13% 3%
17% 3%
23% 5%
31% 6%
of exit:
7% IPO 28%
Bankruptcy to strategic buyer
Sold
31%
5% 2%
Secondarybuyout Sold toLBO-backed firm to management
Sold
40%
38% 35%
24% 31% 7% 5%
17% 19%
1%
1%
1%
2%
2% 1% 1%
1%
Other/unknown
26%
18%
12%
11%
10%
7%
No exit byNov. 2007
3%
5%
9%
27%
43%
98% 74%
54%
14% 47% 53% 61% 70%
12% 40% 48% 58% 75%
14% 53% 63% 70% 82%
13% 41% 49% 56% 76% 73%
9% 42% 40% 49% 51% 55% 58%
13%
12%
% of deals
11% 24%
exited within
24months (2 years) 60 months (5 years) 72months (6 years) 84 months (7 years) 120months (10 years)
table reports exit information for 17,171 worldwide leveraged buyout transactions that include database announced between 1/1/1970 and every transaction with a financial sponsor in the CapitallQ of transactions, on an equally-weighted basis. The numbers are expressed as a percentage 6/30/2007.
Note: The
Exit status is determined and Lerner detailed
(2007),
description
SDC, Worldscope, Amadeus, Cao, using various databases, including CapitallQ, as well as company and LBO firm web sites. See (2008) for a more Str?mberg
of the methodology.
on
Conditional
company second
common
most
exit
is a
sale
common
the most
exited,
having
buyer; this occurs
to a strategic (nonfinancial)
to another
private
route
is
the
sale
of
the
in 38 percent of exits. The equity
fund
in a
secondary
considerably over time. leveraged buyout (24 percent); Initial public offerings, where the company is listed on a public stock exchange (and the private equity firm can subsequently sell its shares in the public market), account for 14 percent of exits; this route has decreased significantly in relative this route has
over
importance
increased
time.
the high debt levels in these transactions, one might expect a nontrivial fraction of leveraged buyouts to end in bankruptcy. For the total sample, 6 percent of deals have ended in bankruptcy or reorganization. Excluding post-2002 lever Given
aged buyouts, which may not have had enough time to enter financial distress, the incidence increases to 7 percent. Assuming an average holding period of six years, out
this works
to an
annual
rate
default
of
1.2
percent
per
year.
Perhaps
surpris
ingly, this is lower than the average default rate of 1.6 percent thatMoody's reports for all U.S. corporate bond issuers from 1980-2002 (Hamilton et al., 2006). One caveat is that not all cases of distress may be recorded in publicly available data sources;
some
of
these
cases
may
be
"hidden"
in
the
relatively
large
fraction
of
exits (11 percent). Perhaps consistent with this,Andrade and Kaplan find that 23 percent of the larger public-to-private transactions of the 1980s (1998)
"unknown" defaulted
at
some
point.
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Journal ofEconomie Perspectives
130
The
bottom panel
2 shows average holding
The
transactions.
buyout
leveraged
of Table
on
is done
analysis
for individual
periods
a cohort
to avoid
basis,
the
bias resulting from older deals being more likely to have been exited. Over the whole sample, the median holding period is roughly six years, but this has varied over time. Median holding periods were less than five years for deals from the early affected by the "hot" initial public offering markets
1990s, presumably 1990s. oriented, ownership
companies
investment,
funds have
increased
been
accused
of
sustained
In our
time.
more
becoming
common.
Instead,
we
analysis,
as exits within 24 months
more
become
within 24 months
a
for
that "quick flips," defined have
have
short-term
to "flip" their investments rather than to maintain
preferring of
funds
equity
private
Recently,
of the late
see
no
their
evidence
of the private equity fund's
holding
of
periods
private
equity
since the 1990s. Overall, only 12 percent of deals are exited of the leveraged buyout acquisition date.
Finally, because of the high fraction of secondary buyouts in recent years, the individual holding periods understate the total time in which leveraged buyout firms are held by private equity funds. Accounting for secondary buyouts, Str?m leveraged buyout is still in private equity berg (2008) shows that the median nine
ownership
after
years
the original
buyout
transaction.
In
comparison,
Kaplan
lever (1991), who also takes secondary buyouts into account, found the median aged-buyout target remained in private ownership for 6.82 years, which is consistent with privately owned holding periods having increased since the 1980s.
Is Private Equity a Superior Organizational
Form?
Proponents of leveraged buyouts, like Jensen (1989), argue that private equity firms apply financial, governance, and operational engineering to their portfolio and,
companies, In
superior
in so
some
contrast,
doing,
argue
information,
improve
that but
private
do
not
firm equity
create
and
operations firms any
take
create
advantage value.
operational
economic of
value.
tax breaks
and critics
Moreover,
sometimes argue that private equity activity is influenced by market timing (and market mispricing) between debt and equity markets. In this section, we consider the proponents' views and the first set of criticisms about whether private equity creates more
value.
operational
In
the next
section,
we
consider
market
timing
issues
in
detail.
and Operational Financial, Governance, Engineering firms Private equity apply three sets of changes invest,
which
we
categorize
as financial,
governance,
to the firms in which and
operational
they
engineering.
and Kaplan (1989a, b) describe the financial and governance with associated private equity. First, private equity firms pay engineering changes to incentives in their portfolio companies. They careful attention management Jensen
(1989)
team a large equity upside through stock and typically give the management was unusual among public firms in the early 1980s (Jensen that options?a practice
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StevenN. Kaplan
and Per Str?mberg
131
and Murphy, 1990). Kaplan (1989b) finds that management ownership percent a to four in from factor of increase ages going private ownership. Private by public firms
equity
also
require
company, downside
as well.
a
to make
management
so thatmanagement
investment
meaningful
in
the
not only has a significant upside, but a significant because
Moreover,
the
are
companies
private,
management's
cannot sell its equity or exercise its is,management equity is illiquid?that options until the value is proved by an exit transaction. This illiquidity reduces manage ment's
to
incentive It remains
the
manipulate case that
short-term
performance. teams
management
obtain
significant
in
stakes
equity
portfolio companies. We collected information on 43 leveraged buyouts in the United States from 1996 to 2004 with a median transaction value of over $300 Of
million.
these,
23 were
The
transactions.
public-to-private
median
execu
chief
tive officer receives 5.4 percent of the equity upside (stock and options) while the team as a whole gets 16 percent. Acharya and Kehoe (2008) find management trans similar results in the United Kingdom for 59 large buyouts (with a median action value of over $500 million) officer
executive
gets
3 percent
from 1997 to 2004. They report themedian
of
the
the median
equity;
chief
team
management
as
a
gets 15 percent. These magnitudes are similar to those in the 1980s public (1989b). Even though stock- and option to-private transactions studied by Kaplan more have become based compensation widely used in public firms since the 1980s,
whole
(and upside) remain greater in leveraged ownership percentages management's in than buyouts public companies. The second key ingredient is leverage?the borrowing that is done in connec tion
with
the
transaction.
Leverage
creates
pressure
on
not
managers
to waste
money, because they must make interest and principal payments. This pressure in Jensen reduces the "free cash flow" problems described (1986), in which management
dissipate and
many
teams
in mature
industries
with
weak
corporate
governance
cash flows rather than returning them to investors.2 In the United other
countries,
leverage
also
potentially
increases
firm
value
could
States through
the tax deductibility of interest. On the flip side, if leverage is too high, the inflexibility of the required payments (as contrasted with the flexibility of payments to equity) increases the chance of costly financial distress.
Third, governance engineering refers to the way that private equity investors control the boards of their portfolio companies and are more actively involved in governance than public company boards. Private equity portfolio company boards are smaller than comparable public company boards and meet more frequently 1996; Acharya and Kehoe, 2008; Cornelli and Karakas, (Gertner and Kaplan, (2008) report that portfolio companies have twelve 2008).3 Acharya and Kehoe formal
meetings
per
year
and
many
more
informal
contacts.
In
addition,
2 Axelson,
private
also argue that leverage provides discipline to the (forthcoming) Str?mberg, and Weisbach debt providers?to acquiring leveraged buyout fund, which must persuade third-party investors?the co-invest in each deal. 3 evidence on public firm boards (Yermack, 1996) suggests that smaller boards are more Empirical efficient.
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Journal ofEconomie Perspectives
132
Acharya firms are replaced a
four-year
to
hesitate
poorly
replace
management.
performing
(2008) report that one-third of chief executive officers of these in the first 100 days while two-thirds are replaced at some point
and Kehoe
over
not
do
investors
equity
period.
and governance engineering were common by the late 1980s. Today, most large private equity firms have added another type that we call "operational engineering," which refers to industry and operating expertise that they apply to Financial
add
to
value
investments.
their
most
Indeed,
top
private
are
firms
equity
now
to hiring dealmakers with financial engi organized now firms often hire professionals with operating neering skills, private equity industries. In addition
around
an
and
backgrounds
For
focus.
industry
Lou
example,
the
Gerstner,
former
chief
executive officer of RJR and IBM is affiliated with Carlyle, while Jack Welch, former chief executive officer of GE, is affiliated with Clayton Dubilier. Most firms
equity
private
also
use
make
Private equity firms use
attractive
to
investments, the value
implement
or
internal
value plans.
A
creation plan
might
improvements, productivity as well as management opportunities,
acquisition
and MacArthur,
2008; Gadiesh
and Kehoe,
strategic
and
investments,
elements changes
changes
to identify
knowledge
those
include
and
top
groups.
consulting
for
plans
and
opportunities
external
their industry and operating
develop
creation
of
the
of or
to
cost-cutting
repositioning, (Acharya
upgrades
2008).
Operating Performance The empirical evidence on the operating performance of companies after they have been purchased through a leveraged buyout is largely positive. For U.S. in deals the 1980s, Kaplan (1989b) finds that the ratio of operating public-to-private to to 10 sales increased by income 20 percent (absolutely and relative to industry). to sales in ratio of cash flow (operating income less capital expenditures) creased by roughly 40 percent. The ratio of capital expenditures to sales declined. These changes are coincident with large increases in firm value (again, absolutely and relative to industry). Smith (1990) finds similar results. Lichtenberg and Siegel
The
(1990) find that leveraged buyouts experience productivity after the buyout.
significant increases
in total factor
on private equity and leverage buyouts has post-1980s empirical work on focused buyouts in Europe, largely because of data availability. Consistent with the U.S. results from the 1980s, most of this work finds that leveraged buyouts are Most
with significant operating and productivity improvements. This work includes Harris, Siegel, and Wright (2005) for the United Kingdom; Boucly, Sraer, and Thesmar (2008) for France; and Bergstr?m, Grubb, and Jonsson (2007) for Sweden. Cumming, Siegel, and Wright (2007) summarize much of this literature
associated
and
there
conclude
"is a
general
consensus
across
different
mea
methodologies,
sures, and time periods regarding a key stylized fact: LBOs [leveraged buyouts] and [management buyouts] enhance performance and have a salient especially MBOs effect
on
work
There results?more
practices."
has been recent
one
exception
public-to-private
to the largely uniform positive buyouts.
Guo
et al.
(2007)
operating
study U.S.
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public
Leveraged Buyouts and Private Equity
133
to 2006. The 94 leveraged buyouts to-private transactions completed from 1990 are concentrated in deals completed by 2000. The with available post-buyout data
in operating and cash flow margins that are much in the 1980s data for the United States and in the
increases
authors find modest
than those found
smaller
data. At the same
time, they find high investor returns (adjusted for industry or the overall stock market) at the portfolio company level. Acharya and Kehoe (2008) and Weir, Jones, and Wright (2007) find similarlymodest operating European
over roughly the improvements for public-to-private deals in the United Kingdom same period. Nevertheless, Acharya and Kehoe also find (2008) high investor
returns.
These
results
that
suggest
post-1980s
transactions
public-to-private
may
differ from those of the 1980s and from leveraged buyouts overall. the empirical evidence is consistent overall with significant operating While some caution. improvements for leverage buyouts, it should be interpreted with First, some
studies, particularly
those in the United
because
data
to selection
subject
For
available.
bias
most
example,
U.S.
performance
for
of financial
studies
States, are potentially
private
are
firms
performance
not
study
always
leveraged
buyouts that use public debt or subsequently go public, and leveraged buyouts of public companies. These may not be representative of the population. Still, studies in countries
undertaken
not
do
therefore
where
suffer
reporting
data
accounting biases?for
on
is available
example,
Boucly,
private Sraer,
firms, which and
Thesmar
and Bergstr?m, Grubb, and Jonsson (2007) for Sweden?find (2008) significant operating improvements after leveraged buyouts. Second, the decline in capital expenditures found in some studies raises the for France
current cash flows, but hurt future possibility that leveraged buyouts may increase to concern at the performance of leveraged test is look this of cash flows. One an initial public offering. In a buyout companies after they have gone through recent paper, Cao and Lerner (2007) find positive industry-adjusted stock perfor mance
such
after
initial
public
In
offerings.
another
test
of whether
future
pros
pects are sacrificed to current cash flow, Lerner, Sorensen, and Str?mberg (2008) as measured by patenting. Although study post-buyout changes in innovation relatively few private equity portfolio companies do
patent
focus
experience
Furthermore,
patenting.
portant
not
(as measured
their
innovation
any patents
meaningful filed
by subsequent activities
decline
post-buyout
citations)
in a few
core
engage in
in patenting,
post-buyout
appear
more
those that
innovation economically
or im
than those filed pre-buyout, as firms
areas.
Overall, interpret the empirical evidence as largely consistent with the existence of operating and productivity improvements after leveraged buyouts. Most of these results are based on leveraged buyouts completed before the latest we
private
pleted
equity
wave.
Accordingly,
the
performance
in the latest private equity wave
of
leveraged
is clearly a desirable
buyouts
com
topic for future
research.
Employment Critics of leveraged buyouts often argue that these transactions benefit private equity investors at the expense of employees who suffer job and wage cuts.While
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Journal ofEconomie Perspectives
134
such reductions would be consistent the political
improvements,
operating this manner
be more
would
(and arguably expected) with productivity and implications of economic gains achieved in see
(for example,
negative
comments
from
the
Service
Employees International Union, 2007). (1989b) studies U.S. public-to-private buyouts in the 1980s and finds Kaplan that employment increases post-buyout, but by less than other firms in the industry.
a similar result. Davis, Haltiwanger, Jarmin, Lichtenberg and Siegel (1990) obtain a Miranda and Lerner, (2008) study large sample of U.S. leveraged buyouts from at the establishment level. They find that employment at leveraged 1980 to 2005 firms increases by less than at other firms in the same industry after the buyout buyout, but also find that leveraged buyout firms had smaller employment before
the
The
transaction.
buyout
relative
in retail businesses. They find no difference sector.
For
a
subset
of
at new
employment
their
sample,
as well
establishments
similar
as
at
al.
ones.
existing
in the manufacturing are
(2008)
to measure
able
For
this
subsample,
firms.
non-buyout
the United
Outside
States, Amess, and Wright (2007a) study buyouts in the from 1999 to 2004 and find that firms that experience leveraged
United Kingdom have
buyouts
et
growth
concentrated
have higher job growth in new establishments
the leveraged buyout companies than
in employment
Davis
are
declines
employment
employment
to other
similar
growth
but
firms,
increase
more
wages
slowly.The one exception to the findings in the United States and United Kingdom are those for France by Boucly, Sraer, and Thesmar (2008), who find that leveraged companies
buyout
experience
and wage
greater job
growth than other
similar
companies. then,
Overall,
leveraged
experience are
findings
not
the
evidence
buyouts,
consistent
with
that
suggests but
at a slower
concerns
employment
rate
over
than
at other
destruction,
job
at
grows similar but
firms
firms.
neither
that These
are
they
consistent with the opposite position that firms owned by private industry experi ence especially strong employment growth (except, perhaps, in France). We view the empirical evidence on employment
equity
portfolio
companies
create
as largely consistent with a view that private
economic
value
by operating
more
efficiently.
Taxes
debt in leveraged buyout transactions gives rise to interest tax are deductions that valuable, but difficult to value accurately. Kaplan (1989a) finds that, depending on the assumption, the reduced taxes from higher interest deduc The
additional
tions can explain from 4 percent to 40 percent of a firm's value. The lower estimates assume that leveraged buyout debt is repaid in eight years and that personal taxes offset the benefit of corporate tax deductions. The higher estimates assume that leveraged buyout debt ispermanent offset.
Assuming
that
the
truth
lies between
estimate of the value of lower taxes due
these
and that personal various
to increased
assumptions,
taxes provide no a reasonable
leverage for the 1980s might estimates would be lower for leveraged
be 10 to 20 percent of firm value. These buyouts in the 1990s and 2000s, because both the corporate tax rate and the extent of leverage used in these deals have declined. Thus, while greater leverage creates
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StevenN. Kaplan
and Per Str?mberg
135
some value for private equity investors by reducing taxes, it is difficult to say exactly how
much.
Asymmetric Information The
favorable
generally
are also potentially mation
on
claim
that
future
results
on
operating
company
portfolio
incumbent
Critics
performance. is a
management
on
information
value
creation
consistent with private equity investors having superior source
of
this
extent, supporters of private equity implicitly agree has
and
improvements
a
to make
how
firm
of
inside
private
infor often
equity
information.
some
To
that incumbent management better.
perform
After
all,
one
of
the
justifications for private equity deals is that with better incentives and closer to deliver better results. A less monitoring, managers will use their knowledge attractive
claim,
is that
however,
they intend to keep
because the new
owners.
a result,
As
incumbent
favor
managers
a
private
equity
their jobs and receive lucrative compensation incumbent
managers
highest price for existing shareholders?thus
may
be
to
unwilling
fight
buyout
under for
the
giving private equity investors a better
deal.
Several observations
suggest that it is unlikely that operating improvements are a result of simply private equity firms taking advantage of private information. First, studies the forecasts the private equity firms released Kaplan (1989b) publicly at the time of the leveraged buyout. The asymmetric information story suggests that actual should
performance
exceed
the
forecasts.
In
fact,
actual
after
performance
the
buyout lags the forecasts. Moreover, Ofek (1994) studies leveraged buyout attempts that failed because the offer was rejected by the board or by stockholders (even though management supported it) and finds no excess stock returns or operating improvements for these firms. It would be useful to replicate these studies with more
recent
transactions.
Second,
firms
equity
private
tioned
frequently
bring
and Kehoe
in new
men
As
management.
earlier, Acharya (2008) report that one-third of the chief executive officers in their sample are replaced in the first 100 days and two-thirds are
over
replaced
a
four-year
that itwill be in a position
Thus,
incumbent
owners.
equity
Third, firms
period.
to receive high-powered
have
it seems likely that at times in the boom-and-bust in their
overpaid
leveraged
buyouts
and
cannot
management
be
sure
incentives from the new private
experienced
cycle, private equity losses.
For
exam
ple, the late 1980s was one such time, and it seems likely that the tail end of the private equity boom in 2006 and into early 2007 will generate lower returns than investors
as well.
expected
If incumbent
management
provided
inside
information,
it clearly wasn't enough to avoid periods of poor returns for private equity funds. While these findings are inconsistent with operating improvements being the result of asymmetric information, there is some evidence that private equity funds are able to acquire firms more than other et bidders. Guo al. cheaply (2007) and Acharya
and Kehoe
only modest
perience large financial
(2008) find that post-1980s public-to-private transactions ex increases in firm operating performance, but still generate
returns to private equity funds. This finding suggests that private
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Journal ofEconomie Perspectives
136
equity firms are able to buy low and sell high. Similarly, Bargeron, Schlingemann, Stulz, and Zutter (2007) find that private equity firms pay lower premiums than are consistent with public company buyers in cash acquisitions. These findings or industries that turn out to be under private equity firms identifying companies valued. Alternatively, this could indicate that private equity firms are particularly boards
target
and
not
do
management
the best
get
in these acquisitions.
possible price Overall,
that
and/or
negotiators,
good
then,
the
not
does
evidence
an
support
The
management.
are
results
consistent
potentially
for
role
important
on the part of private equity firm-specific information
investors and
with
private
superior
incumbent investors
equity
bargaining well, target boards bargaining badly, or private equity investors taking advantage of market timing (and market mispricing), which we discuss below.
Private Equity Fund Returns company-level empirical evidence suggests that leveraged buyouts by private equity firms create value (adjusted for industry and market). This evidence The not
does
necessarily
that
however,
imply,
private
equity
funds
earn
returns
superior
for their limited partner investors. First, because private equity firms often purchase firms in competitive auctions or by paying a premium to public shareholders, sellers likely
a
capture
amount
meaningful
of value.
For
in KKR's
example,
of
purchase
RJR Nabisco, KKR paid a premium to public shareholders of roughly $10 billion. After the buyout, KKR's investors earned a low return, suggesting thatKKR paid out
most, ifnot all of the value-added toRJR's public shareholders. Second, the limited partner investors in private equity funds pay meaningful fees. Metrick and Yasuda (2007) estimate that fees equal $19 in present value per $100 of capital under for
management net
investors
the median
of
fees
will
private be
lower
fund.
equity than
As
return
the
a result, on
the
the
return
private
to outside fund's
equity
investments.
underlying
Kaplan and Schoar (2005) study the returns to private equity and venture an investor (or limited capital funds. They compare how much partner) in a private net to fees what the of investor would have earned in an fund earned equity equivalent investment in the Standard and Poor's 500 index. They find that private equity fund investors earn slightly less than the Standard and Poor's 500 index net of
fees,
ending
with
an
average
ratio
of
93
percent
to 97
percent.
On
average,
therefore, they do not find the outperformance often given as a justification for investing in private equity funds. At the same time, however, these results imply that the private equity investors outperform the Standard and Poor's 500 index gross of fees
(that
is, when
fees
are
added
back).
Those
returns,
therefore,
are
consistent
with private equity investors adding value (over and above the premium paid to selling shareholders). At least two caveats are in order. First, Kaplan and Schoar (2005) use data from VentureEconomics which samples only roughly half of private equity funds, leaving an unknown
and
potentially
important
selection
bias.
Second,
because
of data
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avail
Leveraged Buyouts and Private Equity
issues,
ability
and
Kaplan
Schoar
compare
to the Standard
performance
500 index without making any adjustments for risk. Kaplan and Schoar (2005) also find strong evidence mance?that
mance
is, performance
private
because
In contrast,
funds
persistence
little
show
result
are
funds
worst-performing
mutual
This
persistence.
the
equity
of persistence
in one
firm
fund
Poor's
in perfor
predicts
perfor
funds. In fact, their results likely understate
by the firm in subsequent
persistence fund.
by
a
and
137
persistence
explains
less and
limited
why
likely hedge
a
to raise funds often
partners
subsequent
show
uncertain
strive
to invest
in private equity funds thathave been among the top performers in the past (Swensen, Of
2000).
course,
only
some
limited
partners
can
succeed
in such
a
strategy.
Phalippou and Gottschalg (forthcoming) use a slightly updated version of the Kaplan and Schoar (2005) data set. They obtain qualitatively identical results to (2005) for the average returns and persistence of private Kaplan and Schoar funds relevant here.
equity/buyout
Boom
and Bust Cycles in Private Equity
Portfolio Company The
of
pattern
decades
suggests
Level
that
equity
private credit
market
commitments conditions
and
may
transactions
affect
this
activity.
over One
recent hypoth
esis is that private equity investors take advantage of systematic mispricings in the debt and equity markets. That is,when the cost of debt is relatively low compared to the cost of equity, private equity can arbitrage or benefit from the difference. This argument relies on the existence of market frictions that enable debt and equity markets to become and Wurgler Greenwood, of market
advantage
(2000) and Baker, segmented. Baker and Wurgler take (2003) offer arguments that public companies
mispricing.
see how debt mispricing might matter, assume that a public company is run a can and If firm borrow at a rate unleveraged private equity being optimally. too low given the risk, the private equity firm will create value by borrowing. that is To
In
the
recent
wave,
interest
rate
spreads
for
private
equity
borrowing
increased
from roughly 250 basis points over the benchmark LIBOR (London Interbank in 2006 to 500 basis points over LIBOR Offered Rate) in 2008 (Standard and Poor's, 2008). Under the assumptions that debt funds 70 percent of the purchase
price and has a maturity of eight years, debt mispricing of 250 basis points would justify roughly 10 percent of the purchase price or, equivalently, would allow a
private equity fund investor to pay an additional 10 percent (that is, the present value of an eight-year loan for 70 discounted at the higher interest rate is 60, not 70). The mispricing theory implies that relatively more deals will be undertaken when debt markets are unusually favorable. Kaplan and Stein (1993) present
consistent with a role for overly favorable terms from high-yield bond investors in the 1980s buyout wave. The credit market turmoil in late 2007 and early
evidence
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138
Journal ofEconomie Perspectives
Figure 3
in Large U.S. Public-to-Private Buyouts, 1982 to 2006 Enterprise Value to EBITDA " a measure cash (UEBITDA, of flow, standsfor earnings before interest,taxes, depreciation, and amortization) 12.00 10.00 8.00 6.00 4.00 2.00 0.00
\\\\\\\\
\\\\\%\\\\
Source: Kaplan and Sein (1993) and Guo, Note: The first private equity wave began in 2007. 2003 or 2004 and ended
and Song (2007). Hotchkiss, in 1982 or 1983 and ended in 1989;
the second
began
in
2008 suggests that overly favorable terms from debt investors may have helped fuel the buyout wave from 2005 through mid-2007. To study buyout market cyclicality, we make more detailed "apples-to-apples" comparisons of buyout characteristics over time by combining the results in Kaplan
(1993) for the 1980s buyout wave with those in Guo et al. (2007) for the last ten years. Both papers study public-to-private transactions in the United States. First, we look at valuations or prices relative to cash flow. To measure the price
and Stein
paid for these deals, we calculate enterprise value as the sum of the value of equity and net debt at the time of the buyout. Firm cash flow is calculated using the standard measure
of firm-level performance, EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. Figure 3 reports themedian ratio of enterprise value to cash flow for leveraged buyouts by year. The figure shows that prices paid for cash flow were generally higher at the end of the buyout
waves
than at the beginning. (The firstprivate equity wave began in 1982 or 1983 and ended in 1989; the second began in 2003 or 2004 and ended in 2007.) The more recent period, in particular, exhibits a great deal of cyclicality, first dipping substantially from 2000 through 2002, and then rising afterwards. Figure 3 also shows that valuation multiples in the recent wave exceeded those
in the 1980s wave, although this conclusion is open to some interpretation. In to were higher in the last decade ratios all of values cash flow corporate general,
the ratios in Figure 3 are deflated by the median ratio for nonfinancial companies in the Standard and Poor's 500 index, the valuations of to the Standard and Poor's 500 are slightly lower in deals relative leveraged buyout than in the 1980s. When
the
recent
wave
relative
to
the
previous
wave.
Even
after
such
a
calculation,
cyclicality of the recent wave remains.
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the
StevenN. Kaplan
and Per Str?mberg
139
Figure 4 EBITDA
to Interest in Large U.S. Public to Private Buyouts, 1982 to 2006 " a measure of cashflow, standsfor earnings before interest,taxes, ("EBITDA, depreciation, and amortization)
\\\\\W\
'%W\\W\X'
Source: Kaplan and Stein (1993) and Guo, Hotchkiss, and Song (2007). Note: The first private equity wave began in 1982 or 1983 and ended in 1989. The in 2007. in 2003 or 2004 and ended equity wave began
second
private
Next, we look at changes compare the ratio of equity used
in leverage buyout firm capital structures. We to finance leveraged buyouts in each time period and find that the share of equity used to finance leveraged buyouts was relatively constant in the firstwave at 10 percent to 15 percent and relatively constant in the second wave, but at roughly 30 percent. This striking increase in equity percentage from one era to the other is both a prediction of and consistent with the arguments in Kaplan
and Stein
that debt
investors offered overly favorable terms, particularly too much leverage, in the buyout wave of the 1980s. Valuations relative to a standardized measure of profits?EBITDA (earnings (1993)
interest, taxes, depreciation and amortization)?were higher in the recent were rates lower. Interest also changed. Figure 4 combines wave, but debt levels to forecast interest for the lever these factors by measuring the ratio of EBITDA before
of the aged buyouts of the two eras. This interest coverage ratio is a measure a transaction. ratio it of When this is that the lower, fragility buyout implies buyout ismore fragile, because the firm has less of a cushion from not being able tomeet interest payments. Figure 4 has two interesting implications. First, interest coverage ratios are higher in the recent wave, suggesting the deals are less fragile. Second, the cyclical pattern of the second wave remains. Coverage ratios are higher from
2001 to 2004 than in the periods before and after. Leveraged buyouts of the most recent wave also have been
associated
with
more
liberal repayment schedules and looser debt covenants. Consistent with this, we find patterns similar to (if not stronger than) those in Figure 4 when we factor in debt principal repayments. Demoriglu and James (2007) and Standard and Poor's (2008) also confirm that loan covenants became less restrictive at the end of the
recent
wave.
Figure 5 considers
cyclicality in private equity in one additional
way. It com
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140
Journal ofEconomie Perspectives
Figure 5 Standard
Value Less High-Yield Rates, 1985-2006 8e Poor's EBITDA/Enterprise " a measure stands cash ("EBITDA, of flow, for earnings before interest,taxes, depreciation, and amortization) 4.00% T
for S&P 500 companies less Merrill Lynch High-Yield Master Value EBITDA/Enterprise is the sum of market value of equity, book value of long (Cash Pay Only) Yield. Enterprise Value and short-term debt less cash and marketable securities.
Note: Median
to enterprise value for the Standard & Poor's pares the median ratio of EBITDA rate on to the interest 500, average high-yield bonds?the Merrill Lynch High Yield 1985 to 2006. In particular Figure 5 looks at from (cash pay bonds)?each year
measures the relation between operating earnings yield net of interest rate. This the cash flow generated per dollar of market value by the median company in the Standard & Poor's 500 and the interest rate on a highly leveraged financing. One can interpret thismeasure as the excess (or deficit) from financing the purchase of an entire company with high-yield bonds.
pattern is suggestive. A necessary (but not sufficient) condition for a on private equity boom to occur is for earnings yields to exceed interest rates true in in boom late-1980s boom and the This held the bonds. pattern high-yield The
earnings yields are less than interest rates from high-yield bonds, private equity activity tends to be lower. These patterns suggest that the debt used in a given leveraged buyout may be driven more by credit market conditions than by the relative benefits of leverage for of 2005 and 2006. When
operating
the firm. Axelson, Jenkinson, Str?mberg, and Weisbach (2008) find evidence consistent with this in a sample of large leveraged buyouts in the United States and Europe 1985-2007. They find that leverage is cross completed between to leverage in similar-size, same industry, public sec tionally unrelated to firm-specific factors that explain is unrelated leverage in public
firms and firms. In
stead, leveraged buyout capital structures are most strongly related to prevailing in leveraged buyouts debt market conditions at the time of the buyout. Leverage decreases
as
interest
rates
rise.
The
amount
of
leverage
available,
in turn,
seems
the firm. that the private equity fund pays to acquire that and Wofenzon find Richardson, (2007) private equity Similarly, Ljungqvist, funds accelerate their investment pace when interest rates are low. These results are to affect the amount
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Leveraged Buyouts and Private Equity
consistent with the notion in the
private
that debt financing availability affects booms
141
and busts
market.
equity
patterns raise the question as towhy the borrowing of public firms does not follow the same credit market cycles. One potential is that public explanation firms are unwilling to take advantage of debt mispricing by increasing leverage, These
either
because
dislike
managers
or
debt
because
about high debt levels. A second explanation access
to credit
markets
because
are
they
market
public
investors
worry
is that private equity funds have better which
borrowers,
repeat
enables
to
them
build reputation with lenders. Recent papers by Ivashina and Kovner (2008) and Demiroglu and James (2007) suggest thatmore prominent private equity funds are to obtain
able
loans
cheaper the
is that
explanation
and
looser
covenants
debt
structures
compensation
than
of
private
incentives to take on more
Private Equity Fund Level The time series of private equity fund commitments a boom
by
the
studying we
First,
A
lenders. funds
equity
third
provide
debt than is optimal for the individual firm (Axelson, and Weisbach, forthcoming).
Jenkinson, Str?mberg,
to exhibit
other
and
bust
relation
pattern.
between
consider
the
In
this
section,
commitments
relation
earlier appear
this more
consider
closely
returns.
and
between
examined
we
private
equity
and
fundraising
subse
quent private equity fund returns. Table 3 presents illustrative regressions inwhich the dependent variable is the capital-weighted return to all private equity funds in a
raised
returns
year
vintage
Venture the
addition, their
to this as
refer
for U.S.
private
the
equity
returns
Economics
may
returns
have
the more
that
funds
not
does
from
comprise over time.
change
for
recent
Venture
all
is
private
are
probably
the as
of
are noisy funds.
equity
years
use
We
Economics
return measures
vintage
factor
(This
return."
year
"vintage
funds
2007 for vintage years 1984 to 2004. The
September because
year. We
particular
In
still active
and
because
unimportant
we obtain similar results when we eliminate all vintages after 1999.) As independent we
variables, the
ing
year
1 to 4 in Table
Regressions
vintage
subsequent
to
committed
capital
vintage
previous
and
use
private
to
relative
the
total
value
year
a
Including
the
of
3 indicate a strong negative returns.
in the
funds
equity
vintage
U.S.
and
year
stock
market.
relation between fundrais
time
trend
does
not
affect
the
this simple regression finding can only be considered illustrative of patterns, it suggests that inflows of capital into private equity funds in a
results. While broader
year
given
can
into
private
these
returns
fund
is associated
consider
regressions,
the the
with
lower
variables by
to which
extent
dependent
Venture
are
the
two
Economics.
that
regressions).
The
vintage
year
affect
is the annual
stock market returns
year's
previous
Note
returns
past
variable
the
annual
different from the vintage year return (which was previous
ten-
subsequent
to twelve
returns.
subsequent
private equity funds as a fraction of the U.S. independent as reported
the
during
these funds are active. It strongly suggests that an influx of capital
equity we
Next In
realized
explain
year period when
return
commitments.
capital
capital
from 1987 to 2006. The to
return
private to
the
again,
equity, private
the dependent
measures
to U.S.
committed
annual
equity
variable return
This content downloaded from 129.79.119.131 on Tue, 18 Aug 2015 18:29:11 UTC All use subject to JSTOR Terms and Conditions
is
in the to all
142
Journal ofEconomie Perspectives
Table 3 Relation
of Private Equity Returns
inUnited
and Fundraising
States
A
Panel
variable: Vintage year average internal rate of return to private equity (capital weighted) from 1984 to 2004
Dependent
equity commitments t stock market, Private equity commitments
Private
stock market,
(6.2) -32.60**
to
0.35
0.35
(7.2) -20.79*
(7.5)
(7.0)
(-1.6) -28.66**
(-2.4) to
-36.87***
t-\
(-2.2)
(-3.0)
equity commitments t+ t-\ stock market, Trend Private
Adjusted
0.31
0.31
Constant
(4)
(3)
(2)
(1)
to
-24.78***
(-1.0) 0.36
(-1.2) 0.28
R2
(-3.5) -0.002
-0.003
-0.004
Panel
-0.002 (-0.8) 0.41
(-0.8) 0.44
B
!variable: Private equity commitments toStockMarket, tfrom (as a fraction of the total value of theU.S. stockmarket)
1984 to 2007
(2)
(1) -0.091
Constant Annual
private equity return,
t-\
Annual
private equity return,
t-2
Trend
Adjusted
R2
-0.292
(-0.7) 0.007**
(-1.8) 0.008***
(2.1)
(2.6) 0.007**
0.031***
(2.4) 0.031***
(4.1) 0.40
(4.6) 0.50
internal rate of return is the average internal rate of return to U.S. equity vintage year a given year, according to Venture Economics. Mean vintage year internal rate raised in funds private equity are of return is 16.5 percent. Private equity commitments capital committed to U.S. private equity funds from Private Equity Analyst as a fraction of the total value of the U.S. stock market. Mean private equity return to all U.S. private return is the annual are 0.43 percent. Private equity annual commitments
Note: Private
equity funds according
to Venture Economics. Mean
parentheses. *** indicate *, **, and
statistical significance
raised
funds return
is a
in a
particular
geometric
year
average
annual
return is 18.6 percent.
at the 10, 5, and
over
the
of many
life of years
1 percent
the
of
errors are in
levels, respectively.
is, the vintage
fund?that
returns.
Standard
In
contrast,
the
year annual
return to private equity is the return to all private equity funds of different vintages in a
given Again,
calendar these
year. regressions
are meant
sions in panel B, capital commitments
only
to be
suggestive.
are positively and
In
these
two
regres
significantly related
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to
StevenN Kaplan
lagged
private
returns?in
equity
returns. The positive fund
equity To
more
when
with a boom
Some
time
above
regressions,
when
any
private
to
follow
good
class.
returns
realized
factors.
cyclical
returns
fund
equity
to this asset
is committed
to decline
tend
equity
over
the
capital
seem
investors
words,
143
trend is consistent with significant secular growth in private
commitments
summarize
other
and Per Str?mberg
Capital
decline.
to decline
tend
to
commitments
These
are
patterns
private
consistent
and bust cycle in private equity.
Speculations
empirical evidence is strong that private equity activity creates economic value on average. We suspect that the increased investment by private equity firms The
in operational a
has
activity
will ensure
engineering
Because
future.
creates
equity
private substantial
permanent
that this result continues
economic
value,
we
believe
to hold
that
in the
private
equity
component.
However, the evidence also is strong that private equity activity is subject to boom and bust cycles, which are driven by recent returns as well as by the level of rates
interest particularly
to
relative true
for
and
earnings
larger
stock
market
substantially?when
seems
pattern
interest rates on buyout-related debt
is even
debt
buyout
This
transactions.
public-to-private
From the summer of 2007 intomid-2008,
increased
values.
at all. At
available
same
the
time,
corporate earnings have softened. In this setting, private equity activity is likely to be relatively low, particularly large public-to-private buyouts. Institutional investors are
to continue
likely
because
reported 2007,
September
to make private
Venture
not
have
Economics
reports
three years of 15.3 percent versus Standard 12.7
private
private
equity but
declined, equity
and Poor's
for
are
returns
a
at
time,
still
robust.
over
the
500 stock market
least, As
of
previous
returns of
percent.
likelihood
The robust
debt
while
not
expect
to private equity funds remain
that investors' commitments
markets
remain
unfavorable
to invest the capital committed. Given do
to
commitments
returns
that many
private
equity
will
create
pressure
for
private
firms
the fee structure of private equity funds, we firms
will
return
the money.
However,
these
patterns suggest that the structure of private equity deals will evolve. investments with less First, we suspect that private equity firms will make at least initially.While this change may reduce themagnitude of expected leverage, returns (and compensation),
change
risk-adjusted
as long as the private equity firms add value, itwill not
returns.
Second, we suspect that private equity firmswill be more likely to takeminority rather than buying the entire equity positions in public or private companies company. both
Private equity firms have experience
in venture
capital
investments
and
with minority equity investments,
in overseas
investments,
particularly
in
relatively new operational engineering capabilities of private equity firms may put them in a better position to supply minority investments than in the past, because private equity firms can provide additional value without having full Asia. The
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144
Journal ofEconomie Perspectives
control.
Moreover,
and
executives
top
boards
of
public
companies
may
have
an
and hedge fund increased demand for minority equity investments. Shareholder activism and hostility have increased substantially in recent years (Brav, Jiang, Partnoy, and Thomas et al., forthcoming). In the face ofthat hostility, private equity firms are likely to be perceived as partners or "white knights" by some chief officers
executive
and
boards.
Finally, what will happen private equity boom of 2005
to funds and
transactions completed in the recent It seems plausible that the ultimate
to mid-2007?
returns to private equity funds raised during these years will prove disappointing because firms are unlikely to be able to exit the deals from this period at valuations as high as the private equity firmspaid to buy the firms. It is also plausible that some
during the boom were less driven by the potential of operating and governance improvements, and more driven by the availability of debt financing, which also implies that the returns on these deals will be disap of the transactions undertaken
pointing. If and
when
private
returns
equity
decline,
private
commitments
equity
also
will decline. Lower returns to recent private equity funds are likely to coincide with some failed transactions, including debt defaults and bankruptcies. The relative magnitude of defaults and failed deals, however is likely to be lower than after the a downturn of roughly similar previous boom in the early 1990s, assuming magni returns for this period may disappoint, the transactions tude.While private equity of
the
recent
wave
had
higher
coverage
ratios
debt than those of the 1980s, which reduces will subsequently default.
and
looser
debt
the likelihood
covenants
on
their
that those companies
This research has been supported by theKauffman Foundation, theLynde and Harry Bradley Foundation, and theOlin Foundation throughgrants to theStigler Centerfor the Study of theEconomy and, theState, and by theCenterfor Research in SecurityPrices. We thankJimHines, Antoinette Schoar, Andrei Shleifer,JeremyStein, Timothy Taylor, and Mike
Wright for very helpful comments.
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143-64. 27(1): and Poor's. Standard Review
of Financial
2008.
Economics,
Leveraged Lending
1Q08.
http://www.lcdcomps.com/pg/ research/us_research.html. Stein, Jeremy. 2005. "Why Are Most Funds
Open-End?
Competition
trage." Quarterly 247-72. of
Str?mberg, Private
Journal
Per. 2008. Equity."
and
the Limits of Arbi
of Economics,
120(1):
"The New Demography http://www.sifr.org/
pelle.html. Swensen, David. 2000. Pioneering Portfolio Man to Institu agement: An Unconventional Approach tional Investment. New York: Free Press. Weir, Charlie, Peter Jones, and Mike Wright. Private Eq 2007. "Public to Private Transactions, in the UK: An Empirical uity and Performance Analysis
of the Impact of Going
Private." http://
papers, ssrn.com/sol3/papers.cfm?abstract_ id= 1138616. 1996. "Higher Market Valu Yermack, David. with a Small Board of Direc ation of Companies to ys.""Journal ofFinancial Economics, 40(2): 185 211.
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Journal ofEconomie Perspectives?Volume
23, Number 1?Winter 2009?Pages
121-146
Buyouts and Private Equity
Leveraged
Steven N. Kaplan
and Per Str?mberg
a leveraged buyout, a company is acquired by a specialized investment firm a relatively large portion of using a relatively small portion of equity and outside debt financing. The leveraged buyout investment firms today refer to
In
(and are generally referred to) as private equity firms. In a typical an leveraged buyout transaction, the private equity firm buys majority control of existing or mature firm. This arrangement isdistinct from venture capital firms that themselves
or emerging companies, and typically do not obtain typically invest in young In this control. paper, we focus specifically on private equity firms and the majority in which they invest, and we will use the terms private equity and leveraged buyouts leveraged buyout
interchangeably. buyouts first emerged
Leveraged 1980s. As leveraged predicted dominant
as an
activity increased
important phenomenon in that decade, Jensen
in the
(1989) buyout that the leveraged buyout organizations would eventually become the form. He argued that the private equity firm corporate organizational
itself combined
stakes in its portfolio companies, ownership for the private equity firm professionals, and a lean, with minimal overhead costs. The private equity firm then
concentrated incentives
high-powered efficient organization
managerial compensation, highly leveraged capital applied performance-based to the structures (often relying on junk bond financing), and active governance
isNeubauer Family Professor ofEntrepreneurship and Finance, Uni Steven N. Kaplan School ofBusiness, Chicago, Illinois. Per Str?mberg isProfessor Graduate versityof Chicago
ofFinance at theStockholm School ofEconomics and Director of theInstitutefor Financial Research (SIFR), both in Stockholm, Sweden. Both authors are also Research Associates, National
are
Bureau
of
Economic
([email protected])
Research,
Cambridge,
Massachusetts.
Their
and ([email protected]).
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addresses
122
Journal ofEconomie Perspectives
in which
companies
invested.
and
leverage,
weak
to
According
to those of the typical public
superior low
it
A
governance.
corporate
with dispersed
corporation
few
shareholders, this
later,
years
were
structures
these
Jensen,
prediction
junk bond market crashed; a large number of high profile leveraged buyouts resulted in default and bankruptcy; and leveraged (so called public-to-private transactions) virtually buyouts of public companies by the early 1990s. disappeared seemed
The
premature.
But the leveraged buyout market had not died?it was only in hiding. While leveraged buyouts of public companies were relatively scarce during the 1990s to purchase private companies and early 2000s, private equity firms continued In
divisions.
and
the United buyout
the mid-2000s,
States
transactions
public-to-private
the rest of the world)
(and
when
reappeared
a second
experienced
leveraged
boom.
In 2006 and 2007, a record amount of capital was committed terms
in nominal
both
and
commitments
as
and
a fraction
of
rivaled,
if not
transactions
the overall
stock
overtook
the
to private equity,
market.
Private
equity
the first wave
of
activity
in the late 1980s that reached
its peak with the buyout of RJR Nabisco in 1988. in in with the turmoil the debt However, 2008, markets, private equity appears to have declined again. start the paper by describing
We describe the
equity
private
fundraising,
equity
typical
or SunGard
RJR Nabisco
leveraged
and
as
such
characteristics
and
KKR,
the
of
buyout
on how private
evidence
present
transaction
and
Carlyle,
transaction,
buyout
Systems. We
Data
activity,
as Blackstone,
such
organizations
of a
components
how the private equity industry works. We
have
over
varied
time.
The
article in
changes that
private
then considers structures,
capital
investors
equity
on
value
economic
and
This
then
evidence At
average.
equity. We and
incentives,
management introduce,
the effects of these changes. creates
the effects of private review
describe governance
corporate
the
the
evidence
empirical
on
suggests that private equity activity same
the
there
time,
is also
evidence
consistent with private equity investors taking advantage of market timing (and market mispricing) between debt and equity markets particularly in the public-to private
transactions also
We equity boom
at and
of
review
the
fund
bust
the
the
15 years.
that
on
evidence
empirical
level.
cycles
last
Private
equity
are
returns
past
returns
and to
appears
activity to
related
the economics
and
to
experience to
the
level
private
recurring of
interest
rates relative to earnings. Given that the unprecedented boom of 2005 to 2007 it seems likely that there will be a decline in private equity
has just ended, investment boom
may
and
in
fundraising
eventually
lead
to
the
some
next
several
defaults
and
years.
While
investor
the losses,
recent the
market
magnitude
is likely to be less severe than after the 1980s boom because capital structures are less fragile and private equity firms are more sophisticated. Accordingly, we expect that a significant part of the growth in private equity activity and institutions
is permanent.
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StevenN. Kaplan
Private
Firms,
Equity
Blackstone,
and
Carlyle,
with
organizations
as a
are
KKR
equity firms. In the late 1980s, Jensen decentralized
123
and Transactions
Funds,
Private Equity Firms The typical private equity firm is organized corporation.
and Per Str?mberg
few
relatively
the most
prominent
private
these firms as
described
(1989)
or limited liability
partnership of
three
investment
lean, em
and
professionals
ployees. In his survey of seven large leveraged buyout partnerships, Jensen found an 13
of
average
investment
who
professionals,
tended
to come
an
from
investment
banking background. Today, the large private equity firms are substantially larger, are still small relative to the firms in which they invest. KKR's S-l (a although they in preparation for KKR's form filed with the Securities and Exchange Commission initial public offering) reported 139 investment professionals
other
large
firms
equity
private
to have
appear
more
sionals. In addition, private equity firms now appear wider
of
variety
and
skills
was
than
experience
true
than
in 2007. At least four
100
investment
profes
to employ professionals with a 20
years
ago.
Private Equity Funds A private equity firm raises equity capital through a private equity fund. Most private a
equity
are
funds
amount
certain
"closed-end"
of money
vehicles
to pay
for
in which
investors in
investments
to
commit as well
companies
provide as man
agement fees to the private equity firm.1 Legally, private equity funds are organized as limited partnerships in which the general partners manage the fund and the limited partners provide most of the capital. The limited partners typically include institutional and
insurance as
serves
such
investors,
the
companies, fund's
as
as
public
is customary
funds,
pension
individuals.
wealthy It
partner.
general
and
corporate
as well
The for
the
endowments,
private
firm
equity
to
partner
general
provide at least 1 percent of the total capital. The fund typicallyhas a fixed life,usually ten years, but can be extended forup to three additional years. The private equity firm normally has up to five years to invest the fund's capital committed into companies, and then has an additional five to eight years to return the capital to its investors.After committing their capital, the limited partners have little say in how the general partner deploys the investment funds, as long as the
basic
covenants
of
the
fund
agreement
are
followed.
Common
covenants
include
fund capital can be invested in one company, on types of securities a fund can invest in, and on debt at the fund level (as opposed to debt at the portfolio company level,which isunrestricted). Sahlman (1990), Gompers and Lerner restrictions on how much
(1996), and Axelson,
rationale
for
The the
1
equity
private
partner
general
In a "closed-end"
Str?mberg, and Weisbach
fund
these
fund,
(forthcoming) discuss the economic
structures. firm
earns
or an
is
general
partner
annual
management
investors cannot
withdraw
in three
compensated fee,
their funds until
usually
the fund
a
(2005)
of
is terminated.
funds, for example, where investors can withdraw their funds whenever for an economic funds. analysis of closed- vs. open-end
contrasts with mutual See Stein
First,
ways.
percentage
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This
they like.
124
Journal ofEconomie Perspectives
and
committed,
capital
the
Second,
employed.
to as
referred
"carried
as
then,
are
investments earns
partner
general
that
interest,"
almost
on
evidence
empirical
For
assume
example,
those a
that
share
always
general partners charge deal and monitoring invest. Metrick and Yasuda (2007) describe provide
a
a
realized, of
of
percentage
the
of
profits
20 percent.
equals
capital
the
fund, some
Finally,
fees to the companies inwhich the structure of fees in detail
they and
fees.
private
equity
firm, ABC
Partners,
a
raises
private
equity fund, ABC I, with $2 billion of capital commitments from limited partners. At a 2 percent management fee, ABC Partners would receive $40 million per year for the five-year investment period. This would decline over the following five years as ABC exited or sold its investments. The management fees typically end after ten years, although the fund can be extended thereafter. ABC would invest the differ ence between the $2 billion and the cumulative management fees into companies. IfABC's investments turned out to be successful and ABC was able to realize
would be entitled to a $6 billion from its investments?a profit of $4 billion?ABC carried interest or profit share of $800 million (or 20 percent of the $4 billion tomanagement fees of $300 to $400 million, ABC partners would profit). Added
have received a total of up to $1.2 billion over the fund's life. In addition,
sometimes
partners
general
are paid
deal
charge
and
fees
monitoring
that
to the general partner by the portfolio companies not by the limited partner. The extent to which these fees are shared with the limited partners is a issue
contentious
somewhat
in
fundraising
These
negotiations.
fees
are
commonly
split 50-50 between general and limited partners. The Private Equity Analyst (2008) lists 33 global private equity firms (22 U.S. at the end of 2007. based) with more than $10 billion of assets under management The same publication lists the top 25 investors in private equity. Those investors are (California Public Employees' by public pension funds, with CalPERS CalSTERS State Teachers' Retirement System), (California System), Public School Retirement System), and theWash (Pennsylvania Employees'
dominated
Retirement PSERS
ington State Investment Board
the top four slots.
occupying
Private Equity Transactions In a typical private equity transaction, the private equity firm agrees to buy a company. If the company is public, the private equity firm typically pays a premium
of 15 to 50 percent over the current stock price (Kaplan, 1989b; Bargeron, Schlingemann, Stulz, and Zutter, 2007). The buyout is typically financed with 60 to the term, leveraged buyout. The debt almost always 90 percent debt?hence includes
a
loan
portion
that
is senior
and
secured,
and
is
arranged
by
a bank
or
an
investment bank. In the 1980s and 1990s, banks were also the primary investors in these
loans.
More
recently,
fraction of the senior and investors
and
"collateralized
however,
institutional
secured
loans. Those
loan
obligation"
managers,
investors
a
purchased
investors include hedge who
combine
a number
large
fund of
term loans into a pool and then carve the pool into different pieces (with different seniority) to sell to institutional investors. The debt in leveraged buyouts also often includes a junior, unsecured portion that is financed by either high-yield
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Leveraged Buyouts and Private Equity
Figure 1 U.S. Private Equity Fundraising and Transaction U.S. Stock Market Value from 1985 to 2007
Values
as a Percentage
125
of Total
,_,
3.50%n
Sources: Private Equity Analyst, CapitallQ,
bonds or "mezzanine
Str?mberg
(2008),
authors'
calculations.
(that is, debt that is subordinated to the senior debt). (2007) and Standard and Poor's (2008) provide more
debt"
and James Demiroglu detailed descriptions.
The private equity firm invests funds from its investors as equity to cover the team of remaining 10 to 40 percent of the purchase price. The new management the purchased
(which may or may not be identical to the pre-buyout typically also contributes to the new equity, although the
company
team) management amount is usually a small fraction of the equity dollars contributed. 2005 buyout of Sun (2005) describes a large leveraged buyout?the Kaplan Gard Data Systems?in detail. Axelson, Jenkinson, Str?mberg, and Weisbach (2008) provide a detailed
description
of capital structures in these kinds of lever
aged buyouts. to Private Equity Funds Private equity funds first emerged in the early 1980s. Nominal dollars committed each year to U.S. private equity funds have increased exponentially since then, from
Commitments
$0.2 billion in 1980 to over $200 billion in 2007. Given the large increase in firmmarket values over this period, it ismore appropriate to measure committed capital as a
percentage of the total value of theU.S. stockmarket. The deflated series, presented in Figure 1, suggests thatprivate equity commitments are cyclical. They increased in the 1980s, peaked in 1988, declined in the early 1990s, increased through the late 1990s,
peaked in 1998, declined again in the early 2000s, and then began climbing in 2003. By 2006 and 2007, private equity commitments appeared extremely high by historical standards, exceeding 1 percent of the U.S. stock market's value One caveat to this observation
is that many of the large U.S. private equity firms have only recently global in scope. Foreign investments by U.S. private equity firms were much smaller 20 years ago, so the comparisons are not exacdy apples to apples.
become
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126
Journal ofEconomie Perspectives
Figure 2 Global Private Equity Transaction
Volume,
1985-2006
information on capital commitments to Although we do not have comparable non-U.S. funds, it is clear that they also have grown substantially. In 2007, the Private Equity Analyst lists three non-U.S. private equity firms among the twelve largest in the world
in assets
under
management.
Private Equity Transactions Figure 2 shows the number
and
combined
transaction value
of worldwide
leveraged buyout transactions backed by a private equity fund sponsor based on In total, 17,171 private equity-sponsored buyout transactions data from CapitallQ. occurred from January 1, 1970, to June 30, 2007. (This excludes transactions
but not completed by November 1, 2007.) Transaction values equal the enterprise value (market value of equity plus book value of debt minus cash) of the transaction values are not acquired firms, converted into 2007 U.S. dollars. When announced
(generally smaller, private-to-private deals), we impute values as a func tion of various deal and sponsor characteristics. Figure 1 also uses the CapitallQ data to report the combined transaction value of U.S. leveraged buyouts backed by a private equity fund sponsor as a fraction of total U.S. stock market value. recorded
and discusses potential Str?mberg (2008) describes the sampling methodology biases. The most important qualification is that CapitallQ may underreport private equity transactions before the mid-1990s, particularly smaller transactions. Overall
buyout transaction activitymirrors the patterns in private equity fund Transaction and fundraising volumes exhibit a similar cyclicality. Transac raising. tion values peaked in 1988; dropped during the early 1990s, rose and peaked in the later 1990s, dropped in the early 2000s; and increased dramatically from 2004 to
2006. A huge fraction of historic buyout activity has taken place within the last few recorded 5,188 buyout transactions years. From 2005 through June 2007, CapitallQ
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StevenN. Kaplan
and Per Str?mberg
127
Table 1 Global
1985-1989
LBOs
1990-1994
$257,214 642
enterprise value of transactions
Combined Number
across Time
Characteristics
Buyout Transaction
Leveraged
2000-2004
1995-1999
,614
$553,852
1,123
L,055,070
4,348
2005-6/
1970-6/
30/2007
30/2007
1,563,250
$3,616,787
5,188
5,673
17,171
by type: (% of combined
enterprise value) Public to private
49% 31% 17% 2% 0%
private
Independent Divisional Secondary Distressed
54% 31% 6% 1%
15% 44% 27% 13% 1%
18% 19% 41% 20%
34% 14% 25% 26% 1%
27% 23% 30% 20%
72% 13% 13%
60% 16% 20%
44% 17% 32%
47% 15% 30%
52% 15% 26%
4%
6%
4% 3%
by target location: (% of combined
LBOs
enterprise value) United States and Canada United Western
7%
Kingdom
UK)
Europe
(except
1% 2%
3%
Asia and Australia Rest ofWorld
3%
for 17,171 worldwide table reports transaction characteristics leveraged buyout transactions database announced between every transaction with a financial sponsor in the CapitallQ sum is net the of to pay for the value and and 6/30/2007. debt used 1/1/1970 Enterprise equity of 2007 U.S. dollars. For the transactions where in millions transaction value was not enterprise
Note: The
that include
recorded,
these have been
imputed using
in Str?mberg
the methodology
(2008).
estimated enterprise value of over $1.6 trillion (in 2007 dollars), with those 2*/2years accounting for 30 percent of the transactions from 1984 to 2007 and
at a combined 43
of
percent
total
the
real
transaction
value,
respectively.
2006 Although Figure 2 only includes deals announced through December 2007), the number of announced (and closed by November leveraged buyouts continued to increase until June 2007 when a record number of 322 deals were
After that, deal activity decreased substantially in the wake of the new buyouts were announced. In in markets. 133 turmoil credit January 2008, only
announced. As
the
private
market
equity
evolved, as summarized The
analysis. some
extent
first, a U.K.,
late
has
in Table 1980s
buyout
grown,
wave From
phenomenon.
transaction
1; Str?mberg was
(2008)
presents a U.S.,
primarily
1985-89,
these
also
characteristics
three
a more
and
Canadian, countries
have
detailed to
accounted
for 89 percent of worldwide leveraged buyout transactions and 93 percent of transaction value. The leveraged buyout business was dominated by worldwide relatively
large
transactions,
in mature
industries
(such
as
manufacturing
and
retail); public-to-private deals accounted for almost half of the value of the trans actions. These transactions in the first buyout wave helped form the perception of private equity that persisted formany years: leveraged buyouts equal going-private transactions
of
large
firms
in mature
industries.
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128
Journal ofEconomie Perspectives
Following the fall of the junk bond market in the late 1980s, public-to-private activity declined significantly, dropping to less than 10 percent of transaction value, while the average enterprise value of companies acquired dropped from $401 million to $132 million (both in 2007 dollars). Instead, "middle-market" buyouts of traded firms?either independent companies or divisions of larger non-publicly for the bulk of private equity significantly and accounted new as information to industries such activity. Buyout activity spread technology/ corporations?grew
financial
media/telecommunications,
ing and retail firms became value
transaction
as
twice
fell,
and
services,
were
deals
many
care
health
as buyout
less dominant
while
manufactur
targets. Although in
undertaken
aggregate versus
1990-94
1985-89. As private equity activity experienced steady growth over the following period a in for the market continued to evolve. from 1995-2004 2000-2001), dip (except
Public
company
accounted
An
transactions.
increased,
buyouts
for over
80
of
percent
transaction
fraction
increasing
buyouts of private companies
although of
buyouts
more
value
and
were
so-called
than
90
still of
percent
secondary
buyouts?
private equity funds exiting their old investments and selling portfolio companies to other private equity firms. By the early 2000-2004 period, secondary buyouts comprised over 20 percent of total transaction value. The largest sources of deals in this
were
however,
period,
large
corporations
off divisions.
selling
theWestern Euro Buyouts also spread rapidly to Europe. From 2000-2004, market the United had 48.9 percent of pean private equity (including Kingdom) worldwide leveraged buyout transaction value, compared with 43.7 percent in the States. The scope of the industry also continued to broaden, with compa nies in services and infrastructure becoming increasingly popular buyout targets. The private equity boom from 2005 to mid-2007 magnified many of these
United
trends.
Public-to-private
together accounting
over
value
transaction
and
formore this
secondary
grew
buyouts
in numbers
rapidly
and
size,
than 60 percent of the $1.6 trillion leveraged buyout
time.
in
Buyouts
industries
nonmanufacturing
contin
to grow in relative importance, and private equity activity spread to new parts of the world, particularly Asia (although levels were modest compared toWestern
ued
and
Europe
As
America).
(deflated) deal
average
large
transactions
public-to-private
sizes almost tripled between
returned,
2001 and 2006.
and Timing of Exit
Manner
Because ment
North
exits
most are
an
private important
equity aspect
funds of
have the
a
private
limited
contractual
equity
process.
lifetime, Table
invest
2 presents
statistics on private equity investment exits using the CapitallQ buyout sample. The top panel shows the frequency of various exits. Given that so many leveraged
buyouts occurred recently, it is not surprising that 54 percent of the 17,171 sample transactions (going back to 1970) had not yet been exited by November 2007. This raises
two
important
issues.
First,
any
conclusions
about
the
long-run
economic
impact of leveraged buyouts may be premature. Second, empirical analyses of the performance of leveraged buyouts will likely suffer from selection bias to the extent they
only
consider
realized
investments.
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129
Leveraged Buyouts and Private Equity
Table 2 of Leveraged
Exit Characteristics
1970-
across Time
1990-
1985-
1984
Year oforiginal LBO Type
Buyouts
1995-
2000-
2003-
2006-
Whole
1989
1994
1999
2002
2005
2007
period
6% 25%
5% 23%
8% 11%
6% 9%
3% 6% 11%
3% 1%
14%
35%
38%
40%
37%
13% 3%
17% 3%
23% 5%
31% 6%
of exit:
7% IPO 28%
Bankruptcy to strategic buyer
Sold
31%
5% 2%
Secondarybuyout Sold toLBO-backed firm to management
Sold
40%
38% 35%
24% 31% 7% 5%
17% 19%
1%
1%
1%
2%
2% 1% 1%
1%
Other/unknown
26%
18%
12%
11%
10%
7%
No exit byNov. 2007
3%
5%
9%
27%
43%
98% 74%
54%
14% 47% 53% 61% 70%
12% 40% 48% 58% 75%
14% 53% 63% 70% 82%
13% 41% 49% 56% 76% 73%
9% 42% 40% 49% 51% 55% 58%
13%
12%
% of deals
11% 24%
exited within
24months (2 years) 60 months (5 years) 72months (6 years) 84 months (7 years) 120months (10 years)
table reports exit information for 17,171 worldwide leveraged buyout transactions that include database announced between 1/1/1970 and every transaction with a financial sponsor in the CapitallQ of transactions, on an equally-weighted basis. The numbers are expressed as a percentage 6/30/2007.
Note: The
Exit status is determined and Lerner detailed
(2007),
description
SDC, Worldscope, Amadeus, Cao, using various databases, including CapitallQ, as well as company and LBO firm web sites. See (2008) for a more Str?mberg
of the methodology.
on
Conditional
company second
common
most
exit
is a
sale
common
the most
exited,
having
buyer; this occurs
to a strategic (nonfinancial)
to another
private
route
is
the
sale
of
the
in 38 percent of exits. The equity
fund
in a
secondary
considerably over time. leveraged buyout (24 percent); Initial public offerings, where the company is listed on a public stock exchange (and the private equity firm can subsequently sell its shares in the public market), account for 14 percent of exits; this route has decreased significantly in relative this route has
over
importance
increased
time.
the high debt levels in these transactions, one might expect a nontrivial fraction of leveraged buyouts to end in bankruptcy. For the total sample, 6 percent of deals have ended in bankruptcy or reorganization. Excluding post-2002 lever Given
aged buyouts, which may not have had enough time to enter financial distress, the incidence increases to 7 percent. Assuming an average holding period of six years, out
this works
to an
annual
rate
default
of
1.2
percent
per
year.
Perhaps
surpris
ingly, this is lower than the average default rate of 1.6 percent thatMoody's reports for all U.S. corporate bond issuers from 1980-2002 (Hamilton et al., 2006). One caveat is that not all cases of distress may be recorded in publicly available data sources;
some
of
these
cases
may
be
"hidden"
in
the
relatively
large
fraction
of
exits (11 percent). Perhaps consistent with this,Andrade and Kaplan find that 23 percent of the larger public-to-private transactions of the 1980s (1998)
"unknown" defaulted
at
some
point.
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Journal ofEconomie Perspectives
130
The
bottom panel
2 shows average holding
The
transactions.
buyout
leveraged
of Table
on
is done
analysis
for individual
periods
a cohort
to avoid
basis,
the
bias resulting from older deals being more likely to have been exited. Over the whole sample, the median holding period is roughly six years, but this has varied over time. Median holding periods were less than five years for deals from the early affected by the "hot" initial public offering markets
1990s, presumably 1990s. oriented, ownership
companies
investment,
funds have
increased
been
accused
of
sustained
In our
time.
more
becoming
common.
Instead,
we
analysis,
as exits within 24 months
more
become
within 24 months
a
for
that "quick flips," defined have
have
short-term
to "flip" their investments rather than to maintain
preferring of
funds
equity
private
Recently,
of the late
see
no
their
evidence
of the private equity fund's
holding
of
periods
private
equity
since the 1990s. Overall, only 12 percent of deals are exited of the leveraged buyout acquisition date.
Finally, because of the high fraction of secondary buyouts in recent years, the individual holding periods understate the total time in which leveraged buyout firms are held by private equity funds. Accounting for secondary buyouts, Str?m leveraged buyout is still in private equity berg (2008) shows that the median nine
ownership
after
years
the original
buyout
transaction.
In
comparison,
Kaplan
lever (1991), who also takes secondary buyouts into account, found the median aged-buyout target remained in private ownership for 6.82 years, which is consistent with privately owned holding periods having increased since the 1980s.
Is Private Equity a Superior Organizational
Form?
Proponents of leveraged buyouts, like Jensen (1989), argue that private equity firms apply financial, governance, and operational engineering to their portfolio and,
companies, In
superior
in so
some
contrast,
doing,
argue
information,
improve
that but
private
do
not
firm equity
create
and
operations firms any
take
create
advantage value.
operational
economic of
value.
tax breaks
and critics
Moreover,
sometimes argue that private equity activity is influenced by market timing (and market mispricing) between debt and equity markets. In this section, we consider the proponents' views and the first set of criticisms about whether private equity creates more
value.
operational
In
the next
section,
we
consider
market
timing
issues
in
detail.
and Operational Financial, Governance, Engineering firms Private equity apply three sets of changes invest,
which
we
categorize
as financial,
governance,
to the firms in which and
operational
they
engineering.
and Kaplan (1989a, b) describe the financial and governance with associated private equity. First, private equity firms pay engineering changes to incentives in their portfolio companies. They careful attention management Jensen
(1989)
team a large equity upside through stock and typically give the management was unusual among public firms in the early 1980s (Jensen that options?a practice
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StevenN. Kaplan
and Per Str?mberg
131
and Murphy, 1990). Kaplan (1989b) finds that management ownership percent a to four in from factor of increase ages going private ownership. Private by public firms
equity
also
require
company, downside
as well.
a
to make
management
so thatmanagement
investment
meaningful
in
the
not only has a significant upside, but a significant because
Moreover,
the
are
companies
private,
management's
cannot sell its equity or exercise its is,management equity is illiquid?that options until the value is proved by an exit transaction. This illiquidity reduces manage ment's
to
incentive It remains
the
manipulate case that
short-term
performance. teams
management
obtain
significant
in
stakes
equity
portfolio companies. We collected information on 43 leveraged buyouts in the United States from 1996 to 2004 with a median transaction value of over $300 Of
million.
these,
23 were
The
transactions.
public-to-private
median
execu
chief
tive officer receives 5.4 percent of the equity upside (stock and options) while the team as a whole gets 16 percent. Acharya and Kehoe (2008) find management trans similar results in the United Kingdom for 59 large buyouts (with a median action value of over $500 million) officer
executive
gets
3 percent
from 1997 to 2004. They report themedian
of
the
the median
equity;
chief
team
management
as
a
gets 15 percent. These magnitudes are similar to those in the 1980s public (1989b). Even though stock- and option to-private transactions studied by Kaplan more have become based compensation widely used in public firms since the 1980s,
whole
(and upside) remain greater in leveraged ownership percentages management's in than buyouts public companies. The second key ingredient is leverage?the borrowing that is done in connec tion
with
the
transaction.
Leverage
creates
pressure
on
not
managers
to waste
money, because they must make interest and principal payments. This pressure in Jensen reduces the "free cash flow" problems described (1986), in which management
dissipate and
many
teams
in mature
industries
with
weak
corporate
governance
cash flows rather than returning them to investors.2 In the United other
countries,
leverage
also
potentially
increases
firm
value
could
States through
the tax deductibility of interest. On the flip side, if leverage is too high, the inflexibility of the required payments (as contrasted with the flexibility of payments to equity) increases the chance of costly financial distress.
Third, governance engineering refers to the way that private equity investors control the boards of their portfolio companies and are more actively involved in governance than public company boards. Private equity portfolio company boards are smaller than comparable public company boards and meet more frequently 1996; Acharya and Kehoe, 2008; Cornelli and Karakas, (Gertner and Kaplan, (2008) report that portfolio companies have twelve 2008).3 Acharya and Kehoe formal
meetings
per
year
and
many
more
informal
contacts.
In
addition,
2 Axelson,
private
also argue that leverage provides discipline to the (forthcoming) Str?mberg, and Weisbach debt providers?to acquiring leveraged buyout fund, which must persuade third-party investors?the co-invest in each deal. 3 evidence on public firm boards (Yermack, 1996) suggests that smaller boards are more Empirical efficient.
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Journal ofEconomie Perspectives
132
Acharya firms are replaced a
four-year
to
hesitate
poorly
replace
management.
performing
(2008) report that one-third of chief executive officers of these in the first 100 days while two-thirds are replaced at some point
and Kehoe
over
not
do
investors
equity
period.
and governance engineering were common by the late 1980s. Today, most large private equity firms have added another type that we call "operational engineering," which refers to industry and operating expertise that they apply to Financial
add
to
value
investments.
their
most
Indeed,
top
private
are
firms
equity
now
to hiring dealmakers with financial engi organized now firms often hire professionals with operating neering skills, private equity industries. In addition
around
an
and
backgrounds
For
focus.
industry
Lou
example,
the
Gerstner,
former
chief
executive officer of RJR and IBM is affiliated with Carlyle, while Jack Welch, former chief executive officer of GE, is affiliated with Clayton Dubilier. Most firms
equity
private
also
use
make
Private equity firms use
attractive
to
investments, the value
implement
or
internal
value plans.
A
creation plan
might
improvements, productivity as well as management opportunities,
acquisition
and MacArthur,
2008; Gadiesh
and Kehoe,
strategic
and
investments,
elements changes
changes
to identify
knowledge
those
include
and
top
groups.
consulting
for
plans
and
opportunities
external
their industry and operating
develop
creation
of
the
of or
to
cost-cutting
repositioning, (Acharya
upgrades
2008).
Operating Performance The empirical evidence on the operating performance of companies after they have been purchased through a leveraged buyout is largely positive. For U.S. in deals the 1980s, Kaplan (1989b) finds that the ratio of operating public-to-private to to 10 sales increased by income 20 percent (absolutely and relative to industry). to sales in ratio of cash flow (operating income less capital expenditures) creased by roughly 40 percent. The ratio of capital expenditures to sales declined. These changes are coincident with large increases in firm value (again, absolutely and relative to industry). Smith (1990) finds similar results. Lichtenberg and Siegel
The
(1990) find that leveraged buyouts experience productivity after the buyout.
significant increases
in total factor
on private equity and leverage buyouts has post-1980s empirical work on focused buyouts in Europe, largely because of data availability. Consistent with the U.S. results from the 1980s, most of this work finds that leveraged buyouts are Most
with significant operating and productivity improvements. This work includes Harris, Siegel, and Wright (2005) for the United Kingdom; Boucly, Sraer, and Thesmar (2008) for France; and Bergstr?m, Grubb, and Jonsson (2007) for Sweden. Cumming, Siegel, and Wright (2007) summarize much of this literature
associated
and
there
conclude
"is a
general
consensus
across
different
mea
methodologies,
sures, and time periods regarding a key stylized fact: LBOs [leveraged buyouts] and [management buyouts] enhance performance and have a salient especially MBOs effect
on
work
There results?more
practices."
has been recent
one
exception
public-to-private
to the largely uniform positive buyouts.
Guo
et al.
(2007)
operating
study U.S.
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public
Leveraged Buyouts and Private Equity
133
to 2006. The 94 leveraged buyouts to-private transactions completed from 1990 are concentrated in deals completed by 2000. The with available post-buyout data
in operating and cash flow margins that are much in the 1980s data for the United States and in the
increases
authors find modest
than those found
smaller
data. At the same
time, they find high investor returns (adjusted for industry or the overall stock market) at the portfolio company level. Acharya and Kehoe (2008) and Weir, Jones, and Wright (2007) find similarlymodest operating European
over roughly the improvements for public-to-private deals in the United Kingdom same period. Nevertheless, Acharya and Kehoe also find (2008) high investor
returns.
These
results
that
suggest
post-1980s
transactions
public-to-private
may
differ from those of the 1980s and from leveraged buyouts overall. the empirical evidence is consistent overall with significant operating While some caution. improvements for leverage buyouts, it should be interpreted with First, some
studies, particularly
those in the United
because
data
to selection
subject
For
available.
bias
most
example,
U.S.
performance
for
of financial
studies
States, are potentially
private
are
firms
performance
not
study
always
leveraged
buyouts that use public debt or subsequently go public, and leveraged buyouts of public companies. These may not be representative of the population. Still, studies in countries
undertaken
not
do
therefore
where
suffer
reporting
data
accounting biases?for
on
is available
example,
Boucly,
private Sraer,
firms, which and
Thesmar
and Bergstr?m, Grubb, and Jonsson (2007) for Sweden?find (2008) significant operating improvements after leveraged buyouts. Second, the decline in capital expenditures found in some studies raises the for France
current cash flows, but hurt future possibility that leveraged buyouts may increase to concern at the performance of leveraged test is look this of cash flows. One an initial public offering. In a buyout companies after they have gone through recent paper, Cao and Lerner (2007) find positive industry-adjusted stock perfor mance
such
after
initial
public
In
offerings.
another
test
of whether
future
pros
pects are sacrificed to current cash flow, Lerner, Sorensen, and Str?mberg (2008) as measured by patenting. Although study post-buyout changes in innovation relatively few private equity portfolio companies do
patent
focus
experience
Furthermore,
patenting.
portant
not
(as measured
their
innovation
any patents
meaningful filed
by subsequent activities
decline
post-buyout
citations)
in a few
core
engage in
in patenting,
post-buyout
appear
more
those that
innovation economically
or im
than those filed pre-buyout, as firms
areas.
Overall, interpret the empirical evidence as largely consistent with the existence of operating and productivity improvements after leveraged buyouts. Most of these results are based on leveraged buyouts completed before the latest we
private
pleted
equity
wave.
Accordingly,
the
performance
in the latest private equity wave
of
leveraged
is clearly a desirable
buyouts
com
topic for future
research.
Employment Critics of leveraged buyouts often argue that these transactions benefit private equity investors at the expense of employees who suffer job and wage cuts.While
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Journal ofEconomie Perspectives
134
such reductions would be consistent the political
improvements,
operating this manner
be more
would
(and arguably expected) with productivity and implications of economic gains achieved in see
(for example,
negative
comments
from
the
Service
Employees International Union, 2007). (1989b) studies U.S. public-to-private buyouts in the 1980s and finds Kaplan that employment increases post-buyout, but by less than other firms in the industry.
a similar result. Davis, Haltiwanger, Jarmin, Lichtenberg and Siegel (1990) obtain a Miranda and Lerner, (2008) study large sample of U.S. leveraged buyouts from at the establishment level. They find that employment at leveraged 1980 to 2005 firms increases by less than at other firms in the same industry after the buyout buyout, but also find that leveraged buyout firms had smaller employment before
the
The
transaction.
buyout
relative
in retail businesses. They find no difference sector.
For
a
subset
of
at new
employment
their
sample,
as well
establishments
similar
as
at
al.
ones.
existing
in the manufacturing are
(2008)
to measure
able
For
this
subsample,
firms.
non-buyout
the United
Outside
States, Amess, and Wright (2007a) study buyouts in the from 1999 to 2004 and find that firms that experience leveraged
United Kingdom have
buyouts
et
growth
concentrated
have higher job growth in new establishments
the leveraged buyout companies than
in employment
Davis
are
declines
employment
employment
to other
similar
growth
but
firms,
increase
more
wages
slowly.The one exception to the findings in the United States and United Kingdom are those for France by Boucly, Sraer, and Thesmar (2008), who find that leveraged companies
buyout
experience
and wage
greater job
growth than other
similar
companies. then,
Overall,
leveraged
experience are
findings
not
the
evidence
buyouts,
consistent
with
that
suggests but
at a slower
concerns
employment
rate
over
than
at other
destruction,
job
at
grows similar but
firms
firms.
neither
that These
are
they
consistent with the opposite position that firms owned by private industry experi ence especially strong employment growth (except, perhaps, in France). We view the empirical evidence on employment
equity
portfolio
companies
create
as largely consistent with a view that private
economic
value
by operating
more
efficiently.
Taxes
debt in leveraged buyout transactions gives rise to interest tax are deductions that valuable, but difficult to value accurately. Kaplan (1989a) finds that, depending on the assumption, the reduced taxes from higher interest deduc The
additional
tions can explain from 4 percent to 40 percent of a firm's value. The lower estimates assume that leveraged buyout debt is repaid in eight years and that personal taxes offset the benefit of corporate tax deductions. The higher estimates assume that leveraged buyout debt ispermanent offset.
Assuming
that
the
truth
lies between
estimate of the value of lower taxes due
these
and that personal various
to increased
assumptions,
taxes provide no a reasonable
leverage for the 1980s might estimates would be lower for leveraged
be 10 to 20 percent of firm value. These buyouts in the 1990s and 2000s, because both the corporate tax rate and the extent of leverage used in these deals have declined. Thus, while greater leverage creates
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StevenN. Kaplan
and Per Str?mberg
135
some value for private equity investors by reducing taxes, it is difficult to say exactly how
much.
Asymmetric Information The
favorable
generally
are also potentially mation
on
claim
that
future
results
on
operating
company
portfolio
incumbent
Critics
performance. is a
management
on
information
value
creation
consistent with private equity investors having superior source
of
this
extent, supporters of private equity implicitly agree has
and
improvements
a
to make
how
firm
of
inside
private
infor often
equity
information.
some
To
that incumbent management better.
perform
After
all,
one
of
the
justifications for private equity deals is that with better incentives and closer to deliver better results. A less monitoring, managers will use their knowledge attractive
claim,
is that
however,
they intend to keep
because the new
owners.
a result,
As
incumbent
favor
managers
a
private
equity
their jobs and receive lucrative compensation incumbent
managers
highest price for existing shareholders?thus
may
be
to
unwilling
fight
buyout
under for
the
giving private equity investors a better
deal.
Several observations
suggest that it is unlikely that operating improvements are a result of simply private equity firms taking advantage of private information. First, studies the forecasts the private equity firms released Kaplan (1989b) publicly at the time of the leveraged buyout. The asymmetric information story suggests that actual should
performance
exceed
the
forecasts.
In
fact,
actual
after
performance
the
buyout lags the forecasts. Moreover, Ofek (1994) studies leveraged buyout attempts that failed because the offer was rejected by the board or by stockholders (even though management supported it) and finds no excess stock returns or operating improvements for these firms. It would be useful to replicate these studies with more
recent
transactions.
Second,
firms
equity
private
tioned
frequently
bring
and Kehoe
in new
men
As
management.
earlier, Acharya (2008) report that one-third of the chief executive officers in their sample are replaced in the first 100 days and two-thirds are
over
replaced
a
four-year
that itwill be in a position
Thus,
incumbent
owners.
equity
Third, firms
period.
to receive high-powered
have
it seems likely that at times in the boom-and-bust in their
overpaid
leveraged
buyouts
and
cannot
management
be
sure
incentives from the new private
experienced
cycle, private equity losses.
For
exam
ple, the late 1980s was one such time, and it seems likely that the tail end of the private equity boom in 2006 and into early 2007 will generate lower returns than investors
as well.
expected
If incumbent
management
provided
inside
information,
it clearly wasn't enough to avoid periods of poor returns for private equity funds. While these findings are inconsistent with operating improvements being the result of asymmetric information, there is some evidence that private equity funds are able to acquire firms more than other et bidders. Guo al. cheaply (2007) and Acharya
and Kehoe
only modest
perience large financial
(2008) find that post-1980s public-to-private transactions ex increases in firm operating performance, but still generate
returns to private equity funds. This finding suggests that private
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Journal ofEconomie Perspectives
136
equity firms are able to buy low and sell high. Similarly, Bargeron, Schlingemann, Stulz, and Zutter (2007) find that private equity firms pay lower premiums than are consistent with public company buyers in cash acquisitions. These findings or industries that turn out to be under private equity firms identifying companies valued. Alternatively, this could indicate that private equity firms are particularly boards
target
and
not
do
management
the best
get
in these acquisitions.
possible price Overall,
that
and/or
negotiators,
good
then,
the
not
does
evidence
an
support
The
management.
are
results
consistent
potentially
for
role
important
on the part of private equity firm-specific information
investors and
with
private
superior
incumbent investors
equity
bargaining well, target boards bargaining badly, or private equity investors taking advantage of market timing (and market mispricing), which we discuss below.
Private Equity Fund Returns company-level empirical evidence suggests that leveraged buyouts by private equity firms create value (adjusted for industry and market). This evidence The not
does
necessarily
that
however,
imply,
private
equity
funds
earn
returns
superior
for their limited partner investors. First, because private equity firms often purchase firms in competitive auctions or by paying a premium to public shareholders, sellers likely
a
capture
amount
meaningful
of value.
For
in KKR's
example,
of
purchase
RJR Nabisco, KKR paid a premium to public shareholders of roughly $10 billion. After the buyout, KKR's investors earned a low return, suggesting thatKKR paid out
most, ifnot all of the value-added toRJR's public shareholders. Second, the limited partner investors in private equity funds pay meaningful fees. Metrick and Yasuda (2007) estimate that fees equal $19 in present value per $100 of capital under for
management net
investors
the median
of
fees
will
private be
lower
fund.
equity than
As
return
the
a result, on
the
the
return
private
to outside fund's
equity
investments.
underlying
Kaplan and Schoar (2005) study the returns to private equity and venture an investor (or limited capital funds. They compare how much partner) in a private net to fees what the of investor would have earned in an fund earned equity equivalent investment in the Standard and Poor's 500 index. They find that private equity fund investors earn slightly less than the Standard and Poor's 500 index net of
fees,
ending
with
an
average
ratio
of
93
percent
to 97
percent.
On
average,
therefore, they do not find the outperformance often given as a justification for investing in private equity funds. At the same time, however, these results imply that the private equity investors outperform the Standard and Poor's 500 index gross of fees
(that
is, when
fees
are
added
back).
Those
returns,
therefore,
are
consistent
with private equity investors adding value (over and above the premium paid to selling shareholders). At least two caveats are in order. First, Kaplan and Schoar (2005) use data from VentureEconomics which samples only roughly half of private equity funds, leaving an unknown
and
potentially
important
selection
bias.
Second,
because
of data
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avail
Leveraged Buyouts and Private Equity
issues,
ability
and
Kaplan
Schoar
compare
to the Standard
performance
500 index without making any adjustments for risk. Kaplan and Schoar (2005) also find strong evidence mance?that
mance
is, performance
private
because
In contrast,
funds
persistence
little
show
result
are
funds
worst-performing
mutual
This
persistence.
the
equity
of persistence
in one
firm
fund
Poor's
in perfor
predicts
perfor
funds. In fact, their results likely understate
by the firm in subsequent
persistence fund.
by
a
and
137
persistence
explains
less and
limited
why
likely hedge
a
to raise funds often
partners
subsequent
show
uncertain
strive
to invest
in private equity funds thathave been among the top performers in the past (Swensen, Of
2000).
course,
only
some
limited
partners
can
succeed
in such
a
strategy.
Phalippou and Gottschalg (forthcoming) use a slightly updated version of the Kaplan and Schoar (2005) data set. They obtain qualitatively identical results to (2005) for the average returns and persistence of private Kaplan and Schoar funds relevant here.
equity/buyout
Boom
and Bust Cycles in Private Equity
Portfolio Company The
of
pattern
decades
suggests
Level
that
equity
private credit
market
commitments conditions
and
may
transactions
affect
this
activity.
over One
recent hypoth
esis is that private equity investors take advantage of systematic mispricings in the debt and equity markets. That is,when the cost of debt is relatively low compared to the cost of equity, private equity can arbitrage or benefit from the difference. This argument relies on the existence of market frictions that enable debt and equity markets to become and Wurgler Greenwood, of market
advantage
(2000) and Baker, segmented. Baker and Wurgler take (2003) offer arguments that public companies
mispricing.
see how debt mispricing might matter, assume that a public company is run a can and If firm borrow at a rate unleveraged private equity being optimally. too low given the risk, the private equity firm will create value by borrowing. that is To
In
the
recent
wave,
interest
rate
spreads
for
private
equity
borrowing
increased
from roughly 250 basis points over the benchmark LIBOR (London Interbank in 2006 to 500 basis points over LIBOR Offered Rate) in 2008 (Standard and Poor's, 2008). Under the assumptions that debt funds 70 percent of the purchase
price and has a maturity of eight years, debt mispricing of 250 basis points would justify roughly 10 percent of the purchase price or, equivalently, would allow a
private equity fund investor to pay an additional 10 percent (that is, the present value of an eight-year loan for 70 discounted at the higher interest rate is 60, not 70). The mispricing theory implies that relatively more deals will be undertaken when debt markets are unusually favorable. Kaplan and Stein (1993) present
consistent with a role for overly favorable terms from high-yield bond investors in the 1980s buyout wave. The credit market turmoil in late 2007 and early
evidence
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138
Journal ofEconomie Perspectives
Figure 3
in Large U.S. Public-to-Private Buyouts, 1982 to 2006 Enterprise Value to EBITDA " a measure cash (UEBITDA, of flow, standsfor earnings before interest,taxes, depreciation, and amortization) 12.00 10.00 8.00 6.00 4.00 2.00 0.00
\\\\\\\\
\\\\\%\\\\
Source: Kaplan and Sein (1993) and Guo, Note: The first private equity wave began in 2007. 2003 or 2004 and ended
and Song (2007). Hotchkiss, in 1982 or 1983 and ended in 1989;
the second
began
in
2008 suggests that overly favorable terms from debt investors may have helped fuel the buyout wave from 2005 through mid-2007. To study buyout market cyclicality, we make more detailed "apples-to-apples" comparisons of buyout characteristics over time by combining the results in Kaplan
(1993) for the 1980s buyout wave with those in Guo et al. (2007) for the last ten years. Both papers study public-to-private transactions in the United States. First, we look at valuations or prices relative to cash flow. To measure the price
and Stein
paid for these deals, we calculate enterprise value as the sum of the value of equity and net debt at the time of the buyout. Firm cash flow is calculated using the standard measure
of firm-level performance, EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. Figure 3 reports themedian ratio of enterprise value to cash flow for leveraged buyouts by year. The figure shows that prices paid for cash flow were generally higher at the end of the buyout
waves
than at the beginning. (The firstprivate equity wave began in 1982 or 1983 and ended in 1989; the second began in 2003 or 2004 and ended in 2007.) The more recent period, in particular, exhibits a great deal of cyclicality, first dipping substantially from 2000 through 2002, and then rising afterwards. Figure 3 also shows that valuation multiples in the recent wave exceeded those
in the 1980s wave, although this conclusion is open to some interpretation. In to were higher in the last decade ratios all of values cash flow corporate general,
the ratios in Figure 3 are deflated by the median ratio for nonfinancial companies in the Standard and Poor's 500 index, the valuations of to the Standard and Poor's 500 are slightly lower in deals relative leveraged buyout than in the 1980s. When
the
recent
wave
relative
to
the
previous
wave.
Even
after
such
a
calculation,
cyclicality of the recent wave remains.
This content downloaded from 129.79.119.131 on Tue, 18 Aug 2015 18:29:11 UTC All use subject to JSTOR Terms and Conditions
the
StevenN. Kaplan
and Per Str?mberg
139
Figure 4 EBITDA
to Interest in Large U.S. Public to Private Buyouts, 1982 to 2006 " a measure of cashflow, standsfor earnings before interest,taxes, ("EBITDA, depreciation, and amortization)
\\\\\W\
'%W\\W\X'
Source: Kaplan and Stein (1993) and Guo, Hotchkiss, and Song (2007). Note: The first private equity wave began in 1982 or 1983 and ended in 1989. The in 2007. in 2003 or 2004 and ended equity wave began
second
private
Next, we look at changes compare the ratio of equity used
in leverage buyout firm capital structures. We to finance leveraged buyouts in each time period and find that the share of equity used to finance leveraged buyouts was relatively constant in the firstwave at 10 percent to 15 percent and relatively constant in the second wave, but at roughly 30 percent. This striking increase in equity percentage from one era to the other is both a prediction of and consistent with the arguments in Kaplan
and Stein
that debt
investors offered overly favorable terms, particularly too much leverage, in the buyout wave of the 1980s. Valuations relative to a standardized measure of profits?EBITDA (earnings (1993)
interest, taxes, depreciation and amortization)?were higher in the recent were rates lower. Interest also changed. Figure 4 combines wave, but debt levels to forecast interest for the lever these factors by measuring the ratio of EBITDA before
of the aged buyouts of the two eras. This interest coverage ratio is a measure a transaction. ratio it of When this is that the lower, fragility buyout implies buyout ismore fragile, because the firm has less of a cushion from not being able tomeet interest payments. Figure 4 has two interesting implications. First, interest coverage ratios are higher in the recent wave, suggesting the deals are less fragile. Second, the cyclical pattern of the second wave remains. Coverage ratios are higher from
2001 to 2004 than in the periods before and after. Leveraged buyouts of the most recent wave also have been
associated
with
more
liberal repayment schedules and looser debt covenants. Consistent with this, we find patterns similar to (if not stronger than) those in Figure 4 when we factor in debt principal repayments. Demoriglu and James (2007) and Standard and Poor's (2008) also confirm that loan covenants became less restrictive at the end of the
recent
wave.
Figure 5 considers
cyclicality in private equity in one additional
way. It com
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140
Journal ofEconomie Perspectives
Figure 5 Standard
Value Less High-Yield Rates, 1985-2006 8e Poor's EBITDA/Enterprise " a measure stands cash ("EBITDA, of flow, for earnings before interest,taxes, depreciation, and amortization) 4.00% T
for S&P 500 companies less Merrill Lynch High-Yield Master Value EBITDA/Enterprise is the sum of market value of equity, book value of long (Cash Pay Only) Yield. Enterprise Value and short-term debt less cash and marketable securities.
Note: Median
to enterprise value for the Standard & Poor's pares the median ratio of EBITDA rate on to the interest 500, average high-yield bonds?the Merrill Lynch High Yield 1985 to 2006. In particular Figure 5 looks at from (cash pay bonds)?each year
measures the relation between operating earnings yield net of interest rate. This the cash flow generated per dollar of market value by the median company in the Standard & Poor's 500 and the interest rate on a highly leveraged financing. One can interpret thismeasure as the excess (or deficit) from financing the purchase of an entire company with high-yield bonds.
pattern is suggestive. A necessary (but not sufficient) condition for a on private equity boom to occur is for earnings yields to exceed interest rates true in in boom late-1980s boom and the This held the bonds. pattern high-yield The
earnings yields are less than interest rates from high-yield bonds, private equity activity tends to be lower. These patterns suggest that the debt used in a given leveraged buyout may be driven more by credit market conditions than by the relative benefits of leverage for of 2005 and 2006. When
operating
the firm. Axelson, Jenkinson, Str?mberg, and Weisbach (2008) find evidence consistent with this in a sample of large leveraged buyouts in the United States and Europe 1985-2007. They find that leverage is cross completed between to leverage in similar-size, same industry, public sec tionally unrelated to firm-specific factors that explain is unrelated leverage in public
firms and firms. In
stead, leveraged buyout capital structures are most strongly related to prevailing in leveraged buyouts debt market conditions at the time of the buyout. Leverage decreases
as
interest
rates
rise.
The
amount
of
leverage
available,
in turn,
seems
the firm. that the private equity fund pays to acquire that and Wofenzon find Richardson, (2007) private equity Similarly, Ljungqvist, funds accelerate their investment pace when interest rates are low. These results are to affect the amount
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Leveraged Buyouts and Private Equity
consistent with the notion in the
private
that debt financing availability affects booms
141
and busts
market.
equity
patterns raise the question as towhy the borrowing of public firms does not follow the same credit market cycles. One potential is that public explanation firms are unwilling to take advantage of debt mispricing by increasing leverage, These
either
because
dislike
managers
or
debt
because
about high debt levels. A second explanation access
to credit
markets
because
are
they
market
public
investors
worry
is that private equity funds have better which
borrowers,
repeat
enables
to
them
build reputation with lenders. Recent papers by Ivashina and Kovner (2008) and Demiroglu and James (2007) suggest thatmore prominent private equity funds are to obtain
able
loans
cheaper the
is that
explanation
and
looser
covenants
debt
structures
compensation
than
of
private
incentives to take on more
Private Equity Fund Level The time series of private equity fund commitments a boom
by
the
studying we
First,
A
lenders. funds
equity
third
provide
debt than is optimal for the individual firm (Axelson, and Weisbach, forthcoming).
Jenkinson, Str?mberg,
to exhibit
other
and
bust
relation
pattern.
between
consider
the
In
this
section,
commitments
relation
earlier appear
this more
consider
closely
returns.
and
between
examined
we
private
equity
and
fundraising
subse
quent private equity fund returns. Table 3 presents illustrative regressions inwhich the dependent variable is the capital-weighted return to all private equity funds in a
raised
returns
year
vintage
Venture the
addition, their
to this as
refer
for U.S.
private
the
equity
returns
Economics
may
returns
have
the more
that
funds
not
does
from
comprise over time.
change
for
recent
Venture
all
is
private
are
probably
the as
of
are noisy funds.
equity
years
use
We
Economics
return measures
vintage
factor
(This
return."
year
"vintage
funds
2007 for vintage years 1984 to 2004. The
September because
year. We
particular
In
still active
and
because
unimportant
we obtain similar results when we eliminate all vintages after 1999.) As independent we
variables, the
ing
year
1 to 4 in Table
Regressions
vintage
subsequent
to
committed
capital
vintage
previous
and
use
private
to
relative
the
total
value
year
a
Including
the
of
3 indicate a strong negative returns.
in the
funds
equity
vintage
U.S.
and
year
stock
market.
relation between fundrais
time
trend
does
not
affect
the
this simple regression finding can only be considered illustrative of patterns, it suggests that inflows of capital into private equity funds in a
results. While broader
year
given
can
into
private
these
returns
fund
is associated
consider
regressions,
the the
with
lower
variables by
to which
extent
dependent
Venture
are
the
two
Economics.
that
regressions).
The
vintage
year
affect
is the annual
stock market returns
year's
previous
Note
returns
past
variable
the
annual
different from the vintage year return (which was previous
ten-
subsequent
to twelve
returns.
subsequent
private equity funds as a fraction of the U.S. independent as reported
the
during
these funds are active. It strongly suggests that an influx of capital
equity we
Next In
realized
explain
year period when
return
commitments.
capital
capital
from 1987 to 2006. The to
return
private to
the
again,
equity, private
the dependent
measures
to U.S.
committed
annual
equity
variable return
This content downloaded from 129.79.119.131 on Tue, 18 Aug 2015 18:29:11 UTC All use subject to JSTOR Terms and Conditions
is
in the to all
142
Journal ofEconomie Perspectives
Table 3 Relation
of Private Equity Returns
inUnited
and Fundraising
States
A
Panel
variable: Vintage year average internal rate of return to private equity (capital weighted) from 1984 to 2004
Dependent
equity commitments t stock market, Private equity commitments
Private
stock market,
(6.2) -32.60**
to
0.35
0.35
(7.2) -20.79*
(7.5)
(7.0)
(-1.6) -28.66**
(-2.4) to
-36.87***
t-\
(-2.2)
(-3.0)
equity commitments t+ t-\ stock market, Trend Private
Adjusted
0.31
0.31
Constant
(4)
(3)
(2)
(1)
to
-24.78***
(-1.0) 0.36
(-1.2) 0.28
R2
(-3.5) -0.002
-0.003
-0.004
Panel
-0.002 (-0.8) 0.41
(-0.8) 0.44
B
!variable: Private equity commitments toStockMarket, tfrom (as a fraction of the total value of theU.S. stockmarket)
1984 to 2007
(2)
(1) -0.091
Constant Annual
private equity return,
t-\
Annual
private equity return,
t-2
Trend
Adjusted
R2
-0.292
(-0.7) 0.007**
(-1.8) 0.008***
(2.1)
(2.6) 0.007**
0.031***
(2.4) 0.031***
(4.1) 0.40
(4.6) 0.50
internal rate of return is the average internal rate of return to U.S. equity vintage year a given year, according to Venture Economics. Mean vintage year internal rate raised in funds private equity are of return is 16.5 percent. Private equity commitments capital committed to U.S. private equity funds from Private Equity Analyst as a fraction of the total value of the U.S. stock market. Mean private equity return to all U.S. private return is the annual are 0.43 percent. Private equity annual commitments
Note: Private
equity funds according
to Venture Economics. Mean
parentheses. *** indicate *, **, and
statistical significance
raised
funds return
is a
in a
particular
geometric
year
average
annual
return is 18.6 percent.
at the 10, 5, and
over
the
of many
life of years
1 percent
the
of
errors are in
levels, respectively.
is, the vintage
fund?that
returns.
Standard
In
contrast,
the
year annual
return to private equity is the return to all private equity funds of different vintages in a
given Again,
calendar these
year. regressions
are meant
sions in panel B, capital commitments
only
to be
suggestive.
are positively and
In
these
two
regres
significantly related
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to
StevenN Kaplan
lagged
private
returns?in
equity
returns. The positive fund
equity To
more
when
with a boom
Some
time
above
regressions,
when
any
private
to
follow
good
class.
returns
realized
factors.
cyclical
returns
fund
equity
to this asset
is committed
to decline
tend
equity
over
the
capital
seem
investors
words,
143
trend is consistent with significant secular growth in private
commitments
summarize
other
and Per Str?mberg
Capital
decline.
to decline
tend
to
commitments
These
are
patterns
private
consistent
and bust cycle in private equity.
Speculations
empirical evidence is strong that private equity activity creates economic value on average. We suspect that the increased investment by private equity firms The
in operational a
has
activity
will ensure
engineering
Because
future.
creates
equity
private substantial
permanent
that this result continues
economic
value,
we
believe
to hold
that
in the
private
equity
component.
However, the evidence also is strong that private equity activity is subject to boom and bust cycles, which are driven by recent returns as well as by the level of rates
interest particularly
to
relative true
for
and
earnings
larger
stock
market
substantially?when
seems
pattern
interest rates on buyout-related debt
is even
debt
buyout
This
transactions.
public-to-private
From the summer of 2007 intomid-2008,
increased
values.
at all. At
available
same
the
time,
corporate earnings have softened. In this setting, private equity activity is likely to be relatively low, particularly large public-to-private buyouts. Institutional investors are
to continue
likely
because
reported 2007,
September
to make private
Venture
not
have
Economics
reports
three years of 15.3 percent versus Standard 12.7
private
private
equity but
declined, equity
and Poor's
for
are
returns
a
at
time,
still
robust.
over
the
500 stock market
least, As
of
previous
returns of
percent.
likelihood
The robust
debt
while
not
expect
to private equity funds remain
that investors' commitments
markets
remain
unfavorable
to invest the capital committed. Given do
to
commitments
returns
that many
private
equity
will
create
pressure
for
private
firms
the fee structure of private equity funds, we firms
will
return
the money.
However,
these
patterns suggest that the structure of private equity deals will evolve. investments with less First, we suspect that private equity firms will make at least initially.While this change may reduce themagnitude of expected leverage, returns (and compensation),
change
risk-adjusted
as long as the private equity firms add value, itwill not
returns.
Second, we suspect that private equity firmswill be more likely to takeminority rather than buying the entire equity positions in public or private companies company. both
Private equity firms have experience
in venture
capital
investments
and
with minority equity investments,
in overseas
investments,
particularly
in
relatively new operational engineering capabilities of private equity firms may put them in a better position to supply minority investments than in the past, because private equity firms can provide additional value without having full Asia. The
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144
Journal ofEconomie Perspectives
control.
Moreover,
and
executives
top
boards
of
public
companies
may
have
an
and hedge fund increased demand for minority equity investments. Shareholder activism and hostility have increased substantially in recent years (Brav, Jiang, Partnoy, and Thomas et al., forthcoming). In the face ofthat hostility, private equity firms are likely to be perceived as partners or "white knights" by some chief officers
executive
and
boards.
Finally, what will happen private equity boom of 2005
to funds and
transactions completed in the recent It seems plausible that the ultimate
to mid-2007?
returns to private equity funds raised during these years will prove disappointing because firms are unlikely to be able to exit the deals from this period at valuations as high as the private equity firmspaid to buy the firms. It is also plausible that some
during the boom were less driven by the potential of operating and governance improvements, and more driven by the availability of debt financing, which also implies that the returns on these deals will be disap of the transactions undertaken
pointing. If and
when
private
returns
equity
decline,
private
commitments
equity
also
will decline. Lower returns to recent private equity funds are likely to coincide with some failed transactions, including debt defaults and bankruptcies. The relative magnitude of defaults and failed deals, however is likely to be lower than after the a downturn of roughly similar previous boom in the early 1990s, assuming magni returns for this period may disappoint, the transactions tude.While private equity of
the
recent
wave
had
higher
coverage
ratios
debt than those of the 1980s, which reduces will subsequently default.
and
looser
debt
the likelihood
covenants
on
their
that those companies
This research has been supported by theKauffman Foundation, theLynde and Harry Bradley Foundation, and theOlin Foundation throughgrants to theStigler Centerfor the Study of theEconomy and, theState, and by theCenterfor Research in SecurityPrices. We thankJimHines, Antoinette Schoar, Andrei Shleifer,JeremyStein, Timothy Taylor, and Mike
Wright for very helpful comments.
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