47525
THE IMPACT ON PRODUCTIVITY OF MANAGEMENT BUYOUTS AND PRIVATE EQUITY
Yan Alperovych
Introduction
A management buyout (MBO) is a form of transaction in which management teams acquire a firm or its division(s) from its current shareholders. As managers often lack sufficient financial resources, these operations are executed with the help of financial backers known as private equity (PE) firms. The transaction is typically financed with a mixture of equity and debt, the latter being a larger proportion of the total deal value than the former.1
Buyouts first attracted academic attention in the middle of the 1980s. The seminal paper by Jensen (1986) proposed that at the heart of this phenomenon lies the problem of agency costs of free cash flows (FCF). The latter are defined as excess cash that remains within a firm after it has financed all positive net present value projects.
The underlying mechanism of the agency conflict arising from these cash flows is based on the hypothesis that corporate managers could pursue objectives that might be prestigious/beneficial to them but do not necessarily maximize shareholders’ wealth (Jensen & Meckling, 1976; Hart, 1995). For instance, managers face strong incentives to let their firms grow beyond their optimal size as it increases their power. A way to align the interests of managers with those of shareholders is to provide the former with an equity stake and introduce pay-for-performance compensation structures (e.g., grant them stock options) in the firms they manage. However, these mechanisms may be insufficient when companies are able to generate abundant FCFs. Available present and future cash can still allow managers to engage in all kinds of investment policies even though the latter may not earn the marginal required rates of return. In the absence of FCFs, pursuing these policies would require managers to raise funds from external sources and these will obviously be more expensive than those internally available. As a consequence, corporations with substantial current or future cash flow generation capacity could be fraught with an internal conflict of interest over the FCFs. Managers would have a strong incentive to retain FCFs and thus increase resources at their disposal.2 Shareholders, on the other hand, would prefer this cash to be distributed, as this will limit the managers’ power and provide further discipline to eliminate organizational inefficiencies and wasteful expenditures.
476The distribution of the FCFs is therefore a keystone in this theory. Jensen (1986) argued that one efficient mechanism to force managers to distribute cash is debt. Indeed, promises of future dividends, their possible increases, or share buybacks are weak compared to commitments to honor the financial obligations. Failure to make debt service payments, and hence distribute FCFs, gives bondholders the right to force the company into bankruptcy. This poses sufficient threat and motivates management to pursue value-enhancing and cash-generating strategies. The problem is how to force managers to borrow.
Jensen (1989) advocated that the solution is in the active ownership by investors who hold large equity and debt positions, sit on the boards, and thoroughly monitor and fire managers whenever necessary.
The buyout in this context seems to combine all of the benefits. On the one hand, there are active investors (PE firms), and managers with an increased equity stake and high-powered incentive structures. This ensures that management team and PE investors’ interests are realigned. On the other, increased degrees of financial leverage ensure that extra cash is paid out from the firm. Jensen (1993) advanced that this form of organization is capable of eliminating much of the waste and unlocking the value creation blocked by inefficient management practices, and by the inability of widespread passive ownership to keep the managers in check.
While definitely appealing, these arguments implicitly rely on the assumption of a dispersed listed corporate ownership, in which property rights are separated from control rights. The buyout in this case is referred to as a public-to-private (PTP) transaction and the underlying firm is effectively delisted from the stock market in this process. This, though, is a very limiting conjecture with a potential to introduce a systematic bias in the conclusions. The reason is that targets of PTP buyouts are necessarily large firms. As will be detailed later, most often buyout transactions are operated over much smaller and plausibly structurally different privately held targets. The latter includes but is not limited to the divisions of larger firms, family-owned firms, founder-owned firms, and even firms owned by other PE-firms themselves. In most of these examples (except for the divisions) the ownership is already concentrated. There must therefore be little room for any type of agency conflicts advocated by Jensen (1986, 1989, 1993), and buyouts in these cases should remedy some other issues than the distribution of the FCFs. Furthermore, given the heterogeneity of the buyout’s origins, the issues to solve may vary accordingly.
Interestingly, the explanation of this structure was provided by a more entrepreneurship-oriented strand of literature (Wright et al., 2000). Here, buyouts are seen as mechanisms that allow mutating operations depending on the need and the context in which a buyout is executed. For example, buyouts can be a solution for a family succession issue (Howorth et al., 2004). Divisional buyouts may be a way for existing management to gain independence from the otherwise rigid parental structures, and thus implement necessary value-enhancing policies (Meuleman et al., 2009). Pass-the-parcel buyouts involving the transfer of ownership from one outgoing PE firm to the incoming one may be a way to organize a better liquidity in the PE exit market (Arcot et al., 2015; Degeorge et al., 2016).
This discussion suggests that buyouts are associated with some structural changes in the underlying firms and that these changes may lead to operating and economic improvements. Kaplan and Strömberg (2009) argued that these improvements may be brought about by changes in the operations (operating engineering) or in the governance (governance engineering).3 This chapter provides a synthetic review on these two non-mutually exclusive channels.
477Buyouts, operating performance, and productivity: general evidence
Improved governance, advice, and coaching provided by PE firms should theoretically lead to major organizational changes that could lead to value creation (Phan & Hill, 1995). A recent paper by Gompers et al. (2016) confirms that PE firms consider increases in revenues, follow-on acquisitions, and cost-cutting as important mechanisms through which value improvements can be achieved.4 In addition, this study also advocates that PE firms expect to create value via changes and redefinitions of corporate strategies and/or business models. Combined, this should result in improvements in revenues, in growth of revenues, and in reduced costs, all of which are the components of performance and productivity. Consequently, these ideas essentially underpin two closely related types of studies. The first ones look at changes in the pre-to-post accounting and/or economic measures of operating performance that accompany the buyout transaction. The second ones investigate a deeper structural governance characteristics in buyout firms. Some relevant evidence is reviewed later in this chapter.
Changes in accounting and economic performance
A series of early examinations of the improved performance assumption include studies by Kaplan (1989), Lichtenberg and Siegel (1990), Smith (1990), Liebeskind et al. (1992), Opler (1992), Thompson et al. (1992), Wright et al. (1992), and Wright et al. (1996).
Kaplan (1989) used the data on 76 PTP MBOs closed during 1980–1986 in the US. He found that operating income net of industry changes remained unchanged in the first two years after the transaction but was substantially higher (by 24%) in the third post-transaction year. Recognizing that operating income is not the best metric (as it can be biased by the post-buyout divestures), he used the ratios of operating income to assets and to sales to control for the post-buyout asset moves. After the correction, he found that both ratios increased significantly post-acquisition (by about 20%) in all three post-transaction years, and this after controlling for the industry changes in these variables. Similarly, he documented the increases in the industry adjusted net cash flows (operating income less capital expenditures) and in the ratios of net cash flows to assets and to sales in the first three post-buyout years. It is worth noting that Kaplan (1989) also documented reductions in capital expenditures in all three post-buyout years on an industry-adjusted basis. He interpreted these results as being consistent with the improvements in efficiency assuming pre-buyout companies had been investing in negative net present value projects.
In a similar vein, Smith (1990) looked at the changes in operating performance for the MBO transactions of 58 listed firms executed between 1977 and 1986 in the US. He found significant increases in the industry adjusted operating returns (after controlling for asset sales) between the last pre- and the first post-buyout years. Moreover, the results indicated that such increases were not due to the reductions in the headcount. The evidence also suggested that working capital resources of MBO firms diminished after buyouts although these reductions contributed only marginally to the improvements in the operating returns. Similarly to Kaplan (1989), this study documented the significant reductions in the capital expenditures. Interestingly, Smith (1990) concluded that these reductions had no impact on the improvements in the operating performance.
It is important to stress that the above-mentioned investigations were using essentially accounting measures to quantify the improvements and value creation following the buyout transaction. One important limitation of such metrics is that they cannot account directly for 478the input–output transformation process. They can also be subject to managerial manipulation. Moreover, changes in these measures before and after the buyout may confound the value creation and value capture (Wood & Wright, 2009).5 In other words, these measures may not be representative of the real performance. Although mentioned contributions provided some indirect evidence against these arguments, a more thorough analysis was clearly necessary.
Lichtenberg and Siegel (1990) were among the first to provide such examination. Instead of using accounting measures directly, they computed the total factor productivity (TFP) to evaluate the impact of MBO and LBOs on efficiency. Moreover, in contrast to the previous analyses performed at the firm level, this study was based on the plant-level data. The authors argued that notwithstanding the correlation between the productivity and operating performance, the former is a cleaner measure of technical efficiency and is a more fundamental determinant of key economic and financial variables such as profits and stock prices. Using a large sample of more than 20,000 manufacturing establishments from the US Census Bureau Longitudinal Research Database (LRD), they documented that productivity in the first three years after the buyout was significantly higher than in any of the eight years before the buyout. The authors also reported that pre-to-post increases in productivity were more pronounced in MBOs compared to LBOs on average but not on median.
Interestingly, early buyouts (from 1981 and 1982) did not show any significant improvements in productivity, while later deals witnessed increasing patterns of the efficiency gains, as if increasing competition in the PE industry forced financial sponsors to put more emphasis on the fundamental changes in the operations of their targets. An important limitation of this study, acknowledged by the authors, was the impossibility of establishing a causal relationship between the buyout transaction and efficiency gains due to the nature of the data employed.
Somewhat later papers arrived at almost the same conclusions. Opler (1992), in line with the conventional wisdom at that time, found that operating profits to sales rose by an average of 16.5% (11.6% industry adjusted) from the pre-buyout year until two years after the transaction. The situation was similar with the operating profits per employee, both in absolute and in industry-adjusted terms. Finally, there was a significant drop in capital expenditure and no significant impact of buyouts on R&D. Liebeskind et al. (1992) focused on the restructuring activities of the buyout firms isolating four distinct aspects: corporate downsizing, corporate refocusing, portfolio reorganization, and changes in the industry characteristics of portfolio businesses. Using the Large Establishment Database, the study compared 33 large LBO firms and 33 matched public corporations. Their results showed that LBO firms significantly downsized operations. At the same time, both LBO and comparable firms were similar in terms of the three other aspects mentioned earlier. The authors concluded that LBOs seemed to create value by downsizing the firm and foregoing excess growth.
The discussions so far were based on US data. Non-US investigations quickly followed and the UK-based evidence emerged among the first. Thompson et al. (1992) used the data compiled by the Centre for Management Buyout Research (CMBOR) to identify whether the UK management buyouts also enjoyed improvements in performance and productivity like their US peers. In parallel, Wright et al. (1992) adopted a survey approach to isolate performance implications of the management buyouts in the UK. Their survey of 182 mid-1980 MBOs showed that 68% of buyouts improved profitability. In both studies, authors found evidence consistent with the US results in that buyouts indeed enjoy improvements in operating performance at least over the short term. The UK buyouts ventured more into product developments, post-LBO asset acquisitions, and disposed of less assets.6
479Wright et al. (1996) focused on the longer-term effects of buyouts: the longevity, financial performance, and productivity. They used a larger sample of 251 buyouts completed in the period 1982–1984, and for which authors had accounting and financial data (e.g., liquidity, profitability, and employee productivity). A matched sample of 446 non-buyout firms was also collected from the publicly available sources. The results revealed that buyouts and non-buyouts are essentially indistinguishable in terms of return on assets or labor productivity (profit/employee) in the early years after the buyout. The improvements, however, were observed in three to five years, leading the authors to conclude that it could take some time for the UK buyout firms to increase their profitability significantly above their sector average. More importantly, the effects of MBOs on the TFP were also calculated in every year up to six years after the buyout. The results showed that MBO firms were not significantly more productive in the first two post-buyout years compared to their non-LBO peers. However, the relative productivity of buyouts improved by about 20% by the fifth year after the buyout. On average, UK buyout firms exhibited a 9% greater productivity compared to their non-buyout peers over the first six years after the transaction.
Changes in governance
In parallel to the analyses of changes in productivity and operating performance, scholars also delved into more governance-related factors that affect firms during the buyout transaction. Examples include Baker and Wruck (1989), Phan and Hill (1995), Cotter and Peck (2001), and Acharya et al. (2009, 2013).
Baker and Wruck (1989) documented the organizational changes, which occurred in The O.M. Scott & Sons Company when it underwent its MBO transaction. The study was based on a series of interviews with the key players involved with the deal, notably target managers and PE investors. Both sides stressed that changes within the Scott & Sons Company stemmed from the constraints imposed on the firm by the high degree of financial leverage. Improvements were also resulting from changes in the management compensation schemes, and from changes in the monitoring and advice received by the target’s management team. All three factors, directly related to the corporate governance mechanisms, forced managers to run the company in a way that would generate cash.
Phan and Hill (1995) investigated the effect of an increased management stake and increased debt on firm goals, strategy, and structure after the LBO. Using a survey of 214 PTP buyouts completed between 1986 and 1989 (inclusive) they first showed a considerable increase in management stockholdings. The mean levels were observed to shift from 14.2% to 35.7% from one year before to one year after the LBO. They next presented evidence on the changes in the firm goals, structure, and strategy. In their results, the LBO firm’s management seemed to give priority to efficiency gains as opposed to growth. In addition, managers showed clear intent to decentralize operations and reduce the unnecessary diversification and hierarchical complexity. Efficiencies (measured in terms of productivity and profitability) were gained as a result of these governance and structural changes. Finally, managerial holdings appeared to be a more important factor than debt itself in fostering the above-mentioned changes.
Corporate governance and its impact on performance can also be evaluated from the board of directors’ perspective. Cotter and Peck (2001) took this approach and studied how the investor activism relates to the structure of debt and to the post-LBO monitoring and compensation of management. The study compared 64 US-based LBOs led by either the buyout specialists (PE firms), or by management, or by third-party equity investors, during 4801984 and 1989. Their findings suggested no systematic differences in the CEO compensation schemes in buyouts controlled by PE-firms, as opposed to those controlled by management or by other investors. However, they did document some marked differences in the composition of the boards across these three types of buyouts. PE-led LBOs were observed to have smaller boards. In addition, whenever a PE house controlled the LBO firm, its board representation was stronger. In other words, PE houses secured more seats in smaller, and potentially more efficient boards. Interestingly, in such PE-led buyouts increased debt levels did not lead to improved performance (measured as EBITDA to total sales post-buyout). The situation was in sharp contrast to the other buyout types, in which increased senior debt levels led to improvements in performance after the buyout. Cotter and Peck (2001) interpreted this finding as an evidence that debt and active monitoring by PE investors could be substitutes.
In a related series of studies Acharya et al. (2009, 2013) investigated the impact of corporate governance on performance in buyouts closed in Western Europe. A distinctive aspect of these works was an attempt to isolate the leverage and asset specific effects on performance. Such decomposition allowed them to quantify that less than 30% of the buyout out-performance generated by the top PE houses was due to the increased debt. The remaining 70% was represented by an actual outperformance. To explain this residual outperformance, the authors resorted to (i) 20 structured interviews with the chairmen or CEOs of public or private boards, (ii) factual analyses of the board compositions of the FTSE 100 firms, (iii) detailed case studies of 10 FTSE 100 firms, and (iv) high-level data on the composition of the boards of 66 PE-backed firms in the UK. Analyses of this high-quality data revealed that boards of the PE-backed companies were much more effective and added much more value to the firm than boards of publicly owned companies. This value added was primarily due to the exceptionally high focus on strategic and performance priorities, as well as the much greater commitment by the board members. The boards of PE-backed firms were also found to be considerably smaller than those of publicly listed firms.
Buyouts, operating performance, and productivity: later investigations
After the initial spurt in the research on performance implications of the buyouts, studies have taken a more granular and more international approach towards the issue. First, analyses employing more integrated and complex methods to measure productivity both in and outside of the US appeared. Second, scholars recognized that the heterogeneity of buyout types may have an impact on post-buyout efficiency and operating performance. We review available evidence in the following subsections.
New approaches to measure efficiency
There are three distinct elements to consider to measure productivity. The first one is the unit of analysis, which can be a firm or a plant (establishment). Plant-level data is more granular and allows a finer evaluation of efficiency. However, it is costlier to obtain, to treat, and is sometimes limited to manufacturing sectors only. Firm-level data is more readily available, but can lack precision depending on the specific research question. The second element is the method employed to assess efficiency. In most cases, plant-level studies resort to TFP, although some firm-level applications are also available. The last consideration is related to the missing counterfactual problem.
481The central question in all studies pertaining to productivity and performance in buyouts is whether observed patterns are attributable to the transaction itself, or to other more fundamental factors, latent or not. To answer this concern one ideally wants to observe what would have been the level of efficiency/performance had the firm not undergone a buyout (counterfactual). This observation must occur while keeping all other observable and unobservable variables fixed, which is obviously impossible. Since we can only observe buyout or non-buyout firms, we always miss the counterfactual. It is this particular reason that makes it difficult to separate the buyout effect from the non-random selection of very promising targets by PE firms. Put in the conventional wording of PE research, it is very difficult to separate selection from value-adding.
To work around this problem scholars often, as was the case in the reviewed studies so far, resort to the samples of matched control firms. The matching can be based on some ex ante specified criteria, like size, industry, pre-buyout profitability, and/or growth patterns. Alternatively, one could make use of the more sophisticated propensity score matching methods (Rosenbaum & Rubin, 1983, 1985; Dehejia & Wahba, 2002). The matching, however, does not necessarily solve the problem completely. It allows the researcher to control for the selection based on the observable heterogeneity, while the “true” selection may be based on unobservables. Two approaches are possible in this case. The first is related to Heckman’s (1976) solution of the sample selection problem. The second approach consists of finding an exogenous factor (instrument) that affects the treatment (the buyout transaction) but not the outcome (productivity). Some recent studies, which are reviewed later, started to employ one or other of these solutions to ascertain the impact of buyouts on productivity.
Analyses at the establishment level
In most of the investigations of the late 1980s and early 1990s, productivity was measured using accounting ratios. One notable exception is the study by Lichtenberg and Siegel (1990), which used the TFP approach in the context of the US manufacturing establishments. Harris et al. (2005) applied the same methods to estimate the efficiency of 35,752 manufacturing establishments in the UK before and after buyout. Their findings also suggested the existence of improvements in plant TFP levels. In contrast to Lichtenberg and Siegel (1990), MBO plants were found to be less productive than plants in the control group before the transaction. However, consistent with prior literature, MBO plants experienced considerable improvements and became more efficient than plants in the control group after the buyout. More recently Davis et al. (2014) compiled a comprehensive dataset using Longitudinal Business Database (LBD), Annual Survey of Manufacturers, Census of Manufacturers, and CapitalIQ. This allowed them to track and compare 3,200 buyout firms (15,000 establishments) with matched comparable firms before/after the buyout transaction. The matching was performed in terms of size, industry, age, and single/multi-establishment status. The authors documented that buyout targets engaged in much more aggressive policies of resource reallocation (especially labor) from the least to the most productive (in terms of TFP) establishments. Further analyses showed that buyout targets open new plants in the upper part of the TFP distribution twice as frequently in comparison to control firms and have a lower likelihood of opening low-productivity plants. The average gain of TFP in the PE-backed establishments amounted to 2.1 log points over the first two years after the buyout. The authors concluded that this resulted in material improvements in operating margins in buyout firms.
482Another investigation by Bernstein and Sheen (2016) looked at the operational consequences of PE buyouts using evidence from the restaurant industry. Although the authors did not used the TFP measure, this paper is closely related to the literature just discussed as it looks at changes occurring in the lowest possible store-level operational practices. The study used the data on every restaurant inspection conducted in Florida during 2002–2012 with all information mapped to the acquisitions of restaurant chains by PE firms (3,400 acquired restaurants out of about 50,000). The results indicated that restaurants in the PE-backed chains commit fewer health violations after the acquisition. Moreover, the improvements in practices were found to be in the areas considered by the FDA as the most dangerous for clients. Relatedly, this study demonstrated that these improvement trends had not existed before the buyout transaction and that these trends steadily increased over the first five years | after the buyout. The data also allowed the distinction between the restaurants directly owned by the PE sponsors and those operated by franchisees on behalf of the PEs. This is crucial in isolating the PE treatment effect. The authors found that both directly owned restaurants and franchisees had similar operating patterns prior to the buyout, yet after the buyout improvements occurred mostly in the directly owned stores. Finally, the extent of the improvements seemed to be particularly marked in buyouts sponsored by the PE firms with previous restaurant industry experience. All of the conclusions in this study were in line with the operational engineering mechanism described earlier.
Analyses at the firm level
In parallel to the establishment-level analyses, firm-level studies provided some additional evidence. Ames (2002) focused on MBOs of the UK manufacturing firms over the period 1986–1997. The analyses used the augmented Cobb-Douglas production function to capture the MBO effect on productivity. He suggested that improved governance systems, managerial ownership, and debt level bonded managers to focus on cash-generating and value-enhancing activities. This should, in turn, be reflected in the improvements in firm-level productivity. The rationale for this is that firm production is enhanced with an additional unobservable managerial/organizational/governance skills factor. The latter then affects the technical relationship between the firm’s outputs and inputs in two possible non-mutually exclusive ways: (i) an overall shift in the production function, and (ii) improvements in the marginal value-added product of capital and labor. The results suggested that both mechanisms were at play. A permanent shift in the production function implied a permanent improvement in productivity of the order of 16.13% for MBO firms compared to the control group. The marginal productivities of labor and capital were respectively 32.01% higher and 75% lower for MBO firms compared to the non-MBO companies. In a related paper, Amess (2003) used a stochastic production frontier approach to estimate the longer-term technical efficiency effects of MBOs. Consistent with prior results (e.g., Lichtenberg & Siegel, 1990; Wright et al., 1996) the analyses indicated that MBO firms had superior efficiency starting from two years before and up to four years after the transaction. MBOs were found to have a transitory effect on firm-level technical efficiency as their superior productivity indicators vanished beyond the fifth year after the transaction.
Analyses using the dynamic Data Envelopment Analysis (DEA) methodology were provided by Alperovych et al. (2013). DEA is an alternative non-parametric technique to estimate efficiency (see Färe & Grosskopf, 1996; Tone & Tsutsui, 2010), and differs in several aspects from accounting measures, TFP, or stochastic frontiers. First, it draws on the micro-economic theory of firms’ optimizing behavior7 and thus has stronger theoretical foundations than 483accounting ratios. More importantly, DEA requires no statistical assumptions about the nature of production technologies that convert inputs into outputs.8 The authors used a dataset of 88 PE-backed leveraged buyouts (LBOs) in the UK completed and exited during the period 1999–2008. The analyses focused on the first three post-buyout years and showed general increases in post-buyout efficiency over time. The observed productivity patterns seemed to be convex, suggesting the major improvements had happened in the first two years after the transaction. These improvements were also benchmarked to the efficiency of the 335 comparable non-buyout firms. The buyouts were found to be more efficient than average comparable firms both across the three post-buyout years, and in every year during this period.
Buyout heterogeneity
Early empirical investigations, it was observed, focused on the US (and to an extent on the UK) and mostly encompassed cases of PTP transactions (see, for instance, Kaplan, 1989; Smith, 1990; Wright et al., 1992).9 This prevalence of the PTP cases is perhaps not surprising given the nature of organizations and the structure of their ownership in the US/UK at that time.10 The structure of the European buyout industry and buyout origins seemed to be more nuanced. Wright et al. (1992) documented that divestments accounted for 62.8% of the UK buyouts in 1989. In France, Germany, Italy, and Spain, this proportion was 31%, 61.1%, 38.9%, and 0% respectively. Yet a large fraction of buyouts also came from family/private firms, especially in Continental Europe. In these same countries, private buyouts accounted for 29.7% in the UK, 44.8% in France, 38.9% in Germany, 50% in Italy, and as much as 75% in Spain. (Desbrières & Schatt, 2002) argued that this pervasiveness of private/family MBOs was due to the presence of a considerable number of medium-sized private firms, the owners of which were facing succession problems. One particular type of transaction called a secondary buyout (SBO) also appeared in the 2000s. These transactions are characterized by the transfer of ownership from the initial outgoing PE investors to the new incoming ones. They have recently undergone an academic scrutiny to understand their performance and underlying rationale.
As buyouts manifestly originate from different sources there may be some heterogeneous implications of these vendor sources on performance and efficiency. Before turning to the existing evidence, it is worth discussing the reasons for this conjecture.
Vendor sources and efficiency: the rationale
Different ownership and control regimes impact levels of efficiency. Since the former mutate during the transaction, the pre-buyout ownership structure will impact on the opportunities for improvements in efficiency after a transaction. For example, divisional buyouts may be initiated where incumbent management perceives opportunities for performance improvements. The latter are possible because parental control systems in large organizations may impose some element of regular budgetary targets and reporting of management accounts (Wright et al., 2000). However, shortcomings in parental control arising from lack of fit of parent-wide systems with the contingent context of the division, and inability of the parent to devote sufficient attention to or understand distant divisions (in terms of geography and products) in large complex organizations (Wright & Thompson, 1987), create the potential for efficiency improvements. Post-buyout, more appropriate control systems are likely to be introduced by management and PE firms to ensure that performance is at a level commensurate with finance servicing commitments.
484In buyouts involving private and family firms, owner-managers prior to the change in ownership generally have incentives to operate the business profitably. It is therefore unlikely that these types of firms generate significant agency costs (Howorth et al., 2004). Nevertheless, these systems are often in need of professionalization. This is especially relevant where the business has outgrown the ability of the founder to exercise personal oversight or where the founder’s attention is no longer as close as it once was (Hellmann & Puri, 2002). Further, where private and family firms face succession problems, a buyout offers a way for the firm to stay independent and/or for the firm’s management to remain employed (Meuleman et al., 2009). In this context, the buyout provides the opportunity to professionalize control systems that can help improve efficiency, but there may be a learning transition period as the new owner-managers and PE firms deal with the implications of the loss of tacit knowledge of the founder (Howorth et al., 2004).
As mentioned earlier, an SBO involves the refinancing of the initial buyout together with the arrival of a new set of PE investors. Such shifts in ownership could happen when the initial buyout underperforms.11 In such cases, other exit routes may be unavailable, as the target is not attractive enough for trade sale or public offering (Wright, Robbie, & Albrighton, 2000). In addition, in SBOs, there may be little room for efficiency improvements if the previous PE firm has already transformed the operations and systems to enhance it (Jelic & Wright, 2011).
On balance, the discussion so far suggests that improvements in post-buyout efficiency may be expected and that the relative magnitude of efficiency gains is a function of vendor source type. The following sections discuss the empirical investigations related to this observation.
Vendor sources and efficiency: the evidence
As mentioned earlier, Desbrières and Schatt (2002) conducted analyses of French LBOs. Their results suggested that family/private firms were actually in a better financial situation than comparable firms in the same industry. This conclusion was in sharp contrast with the prevailing agency cost-related arguments advanced by the Anglo-Saxon literature. The hypothesis that divisional buyouts seemed to outperform other buyout types was supported. Another investigation of the buyout origins with a particular emphasis on divisional buyouts was also provided by Meuleman et al. (2009). Using the hand-collected data from the Centre for Management Buyout Research on the 238 PE-backed buyouts in the UK during 1993–2003, the authors studied performance implications of the different vendor sources. Strikingly, the study documented that divestments were not associated with significant changes in profitability. However, divisional buyout did show significant improvements in efficiency. The latter was measured using the atomistic measure of sales per employee.
Boucly et al. (2011) documented changes in corporate behavior in 839 French LBOs completed between 1994–2004. Their findings showed that French firms became more profitable, grew faster, issued additional debt, and increased capital expenditures relative to the carefully constructed control group in the three years after the transaction. They further stressed that these improvements pertain more to the private-to-private buyouts as opposed to the divisional or PTP ones. Concerning the latter, Guo et al. (2011) reexamined the more recent wave of PTP buyouts completed between 1990 and 2006 in the US. Their analyses of buyouts for which the post-transaction data were available suggested that gains in operating performance were comparable or slightly in excess of the improvements in benchmark 485firms. Moreover, the gains themselves seemed to be much lower than those documented in earlier studies. Relatedly, Cohn et al. (2014) used confidential federal corporate tax return data to compile a sample of 317 US PTP LBOs closed between 1995 and 2007, and with assets of no less than $10 million. According to the authors, this represented about 90% of LBOs of this size during the period under study. Using accounting measures such as return on sales, return on assets, and economic value added (EVA), the study concluded that the evolution of performance of LBOs relative to the control group of similar listed peers was essentially flat from the two years before to the three years after the transaction.
One interesting question pertaining to the studies based on the accounting items is whether the latter could introduce some noise into the measurements of performance or efficiency. Ayash and Schütt (2016) argued that this is indeed the case. More specifically, they illustrated that most of the post-buyout performance measures were suffering from the upscale bias due to neglecting intangibles while at the same time accounting for profits generated by the latter. This seems to be especially relevant for the cases of active acquisition strategies put in place after the buyout, in which acquired firms generate high levels of goodwill. Authors suggested that this bias alone can explain mixed findings on the recent wave of PTP transactions in the US, as discussed in Guo et al. (2011) and Cohn et al. (2014).
Apart the analyses of private and divisional buyouts, a series of papers also focused on performance and efficiency implications of SBOs. The previously mentioned study by Alperovych et al. (2013) made a distinction between private, divisional, and SBOs. The results offered a nuanced view indicating that private and divisional buyouts were more efficient than an average comparable firm. Private and divisional buyouts were also very close to or above the average in terms of efficiency measured between the pre-transaction year and during the three years after. To an extent, divisional buyouts were more efficient than other buyout types. SBOs, surprisingly, also showed some positive trend in efficiency. They were, however, less efficient than their peers.
In parallel, Wang (2012) studied several aspects of SBOs, one of which was operating performance patterns following the change of ownership. Using a hand-collected sample of UK buyouts and a three-year event window centered on the transaction year, he looked at the effects of SBOs on the target’s size, operating cash flows, and profitability. The conclusions were mixed. He documented the increases in the operating cash flows and profits. These improvements, however, seemed to be rooted in the aggressive acquisitions strategies adopted by the new investors. After the size adjustments in the measures, he suggested that profitability actually dropped in the SBOs. Finally, matched sample analyses, in which SBOs were paired with first-time buyouts, indicated that SBOs performed better at generating cash and worse at generating profits.
Achleitner and Figge (2014) studied the value creation (operating performance, leverage, pricing, and return on equity) in SBOs using proprietary data on 2,456 PE buyouts including 448 SBOs. The granularity of the data allowed them to evaluate the changes in operating performance – i.e., growth in EBITDA, growth in sales, and changes in margins – during the PE holding period. Their estimates of the SBO effect suggested that its impact on the growth in EBITDA was negative, on the growth in sales was positive, and on the changes in margins was again negative. None of these results was significantly different from zero in the statistical sense. This implied that SBOs exhibited no different growth rates and changes in margins compared to the non-financial buyouts.
Bonini (2015) focused on SBOs exclusively and constructed a panel data tracking target companies through the buyout holding period including primary and secondary buyouts. A 486clear advantage of this approach is that it rules out the endogeneity concerns discussed earlier. The cost is the drastic reduction in the sample size, as this approach puts more strain on data availability. Bonini (2015) was able to compile data on 163 firms from one year before the first buyout until two years after the second one. His results, in contrast to Wang (2012) and Achleitner and Figge (2014), demonstrated that SBOs did exhibit incremental operating performance in comparison to the peer sample. However, SBOs seemed to severely underperform first-round buyouts. Two contemporaneous studies on SBOs were carried out by Arcot et al. (2015) and Degeorge et al. (2016). Although both focused on performance of SBOs from the investors’ standpoint, they provided valuable evidence on whether SBOs were creating value or witnessed the opportunistic behavior of PE fund managers. Arcot et al. (2015) investigated the underlying raison-d’être of SBOs and advocated that it was the pressure to buy/sell that forced PE funds to engage in SBO transactions. Building on these findings, Degeorge et al. (2016) examined more closely the performance of SBOs using the data from the private placement memoranda collected via direct surveys. These data provided exact information (though not totally complete) on the distributed-to-invested amounts, i.e., cash multiples, entry and exit dates, and internal rates of return (IRRs) for each deal of each fund raised by a sampled PE firm. The authors were also able to construct a deal-specific public market equivalent (PME) in the spirit of Kaplan and Schoar (2005).12 In terms of performance, SBOs were found to generate lower multiples, lower PME, and lower IRRs in comparison to the primary buyouts. Further analyses indicated that SBOs bought late with respect to the fund’s investment period underperformed other buyouts, while SBOs bought early were no different from other buyout types.
Given the average and median underperformance of SBOs relative to primary buyouts, it seems natural to investigate the possible reasons for these patterns. As the preceding discussion on the improvements in performance in buyouts indicates, one might expect that further value should be added at each step of the series of buyouts. At the same time, if all improvements and transformations of the internal structures have been implemented by the outgoing investors, the ability of the incoming ones to further add value must be limited. Along these lines, Degeorge et al. (2016) argued that additional value can be generated when some complementary skills exist between buy- and sell-side investors. Conversely, one should not expect any additional value creation whenever there is no skill-wise complementarity between the incoming and outgoing PE investors. They studied three types of skills in this context. The first type relates to the focus of a PE firm on boosting margins or revenues. Complementarity in this case implies that the outgoing PE firm was focusing on boosting revenues, while the incoming would focus on boosting margins via cost-cutting and/or price increases (or vice versa). The second type relates to the professional profiles of general partners (ex-bankers vs. ex-consultants). The argument here is ex-bankers are presumably better at M&A buy-and-build strategies, while ex-consultants are more efficient in internal restructuring strategies (Acharya et al., 2013). Here, the complementarity would imply that operation-oriented PE firms could add value to a company that was previously backed by a finance-oriented backer. Finally, some complementarity might exist between the regionally-focused PE firms and their globally-oriented counterparts. The idea is that regionally-oriented firms can develop a company to a certain point where it needs the help of a more internationally-oriented PE firm to grow further. The empirical evidence provided by Degeorge et al. (2016) suggested that deals transacted between parties with similar skills were associated with greater value creation in SBOs. This corroborated to an extent the evidence on PE firm experience positively affecting operating performance in buyouts (Meuleman et al., 2009; Alperovych et al., 2013).
487On balance, the overall evidence seems to lean towards a positive effect for LBOs on performance or productivity. This result, however, should be nuanced. First, performance and productivity can be measured with various techniques, e.g., accounting versus TFP, stochastic frontiers, and DEA. Second, buyout heterogeneity seems to be an important factor affecting the post-buyout improvement potential.
Do performance and productivity matter?
The discussions in the preceding sections ascertained that buyouts generally had a positive effect on productivity and performance. This observation seems to hold across different nations, and also across time, although performance of the PTP buyouts has recently deteriorated (Guo et al., 2011). Do these productivity gains translate into actual economic added value? Amess and Girma (2009) investigated the relationship between firm-level productivity and market values of 706 manufacturing firms in the UK over the period 1996–2002 and found a positive relationship. This suggests that stock markets seem to pay attention and price the adoption of lean management practices and better resource utilization. The question is whether this effect is present in the buyouts.
Kaplan (1989) was able to identify market values of 25 out of 76 buyouts in his dataset. The valuations were detected either because these firms had gone public again (reverse LBOs), or had issued public debt, or had preferred stock outstanding, or were acquired by other listed firms. Using these valuations, he could estimate whether operating improvements he had observed translated into increases in the market values of the underlying firms. The results implied that pre- and post-buyout investors earned a median total market-adjusted return of 77%. Pre-buyout investors earned about 37%, while post-buyout investors realized a median 28%, both being market-adjusted. Kaplan (1989) concluded that these figures were evidence that operating improvements are associated with material value increases.
An almost identical approach was used by Guo et al. (2011). They used available information after the buyout on a more recent wave of PTP transactions (1990–2006), again in the US. Large increases in total firm value were observed between buyout and exit dates. The results surprisingly indicated that the median market- and risk-adjusted returns to preand post-buyout investors were about 73% and 41% respectively. How much of this return is attributable to the improvements in operations? To answer this question the authors estimated the hypothetical returns to pre- and post-buyout shareholders assuming the targets had not gone through a buyout. Interestingly, the performance gains accounted for as much as 23% pre- and 18.5% post-buyout returns, on a par with industry-wide valuations and effects of debt tax shields.
Conclusions and avenues for future research
The evidence reviewed in this chapter seems to corroborate an assumption that improvements in operations and productivity are important drivers of value creation. These improvements come from various sources, e.g., growth in sales, acquisitions, refocusing firm strategies and operations, cost-cutting mechanisms, divestments of unproductive units, reallocations of labor, etc. Despite this fact, critics still argue that buyouts harm companies because of the excessive use of leverage, short-sightedness of PE firms, and potentially considerably negative social impact (layoffs). However, the core of the criticism seems to be case-based as the systematic academic evidence tends to disagree with it.
488It appears that improvements in productivity after the buyout transaction are detectable. Yet the underlying mechanisms that generate these improvements seem to differ. Early evidence put an accent on the debt bonding and cost-cutting strategies. Later evidence suggested that value increases have to also be sought in revenue-enhancing strategies and improvements in corporate governance mechanisms. Moreover, as PE firms accumulate experience they seem to better translate it into the changes operated within portfolio companies.
Existing evidence also comes with some limitations. The first point is the absence of a uniform way of measuring performance and productivity. Most of the studies make use of ratios (for example EBITDA/assets) or productivity metrics. Reliance on accounting data has the potential to introduce bias due to the underlying dependence on local accounting standards that affect reporting. This also renders the cross-country comparisons more delicate, especially for the smaller buyouts as they are not necessarily subject to IFRS requirements. Relatedly, accounting measures can also be subject to misreporting, whether intentional or not. Although some work has been recently initiated in this direction (Ayash & Schütt, 2016), more evidence is necessary especially in settings other than the US. Reliance on the TFP measures puts a serious strain on data quality. In some developed countries like the US or UK, such data gradually becomes available to researchers although at some collection and processing cost. We are yet to see the data of such quality appear in the developing and other developed countries. One positive aspect, it should be noted, is that the use of various performance/efficiency measures is providing a more comprehensive and rich view on the question. At the same time, this heterogeneity in the metrics makes it difficult to draw comparisons between different studies. Thus, more universally comparable measures of performance and productivity may be welcome.
The second limitation is related to the way we account for the quality and experience of the fund management team. For example, up to now this was generally done by counting the number of deals executed by a team or a PE firm before a focal transaction. This, however, is a very narrow view of the team quality and experience. Some work has begun on the implications of professional profiles of fund managers (ex-consultants vs. ex-bankers). It would definitely be insightful to investigate the social characteristics of these individuals and the linkages they might have on performance. Interestingly, these kinds of studies have started to appear in venture capital literature (Hsu & Bengtsson, 2010; Kaplan et al., 2012; Hegde & Tumlinson, 2014; Bengtsson & Hsu, 2015; Ewens & Rhodes-Kropf, 2015; Bottazzi et al., 2016; Gompers et al., 2016).
Third, the magnitude of improvements in productivity and performance seems to decay over time. This may be because of the overall maturation of the PE industry accompanied by increased competition for deals between PE firms, and by concentration of the PE firms within the industry. Yet in light of the ever-increasing experience of the incumbent PE firms, it is unclear why the latter are not able to deliver the increases in performance in the way they used to do. The improvements in productivity that accompany the buyout firm may also affect the competitors in the respective product markets and industries (in a similar manner to IPOs; see Chemmanur et al., 2010; Chod & Lyandres, 2011). Some preliminary evidence on the impact of PE on industry performance has recently been documented by Bernstein et al. (2017). A plausible assumption therefore may be that non-PE-backed competing firms adjust their product market strategies in the reaction to a buyout.
Finally, the structure of the PE industry in terms of buyout origins seem to be very different across countries and depends on historical, demographic, and economic factors. This warrants more macro-level research to better understand the global implications of PE-backed buyouts.
489Notes
1 See Axelson et al. (2013) and Global private equity report (2015) for the recent statistics on the acquisition debt multiples and leverage in buyouts.
2 Additionally, cash retention also lowers the likelihood of being scrutinized (and disciplined) by capital markets once the firm seeks financing.
3 According to Kaplan and Strömberg (2009), there is also a third channel, financial engineering, associated with the use of leverage. This channel is beyond the scope of this chapter.
4 These mechanisms are listed in the order of importance following P. Gompers et al.’s (2016) results obtained via a direct survey of PE specialists.
5 Value capture is related to the transfers of value from other stakeholders, like employees via cuts in headcount for example. Value creation is related to improvements in efficiency and effectiveness.
6 Thompson and Wright (1995) summarized this accounting-based evidence produced by the UK studies.
7 Efficiency in this sense is estimated as a score obtained from the linear program, which maximizes outputs at fixed levels of inputs. Alternatively, the same score can be obtained by minimizing inputs at fixed levels of outputs.
8 This contrasts with other studies that use total factor productivity (Lichtenberg & Siegel, 1990; Wright et al., 1996; Ames, 2002; Harris et al., 2005; Davis et al., 2014) and stochastic frontier modeling (Amess, 2003).
9 It should be noted though that in some studies the line was drawn between “full LBOs” and “divisional LBOs”. See also Lichtenberg and Siegel (1990) for an example of the same distinction.
10 This prevalence is also due to the data availability problem. The specific financial and employee data on private companies is very difficult to obtain in the US. Conversely, in PTP deals, pre-buyout data is available. This also explains why researchers used it more often. To an extent, the task is easier in the UK and Continental Europe, where firms are required to disclose their financial statements with the government authorities. These statements are later accessible via commercial databases.
11 See Axelson et al. (2009) and Arcot et al. (2015) for the theory and empirical evidence on other non-target-related reasons for SBO transactions.
12 PME is a ratio of the present value of the capital received to the present value of the capital invested, both discounted by the rate of return on a benchmark index. A frequent choice for the latter is the S&P 500.
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