53028
DISTRESS, FAILURE, AND RECOVERY IN PRIVATE EQUITY BUYOUTS
Nick Wilson
Introduction
This chapter examines the evidence in relation to private equity (PE) involvement in buyout activity and the influence of PE ownership on the risks and severity of financial distress (debt default) and failure (insolvency, bankruptcy) among their portfolio firms. We discuss whether companies acquired through PE buyouts are more likely to default on their debt obligations or enter legal insolvency processes than other firms.
Early work on modeling financial health in the corporate sector (Altman, 1968) confirmed that relatively high leverage in firms is associated with an increased risk of financial distress and the likelihood of bankruptcy. This is the case when firms fail to generate sufficient profit and cash flow to cover the regular interest payments associated with their debt obligations. In consequence creditors take (legal) action to recover their funds that can result in the winding up or liquidation of the company or the sale and restructuring of the company’s assets. In either event the existing shareholders lose both control and some or all of their investment. Of course, such action precipitates wider economic and social costs (e.g., employment). PE-backed buyouts often involve high debt levels secured against the target company’s assets as part of the process of both ownership change and as a means of monitoring management and changing incentives. PE investors acquire their “portfolio companies” with equity provided by the PE investors and debt capital (bank loans, bonds holders, mezzanine finance). Leveraged buyouts (LBOs) of large companies and/or delistings are particular examples of buyouts that result in a capital structure involving significant use of debt capital and investment grade bond issuance. LBOs have been a particular feature of the US buyout market.
Some commentators and analysts have raised concerns around the susceptibility of PE-backed buyouts to defaults, consequent lender losses, and insolvency due to “over-leverage,” i.e., levels of debt that become burdensome or unsustainable. Although PE investors often target underperforming firms, as we will discuss, their aim is to implement changes and investments to generate sufficient profits, cash, and productivity necessary to meet debt obligations and ultimately return value to investors on PE exit. However, how these firms might perform during downturns raised concerns among analysts and policy makers, particularly during the onset of the 2008 financial crisis and consequent recession. For instance the Boston Consulting Group (2008) analyzed a sample of 328 PE-backed companies and found that 60% 531were trading at “distressed levels.” The study predicted, at this time, that half of the world’s PE-backed companies would default within three years. In the vagaries of this recession, the study offered no comparable evidence for other company types. Moreover, and as we discuss later, these predictions did not materialize and it is interesting to understand why.
Another study of the US market, released by Moody’s (see Thomas, 2010), suggested that larger PE acquisitions were defaulting at a higher rate than comparable public companies. In the UK, it was suggested, that because of the large number of PE deals in the mid 2000s PE investments could potentially increase financial fragility in the economy. The PE portfolio firms had issued bonds due to mature in 2014–2015. Indeed the Bank of England (2013) went further and pointed out that the risk of default and PE buyout failures posed a threat to the stability of the financial system, a risk that was compounded, in the post-crisis period by the need for PE companies “to refinance a cluster of buyout debt maturing in an environment of much tighter credit conditions” (Bank of England Quarterly Bulletin, 2013Q1). Again the evidence for this proposition has not appeared post-2015. PE investment activity has been linked to macro-economic stability in other studies. Analysts of the macro-economy have pointed out that PE investment activity is cyclical (Axelson et al., 2013) with PE fund raising and deal values increasing during financial boom times. This again raises two major concerns. First, does the pressure on PE investors to complete deals during boom periods lead to poor investment decisions, e.g., the selection of low quality target firms with an increased likelihood of failure? Do the PE investors “overstretch” themselves and fail to introduce the necessary changes in organization structure and strategy required to secure growth and profitability among their portfolio firms? Second, the cyclical nature of PE investment may, it has been suggested, exacerbate any shocks to the financial sector and the dynamics of boom and bust cycles. Is this the case or are PE-backed companies more resilient in downturns and can they therefore play a stabilizing role? The chapter seeks to understand and evidence these alternative considerations.
Evaluating the impact of a change of ownership and governance on firm-level performance is not without its challenges. Of relevance in an evaluation of financial distress or insolvency risk for this subsample (PE portfolio firms) of the corporate population is the type and source of the buyout and the context. Buyouts encompass a wide range of company types, including “corporate unbundling,” i.e., the divestment of subsidiaries or large companies that may be domestically owned or international; the privatization of public assets; the transfer of ownership of family or owner-managed businesses; and the transfer of ownership of listed companies to private ownership (delisting) This latter activity gave rise to the term “leveraged buyout” and has involved some well publicized “mega-deals” involving high leverage, primarily in the US sector.
As suggested earlier, in most cases PE investors target potentially profitable firms for acquisition and/or firms where they believe that value can be added, created, and result in capital gain. At the time of buyout and pre-buyout they are likely to be “underperforming” (Wilson & Wright, 2013). Moreover, PE has played a role in the buyout and restructuring of companies in difficulty including financially distressed firms and/or firms that have already entered the legal insolvency process (Chapter 11, Administration, Receivership in the US). Wright et al. (1998) point out that the early UK buyout market involved transactions of companies that were already in receivership. Thus PE portfolio companies are often at the higher end of the risk spectrum pre-buyout and in relation to comparable companies. Thus it is important to assess the financial position, cash flow, and leverage of the target company pre-buyout when evaluating post-buyout performance. PE investors are often “active owners” and work with existing management (MBOs) or effect new management regimes (MBIs). 532The PE firm will usually appoint board members (directors) and monitor management closely (and/or structure incentives to overcome agency problems) in order to implement their strategic objectives, i.e., policies, practices, investments in capital, technology, and operational improvements. Although PE sponsors are known for increasing leverage in their portfolio firms, this should be placed in the context of pre-buyout leverage, the ability of the firm to cover interest payments, the relative price of debt, and the firm’s (sponsors) propensity to adjust capital structure if and when required. Moreover, debt finance is seen as part of the mechanism that owners use to discipline management.
In assessing the outcomes of PE involvement in buyouts, the extent of active involvement by the PE sponsors in the company post-investment and their experience and expertise are of particular interest as the PE sector has been developing since the late 1980s. Moreover, the extant evidence from which we base our evaluation emanates from different countries and legal regimes and cuts across industry sectors, company size, risk, and maturity (age). As mentioned earlier, PE buyout deals occur at different stages of the macro-economic and credit cycle. Evaluation of post-buyout performance requires comparisons and counterfactuals.
PE target companies
What types of company do PE investors target for acquisition? In order to evaluate the impact of PE ownership and governance on firm-level financial distress and failure, it is necessary to take account of the financial and economic health of the company at the time of the buyout transaction; in other words, the prior probability of distress and failure. Indeed, an investor that aims to add value to their investment will likely acquire firms that are in need of capital and/or restructuring in order to manifest their potential.
There are only a few studies that examine the characteristics of PE target companies and their performance pre-acquisition. Borell and Tykvova (2012) in a comprehensive study of European-based firms provide some evidence on the buyout targets of PE investors. The authors distinguish between “syndicated” and “non-syndicated investments” as important in assessing targets and portfolio firm outcomes. They suggest that the syndication pattern and investor experience determine the choice of buyout targets. The authors argue that syndicates are “better able to manage high risks arising from investments in highly financially constrained companies than stand-alone investors” (2012: 5). This is because syndicates of investors are better informed (have wider networks) and have a synergistic combination of skills to bring to the target firm. This leads to better target selection, effective monitoring of the investee, and high quality support for the company during the investment stages. All these factors, the authors suggest, reduce the risk of distress and bankruptcy. Analyzing their sample of PE targets, they report that:
[b]uyouts are significantly larger and older than non-buyout companies. Moreover, buyout companies have a median leverage of 57% and ROA of 5.72% in the years before the transaction. In contrast, firms which did not experience a buyout transaction show a significantly higher median leverage of nearly 65% and a lower ROA of 2.1%.
(2012: 11)
The implication is that the buyout targets are able to bear an increase in leverage from their starting position.
Wilson and Wright (2013) in a study of the population of private and listed companies in the UK from 1995–2010 examine the subsample of all known UK buyouts. The buyout 533companies are identified within the population and tracked pre-buyout and post-buyout. The data on buyouts has over 25,000 company-year observations and 1,179 instances of buyouts that enter into an insolvency process. The data set includes three years of pre-buyout data for buyout subsamples and PE-backed buyouts are identified as a subpopulation of all buyouts and buyins. The authors report an analysis of the pre-buyout characteristics focusing on PE targets. The characteristics of PE-backed targets are compared with non-backed buyouts and a large control sample of non-buyouts matched by year, sector, age, and size. The authors estimate a panel logit model determining the probability of PE-backed buyout compared to the control samples. Within the buyout population, it is reported that PE sponsors select larger buyouts with better profitability and cash generation. PE targets are less likely to have problems with short-term debt but are more likely to have some debt and creditor charges on assets. Compared to the non-buyout population PE targets have stronger cash flow. The authors suggest that PE-backed firms benefit from refinancing and are in a better position to service debt from cash flow, i.e., “we find that PE investors target underperforming companies with better prospects in terms of profit and cash generation” (2013: 988).
It is interesting to examine whether the characteristics of PE investor target companies has changed over time. In an updated study the authors (2016) re-estimate the PE target models using an extended sample to 2013. The purpose of this analysis is to profile the characteristics of PE target companies compared to a control group of matched firms and non-PE buyouts during the whole time period and for sub-periods: 1995–2001, 2002–2008, and 2009–2013. The period 1995–2001 was relatively turbulent, with recovery from the early 1990s recession and the dot.com boom and its aftermath. In contrast, the period from 2002, with the exception of a short recession, was a stable period of low insolvency across all sectors and was also marked by growth in the buyout market culminating in a peak in 2007, before the credit crisis and recession of 2009 onwards. The authors examine whether there is a change in the characteristics of the target companies over these periods. In summary the authors report that PE targets tend to be established companies in terms of age and size and are more likely to have a higher proportion of tangible assets. The targets are in stable industry sectors with a lower than average failure rate and are less likely to be diversified (single product). Among the riskier sectors, PE investors have a preference for advanced manufacturing technologies and the high-tech end of the services sector. The firms that PE investors target are generally cash generative, profitable, and have high interest coverage ratios on existing debt. Confirming the earlier study the target firms are likely to have borrowed and have charges on assets. These firms have lower levels of equity and lower than average productivity thus providing opportunities for investors to realize performance improvement and growth post-investment. The authors do not detect much change in the profiles of targets across the time periods other than within the evolving industry sectors (high-tech and knowledge intensive sectors).
Portfolio company performance post-buyout
Although this chapter examines the evidence on financial distress among PE portfolio companies, evidence on the drivers of post-buyout performance has relevance for our discussion. There are many studies which show that buyouts generally have a positive effect on profitability and growth (Cumming et al., 2007). Moreover, PE-backed buyouts perform comparably well post-buyout and this evidence is discussed elsewhere in this volume (see Alperovych, this volume). Nonetheless, there is some evidence that the failure rates of buyouts in terms of entering formal bankruptcy proceedings increase in times of market 534peaks. This is particularly the case in the early years of buyout activity. Toms et al. (2015) find that “PE experiments” in the period prior to 1980, “either failed disastrously, in the absence of both resource-based investment and governance skills, or were only partially successful due to limited resource base and a ‘hands off’ approach to monitoring from the investor” (2015: 753). They argue that the pre-1980 institutional and regulatory climate, “by emphasizing creditor protection and capital maintenance not only stifled capital restructuring, but also failed to prevent fraud at the expense of creditors and minorities” (2015: 753). In the second phase that was characterized by corporate unbundling, i.e., divestment and downsizing, PE investments typically involved performance improvements through cost-cutting and efficiency improvements. Wilson et al. (1996) analyzed survey data and financial records of buyouts completed during 1982–1924 and tracked them over a five-year period. The sample comprised a matched sample of 110 buyouts of which 53 had entered receivership within the time frame. A second sample of 120 buyouts completed in 1983–1985 was tracked to 1993. The purpose was to analyze the characteristics of failures compared to survivors. The survey data comprised a rich range of variables dealing with the initial transaction characteristics of the buyout, management team, their motivations and experience, and details of the financial transaction. Their evidence was consistent with the view that mechanisms introduced to deal with agency cost problems, particularly managerial incentives, are associated with a lower probability of failure. Consistent with agency cost arguments, variables measuring the taking of restructuring action at the time of the buyout reduced the probability of failure, while delay in taking such actions was positively associated with failure.
Toms et al. (2015) report that:
[i]n the third period, when much of the corporate restructuring of the 1980/1990s had been completed, there was a shift in emphasis towards both efficiency improvements and growth seeking, with private equity executives’ human capital governance resources involving more strategic value adding skills, especially for private equity firms with long experience.
CMBOR (2014) report that about 15% of PE-backed buyouts completed during the mid-1990s failed by the end of 2008, while around 25% of those completed during the first peak of buyout activity in the 1980s went bankrupt. Of course not all of these were PE-backed firms. What is the evidence relating to financial distress among PE portfolio firms?
Portfolio companies and financial distress: empirical evidence
In analyzing corporate outcomes it is, of course, necessary to have an outcome definition. The terms financial distress, default, insolvency, and bankruptcy are often used interchangeably or are seen as escalating states of financial difficulty with the end stage being company closure and liquidation. The latter is usually described by juridical definitions such as bankruptcy, administration, Chapter 11, etc. A company that enters a formal (legal) bankruptcy procedure incurs losses for investors and other creditors, owners lose control over assets, and there are clear economic (e.g., job losses), reputational (investor confidence in the PE firm), and social costs. Financial distress, on the other hand, is a state that may involve or require financial restructuring (i.e., renegotiating the debt finance) for survival, but the company may be able to recover without disruption to the company’s productive activities and without much reputational loss for the PE sponsor. In analyzing financial distress in PE-backed 535companies we need to be mindful of these definitions. Indeed the reports on default rates cited earlier (BCG, Moody’s) were criticized for “developing new and expansive definitions of what constitutes default” (Thomas, 2010: 1). Including “debt renegotiation” with creditors as financial distress may not be appropriate since one of the cited strengths of PE investors is that they are able to use their networks and bargaining power to adjust the capital structure of their portfolio firms if required as a means of securing the firm’s future. In a survey of relevant studies Thomas (2010) concludes that:
[w]hile the credit performance of private equity-backed companies deserves ongoing scrutiny, the data to-date support the contention that the changes in organizational structure and strategy introduced by private equity investors reduce the incidence of default. Claims to the contrary either rely on misleading data, or involve speculation about future default rates that have no historical analogue.
(2010: 13)
Many of the early studies of financial distress among PE portfolio companies emanate from the US market. Jensen (1989) contended that, “LBOs do get into financial trouble more frequently than public corporations do. But few LBOs ever enter formal bankruptcy. They are reorganized quickly (a few months is common), often under new management, and at much lower costs than under a court-supervised process” (1989: 24). In further studies the focus has been on the larger PE-backed companies that have debt financing and have issued bonds. The default rate on these bonds can then be compared with the default rate generally on investment grade corporate bonds. Kaplan and Stein (1993) in an early study demonstrated the cyclicality of default and bankruptcy rates. In a relatively small sample the authors analyzed US MBOs in two time periods. In the period 1980–1984 they looked at 41 buyout transactions and reported a low incidence of default (one firm defaulted, 0.41% rate). The analysis of a second period 1985–1989 showed that out of 83 companies 22 defaulted and 9 went into bankruptcy proceedings. In these early waves of buyout activity, the default rate on acquisitions completed during the second half of the 1980s was the highest of any period on record. It has been argued that PE investments were overvalued on acquisition, debt levels were too high, and incentive structures were poorly designed and implemented during this early phase of PE activity. The nascent PE investors lacked experience. The Bank for International Settlements (BIS, 2008) reported a study of PE investments. The BIS studied 650 PE-backed businesses that were acquired over different time periods: 1982–1986, 1987–1991, 1992–1996, 1997–2001, and 2002–2006. They undertook a matching exercise to compare each PE-backed company with up to five public firms in the same industry and size band. BIS confirmed higher leverage for PE companies but found that “default rates have not been consistently higher than those of similar publicly traded firms.” The highest default rate observed for portfolio companies was 3.84% in 1997–2001, and this was lower than the default rate for the public company comparators (4.03%) in the same period.
A study by Kaplan and Strömberg (2009) examined a larger sample of 17,171 buyouts from the global population of PE transactions in the period 1970–2007. This analysis found that only 6% of deals resulted in some form of restructuring or bankruptcy, i.e., ended in bankruptcy or reorganization. The authors report that, taking account of the average holding period of six years, the annual default rate was 1.2% and lower than the average default rate on US corporate bonds (1.6%). Moreover, the authors pointed out that PE-backed firms that have periods of financial difficulty tend to be able to avoid formal bankruptcy (Jensen, 1989).
536Chapman and Klein (2009) focus on data related to 288 mid-market buyouts in the period 1984–2006. The average deal value was $78.3 million (largest transaction $4 billion). The PE investors typically had equity contributions of around 35%. A total of 35 companies in the sample defaulted (default rate of 2.66%). In the US, Guo et al. (2011) analyze a sample of 192 businesses acquired by PE investors from 1990 to 2006. Of these acquisitions, 23 ended in some type of default. The default rate was deemed to be around 3.14% based on the average holding period. On analyzing the breakdown of these defaults, 14 were bankruptcy filings and 2 were voluntary restructurings. The remaining seven defaults are assumed to be missed payments or voluntary restructurings. These authors report that most defaults are “prepackaged” bankruptcies. In these cases senior creditors take control of the firm whereas the PE investors lose their investment. The costs of the bankruptcy are therefore low in terms of there being “minimum disruption to the company.” This is important in that it distinguishes “financial” from “economic” distress. Economic distress refers to situations where the portfolio company default results in employment loss or layoffs, the closing down of facilities, and/or the liquidation of assets via sale or receivership. Kaplan and Andrade (1998) argued that a company where default arises because the company has an unsustainable capital structure has more chance of recovery to a healthy condition than a company that defaults because of a drop in revenue due to increased competition, unmatched technological changes, or an outdated business model
Demiroglu and James (2010) examined deals that involved “reputable private equity groups” and concluded that these firms are less likely to exhibit financial distress within five years following the transaction. The authors have a sample of 180 US public-to-private LBOs between 1997 and 2007. They find that before 2001 “ten buyout firms filed for bankruptcy and three firms violated financial covenants but later received waivers.” In the later period, two firms experienced financial distress, one filed for bankruptcy, and one experienced “technical defaults.” The annualized default rate was less than 2% for this sample. These authors point to PE investor experience as a vital determinant of the survival of portfolio companies.
The US studies focus primarily on financial distress as an outcome, i.e., default of bonds and loans, whereas studies of the European buyout market, where there are fewer bond issues as part of the portfolio firm financing, focus on bankruptcy as the outcome variable. A study of 839 French LBO deals’ failure rate of PE-backed and non-PE-backed from 1994–2004 (Boucly et al., 2011) found no significant increase in bankruptcy rates post-buyout as compared to a control sample. The authors found that 6.67% of buyouts and 6.7% of the control sample become bankrupt at some point. Moreover 4.17% of buyouts and 4.58% of the control become bankrupt within the three years after the PE transaction. Thus when compared with non-buyouts there is little difference in the company failure rate. In recent years more evidence has been amassed on the post-buyout fortunes of PE-backed buyouts.
Borell and Tykvova (2012) investigated the relative incidence of financial distress and bankruptcy in European buyout companies using data on buyouts and comparable non-buyout firms. The study is comprehensive in that it examines all buyout transactions covering 15 countries in the pre-crisis period 2000–2008. Of particular importance is how PE “experience” is both a determinant of the choice of company targets and is a factor in reducing the risk of bankruptcy ex post. In particular, as discussed earlier, PE investors select firms that are less financially constrained than comparable companies. Borell and Tykvova (2012) suggest that, “after the buyout, in particular when the buyout takes place under favorable debt market conditions, private equity investors tighten the companies’ financial constraints. However, this tightening does not raise mortality rates over those of comparable 537non-buyout companies” (2012: 21). The balance of their analysis points to the conclusion that PE-backed companies do not exhibit financial distress or higher failure rates than their comparators. Although the authors suggest that the “distress risk” of buyout companies increases post-buyout, it does not exceed that of comparable non-buyout companies. As mentioned, the important intervening variable is “private equity experience.” Inexperienced PE investors, the authors find, do not fare as well in managing their acquisitions through the restructuring process and into growth/stability and particularly in downturns. The authors argue that experienced PE investors are more adept at managing distress risk due to better target selection, negotiation skills, information, and value-adding abilities. They suggest that PE sponsors, committed to protect their reputation with investors and financial institutions, react faster and more effectively to deal with financial problems. This may involve using their influence and bargaining strength to renegotiate loans and covenants to more favorable terms. They find that “only inexperienced PE investors seem to increase mortality rates” (2012: 21). There is evidence that PE sponsors, over the time period under study, developed particular specialisms based on type of firm, e.g., industry sector, technology, divestments, turnaround, or distressed acquisitions (Wilson & Wright, 2013).
A number of other studies emphasize the role of investor experience when analyzing the outcomes of PE-backed companies. PE experience has a bearing on the implementation of investment and change post-transaction. Meuleman et al. (2009) suggest that experienced investors have superior selection skills and better information (reduced informational asymmetry) making them better equipped to be able to identify potentially high-performing companies. The authors find that PE investors look to stable industry sectors and find companies with lower variances in revenues, profits, and cash flow. The authors also point to the benefits of active ownership and PE roles in effecting organizational and strategic changes, monitoring, reducing costs, and stimulating growth. PE investors have informed networks and long-term relationships with banks. PE portfolio companies are therefore better placed to withstand economic downturns. Later studies are able to track PE portfolio companies through two economic cycles and the post-2008 crisis/global recession.
Wilson et al. (2012) examine a longitudinal panel of all UK PE-backed companies from 1995–2010 in order to assess their relative performance. The time period under study incorporates the recovery from the early 1990s recession, a minor downturn during 2000 and 2003 as well as the global recessionary period of 2008–2010. The analysis demonstrates that PE-backed buyouts experienced higher profitability, productivity, and growth relative to comparable non-buyout companies. The study does not model bankruptcy as an outcome but does provide strong evidence that the PE portfolio companies weather recession well relative to other companies and have a lower likelihood of failure. The authors provide evidence contrary to the conjecture that PE-backed buyouts would be more vulnerable in downturns, relative to comparable businesses, given their higher leverage. Indeed the authors conclude that “during the severe global recession PE-backed buyouts experienced higher growth, productivity and profitability, and working capital management” and that “this evidence is consistent with PE firms both adding more value to portfolio companies and being actively involved in taking timely action to assist their investees” (2012: 201).
Several studies have looked at bankruptcy rates following the second wave of PE-backed buyouts from the end of the 1990s to the financial crisis beginning in 2008 and its aftermath. Perhaps the most extensive studies are Wilson et al. (2010) and Wilson and Wright (2013) who analyze the population of UK companies over the period 1995–2010. The studies track the performance of the subsample of all UK MBOs and MBIs and identifies those that are PE-backed. The studies analyze a panel database of over 9 million company-year 538observations and 153,000 insolvencies during the period. The legal insolvency definition includes administrations, receivership, liquidations, and credit voluntary arrangements. Insolvency is chosen as the outcome in preference to measures of “financial distress” (e.g., loan restructuring). The latter definitions, the authors suggest, “do not distinguish transitory cash-flow problems from serious structural problems. Formal insolvency, on the other hand, involves the loss of assets (or, in the case of administration, control over assets) funds for creditors and the loss of reputations of PE investors and company directors” (Wilson & Wright, 2013: 949). The studies incorporate data for several years pre-buyout for the buyout subsample and the post-buyout sample has over 25,000 company-year observations and over 1,100 instances of insolvency. Around 50% of the buyout sample is classified as PE-backed buyouts. The authors undertake a multivariate analysis and employ a novel discrete time hazard model to identify the factors that determine insolvency. Controlling for a range of risk factors, the study finds that buyouts have a higher failure rate than the population of non-buyout companies, with the MBI sub-category having a higher failure rate than MBOs, which in turn have a higher failure rate than PE-backed buyouts. The analysis indicates a default rate for UK PE-backed buyouts of 5.3%. They note that the insolvency risk is not higher (in fact is lower) than expected given pre-buyout risk characteristics. The analysis finds that PE insolvencies are not differentially associated with leverage (see Hotchkiss et al., 2012). Interestingly the authors find that MBOs and PE-backed buyouts only have a higher insolvency risk than the non-buyout population pre-2003, controlling for age, size, and sector; post-2003, when changes to the UK bankruptcy process were introduced, there is no significant difference. In contrast MBIs always have a higher propensity to insolvency. Post-2003 recovery through refinancing was a more realistic option for companies in distress. The authors conclude that:
PE backed companies, as well as targeting better buy-out prospects, are in a better position because of active ownership and governance to adjust capital structure over the economic cycle and, therefore, manage insolvency risk and protect assets. PE investors protect their financial and reputational capital by actively restructuring and renegotiating finances when distress is finance rather than economic related.
(Wilson & Wright, 2013: 989)
PE-backed insolvencies are not differentially associated with leverage when compared to the overall population of companies (Wilson & Wright, 2013). Proactive investments in capital and operating expenditures (CAPEX, OPEX) post-buyout are effective in securing longevity.
Hotchkiss et al. (2012) adopt a similar methodology to Wilson and Wright (2013) over the same time period but for a sample of 2,156 “leveraged” PE-backed firms in the US. They use non-PE-backed leveraged firms as a control group. The authors examine whether PE-backed firms are more likely to default on their debt obligations than other firms with similar characteristics. Additionally, they investigate how PE-backed companies that become financially distressed take action to resolve the distress. The authors look at default and bankruptcy and define distress widely as (a) a missed interest or principal payment on a debt obligation, (b) a filing of a court-led bankruptcy, or (c) the execution of an out-of-court “distressed exchange.” Examination of the impact of PE ownership on default probabilities is undertaken using the discrete time hazard model of default (Wilson & Wright, 2013). The authors report, that “holding levels of leverage constant across the full sample, PE backed firms are no more – and no less – likely to default than non-PE backed 539firms” (2013: 15). Moreover, they show when comparing PE-backed and non-PE-backed firms in financial distress “that PE-backed firms resolve distress more easily, quickly and at a lower cost than similarly leveraged firms that are not backed by PE owners, and that PE-backed firms are more likely to survive the restructuring as an independent going concern” (Wilson & Wright, 2013: 15).
Studies covering other countries do not find relatively high failure rates for PE transactions. For instance, Lopez-de-Silanes et al. (2013) analyzed a sample of 7,453 investments made in 81 countries between 1971 and 2005. They reported that around 10% of PE transactions resulted in bankruptcy. The bankruptcy rate was observed to vary between countries, with 9% in the UK, 12% in the US, 13% in Germany, 8% in France, and 5% in Scandinavia. Given the length of the time period the failure rate is relatively small.
A common theme in these studies is the notion that “active ownership,” investor experience, and the PE sponsors’ relationship with banks and other financiers is important for both managing risk post-buyout and for proactive intervention to adjust the finances of their portfolio companies if a firm shows symptoms of financial distress. Although often highly leveraged at the time of the buyout, PE investors are willing and able to adjust the company out of debt in response to economic conditions and the relative prices of equity and debt. Indeed in low interest rate environments it may make economic sense to use debt finance and high leverage. Ivashina and Kovner (2011) show that PE firms with long-term bank relationships obtain deal-related financing at lower interest rates and with more favorable covenants than PE firms without a strong bank connection. Specifically, the authors find that portfolio companies, backed by more experienced PE investors that already have a strong track record, can borrow on more favorable terms than other comparable companies. Although in relation to the use of “covenant-lite” loans, Thomas (2010) finds no strong evidence to support this proposition. In the UK, during the crisis-recession period of 2008–2010, there was some evidence that PE companies had been particular beneficiaries of “forbearance” by commercial banks who were more likely to tolerate payment delays (Bank of England, 2013) in preference to forcing bankruptcy.
There has been some work examining outcomes when PE portfolio firms fail and are processed through bankruptcy (Citron & Wright, 2008; Cressy & Farag, 2012). Of particular interest are the “recovery rates” for investors, how much typically PE sponsors are able to recover from the process of company liquidation or administration procedures, and how this compares to the recovery rates for shareholders of other companies. Wright et al (2014) analyze data on 100 PE-backed buyouts and 100 public limited companies that have entered into administration or receivership. They find that PE sponsors recover 63% of secured debt in contrast to 30% recovered by PLC creditors. Recovery rates for PE sponsors that have syndicates of investors (multiple creditors) are lower at 54% but still higher than that of PLC creditors. Moreover, “the greater percentage recovery in PE deals is accompanied by a greater average time to recovery than in PLC deals of 40 days on average.”
Discussion and conclusions
This chapter has surveyed the evidence relating to financial distress and failure among PE-backed portfolio companies in the post-buyout period. Table 28.1 summarizes the empirical evidence on both default and bankruptcy rates. The balance of evidence relating relative default rates on bonds and loans and/or the incidence of enforced bankruptcy among portfolio companies indicates that financial distress and failure are not more likely as a result of this particular form of ownership change. PE portfolio firms are not placed at increased 540risk of failure due to changes in leverage, and in fact these firms appear to be more resilient during downturns than comparable firms.
Table 28.1 Portfolio company default and bankruptcy rates
Researchers point to the PE investors’ active involvement in strategic and operational management post-buyout as an important determinant of success and to the actions that the PE sponsors take to adding value through investments in technology (capital expenditure) and management practices (operational expenditure).
The extant studies find that firms backed by PE investors are particularly proactive in protecting their assets and reputation, and therefore are effective in negotiating restructurings of portfolio companies that become distressed and/or require refinancing through the economic cycle, reducing the likelihood of entering formal insolvency (Acharya et al., 2009). Further research could examine financial distress among PE-backed firms and the likelihood of recovery under different regulatory regimes. For instance, Wilson and Wright (2013) find the PE-backed firms created post-2003 had a lower failure rate than other buyouts. This may be attributed to the more stable economic conditions or to PE investors gaining experience, but it also coincides with changes in the insolvency legislation. The Enterprise Act 2002 in the UK aimed to promote a corporate rescue culture and increase the likelihood of the continuation of a business as a going concern. More specifically, prior to the Act the “administrative receiver” was only accountable to the “charge-holder” (i.e., creditors that had obtained a fixed or floating charge on assets), with little incentive to act in the interests of other creditors and/or rescue a company. The 2002 Act gave greater weight and negotiation rights to other creditors and may have favored PE investors by increasing the chances of restructuring the finances of distressed portfolio firms prior to formal insolvency procedures being triggered.
The earlier discussion highlights the heterogeneity of buyout firms and the source of the buyout, e.g., “corporate unbundling” and divestments of foreign and domestic subsidiaries or divisions, family firm exits, and privatizations. Analysis that takes a more detailed account of post-buyout performance in relation to vendor types and the specific agency governance issues would be fruitful.
Further work that explores in more detail the PE sponsors’ experience with current and previous funds and the timing of their investments would also be fruitful. Moreover, the PE 541sponsors create effective boards of directors and are more vigilant in monitoring management and in structuring incentives. Future research could explore the role of boards and their changing characteristics pre- and post-buyout. To date there is little systematic evidence on the role and composition of boards in PE-backed firms. Examining board composition, experience, and diversity in PE portfolio companies, across the range of buyout types and stages of development and in comparison to other company types, would be insightful when researching corporate outcomes.
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