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The Determinants of Bankruptcies Post LBO, Master Thesis, Jonas

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The Determinants of Bankruptcies Post LBO, Master Thesis, Jonas The Determinants of Bankruptcies post LBO - A study of North American post LBO bankruptcies 1980-2006 Jonas Granström ♠ Pär Warnström ♣ Master’s Thesis in Finance Stockholm School of Economics This thesis aims to shed light upon the determinants of default amongst leveraged buy out targets. We study 519 North American bankruptcies of leveraged buyout transactions and examine specific characteristics of the private equity sponsor, the target firms and the economic climate at the time of the transaction. We study three main areas, private equity firm characteristics, target firm characteristics and economic climate. We find that young firms are more likely to face bankruptcy and that increasing profitability of the industry the target is active within at the time of the buyout have negative correlation with bankruptcy. Moreover, we find that deals made in boom periods as proxied by periods of low US-yield spread are more likely to default. Keywords: Private Equity, Buyouts, Financial Distress Tutor: Associate Professor Per Strömberg Date: Location: Stockholm School of Economics Discussants: Acknowledgements: We would like to thank Per Strömberg for his valuable support and advice throughout the process of writing this paper. ♠ [email protected] ♣ [email protected] 0 Contents 1. Introduction .......................................................................................................................... 2 2.Theoretical framework .......................................................................................................... 5 2.1 Previous Research .......................................................................................................... 6 2.1.1 Financial Distress in Leverage Buyouts .................................................................. 6 2.1.2 Bankruptcy Prediction Research ............................................................................. 8 2.1.3 Ownership and control ............................................................................................ 9 3. Hypotheses ......................................................................................................................... 11 3.1 Private Equity sponsor characteristics .......................................................................... 11 3.1.1 Top Tier fund status .............................................................................................. 11 3.1.2 Club Deals ............................................................................................................. 11 3.2 Target firm characteristics ............................................................................................ 12 3.2.1 Firm age ................................................................................................................. 12 3.2.2 Previous owner ...................................................................................................... 13 3.2.3 Management involvement ..................................................................................... 14 3.2.4 Financials .............................................................................................................. 15 3.2.5 Industry .................................................................................................................. 17 3.3 Economic climate ......................................................................................................... 17 3.3.1 US Spread .............................................................................................................. 17 4 Sample and Data .................................................................................................................. 18 5 Methodology ....................................................................................................................... 19 5.1 Regression .................................................................................................................... 19 5.2 Variables ....................................................................................................................... 19 5.2.1 Dependent variable ................................................................................................ 19 5.2.2 Control Variables .................................................................................................. 19 6. Results and Analyses .......................................................................................................... 21 6.1 Private Equity sponsor characteristics .......................................................................... 21 6.2 Target firm characteristics ........................................................................................... 22 6.3 Economic climate ......................................................................................................... 22 7. Discussion .......................................................................................................................... 23 8. Conclusions ........................................................................................................................ 24 9. References .......................................................................................................................... 26 10. Appendix .......................................................................................................................... 29 1 1. Introduction This paper aims to examine the characteristics of private equity backed North American firms that faced financial distress 1980-2006. We look at specific characteristics of the target firm as well as the private equity sponsors. We study North American bankruptcies of leveraged buyout transactions and examine specific characteristics of the private equity sponsor, the target firms and the economic climate at the time of the transaction. Using bankruptcy data from Capital IQ (CIQ) and Buy out data from The Institute for Financial Research (SIFR) we study three main areas, private equity firm characteristics, target firm characteristics and economic climate. During the 1980s leveraged buyouts emerged as an important phenomenon (Kaplan and Stömberg (2009)) and became the source of considerable controversy, (Opler and Titman (1993)). A leveraged buyout is when a specialized investment firm (Private Equity firm) acquires a company by using a large portion of debt financing. Typically these firms buy majority control of an existing mature company (Kaplan and Stömberg (2009)) According to Kaplan and Strömberg (2009), private equity firms typically apply financial, governance and operational engineering, in order to improve the acquired firms’ performance. After an acquisition management incentives are aligned by giving management large equity upsides through stock and options. Secondly, leverage is applied; leverage put pressure on management not to invest unwisely as they need to make significant interest and principal payments. Leverage also increases firm value through tax deductibility of interest. Arguably adding leverage increase the risk of financial distress, if the leverage is too high the company will face challenges making the required payments. The third element is governance engineering. Compared to public company boards private equity controlled boards are more actively involved in governance and is more inclined to replace management not meeting expectations. In addition to governance engineering, today’s private equity firms also use what academics refer to as operational engineering which in 2 practice means that PE-firms bring industry and operating expertise in order to add value. In the 1980s financial markets experienced a first surge of LBO activity that came to a halt when the junk bond market that had been fueling LBOs collapsed. The following recession of the early 1990s brought most of the early LBO activity to an end and many of the highly levered portfolio companies defaulted ((Andrade and Kaplan (1998)), in the aftermath public to private transactions virtually ceased (Kaplan and Strömberg (2009)). However, the buyout industry/market did not disappear all together, rather it changed guise and primarily focused on acquiring privately held companies and divisions (Kaplan and Strömberg (2009)). In the mid 2000s the world experienced a second LBO boom that peaked in 2006-2007 with unprecedented amounts of capital allocated to private equity. However, the credit crunch and the recessionary times that followed brought this boom period to an end and financial problems incurred by firms that performed LBOs in the mid 2000s have given rise to renewed concerns about the potential financial distress costs created by these transactions. The LBOs of the 1980s are well studied by academics and proponents of leveraged buyouts such as Jensen (1986, 1989) argue that the LBO transactions created economic value by improving management incentives and mitigating free cash flow issues by applying high leverage. Furthermore, Jensen argued that the cost of financial distress in LBO’s is not large. Several academic studies (e.g., Kaplan (1989a) concluded that although tax benefits were a large source of the gains, value was created in LBOs. For example, Kaplan (1989b) found that cash flows improve after LBOs. However, other researchers, e.g. Lowenstein (1985) and more recently Guo et al. (2009) are not convinced and argue that just as much of the value created to equity owners could be attributed to tax benefits and value transfers
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