The Role of Deal-Level Compensation in Leveraged Buyout Performance
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The Role of Deal‐Level Compensation in Leveraged Buyout Performance Sven Fürth1 | Christian Rauch2| Marc Umber3 September 2013 Abstract This paper analyzes the influence of deal‐level compensation structures for buyout fund managers on the performance of Leveraged Buyouts. We use a unique and hand‐collected data set of 93 LBO deals in the United States over the period 1999‐2008 for which we can distinguish between different fund‐ and deal‐level compensation components that fund managers receive. Our results show that higher deal‐level compensation is negatively related to deal‐level performance. A one percent increase in the fees‐to‐proceeds ratio lowers the return to LPs by 127 percentage points. We also document that the occurrence of deal‐level fees does not depend on the structure of the fund‐level compensation structures, but instead on the profitability of the LBO target company and the historic performance of the buyout firm. These results are robust to changing market environments, characteristics of the LBO and restructuring activities in the target company, terms of the partnership agreements between investors and fund managers, fund structure and –profitability and different performance measures. JEL classification: G23, G24, G34, G12, G15 Keywords: Private Equity, IPO, Insider Trading, Buyout 1 Goethe University Frankfurt, Finance Department, House of Finance, Grueneburgplatz 1, 60323 Frankfurt am Main, Germany. Phone: +49‐(0)69‐798‐33727. E‐mail: [email protected]‐frankfurt.de. 2 (Corresponding Author) Goethe University Frankfurt, Finance Department, House of Finance, Grueneburgplatz 1, 60323 Frankfurt am Main, Germany. Phone: +49‐(0)69‐798‐33731. E‐mail [email protected]. 3 Frankfurt School of Finance & Management, Sonnemannstrasse 9‐11, D‐60314 Frankfurt am Main, Germany. Email: [email protected] For valuable comments and suggestions we would like to thank Michael Grote, Günter Strobl, as well as participants at the 2012 Southern Finance Association Annual Meeting, the 2012 Financial Management Association Europe Annual Meeting, the Frankfurt School of Finance Brown Bag Seminar, the Goethe‐University Brown Bag Seminar, and the UniCredit Research Workshop. Sven Fürth gratefully acknowledges the financial support of “Vereinigung der Freunde und Förderer der Goethe Universität Frankfurt” and of “Commerzbank Stiftung Frankfurt”. All remaining errors are our own. 1 Which incentive structures should principals choose for agents to maximize their returns? This question is at the core of many agency problems and has therefore been tackled in many different settings. Classic agency theory states that more performance‐linked compensation leads to better performing agents, ultimately resulting in a higher return to the principal (Jensen and Meckling, 1976; Fama, 1980; Fama and Jensen, 1983a and 1983b; Jensen and Ruback, 1983; Jensen, 1986). Empirically, this finding has been documented in various settings (e.g. Agarwal, Daniel and Naik, 2009). This paper adds to this body of literature by analyzing an under‐researched compensation structure which unique for one specific asset class: deal‐ level compensation for General Partners (GPs) in Leveraged Buyouts (LBO). What makes this compensation structure unique and why would analyzing it help expand the knowledge about the link between compensation and performance? In LBO funds, GPs are commonly paid based on the overall performance of the fund, and for their general fund management services. The former is usually referred to as “Carried Interest” or “Carry”, the latter is known as the “management fee”. The carry is a fixed percentage of the return that GPs generate for the fund investors (known as Limited Partners, LPs), whereas the management fee is a percentage of the fund volume, paid out annually to the GPs. In addition to these fund‐level fees, some LBO deals exhibit an additional compensation component for the GPs on deal level, i.e., Termination Fees, Transaction Fees, as well as deal‐level Management Fees. Deal‐level management fees are paid for monitoring and general advisory services the buyout firm provides for the portfolio company. Transaction fees are paid specifically for advisory on corporate transactions as part of the LBO restructuring process in the portfolio companies, e.g., recapitalizations or Mergers and Acquisitions (M&A). Termination fees are paid in connection with the exit of the buyout fund. These deal‐level fees exhibit a set of very interesting features, making them suitable to obtain a better understanding of the relationship between incentivization and performance. First, the GPs as agents choose the magnitude and structure of the deal‐level fees without explicit acknowledgment. The LPs as principals have little say in whether or not these fees are being paid out to the GPs and/or in which magnitude they are being paid out. This feature is unique in the sense that agents rarely may choose their own compensation without approval or oversight by the principal. Second, deal fees are paid to the GP by the portfolio companies. 2 Even though deal‐level fees are linked to certain services rendered by the GP, the portfolio companies compensate their owners for advising them. Third, deal‐level fees are not linked to the adequate performance measure. The payment of the fees depends on actions taken by the GP regardless of the return these actions yield for the LPs. This is especially interesting since GPs are already compensated for general management services through the fund‐level management fee. An additional fee for non‐performance related actions comes as a surprise. Given these unique features, we believe there are three major reasons why these fees should influence the performance of the LBOs. First, the fact that the portfolio companies’ cash is used to fund the fees has a direct influence on the performance of the LBO: instead of compensating the GPs with this cash, it could have been distributed to the LPs as a cash payout, directly boosting their rate of return. Second, deal‐level fees could be justified by the creation of additional incentives for the GP to perform well in the restructuring activities and value creation in their LBOs. After all, being paid money for a task increases the willingness to perform well (Holmstrom and Ricard I Costa, 1986). For example, a GP who is being paid for monitoring will do so more closely and diligently than a GP who is not compensated for her monitoring activities. In that sense, deal‐level fees should create strong positive incentives for the GPs to perform well, ultimately boosting the performance for the buyout deals. Third, deal‐level fees might also create an adverse effect: by receiving lump‐sum payments from their portfolio companies the incentives of GPs and LPs become misaligned. As explained above, GPs receive a major component of their compensation through Carry. By receiving deal‐level fees independently of their fund’s performance, GPs might be able to disentangle their income from the income generated for the LPs. The resulting agency costs could lead to lower LBO performance especially, since GPs receive the deal‐level fees without necessarily having to create value in the deals. For example, transaction fees are not tied to the success of a certain M&A performance, rather they are tied to whether or not M&A transactions are completed. This also applies to monitoring fees. They are paid out regardless of whether or not the GPs diligently fulfill their board member duties. We believe that the fees’ unique structure and their interesting implications make them most suitable to advance the knowledge about the link between incentivization in principal‐agency relationships and performance. Consequently, it is the main goal of this paper to answer the 3 questions: how do deal‐level fees in LBOs influence the performance of these deals? To find an answer to this research question we use a data set of 93 leveraged buyout deals over the period 1996 to 2008 in the United States. Although this number represents only a fraction of the total U.S. leveraged buyout market in this period, our sample is highly homogenous and contains all necessary information needed for the purposes of our analysis. For every LBO, we have the full GP compensation, both on fund‐ as well as on deal‐level. On fund‐level, this includes the management fees, preferred returns, and performance‐linked Carried Interest. On deal‐level, we obtain all portfolio company‐specific management fees, transaction fees, and termination fees. To measure the relationship between compensation and performance, we also obtain the main performance metrics on fund‐ and deal‐level. These are the Internal Rate of Return (IRR) and Cash Multiple on fund level (annually throughout the duration of the funds, as well as ex‐post numbers after the fund closings), as well as deal‐level IRR and cash multiple for each LBO. We choose these performance measures based on a broad body of literature in this field which has established the IRR and the Cash Multiple as the most widely used and relevant performance metrics in Private Equity. We tackle our main research questions by running a simple and clear‐cut two‐step analytical framework. In a first step, we analyze the different fee structures in a univariate setting. We analyze when the fees are being paid, what their magnitudes are and who receives them. Most importantly, we question whether deal‐level fees follow a certain pattern, i.e. whether or not the occurrence of deal‐levels depends on certain factors. Since LBO returns can be driven by a plethora of influence factors other than the fund manager’s compensation, we have to carefully craft a set of variables controlling for these factors. We do so by compiling proxy variables for three different groups of possible influence factors, in line with the findings of prior literature. The first group contains all restructuring activities that buyout firms engage in after they acquire a portfolio company and start to increase the enterprise value.