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A Study of Performance and Value Creation in Private Equity-Backed Initial Public Offerings

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A Study of Performance and Value Creation in Private Equity-Backed Initial Public Offerings Master’s Thesis TOWARD A NEW ERA FOR THE BARBARIANS? A Study of Performance and Value Creation in Private Equity-Backed Initial Public Offerings AUTHORS: Johannes Buster Kaae Pilegaard (91910) Katrine Bøgelund Vendelbo (93490) SUPERVISOR: Aleksandra Gregorič Department of Strategy and Innovation Center for Corporate Governance COPENHAGEN BUSINESS SCHOOL MSc Finance & Strategic Management No. of Characters: 272,558 (119.81 pages) 15 May 2019 Copenhagen Business School MSc Finance & Strategic Management LIST OF ABBREVIATIONS App.: Appendix ATO: Asset Turnover BHAR: Buy-and-Hold Abnormal Returns BHR: Buy-and-Hold Returns CEO: Chief Executive Officer CFO: Chief Financial Officer EBITDA: Earnings before Interest, Taxes, Depreciation, and Amortization FCF: Free Cash Flow GP: General Partner HR: Human Resources ICA: Index of Competitive Advantage IPO: Initial Public Offering IRR: Internal Rate of Return LBO: Leveraged Buyout LLC: Limited Liability Corporation LP: Limited Partner NPV: Net Present Value OLS: Ordinary Least Squares OP: Operating Partner OTC: Over-the-Counter PBO: Primary Buyout PE: Private Equity REIT: Real Estate Investment Trusts RLBO: Reverse Leveraged Buyout ROA: Return on Assets RQ: Research Question R&D: Research and Development SBO: Secondary Buyout S&P: Standard & Poor’s UK: The United Kingdom US: The United States of America VC: Venture Capital VRIN: Valuable, Rare, Inimitable, and Non-substitutable Copenhagen Business School MSc Finance & Strategic Management ABSTRACT Using a sample of 318 private equity-backed (PE-backed) IPOs, listed for flotation on US stock ex- changes between 1997 and 2014, this study presents a tripartite analysis of the value creation mech- anisms employed by the sponsors and ensuing performance implications, utilizing the portfolio firm as the unit of analysis. Firstly, we examine the aftermarket and operating performance for the three years following the listing, adopting a matched control group of non-backed firms to reduce selection bias. Secondly, we perform a comparative analysis of the use of various value creation levers for firms acquired prior to versus after the financial crisis with particular emphasis on the gravitation toward increased use of operational engineering. Finally, we estimate a multiple regression model, relying on OLS methodology, to examine which operational mechanisms are associated with portfo- lio firm performance, and inquire into the contingencies which may moderate the main effects. By computing Buy-and-Hold Abnormal Returns, we detect signs of superior performance for PE- backed IPOs relative to both the market and non-backed peers. In terms of operating performance, we find that PE-backed IPOs enjoy greater efficiency while exhibiting weak to no signs of superior profitability, posing a puzzle. The performance largely appears robust to the financial crisis with some signs that PE-backing counteracts the documented negative impact of the latter on IPO firm profita- bility. While we find that conventional governance levers of control and monitoring seem to sustain their relevance after the crisis, we find evidence in favor of a shift in the prototypical PE model toward heavier reliance on mechanisms aimed at operational and strategic improvements, particularly the injection of industry expertise and use of add-on investments. Confirming the difficulty in drawing generalizations as to which factors contribute to portfolio firm performance, we find that the impact of operational mechanisms is circumscribed by several contingencies and furthermore differs across performance measures. Particularly, while sponsor specialization seems especially conducive to firm efficiency in secondary buyouts, the market appears to penalize this combination. Moreover, we find that industry expertise appears of greater importance for firms acquired after the crisis, cementing the need for sponsors to move above and beyond mere financial and governance engineering. Hence, we contribute to existing literature by updating the body of knowledge on PE-backed IPO performance from a contemporary perspective while providing a novel, systematic inquiry into the change in the archetypical approach to value creation employed by PE. Finally, we shed new light upon the prevalence and importance of sponsor resource heterogeneity, which we believe will con- stitute an imperative determinant and driver of performance at the portfolio firm level going forward. 1 Copenhagen Business School MSc Finance & Strategic Management TABLE OF CONTENTS 1. INTRODUCTION .......................................................................................................................... 4 2. INTRODUCTION TO PRIVATE EQUITY ............................................................................... 7 2.1. DEFINING PRIVATE EQUITY ............................................................................................... 8 2.2. THE PRIVATE EQUITY MODEL ........................................................................................... 9 2.3. THE DIVESTMENT PROCESS ............................................................................................. 10 3. THE HISTORY OF PRIVATE EQUITY ................................................................................. 11 3.1. EMERGENCE OF THE INDUSTRY ..................................................................................... 11 3.2. THE PRIVATE EQUITY INDUSTRY FROM A US PERSPECTIVE .................................. 13 4. THEORETICAL BACKGROUND............................................................................................ 16 4.1. FINANCIAL ENGINEERING ................................................................................................ 16 4.1.1. Capital Structure Optimization ......................................................................................... 16 4.1.2. Utilization of Interest Tax Shield ...................................................................................... 17 4.2. GOVERNANCE ENGINEERING .......................................................................................... 18 4.2.1. Reducing the Free Cash Flow Problem............................................................................ 19 4.2.2. Increased Incentive Alignment ......................................................................................... 20 4.2.3. Monitoring and Controlling Mechanisms ........................................................................ 21 4.3. OPERATIONAL ENGINEERING ......................................................................................... 22 4.3.1. Increasing Margins and Reducing Costs .......................................................................... 22 4.3.2. Optimization of Current Asset Allocation......................................................................... 23 4.3.3. Enhancing Managerial Efficiency .................................................................................... 24 4.3.4. Devoting Attention to Strategic Objectives ....................................................................... 24 4.3.5. Utilizing Knowledge: Expertise and Specialization ......................................................... 26 4.4. VALUE CAPTURE VERSUS VALUE CREATION ............................................................. 28 4.4.1. Maximizing Market Valuations ......................................................................................... 28 4.4.2. Private Information .......................................................................................................... 28 4.4.3. Expert Deal-Makers .......................................................................................................... 29 5. EMPIRICAL REVIEW ............................................................................................................... 30 5.1. AFTERMARKET PERFORMANCE: PATTERNS AND DRIVERS .................................... 30 5.2. OPERATING PERFORMANCE: PATTERNS AND DRIVERS ........................................... 32 5.3. PRIVATE EQUITY AND THE FINANCIAL CRISIS ........................................................... 33 5.4. SECONDARY BUYOUTS ..................................................................................................... 35 5.5. SPONSOR SPECIALIZATION .............................................................................................. 36 5.6. EXPANSION STRATEGIES .................................................................................................. 37 5.7. HOLDING PERIOD ................................................................................................................ 38 5.8. MANAGEMENT AND BOARD ............................................................................................ 39 2 Copenhagen Business School MSc Finance & Strategic Management 6. HYPOTHESES DEVELOPMENT ............................................................................................ 39 6.1. OUTPERFORMANCE OF PE-BACKED IPOS ..................................................................... 40 6.2. CHANGE IN THE APPROACH TO VALUE CREATION ................................................... 41 6.3. ASSOCIATION BETWEEN OPERATIONAL LEVERS AND PERFORMANCE .............. 41 6.3.1. Holding Period ................................................................................................................. 42 6.3.2. Specialization ...................................................................................................................
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