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Managerial Divestment in Leveraged Buyouts

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Managerial Divestment in Leveraged Buyouts Managerial Divestment in Leveraged Buyouts James Ang≠ Florida State University Irena Hutton* Florida State University Mary Anne Majadillas** California State University, Northridge Keywords: Leveraged buyouts, private equity, agency costs, earnings management, buyout pricing, buyout premium, buyout performance ≠ Department of Finance, College of Business, Florida State University, Tallahassee, FL 32306. Phone: (850) 644-8208, fax: (850) 644-4225, email: [email protected] * Department of Finance, College of Business, Florida State University, Tallahassee, FL 32306. Phone: (850) 645-1520, fax: (850) 644-4225, email: [email protected] **Department of Finance, Real Estate, and Insurance, College of Business and Economics, California State University, Northridge, CA 91330. Phone: (818) 677-4533, fax: (818) 677-6079, email: [email protected] 1 ABSTRACT We examine changes in managers’ investment in the firm by means of a leveraged buyout and find evidence of agency costs opposite of those described in the extant literature. In the majority of leveraged buyouts during 1997-2007, managers divested a portion of their pre-LBO share holdings while maintaining an ownership stake in the post-LBO firm. We find that such divestment opportunities encourage managers to behave in a way that benefits existing shareholders but is costly to new investors. Specifically, we provide evidence of a positive relation between management’s divestment and pre-LBO upward accrual-based and real earnings management, market timing, more aggressive buyout negotiations and higher buyout premium. We also find that following the buyout, private equity investors mitigate risk taking and low effort tendencies of divesting managers. 2 Leveraged buyouts (LBOs) have received a lot of attention in academic literature as a unique organizational form that is effective at reducing agency costs of managerial discretion. In fact, at the peak of buyout activity in 1980’s the argument for this new organizational form was so convincing that Jensen (1989) famously wrote about the “eclipse of the public corporation”. In LBOs, the reduction in agency costs stems from three changes to corporate governance. First, managers’ incentives are improved through an increase in their post-buyout equity stakes. Second, the large amount of debt used to finance the buyout transaction encourages financial discipline by diverting free cash flow to debt payments. Third, the concentration of equity in the hands of private investors leads to closer monitoring and better representation on the board of directors. This monitoring effort is strengthened by yet another group of actively monitoring stakeholders – creditors. In other words, these changes in firm governance simultaneously strengthen the alignment of managers’ and new investors’ objectives. However, the success of this new governance structure crucially depends on the assumption that managers invest a significant share of own wealth into the buyout firms. If, instead, managers reduced their investment in the firm, the alignment of managers’ and new investors’ objectives may no longer hold as the managers’ objectives would be aligned with those of the selling shareholders and not the buyout team and creditors. Our paper examines agency problems brought on by managerial divestment. It is commonly assumed that when a firm is taken private in a buyout, managers are encouraged to commit substantial personal wealth to acquire partial ownership in the post-buyout firm. This gives assurance to the outside investors and creditors that managers objectives are aligned with theirs and ensures capable management during the first two to three years following an LBO (i.e., the seasoning stage), which are considered to be the high risk part of the deal. However, in firms where managers already hold a significant equity stake, the buyout allows managers to sell their pre-LBO equity for cash at a sizeable buyout premium and then reinvest only a fraction of that amount in the post-LBO firm. 3 According to Kaplan and Stein (1993), during the early phase of the 1980’s buyout wave, managers reinvested more than a half of their cashed-out equity back into the firm. Such significant commitment of personal wealth worked well to align the interests of managers and post-buyout shareholders, reinforcing the standard view of leverage buyout. As the buyout wave of the 1980’s progressed, the amount of reinvested equity decreased and so did the incentive for well structured deals. In other words, the interests of managers became more similar to the interest of selling shareholders rather than new buyout investors. Although the post-LBO managerial ownership remained significant, despite a decrease in reinvestment levels, it was not sufficient to overcome the negative effects of managerial divestment. Such shift in management reinvestment tendencies warrants a reexamination of the relation between changes in managers’ personal wealth, effectiveness of a buyout in resolving agency problems and emergence of new agency problems. We focus our attention on managers’ actions due to the divestment-related agency problems. We highlight the differences in agency problems associated with high divestment buyouts (new buyouts) and buyouts with investment or low divestment (old buyouts). Specifically, we compare agency problems that arise prior to the buyout, during the buyout process, and following the buyout. These differences provide the foundation for our empirical analyses and are summarized in Table 1. [Insert Table 1 here] Our analysis is based on the assumption that the managers’ objective function is a weighted average of gains received from selling their pre-buyout equity stake and potential gains from the post- buyout equity stake. Therefore, prior to the buyout when managers contribute additional personal equity (Investment), reinvest all of their dollar investment in the firm (Rollover) or realize a small divestment (Low Divestment) there may be an incentive to take actions to depress pre-buyout firm value, trading off 4 future gains for current gains.1 However, in a high divestment (High Divestment) buyout where managers intend to cash out a significant part of their shareholdings, there is a strong opposite incentive to increase short term firm value prior to buyout, trading off current for future gains. The existing literature uses earnings management and changes in stock price among several other measures as evidence of such incentives. Although management shareholders are likely to eventually make large personal financial gains in both scenarios, the agency costs of investment, rollover or low divestment buyouts are likely to be detrimental to the firm’s existing shareholders, whereas agency costs of high divestment buyouts are likely to come at the expense of new investors (private equity and creditors). The method of firm sale itself can have wealth implications for the firm’s managers. While unexplored in the context of buyouts, the mergers and acquisitions literature suggests that auctioned-off firms can generate greater wealth effects and higher likelihood of merger completion than firms sold though negotiations with a sole buyer.2 Applied to buyouts, this suggests that firms with managerial investment, rollover or low divestment may encourage negotiated sales that are likely to result in fewer competing bids and, possibly, a lower buyout premium. Firms with higher managerial divestment are more likely to initiate an auction by soliciting bids from numerous strategic and financial parties, potentially leading to more competing bids and a higher buyout premium. Lastly, changes in managerial wealth by means of a buyout can negatively affect post-buyout performance even despite the positive effect that post-LBO ownership stake has on managers’ effort levels. Bitler, Moscowitz and Vissing-Jorgensen (2005) find that, while there is a positive relation between an entrepreneur’s ownership and effort, personal wealth and effort are negatively related. In investment, rollover or low divestment buyouts, the effect of high post-LBO managerial ownership often 1 See, for example, Fischer and Louis (2008) and Perry and Williams (1994). 2 Recent studies examine the relation between method of sale and wealth gains to the firms existing shareholders. See, for example, Dasgupta and Hansen (2008), Boone and Mulherin (2008), Anilowski, Macias, Sanchez (2009). 5 combined with a high personal wealth investment can motivate managers to apply more effort and increase firm performance. In high divestment buyouts, however, the negative effect of a large increase in personal wealth taken out of the firm offsets the positive effect of the much smaller amount committed to maintain managerial ownership. Additionally, the new incentive structure may not only affect the level but also the volatility of post-LBO cash flows. After cashing out most of their wealth, managers may view their relatively small remaining equity in the firm as a bonus in the form of cheap call option and improve its upside potential by making risky investments [Jensen and Meckling (1976)]. We find that in 79% of LBO deals the management team cashes out some wealth at the time of the LBO. Moreover, in 44% of the LBO firms, managers cash out more than 50% of their pre-LBO holdings. Our results support significant agency costs of such divestments. First, we observe a positive relation between pre-LBO accrual-based and real manipulation and managerial divestment. We also find evidence of market timing in that high
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