RLBO PERFORMANCE Abstract This thesis investigates whether or not reverse leveraged buyouts (RLBOs) outperform the stock market. To research this, 100 RLBOs that are listed on a large United States stock exchange between 1996 and 2013 are analyzed. One and three year time periods are examined to find stock outperformance. Raw buy-and-hold returns and alphas are used to measure performance. Raw buy-and-hold returns suggest underperformance of the market by RLBOs, while alphas suggest outperformance of the stock market. Name: Andrew Leek Student number: 10561897 Specialization: Finance and Organization – BSc ECB Field: Finance Supervisor: dr. J.E. Ligterink Statement of Originality This document is written by Student Andrew Leek who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents. Table of Contents 1. Introduction .................................................................................................................... 2 2. Literature review ............................................................................................................ 4 2.1. LBOs in general ..................................................................................................... 4 2.2. Reverse-LBO performance ........................................................................... 6 2.3. Reverse-LBO characteristics ........................................................... 10 3. Data .............................................................................................................................. 11 3.1. Data sources ..................................................................................................... 11 3.2. Descriptive statistics..................................................................................... 12 4. Methodology ................................................................................................................ 13 5. Results .......................................................................................................................... 16 6. Discussion ..................................................................................................................... 19 6.1. Literature comparison ...................................................................................... 19 6.2. Limitations ................................................................................................ 21 7. Conclusion .................................................................................................................... 22 7.1. Concluding remarks ............................................................................................ 22 7.2. Further research ....................................................................................... 23 8. Reference list ................................................................................................................ 24 9. Glossary ........................................................................................................................ 25 10. Appendix ....................................................................................................................... 26 1 1. Introduction Private equity (PE) firms are controversial. PE firms use debt to acquire companies by way of a leveraged buyout (LBO) (Palepu, 1990). After an acquisition a PE firm restructures a company in such a way that the firm can earn significant returns on their investment. According to Lerner et al. (2011), many critics of PE firms argue that these firms try to cash out without creating any value for stakeholders. One way a PE firm can cash in on their investment is by going public with a company they acquired. This is known as a reverse LBO (RLBO), also called an LBO-backed public offering (Holthausen & Larcker, 1996) (Cao, 2011). PE firms can, as seen with Refco (Cao & Lerner, 2009), take a company to the stock exchange at more than double the value. After the public offering, Refco collapsed and a dozen lawsuits were filed. The New York Times (2005) argued that overleveraged companies are listed publicly too easily, as it is unclear who will invest in them. The New York Times (2005) also mention that PE firms have to sell $500 billion of assets, while the industry has never sold more than $153.2 billion. More recently, the LBO-practices of PE firms in the Netherlands were heavily criticized. The PVDA, a political party, has proposed initiatives against these practices (FD, 2015). As seen above LBOs are under public scrutiny. It is uncertain if they add value for stakeholders. PE firms don’t share much data on transactions they enter into (Degeorge & Zeckhauser, 1993). Holthausen and Larcker (1996) mention that high leverage and concentrated equity ownership could contribute to LBO firms operating more efficiently. Holthausen and Larcker (1996) imply that a decline of these two factors would result in a decline of overall performance. Measuring the performance of RLBOs can provide more data on private equity activities and whether or not these activities are sustainable. By looking at companies that have undergone an LBO and then subsequently have undergone an IPO, the effect of an LBO on the stock performance of a company can be measured. Therefore, the research question is: Do buyout-backed IPO companies outperform the stock market? 2 With this research question there can be argued that RLBOs are profitable investment opportunities. A company that goes public after an LBO should not automatically imply a bad investment opportunity. This thesis will analyze 100 buyout-backed IPOs from 1996 to 2013 in the United States (U.S.). Raw buy-and-hold returns and alphas will provide information on stock performance. Jensen’s alpha methodology will give any under- or outperformance of a stock adjusted for market factors. Firstly, current literature on this research topic will be reviewed. Literature on RLBOs, regular IPOs and abnormal returns will be discussed. Secondly, the main hypothesis is explained and its relevance proved. Thereafter the data sources and criteria are shown. Thirdly, the methodology is discussed and research methods will be explained. Also, the regression methods will be further detailed. Fourthly, the results will be interpreted and these results will be compared in the discussion to other results found in existing literature. Lastly, a conclusion will be drawn from these results and findings. Also, possible future research topics will be suggested. 3 2. Literature This thesis will mainly be focusing on buyout-backed IPO long-term performance using raw returns and alphas. First of all, LBOs in general will be looked at. Secondly, research investigating RLBO characteristics and performance is discussed. Lastly, literature regarding RLBO timing and exits are analyzed. 2.1. LBOs Consequences of LBOs in general has been researched by Palepu (1990) and more recently by Kaplan and Strömberg (2009). LBOs have several characteristics according to Palepu (1990). A characteristic of LBOs is a significant increase in leverage. Management’s ownership also rises substantially. Corporate governance changes because of large block- holder investors join the board and actively monitor performance and strategy. Investors cannot access public equity markets after a buyout. These factors distinguish LBOs from a typical public firm according to the author. Palepu (1990) also observes, that over time LBOs have increased in size and frequency. Organizational changes caused by LBOs have improved incentives for managers to maximize firm value. This leads to better operating and investment decisions (Palepu, 1990). Kaplan & Strömberg (2009) make clear that LBOs lead to changes in corporate governance, capital structures and management incentives. They also find that market timing is an important factor in economic value creation. Opponents of private equity argue that increased leverage leads to short-term decision making and vulnerability to financial distress. Palepu describes three reasons why an LBO might fail: a structure prone to failure, poor management performance and bad general economic conditions. Furthermore, the author argues that mostly large successful LBOs go public. A reason according to Palepu for going public are that investors gain liquidity and diversification opportunities. Also, Palepu (1990) mentions that buyouts increase a firm’s depreciation and interest tax shields. Kaplan and Strömberg (2009) argue that increased leverage from LBOs creates pressure on management of the target firm to efficiently allocate money. The authors refer to this as ‘’free cash flow’’ problems as first mentioned in Jensen (1986). The free cash flow should be returned to investors, instead of being dissipated Kaplan (1991) recognizes two forms of post-buyout behavior. Firstly, an LBO brings more efficient management to a firm under which the LBO firm remains private for an 4 uncertain period of time. Secondly, an LBO can bring one-time improvement to a company. After these improvements the firm can be brought back to the market in a reverse LBO. If a firm is brought back to the market quickly, then the LBO is called a ‘’revolving door’’ LBO. The author also