Technische Universität München KfW Stiftungslehrstuhl für Entrepreneurial Finance Univ.-Prof. Dr. Dr. Ann-Kristin Achleitner Structure and determinants of financial covenants in leveraged buyouts Florian T. Tappeiner Vollständiger Abdruck der von der Fakultät für Wirtschaftswissenschaften der Technischen Universität München zur Erlangung des akademischen Grades eines Doktors der Wirtschaftswissenschaften (Dr. rer. pol.) genehmigten Dissertation. Vorsitzender: Univ.-Prof. Dr. M. Moog Prüfer der Dissertation: 1. Univ.-Prof. Dr. Dr. A.-K. Achleitner 2. Univ.-Prof. Dr. G. Friedl Die Dissertation wurde am 30.09.2010 bei der Technischen Universität München ein- gereicht und durch die Fakultät für Wirtschaftswissenschaften am 15.12.2010 ange- nommen. II III TABLE OF CONTENTS 1 INTRODUCTION ........................................................................................................ 1 1.1 Relevance and Objectives ............................................................................. 1 1.2 Structure of Analysis ..................................................................................... 5 2 CHARACTERISTICS OF LEVERAGED BUYOUTS ...................................................... 8 2.1 Introductory Remarks .................................................................................. 8 2.2 Private Equity and Leveraged Buyouts ....................................................... 8 2.3 Capital Structure ........................................................................................... 9 2.3.1 Theoretical Considerations .............................................................. 11 2.3.2 Empirical Description ...................................................................... 14 2.3.3 Equity Parties ................................................................................... 18 2.3.4 Debt Parties ...................................................................................... 23 2.4 Research Model ............................................................................................ 25 3 THEORETICAL FRAMEWORK ................................................................................ 27 3.1 Introductory Remarks ................................................................................ 27 3.2 The Conflict View - Agency Theory ........................................................... 27 3.2.1 Agency Conflict between Debt and Equity Holders ......................... 27 3.2.1.1 Asset Substitution ............................................................. 30 3.2.1.2 Underinvestment ............................................................... 34 3.2.1.3 Claim Dilution .................................................................. 36 3.2.2 Agency Costs of Debt ........................................................................ 36 3.2.3 Agency Theory of Covenants ............................................................ 37 3.3 The Control View – Financial Contracting Theory ................................. 40 3.3.1 Contractual Incompleteness ............................................................. 40 3.3.2 The Aghion-Bolton Model ................................................................ 42 3.3.3 The Rajan-Winton Model ................................................................. 55 3.3.4 Additional Functions of Financial Covenants .................................. 60 3.3.5 Excursus: Signaling Theory of Financial Covenants ....................... 60 3.4 Summary ...................................................................................................... 62 4 CLASSIFICATION AND TYPES OF COVENANTS ..................................................... 64 IV 4.1 Introductory Remarks ................................................................................ 64 4.2 The Conflict View – Action-restricting Covenants ................................... 64 4.2.1 Covenants limiting Asset Substitution .............................................. 65 4.2.2 Covenants limiting Underinvestment ............................................... 66 4.2.3 Covenants limiting Claim Dilution ................................................... 68 4.3 The Control View – Financial Covenants ................................................. 69 4.3.1 Types of Financial Covenants .......................................................... 70 4.3.2 Construction ..................................................................................... 73 4.3.3 Measure of Restrictiveness ............................................................... 78 4.3.4 Effectiveness of Financial Covenants ............................................... 81 4.4 Covenants in Leveraged Buyouts ............................................................... 82 4.5 Summary ...................................................................................................... 86 5 HYPOTHESES ......................................................................................................... 91 5.1 Introductory Remarks ................................................................................ 91 5.2 Literature Review ........................................................................................ 91 5.3 Hypotheses Development ............................................................................ 97 5.3.1 Target related ................................................................................... 98 5.3.1.1 Firm Size .......................................................................... 98 5.3.1.2 Growth ............................................................................ 100 5.3.1.3 Profitability ..................................................................... 102 5.3.1.4 Firm Risk ........................................................................ 102 5.3.1.5 Tangibility ...................................................................... 103 5.3.2 Transaction related ........................................................................ 104 5.3.2.1 Leverage ......................................................................... 104 5.3.2.2 Interest Costs .................................................................. 105 5.3.2.3 Maturity .......................................................................... 106 5.3.2.4 Share of Bank Debt ........................................................ 107 5.3.2.5 Creditor Rights Dilution ................................................. 108 5.3.3 Sponsor related ............................................................................... 108 5.3.3.1 Sponsor Reputation ........................................................ 108 5.3.3.2 Banking Relationship ..................................................... 110 5.3.4 Lead Arranger related .................................................................... 113 5.3.4.1 Organization ................................................................... 113 5.3.4.2 Final Hold ....................................................................... 113 5.3.5 Macroeconomic related .................................................................. 116 V 5.4 Summary .................................................................................................... 117 6 EMPIRICAL STUDY .............................................................................................. 119 6.1 Introductory Remarks .............................................................................. 119 6.2 Datasets ....................................................................................................... 119 6.2.1 LBO Sample .................................................................................... 119 6.2.2 Benchmark Sample ......................................................................... 131 6.3 Financial Covenants in Sponsored versus Non-sponsored Loans ......... 133 6.3.1 Types and Combinations of Financial Covenants .......................... 133 6.3.2 Financial Covenant Thresholds ..................................................... 141 6.4 Descriptive Statistics .................................................................................. 144 6.4.1 Covenant Restrictiveness ................................................................ 144 6.4.2 Financial Covenant Pecking Order ............................................... 149 6.4.3 Explanatory Variables .................................................................... 152 6.4.3.1 Target related .................................................................. 152 6.4.3.2 Transaction related ......................................................... 155 6.4.3.3 Sponsor related ............................................................... 158 6.4.3.4 Lead Arranger related ..................................................... 162 6.4.3.5 Macroeconomic related .................................................. 163 6.5 Determinants of Financial Covenant Restrictiveness ............................ 163 6.5.1 Difference in Means ....................................................................... 163 6.5.2 Multiple Regression Analysis ......................................................... 165 6.5.2.1 Target related .................................................................. 169 6.5.2.2 Transaction related ......................................................... 171 6.5.2.3 Sponsor related ............................................................... 173 6.5.2.4 Lead Arranger related ....................................................