20.7Empirical Evidence on the Gains from Leveraged Buyouts (lbOs)

From the late 1970s to the late 1980s, a number of large publicly traded firms were

taken over in highly leveraged transactions that transformed the public companies into

privately held firms. The announcements of those LBOs generally resulted in dramatic

increases in the stock prices of the target firms, which suggests that LBOs create sub-

stantial value. However, because these LBOs did not involve the combination of two

firms, the kind of synergies discussed previously do not apply. Most analysts point to

improved management incentives as the motivation for LBOs.

How Leveraged Buyouts Affect Stock Prices

Avariety of studies have examined the premiums offered in LBOs as well as the stock

returns when the LBO transactions are first announced. These studies find that the aver-

age price paid in an LBO was 40 to 60 percent above the market price of the stocks

one to two months before the offers. Around the time of the announcements of these

offers, the stock price increased about 20 percent, on average.

Characteristics of HigherPremium Targets.Lehn and Poulsen (1989) found that

higher premiums were offered for firms with high cash flows, relatively low growth

opportunities, and high tax liabilities relative to their equity values. The higher premi-

ums for the high-cash flow/low-growth firms support the idea that there are larger gains

associated with levering up firms with these characteristics (for example, leverage

reduces their tendency to overinvest). The relation between the tax liabilities and the

premium suggests that part of the tax gain from the LBO transaction is passed along

to the original shareholders.

Competing Bids.The presence of competing bids also affects the premium offered

in LBOs. Lowenstein (1985) studied 28 LBOs, finding that those with less than three

competing bids received an average premium of 50 percent while those with more than

three competing bids received an average premium of 69 percent.

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Strategy, Second Edition

Chapter 20

Mergers and Acquisitions

713

EXHIBIT20.4Summary of Changes in Firm Operations afterLBOs*

	Kaplan	Muscarella and	Opler	Smith
Variable	(1989)	Vetsuypens (1990)	(1993)	(1990)

Cash flow/sales	20.1%	23.5%	8.8%	18%
Sales per employee	NA†	3.1%	16.7%	18%

Taxes	NA	NA	90.5%	80%
Investment/sales	31.6%	11.4%	46.7%	25%
Employees	0.9%	0.6%	0.7%	22%
R&D/sales	NA	NA	0.0%	75%
Time period studied	1980–86	1976–87	1986–89	1976–86
Number of LBOs	37	43	46	18
Window in years (before, after)	( 1, 2)	Variable	Variable	( 1, 2)

*Expressed as a percent increase or decrease.

^†NAmeans statistic not available or not computed.

Cash Flow Changes Following Leveraged Buyouts

Anumber of studies have analyzed operating changes following LBOs. These studies,

summarized in Exhibit 20.4, examined changes in a number of variables that provide

insights into how LBOs affect a firm’s performance.

The results summarized in Exhibit 20.4 indicate that the magnitude of the cash

flow improvements following LBOs declined in the latter half of the 1980s. For exam-

ple, Kaplan (1989) found that from 1980 to 1986, cash flows increased, on average,

by 20.1 percent following an LBO. However, Opler (1993) found an average improve-

ment in cash flows of only 8.8 percent for LBOs initiated between 1986 and 1989.

One explanation for this decline in the performance of LBOs is that the success of the

earlier deals attracted a number of new investors, resulting in “too much money chas-

ing too few good deals,” which in turn led to buyouts of firms with less potential for

improvement.

Additional evidence suggests that LBOs occurring in later years were priced higher

and were more highly leveraged, leading to much higher default rates on LBO debt.

Kaplan and Stein (1993) found that noneof the 24 LBOs in their sample initiated

between 1980 and 1983 subsequently defaulted on their debt. However, defaults

claimed 46.7 percent of the LBOs initiated in 1986, 30.0 percent of those initiated in

1987, 16.1 percent of those initiated in 1988, and 20.0 percent of those initiated in

1989. Despite their high default rates, the firms that initiated these later LBOs still

tended to show improvements in productivity. In many cases, however, the productiv-

ity gains were not sufficient to justify their high prices and the firms did not generate

sufficient cash flows to pay off the high levels of debt incurred in the LBOs.

Productivity Increases Following LBOs.Exhibit 20.4, which summarizes four LBO

studies, provides evidence that at least part of the post-LBO increase in cash flows is

due to increased productivity. The three studies that measured the average change in

the value of sales per employee (labor productivity) found that labor productivity

increases after LBOs. Astudy by Lichtenberg and Siegel (1990), using plant-level data,

provides additional evidence about the sources of productivity improvements. They

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Strategy, Second Edition

714Part VIncentives, Information, and Corporate Control

documented significant post-LBO reductions in the ratio of white-collar to blue-collar

labor, reflecting perhaps a reduction in excess overhead. In addition, Smith (1990)

found strong evidence that working capital is reduced after LBOs.

The Direction of Causation forthe LBO Cash Flow Improvement.The increase

in cash flows following LBOs may not solely reflect improvements resulting from the

LBOs. Perhaps firms that undergo leveraged buyouts would have shown similar

improvements without the LBOs. Managers and LBO sponsors are unlikely to consider

an LBO of a firm for which business prospects are forecasted to be unfavorable. There-

fore, firms that undergo LBOs are likely to experience subsequent increases in their

cash flows even without productivity improvements. In addition, some of the observed

increase in the cash flows of LBOs probably can be explained by the selection process

of LBO candidates. However, we are unaware of any convincing evidence on this.

Cost Deferral as an Explanation forthe LBO Cash Flow Improvement.Another

explanation for the observed increase in cash flows following LBOs is that higher lever-

age ratios provide managers with an incentive to increase cash flows in the short run

at the expense of their long-run cash flows (see Chapter 16). Critics of leveraged buy-

outs say that after initiating a leveraged buyout, firms improve their cash flows in the

short run by deferring maintenance, cutting R&D, and reducing advertising and pro-

motion budgets. If these actions were the prime cause of the observed increase in cash

flows, then one would expect the increase to be reversed later. Although it is certainly

plausible that some of the increase in cash flows can be explained by this possibility,

we again are unaware of any convincing evidence suggesting that part of the short-term

gain in cash flows comes at the expense of long-term cash flows.

Smith (1990), Lichtenberg and Siegel (1990), and Opler (1993) found that post-

LBO research and development expenditures do not generally decline. However, this

may not be particularly relevant since most firms that have done LBOs belong to indus-

tries that conduct little R&D. Smith (1990) also found no significant reductions in

advertising or maintenance following LBOs, but she is cautious about interpreting these

results because of the limited size of her sample.

Result 20.7

On average, cash flows of firms improve following leveraged buyouts. Three possible expla-nations for these improvements are:

•	Productivity gains.
•	Initiation of LBOs by firms with improving prospects.
•	The incentives of leveraged firms to accelerate cash flows, sometimes at the expenseof long-run cash flows.

While we expect all three factors to contribute to the observed increase in cash flows, existing

empirical evidence suggests that a major part of the increase is due to productivity gains.