16         MCA: april 2007, nummer 3   Clara Natoli: beeld
                                                                        ‘MBOs are
                                                                    often preceded
                                                                         by insider
This paper describes the evolution of                                  purchasing’
the buy-out markets in the UK and
                                                            and Continental Europe from 1996 through 2005 has
Continental Europe over the past two                        been steady, although the weak European stock
                                                            markets of 2000-2004 have dampened activity. Al-
decades. Particular attention is paid                       though the UK has by far the most active of these
                                                            markets, there has also been considerable buy-out
to public-to-private transactions, the                      activity in France, Germany, Italy, Spain, and the
                                                            Netherlands. Panel B shows a more striking evolu-
exit routes for investors, the                              tion in terms of value: during the past 10 years
                                                            (1996-2005), the combined value of all buy-outs in
performance and the refinancing.                            Europe rose more than fivefold and broke through
                                                            the € 100 billion mark in 2005.
The motives to undertake a leverage                             In the remainder of this paper, we shall firstly
                                                            discuss the UK buy-out market (Section 1) and the
buy-out and the potential sources of                        LBO market in Europe (Section 2). We list the poten-
                                                            tial sources of value as predicted by economic theory
value as derived from the theoretical                       in Section 3, which is then followed by a concise
                                                            summary of the empirical results in Section 4. Sec-
literature are discussed.                                   tion 5 concludes.

                                                            1 The buy-out market in the UK
Prof.dr.ir. Luc Renneboog: The European                     Growth in buy-outs
buy-out market appears to be entering its third pe-         The first phase of the modern buy-out market in the
riod of significant growth, following the waves of          UK began in the early 1980s (see Figure 1), roughly
buy-outs during the latter halves of the 1980s and          the same time as the US market got its start (Wright
1990s.1 In recent years, successive records have been       et al., 2000). The relaxing in 1981 of the prohibition
set in terms of both individual deal size and the           on companies providing financial assistance, that
total market value of transactions in a given year.         is security for debt, to purchase their own shares re-
In 1997, for example, the UK market broke the £ 10          duced the barriers faced by lenders in obtaining se-
billion barrier for the first time. Only three years        curity for the funds they advanced. Furthermore,
later, in 2000, more than £ 20 billion worth of deals       the introduction of a secondary tier stock market in
were completed. The first Continental European              1980 (the Unlisted Securities Market) opened up
deal larger than £ 3 billion, the buy-out of MEPC by        possibilities for realizing exit gains from smaller
Leconport, was completed in 2000. And 2005 saw              buy-outs.
the closing of the 20,000th transaction in the com-             The second phase in the development of the UK
bined UK-European buy-out market since the late             buy-out market comprised the rapid market growth
1970s, when the first recognizably ‘modern’ LBOs            from the mid-1980s to the end of the decade. The
appeared in the US and UK (Wright et al., 2006a).           buy-outs completed during this period were increa-
With a few notable exceptions such as France and            singly the result of corporate refocusing strategies,
the Netherlands, buy-out markets in Continental             and a first peak in the value of deals was reached in
Europe did not materialize in earnest until around          1989. Such transactions, which generally included
1996. As can be seen in Panel A of Table 1, the             the existing management and were thus dubbed
growth in the number of buy-out deals in the UK             management buy-outs or MBOs, offered an alternative
                                                            to a trade sale to a third party. Buy-outs were especi-
                                                            ally attractive in cases where the selling company
Noot                                                        wanted a speedy low-profile sale or when there
1 This paper is based on Wright, Renneboog, Scholes & Si-   were few external bidders for the business.
mons (2006).                                                In addition to the many MBOs, the late 1980s saw

                                                            MCA: april 2007, nummer 3                         17
large numbers of ‘management buy-ins’ (MBIs),             showing a marked resurgence during the second
transactions in which private equity firms (or, in        half of the 1990s (Renneboog, Simons & Wright,
some cases, institutional investors) brought in           2006). Due to the high costs and risks associated
their own management teams to run the purchased           with such deals, the first PTPs were relatively small
businesses. The advent of specialist private equity       and invariably involved incumbent management.
and mezzanine funds, along with entry by US               But, as the process became better understood and
banks starting in the mid-1980s, helped fund the          those initial deals were successfully completed,
development of MBIs as well as MBOs.                      there was a growing tendency towards larger and
   The third phase of UK buy-out development,             investor-led or institutional buy-outs (IBOs) of
which began with the recession of the early 1990s,        larger public companies. This suggests that the op-
involved the restructuring of many of the largest         portunities to restructure listed corporations by ta-
transactions of the previous phase along with a re-       king them private may be greater than once
turn to the smaller buy-outs which characterized          thought. Both in terms of volumes and values, PTPs
the first half of the '80s. As in the US, both the        have been far more important in recent years than
number and value of UK. MBIs fell sharply as it be-       in the top deal years of the 1980s, reaching a peak in
came clear that many of the highly leveraged deals        1999-2000, and then easing before recovering in
completed during the late '80s – often premised on        value terms in 2005. The Continental European
major asset sales or ‘unbundling of assets’ – were        trend has been similar.
having problems servicing their debt. The recession
exacerbated these problems and made turnarounds           Exit
longer and more difficult. Many foreign banks             Studies of the longevity of buy-outs suggest that
abandoned the buy-out market, and those banks             private equity firms are under significant pressure
which remained active tightened their terms and           to achieve their target returns and hence work to-
covenants. Both private equity and debt providers         wards a timely exit. The most common type of exit
were heavily involved in restructuring the problem        has varied somewhat over the life of the UK buy-out
cases in their portfolios, and some of the latter alto-   market. Sales to corporate buyers, or ‘trade sales’ as
gether disbanded their lending teams which specia-        they are typically called, have generally been the
lized in buy-out type transactions.                       most common form of exit in the UK, accounting
    The end of the recession in 1994 saw the emer-        for about a third of all exits during the recessionary
gence of a fourth phase of UK buy-out activity – one      period 1990-1994 (when receivership was an even
which saw rapid growth in total transaction value,        more common end) and for close to 50% during the
which reached a new peak in 2000. At the same             latter half of the '90s. For the largest, most success-
time, though, a focus by private equity investors on      ful buy-out portfolio companies, however, the most
larger transactions kept the total number of buy-         popular choice is likely to be an Initial Public Offe-
outs to drop from exceeding their ‘local peak’ of 709     ring (IPO). This was the choice in roughly a third of
reached in 1997 until six years later in 2003. The        the exits in the second half of the 1980s. But since
years after 2000 saw a sharp plunge in the total          then, the percentage of exits through IPOs has fal-
value of new deals in the wake of the collapse of the     len sharply, from about 10% in the 1990s to 5% du-
dot.com boom and its repercussions.                       ring the last five years. The total value of exits
    But a major resurgence in the value of the UK         reached a record of £ 18 billion in 2004 and remai-
buy-out market began in 2004, the start of the cur-       ned high at £ 15 billion in 2005.
rent phase five. In 2005, there were a record-high 49         Secondary buy-outs – sales of portfolio firms
buy-outs with purchase prices in excess of £ 100          from one PE firm to another – have gained in impor-
million, and the total value of deals also set a new      tance since their start in the early 1990s, and they
record of £ 24.2 billion.                                 now account for almost a third of all exits. A num-
                                                          ber of factors have contributed to financial investors'
Public-to-private                                         decisions to sell their portfolio firms to other PE
Public-to-private transactions (PTPs) have developed      firms. Chief among them are (1) difficulties in exi-
over the life cycle of the market's growth, starting      ting buy-outs through IPOs; (2) the reduced acquisi-
somewhat later than general activity in 1985 and          tion appetite of corporations (especially for smaller

18                           MCA: april 2007, nummer 3
Panel A: Number of Buy-outs/Buy-ins

Country Name               1996          1997         1998          1999         2000           2001     2002      2003      2004     2005

Austria                        1             2             2            1             2            1        4          0        1         0
Belgium                        2             3            4             5             5            4        2          1        5         8
Denmark                        3             2             3            3             5            2        2          1        2         6
Finland                        1             3            6             3             2            3        4          5        5         6
France                       26            25            48            64            38           19       25         35       22        63
Germany                       17            21           22            18            15           21        8         11       17        22
Ireland                        1             3            4             2             3            5        4          5        4         2
Italy                         15           10            13            24            10            6       15         12       17        19
Netherlands                   14            13           20            18            15            7        9          8        9        14
Norway                         2            0             0             0             2            2        2          3        4         5
Portugal                       4             2             3            3             3            0        1          1        0         2
Spain                          3            8            20            11            10           12       11         11        9        22
Sweden                         5            6             8             7             4            2        6          6        5        13
Switzerland                   11             7            5             7             4            1        2          1        4         0

Total (CE)                  105           105           158           166           118           85       95       100       104       182

UK                          646           709           691          656            618          642      637        711      701      685

Total (inc. UK)             751           814          849            822           736          727      732        811      805      867

Panel B: Value of Buy-outs/Buy-ins (€m)

Country Name              1996          1997          1998          1999         2000          2001     2002       2003     2004     2005

Austria                      72           128            95          680           734            47      154       303       88        28
Belgium                     147           414          820         2,595           337         1,744      517      1,448    2,266    4,057
Denmark                     411           263          267         2,173         1,313          500     1,391       848      260     7,060
Finland                     724          440           560         1,085           675         1,047     480       1,039      977    2,044
France                   2,189         5,275         6,198         8,387        6,503          6,387   15,557      8,772   11,489   20,714
Germany                  1,704         3,538         5,265         4,629       15,084          7,229    8,143     11,908   17,915    11,727
Ireland                     116           119          244         1,475           259         5,021   4,930         747     970       770
Italy                    1,146          3,121          673         2,756         2,555         1,002    3,428      7,773    3,013    17,512
Netherlands              1,001         1,059         3,528        2,906          1,856         4,433    1,870     4,958     7,612   10,256
Norway                      315          180             22          225        1,004          1,370      142       308       455      426
Portugal                    158            64            83          206            83             2       26        54         8       76
Spain                       227           374          859         1,715           941         1,528   2,069        934     2,274    9,391
Sweden                     700           1375          928         2,926         3,169         3,005    1,116      2,226    1,701    4,702
Switzerland               1,316        2,426         1,347         1,013         1,772           715    2,766       864     1,570      563

Total (CE)              10,226        18,776       20,889         32,771       36,285         34,030   42,589     42,182   50,598   89,326

UK                      12,555         17,114       23,273       26,864        38,349         31,343   24,844     23,570   30,144   35,406

Total (inc. UK)         22,781       35,890         44,162       59,635        74,634         65,373   67,433     65,752   80,742   124,732

Table 1:
Number and value of buy-outs/buy-ins in Continental Europe (CE) and UK 1996-2005

Source: CMBOR/Barclays Private Equity/Deloitte; Wright, Renneboog, Scholes & Simons (2006).

                                                                                      MCA: april 2007, nummer 3                       19
deals), which appear increasingly intent on achie-        2 Buy-outs in Continental Europe
ving greater focus; and (3) the need for private equity   Despite the growth in the UK and Continental Euro-
firms to exit from deals when their funds are nea-        pean markets, the maturity of the different buy-out
ring the ends of their contractual lives.                 markets varies markedly. One common indicator of
                                                          the relative maturity of buy-out market is the ratio
Performance                                               of the value of buy-out transactions to a country's
The premiums measured over an anticipation win-           GDP. As can be seen in Figure 2, the UK and the Ne-
dows of 40 days for period 1997-2003 are high and in      therlands have the largest buy-out markets as a pro-
line with the premiums paid in other takeovers.           portion (about 1.5%) of their GDP, while the French
They are highest for institutional buy-outs (IBOs) at     and German markets appear to be about half that
47.4%, and somewhat lower for management buy-             size. Spain and Italy have relatively undeveloped
outs (MBOs) and management buyins (MBIs) at               buy-out markets, representing only about 0.5% of
about 39% (see Table 2, panel A). Renneboog et al.        GDP.
(2006) also calculate the cumulative average abnor-          The factors influencing the development of pri-
mal returns (CAARs) measured over 40 days on either       vate equity-backed buy-outs differ significantly
side of the event date which is the announcement of       from country to country. As mentioned above, the
the public-to-private transaction. The CAARs, which       UK represents the most mature market, with Fran-
are corrected for the market movement and for the         ce closely following. Germany represents the less
firm's systematic risk, are between 32% for IBOs and      developed, though large, European PE economies,
between 37.7% for MBIs (Panel B, Table 2). Private        and Central and Eastern Europe is representative of
equity returns have been declining in recent years,       the largely undeveloped, emerging markets.
due to the negative trend in the stock market over            Wright et al. (2006a) argue that in terms of the
the period 2000-2004, the higher competition for          supply of buy-out opportunities, most opportuni-
deals, and the prevalence of auctions.                    ties in the UK have come from the restructuring of
                                                          diversified groups, with going private transactions
Refinancings and partial sales                            becoming more important only in recent years. In
In recent years, with the traditional forms of exit       France, by contrast, the marked growth in buy-outs
proving more difficult, refinancings and partial          has been driven mainly by succession and portfolio
sales have become a popular way for private equity        reorganization issues in the large number of family
houses to cash out part of their investment while at      controlled listed and unlisted companies. But even
the same time keeping control of their portfolio          so, divestments by French corporations, in response
company. There are two common methods of exi-             to growing competitive pressures and an increasing
ting through refinancing. First, the private equity       focus on corporate governance and shareholder
house can refinance a business they own by having         value, have recently become a major part of the
it borrow more and then paying themselves special         French private equity market. By contrast, in coun-
dividends from the borrowings. Alternatively, the         tries like Germany, Spain, and Italy, the reluctance
PE firm can sell some of its property assets to a third   of founders of small and medium-sized firms to sell
party (for example, to an insurance company), lease       to private equity firms – or to cede control at all –
back the property, and transfer the proceeds from         has restricted market growth. As a result, divest-
the sale to the PE firm in the form of a dividend. In     ments and secondary deals have been the most im-
2005, the total refinancings accounted for almost a       portant sources of buy-outs in these countries. In
third of the total value realized in the UK, as com-      CEE, the transition from communism has been the
pared to a little over a tenth in 1997.                   main source of opportunities as many state-owned
A partial sale of the portfolio company provides ano-     firms were privatized, though these volumes have
ther means of realizing part of the initial invest-       steadily declined in recent years. The overall Conti-
ment without losing control. These sales made up          nental European market for PTP transactions is still
just under a third of the total value realized in the     small, in part because these countries have far
UK in 2001, when the value of the FTSE 100 fell           fewer listed companies in the first place. Culture
sharply, but have since become less popular and           may also play a role in this, with managers in some
now account for less than 10% of the total.               countries apparently expressing such pride in their

20                           MCA: april 2007, nummer 3
Panel A: Premiums (measured over anticipation window of 40 days)

Deal type              Obs.       Mean (%)           t-value

MBO                      137            39.1         7.579***
MBI                       18            38.8         2.957***
IBO                       22            47.4         2.957***

Panel B: Cumulative average abnormal returns [-40,40]

Deal type              Obs.       Mean (%)           t-value         Median

MBO                      137            33.4         8.575***              31.3
MBI                       18             37.7       4.636***               43.5
IBO                       22            32.0         2.785***              33.5

The premiums (%) are calculated as follows:
Premium = LN (final price offered / pre-takeover share price). The anticipation window is the number of days prior to the
announcement date of the leveraged PTP. The abnormal returns are the real returns minus the expected returns which were
calculated with the CAPM corrected for thin trading and mean reversion. The betas were trimmed at the 5% and the 95% level
of the distribution. The estimation window spans transaction days –235 to –41 whereby 0 stands for the first announcement
date. The FTSE All Shares Index is the market index. Obs. stands for the number of observations (firms). ***, ** and * stand for
statistical significance at the 1%, 5% and 10% level, respectively. Source: Renneboog, Simons & Wright (2007).

Table 2:
Premiums of and share price reactions to public-to-private transactions in the UK

         800                                                                                                                30000

                                                                                                                                    £ million

         400                                                                                                                15000
          0                                                                                                                 0
               1980   1982     1984     1986     1988     1990      1992     1994     1996   1998   2000   2002   2004

                  Total Number
                  Total Value (£m)

Figure 1:
UK Buy-outs/buy-ins, 1980 - 2005

Source: CMBOR/Barclays Private Equity/Deloitte; Wright, Renneboog, Scholes & Simon (2006).

                                                                                      MCA: april 2007, nummer 3                          21
listings to even consider going private.
    The ‘infrastructure’ for doing buy-out deals also
differs significantly across countries. The UK has
more developed private equity and debt markets,
better intermediary networks, and more favourable
legal and taxation frameworks. Nevertheless,
changes are underway in the other countries to im-
prove their institutional and regulatory infrastruc-                 UK
ture. The French private equity industry grew rapid-
ly from the mid-1980s, with law firms playing a          Netherlands
particularly important role in the diffusion of the
buy-out concept. The infrastructure to complete              Germany
German deals was for a long time less than favoura-
ble – few intermediaries, an underdeveloped private           Belgium
equity market, and high rates of taxation. Many of
these restrictions did not begin to ease until the              France
mid-1990s, when, for example, the country's puni-
tive capital gains tax regime relating to share dis-           Finland
posals began to be relaxed.
    There are also substantial cross-country diffe-            Sweden
rences in exit routes and their importance to private
equity firms in realizing the value of their buy-out           Ireland
investments. The stock markets facilitate IPOs of
buy-out companies in various ways. Even highly de-       Switzerland
veloped stock markets provide limited exit opportu-
nities to all but larger, fastest-growing businesses.            Spain
At the same time, as many corporations complete
their restructuring and markets become more con-               Norway
centrated and global, the corporate M&A market
provides less scope for the trade sale as an exit                  Italy
route, especially for smaller deals. As a result, se-
condary buy-outs and buy-in transactions have be-           Denmark
come a popular exit route for PE buy-out invest-
ments in the UK market; and they are likely to                 Austria
become increasingly important in other markets as
they mature, particularly as companies seek exits            Portugal
when both the stock and M&A markets are weak.

3 Reasons for leveraged buy-outs and                                    0%       0,5   1   1,5   2    2,5    3    3,5    4     4,5
PTP transactions
Taxes                                                                             2003
As the vast majority of public-to-private transactions                            2002
take place with a substantial increase in leverage,
the increase in interest deductions may constitute
an important source of wealth gains. Tax deductibi-      Figure 2:
lity of the interest on the new loans constitutes a      Buy-outs as a percentage of GDP
major tax shield increasing the pre-transaction (or
pre-recapitalization) value. Clearly, the extent to      Source: CMBOR/Barclays Private Equity/Deloitte and OECD Statistics;

which tax benefits can play a role in the wealth         Wright et al. (2006).

22                           MCA: april 2007, nummer 3
gains in going-private transactions depends on the        Consequently, individual shareholders owning small
fiscal regime and the marginal tax rates a company        equity stakes may underinvest in monitoring activi-
is subject to. Lowenstein (1985, p. 759) is critical to   ties. As mentioned above, going-private transactions
LBOs and calls for a restriction of the tax benefits      essentially constitute a reunification of ownership
(the 'truffles from the tax man'), judging that tax-re-   and control. After an IBO, the post-transaction equi-
lated benefits 'are so large as to dispense the need to   ty ownership resides in fewer hands and the inves-
create the other, real gains', a claim supported by       tors will have stronger incentives and more informa-
Frankfurter & Gunay (1993). Still, in spite of the ap-    tion to actively invest in monitoring management
parent advantages of high leverage in LBOs, it is         (Maug, 1998 and Admati, Pleiderer & Zechner, 1994),
questionable whether it constitutes a true motive to      thereby ‘protecting their reputation as efficient pro-
go private. Indeed, in a competitive market for cor-      moters’. Hence, the control hypothesis suggests that
porate control, the predictable and obtainable tax be-    the wealth gains from going private are largely the
nefits will be appropriated by pre-buy-out investors,     result of increased quality of control.
leaving no tax-related incentives for the post-buy-out
investors to take a company private.                      Free cash flow hypothesis
                                                          Jensen (1986, p. 323) defines free cash flow as ‘cash
Incentive realignment                                     flow in excess of that required to fund all projects
When the manager-entrepreneur of a firm is also           which have positive net present value (NPV) when
the sole residual claimant, he extracts pecuniary         discounted at a relevant cost of capital’. Using empi-
rents and non-pecuniary benefits, with the opti-          rical results on executive remuneration and corpora-
mum mix being a deliberation of the marginal costs        te performance, he argues that managers have in-
and marginal utility associated with the increase of      centives to retain resources and grow the firm
a type of benefit. When the manager sells off a por-      beyond its optimal size – the so-called ‘empire buil-
tion of the residual claims to outsiders, the margi-      ding’ – which is in direct conflict with the interest
nal costs of non-pecuniary benefits decrease as he        of shareholders. This problem is most severe in cash
will bear only a fraction of those costs. Consequent-     generating industries with low growth prospects.
ly, the manager increases his private benefits (a be-     By exchanging debt for equity, managers credibly
havioral pattern called 'shirking') which decreases       ‘bond their promise’ to pay out future cash flows ra-
the firm's value. The need to realign incentives of       ther than retaining them to be subsequently inves-
managers with those of shareholders is frequently         ted in negative NPV projects. The risk of default at-
mentioned as a potentially important factor in            tached to the capital restructuring via LBOs serves
going-private transactions. The incentive rea-            as a motivating factor to make the firm more effi-
lignment hypothesis states that the wealth gains          cient. Jensen (1986, p. 325) states that ‘many of the
from going private are largely the result of a reunifi-   benefits in going-private and leveraged buy-out
cation of ownership and control. The effects of the       transactions seem to be due to the control function
incentive realignment hypothesis at higher levels of      of debt’. Applying the carrot and stick theory, the
managerial ownership are heavily contested becau-         carrot represents the increased managerial share
se entrenchment effects are rendering management          ownership allowing managers to reap more of the
– even in the wake of poor performance – immune to        benefits from their efforts. The stick appears when
board restructuring and may delay corporate re-           firms borrow heavily in order to effectuate this in-
structuring (Franks, Mayer & Renneboog, 2001).            centive alignment, which ‘forces the managers to
LBOs provide an attractive setting to reinvestigate       efficiently run the company to avoid default’ (Cotter
the influence of high managerial control.                 & Peck, 2001, p. 102).

Control hypothesis                                        Wealth transfer hypothesis
Grossman & Hart (1980) describe the free-rider pro-       There are three main mechanisms through which a
blem on monitoring managerial actions as faced by         firm can transfer wealth from bondholders to stock-
public corporations with a dispersed shareholder          holders: (i) by an unexpected increase in the risk of
structure. The investment in monitoring by one sha-       investment projects or (ii) via (large increases in) di-
reholder becomes a public good for all shareholders.      vidend payments, or (iii) by an unexpected issue of

                                                          MCA: april 2007, nummer 3                           23
Study                                                Sample         Obs.   Type   Event             CAAR    Anticipation
                                                     period/               of     window                    Window
                                                     country               deal

DeAngelo, DeAngelo & Rice (1984)                     1973-80 / US   72     ALL    -1,0 days     22.27%***   40 days
                                                                                  -10,10 days   28.05%***
Lowenstein (1985)                                    1979-84        28     MBO    -             -           30 days

Torabzadeh & Bertin (1987)                           1982-85 / US   48     ALL    -1,0 months   18.64%***   -
                                                                                  -1,1 months   20.57%***
Lehn & Poulsen (1989)                                1980-87 / US   244    ALL    -1,1 days     16.30%***   20 days
                                                                                  -10,10 days   19.90%***
Amihud (1989)                                        1983-86 / US   15     MBO    -20,0 days    19.60%***   20 days

Kaplan (1989a , 1989b)                               1980-85 / US   76     MBO    -40,60 days   26.00%***   40 days

Marais, Schipper & Smith (1989)                      1974-85 / US   80     ALL    0,1 days      13.00%***   -
                                                                                  -69,1 days    22.00%***
Asquith & Wizman (1990)                              1980-88 / US   47     ALL    -             -           1 day

Lee (1992)                                           1973-89 / US   114    MBO    -1,0 days     14.90%***   -
                                                                                  -69, 0 days   22.40%***
Lee, Rosenstein, Rangan & Davidson (1992)            1983-89 / US   50     MBO    -1,0 days     17.84%***   -
                                                                                  -5,0 days     20.96%***
Frankfurter & Gunay (1992)                           1979-84 / US   110    MBO    -50,50 days   27.32%***   -
                                                                                  -1,0 days     17.24%***
Travlos & Cornett (1993)                             1975-83 / US   56     ALL    -1,0 days     16.20%***   1 month
                                                                                  -10,10 days   19.24%***
Harlow & Howe (1993)                                 1980-89 / US   121    ALL    -             -           20 days

Easterwood, Singer, Seth & Lang (1994)               1978-88 / US   184    MBO    -             -           20 days

Halpern, Kieschnick & Rotenberg (1999)               1981-85 / US   126    ALL    -             -           -

Goh, Gombola, Liu & Chou (2002)                      1980-96 / US   323    ALL    -20,1 days    21.31%***   -
                                                                                  0,1 days      12.68%***
Andres, Betzer & Hoffmann (2003)                     1996-02 / EU   99     ALL    -1,1 days     15.78%***   -
                                                                                  -15,15 days   21.89%***
Renneboog, Simons & Wright (2006)                    1997-03 / UK   177    ALL    -1,0 days     22.68%***   20 days
                                                                                  -5,5 days     25.53%***
                                                                                  -40,40 days   29.28%***

Table 3:
The impact of leveraged buy-outs on the share price

Source: Renneboog & Simons (2006).

24                                   MCA: april 2007, nummer 3
                          ‘Public-to-private transactions:
                                     high costs and risks’

Premium        Tax          Incentive       Control       FCF           Wealth        Trans      Defen-    Under   Bidder
                            Realignm.                                   transfer      cost       sive      value   comp.

56.3%          -            Inconcl.        Inconcl.      -             -             -          -         -       -

56.0%          -            -               -             -             -             -          -         -       Yes

-              -            -               -             -             -             -          -         -       -

36.1%          No           -               -             Yes           -             -          -         -       -

42.9%          -            -               -             -             -             -          -         -       Yes

42.3%          Yes          -               -             -             -             -          -         -       -

-              -            -               -             -             No            -          -         -       -

37.9%          -            -               -             -             No            -          -         -       -

-              -            -               -             -             -             -          -         No      -

-              -            -               -             -             -             -          -         -       Yes

-              Yes          No              -             Yes           -             -          -         -       -

41.9%          Inconcl.     Inconcl.        Inconcl.      Inconcl.      No            No         -         Yes     -

44.9%          -            -               -             -             -             -          -         Yes     -

32.9%          -            -               -             -             -             -          -         -       Yes

Not            No           No              -             No            -             -          -         -       Yes
-              -            -               -             -             -             -          -         Yes     -

-              No           No              Yes           No            No            -          -         Yes     -

41.00%         No           Yes             Yes           No            -             Yes        No        Yes     Yes

Yes = supportive, No = unsupportive, Inconcl. = inconclusive. All estimated shareholder wealth effects from Table 3 and 4 are
reproduced here. ***, **, * stand for statistically significant at the 1, 5 and 10% level, respectively.
ALL = all going private deals, MBO = MBO deals only, FCF = Free Cash Flow hypothesis, Bidder Comp. = Bidder competition.

                                                                             MCA: april 2007, nummer 3                      25
debt of higher or equal seniority. All these elements    the announcement of taking the company private,
can effectuate wealth expropriation of specific sta-     estimated the costs of maintaining a quote at GBP 1
keholders. In a going-private transaction, especially    million.
the third mechanism can lead to substantial bond-
holder wealth expropriation.                             Takeover defense hypothesis
   In line with the theoretical controversy and          Lowenstein (1985, p. 743) reports that some corpora-
measurement problems of going-private losses to          tions have gone private via an MBO ‘as a final defen-
the bondholders, the empirical research does not         sive measure against a hostile shareholder or tender
provide convincing evidence of wealth expropria-         offer’. Afraid of losing their jobs when the hostile
tion for most categories of bondholders. Marais al.      suitor takes control, management may decide to
(1989) find that going-private transactions are follo-   take the company private. Stulz (1988) constructs a
wed by 'pervasive' debt downgradings by Moody's,         model in which pressures from the market for cor-
which reflects a systematic increase in perceived de-    porate control interact with managerial ownership
fault risk. Correspondingly, Cook et al. (1992) find     and finds a curvilinear relationship with firm
that bondholder losses are sensitive to the presence     value. The high levels of equity ownership of firms
of restrictive covenants. They find an average loss of   where management is entrenched, make it unlike-
3% in 29 MBOs from 1981-89, with a range of returns      ly that these firms are taken over by outside parties.
of -16.9% to 11.5%. Warga & Welch (1993) confirm the     However, maintaining this control over the compa-
significant bondholder wealth losses for successful      ny can put management in the predicament of hav-
LBOs in the 1985-1989 period. These results show         ing too much of their personal wealth invested in
that bondholders with covenants offering low pro-        the firm (Halpern et al., 1999). In an attempt to re-
tection against corporate restructuring lose some        duce the non-diversifiable risk of this investment,
percentage of their investment.                          entrenched managers may impose considerable
                                                         costs on the outside shareholders.
Transaction costs
DeAngelo et al. (1984) remark that the costs of          Undervaluation hypothesis
maintaining a stock exchange listing are very            As a firm can be viewed as a portfolio of projects,
high. From the proxy statements of, for example,         there may be asymmetric information between ma-
Barbara Lynn Stores Inc., they infer that the costs      nagement and outsiders about the maximum value
of public ownership, registration, listing and other     which can be realized with the existing assets. It is
stockholder servicing costs, are about $ 100,000         possible that management, which has superior in-
per annum. Perpetuity-capitalized at a 10% dis-          side information and knows the true distribution of
count rate, this implies a one million dollar value      future returns, realizes that the share price is under-
increase from going private. Other US estimates of       valued in relation to the true potential of the firm.
servicing costs mentioned in their paper range           When the management is the acquiring party, it
from $ 30,000 to $ 200,000, excluding manage-            may employ specific accounting and finance techni-
ment time. However, depending on the size of the         ques to depress the pre-announcement share price
company, Benoit (1999) reports that for UK quoted        (Schadler & Karns, 1990). By manipulating divi-
firms, the fees paid to stockbrokers, registrars, la-    dends, refusing to meet with security analysts or
wyers, merchant bankers and financial PR compa-          even deliberately depressing earnings, managers
nies, as well as the exchange fee and the auditing,      can use the information asymmetry to their advan-
printing and distribution of accounts, can even          tage prior to an MBO. Both Harlow & Howe (1993)
amount to £ 250,000. Some UK CEOs estimate that          and Kaestner & Liu (1996) find that MBOs are prece-
these costs may even be higher: Roy Hill, CEO of Li-     ded by significant abnormal buying of company sha-
berfabrica, just after being bought by a trade buyer     res by insiders, whereas outsider-induced buy-outs
in 1999, estimates these costs at £ 400,000, while       are not. They interpret this finding as a confirmati-
Jurek Piasecki, CEO of Goldsmiths, 3 months after        on that pre-buy-out insider trading is associated
going private in 1999 put City-associated costs at       with private managerial information. Alternatively,
£ 500,000. An even higher estimate comes from            it is possible that specialized outsiders (like instituti-
the executive chairman of Wainhomes, who, upon           ons or private equity investors) realize that a firm

26                           MCA: april 2007, nummer 3
       ‘Going private alone worth at least
                     one million dollars?’

has substantial unrealized lock-up value which inci-     grow over the coming years. With strong buying
tes them to buy a toehold stake which may be follo-      power at the disposal of specialized venture capital,
wed by a management or institutional buy-in.             private equity firms, and hedge funds, and with the
                                                         growth of club buy-outs, it may only be a matter of
4 Empirical results                                      time before we see very large firms (even FTSE 100
The answer to the question as to which of the above      companies) being taken private.
reasons to go private via a leveraged buy-out are           With the higher profile of the private equity
supported by empirical results is summarized in          asset class enabling buy-out funds to attract the
Table 3. First, we conclude that the evidence on the     best managers to run the target companies, banks
undervaluation hypothesis is not clear-cut. Second,      have been more willing to gear up deals and even re-
bondholder wealth transfers seem to exist but are        finance them after a short period of time. Although
only playing a very limited role in the wealth gains     this strategy involves significant risks--and gro-
of pre-buy-out shareholders. Other wealth transfer       wing concerns about the near-term performance of
(or expropriation) hypotheses have not been tested       European economies and trends in interest rates are
directly (as is the takeover defense hypothesis).        beginning to raise questions about the degree of le-
Third, the evidence on shareholder-related agency        verage in buy-out deals--there is also potential for
costs hypotheses, more specifically the incentive        commensurately higher returns.
realignment and free cash flow hypotheses, is               The UK market has become quite mature and
mixed. There is evidence that the incentive rea-         has one of the highest proportions of buy-out values
lignment hypothesis is only valid for firms where        to GDP. Elsewhere in Europe, pressures on larger
pre-transaction managers hold small equity stakes.       corporations to restructure may lead to increased
Fourth, the increased tax shields from going private     deal activity, notably divestments. The growing
might be a source of wealth gains, but this evidence     number of large secondary buy-outs provides valua-
is mixed. Fifth, remarkable is that most of the evi-     ble liquidity for the buy-out market at a time when
dence in this strand of the literature – with the ex-    exits have become difficult. Trade sale opportuni-
ception of a paper on UK divisional buy-outs and         ties appear to be growing once again and stock mar-
another on the second public-to-private wave –           kets have become more encouraging, which should
comes from the US. The most recent UK research           help allay building concerns of institutional inves-
shows that much is to be gained from identifying         tors about the recycling of capital seen in recent
undervalued takeover targets which can then be           years. Economic theory discerns several sources of
taken private. This effect is found to be stronger for   value in LBOs, and more narrowly in public-to-pri-
MBOs and IBOs (which mostly retain part of the in-       vate transactions: the potential value creation re-
cumbent management) than in MBIs, as the former          sults from improved incentives effects, the reunifi-
are better placed to exploit undervaluation issues       cation of ownership and control, the reduction of
due to informational asymmetries. The potential          free cash flow, wealth transfers from bondholders
for increased incentive realignment in the private       and other stakeholders, increased tax shields, un-
firm also seems an important determinant of the          dervaluation of the target firm, or reduced transac-
shareholder wealth effects in PTP transactions as        tion costs. Empirical research reveals that the main
both the premium and CAARs are higher for firms          source of value in LBOs stems from undervaluation
with lower levels of managerial ownership (Renne-        of the target firm, incentive realignment through
boog & Simons, 2005).                                    increasing managerial equity stakes and the reuni-
                                                         fication of ownership and control.
5 Conclusions
In the past two decades, European buy-out markets        References
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2                                           MCA: april 2007, nummer 3

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