The Determinants of Leverage and Pricing in Buyouts

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Credit conditions have a strong effect on prices paid in LBOs, even after controlling for prices of equivalent public market companies.

Private equity firms have become increasingly important sources of capital and governance for companies, and their financing choices have implications for the study of private equity and for corporate finance. In Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts (NBER Working Paper No. 15952), co-authors Ulf Axelson, Tim Jenkinson, Per Strömberg, and Michael Weisbach examine how private equity funds structure the financing of their leveraged buyouts (LBOs), and they compare this result to the capital structure of similarly-sized public corporations. The researchers also ask whether the financing of a buyout affects its pricing and investment return.

Typically, in a private equity transaction, the private equity firm forms a new company to bid for a controlling stake in "and often majority ownership of" an existing company. The new company is established specifically for the purposes of the transaction, and is usually just a shell with nominal capital and temporary directors. In order to raise the capital for an LBO, the private equity sponsor takes funds from its limited partners and lines up debt financing -- conditional on the acquisition closing -- using the target firm's assets as collateral. The syndicated loan market usually provides the debt.

This study relies on a sample of 1,157 LBO deals undertaken from 1980 through 2008, and includes 694 North American firms and 463 international firms, most of those from Western Europe. Some of the transactions were completed after the recent financial crisis, providing a view of private equity financial choices in both boom and bust credit markets. Although there are some public-to-private deals, the vast majority of the transactions involved the purchase of private companies and divisions of public companies. Most of the major market players, 176 private equity firms in all, are included in the sample.

After compiling data on each deal's financing structure, including debt securities' pricing and payback schedules, the researchers find that much of the debt used in buyouts is non-amortizing -- for some tranches, even interest payments are optional. Contingent credit facilities are also commonly used to provide additional financial flexibility. The cost of borrowing is the main driver of both the quantity and the composition of debt in leveraged buyouts. When credit is abundant and cheap, buyouts become more highly leveraged in order to maximize the returns on each deal. The authors observe no such effect in similarly-sized public firms.

Buyout capital structures appear to be "inverted" relative to comparable public companies: on average, debt comprises around 70 percent of enterprise value in buyouts, which is about the proportion of equity in public companies. But the size of an LBO's debt can vary greatly since its financing is so sensitive to credit market conditions.

Credit conditions have a strong effect on prices paid in LBOs, even after controlling for prices of equivalent public market companies. The use of high leverage in transactions also is found to negatively affect fund performance in most instances.

-- Frank Byrt