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A theory of LBO activity based on repeated debt-equity conflicts
Andrey Malenko Nadya Malenko
MIT Boston College Sloan School of Management Carroll School of Management
December 15, 2012
NES 20th Anniversary Conference
Motivation
Source: Bain & Company, Global Private Equity Report 2012
US buyout deal value
1. Overheating • Suggested by Kaplan and Stein (1993) • Requires irrational investors
2. Market timing • a-la Baker and Wurgler (2002) • PE firms are arbitrageurs between debt and equity
markets • Requires an explanation why PE firms are specific
3. Changing aggregate discount rates • Haddad, Loualiche, Plosser (2011) • Trade-off between illiquidity and higher CF growth
Existing Explanations
Theory of LBO activity • how activity is related to aggregate economic
conditions, takeover premiums and leverage ratios Key ingredients 1. Conflicts between PE firms and debtholders 2. Repeated deals
Main result: A theory based on these key ingredients can capture many of the existing stylized facts
This Paper
Example: dividend recapitalization • Simmons Bedding and Thomas H. Lee Partners • two dividend recapitalizations ($375 m), bankruptcy in 2009
Moody’s: credit ratings and PE sponsor’s “track record”
Conflicts of Interest and Repeated Interactions
Infinite horizon, 𝑡 = 0,1,2, …
Players: • two PE firms • lenders • targets
Model Setup
(1) A target is available with prob. 𝛾 PE firms privately learns potential surplus 𝑧𝑖 from the deal
• 𝑧𝑖 i.i.d. from 𝐹(⋅,𝜃𝑖) • 𝐹(⋅,𝜃2) FOSD 𝐹(⋅,𝜃1) for 𝜃2 > 𝜃1 • 𝜃𝑖 - quality of PE firm (common knowledge)
Model Setup
(1) With prob. 𝛾 a
target is available. Each PE firm
learns its surplus.
Period 𝑡 Period 𝑡 + 1
(2) (3) (4) (5)
(2) PE firms raise debt with face value 𝐷
• interest rate is endogenous • tax benefits, incentives
PE firms bid in an English auction Winner acquires the target
Model Setup
(1) With prob. 𝛾 a
target is available. Each PE firm
learns its surplus.
Period 𝑡 Period 𝑡 + 1
(2) PE firms obtain financing and
bid for the target.
(3) (4) (5)
(3) State 𝑠 ∈ {𝐻, 𝐿} is publicly realized with prob. (𝑝, 1 − 𝑝)
• 𝐻: target is worth 𝑋𝐻 + 𝑧𝑖 • 𝐿: target is worth 𝑋𝐿
Stand-alone value: 𝑉0 = 𝑞𝑋𝐻+(1−𝑞)𝑋𝐿1+𝑟𝑓
= 𝑝𝑋𝐻+(1−𝑝)𝑋𝐿1+𝑟𝑓+𝜋
• 𝑞 - risk-neutral probability, 𝜋 - risk premium
Model Setup
(1) With prob. 𝛾 a
target is available. Each PE firm
learns its surplus.
Period 𝑡 Period 𝑡 + 1
(2) PE firms obtain financing and
bid for the target.
(3) State 𝑠 is realized.
(4) (5)
(4) PE firm decides how much to divert
• diversion of 𝑥 generates 𝜆𝑥, 𝜆 < 1
Assumption: 1 − 𝜆 𝑋𝐻 + 𝑧 ≥ 𝐷 > 𝑋𝐿
Model Setup
(1) With prob. 𝛾 a
target is available. Each PE firm
learns its surplus.
Period 𝑡 Period 𝑡 + 1
(2) PE firms obtain financing and
bid for the target.
(3) State 𝑠 is realized.
(4) The PE firm decides how much cash
flows to divert.
(5) All agents
receive cash flows.
If PE firm can commit not to expropriate:
PE firm’s surplus from the deal:
𝑉0 + 𝑞𝑧𝑖1+𝑟𝑓
− 𝑃𝑃𝑃𝑃𝑃
Hence: • All positive surplus deals take place
• PE firm with the highest surplus buys the target
Commitment Case
If PE firm cannot commit not to expropriate:
Interest rate on debt is higher PE firm’s surplus from the deal:
𝑉0 + 𝑞(𝑧𝑖−�̂�)1+𝑟𝑓
− 𝑃𝑃𝑃𝑃𝑃
• �̂� = 1−𝑞𝑞
(1 − 𝜆)𝑋𝐿
Hence: • Deals with surplus 𝑧𝑖 < �̂� do not take place • Who wins the auction depends on the surplus from
the deal and the ability to commit
No Commitment Case
Full commitment Both bidders can commit not to expropriate
Bidder 𝒊 commitment Only bidder 𝑃 can commit not to expropriate
No commitment No bidder can commit not to expropriate
Equilibria with Repeated Deals
Trade-off: • benefit from expropriation today • costly financing in future deals
The higher quality bidder has more commitment power
Existence of Equilibria
Full commitment
“Weak bidder” commitment
“Strong bidder” commitment
No commitment
𝛾 𝛾1 𝛾2 𝛾3
Trade-off: • benefit from expropriation today • costly financing in future deals
The higher quality bidder has more commitment power
Existence of Equilibria
Full commitment
“Weak bidder” commitment
“Strong bidder” commitment
No commitment
𝑃𝑓 𝑃𝑓1 𝑃𝑓2 𝑃𝑓3
Properties of Equilibria
0%
25%
50%
75%
100%
No commitment Bidder 2commitment
Full commitment
Buyout activity
Composition of winning acquirers The fraction of targets acquired by the higher quality firm
is the highest in the “bidder 2” commitment equilibrium
Properties of Equilibria
0%
15%
30%
45%
60%
No commitment Bidder 2commitment
Full commitment
Fraction of targets acquired by high quality firms
Properties of Equilibria
0%
5%
10%
15%
20%
25%
30%
No commitment Bidder 2commitment
Full commitment
Average takeover premium
If PE firm raises debt 𝐷, its surplus in state H is
g 𝐷 + 𝑧𝑖
• 𝑔 𝐷 is maximized at 𝐷∗
• 𝑔 0 = 0, 𝑔′′ 𝐷 < 0, 𝑙𝑃𝑙𝐷→0
𝑔′ 𝐷 = ∞
• 1 − 𝜆 𝑋𝐻 + 𝑧 ≥ 𝐷∗ > 𝑋𝐿
Extension: Endogenous Leverage
Extension: Endogenous Leverage
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.80
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Loss of future surplus from expropriation, ∆S
Deb
t, D
Optimal debt;Expropriation
Suboptimal debt;No expropriation
Optimal debt;No expropriation
Consistent with existing evidence
• Boom-and-bust pattern in LBO activity
• Correlation between LBO activity and discount rates (Haddad, Loualiche, and Plosser, 2011)
• Correlation between deal leverage and economic conditions (Axelson et al., 2012)
• Identity of a PE sponsor matters for cost of debt and leverage (Demiroglu and James, 2010; Ivashina and Kovner, 2011)
New implications
• Takeover premiums and buyout activity
• Composition of acquirers: Fraction of deals done by major PE firms is inverted U-shaped in drivers of deal activity
• “Expropriation” decisions by PE sponsors
• Past “expropriation” by sponsors and cost of debt
Empirical Implications
Key idea
Take two well-known features of the PE industry: 1. Conflict between PE sponsors and creditors 2. Repeated deals
Examine their implications for buyout activity
Implications
Match much of the existing evidence, often attributed to market inefficiencies
Provide further testable implications
Conclusion