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