Buyouts have been at the centre of corporate finance since the intense merger and acquisition activities of 1980s led to the development of a vibrant buyout market. The total number of UK buyouts has surpassed 10,000 (CMBOR, 2010), representing around 20% of the global buyout activity (Stromberg, 2008). At the same time, private equity (PE) funds have grown in their size and importance as market players managing around $1 trillion of capital annually; two thirds of which is accounted for by buyout specialists (Metrick and Yasuda, 2010). As PE firms strengthen their foothold in financial markets, they have come to the receiving end of the criticism. Several high profile takeovers and bankruptcies in the last decade intensified the public attention on PE funds and their alleged malpractices.4 Researchers that analyse wealth creation in buyouts have found largely positive results that suggest a favourable effect in the wake of a buyout announcement as well as performance improvements during PE involvement in the target firm. However, it is understandable that public opinion remains divided over the usefulness of buyouts due to the fact that PE funds have a relatively short term vision, which results in the abandonment of targets within 3-5 years. Although this short term vision would increase PE investors incentives to be more actively involved in the firm to obtain the best possible return (Cressy et al., 2007), suspicions over whether economic impacts such as employment will contribute to the financial health of the general public, and whether the positive consequences of the PE involvement will be sustained in the long run are alive.
4 The acquisition of a FTSE 100 company; Alliance Boots Plc and the bankruptcy of Southern Cross Care
Homes are arguably the most publicised examples of UK buyouts. Alliance Boots is the largest buyout in the UK history, being valued at £11.40 ($22) billion in 2007. Southern Cross Care Homes, an operator of retirement houses, was sold to Blackstone Capital in 2004. Shortly after an IPO exit, the company went bankrupt in 2011.
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A management buyout (MBO) has three distinctive features that make the transaction and its consequences remarkably different from a regular acquisition. The takeover of the company by its own management team, the presence of PE investors and use of high leverage are characteristics of a typical MBO. The value is then created through combined effects of debt, managerial incentivisation and an active PE investor which involves in the decision-making process and monitors the firm effectively. Value creation is measured as post-deal financial gains to pre-buyout shareholders, the post-buyout improvements in operating performance and as the return obtained by the PE investor following exit. These measures often suggest increases in the share price following the announcement of the buyout (Renneboog et al., 2007; Geranio and Zanotti, 2010), and improvements in the post-buyout operating performance (Kaplan, 1989a; Smith, 1990; Opler, 1992), and large positive returns to PE investor in the form of IRR (Nikoskelainen and Wright, 2007). The positive outcomes of buyouts prompted Jensen (1989) to anticipate buyout superiority over traditional public corporations which would see all companies being eventually reverted to the superior buyout form. Although buyout markets collapsed soon after Jensen’s prediction, they quickly recovered and survived multiple financial crises confirming a long lasting buyout phenomenon. The last decade has been particularly tumultuous; starting with high-tech bubble and ending with a global recessionist environment it paved the way for a thorough evolution of buyout deals. The gradual demise of IPOs (Gao et al., 2013) and increasing investor risk-aversion left PE funds with an exit dilemma, resulting in a decline in the number of primary buyouts.5 In such circumstances, an interesting question that arises is whether Jensen’s theory still holds and whether primary buyouts can still generate value through operations.
5
The UK buyout market recorded only 1 IPO exit in 2008 and 2009. The number of MBOs hit a record low and receiverships accounted for 157 of 245 buyout exits in 2009, making it the worst exit environment in the UK (CMBOR, 2010).
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Studies on value creation can be broadly examined in two buyout waves. The general tendency in the literature is such that first wave buyouts are characterised by high leverage and large performance improvements while debt levels decrease and operating gains become smaller in the second wave. Kaplan (1989a) shows large increases in firm value two months before buyout announcement to post-buyout period. Industry adjusted operating income and net cash flows improve over three years after buyout while capital expenditures decline. Smith (1990) finds significant improvements in industry adjusted operating returns from the year prior to buyout to one post buyout year. Operational improvements are maintained in the medium term and they are not due to layoffs or reductions in expenditures. Similarly, Opler (1992) finds that industry adjusted operating cash flow to sales increase by 11.6% in the two years after buyout. Consistent with Kaplan (1989a), capital expenditures and R&D decline, nonetheless this evidence contrasts with Smith (1990). Guo et al. (2011) find that operating gains in the second wave are small or non-existent relative to a control sample matched on industry and pre-buyout characteristics. They argue that without larger operating gains, sustenance of high returns is unlikely under less favourable market conditions.
The UK evidence for first wave buyouts is largely consistent with US studies. For example Wright et al. (1992) find significant performance improvements after buyout. The second wave evidence on performance is less conclusive. Weir et al. (2008) show that buyout performance deteriorates relative to pre-buyout period; however not outmatched by the performance of comparable public firms. Cressy et al. (2007) find that PE-backed buyouts outperform non-buyouts 4.5% in terms of profitability in the three years after buyout. The profitability in the buyout year is an important determinant of post-buyout profitability, suggesting that selectivity of PE investors could play an important role in good performance. In a similar vein, Chung (2011) documents that PE firms target already profitable companies. PTPs reduce their size and expenditures, while private-to-private buyouts are associated with
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substantial post-buyout growth. Jelic and Wright (2011) provide evidence of better profitability and improvements in employment and sales, but deterioration in efficiency. However most of the improvements remain limited to short term.
Apart from the changing market conditions, one of the important reasons for documenting lower returns in the recent buyout studies is the changing characteristics of samples used in the research. The recent buyout literature has increasingly recognised the heterogeneity of buyouts; meaning that type of buyout (LBO/MBO/MBI), and source of buyout (PTP, divestment, private-to-private) have different characteristics and important implications for the subsequent trajectory of the company (Wright et al., 2000; Nikoskelainen and Wright, 2007). Studies using mixed samples of public-to-private and private-to-private buyouts (e.g., Boucly et al., 2011; Chung, 2011; Jelic and Wright, 2011) that allow researchers to more closely examine relative performance of different types of buyouts suggest substantial differences between buyouts of public and private origin. In particular, studies that utilise a large number of private-to-private buyouts often report small performance improvements following transaction (e.g., Desbrieres and Schatt, 2002; Jelic and Wright, 2011). These studies, however, mostly examine private-to-private buyouts in the classical agency framework, which is more suitable to public firms than private firms. A special focus on private-to-private buyouts would better address their motives and performance.
This study examines MBOs in the UK market. This choice is imposed by several requirements. The European Union and UK regulations allow us to access private firm financial statements which are not publicly available in the US. For this reason, US buyout research is mostly restricted to PTP transactions, and in the PTP transactions it is restricted to buyouts that issue public debt during private period. However, results obtained from subsamples of debt issuing buyouts are likely to be biased (Cohn et al., 2014). The UK choice enhances sample representation and mitigates bias. Moreover, the UK market is the largest
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buyout market in Europe, enabling us to utilise a larger and more representative sample than other European markets.
This study has two main objectives. First, we aim to examine the performance of buyouts in the last decade. This period is chosen due to evolving nature of buyout markets. Second, we aim to shed light on the performance of non-public-to-private (PTP) buyouts. Stromberg (2008) reports that private-to-private and divisional buyouts account for 78% of all buyouts while in 6.7% of the cases a public firm becomes the target of buyout. More efforts need to be dedicated to explain the motives and consequences of the non-PTP buyouts given their large share in the buyout market. We use a hand-collected sample of 412 UK management buyouts completed between 2000 and 2009, of which 308 are private-to-private and 104 are divestment buyouts. Our study adds to the growing performance studies of non-PTP buyouts, namely Meuleman et al. (2009), Chung (2011), and Boucly et al. (2011).
The results suggest improvements in industry adjusted profitability and growth following buyout. The main focus of the post-buyout company is on growth rather than improved profitability and efficiency. However, we find little evidence that changes in performance are associated with the MBO transaction. PE-backed buyouts and buyouts in general have an increasing trend of profitability prior to transaction, where profitability peaks at year -1 and reverts to year -3 levels several years after buyout, which may indicate practice of earnings management or selective PE investment prior to buyout. When this potential selection effect is controlled, the performance improvements disappear. Divisional and full buyouts do not show substantial differences.6 The results also support the idea of a pecking order exit for buyouts. Buyouts that successfully complete an exit transaction have higher pre-exit profitability, lower efficiency and growth than non-exited buyouts. Regression tests confirm
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that PE-backing is not positively associated with performance improvements. Leverage; however, significantly impacts profitability, efficiency and growth despite being low.
The rest of the chapter is organised as follows: Section 2 discusses motives of buyout transactions and develops hypotheses. Section 3 describes data and methodology, and discusses sample issues. Section 4 presents empirical results. Concluding remarks are offered in Section 5.
3.2 Literature and Hypothesis Development