Predicting leveraged buyout success

Do fixer-uppers and non-fixer-uppers influence takeover success probability in Europe?

Bachelor Thesis 2011 54 Pages

Business economics - Investment and Finance



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1. Introduction

2. Literature review and de(inition of (ixer-uppers and non-(ixer-uppers
2.1 Transaction characteristics of leveraged buyouts
2.2 Development of LBOs in Continental Europe and in the United States
2.3 Review of empirically tested drivers for becoming a LBO target
2.3.1 Major findings
2.3.2 Further investigations and new aspects of empirical research
2.4 Fixer-uppers and non-fixer-uppers

3. Data and Methodology
3.1 Sample selection
3.2 Employed variables
3.3 Descriptive statistics
3.4 Methodology

4. Empirical results
4.1 Equations and controls
4.2 Major findings

5. Conclusion

List of references


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Figure 1: LBO Deal volume in the US and in total

Figure 2: LBO volume in the US and in Continental Europe

Figure 3: LBO volume US and Europe 2001 - 2009

Figure 4: LBO sample statistic I (Number of transactions)

Figure 5: LBO sample statistic II (Deal attitude)

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1. Introduction

The financial crisis of 2008 and 2009 still has a remarkable impact on today's attitude towards financial models and practices used on regular basis before the burst of the American real estate bubble. The dramatic decline of stock markets and the deepest recession since the worldwide economic crisis of the 1930th have led to an atmosphere of mistrust and awareness of risk not known before in recent history. Today everybody knows about the financial problems of states like Greece, Portugal, Ireland or even the United States of America. The dramatic problems have led to instability of currencies like the Euro and of the political system as well. Today people are protesting in front of the Greek parliament because of an aspect of the financial system, nearly everybody already had contact with. It does not matter whether we speak about a private person, a company or a state, they all depended on this phenomenon. What we speak about is the use of foreign capital, hence the use of debt to finance an investment. In today's economy debt is an integral part of business, especially companies and states are heavily dependent on it, as without they would not be able to keep business and life going.

The use of debt is also the central part of various financing techniques, among other things, the so called leveraged buyout (LBO from here on). In the last decades leveraged buyouts have become a quite popular model in both strategic mergers and acquisitions (M&A from here on) and return orientated investing, for example in the sector of private equity. By using a high percentage of debt, the return on the used equity can be maximized or in case of strategic, activity huge acquisitions can be realized without the need for additional equity. The latter is also important as the costs of debt are lower compared to the costs of equity. Besides, debt is a useful instrument in order to safe taxes1.

On the other side, increasing debt also increases the costs of bankruptcy2 and the dependence on the capital markets which is why in case of non-perfect capital markets3 an optimal debt to equity ratio or better to say capital structure exists. In case of leveraged buyouts this optimal debt to equity ratio is the most important aspect as it determines both the expected return on equity and the potential risk in case of failure. Various researches have been done in the area of leveraged buyouts, focusing on the identification of potential targets, the question who benefits of the high debt ratio used4 or the investigation of drivers for the used leverage and the final buyout prices.5 However another aspect of interest has not been brought up in research activity, neither for the United States (US from here on) nor the European market. While we already know quite a lot about how potential LBO targets might be identified, we only find a few drivers which influence the overall probability that the LBO is actually closed after the announcement. In our research we will concentrate on this aspect of LBOs by checking various target characteristics and their influence on the final result of the LBO attempt. Therefore, we will investigate both absolute values of several key figures and the development in the years prior to the announcement. Besides it is important to point out that our study is based on LBO attempts in the European market, which still is relatively unexplored compared to the origin of LBOs, the US market.

In a second step, we will try to identify a sort of company profile which increases the probability the LBO is closed successfully. To be more precise, we will investigate whether fixer-uppers, hence target companies (targets from here on) which depend on further financial aid and support of their buyers right after the deal close, increase the takeover success probability or not. The same we will do with respect to the fixer-upper counterparts, the non-fixer-uppers.

At first we will check for a list of standard figures which also have been investigated in question of predicting which companies are probable to become the target of a LBO. Our results show that the target's size in total assets is a quite important driver for the overall success of the takeover process, such as the generated cash flow and EBITDA margin. Additionally, we identify various growth rates measured by the 3 year CAGRs to have significant influence on the final outcome of the LBO attempt. Out of the results we are able to identify non-fixer-uppers as a potential company profile with positive influence on the takeover success probability, although the results suggest that more detailed research has to be done in the area to be able to give a definite answer.

Our paper is organized in the following way. In section 2 we will start with a description of the motivation and the construction of a LBO and show what risks and chances are connected to it. Besides, we compare the development of LBOs in Europe and in the US market to give both an impression of how the distribution and shares have changed in the last decades and how LBO activity and volume are generally processed. In a next step, we will review the literature connected to the prediction of LBO targets in the US as well as in the European market and summarize the major findings before we outline which aspects have not been investigated yet. This is an important part of the study as the identification of LBO targets actually takes place right before the period which decides whether the deal is actually closed or canceled. Hence the two research areas are closely related. We will close section 2 with an introduction to fixer-uppers and non- fixer-uppers and the main differences between those two company profiles.

In Section 3 we will describe the sample and the variables we use to identify possible drivers of takeover success probability. Here we will also present our hypotheses towards the impact of the various variables and the fixer-upper and non-fixer-upper profiles. Additionally, we will provide information towards descriptive statistics and the used methodology. Section 4 presents the various regression equations employed and our major findings. Besides, we will outline which aspects should be investigated in further research. Finally Section 5 concludes the paper.

2. Literature review and definition of fixer-uppers and nonfixer-uppers

2.1 Transaction characteristics of leveraged buyouts

The LBO describes a special form of common M&A or better to say a way of financing. Its main characteristic is the high percentage of debt an investor uses when executing a LBO while the level of equity held inside the deal is relatively low. Hence all transactions, that uses debt financing of more than fifty percent of the total volume can be referred to as LBOs.6

The main reason for this deal design lies in the possible increase of return on invested equity, which is caused by the high level of debt. As long as the realized return of the deal is higher than the interest rate the investor has to pay for the used loan, the return rate improves with an increasing positive delta in between the two referred factors. In standard literature this phenomenon is called the “leverage effect”. Apart from this possible increase in returns, there is another argument which can be found frequently in related literature, which is the tax savings or tax benefit effect. Opler and Titman describe this effect as the use of payable debt interest in order in reduce the taxable earnings of the company.7

The big chances which come hand in hand with this quite speculative deal design are compensated by an increasing risk the investors faces when executing the deal. In fact there are two main risks occurring which both can lead to grave losses for the investors. First the use of a high leverage, which describes the ratio between used debt and equity, can also result in a decreasing return for the investor in case the deal does not create the anticipated success after the execution. As we learn in a report of the german Bundesbank from 2007, an investor even might face a total loss of equity in case the leverage effect turns out the be negative.8

The second risk lies in the design of LBOs, which includes the transfer of the used loan into the books of the target company. Hence the level of the companies' debt increases dramatically and in the same time the probability to fail.9

In Gaughan we learn, that LBO transactions are often directly connected to a going private transaction10, which means that all outstanding shares of a public company are bought of the shareholders with the capital raised for the deal to take the company private. Hence after the execution, the company is not listed at a stock exchange anymore. There are several aspects which can motivate investors to execute a public to private transaction. Renneboog for example states, that investors use the status of private companies to benefit from tax savings or a reduction in agency costs.11 Nevertheless the most important point is the restructuring process investors initiate after the public to private transaction. It is important to clarify, that investors executing an LBO are in majority Private Equity funds founded by companies such as Blackstone Group Inc. or Kohlberg Kravis & Roberts (KKR from here on), which collect equity of private and institutional investors in order to invest in connection with loan financed capital. After the buyout, those funds aim for a deal exit in a certain period of time to return the invested money and to realize the anticipated profits. Those periods are relatively short ,which indicates that the funds seek for an immediate maximization of the companies value compared to the value of the company in the public status. Betzer underlines that in his paper from 2006 when he states that “Private Equity firms only try to detect inefficiencies in the targetfirm in order to increase its value“.12

LBO activity is directly related with the phenomenon of waves in M&A activity.13 Even more important is the fact, that the probability of success in case of a LBO is ,compared to standard M&A transactions, even more dependent on the current market situation and especially the access to big amounts of debt. In times of low interest rates and easy access to credit, the financing via LBO is quite attractive for investors as the probability of a positive leverage effect increases with a decreasing interest rate for debt. The low interests rates in the last decade are an important reason why even in M&A markets like Germany, which have the reputation of being relatively conservative in question of debt financing, LBOs have gained more importance during the last period of upturn in economy.14

Generally, the original american idea of financing via LBO has become quite popular in European markets nowadays. This is why we will now turn attention to the historical development of LBOs in the Western Europe M&A market and its present importance compared to the M&A market in the US.

2.2 Development of LBOs in Continental Europe and in the United States

The terminology of LBOs is a rather new to express the financing of transactions with a high degree of debt. Nevertheless, the idea behind LBOs was already present in the early 20th century. In this time Henry Ford and his son Edsel used a big amount of debt to finance the going private transaction of Ford Motor Company.15 Therefore, this transaction can be characterized as the first ever observed LBO in modern history. Afterwards LBOs constantly gained importance on capital markets, especially in the US (see Figure I). This development was also supported by the time of deconglomeration in the 1970th and 1980th in which big conglomerate companies were separated into a huge number of smaller companies through the selloff of business units.16 The trend topped in some of the biggest LBOs in the 4th merger wave, among other things the buyout of RJR Nabisco by Kohlberg Kravis & Roberts (KKR) in 1988, which had a total volume $24,6 billion.

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Figure 1: LBO Deal volume in the US and in total

Source: Thompson Financial Securities Data (see Gaugham (2002), P. 287ff)

In the 1970th and 1980th the US LBO market was by far the most important one. However, in the late 20th century the European LBO market gained importance as well. With the boom in the 1990th, the value of LBOs in Western Europe rose significantly and reached the level of the United States Market around the start of the 21th century. Driven by the New Economy boom, in which the international stock markets experienced a historical boom caused by cheap money and upcoming Start Up enterprises, the value of European LBOs exceeded the US LBOs and dominated it from 2001 onwards. This development is directly connected to the 5th merger wave, which is described by Renneboog as the first merger wave, in which European companies participated on the same level like their US and UK counterparts.17 Figure I shows that the US LBO share of the total volume reduced from over 90 % to less than 50 % in 2005. In the same time European LBO market share skyrocketed from less than 5 % in 1988 to more than 50 % in 2005.

Concluding the points above, we can observe a trend towards a global LBO market in which the US as well as the European LBO market are of at least the same importance when referring to the total deal volume (see Figure II).

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Figure 2: LBO volume in the US and in Continental Europe

Source: Thompson Financial Securities Data (see Gaugham (2002), P. 292)

After the terrorist attacks of 09/11 in 2001 and the wars in Afghanistan and Iraq in 2002 and 2003, interest rates in the US were cut to a record low to prevent the economy from another disaster such as the one after the burst of the New Economy bubble in 2000 / 2001. Although today a lot of prominent economists criticize the Federal Reserve and its former chairman, Alan Greenspan, to have created the basement of the financial crisis, the economic development and in the same time M&A and LBO activity got supported and even topped the record highs of the 1980th both in the US and in Europe.

However in 2007, right with the start of the world financial crisis of 2008 and 2009, we can observe the record high of LBO transaction volume with a total amount of $ 503 billion.18 With the insolvency of Lehman Brothers, Inc. and the crash of the international stock markets both the European and the US LBO market saw a dramatic decline in deal volume. Of the record volume of $ 503 billion in 2007, we could observe a reduction of 66 % to $170 billion in 2008 and of another 52 % to $81 billion in the recession year of 2009 (see Figure III) . Hence the LBO volume dropped more than 80 % to a level comparable to the one in 2001 in only two years.

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Figure 3: LBO volume US and Europe 2001 - 2009 Source: Bain & Company (2010), P. 4

After the rebound of the economy the market for LBO financing also managed the turnaround. Although there is still a long way to go to reach the volume levels of 2007 and problems such as the European debt crisis and the political rumors in Arabia and Africa are not solved yet, investors turn back to a positive future perspective. Reasons are the increasing willingness of banks to offer debt for reasonable interest rates and the fair valuation of potential takeover targets. Especially some European markets like Germany offer a lot of potential for LBO transactions as we learn in the new Private Equity Trend Report of PriceWaterhouseCoopers.19

We conclude at this point that the European LBO market is characterized by an impressive development in the last twenty years. Apart from short but hard downturns in the crises of 2001 and 2008, it developed from a side activity market to a fifty percent total share market, which in times generated more deal volume as the benchmark market in the US. Besides, it owns the best perspective apart from Asian markets which might turn out to be the next upcoming big volume markets in the next decades.Consequently, there are sufficient reason to conduct some further research on the European LBO market.

2.3 Review of empirically tested drivers for becoming a LBO target

As said the probability of becoming a LBO target is a quite important factor for our research topic. Especially for the US market we find a lot of accessible research referring to the question, what kind of company characteristics can have a positive or negative impact on it. Next to the support of our research we find further reasons why this question is actually of high interest from both the empirical perspective and the business perspective.

In their paper about European M&A Renneboog and Martinova describe the wealth effects of shareholders of the acquiring and of the target company as well. They point out that especially the target companies' shareholders receive great premiums on the pre-announcement share price, on average 10 % to 30 %.20 Betzer even names 35% to 56 % for the US and 36 % to 41 % for the European market.21 Hence, investors with the ability to predict upcoming takeover targets would be able to realize significant abnormal returns with a strategy to buy the shares of the predicted takeover targets shortly before the official takeover announcement.

Another source of business interest can be seen in managers of target companies, who are interested in getting to know whether their company fulfills some kind of takeover target scheme or not, as in case they do, takeover defense tactics could be launched earlier for example. The result would be a decreasing probability of takeover success or primarily a decreasing interest of acquirers to purchase the company. Yet empirical work in this area has not come to a straight forward perspective. Especially for the US market, some drivers for becoming a LBO target have been identified. Nevertheless the authors come to different conclusions and results concerning the quality of different factors. For the European market, research has been done by scientists like Achleitner, Betzer, Renneboog or Andres. Therefore, in the next chapter 2.2.1 we first want to look back on the major findings of done research for both the US and the European market. Additionally in 2.2.2 we will show what kind of research has not been done yet and introduce the topic of fixer uppers and non-fixer- uppers.

2.3.1 Major findings

In existing literature we can identify several aspects, which scientists identified as possible drivers for the probability of becoming a LBO target. In the following we want to present and discuss those aspects.

1. Generated free cash flow / free cash flow hypothesis (Jensen)

In 1986 Michael C. Jensen proclaimed the argumentation that managers of companies, who generate relatively high free cash flows reinvest the money in projects with negative net present value instead of increasing the payout ratio of the company. Jensen argues that this effect is caused by agency problems in between the principles (e.g. the shareholders) and the managers in the company, who try to maximize their own wealth.22

To handle the problem of wasting free cash flows, Jensen identifies debt as a disciplinarian method for managers. He argues that a high debt ratio reduces the misuse of capital as the company has to pay a high amount of interest.23 We can find the argumentation in Renneboog, that through the high debt share used in LBO transactions the inefficiencies caused by agency problems in the target companies can be reduced.24 The reason lies in the fact that the used debt is directly transferred in the books of the target company right after the execution of the buyout. Hence, a high generated free cash flow could be an indicator for investors that the observed company might be a possible target of a LBO. This argumentation is also underlined by Opler and Titman, who find strong support for high generated free cash flow as a positive driver for the probability to become a LBO target.25

Nevertheless, neither Weir et al. nor Betzer cannot underline the free cash flow hypothesis in all its details as a definite variable for the probability of becoming a target26 27, although Betzer agrees about the fact, that LBO targets are mostly characterized by stable cash flows and low growth opportunities.

In summary, we find a lot of arguments that the free cash flow hypothesis of Jensen can be used to predict possible takeover targets of LBO. On the other hand, we have to keep in mind that through empirical research not all aspects of the theory can be supported.

2. Ratio debt to total assets (Leverage)

The leverage of a company gives information about how much debt the company uses. In fact this factor is quite important for potential LBOs as with the LBO the company will receive a big amount of additional debt. In his paper Betzer names the ability to indebt a company as central question for LBO transactions although he cannot find empirical evidence for the phenomenon.28

Leverage also plays an important role in the investigations of Achleitner et al. in their 2010 published research paper of the European Private Equity market. They argue that leverage has to be seen as a combination of two factors, which are the disciplinary function of debt (see factor Generated Free Cash Flow) and the possibility to save taxes.29 This argument was also tested by Opler and Titman for the US market and states that the initiators of a LBO might be interested saving payable taxes by generating high interest payments for debt. In modern literature this phenomenon is called tax shield.

Achleitner et al. underline the leverage argumentation with their statistical research as they can confirm both the disciplinary function of debt and the tax shield phenomenon30. They conclude that possible takeover targets are characterized by a low existing leverage and therefore high debt capacity for future debt as well as by high outstanding tax liabilities, which generate the tax shield for the potential investors. We can find further support for this in Renneboog.31

3. Market to Book ratio and Tobin's Q

In LBO transactions, the estimated value of potential targets is one of the key success factors. Hence, the valuation process is quite important for the buying party. Apart from complex models such as the discounted cash flow valuation (DCF from here on), which uses the discounted free cash flows and future returns, valuation of public companies can be done easily through the share value of all traded shares the company emitted.32 Nevertheless, it is always important to compare the stock market value of a company with the value of a company's assets. The reason lies in the nature of stock markets and the related pricing process, which reflects both the current value of the company's business and the future expectations. In case the future expectations are good, stock markets tend to value the company higher and therefore increase the price a potential public to private investor faces.

The market to book ratio (MTB from here on) measures by how much the company's market value exceeds the book value of the companies' equity. Hence a MTB value of less than 1 states, that the current market value is less than the overall book value of the company. On stock markets investors use this ratio quite regularly as an indicator whether a stock is over- or undervalued. As we learn in Fama and French, companies with low MTB ratio, so called value stocks, tend to have higher average returns.33

In case of Tobin's Q the ratio is quite similar, apart from the fact that the current book value is replaced by the amount the company would have to pay to replace all its assets, the so called replacement costs. Betzer employs Tobin's Q in his research and finds evidence for the assumption that LBO targets are characterized by lower Q rates than companies which remain public.34 This is also supported by Weir, Liang and Wright in their investigations of public-to-private transactions in the UK.35

Summarizing the points above, research has shown that the MTB ratio as well as the Tobin's Q ratio can be used to predict potential targets of LBO investors. Hence in both cases we expect a higher probability for the value stocks, the companies with a low MTB or Tobin's Q respectively. As we will see in the next paragraph, this results can be used to identify another variable.


1 See Graham, Harvey (2000), p. 10.

2 Also referred to as financial distress costs.

3 According to Modigliani and Miller (1958) the capital structure does not influence the firm value in case of perfect capital markets.

4 See Jenkinson, Stucke (2011).

5 See Axelson et al (2010).

6 See Gaughan (2002), p. 285.

7 See Opler, Titman (1993), p. 1988.

8 See Bundesbank (2007), p. 17.

9 See Bundesbank (2007), p. 16.

10 See Gaughan (2002), p. 285.

11 See Renneboog, Simons (2005), p. 7.

12 See Betzer (2006), p. 1.

13 See Berk, DeMarzo (2007), p. 875.

14 See Bundesbank ( 2007), p. 15.

15 See Gaughan (2002), p. 286.

16 See Gaughan (2002), p. 285.

17 See Renneboog, Martinova (2006), p.1.

18 See Bain & Company (2010), p. 4.

19 See PwC (2011), p.15.

20 See Renneboog, Martinova (2006), p. 7.

21 See Betzer (2006), p.1.

22 See Jensen (1986), p. 2.

23 See Jensen (1986), p. 3.

24 See Renneboog, Simons (2005), p. 10.

25 See Opler, Titman (1993), p. 1996.

26 See See Weir et al (2005), p. 29.

27 See Betzer (2006), p. 16.

28 See Betzer (2006), p. 10.

29 See Achleitner et al. (2010), p. 10f.

30 See Achleitner et al. (2010). p. 34.

31 See Renneboog, Simons (2006), p. 12.

32 It is important to point out that the DCF computes the firm value ,while stock markets determine the equity value of a public company. The difference is caused by the amount of net debt.

33 See Fama, French (1998), p. 16.

34 Betzter (2006), p. 8.

35 See Weir, Laing,Wright (2005), p. 29.


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Karlsruhe Institute of Technology (KIT) – FBV
LBO Leveraged Buyout Success success probability M&A mergers acquisitions probit regression empirisch Leonardo & Co Award



Title: Predicting leveraged buyout success