Table of Contents
CHAPTER 1. THEORETICAL BACKGROUND
1.1. Public-to-Private Transactions: Literature Review
1.2. Determinants of Public-to-Private Transactions: Classification
1.3. Case Studies: Buyouts of Alliance Boots and Regent Inns
1.4. Hypotheses Formulation
CHAPTER 2. EMPIRICAL STUDY
2.1. Research Design
2.2. Sampling and Data Collection
2.3. Empirical Results & Discussion
LIST OF REFERENCES
Every year some of the companies listed on the London Stock Exchange abandon their public status. There are a number of causes of a company being delisted: both involuntary, such as bankruptcy or forced delisting as a result of a breach of listing regulations; and voluntary, such as simply delisting itself or ―going dark‖ (without any ownership change) or being bought out by another company (public or private), private equity firm, firm’s own or external management. This thesis focuses on factors which are related to a company becoming private again as a result of one of the following three transaction types: (1) institutional buyout (IBO), i.e. a takeover by a private equity firm; (2) management buyout (MBO), i.e. a takeover by company’s own management; (3) management buy-in (MBI), i.e. takeover by outside management team. It should be noted, however, that in practice the lines between those three transaction types are blurred: management (both external and internal) almost always seeks financial support from a private equity firm; also, external and internal management often combine forces and it is impossible to definitely assign a transaction to second or third category as a result. For those reasons we do not analyze any of the above-mentioned transaction types separately and use a general term ―public-to-private transaction‖, which is an established term for IBO, MBO and MBI in financial literature1. Some authors use a more broad definition of public-to-private transactions, including deals whereby a large private company (which is not a private equity fund) is acting as a strategic investor and buying (usually smaller) public companies. We do not include such deals in our analysis as we argue that the set of determinants behind such deals (gaining market power, cost and revenue synergies, etc.) is different from those determining a public-to-private transaction with a private equity fund or management acting as buyers.
Public-to-private transactions first gained prominence in the US in the 1980s, when the emergence of private equity industry and a junk bond market paved the way for the first wave of leveraged buyouts. In the UK buyout activity was also on the rise during the 1980s, although the number of deals in any given year generally stayed in single digits (Renneboog et al., 2007). The UK market for going-private deals almost completely dried up during most part of the 1990s. However, since 1998 the number of deals has been rising steadily, averaging around 30 deals a year in 1998-2003 (Weir et al. 2005). An ex-post study of the performance of firms taken private during this years showed that newly private firms were able to improve their financial health substantially (Weir et al. 2015). The buyout activity has been relatively subdued since then2 ; however, the study of deals made in the last ten years (2004-2014) as well as their determinants would be a matter of both theoretical and practical interest. Such a study is especially topical now since funds available for private equity firms are at their record levels (estimated to be 4.1 million pounds as of August, 2014)3 and a higher buyout activity is to be expected in coming years. Moreover, the premiums paid in such transactions in the UK have historically been high.
The reasons for public firms being bought out after being listed on a stock exchange for some time are by no means a new topic in financial literature. The most common motivation cited is the desire to reduce agency costs by eliminating the separation between ownership and management with some measure of undistributed cash flow being used as a proxy for the magnitude of such conflicts (Jensen, 1986; Lehn and Poulsen, 1989). A more recent hypothesis named ―financial visibility‖ was introduced by Mehram and Peristiani (2009). They show that firms that attract more analysts who cover them and make earnings-per-share projections have a lower probability of deciding to go private. However, to our knowledge, this hypothesis has only been tested in the US and French markets so far. Furthermore, while Mehram and Peristinani (2009) study US firms, the example they cite as one of the motivations of their study is a case of a UK house building services company (Wainhomes Plc.), which was bought out by a private equity fund and left the London Stock Exchange in 1999, with firm complaining of ―feeling unloved and unwanted by investors‖.
The relationship between ownership structure and the probability of going private has also received little attention from researchers to date; moreover, the evidence has been contradictory. On the one hand, Mehram and Peristiani (2009) find that firms with higher managerial ownership are more likely to go private. Weir et al. (2005) establish a positive relationship between CEO holdings and the probability of being taken private for a sample of UK-listed companies. On the other hand, Song and Walkling (1993) find that lower managerial ownership is associated with a higher probability of being acquired; however, in contrast to our study and those of Mehram and Peristiani (2009) and Weir et.al. (2005) the authors mostly included deals involving strategic acquirers in their sample. Moreover, most authors use percentage of shares held by the members of the board as an indicator of ―insider‖ or ―managerial‖ ownership. However, we argue with the increased percentage of non-executive board members in the UK ―insider ownership‖ should be defined as a percentage of shares held by executive board members (not all board members), since only they can be considered ―true insiders‖.
If we take a look at some of the most notable buyouts that took place in the UK in the last decade, the evidence on the relationship between analyst following, insider ownership and the probability of being taken private is mixed. For example, in 2007 a US private equity firm Kohlberg Kravis Roberts (KKR) acquired a Swiss pharmaceutical company Alliance Boots, which was at listed on the London Stock Exchange at the time of the deal4. Alliance Boots had almost no insider ownership at that time (around one-hundredth of a percent) and had relatively few analysts following it considering its size. Conversely, in 2009 the management of Regent Inns, an owner of chains of bars and restaurants, stood ready to buy out the remaining stake in the troubled company, whilst already owning more than 50% of it. Notwithstanding the fact that Regent Inns was in shaky financial conditioned and majority management-owned, it was still followed by quite a lot of analysts (relative to its modest size). However, no definite conclusions can be made based on those isolated cases and it would be of interest to establish the relationship between analyst following, insider ownership and the probability of being bought out for UK firms by conducting an empirical study on the determinants of the probability of public-to- private deals. In our study we will also pay attention to other factors previously identified as important in the literature on this topic.
This leads us naturally to our research question and research goal. In this study we answer the following research question ―Which factors are related to the probability of a company being taken private?‖ The research goal is to establish the relationship between analyst following, insider ownership and the probability of it being bought out. In order to meet the research goal the following objectives were set:
(1) Conduct a critical review of relevant literature on the topic;
(2) Classify the determinants of public-to-private transactions;
(3) Conduct an empirical study aimed at revealing the determinants of public-to-private transactions in the UK;
(4) Analyze the results, make conclusions and suggest possible implications for investors and the stock exchange.
The recent trend in the research on this topic is the usage of survival models (mostly Cox proportional hazard model) to establish the determinants of a firm going private as a result of it being bought out. The advantage of this method is that it allows the researcher to track firms over their lives as public companies and use panel data instead of cross-sectional data. To date survival models were mostly applied to study buyouts of US firms. In this thesis we will apply this approach to the second-largest market for corporate control - the UK.
The object of the study is a sample of all firms that were listed on London Stock Exchange at any time during the period between 2003 and 2013 (whether they were subsequently acquired, delisted for some other reason or remained public). The subject is a buyout of a public firm by private equity fund, internal or external management.
In the empirical study we test the following hypotheses:
(1) Firms that attract low analyst following (―low financial visibility‖) are more likely to be bought out;
(2) Firms that have higher insider ownership (defined as percentage of shares held by the member of the board of directors, excluding non-executive directors) are more likely to be bought out.
We find significant support for financial visibility hypothesis as UK-listed firms that are followed by more analysts are less likely to be bought out. At the same time, we reject the second hypothesis since firms that have higher insider ownership appear to be less likely to be bought out. The possible explanation of this phenomenon could be that the incentives of managers and shareholders are already well-aligned in firms with high insider ownership and therefore there is less need to abandon public status. The second explanation is that management with substantial holdings is able to block buyout deals that are not beneficial to them, as suggested by Elitzur et al. (1998). We also find some support for Jensen’s free cash flow hypothesis: firms with higher free cash flows relative to sales are more likely to be bought out. Finally, firms with higher debt-to-equity ratio are also more likely to be targeted in a public-to- private deal.
Our study has theoretical as well as practical significance. Firstly, it contributes to existing research on determinants of public-to-private transactions, confirming financial visibility hypotheses as well as providing further insight into the role of insider ownership in the probability of a public firm being taken private by using ―percentage of shares held by executive board members only‖ as an indicator of insider ownership (in contrast to previous papers). The results would be useful for the stock exchange itself as any firm leaving it means less listing fees coming in as well as for investors who are incorporating the probability of a company being taken private into his model or designing an investment strategy based on buying companies with the highest probabilities of being taken private since the premiums paid on public-to-private transactions tend to be substantial5.
The thesis proceeds as follows. In Chapter 1 we provide a review of existing literature on the determinants of public-to-private transactions, classify the theories explaining the motives for public-to-private deals; take a closer look at two of deals with a LSE-listed company as a target in light of those theories and formulate hypotheses. In Chapter 2 we describe research design chosen, sampling and data selection; and, finally, present and discuss the empirical results of our study. We conclude with a summary of key results and implications of our study.
CHAPTER 1. THEORETICAL BACKGROUND
1.1. Public-to-Private Transactions: Literature Review
We begin by reviewing papers focusing on particular costs or benefits of going private versus staying public. Such papers are relevant to our study since we look at institutional and management buyouts of public companies and those transactions are one of the ways by which a company can go private. Costs and benefits of being public versus being private and their magnitude play a major role in the process of considering and negotiating a buyout.
First of all, there are direct costs that a company listed on a stock exchange incurs. They include costs of compliance with stock exchange regulations (cost of producing audited financial statements, corporate governance requirements, etc.) as well as listing fees. Such costs can be very substantial for a small publicly traded company. Pagano (1993) considers the decision to go public as a tradeoff between advantages of being a listed firm and a host of administrative expenses that are to be paid to brokers and the exchange itself both at the time of IPO and over the course of firm’s life as a listed company.
The passage of Sarbanes-Oxley Act in 2002 sparked an interest in the topic in the US. Carney (2006) argues that costs of introducing such legislation outweigh the benefits, especially with respect to smaller firms. He also argues that it might contribute to foreign firms (that have a choice between a number of stock exchanges around the world for their listing) leaving US stock exchanges and listing their shares elsewhere. Zhang (2007) finds that the passage of Sarbanes- Oxley was associated with significant negative abnormal returns on the shares of small companies. Engel et al. (2007) compare the returns on target firms’ stock after the announcement of a going-private transaction before and after the legislation came into force and find that smaller public firms are indeed affected negatively by the passage of Sarbanes-Oxley. They also discover the same effect for firms with high insider ownership. Rosenthal et al. (2011) study US firms that went private in the years surrounding the introduction of Sarbanes-Oxley act, which arguably contributed to a substantial increase in regulatory and compliance costs. The study finds that the firms that are small became a lot more likely to abandon their status as a public company after the introduction of the legislation. In the UK there has been no direct equivalent of Sarbanes-Oxley act; however, many of its provisions have been implemented, thereby increasing regulatory and compliance costs, especially for smaller firms (Piotroski and Srinivasan, 2008). The costs of being listed on the London Stock Exchange include (but are not limited to) preparation of half-yearly and annual financial reports, interim management statements and abiding by UK corporate governance code6. The annual costs of maintaining a listing on the main market of the London Stock exchange are estimated to amount to 300 000 - 400 000 UK pounds.7 In one notable example, Regent Inns, an owner of bar and restaurant chains, saved 200 000 UK pounds in administrative costs by delisting its shares from the London Stock Exchange as a consequence of being bought out by its own management, which came in handy since the firm was relatively small and in deep financial trouble.8
Some of the related costs of being public often mentioned in the literature are initial public offering underpricing cost and fees paid at the time of the initial public offering (underwriting, legal, accounting, auditing, advisory, listing fees, etc.). For instance, Ritter (1987) estimates the total cost of IPO underpricing and fees to be between 20% and 30% of the IPO value in the US (depending on offering type). Direct costs of a typical UK IPO are estimated to be between 5.5% and 11% of IPO proceeds with fees amounting to 6.5%-7% being the most common9. However, such costs are not relevant for our study, since at the time of a buyout they are already sunk (as opposed to ongoing regulatory and compliance costs).
Apart from direct monetary costs of being public there are also indirect costs related to the separation of ownership from management of the firm (agency costs). Such costs can also be considered to be a determinant of a going-private transaction aimed at reducing or eliminating them. Jensen (1986) argues that firms with large undistributed cash flows are more likely to be targeted in such a transaction since it helps to reduce agency costs by stopping management from wasting company’s resources, giving birth to ―free cash flow‖ hypothesis. Lehn and Poulsen (1989) confirm this hypothesis in their study of 263 going-private transactions that took place in the US in the 1980s; they find that the magnitude of free cash flows was the major determinant of going-private transactions. The findings receive further support from the study by Opler and Titman (1993), who study 180 US LBOs completed in the 1980s and find that firms with higher free cash flows are more likely to be targeted in a leveraged buyout deal. Kieschnick and Robert (1998) dispute the findings of Lehn and Poulsen (1989), arguing that firm size and potential for tax savings are more important determinants of going-private transactions than the magnitude of cash flows. Betzer (2006) also fails to find support for free cash flow hypothesis in a sample of leveraged buyouts across Europe.
When we look at more recent studies of the US public-to-private market the evidence is mixed. Bharath and Dittmar (2010) do not find any support for free-cash-flow hypothesis whereas Mehran and Peristani (2009) find that firms with higher free cash flow are more likely to be bought out. In the UK Weir et al. (2005) also fail to find any evidence in favor of free cash flow hypothesis. Some of the most recent papers zoom in on the performance of taken-private companies after the buyout in relation to the magnitude of agency costs. Weir et.al. (2015) study a set of 138 UK firms that were taken private in the period between 1998 and 2004; they find that public-to-private deals helped to reduce agency costs.
Several authors have also focused on the gain of shareholders at the expense of bondholders as a result of a going-private transaction Marais et al. (1989) find that nonconvertible debt securities almost always experience a downgrade following highly levered public-to-private transactions. The effect is more pronounced for firms already having high debt ratios. Asquith and Wisman (1990) also establish that debt holders (especially those holding unsecured debt without any covenants) often suffer losses as a result of public-to-private transactions; however, they also indicate that the magnitude of those losses is small when compared to gains accrued to stockholders. Those findings suggest that more highly levered firms are more likely to go private. On the other hand, there is a competing ―financial distress‖ argument, positing that firms in difficult financial condition are less likely to go private. Opler and Titman (1993) find support for this argument in their study of US market and Weir et.al. (2015) reach the same conclusions looking at the UK market. However, we must note that those conclusions are limited to highly-leveraged deals only. Studies that look at all public-to-private deals (irrespective of whether they can be classified as leveraged buyouts or not) arrive at opposite conclusions: Bharath and Dittmar (2010) find that the relationship between leverage and the probability of being bought out is positive. The authors contest that private equity firms are more likely to target troubled firms in need of a restructuring and return to profitability. In sum, there are a number of competing theories and findings concerning the effect of leverage on the probability of a firm being bought out, but the expected effect is likely to depend on whether all public-to-private deals are included in the sample or only those involving a high degree of leverage.
There also exist a number of theories explaining the motivations behind going private as a result of a buyout by looking at the benefits of a public status that a firm expects to enjoy after listing its shares on a stock exchange. If those benefits fail to materialize, company’s managers or a private equity fund may decide that it would be beneficial to arrange a buyout deal since costs of being public outweigh benefits. One of the primary benefits that a company being listed on a stock exchange expects is increased access to capital. Since one of the main uses of equity capital raised by selling shares to the public are capital expenditures, it is logical that firms that have relatively low need to make such investments could see less benefit in improved capital access as a result of being listed and be more likely to be targeted in a buyout. Several studies (Mehran and Peristani, 2009; Bharath and Dittmar, 2010) find some support for this proposition in their studies of public-to-private transactions involving US-listed firms. Brav et.al. (2009) compare UK public and private firms’ levels of capital expenditures and find that publicly traded firms spend considerably more relative to their size, confirming the proposition that firms with lower need to finance capital expenditures are more likely to be targeted and accept a buyout offer. Also, increased access to capital manifests itself in lower costs of equity for publicly-listed firms as compared to those remaining private. One obstacle to realizing the benefits from lower cost of equity is the existence of trading costs. In one study Domowitz and Steil (2001) that a 4 basis points increase in trading costs is associated with a 0.34 percentage points increase in cost of equity for an average UK firm. However, the inherent problem with such studies is that the estimation of cost of equity depends on the model used; therefore, using cost of equity as a proxy for capital access is always problematic. As for other proxies for capital market access, Diamond and Verrecchia (1991) show that higher liquidity of firm’s shares is related to lower cost of capital; Gompers and Metrik (1998) find that firms with highly liquid shares attract more institutional ownership, which in turn, reduces their cost of capital; Lambert et.al. (2007) document the inverse relationship between the extent and quality of information disclosure and firm’s cost of capital. Finally, Mehran and Peristani (2009) argue that the extent of the following of the firm by equity research analysts can also be used as a proxy for the level of capital market access, as more followed firms are more ―financially visible‖ and attract large institutional investors, benefiting from lower cost of capital as a consequence.
A number of authors also emphasized the existence of a relationship between firm’s growth prospects and the probability of it being bought out. It has been argued that firms with poor growth prospects are also more likely to experience financial distress and go private as a result (Leuz et.al., 2008). However, this study is devoted to voluntary deregistration without being bought out (an occurrence that is termed ―going dark‖) and the authors believe that delisting is a way to hide the fact that a firm lacks growth opportunities from the investing public. The ratio of market capitalization to book value of equity was used as a proxy for growth opportunities. Another study (Bharath and Dittmar, 2010) relates the same indicator to the ease of capital market access, contending that firms that are valued highly by the market (as measured by market-to-book ratio) have lower cost of capital and are less likely to abandon their public status as a result.
Finally, some authors investigate the relationship between insider ownership and the likelihood of public-to-private transactions. Mehran and Peristiani (2009) show that higher insider ownership is associated with higher probability of being bought out; they argue that high insider ownership is associated with low investor interest (and therefore less benefit of staying public). Moreover, the authors maintain that it is easier to initiate and follow through with a buyout when the majority ownership is in the hands of insiders. Conversely, Song and Walking (1993) find that lower managerial ownership is positively related to the probability of being bought out. The problem with some of these studies is that the authors use ―percentage of shares held by the members of the board of directors‖ as an indicator of insider ownership, which might not give a fair picture with increasing numbers of non-executive of board members in US and UK public companies in the last couple of decades.
We will now take a closer look at studies which are devoted to the specific topic of investigating multiple determinants of public-to-private transactions. Firstly, we will pay attention to studies of UK public-to-private market and. Secondly, we will focus on the studies which use a research technique similar to that employed in this thesis.
The earliest study focused on MBOs in the UK is Thomson and Wright (1991). However, due to the lack of MBOs involving public companies at the time, the authors concentrate mainly on the buyouts of private companies and the role of divisional heads-corporate headquarters agency problems. In the late 1990s there was a surge of interest in studying transactions with a target being a public company in the UK due to the increasing number of going-private transactions since 1998. In the study by Weir, Laing and Wright (2005) authors find that firms with higher CEO ownership, higher institutional ownership, and lower growth prospects are more likely to go private. At the same time, the authors show that the proportion of independent directors on the board, the amount of undistributed cash flow generated by the company and possible tax advantages do not influence the probability of a UK-listed company being taken private. They use matched sampling technique with two samples - one with companies that went private between 1998 and 2000 and the other with those remained public; the authors include 95 companies in each sample. Renneboog, Simons and Wright (2007) study going-private transactions in the UK in the period from 1997 to 2003, although their study’s primary concern is to investigate the sources of existing shareholder gains as a result of an announcement of public- to-private transactions, not the determinants of the likelihood of such transactions. They find that the determinants of shareholder gains are pre-transaction undervaluation of target company’s shares, increased tax shields and incentive realignment. Brav et.al (2009) study the same period (1997-2003) and find that UK firms with low market-to-book ratios and low capital expenditures are more likely to be bought out.
Studies on other non-US markets suffer from the lack of transactions eligible for inclusion in the sample; however there has been some of them in the last decade: Michelsen and Klein (2011) study 52 going-private transactions that took place in Germany in 1996-2004 and find that firms that were taken private had lower leverage, profitability, sales growth and stock liquidity. Geranio and Zanotti (2012) include 106 public-to-private transactions across Continental Europe in their sample; they find that firms that were still largely family-owned whilst already being public are more likely to be bought out and taken private again. Martinez and Serve (2011) study 70 going-private transactions in France and show that higher probability of being bought out for French firms is associated with low leverage and low stock liquidity.
We will now turn to studies on going-private transactions which use research technique similar to that we will use. There have been a couple of studies employing survival models (in particular Cox model) to investigate the reasons for companies choosing to return to private status. Bharath and Dittmar (2010) study the determinants of firms going private as a result of being bought out using a sample of all US going-private transactions from 1980 to 2004. They conclude that firms with lower market-to-book ratio, lower stock turnover and lower analyst coverage are more likely to be bought out.
Mehran and Peristiani (2010) also study US-listed firms, but their sample is limited to firms that had an IPO from 1988 and went private in the years 1990-2006. The chief focus of their study is financial visibility hypothesis, i.e. that firms with lower analyst coverage, lower institutional ownership and lower stock turnover are more likely to decide to revert back to private ownership as a result of being bought out. They also find that firms with higher free cash flows and higher leverage are more likely to be targeted in a public-to-private deal.
1 In the text of this thesis we also use ―going-private transaction‖, ―buyout‖ and ―takeover‖ as synonyms of ―publicto-private transaction‖ to avoid constant repetitions of the same term.
2 Table 1 in Appendix 1 contains a year-by-year breakdown of public-to-private deal in the UK from 1980 to 2014
3 Global firms sitting on $7 trillion war chest - http://www.telegraph.co.uk/finance/11038180/Global-firms-sitting- on-7-trillion-war-chest.html (Accessed 05/06/2015)
4 Financial Times. Alliance Boots buyout success story. http://www.ft.com/intl/cms/s/0/668b3192-bdf4-11e1-83ad 00144feabdc0.html#axzz3ZfpEP4iv (Accessed 10/05/2015)
5 Renneboog et al. (2007) estimate an average premium paid over the market price in going-private transactions in the UK at 40%. Some of the estimates for the US market include 50% for all types of going-private transactions (De Angelo et.al., 1984) and 40% for MBOs (Kaplan, 1989). In our sample the premium is 42%.
6 London Stock Exchange. A Guide to Listing www.londonstockexchange.com/home/guide-to-listing.pdf (accessed 01/06/2015).
7 Withers Worldwide. Listing on the Main Market of the London Stock Exchange - An Overview http://www.withersworldwide.com/news-publications/listing-on-the-main-market-of-the-london-stock-exchange-an- overview--2.pdf (accessed 01/06/2015)
8 Morning Advertiser. Regent Inns Sold in Management Buyout http://www.morningadvertiser.co.uk/Operators/Other-operators/Regent-Inns-sold-in-management-buyout (accessed 28/05/2015)
9 London Stock Exchange. The Cost of Capital: An International Comparison http://www.londonstockexchange.com/companies-and-advisors/main-market/documents/brochures/cost-of-capital- aninternational-comparison.pdf (accessed 30/05/15)