essays in private equity

Essays in Private Equity


DISSERTATION


Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy
in the Graduate School of The Ohio State University

By
Ji-Woong Chung
Graduate Program in Business Administration

The Ohio State University
2010


Dissertation Committee:
Professor Isil Erel
Professor Berk A. Sensoy
Professor Michael S. Weisbach, Advisor

Copyright by
Ji-Woong Chung
2010



ii





Abstract

This first essay, “Leveraged Buyouts of Private Companies,” studies the motivations and
the consequences of leveraged buyouts of privately held companies. Over the last two
decades, the number (enterprise value) of leveraged buyout transactions involving
privately held targets totals 10,013 ($855 billion), accounting for 46% (21%) of the
worldwide leveraged buyout market. Yet the vast majority of academic studies focus on
the buyouts of publicly held targets. This chapter investigates the effects of leveraged

buyouts on privately held targets. I find that, unlike the corporate restructuring process of
public firms after the buyouts, private targets sponsored by private equity firms grow
substantially after the buyouts. The overall evidence suggests that private equity firms,
through leveraged buyouts, facilitate private targets’ growth by alleviating targets’
investment constraints.

In the second essay, “Incentives of Private Equity General Partners from Future
Fundraising” which is co-authored with Berk Sensoy, Lea Stern, and Mike Weisbach, we
model and estimate the total incentives facing private equity general partners. Incentives
from the explicit fee structure (“two and twenty”) of private equity funds understate the
actual incentives facing private equity general partners because they ignore the rewards
stemming from the effect of current performance on the ability to raise larger funds in the
future. We evaluate the importance of these implicit incentives in the context of a
iii

learning model in which investors use current performance to update their assessments of
a general partner’s ability, and, in turn, decide how much capital to allocate to the
partners’ next fund. Our estimates suggest that implicit incentives from expected future
fundraising are about as large as explicit incentives from carried interest in the current
fund. This implies that the performance-sensitive component of revenue is about twice as
large as suggested by previous estimates based only on explicit fees. Consistent with the
model, we find that these implicit incentives are stronger when abilities are more scalable
and weaker when current performance is less informative about ability. Overall, the
results suggest that implicit incentives from future fundraising have a substantial impact
on general partners’ welfare and are likely to be an important factor in the success of
private equity firms.

In the last chapter, I study performance persistence in the private equity industry.
Contrary to what has been known in the literature, I find that performance persistence in
private equity is short-living. Current fund performance is positively and significantly

associated with the first follow-on fund performance, but not with the second or third
follow-on funds. Even the statistically significant association between two consecutive
funds’ performance is not economically large. The returns of the best performing quartile
portfolio drops by about half, and those of the worst performing portfolio improve
substantially from one fund to the next fund. There is no difference in the performance of
the second (and after) follow-on funds of current top and bottom performing quartile
portfolios. Performance converges in the long run. The commonality of relevant market
iv

conditions between two consecutive funds largely explains performance persistence.
Also, excessive fund growth conditional on past performance erodes performance and
reduces persistence.
v











Dedication

To my parents, Dong-Jo Chung and Wol-Sun Kim

vi

Acknowledgments

I am grateful to my advisor, Mike Weisbach, and the members of my committee, Isil Erel
and Berk Sensoy, for their constant encouragement, support and guidance. I also thank
my colleague Ph.D. students for their companionship and having spent countless hours
discussing with me on various matters, and the faculty in the Department of Finance for
their guidance. Lastly, I thank the Fisher College of Business for providing generous
financial support.

vii




Vita

2003 B.A. Economics and Applied Statictics,
Yonsei University, South Korea
2003-2005 Graduate Associate, Department of Business
Administration, Yonsei University, South Korea
2005 to present Graduate Associate, Department of Finance,
The Ohio State University

Fields of Study

Major Field: Business Administration

viii




Table of Contents

Abstract ii
Dedication v
Acknowledgments vi
Vita vii
Fields of Study vii
Table of Contents viii
List of Tables xii
List of Figures xiv
Chapter 1: Leveraged Buyouts of Private Companies 1
1.1. Introduction 1
1.2. Hypothesis development 7
1.3. Data and summary statistics 9
1.3.1. Data sources and some institutional background 9
1.3.2. Sample selection 13
1.3.3. Construction of control sample 14
ix

1.3.4. Ownership structure of private targets 16
1.4. Post-buyout growth of target firms 18
1.5. Analysis of Deal rationales 21

1.6. Pre-buyout investment constraints and post-buyout growth 23
1.7. Operating performance after buyouts 25
1.8. Conclusion 27
Chapter 2: Incentives of Private Equity General Partners from Future Fundraising 29
2.1. Introduction 29
2.2. Model 36
2.2.1. Setup 37
2.2.2. Cross-sectional implications 38
2.2.3. Lifetime compensation of GPs 42
2.3. Data 47
2.4. The Empirical Relation between today’s Returns and Future Fundraising 52
2.4.1 Calculating indirect incentives for different types of funds 52
2.4.2. Indirect incentives of older and younger partnerships 55
2.4.3. Indirect incentives and fund size 56
2.5. General Partner Incentives Implied by the Regression Estimates 56
2.5.1. Basic results 56
x

2.5.2. Indirect incentives over the partnership’s life 60
2.5. Discussion and Conclusion 62
Chapter 3: Performance Persistence in Private Equity Funds 65
3.1. Introduction 65
3.2. Data 70
3.3. Testing Performance Persistence 72
3.3.1. Transitional Probabilities 74
3.3.2. Correlation between current fund performance and follow-on fund
performance 76
3.3.3. Multivariate regression 77
3.3.4. Subsequent performance of initial performance quartile 80
3.3.5. Robustness of the results 83

3.4. Why (Not) Performance Persists? 84
3.4.1. Fund flows and fund performance 84
3.4.2. The effect of fund flows on performance persistence 87
3.4.3. The effect of time gap on performance persistence 89
3.4.4. Common market conditions 91
3.5. Conclusion 95
References 97
xi

Appendix A: Tables for Chapter 1 110
Appendix B: Tables for Chapter 2 124
Appendix C: Tables for Chapter 3 141



xii



List of Tables

Table A.1. Distribution of leveraged buyout transactions in the U.K 111
Table A.2. Distribution of final sample of leveraged buyouts 113
Table A.4. Logistic regression to predict the likelihood of being
a leveraged buyout target 115
Table A.5. Ownership characteristics of privately held targets 116
Table A.6. Changes in firm growth after leveraged buyouts of public targets 117
Table A.7. Changes in firm growth after leveraged buyouts of private targets with private
equity 118
Table A.8. Acquisitions and disposals of businesses and operations after leveraged

buyouts 119
Table A.9. Pre-buyout investment constraints and post-buyout growth 120
Table A.10. Operating performance after a buyout: Private equity sponsored targets 121
Table B.1. Descriptive Statistics 125
Table B.2. Committed Capital by Type of Fund and Fund Sequence 126
Table B.3. Fund Growth 128
Table B.4. Fund Performance and Time between Successive Funds 129
Table B.5. Future Fundraising and Current Performance 130
Table B.6. Future Fundraising, Current Performance, and Fund Sequence 132
Table B.7. Future Fundraising, Current Performance, and Fund Size 133
xiii

Table B.8. Future Revenue and Current Performance 134
Table B.9. Future Revenue, Current Performance and Fund Sequence 137
Table C.1. Private equity fund performance and fund raising by vintage year 142
Table C.2. Transition probabilities from current funds’ performance quartiles to follow-
on funds’ performance quartiles 144
Table C.3. Pearson and Spearman correlations between current fund performance and
follow-on fund performance 145
Table C.4. Cross sectional regression of current performance on past performance 146
Table C.5. Subsequent fund performance (unadjusted IRRs) by quartile portfolios based
on current fund performance 147
Table C.6. Current fund performance and follow-on fund growth 150
Table C.7. Fund growth and follow-on fund performance 151
Table C.8. The effects of fund growth and time gap on performance persistence 152
Table C.9. The effects of similar market conditions on performance persistence 153

xiv



List of Figures

Figure A.1. Typical corporate structure after a buyout. 122
Figure B.1. Importance of incentives from future fundraising over the partnership's life
140
Figure C.1. Private equity fund performance and fund raising by vintage year. 161
Figure C.2. Performance of quartile portfolios ranked on current fund performance. 162
Figure C.3. Cash flows of a private equity fund over its life. 163

1



Chapter 1: Leveraged Buyouts of Private Companies

1.1. Introduction
This paper examines the effects of leveraged buyouts on the investment and performance
of privately held targets. The leveraged buyout market for privately held firms is large.
Over the last two decades there have been more than 10,000 acquisitions of private firms
through leveraged buyouts, for an aggregate deal value exceeding $850 billion
(Strömberg, 2007).
1

Despite the importance of these transactions in terms of the
frequency and the size, academic studies have devoted little attention to private-to-private
transactions.
2
Importantly, the economic forces driving these private-to-private leveraged buyouts are
likely to be distinctively different from those driving public-to-private buyouts. In the
existing academic literature, agency theory of free cash flows (Jensen, 1986, 1989, 1993)
has been the important theoretical grounds to understand the motivations and the effects
of leveraged buyouts of public firms. Previous studies document that firms with abundant
free cash flows and low investment opportunities are more likely to engage in leveraged
buyouts (Lehn and Poulsen, 1989, Opler and Titman, 1991, Long and Ravenscraft, 1993,
Dittmar and Bharath, 2009), and that target firms reduce capital expenditures and actively


1
By comparison, during the same period, the number of buyouts of publicly traded firms is 1,398 with a
total enterprise value of approximately $1.1 trillion.
2
This undue emphasis on public-to-private buyouts may be ascribed to several high profile deals involving
public companies such as RJR Nabisco ($31.1b in 1988), Beatrice ($6.1b in 1985), and, more recently,
HCA ($32.7b in 2006), and TXU ($43.8b in 2007) and to the lack of publicly available financial data for
privately held targets and “gone” private companies through leveraged buyouts in the U.S.
2

sell assets or divisions after buyouts (Kaplan, 1988, Smith, 1989, Wiersema et al. 1995,
Dennis, 1994, Magowan, 1989, Chevalier, 1995, Aslan and Kumar, 2009).
3
One potential explanation for the motivations of the leveraged buyouts of private firms is
that private equity firms may be able to improve a target’s value by mitigating
inefficiencies coming from various investment constraints facing small private firms. In

fact, unlike the image reflected in the media as “asset-strippers,” private equity firms
often claim that they take this growth strategy to help the target firms grow and increase
firm value. This paper finds evidence supporting this view. I find that privately held
targets substantially grow after the buyouts led by private equity firms: assets, sales,
capital expenditures, and the number of employees all increase. This finding stands in
stark contrast to what the academic literature has documented regarding corporate
restructuring process after leveraged buyouts.
These
findings are typically interpreted as being consistent with the view that buyouts reduce
free cash flow problems by reversing previously made inefficient investments or
acquisitions. However, the agency view cannot explain the leveraged buyouts of private
firms (Wright et al. 2000) because it is less likely that private firms suffer from agency
problems due to their concentrated ownership structure.
I investigate a sample of 1,009 buyouts in the U.K. between 1997 and 2006, 887 of which
involve privately held targets. The U.K. market provides two advantages: first, the
stringent disclosure and financial reporting environment in the U.K. allow observation of

3
Also managerial compensation is restructured to align the interests of managers with owners, and high
leverage and close monitoring by investors reduce inefficient resource wastes (Baker 1992, Baker and
Wruck, 1989). As a result, after leveraged buyouts, operating performance and plant productivity improve
(Kaplan, 1988, Smith, 1989, Litchenberg and Siegel, 1989, Muscarella and Vetsuypens, 1990, among
others).
3

the characteristics of privately held targets and what these companies actually “do” in the
post-buyout period under private ownership.
4
In the sample of privately held targets, I first document that the average (median)
ownership of the largest owner prior to buyout is 87% (100%) and the vast majority

(95%) of these owners are also managers of the companies. Therefore, it is unlikely that
private targets suffer from the same kinds of agency problems as public companies.
Second, the U.K. leveraged buyout market
is, after the U.S., the second largest in the world, making it possible to examine a large
sample of buyouts.
I also find that, after buyouts led by private equity firms, privately held targets, unlike
publicly traded targets, increase assets, sales, employment, and capital expenditures. For
example, from one year prior to the third year after the buyout, the industry adjusted total
assets increase by 94% for private targets of private equity firms and the value decreases
by 25% for public targets. Similarly, the median value of industry-adjusted capital
expenditures to sales ratio increases by 18% for private targets.

In contrast, the industry-
adjusted capital expenditures to sales ratio decreases by 5% for public targets over the
same period. Private targets also make substantial acquisitions under private equity
ownership: The cash outflows (inflows) associated with acquisitions (disposals) to
tangible fixed assets ratio is 0.644 (0.000) in private targets and 0.039 (0.026) in public
targets.
However, these findings can be driven by selection bias. In other words, private equity
firms may be acquiring private firms which could have grown even without private

4
U.K. company laws require all limited liability companies (both private and public) to file periodic reports
with the Companies House. See the U.K. Companies House for the Companies Act.
4

equity led leveraged buyouts. Indeed, I find that targets of private equity sponsored
buyouts are more profitable and experience faster growth prior to buyout than industry
peer private firms, which suggests that private equity firms do select particular types of
private firms.

To examine whether a target’s growth is more of a selection effect or a treatment effect
by private equity firms, I compare the investment and growth of the target firms of
private equity with the carefully selected three sets of control sample firms. First set of
control firms is private firms which underwent leveraged buyouts without private equity
firms’ involvement. This is a natural set of benchmark because these private firms were
actually put up for sale, experienced similar ownership changes, and could have been
targets of private equity. Second, I construct non-LBO target private firms which have
similar characteristics as private equity led LBO target firms using propensity score
matching. Lastly, I compare targets’ growth with industry median growth, following
previous studies (Kaplan, 1989, Smith, 1990). Comparing with industry median will give
a general idea about how the target firms are different from other industry peer firms. I
find that the targets’ growth is substantially larger than the growth of other benchmark
private firms. Overall, the evidence suggests that even though private equity firms select
targets with growth potential, they do help target firms grow and expand post-buyout.
To further understand whether private equity firms through leveraged buyouts mitigate
investment constraints facing small private targets, I examine the relationship between
pre-buyout investment constraints and post-buyout growth. First, I test whether more
financially constrained targets in terms of size, age, and leverage experience larger post-
5

buyout growth. Second, I investigate whether owner-managers’ risk aversion measured
by ownership concentration and age is associated with post-buyout growth. Lastly, I
examine whether lack of operational expertise is related to larger post-buyout growth. I
assume that if a private firm is managed by owner-managers, the firm does not have
access to outside professional management skills. Though I find that more constrained
firms tend to experience larger post-buyout growth, the statistically significance of the
relationship is not strong, making it harder to draw a strong implication from this
analysis.
Finally, I examine the operating performance of private targets post-buyout to see how
private equity firms’ growth strategy is associated with post-buyout performance. I find

that private targets with private equity sponsors experience an increase in operating
performance: industry-adjusted EBITDA increases by 12% during the first three years
post-buyout. Not surprisingly, the industry-adjusted ratio of operating income to sales
drops by 35%. The reason is because the rate of sales growth exceeds that of EBITDA
after buyouts. This pattern implies that buyouts with private equity sponsors result in
growth but not improved margins. This deterioration of operating efficiency could be the
result of worse investments on the part of private equity firms. However, it could also be
that private equity firms are increasing, i.e., optimizing, investments by taking positive
NPV but less profitable projects which were not previously exploited prior to buyouts
due to investment constraints. Therefore, we observe the decrease in the average
profitability of private targets over time after the buyouts. Though the evidence in this
paper cannot distinguish between these two hypotheses, it is unlikely that private equity
6

firms are making unprofitable and inefficient investments in light of previous studies. For
example, Sheen (2008) finds that private firms which underwent private equity led
leveraged buyouts are more likely than public firms to make an efficient investment in
response to the expected demand shock in chemical industry. Also, Bargeron et al. (2008)
finds that private equity firms tend to pay less acquisition premium than public firms
when acquiring a similar target firm, which suggests that private equity firms tend to
make investments in a most cost saving way.
To my knowledge, this is the first academic study to examine the effects of leveraged
buyouts of private firms, transactions which account for a large fraction of the leveraged
buyout market. Importantly, I show the importance of private equity sponsors and
leveraged buyouts in alleviating the investment constraints facing private firms. With the
existing findings on the buyouts of public firms, the overall evidence suggests that private
equity firms attempt to reorganize target firms in a way which reduces inherent the
targets’ inefficiencies—agency problems in public targets and investment constraints in
private ones.
A closely related study to this paper is Boucly et al. (2009). From the examination of

French leveraged buyouts transactions, they document substantial growth in assets, sales,
and employment. They interpret that private equity and leveraged buyouts can provide
“niche” financing for credit-constrained firms in countries with under-developed capital
market. Though similar in spirit, the evidence in this paper suggests that, even in the U.K.
with relatively well developed financial market, private equity firms take growth strategy
to improve firm value by alleviating investment constraints of small private targets.
7

The paper proceeds as follows: Section 1 develops hypothesis. Section 2 describes data
sources and sample selection. It also presents summary statistics on the deal
characteristics of private and public target firms. Section 3 investigates post-buyout
restructuring processes. Section 4 analyzes deal rationales. Section 5 examines whether
pre-buyout investment constraints are associated with the post-buyout growth of private
targets. Section 6 studies the operating performance of target firms after buyouts, and
Section 7 concludes.

1.2. Hypothesis development
In private companies, entrepreneurs or owners usually serve as the managers of their
company, or the ownership structure is highly concentrated in the hands of a few, such as
founders, angel investors, and venture capitalists. These owners perform close monitoring
on the management and managerial incentive mechanisms are tightly structured to protect
owner wealth from manager expropriation (e.g. Sahlman, 1990, Kaplan and Strömberg,
2003). Therefore, the agency problems associated with incentive misalignment between
owners and managers are unlikely to be found in private companies. Consequently, the
elimination of agency costs of free cash flows (Jensen, 1986, 1993) is less likely to be an
important reason for leveraged buyouts for a private company as it is for a public firm.
Private firms, however, tend to have limited or costly access to public resources imposed
by concentrated ownership structure and information asymmetry. All else equal, when
facing an investment opportunity, managers of private companies are less able or willing
to implement the investment. Owners with substantially undiversified wealth tied up in

8

the firm may not want the extra risks associated with the new investment. Further, the
existing managers may not possess the intimate knowledge and expertise necessary to
execute the new investment, and the firm may not have the financial resources to take
advantage of new investment opportunities. Often owners of private firms tend to have
different goals, such as preserving wealth, keeping the business stable, maintaining stable
income flows, and providing employment opportunities for their descendants.
Private equity firms, through leveraged buyouts, can alleviate these investment
constraints by providing the owners with a whole or partial exit (thereby lowering the
ownership of and reducing the risk exposure to the owners). Private equity firms
sponsoring these transactions reduce information uncertainty of target firms through due
diligence and their reputation in the capital markets. Private equity firms also import
advanced management skills (e.g. operational knowledge and expertise on the corporate
control market) and industry and regional networks into the target companies.

In addition,
private equity firms, being professional investment firms which manage several portfolio
companies, are more risk-tolerant than the individual owners and better positioned to take
risky investments.
In contrast, a public company taken private through a leveraged buyout is less likely to be
resource constrained. One of the main reasons that a firm goes public is to tap the public
capital market and to exploit current and future investment opportunities (e.g. Kim and
Weisbach, 2007). Hence, a public company may pursue a leveraged buyout and go
private because it no longer needs public resources. Public status also provides an
opportunity to engage in mergers and acquisitions (which is a major investment for a
9

company), either by creating shares that serve as a currency for acquisitions (Brau,
Francis, and Kohers, 2005, Brau and Fawcett, 2006) or by establishing a market value for

the firm (Zingales, 1995, Mello and Parsons, 2000, Brau and Fawcett, 2006). These
theories suggest that a firm without large growth investment opportunities, without a
need for large amount of capital, and with no demand for corporate control activities will
be more likely to go private.
In sum, consistent with the traditional argument in support of leveraged buyouts, publicly
held targets will try to increase firm value by eliminating inefficiencies arising from
agency problems after a leveraged buyout. In contrast, financial buyers of private targets
will try to alleviate investment constraints and capitalize on growth opportunities through
a leveraged buyout.

1.3. Data and summary statistics
1.3.1. Data sources and some institutional background
Leveraged buyout transactions are collected from Zephyr;
5

5
Zephyr, which is published by Bureau van Dijk, provides information on mergers and acquisitions, IPOs,
and private equity deals worldwide since 1997. As of January 2009, it contains information on 703,327
deals. Zephyr does not cover deals “involving equity stakes of less than 2 percent, unless the consideration
for the stake is greater than GBP 15 million (i.e. where the market capitalization of the target is over GBP
300 million). When the bidder is an investment trust or pension fund, then the threshold is raised to 5
percent. If the purchase is considered to be significant, then it is entered regardless of the deal value.”
deal information (deal date,
deal type – public-to-private or private-to-private, etc.) is cross-checked using SDC
Platinum and Capital IQ. I select completed management buyout, management buy-in,
and institutional buyout deals with an acquired stake of at least 50% and target companies
that are located in the U.K. The total number of such deals is 4,652. As a comparison,
10

during the same period, the number of completed leveraged buyout deals where the

targets are located in the U.K. and the stake owned after buyout is at least 50% is 4,386 in
the SDC database; Capital IQ contains 3,322 such deals from 1997 to June 2007.
Therefore, Zephyr’s deal coverage appears to be most comprehensive than other
databases typically employed in academic research.
Table 1 provides summary statistics on leveraged buyout transactions. Panel A presents
the distribution of the number of buyouts by transaction year and target status. The
buyouts of independent private firms (“Private”) account for about 40% of the U.K.
leveraged buyout market, after divisional buyouts (“Divisional,” 41%). The buyout of
public firms represents only a small fraction, 4.9%. However, the median deal value of
private targets is £10 million whereas that of public targets is £74.6 million. Therefore,
while public firm buyouts are small in number, they account for 29% of the market in
value. Private firm buyouts make up 11.2%, less than half the size of public firm buyouts.
However, note that only 37.8% of private buyouts report deal values, whereas all public
buyouts do so. If we assume that the size of unreported deals of private buyouts is the
same as for reported deals, the total deal value of private firm buyouts is about £69
billion, approximately the same as the total deal value of public firm buyouts.
Although I do not attempt to explain the difference in deal pricing across target status in
this study, I briefly present the information on deal value multiple.
6

6
Officer (2006) and Bergeron et al. (2009) analyze this issue.
Deal value multiple
on EBITDA is highest among secondary buyout deals, 10.61, and lowest among