Manager Divestment in Leveraged Buyouts

Date01 June 2014
Published date01 June 2014
DOIhttp://doi.org/10.1111/j.1468-036X.2013.12018.x
Manager Divestment in Leveraged
Buyouts
James Ang and Irena Hutton
Department of Finance, College of Business, Florida State University, Tallahassee, FL 32306, USA
E-mail: jang@cob.fsu.edu; ihutton@cob.fsu.edu
Mary Anne Majadillas
Anderson School of Management, University of New Mexico, Albuquerque, NM 87131, USA
E-mail: maj@unm.edu
Abstract
We examine changes in managersinvestment in the rm around leveraged buyouts
and nd agency costs counter to those described in extant literature. In majority of
deals during 19972008, managers divested a portion of their preLBO
shareholdings while maintaining an ownership stake in the postLBO rm. Such
divestment opportunities encourage managers to behave in a way that benets
existing shareholders but is costly to new investors. We report a positive relation
between managements divestment and preLBO earnings management, market
timing, and better buyout pricing. Although managerial divestment also leads to
subpar postbuyout performance, the involvement of private equity mitigates it.
Keywords: leveraged buyouts, private equity, agency costs, earnings management,
buyout pricing, buyout premium, buyout performance
JEL classification: G340
1. Introduction
Leveraged buyouts (LBOs) have received a lot of attention in academic literature as a
unique organisational form that is effective in reducing agency costs of managerial
discretion. In fact, at the peak of buyout activity in the 1980s, the argument for this new
organisational form was so convincing that Jensen (1989) famously wrote about the
eclipse of the public corporation.The reduction in agency costs stems from three
changes to corporate governance. First, managers are encouraged to invest personal funds
in the postbuyout rm to improve their performance incentives. Second, the rm takes on
We thank John Doukas (the editor), an anonymous referee and participants of the Florida
State University seminar series, 2010 European Financial Management Symposium on
Private Equity, 2010 Financial Management Association Meeting and 2009 California
Corporate Finance Conference for helpful discussions and valuable comments. We are
responsible for all remaining errors and omissions.
European Financial Management, Vol. 20, No. 3, 2014, 462493
doi: 10.1111/j.1468-036X.2013.12018.x
© 2013 John Wiley & Sons Ltd
a demanding debt schedule under the new leverageheavy capital structure, which
facilitates nancial discipline. Third, equity ownership concentrated in the hands of
private equity investors gives them a dominant role on the board of directors, further
promoting active monitoring. This effort is supported by yet another group of active
stakeholders the creditors. In other words, these changes in rm governance
simultaneously strengthen the alignment of managersand new investorsobjectives.
However, the success of this new governance structure, in part, is based on the implicit
assumption that managers commit substantial personal wealth to increase their ownership
in the postbuyout rm. This gives assurance to the outside investors and creditors that
managersobjectives are aligned with theirs and ensures capable management during the
rst two to three years following an LBO, which are considered to be the high risk part of
the deal. However, in rms where managers already hold a signicant equity stake, the
buyout may serve as a divestment opportunity and allow insiders to sell their preLBO
equity at a sizeable premium and then reinvest a fraction of that amount in the postLBO
rm.
1
The recent wave of buyout activity has afforded managers many lucrative
opportunities. For example, one of the largest divestments took place during the 2007
buyout of Aramark, when Joseph Neubauer, the rms CEO, received nearly $940 million
for his 23 percent stake in the rm, and, after reinvesting $250 million, netted out $690
million. In other words, the buyout allowed him to reduce his dollar investment in the rm
by 73%, which runs counter to the traditional view of a leveraged buyout.
The rise in divestmentmotivated buyouts over the last three decades warrants a re
examination of the relation between changes in managerspersonal wealth, effectiveness
of leveraged buyouts in resolving traditional agency problems, and emergence of new
agency problems. According to Kaplan and Stein (1993), during the early phase of the
1980s buyout wave, managers reinvested more than half of their cashedout equity back
into the rm, which worked well to align the interests of managers and postbuyout
shareholders. As the buyout wave of the 1980s progressed, the amount of reinvested
equity decreased and so did the incentive for sound deals.
We also argue that manager divestment in leveraged buyouts alters the nature of the
agency problem. Since buyouts allow managers to benet from selling their prebuyout
equity stake, potential appreciation in their remaining postbuyout equity stake, or both,
the source of the wealth gain will inuence their actions around the buyout. In the
traditionalbuyout that has been extensively documented in the literature, managers
invest substantial personal equity in the postbuyout rm expecting to gain from post
buyout rm performance. To maximise the value of their investment, managers have an
incentive to take actions depressing prebuyout rm value and reducing buyout
premium.
2
However, in a buyout where managers divest much of their shareholdings at
the buyout offer price, they may attempt to maximise that payoff by increasing rm value.
This can be achieved by manipulating prebuyout nancials, timing the market as has
been previously shown or by choosing a more competitive method of sale. Thus, the
incentives of managers have a profound effect on the rms shareholders: while the
agency problem in investment buyouts is detrimental to the rms existing shareholders,
the agency problem of high divestment buyouts is harmful to the new investors.
1
This practice of divesting while raising an ownership stake has been criticised in the nancial
press (Davidoff, 2011).
2
See, for example, Fischer and Louis (2008) and Perry and Williams (1994).
© 2013 John Wiley & Sons Ltd
Manager Divestment in Leveraged Buyouts 463
Furthermore, increases in managerspersonal wealth due to divestment can negatively
affect postbuyout rm performance despite the positive effect of the remaining postLBO
ownership stake on managerseffort levels. When managers divest while continuing to
run the rm, much of their postbuyout personal wealth becomes largely independent of
rm performance. Therefore, they may shift the allocation of their time and effort from
active involvement in the rm to the consumption and management of their private
wealth. Bitler et al. (2005) nd that while there is a positive relation between an
entrepreneurs ownership and effort, personal wealth has a negative effect on effort levels.
Elitzur et al. (1998) develop a theoretical model to show how a reduction in managers
wealth in the postLBO rm affects the structure of a buyout and managers efforts in the
postbuyout rm. Their model suggests a negative relation between managersdivestment
and postLBO performance.
Lastly, managers who have divested a portion of their wealth have a greater incentive
to take on nancial and operating risks. Having achieved nancial security, they can
afford to use their remaining equity in the rm as a cheap call option and improve its
upside potential by making risky investments (Jensen and Meckling, 1976). Moreover,
the new postbuyout compensation structure that is also equityheavy may augment the
value of the option to further encourage investment in risky projects (Smith and
Stulz, 1985).
We nd that, contrary to the traditionalbuyout model, in 81% of LBO deals, the
management team cashes out a portion of their wealth at the time of the LBO. More
surprisingly, in 46% of LBOs, managers divested more than 50% of their preLBO
holdings. In dollar terms, the total value of such divestments is $6.1 billion averaging $34
million per rm.
3
Our analyses demonstrate signicant agency costs inherent to such
divestments. First, we observe a positive relation between prebuyout accruals, real
earnings manipulation, and the size of managerial divestment. We also nd evidence of
market timing by managers in that high divestment buyouts are preceded by stock run
ups. Second, we nd that the buyout process and pricing are also affected by the divesting
managersincentives. Divesting managers are more likely to sell the rm through an
auction process or conduct a market check, if the initial offer is unsolicited, to obtain more
favourable buyout pricing. Third, following the buyout, rms with managerial divestment
perform slightly worse than rms with no divestment. However, the difference in
performance is attenuated with the participation of private equity investors consistent with
their monitoring and disciplining roles.
The ability of managers to signicantly increase the amount and liquidity of their
wealth through an LBO and the effect of such divestment on the nancial performance of
the rm are relatively unexplored. While the following three studies empirically
document divestment and its effect on some buyout characteristics, they do not
comprehensively examine performance around the buyout, its pricing and method of sale
in the context of manager divestment. Crawford (1987) analyses 30 deals completed over
19811985 and nds that managers both realise large cashouts and continue to maintain
control after retaining an inexpensive equity stake in an overlevered buyout rm. Kaplan
and Stein (1993) nd that managerial divestment increased during the LBO wave of the
1980s and that it positively affected the likelihood of a rms subsequent nancial
distress. Frankfurter and Gunay (1992) suggest that most buyouts are motivated by
3
These gures do not include severance payments for departing executives.
© 2013 John Wiley & Sons Ltd
464 James Ang, Irena Hutton and Mary Anne Majadillas

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