Manager Divestment in Leveraged Buyouts
Date | 01 June 2014 |
Published date | 01 June 2014 |
Author | Irena Hutton,Mary Anne Majadillas,James Ang |
DOI | http://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 managers’investment in the firm around leveraged buyouts
and find agency costs counter to those described in extant literature. In majority of
deals during 1997–2008, managers divested a portion of their pre‐LBO
shareholdings while maintaining an ownership stake in the post‐LBO firm. Such
divestment opportunities encourage managers to behave in a way that benefits
existing shareholders but is costly to new investors. We report a positive relation
between management’s divestment and pre‐LBO earnings management, market
timing, and better buyout pricing. Although managerial divestment also leads to
subpar post‐buyout 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 post‐buyout firm to improve their performance incentives. Second, the firm 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, 462–493
doi: 10.1111/j.1468-036X.2013.12018.x
© 2013 John Wiley & Sons Ltd
a demanding debt schedule under the new leverage‐heavy capital structure, which
facilitates financial 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 firm governance
simultaneously strengthen the alignment of managers’and new investors’objectives.
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 post‐buyout firm. This gives assurance to the outside investors and creditors that
managers’objectives are aligned with theirs and ensures capable management during the
first two to three years following an LBO, which are considered to be the high risk part of
the deal. However, in firms where managers already hold a significant equity stake, the
buyout may serve as a divestment opportunity and allow insiders to sell their pre‐LBO
equity at a sizeable premium and then reinvest a fraction of that amount in the post‐LBO
firm.
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 firm’s CEO, received nearly $940 million
for his 23 percent stake in the firm, and, after reinvesting $250 million, netted out $690
million. In other words, the buyout allowed him to reduce his dollar investment in the firm
by 73%, which runs counter to the traditional view of a leveraged buyout.
The rise in divestment‐motivated buyouts over the last three decades warrants a re‐
examination of the relation between changes in managers’personal 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 cashed‐out equity back
into the firm, which worked well to align the interests of managers and post‐buyout
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 benefit from selling their pre‐buyout
equity stake, potential appreciation in their remaining post‐buyout equity stake, or both,
the source of the wealth gain will influence their actions around the buyout. In the
‘traditional’buyout that has been extensively documented in the literature, managers
invest substantial personal equity in the post‐buyout firm expecting to gain from post‐
buyout firm performance. To maximise the value of their investment, managers have an
incentive to take actions depressing pre‐buyout firm 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 firm value.
This can be achieved by manipulating pre‐buyout financials, 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 firm’s shareholders: while the
agency problem in investment buyouts is detrimental to the firm’s 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 financial
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 managers’personal wealth due to divestment can negatively
affect post‐buyout firm performance despite the positive effect of the remaining post‐LBO
ownership stake on managers’effort levels. When managers divest while continuing to
run the firm, much of their post‐buyout personal wealth becomes largely independent of
firm performance. Therefore, they may shift the allocation of their time and effort from
active involvement in the firm to the consumption and management of their private
wealth. Bitler et al. (2005) find that while there is a positive relation between an
entrepreneur’s 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 post‐LBO firm affects the structure of a buyout and manager’s efforts in the
post‐buyout firm. Their model suggests a negative relation between managers’divestment
and post‐LBO performance.
Lastly, managers who have divested a portion of their wealth have a greater incentive
to take on financial and operating risks. Having achieved financial security, they can
afford to use their remaining equity in the firm as a cheap call option and improve its
upside potential by making risky investments (Jensen and Meckling, 1976). Moreover,
the new post‐buyout compensation structure that is also equity‐heavy may augment the
value of the option to further encourage investment in risky projects (Smith and
Stulz, 1985).
We find that, contrary to the ‘traditional’buyout 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 pre‐LBO
holdings. In dollar terms, the total value of such divestments is $6.1 billion averaging $34
million per firm.
3
Our analyses demonstrate significant agency costs inherent to such
divestments. First, we observe a positive relation between pre‐buyout accruals, real
earnings manipulation, and the size of managerial divestment. We also find evidence of
market timing by managers in that high divestment buyouts are preceded by stock run‐
ups. Second, we find that the buyout process and pricing are also affected by the divesting
managers’incentives. Divesting managers are more likely to sell the firm 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, firms with managerial divestment
perform slightly worse than firms 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 significantly increase the amount and liquidity of their
wealth through an LBO and the effect of such divestment on the financial performance of
the firm 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
1981–1985 and finds that managers both realise large cash‐outs and continue to maintain
control after retaining an inexpensive equity stake in an over‐levered buyout firm. Kaplan
and Stein (1993) find that managerial divestment increased during the LBO wave of the
1980s and that it positively affected the likelihood of a firm’s subsequent financial
distress. Frankfurter and Gunay (1992) suggest that most buyouts are motivated by
3
These figures 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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