The evolution of capital structure and operating performance after LBOs: Evidence from US tax returns Cohn, Mills, and Towery UBC Winter Conference, 2011

Motivation Difficult to study what happens after firms go private—No longer file financial statements. Existing evidence largely based on: – Firms with public debt outstanding. – Firms that exit (provide some backward looking data). Firms do have to file tax returns! – Unique access to tax returns allows for a more complete view.

Questions addressed What are the real and financial effects of LBOs? – Real Effects: Do better incentives provided by concentrated ownership and disciplining effects of debt lead to better operating performance? – Financial Effects: How does leverage evolve after the LBO – Temporary versus permanent effects on capital structure. – Tax implications.

LBO Trends Axelson et al. (2009)

Answers

What should one expect? Practitioners talk about three sources of gains in LBOs. – Deleveraging. – Multiples expansion. – Operating Improvements. – Generally target >20% IRR to LP’s.

Deleveraging

Multiples Expansion

Operating Improvements

LBO Value Creation

Comments Paper would benefit from some structured hypotheses. – Jensen’s Free Cash Flow. Decrease in investment and increase in profitability. – Underleverage. Permanent increase in leverage. – Debt used as a transaction mechanism. Transitory increase in leverage.

Why do firms go private?

Comments Need for some better comparisons to existing studies. – Mainly regarding how the tax data compares to Gaap financials. – Would be useful to compare your measures versus the gaap data pre-LBO and then during the LBO for the sample of public debt users. EBIT versus EBIAT. – I think you actually report earnings before interest after tax.

Axelson et al. (2009)

Hotchkiss et al. (2010)

This paper

This Paper

Incentives and Performance Improvements (Oyer and Leslie) – Difficult to observe counterfactual. – Significant Heterogeneity.

Leverage changes If this is an optimal capital structure why can’t public firms replicate this? – If the tax benefits are so large??? – What is special about the LBO structure to support so much debt? Debt overhang? Ability of sponsors to minimize risk/reduce bankruptcy costs? Private versus public? – Reduce leverage again after an IPO.

Are LBOs Underlevered? Axelson et al. (2009)

Why isn’t leverage decreased?

Oyer and Leslie Increase in leverage is not permanent.

Comments This does not look like Jensen’s free-cash flow hypothesis. – Higher incentives and debt curtail wasteful spending by managers and focus attention on cash flow generation. No substantial operating improvements. Significant asset growth. Financed largely by debt. Why does interest coverage hardly change despite increased debt?

Is Asset Growth From Cash? Kwik Fit LBO

Conclusions Observe LBOs throughout the lifecycle. How does the data compare to Compustat? More direct tests of hypotheses. Heterogeneity in LBOs. – Underleveraged prior to LBO? – Free cash flow problems? – Overinvestment?