Buy-to-Sell versus Buy-to-Keep: A Product Market Theory of Buyouts Pehr-Johan Norbäck Lars Persson Joacim Tåg

Agenda Introduction General Framework A Product Market Theory of Buyouts Takeaways

Introduction

Private Equity Buyouts (LBOs) Institutional Investors Banks Targets Private Equity Funds 6-10 year Targets Private Equity Partners

Advantages ”Active” owners –Managerial ownership –Debt –Monitoring Solve managerial agency problems

Question Why do not public firms do the same?

Our Contribution

Develop a new framework When do buy-to-sell owners emerge in equilibrium? How does buying to sell affect strategic investments?

A Product Market Theory of Buyouts Why are buyout firms more ”active” owners than public firms? Is ”active” ownership a reason for their existance? Empirical predictions on differences in behavior

The General Framework

Buying to Sell or Buying to Keep Stage 1: Acquistion auction Stage 2: Investment Stage 3: Exit Stage 4: Long run Buy-to-sellBuy-to-keep

Difference in Investment Incentives Stage 2: First order conditions Equal investments only if

Ownership Depends on Investment Stage 1: Valuations Rankings:

Application: A Product Market Theory of Buyouts

Overview Public firms buy to keep (have assets) Buyout firms buy to sell (trade-sale exit) Strategic investment is managerial ownership => Restructuring effort Debt, monitoring also works (”active”)

Structure and Timing Stage 1: Acquistion auction Stage 2: Compensation contract Restructuring intensity Stage 3: Exit auction Stage 4: Product market interaction BuyoutIncumbent

Stage 4: Product Market Competition Firms maximize: Nash-Equilibrium : Reduced form profits:

Assumption 1 Restructuring improves competitiveness:

Structure and Timing Stage 1: Acquistion auction Stage 2: Compensation contract Restructuring intensity Stage 3: Exit auction Stage 4: Product market interaction BuyoutIncumbent

Stage 3: Exit (Trade Sale) First price perfect information auction Incumbent valuation: General: Restructured firm is obtained by an incumbent at price

Structure and Timing Stage 1: Acquistion auction Stage 2: Compensation contract Restructuring intensity Stage 3: Exit auction Stage 4: Product market interaction BuyoutIncumbent

Stage 2: Compensation contract CARA preferences: Linear contract: Maximization

Stage 2: Managerial Ownership Participation: Costs:

Stage 2: Managerial Ownership Incumbent: Buyout:

Stage 2: Managerial Ownership Marginal profit and marginal cost Managerial ownership

Structure and Timing Stage 1: Acquistion auction Stage 2: Compensation contract Restructuring intensity Stage 3: Exit auction Stage 4: Product market interaction BuyoutIncumbent

Result 1: Buyout firms more ”active” Buyout firms more ”active” because they buy to sell Stronger incentive contracts: More restructuring:

Structure and Timing Stage 1: Acquistion auction Stage 2: Compensation contract Restructuring intensity Stage 3: Exit auction Stage 4: Product market interaction BuyoutIncumbent

Stage 1: Equilibrium Ownership Valuations –Buyout –Incumbent Rankings:

Stage 1: Equilibrium Ownership Ownership depends on the sign of

Result 2: Being ”Active” not enough Buyout firms need an advantage to emerge in equilibrium (preemption) –Lower restructuring costs; more experience –Tax shield of debt

Marginal profit and marginal cost Managerial ownership Net acquisition profits Managerial ownership

Empirical Predictions

Buyout firms give management more intense incentive contracts Monitors more and takes on more debt Does more restructuring => better operational improvements Preference for exit through a trade-sale if IPO costs are large and restructuring not too expensive.

Evidence More intense contracts More debt and board representation Higher operational and financial performance Leslie and Oyer (2008): debt and m.ownership returns to ”normal”

Other Applications of the Framework

Applications Reputational concerns: Protecting innovations: Asymmetric information:

Takeaways

General Framework New framework for analysis of buy-to- sell and buy-to-keep ownership Maximizing sales price often not the same as maximizing long run value Affects investments, which in turn affects equilibrium emergence.

Product Market Theory of Buyouts Buyout firms are more ”active” owners because they buy to sell. –Optimal managerial ownership, debt and monitoring higher than at public firms –Returns to “normal” post exit Being ”active” is not enough to outbid incumbents for assets –Preemptive motive –Expertise or tax shield needed

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