Proceedings of 3rd European Business Research Conference
4 - 5 September 2014, Sheraton Roma, Rome, Italy, ISBN: 978-1-922069-59-7
Managerial Incentives for Innovation and Leveraged Buyouts
in The Presence of a Psychological Threshold of Dismissal
Shinsuke Kamoto
Management buyouts of public firms have thrived as a prominent measure of corporate restructure.
Theory of corporate finance demonstrates potential mechanisms of management buyouts for
increasing firm value. (See Shleifer and Vishny (1987) and Bayar (2011).) In post-MBO firms,
managers are induced to realign their interests toward that of shareholders by their increased
shareholding. This convergence of interests between managers and shareholders results in reducing
agency costs that arise from the separation of ownership and control in public firms and increasing
firm value. In addition, high leveraged capital structure of post-MBO firms forces managers to create
sufficient future cash flow by improving operating performance for fulfillment of debt obligation. It is
also well-known that high leverage provides significant value of tax shield. Then, MBOs highly
concentrate firm shares on private equity funds that participate in the going private transactions as
equity financiers. This high concentration of firm shares contributes to increase firm value, providing
strong incentives for the private equity fund to monitor managers closely in order to prevent inefficient
management and improve operating performance.
A number of empirical studies on leveraged buyouts examine the impact of announcements of going
private transactions on shareholders’ value and the sources of the value creation. (See Renneboog,
Simons, and Wright (2007) and Bayar (2011)) They present the findings that are overall consistent
with the above theoretical predictions, indicating shareholders’ value creation of MBOs from
realignments of managerial incentives to increase shareholders’ value, improvements in management
and operating performance, increased tax shield, and close monitoring by dominating outside
shareholders.
Furthermore, several studies examine the impact of going private transactions on the intensity of
innovation for a long time period. (See Zahra (1995), Wright, Wilson, and Robbie 1998, Lerner,
Sorensen, and Strömberg (2011).) These studies demonstrate the positive impact of management
buyouts on the intensity of innovation by presenting findings that post-MBO firms increases
investments in innovation such as new product developments, technological inventions, patenting
activity, R&D staff size and capabilities, and new business creation activities.
The above empirical evidence is so compelling as to raise the following research interest, which is
what discourages managers in public firms from pursuing innovation activities, how the management
buyouts enable them to do so, and what motivates them to go private. This study examines
managerial incentives for innovation and leveraged buyouts and provides a rationale behind the
Proceedings of 3rd European Business Research Conference
4 - 5 September 2014, Sheraton Roma, Rome, Italy, ISBN: 978-1-922069-59-7
empirical evidence that post-MBO private firms increase the intensity of innovation. Based on the
approach by Fluck (1999) and Myers (2000), the study develops a theoretical model that
demonstrates that a self-interested manager is discouraged from pursuing innovation by managerial
perception of the dismissal threshold that emerges from unsophisticated shareholders’ inability to
observe true cash flows of innovative investments.
In this model a manager in a public firm can undertake innovative activity with non-pecuniary costs to
increase the investment value of a project. The manager also has opportunities to extract cash flows
that the firm generates as private benefits because cash flows are unverifiable and shareholder’s
collective action of dismissal is costly. There are two types of shareholders. One is sophisticated
shareholders, and the other is unsophisticated. When the investment is undertaken, both shareholders
are unaware of the innovation undertaken by the manager and they expect the investment to be an
existing type that generates industry average cash flows. When the investment begins generating
cash-flows, sophisticated shareholders can observes true cash flows of the investment but
unsophisticated one cannot. The inability for unsophisticated shareholders to observe true cash flows
induces them to decide to dismiss their manager if distributed dividends fall short of the amount that
the shareholders expect to receive on the basis of industry average performance. Perceiving the
shareholders’ threshold to dismiss, the manager what wishes to stay the managerial position is forced
to reduce extraction of private benefits and to meet the amount of dividends that the unsophisticated
shareholders expect to receive in order to secure the managerial position in the failure of the
innovation. Consequently, the managerial perception hinders managerial innovative activities in public
firms.
Management buyouts provide a potential to free the innovative manager from the above mental
threshold that created by unsophisticated shareholders in public firms. This is why private equity funds
that have expertise participate in going private transactions along with the manager. This study
demonstrates that managerial incentives for innovation in post-MBO firms exceed those in public firms.
However, in exchange for the potential to pursue innovation, the manager is forced to to relinquish
opportunistic extraction of private benefits under stringent monitoring and governance by private
equity funds. Therefore, the self-interested and innovative manager decides whether to go private as a
result of a trade-off between private benefits extraction and innovative value creation. This study
demonstrates the impact of parameters pertaining to firm characteristics and market environments on
managerial incentives to go private through MBOs.
The study on managerial incentives for taking a firm private remains unexplored. To the best of
author’s knowledge, no study has been conducted with the exception of Elitzur, Halpern, Kiechnick,
and Rotenberg (1998). They examine managerial decisions on going private and the impact of
leveraged buyouts on managerial ownership structure and effort provisions. They demonstrate that a
manager, who holds substantial shares of the firm, is induced to go private through leveraged buyouts
by diversification of unsystematic risk and retention of its ownership control. The present paper
Proceedings of 3rd European Business Research Conference
4 - 5 September 2014, Sheraton Roma, Rome, Italy, ISBN: 978-1-922069-59-7
demonstrates another managerial motivation to undertake management buyouts.
Key words: Management Buyout, Innovation, Non-Verifiability of Cash Flows,
Managerial Opportunism, Psychological Threshold
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Shinsuke Kamoto, Faculty of Economics, Kagawa University, 2-1 Saiwaicho, Takamatsu Kagawa
760-8523, Japan, kamoto@ec.kagawa-u.ac.jp