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
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
Year
0
100
1
100
-100
2
100
-100
3
100
-100
4
100
-100
5
100
-100
Debt Levels
750
650
550
450
350
250
FCF Multiple
10
10
10
10
10
10
1000
-750
250
1000
-650
350
1000
-550
450
1000
-450
550
1000
-350
650
1000
-250
750
Free Cash Flow
Debt Repayment
Enterprise Value
Less Debt
Equity Value
IRR
24.57%
Multiples Expansion
Year
0
100
1
100
0
2
100
0
3
100
0
4
100
0
5
100
0
Debt Levels
750
750
750
750
750
750
FCF Multiple
10
11
12
13
14
15
1000
-750
250
1100
-750
350
1200
-750
450
1300
-750
550
1400
-750
650
1500
-750
750
Free Cash Flow
Debt Repayment
Enterprise Value
Less Debt
Equity Value
IRR
24.57%
Operating Improvements
Year
0
100
1
110
0
2
120
0
3
130
0
4
140
0
5
150
0
Debt Levels
750
750
750
750
750
750
FCF Multiple
10
10
10
10
10
10
1000
-750
250
1100
-750
350
1200
-750
450
1300
-750
550
1400
-750
650
1500
-750
750
1100
10.0%
1210
9.9%
1330
9.8%
1460
9.6%
1600
9.4%
Free Cash Flow
Debt Repayment
Enterprise Value
Less Debt
Equity Value
IRR
Assets
ROA
24.57%
1000
10.0%
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
Means
Debt
EBITDA
Interest
Total Assets
Int Cov
Debt/EBITDA
D/A
Asset Growth
Pre (t-1) Post (t+2)
446.60
749.20
26.90
52.40
17.70
45.50
679.00
897.10
1.52
1.15
16.60
14.30
0.66
0.84
0.32
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?