Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts

• Published date: 01 December 2013
• Date: 01 December 2013
• DOI: http://doi.org/10.1111/jofi.12082

THE JOURNAL OF FINANCE •VOL. LXVIII, NO. 6 •DECEMBER 2013

Borrow Cheap, Buy High? The Determinants

of Leverage and Pricing in Buyouts

ULF AXELSON, TIM JENKINSON, PER STR ¨

OMBERG,

and MICHAEL S. WEISBACH∗

ABSTRACT

Private equity funds pay particular attention to capital structure when executing

leveraged buyouts, creating an interesting setting for examining capital structure

theories. Using a large, international sample of buyouts from 1980 to 2008, we find

that buyout leverage is unrelated to the cross-sectional factors, suggested by tradi-

tional capital structure theories, that drive public firm leverage. Instead, variation

in economy-wide credit conditions is the main determinant of leverage in buyouts.

Higher deal leverage is associated with higher transaction prices and lower buyout

fund returns, suggesting that acquirers overpay when access to credit is easier.

“We buy stuff with cheap debt and arbitrage on the difference with equity

markets.” (Guy Hands, founding partner of the private equity firm Terra

Firma, Financial Times, November 15, 2007)

PRIVATE EQUITY INVESTORS are expert, repeat, and largely financially moti-

vated players in capital markets. Over a career executing leveraged buyouts

(LBOs), they arguably make more decisions about firm capital structure than

any other agents in the economy.1Hence, private equity investors’ financing

choices are potentially informative about theories of optimal capital structure.

Yet, unlike publicly traded firms, we know little about what determines lever-

age and pricing in these buyouts. In this paper, we fill this gap by documenting

the factors that affect the financial structure of private equity–backed buyout

firms in detail, and we contrast these factors with those related to the capital

structure of a matched set of publicly traded firms. In doing so, we shed light on

∗Axelson is with the London School of Economics and SIFR; Jenkinson is with the Said Business

School, Oxford University and CEPR; Str¨

omberg is with SIFR, Stockholm School of Economics,

CEPR, and NBER; and Weisbachis with Ohio State University, NBER, and SIFR. We are extremely

grateful to Steve Kaplan for sharing his data on 1980s LBOs, and to Joakim B˚

ang, Ji-WoongChung,

and Reimo Juks for excellent research assistance. We would also like to thank Viral Acharya,

Malcolm Baker, Laura Bottazzi, Phil Canfield, Chris Collins, Marco DaRin, Francois Derrien,

Chris James, Steve Kaplan, Steven Ongena, Morten Sorensen, David Sraer, AyakoYasuda, as well

as the Editor (Cam Harvey), the referees, and participants in numerous seminar presentations for

valuable comments.

1See Kaplan and Str¨

omberg (2009) for an overview of the private equity market.

DOI: 10.1111/jofi.12082

2223

2224 The Journal of Finance R

both the particular functionings of the increasingly important private equity

market, and also on capital structure questions more broadly.

A useful simplification for thinking about buyout capital structure is to con-

trast two broad views that have been expressed in both academic literature and

the popular press. In the first view, most famously put forth by Jensen (1989),

private equity–backed firms have superior governance to publicly traded firms.

Together with active boards, high-powered management compensation, and

concentrated ownership, Jensen argues that leverage is an essential part of

the private equity governance model. Unlike public firms, private equity funds

optimize the capital structure in the companies they acquire to take full ad-

vantage of the tax and incentive benefits of leverage, trading these benefits

off against the costs of financial distress. An implication of this view is that

characteristics related to the debt capacity of a given firm, such as industry,

tangibility of assets, and volatility of cash flows, should explain capital struc-

ture in buyouts.

A second view,reflected in the opening quote from Guy Hands of Terra Firma,

is that the most important factor in buyout capital structure is the ability of buy-

out funds to use “cheap” debt to take levered bets on firms. Private equity funds

are uniquely positioned to time the market by arbitraging debt versus equity

when leverage is relatively cheap due to superior access to debt financing (as

suggested by Ivashina and Kovner (2011)and Demiroglu and James (2010)).2

In addition, the General Partners (or GPs) running private equity funds have

agency problems of their own that are likely to affect their choice of leverage

in their portfolio companies. Axelson, Str¨

omberg, and Weisbach (2009) present

a model in which GPs tend to overinvest, taking value-decreasing investments

in addition to value-increasing ones because of their option-like compensation.

If they are capital-constrained, so that they must raise external debt in order

to complete deals, the investors (the Limited Partners, or LPs) have some pro-

tection against this tendency of GPs to overinvest. However, the model predicts

that, when access to debt is “easy,” private equity funds will nonetheless have

an incentive to lever up as much as possible and to overpay for deals.3Both

the market-timing and the agency stories share the common prediction that

2In this paper,we do not take a stand on the underlying economic reasons for debt being “cheap,”

or equivalently,credit spreads being relatively low. Proposed explanations include relative changes

in credit risk premia (Collin-Dufresne, Goldstein, and Martin (2001)), supply shocks due to changes

in intermediary capital (Leary (2009) and Shin (2011)), or changes in credit market sentiment

(Baker, Ruback, and Wurgler(2004)). Either way, there is now substantial evidence that there are

changes in credit risk premia and debt pricing that are largely unrelated to equity risk premia and

other macroeconomic factors (see Collin-Dufresne, Goldstein, and Martin (2001) and Gilchrist and

Zakrajsek (2011)).

3Consistent with this argument, Kaplan and Stein (1993) provide evidence suggesting that the

booming junk bond markets of the late 1980s led to an overheated private equity market, with low

private equity fund returns as a consequence. Ljungqvist, Richardson, and Wolfenzon (2007) find

that buyout funds accelerate their investment flows when credit market conditions loosen, but do

not address how the leverage and pricing of individual deals vary with credit market conditions.

More recently, Gorbenko and Malenko (2012) present evidence that financial buyers bid more

aggressively in auctions for firms when credit conditions are stronger.

Borrow Cheap, Buy High? 2225

time-series variables measuring economy-wide debt market conditions should

explain buyout leverage better than cross-sectional firm characteristics.

To study the factors affecting buyout capital structure, we construct a new

database containing detailed information about the financing of a large sam-

ple of buyouts. This sample contains 1,157 buyouts, 694 of North American

firms and the remaining 463 of firms from 24 countries outside North America,

mainly in Western Europe. For each buyout in the sample, we obtain detailed

information about the financial structure of the transaction. Unlike most pre-

vious work, our sample includes buyouts of private companies, such as family

firms, corporate divisions, and companies acquired from other private equity

firms, in addition to buyouts of publicly traded firms. The sample covers the

period from 1980 through 2008, which allows for a much longer temporal anal-

ysis than in most previous studies.4Our data include deals from a total of

176 distinct private equity sponsors and incorporate practically all the major

investors active in the market during our period of study.

We first consider the question of whether buyout leverage appears to be

determined by the same factors as comparable publicly traded firms using

a matched sample of buyouts and public firms in the same industry, region,

and time period. Very surprisingly (at least to the authors), there appears

to be no discernible relation between leverage in buyout firms and median

leverage of public firms in the same industry-region-year, regardless of what

leverage measure we use. This result holds when we match our LBO sample

to subsamples of public firms that have adjusted their leverage significantly

over the last years, as well as when we consider long-run LBO leverage using

repayment schedules, alleviating concerns that the lack of relationship is due

to an unrepresentative matching procedure. Furthermore, when we restrict

our analysis to the subsample of 160 public-to-private deals for which we have

information about pre-LBO financials, we also find that there is no relationship

between buyout leverage and pre-LBO leverage.

Given that the quantity of leverage used by buyouts and that by matched

public firms have little to no relation with one another, what does determine

leverage in buyout firms? Cross-sectional characteristics such as industry fixed

effects or variables such as profitability, earnings volatility, and growth oppor-

tunities, which explain most of the variation in public company leverage, have

little explanatory power for buyout leverage. Instead, most of the variation in

buyout leverage is explained by time-series effects. The one robust predictor of

LBO leverage we find is the prevailing condition of debt markets: the higher the

credit risk premium of leveraged loans, measured as the high-yield spread over

LIBOR, the lower the leverage used in buyout transactions. As a consequence,

leverage in LBO deals is procyclical, with leverage peaking during “hot” credit

market conditions, such as in 2006 to 2007, and falling when debt markets

4Guo, Hotchkiss, and Song (2011) study a sample of U.S. public-to-private transactions from

1990 through 2006. Some recent studies consider the motives of other kinds of buyouts: Boucly,

Sraer, and Thesmar (2011) and Chung (2011) examine the performance of buyouts of private

companies, while Wang (2011) and Jenkinson and Sousa (2011) study secondary buyouts.