Buyout Activity: The Impact of Aggregate Discount Rates

• Author: ERIK LOUALICHE,MATTHEW PLOSSER,VALENTIN HADDAD
• DOI: http://doi.org/10.1111/jofi.12464
• Published date: 01 February 2017
• Date: 01 February 2017

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 1 •FEBRUARY 2017

Buyout Activity: The Impact of Aggregate

Discount Rates

VALENTIN HADDAD, ERIK LOUALICHE, and MATTHEW PLOSSER∗

ABSTRACT

Buyout booms form in response to declines in the aggregate risk premium. We doc-

ument that the equity risk premium is the primary determinant of buyout activity

rather than credit-specific conditions. We articulate a simple explanation for this phe-

nomenon: a low risk premium increases the present value of performance gains and

decreases the cost of holding an illiquid investment. A panel of U.S. buyouts confirms

this view. The risk premium shapes changes in buyout characteristics over the cy-

cle, including their riskiness, leverage, and performance. Our results underscore the

importance of the risk premium in corporate finance decisions.

SINCE THEIR EMERGENCE IN THE 1980s, buyouts have been a powerful means to

alter firm incentives. But the use of buyouts has varied widely over time. In

the United States, peak years experience close to 100 public-to-private buyout

transactions while trough years experience as few as 10. We propose a simple

explanation for these fluctuations: buyout activity responds to changes in the

aggregate risk premium. The discount rate affects firm valuations and in turn

the decision of whether to engage in a buyout deal. We document that this

integrated view of capital markets provides a detailed and powerful account of

buyout cyclicality. Our elementary explanation is in stark contrast to existing

literature that focuses on the role of credit-specific conditions.

Empirically,variation in buyout activity is better explained by changes in the

risk premium than by credit market conditions. Figure 1illustrates how buy-

out activity decreases when the aggregate risk premium is high and increases

∗Valentin Haddad is with Princeton University and NBER. Erik Loualiche is with MIT Sloan

School of Management. Matthew Plosser is with the Federal Reserve Bank of New York.The views

expressed in this paper are those of the authors and do not necessarily reflect the position of the

Federal Reserve Bank of New York or the Federal Reserve System. For helpful comments, the

authors thank Bruno Biais (the Editor), Olivier Darmouni, Douglas Diamond, Steven Kaplan, Anil

Kashyap, Ralph Koijen, Adair Morse, Dimitris Papanikolaou, Jonathan Parker, Pietro Veronesi,

anonymous referees, and seminar participants at the Chicago Booth Junior Finance Symposium,

SITE, the European Summer Symposium in Financial Markets, the Northwestern Finance Con-

ference, the Chicago Booth Finance Brownbag, the Economic Dynamics Working Group at the

University of Chicago, the Student Seminar and Macro Lunch at Northwestern University, the

Transatlantic Doctoral Conference, London Business School, and the Cambridge-Princeton Fi-

nance Conference. They also appreciate research assistance from Tara Sullivan and Meru Bhanot.

The authors do not have any potential conflicts of interest, as identified in the Journal of Finance

disclosure policy.

DOI: 10.1111/jofi.12464

371

372 The Journal of Finance R

−10

−5

0

5

10

15

Risk Premium %

0

10

20

30

Volume

1985q1 1990q1 1995q1 2000q1 2005q1 2010q1

Quarter

Deal Volume

Equity Risk Premium

Figure 1. Time series of buyout volume and aggregate risk premium. This figure plots

quarterly deal volume of buyout transactions. The equity risk premium is predicted using annual

returns for a three-year period using D/P,cay, and the three-month T-bill as factors.

when it is low. This factor alone explains over 30% of the total variation in

buyout activity, more than three times the variation explained by credit mar-

ket conditions. To derive additional testable hypotheses at the firm level, we

present a model linking the buyout decision to a single time-varying cost of

capital. We show that the characteristics of buyout targets and their variation

across high- and low-risk premium episodes uniquely reflect our mechanism.

We investigate the impact of the risk premium on buyout decisions through

the central trade-off of performance gains versus the cost of providing incen-

tives. In particular, a buyout brings better management to the firm at the

cost of compensating the acquirer for holding skin in the game. The risk pre-

mium affects both sides of this trade-off. On the performance side, the gains

are muted when the risk premium is high: following the Gordon growth model

intuition, the gains of a buyout increase with the difference between the firm’s

growth rate and the discount rate.1On the other hand, providing incentives

to the acquirer is costly: she has to bear excess risk to be duly motivated to

implement changes at the target. When the risk premium increases, that is,

when the marginal willingness to bear risk decreases, the willingness to bear

this excess risk also decreases and compensating the acquirer becomes more

costly.

1The present value of a cash flow stream starting at X, growing exponentially at rate g,and

discounted at rate ris X/(r−g).

The Impact of Aggregate Discount Rates 373

Using a panel of nonstrategic public-to-private deals from 1982 to 2011, we

document a novel set of facts regarding the quantity and nature of buyout ac-

tivity. Our simple explanation, focused on the risk premium, provides a unified

explanation of these facts, whereas credit-centric hypotheses are difficult to

reconcile with our results. At the aggregate level, buyout activity is negatively

related to the market-wide risk premium. This relation is robust to the inclu-

sion of market signals corresponding to common hypotheses in the literature:

credit market conditions (Axelson et al. (2013)) or measures of debt-equity mis-

pricing (Kaplan and Str¨

omberg (2009)). The risk premium explains as much

as 30% of the variation in activity whereas credit factors alone explain only

up to 10%. Consistent with our emphasis on fundamental conditions, market

expected growth is also positively related to buyout activity. Finally, our theory

rationalizes the correlation between buyout activity,leverage, deal pricing, and

subsequent returns, as documented, for instance, in Axelson et al. (2013).

While these aggregate facts strongly suggest that the risk premium is the

primary driver of buyout activity, we also exploit the cross-section of firms

to further distinguish the risk premium from alternative hypotheses. First,

riskier firms have a higher cost of capital and greater illiquidity costs, mak-

ing them undesirable buyout targets. Using panel data, we confirm that the

propensity of a firm to be bought out is sensitive to risk characteristics. Firms

with high market beta or high idiosyncratic volatility are less likely targets.

Going further, the role of risk characteristics varies over time. The greater

the systematic risk of the firm (i.e., beta), the more sensitive the cost of capital

to changes in the risk premium. In addition, the illiquidity costs of high-beta

firms are more sensitive to changes in the risk premium. Hence, among buyout

targets, we expect fewer high-beta firms when the risk premium is high. Con-

gruent with this prediction, we show that the distribution of buyout firms’ betas

shifts toward lower values during periods associated with a high risk premium.

In contrast, the idiosyncratic risk of buyout targets does not change with the

risk premium—a fact consistent with our theory. These results distinguish our

thesis from an explanation premised on changes in debt capacity that predicts

that both systematic risk and idiosyncratic risk vary with the buyout cycle.

A second set of tests focuses on the impact of the risk premium in the

cross-section of firms. Firms with greater potential performance improvements

should be more sensitive to the risk premium. We proxy for higher potential

gains using three measures of agency problems—a corporate governance in-

dex, an estimate of industry competition, and a measure of cash flows—and

find supportive evidence. Firms with poor corporate governance are more sen-

sitive to changes in the risk premium, as are firms with more potential for a

“free cash-flow” problem. In addition, our framework suggests that it is less

costly to compensate the acquirer when it is easier to resell the firm, and thus

the buyout activity of more liquid firms should be less sensitive to changes in

the risk premium. We measure the ease of exit for acquirers using average

industry-level merger and acquisition (M&A) or initial public offering (IPO)

transaction activity and find that more liquid industries are less sensitive to

movements in the risk premium. These results are robust to the inclusion of