Lifting the Veil on Reverse Leveraged Buyouts: What Happens During the Private Period?

• Author: Sudip Datta,Mai Iskandar‐Datta,Mark Gruskin
• Date: 01 December 2013
• Published date: 01 December 2013
• DOI: http://doi.org/10.1111/fima.12023

Lifting the Veil on Reverse Leveraged

Buyouts: What Happens During the

Private Period?

Sudip Datta, Mark Gruskin, and Mai Iskandar-Datta∗

We document the different types of restructuring activities undertaken during the private period

after the reverse leveraged buyout (RLBO) of previously public firms. Preceding the LBO, firm

leveragesignificantly exceeds that of their peers, while their profitability is better than the industry.

However, despite their superior performance, these firms are undervalued before going private.

While private firms undertake value-enhancement measures by increasing employee productivity,

asset restructuring, decreasing cost of goods sold, and increasing ownership concentration. En-

hanced valuation at the RLBO is a result of value capture, as well as efficiencies obtained from

restructuring activities. We also identify factors determining the private period duration.

Over the past four decades, private firms going public through a reverse leveraged buyout

(RLBO) transaction have increased in frequency and importance. RLBO transactions account

for approximately 20% of all US initial public offerings (IPOs) and the proceeds from these

re-IPOs are approximately twice the size of regular IPO deals (Cao and Lerner, 2009). While

some prior studies examine changes around leveraged buyouts (LBOs) (DeAngelo, DeAngelo,

and Rice, 1984; Lehn and Poulsen, 1989; Kaplan, 1991), others focus on financial and stock price

performance after the RLBO (Cao and Lerner, 2009; Holthausen and Larcker, 1996). However, to

date, there is very little evidence regarding restructuring activities during the privateperiod of pure

RLBO firms (i.e., f irms going from public to private to public). This study offers some unique

new insights on these leveraged deals by examining the financial performance and restructuring

activities of previously public RLBO firms during the private period, specifically from the LBO

to exit at the RLBO. The term RLBO is typically used to describe three distinct classes of

transactions. Public-to-private transactions involve independent, publicly traded entities before

the LBO (we refer to these as pure RLBOs), while division-to-private deals more closely resemble

highly levered going private equity carve-outs. The third type is the private-to-private RLBO,

where an unlisted company is typically acquired bya private equity group and subsequently taken

public via an IPO. In this paper, we focus on public-to-private RLBO firms.

Our research design allows us to analyze efficiencies and productivity gains during the private

period and their impact on valuation following the RLBO. Specifically, we examine changes in

profitability, valuation,f inancial structure, operating structure, and cost structure from pre-buyout

to post-exit. We address the following questions: What types of restructuring activities, in terms

of changes in operating, financial, and cost structures, typically take place prior to a re-IPO? How

do private period restructuring activities drive improvements in valuation? What are the ex ante

Wethank Josh Lerner, Raghu Rau (Editor), and an anonymous refereefor valuable suggestions.

∗Sudip Datta is the T.Norris Hitchman Endowed Chair and Professor of Financein the School of Business Administration

at WayneState University in Detroit, MI. Mark Gruskin is an Assistant Professor of Financeat Penn State – Lehigh Valley

in Center Valley, PA. Mai Iskandar-Datta is the Dean’sResearch Chair, Board of VisitorsFaculty Fellow, and Professor

of Finance in the School of Business Administrationat Wayne State University in Detroit, MI.

Financial Management •Winter 2013 •pages 815 - 842

816 Financial Management rWinter 2013

determinants of private period duration? Our findings should allow us to observe the differences

between public-to-private RLBOs and the commingled RLBO samples used previously in the

literature.

Analysis of these issues is important for several reasons. First, our research design, which

examines only public-to-private RLBOs, allows us to draw clean and reliable conclusions about

firm restructuring activities from pre-LBO through post-RLBO. Our analytical frameworkenables

us to infer the types of restructuring activities that take place during the privateperiod as we are able

to track the same firm across different parts of its journey.1Previous research that examined all

the buyouts together did not allow for a comprehensiveexamination of the f inancial performance

and restructuring activities of firms from pre-LBO to post-RLBO.

Additionally, by commingling different types of deals, previous studies ignore the fact that

private-to-private and division-to-private transactions may reflect completely different attributes,

motivations, and starting points when compared to public-to-private RLBO firms. There are

several reasons for these differences. Bharath and Dittmar (2010) find that different economic

forces motivate private and public firms. There are also structural differences in their firm

characteristics. Private firms are characterized by smaller size, less leverage, lower dividend

payouts, and greater ownership concentration (Villalonga and Amit, 2006). In addition, while

public-to-privatef irms forgo the benefits of access to public markets, private-to-privatef irms may

gain greater access to financing from private equity buyers. Firms that undergo public-to-private

transactions also tend to be larger than their average industry peers relative to division-to-private

or private-to-privateones, and are also less likely to suffer from adverse selection. Due to the size

differential between these different types of RLBOs, their private period restructuring activities

will also differ. For instance, larger enterprises are more likely to optimize the firm’s asset mix

by reversing previous diversification strategies. Thus, they are more likely to engage in asset

sales of unproductive assets. The greater complexity of larger firms may also involve longer

restructuring and entail a greater risk of failure. Moreover, given the pre-buyout size differential,

it is more likely that privatelyheld f irms suffer from a lack of professional managerial skills than

public firms. As such, these fir ms benefit more from enhanced managerial talent after the buyout.

Finally, RLBOs going public for the first time are expected to experience greater informational

asymmetries as compared to our sample of re-IPOs.

Therefore, it is not surprising that the prior literature, based on commingled RLBO samples,

yields mixedand non-generalizable conclusions. For example, prior research finds mixed evidence

regarding Jensen’s (1986) free cash flowtheor y that activegovernance by buyout firms, combined

with a higher concentration of ownership and discipline from high leverage, facilitates value

creation.2It is possible that the heterogeneity of public-to-privateand other buyouts is behind the

mixed results. Specifically, Jensen’s (1986) agency framework cannot explain private-to-private

buyouts. Any agency problems in private firms are of a different nature than those at publicly

held firms (Schulze et al., 2001; Howorth, Westhead, and Wright, 2004).

1In most prior studies, public-to-private LBOs represent a small fraction of the samples. The frequency of these firms is

small on an absolute basis, as well. For example,in Muscarella and Vetsuypens’(1990) sample of 72 RLBOs from 1983

to 1987, only 18 transactions are originally public firms and data availability reduces that number to 14 or less. Smith’s

(1990) study that examines management buyouts includes 17 such deals, while Mian and Rosenfeld’s (1990) sample

includes 32 public-to-private firms. The same applies to Kaplan’s(1991) and Cao and Lerner’s (2009) samples.

2While a number of studies find evidence in support of enhanced efficiencies due to increased leverage and better

alignment of incentives in buyouts (Lehn and Poulsen, 1989; Muscarella and Vetsuypens, 1990; Smith, 1990; Denis,

1992), others find no evidence to support the free cash flow argument in the United States (Maupin, Bidwell,and Orteg ren,

1984; Servaes, 1994; Halpern, Kieschnick, and Rotenberg, 1999; Kieschnick, 1998) and in the United Kingdom (Weir,

Laing, and Wright, 2005; Renneboog, Simons, and Wright, 2007). In addition, Nikoskelainen and Wright (2007) find

that governance mechanisms resulting from a leveraged buyout are not the main driversof value increases.