The evolution of capital structure and operating performance after LBOs:

Evidence from US tax returns

Cohn, Mills, and ToweryUBC 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 TrendsAxelson 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.

DeleveragingYear

0 1 2 3 4 5Free Cash Flow 100 100 100 100 100 100Debt Repayment -100 -100 -100 -100 -100

Debt Levels 750 650 550 450 350 250

FCF Multiple 10 10 10 10 10 10

Enterprise Value 1000 1000 1000 1000 1000 1000Less Debt -750 -650 -550 -450 -350 -250Equity Value 250 350 450 550 650 750

IRR 24.57%

Multiples ExpansionYear

0 1 2 3 4 5Free Cash Flow 100 100 100 100 100 100Debt Repayment 0 0 0 0 0

Debt Levels 750 750 750 750 750 750

FCF Multiple 10 11 12 13 14 15

Enterprise Value 1000 1100 1200 1300 1400 1500Less Debt -750 -750 -750 -750 -750 -750Equity Value 250 350 450 550 650 750

IRR 24.57%

Operating ImprovementsYear

0 1 2 3 4 5Free Cash Flow 100 110 120 130 140 150Debt Repayment 0 0 0 0 0

Debt Levels 750 750 750 750 750 750

FCF Multiple 10 10 10 10 10 10

Enterprise Value 1000 1100 1200 1300 1400 1500Less Debt -750 -750 -750 -750 -750 -750Equity Value 250 350 450 550 650 750

IRR 24.57%

Assets 1000 1100 1210 1330 1460 1600ROA 10.0% 10.0% 9.9% 9.8% 9.6% 9.4%

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 PaperMeans

Pre (t-1) Post (t+2)Debt 446.60 749.20EBITDA 26.90 52.40Interest 17.70 45.50Total Assets 679.00 897.10Int Cov 1.52 1.15Debt/EBITDA 16.60 14.30D/A 0.66 0.84Asset Growth 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?