Prior literature on highly levered transactions (levered buyouts or levered recapitalizations) has emphasized either changes in governance or the structuring of their financing in helping these firms avoid financial distress or bankruptcy. Observing a sample of HLTs over time, we observe that debt composition is a more critical influence than proposed changes in governance for the likelihood of an HLT avoiding financial distress or bankruptcy. Such evidence is consistent with the [Chemmanur, T. & Fulghieri, P. (1994). Reputation, renegotiation, and the choice between bank loans and publicly traded debt. Review of Financial Studies7, 475–506] model and suggests that the critical factor is the ability to informally renegotiate debt terms with a few lenders.
Why do some firms that engage in a highly levered transaction, like a levered buyout or levered recapitalization, encounter financial distress or go bankrupt? More specifically, what is the relative role of changes in their governance and their financing in these outcomes? Some have argued that private equity firms play a special role in helping their portfolio firms avoid such outcomes. However, this conjecture begs the question of how do private equity firms do this; is it by changing firm governance, by structuring the financing of the target to facilitate re-negotiation or both? Thus, the core issue is whether highly levered transactions avoid financial distress or bankruptcy because of governance changes and/or because of the way they are financed?
To address this issue, we examine a sample of HLTs from 1985 through 1990. To present the hypotheses that we test and our evidence on them, we organize our paper as follows. In Section 2, we provide a brief review of the relevant literature and present our hypotheses. In Section 3, we describe our samples and sample data. In Section 4, we provide an analysis of control changes in HLTs, debt composition of HLTs, and the factors influencing the incidence of financial distress and bankruptcy in HLTs. In Section 5, we summarize our evidence and report our conclusions.
We find that after accounting for their debt load and its composition, changes in governance are not significant influences on the incidence of either financial distress or bankruptcy in HLTs. Consequently our evidence suggests that if a private equity firm plays a special role in helping LBOs avoid bankruptcy then it is more likely through their structuring of the firm's debt rather than through their restructuring of the firm's governance. Our evidence is consistent with Chemmanur and Fulghieri (1994) who propose that banks appear to reduce ‘inefficient’ liquidation, which suggests that reputation effects are important to banks.
Why do some firms that engage in a highly levered transaction, like a levered buyout or levered recapitalization, encounter financial distress or go bankrupt? More specifically, what is the relative role of changes in their governance vs. how they are financed in these outcomes? Some have argued that private equity firms play a special role in helping their portfolio firms avoid such outcomes. However, this conjecture begs the question of how do private equity firms do this. Is it by changing the way the firm is governed or by structuring the financing of the target to facilitate re-negotiation? Thus, the core issue is whether highly levered transactions avoid financial distress or bankruptcy because of the way their governance is changed or because of the way they are financed?
To address this issue, we examine a sample of HLTs from 1985 through 1990. In conducting this examination, we distinguish amongst different types of HLTs according to the likelihood of governance changes in the post-HLT firm. Specifically, we distinguish between LBOs led by management, LBOs led by private equity firms, or buyout specialists, and levered recapitalizations (LRCs), typically led by management. Our evidence suggests the following conclusions.
First, there are significantly more changes in the control of LBOs led by private equity firms than in LBOs led by management or LRCs. Second, LRCs typically using more public debt than LBOs led by management or a private equity firm. Further, private equity firm led LBOs tend to use more public debt than management led LBOs. Third, at the margin, the composition of debt rather than governance changes is a more critical determinant of the likelihood of a HLT encountering financial distress or going bankrupt. Consequently we conclude it is the composition of the debt used to finance a HLT rather than how its governance is restructured that matters most to the likelihood of it facing financial distress or bankruptcy.
Our paper makes two important contributions to the literature. First, consistent with Chemmanur and Fulghieri's (1994) and Bolton and Freixas’ (2000) models, we find that larger, less risky firms are more likely to use public debt. More importantly, we find that HLTs using public debt are more likely to face financial distress or go bankrupt. Given the evidence in Andrade and Kaplan (1998) and Platt and Platt (1991) that inappropriate debt loads, rather than economic distress are an important contributing cause of financial distress in HLTs, our evidence is consistent with Chemmanur and Fulghierri's notion that banks, which represent concentrated debt holdings, are less likely to engage in inefficient liquidation of financially distressed companies.
Second, unlike Cotter and Peck (2001), we do not find that private equity firms play a special role in reducing the odds of an HLT encountering financial distress, once size and composition of HLT debt are accounted for in the analysis. Rather, our evidence suggests that whatever role they do play in reducing the odds of these outcomes relates to the structuring of the debt financing of their deals, rather than how they restructure the governance of their target firms.
