The Private Equity Advantage: Leveraged Buyout Firms and Relationship Banking

Abstract:     
This paper examines the impact of leveraged buyout firms' bank relationships on the terms of their syndicated loans. Using a DealScan sample of 1,590 loans financing private equity sponsored leveraged buyouts between 1993 and 2005, we find that bank relationships explain cross-sectional variation in the loan interest rate and covenant structure. Our results indicate that two channels allow leveraged buyouts sponsored by private equity firms to receive favorable loan terms. First, bank relationships formed through repeated interactions reduce inefficiencies from information asymmetry between the lender and the leveraged buyout firm. Second, banks price loans to cross-sell other fee business. These effects are additive. A one standard deviation increase in both bank relationship strength and cross-selling potential is associated with an 18 basis point (6%) decrease in spread and a 0.4 point (7%) increase in the maximum debt to EBITDA covenant. This translates approximately to a 4 percentage point increase in equity return to the leveraged buyout firm. The benefit of these terms is economically significant both in the context of mean equity returns of 17% and relative to previous studies' estimates of leveraged buyouts' risk-adjusted performance ranging from 2% to negative. To the best of our knowledge, this is the first paper to analyze the importance of leveraged buyout firms' bank relationships and provide evidence of favorable leverage terms.

Keywords: private equity, leveraged buyouts, bank debt, relationship banking

JEL Classifications: G20, G21, G23, G24, G32

Working Paper Series