A Theory of LBO Activity Based on Repeated Debt-Equity Conflicts
MIT Sloan School of Management
Boston College - Carroll School of Management
January 30, 2014
We develop a theory of LBO activity based on two elements - the ability of PE-owned firms to borrow against their sponsors' reputation with creditors, and externalities in sponsors' reputations due to competition and club formation. In equilibrium, the two sources of value creation in LBOs - operational improvements and financing - are complements. Moreover, sponsors that never add operational value cannot add value through financing either. Club deals are beneficial ex-post by allowing low-reputation bidders with high valuations to borrow reputation from high-reputation bidders with low valuations, but can destroy value by reducing bidders' investment in reputation. Unlike leverage of independent firms, driven only by firm-specific factors, buyout leverage is driven by economy-wide and sponsor-specific factors. Buyout activity decreases, while the composition of acquirers and PE firms' payoffs are non-monotonic in discount rates. Finally, adding value through financing is easier when operational improvements come from common values (e.g., poor performance of current management) rather than private values (e.g., sponsor's expertise).
Number of Pages in PDF File: 63
Keywords: Private equity, leveraged buyout, LBO, reputation, club deals, externalities, capital structure, debt-equity conflicts
JEL Classification: G23, G32, G34working papers series
Date posted: April 16, 2013 ; Last revised: January 31, 2014
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