A Theory of LBO Activity Based on Repeated Debt-Equity Conflicts

52 Pages Posted: 16 Apr 2013 Last revised: 8 Aug 2015

See all articles by Andrey Malenko

Andrey Malenko

Boston College - Carroll School of Management

Nadya Malenko

University of Michigan, Stephen M. Ross School of Business; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Date Written: September 1, 2015

Abstract

We develop a theory of leveraged buyout (LBO) activity based on two elements: the ability of private equity-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 they 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.

Keywords: Private equity, leveraged buyout, LBO, reputation, club deals, externalities, capital structure, debt-equity conflicts

JEL Classification: G23, G32, G34, D44

Suggested Citation

Malenko, Andrey and Malenko, Nadya, A Theory of LBO Activity Based on Repeated Debt-Equity Conflicts (September 1, 2015). Journal of Financial Economics (JFE), 117 (3), 607-627, September 2015, Available at SSRN: https://ssrn.com/abstract=2251169 or http://dx.doi.org/10.2139/ssrn.2251169

Andrey Malenko

Boston College - Carroll School of Management ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States

Nadya Malenko (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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