Specialization of Private Equity Firms and Corporate Financial Distress

Abstract

We investigate the impact of sector specialization of private equity firms on the distress risk of portfolio companies as proxied by Altman’s Z-Score. Using a matched sample of 25728 firm-year observations, we find that distress risk increases through private equity backing. The effect is stronger for firms backed by specialists rather than generalists. This is because specialist-backed firms have lower distress risk ex ante. Overall, our results are consistent with a “cherry-picking hypothesis.” It suggests that specialists use their superior skills in information production to find less distressed targets, which allows them to increase risk more after the buyout.

Keywords: Leveraged buyout, bankruptcy, default risk, Altman Z-Score, industry specialization

JEL Classification: G23, G24, G32, G33, G34