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* Academy of Management Journal 19(15. Vol. 38. No. 3. 704-739.

PHILLIP H. PHAN York University CHARLES W. L. HILL University of Washington
This article reports the results of an ex post study of tbe effects of leveraged buyouts (LBOs) upon tbe goals, strategy, structure, and performance of firms. Our study was designed lo test arguments that can be logically derived from agency theory. We used a survey to collect data on pre- and post-LBO goals, strategy, structure, and productivity for a sample of 214 firms that underwent buyouts between 198ti and 1969. Our results do not enable us to reject hypotheses hased upon agency theory.

One of the most notahle trends of the 1980s was the explosion in leveraged huyout activity; the total value of leveraged buyouts (LBOs) exceeded $250 hillion in the 1980s. A leveraged buyout involves a swap of equity for debt. The group undertaking an LBO typically raises cash by issuing bonds and then uses that cash to buy the firm's stock. In effect, in ail LBO a firm replaces its stockholders with bondholders and. in the process, transforms the firm from a public to a private entity. Although the boom in such activity is now largely over, debate still rages as to the competitive consequences of LBOs. Some authors have claimed that the high level of debt associated with a buyout forces firms to cut needed capital and R&D investments in order to service debt payments, thereby damaging their long-run efficiency and competitive position (e.g.. Reich, 1989). Others have used agency theory to argue that LBOs improve firm efficiency (e.g., Jensen, 1986. 1988). Currently, researchers lack the empirical evidence required to make a strong judgment with regard to the impact of leveraged buyouts on efficiency (Jacobs. 1991). Although a number of ex ante event studies of buyouts have been undertaken, they only offer evidence as to expected consequences, as measured hy the stock market's reaction to buyout announcements (e.g.. DeAngelo, DeAngelc, & Rice. 1984; Madden, Marples,
We would like to thank Michael Hitt and the two anonymous reviewers for this journal for their very helpful coinmeiit.s on and Ihuughtful analyses of a previous version of this article.


Phan ond Hill


& Chung, 1990). Although these studies suggest that LBOs do increase efficiency, as predicted by agency theory, such a conclusion must be tempered by the fact that expectations do not always match outcomes. Given the very real possibility thai LBOs might lead to a decline in efficiency, there is a need for ex post studies of the relationship hetween a leveraged buyout and the efficiency of an enterprise (Palepu 1990). Such studies are now beginning to appear (Kaplan, 1989; Kaplan & Stein. 1993; Lichtenberg & Siegel, 1990; Liebeskind, Wiersema, & Hansen, 1992; Long& Ravenscraft, 1993a, 1993b; Seth & Easterwood, 1993; Singh, 1990), and they have generated mixed results. For example, the work by Lichtenberg and Siegel indicates that LBOs realize efficiencies and productivity gains, but the studies by Long and Ravenscraft suggest that they lead to a long-term decline in R&D spending and profitability. Drawing on agency theory, we try herein to articulate with more precision than hitherto the mechanism by which an LBO might improve the efficiency of a firm. Although agency theorists talk about the incentive alignment effects of the increase in debt and management stockholdings associated with buyout (e.g., Garvey, 1992; Jensen, 1986), they tend to gloss over the nature of the changes in strategy and structure that are required to bring about an improvement in firm performance. We try to specify the form those changes will take.

Our reason for testing the agency theory perspective is tbat the debate about tbe efficiency effects of leveraged buyouts bas largely been waged between tbose who take an agency theory perspective (e.g., Jensen. 1986, 1988) and those who argue tbat such an interpretation is wrong and that LBOs harm efficiency (Reich, 1989). Thus, the theory is important in this context and deserves to be put through the rigors of serious empirical testing. Agency theorists argue that within public corporations a conflict arises between the goals of professional managers and tbose of stockholders (Borle & Means, 1934; Fama. 1980; Jensen & Meckling, 1976). Building on that basis, Jensen (1986) argued that a serious source of conflict between management and stockholders is the utilization of free cash flow, defined as cash flow in excess of that required to fund all investment projects whose forecasted financial return is positive wben discounted at the relevant cost of capital. Since free cash flow cannot be profitably reinvested witbin a company, Jensen argued that it should be distributed to stockholders in the form of dividends or stock buybacks. However, managers may resist distributing siirplus cash resources to stockholders and may instead invest them in growth-maximizing or empire-building projects that yield low or negative returns and involve excess staff and indulgent perquisites. Managers do this, according to agency arguments, because such investments maximize tbeir own utility (Aoki, 1984; Jensen & Meckling, 1976; Marris, 1964; Williamson, 1964).


Academy of Management Journal


According to agency theory, a number of governance mechanisms can limit conflict between managers and stockholders. These mechanisms include boards of directors, the market for corporate control, the managerial labor market, concentrated ownership, managerial stock ownership, and various incentive alignment devices such as stock option plans and golden parachutes' (Demsetz, 1983; Fama, 1980; Jensen, 1988). However, according to Jensen (1986), in firms generating significant free casb flow, such governance mechanisms are not always sufficient to attenuate the conflict between management and stockholders over the payout of free cash. In such situations, Jensen argued an LBO may be appropriate. Jensen focused primarily on the role of debt in limiting managerial discretion, noting tbat tbe debt used to finance an LBO helps to limit the waste of free casb by compelling managers to use it to service debt payments ratber than spend it inefficiently witbin the firm. Further, Jensen emphasized tbat debt motivates managers to look for efiiciencies. Tbe need to service bigb debt payments forces them to slash unsound investment programs, reduce overhead, dispose of assets that are more vahiable outside of the company, and restructure an organization to increase accountability and control. The proceeds generated by these restructurings can then be used to reduce debt to .sustainable levels, creating a leaner, more efficient, and more competitive organization. Other authors have pointed out that an LBO also frequently involves giving incumbent managers significant equity stakes in a firm (Garvey, 1992; Kaplan & Stein, 1993; Singh, 1990). Tbe result is to transform managers into owners, thereby giving tbem positive incentives to look for efficiency gains that will increase the value of their stockholdings. Thus, increase in management stockholdings may be just as important as increase in debt as a stimulus to efficiency following a buyout. By focusing upon the role of debt, Jensen presented us with a unduly pessimistic view of management, ignoring the possibility that managers will respond positively to the right kind of incentives,

Figure 1 illustrates the model tested herein. Some of the relationships sbown in Figure 1 have already been suggested in the literature (Easterwood, Seth, & Singer, 1989; Jensen, 1986). A central assumption underlying this model and built on Jensen's arguments is that prior to being bought out, LBO firms are characterized by inefficiency and waste. Consequently, there is considerable scope for improving their efficiency through proactive changes in strategy and structure. A body of empirical work indicating that LBO targets are characterized by higher cash flows, lower growth prospects, and greater inefficiencies than firms that remained pub-

' Golden paracbutes are severance contracts tbat bandsomely compensate top-level managers for the loss of tbeir jobs in tbe event of a takeover.

1987. The model includes direct and indirect effects. reduction in scope will occur as the firm divests itself of diversified activities and refocnses on its strategic core. Singh. One postulated indirect effect is that the change in governance structure that follows an LBO— as captured hy the increase in management holdings and deht—will lead managers away from an emphasis on growth goals and toward efficiency goals. Since the model does not fully specify all mediating variables. 19B9.1995 Phan and Hill 707 lie supports this assumption (Lehn & Poulsen. FIGURE 1 Impact of Strategy and Structure on Post-LBO Firm Perfomance Increased Emphasis on Efficiency Goals Increased Decentralization Increased Management Holdings Increased Debt Decreased Diversified Scope Increased Performance Decreased Hierarcbical Complexity Decreased Empbdsis on Growth Goals I Direct Effects (Hypotbesized) Indirect Effects . we expected that significant effects would he left uncaptured by the variables addressed in this study. Maupin.The model also predicts increased decentralization and decreased hierarchical complexity as management pushes operating responsibility to lower levels in an attempt to increase profit accountability. . These changes in strategy and structure are all predicted to have a beneficial effect npon firm performance. Specifically. This change in emphasis leads to changes in the strategy and structure of the firm. Thus. the model specifies a number of direct effects between (1) the changed governance structure and firm performance and (2) the change in goal emphasis and performance. 1990).

market share. 1964.708 Academy of Management Journal June Increased Management Holdings By definition. Consistent with tbis argument are Garvey's (1992) and Singh's (1990) findings that in most LBOs management stockholdings increase. 1991). To the extent that the value of a firm's equity reflects its potential for creating longterm efficiency gains. 19B6. Jensen & Meckling. Because of tbese increases. as was noted. agency theorists mean increases in both debt and management stockholdings. Alternatively^ if efficiency maximization has priority. 1984: Fama. Most LBO sponsors. Tbe implicit argument is that the main components of managerial utility are status. Hypothesis 1: Following a leveraged buyout. bowever. be expected to emphasize profitability. a leveraged buyout is associated with an increase in debt. An increase in management stockholdings is not. casb flow. theorized to be a function of firm size. subject to tbe firm's achieving a satisfactory level of profit. and job security. Tbis is an important point because it addresses a major criticism of free cash flow tbeory—that an extreme debt load forces managers to make cuts tbat lead to sbort-term gain but cripple long-term efficiency (Jacobs. Impact of an LBO on Corporate Goals A central assertion of agency tbeory is tbat tbe change in tbe governance structure of a firm that accompanies an LBO motivates managers to look for efficiencies. 1986. 1976. 1980. 1992. Marris. power. 1993). 1980). 1988. and the like (Aoki. an agency perspective suggests that managerial ownership of a leveraged firm's equity may help ensure that managers maintain a long-run focus. managers can. 1990). Nonetbeless. Thus. 1964). after an LBO tbe goals of top managers sbift from those consistent with growtb maximization toward those consistent with maximizing firm efficiency (Garvey. 1989. researcbers have argued that in most cases an increase in management stockholdings accompanies an LBO (Garvey. income. Jensen. Tully. Kaplan. . Thus. By change in governance structure. Williamson. unless tbe buyout was undertaken by management. tbe proportion of equity held by management will increase. The managerial hegemony and agency theory literature thus suggests that under a pre-LBO governance structure. Firm size is in turn maximized by emphasizing growtb in sales and market sbare. 1992. Singh. insist on top managers taking a significant equity stake in a firm. 1988). Hypothesis 2: Increased debt will be associated with an increased emphasis on efficiency goals. automatic. as principals in the relationship with managers and as major stockholders in the post-LBO firm. and the like (Jensen. after a leveraged buyout. The logic is that managers' stockholdings align their interests witb those of tbe principals (Fama. managers will emphasize sales growtb. at least in the context of an LBO.

If tbat is Lhe case. begs the question of causality. and Jacobsen (1988) suggested that the market share effects found in PIMS studies are spurious and due to failure to control for unobservable factors. is not clear-cut. Hypothesis 4: Increased management stockholdings will be associated with an increased emphasis on efficiency goals. Hypothesis 6: After a leveraged buyout. market share effects disappear. Work on the Profit Impact of Market Strategies (PIMS) database seems to suggest a positive correlation between market share and firm performance (Buzzell & Gale.1995 Phan and Hill 709 Hypothesis 3: Increased debt will be associated with a decreased emphasis on growth and market share goals. Jacobsen and Aaker (1985). The issue. 1985. evidence supports the PIMS position (e. Scherer. however.g. 1980). 1990. empirical work using refined statistical techniques has contradicted it: Rumelt and Wensley (1980). Does an emphasis on efficiency give rise to market share. The changes in governance structure that accompany an LBO are argued to give managers an incentive to reevaluate diversification moves and to look for assets that might he sold off or closed down. 1987). Marris. a counterargument should he recognized. 1964. At this point. Hypothesis 5: Increased management stockholdings will be associated with a decreased emphasis on growth and market share goals. Once these are controlled for. increased emphasis on efficiency goals will be associated with a reduction in the diversified scope of a firm. Kohli. and Venkatraman (1986) and Woo (1987) found similar results. managers looking for efficiencies should not ignore market share goals but instead emphasize them. many firms waste free cash flow by diversifying beyond the point optimal from an efficiency perspective (Hoskisson & Turk. Impact of LBOs on Diversified Scope and Performance At the heart of Jensen's (1986. First. Prescott. Mueller. On the one hand.. or does an emphasis on market share give rise to greater efficiency? We suspect that the former is more likely to be tbe case. This effect might arise for three reasons. 1988) argument is the hypothesis that. the work by Buzzell and Gale (1987). 1987). the renewed emphasis on efficiency that follows a buyout and the reduced emphasis on market share and growth goals should lead managers to question the value of diversification moves made in a prior period of empire building. Hypothesis 7: Decreased emphasis on market share and . which was cross-sectional. prior to their LBOs. On the other hand. Ravenscraft & Scherer. Moreover.

In addition. Thus. the hypothesized disposal of non-value-adding diversified assets should improve performance. a reduction in the diversified scope of a firm will be associated with an improvement in firm performance. Hypothesis 10: After a leveraged buyout. reviews of . Indeed. Hypothesis 10 is largely congruent with the thrust of empirical research on the diversification-performance relationship. Moreover. Hypothesis 8: An increase in debt after a leveraged buyout will be associated with a reduction in the diversified scope of a firm.710 Academy of Management Journal growth goals will be associated with a reduction in the diversified scope of a firm after a leveraged buyout. Hypothesis 9: An increase in management holdings after a leveraged buyout will be associated with a reduction in the diversified scope of a firm. they will be motivated to sell assets and pay down debt in order to shift the capital structure of the firm away from debt. Second. Similarly. There is already a fair amount of evidence broadly consistent with Hypotheses 6-10. thereby allowing them to devote more time to increasing the efficiency of the assets that remain (Hill & Hoskisson. their increased stockholdings give managers a strong incentive to look for ways of increasing efficiency. this too should improve the performance of the firm. Thus. as often occurs after a number of years. thereby increasing the value of their equity holdings. Moreover. If a firm suhsequently relists its stock on the equity markets. Thus. Other things being equal. reduction in scope will reduce the information-processing demands on top management. to the extent that managers increase their stake in the equity ofthe firm after an LBO. 1988) suggested. managers can reap stibstantial gains from any increase in the value of the firm's equity achieved while it was leveraged. Seth and Easterwood (1993) found that after management buyouts. Third. In general. one of Jensen's main arguments is that the need to service high debt payments forces management to sell off assets acquired through empire building and to focus its attention upon improving the efficiency of the businesses that remain. firms did refocus their activities toward core sets of related businesses. as Jensen (1986. This trend was particularly notable for the more extensively diversified unrelated firms in their sample. since tbat will ultimately increase the value of their equity stakes. the need to pay down the debt associated with an LBO may motivate managers to divest diversified assets in order to raise capital. 1987). If many leveraged firms previously engaged in unprofitable diversification. Liebeskind and colleagues (1992) found some evidence of post-LBO downsizing.

Huber. Hill & Pickering. Put another way. Similarly. Thus. particularly of tbe unrelated variety. target firms are characterized by organizational waste and inefficiency (Fox & Marcus. the result should be more effective decision making. Giving lower-level managers and workers more responsibility increases tbeir job satisfaction. 1992. departments. Miller. wbich in turn implies better use of resources and improved efficiency. or any form of on-tbe-job consumption and reduces the need for top managers to conduct costly extensive information searches and time-consuming audits (Alchian & Demsetz." shirking. 1980). Underlying this theme is tbe belief that prior to LBOs. which makes it more difficult for individuals to indulge in "free riding. Indeed. Increased decentralization. 1990). in longitudinal work. We argue that after an LBO managers will attempt (1) to achieve greater decentralization and (2) to reduce hierarchical complexity. 1986. Such waste might exhibit itself in a high number of employees. Ramantijam & Varadarajan. Singb. improves their performance. management undertakes changes in organizational structure tbat boost organizational efficiency. sucb as work groups. 1990. 1989). 1972. Decentralization will increase for three reasons: First. 1990). can improve efficiency in a number of ways (Cbild. 1984. 1984). decentralization can be viewed as a strategy for tigbtening control witbin an organization (Cbild. and overly bureaucratic internal control systems. Hill and Hansen (1991) fotind evidence that reduced diversification was positively associated with performance improvement. Markides (1992) suggested that a strategy of reducing diversification enhances stockholder wealth. and performance (Hoskisson & Hitt. it allows individuals who are close to operations and the market to make decisions. the shift toward efficiency seeking tbat has already been argued to accompany an LBO can be expected to result in managers . a large bead office staff. Decentralization. Third. theme in Jensen's theory is the idea tbat afler a leveraged buyout occurs. First. Quasi-autonomous subunits.u 1995 Phan and Hill 711 this large body of research have suggested a negative relationship between extensive diversification. and divisions can be controlled by monitoring their output and holding members accountable for poor performance (Oucbi. Williamson. we postulate that decentralization will increase and will have a positive effect upon performance. although underdeveloped. 1984. 1975). In so far as sucb individuals are better informed than managers further up in a hierarchy. decentralization has long been argued to have beneficial motivational effects. 1984). decentralization increases task visibility. one might expect that redttced diversification will have a positive impact on firm performance. After an LBO. Jones. Impact of an LBO on Structure and Performance A strong. & Glick. end thus can be expected to improve tbe performance of a firm (Cbild. one way of releasing organizational efficiencies below the level of top management. Second.

S. Only 35. Implicit in the above hypotheses is the idea that prior to an LBO. the increase in management stockholdings that has been argued to accompany an LBO gives managers another strong incentive to look for ways of increasing efficiency. Moreover. Similarly. particularly highly diversified firms. in reality it may not always he the case: some LBO firms may already be very decentralized. there will be less scope for increasing decentralization and thus improving performance. and Hoskisson (1992) found a correlation of only . diverse firms in Hill's sample employed an M-form. In such firms. the increase in debt that accompanies an LBO also gives managers an incentive to look for ways of boosting efficiency. it follows that such "centralized multidivisionals" might encompass scope for ftirther decen- . after a leveraged buyout. At the same time. Second. To take these effects into account. Hypothesis 12: Decreased emphasis on grov\'th goals will be associated with increased decentralization. we should note that there is evidence to suggest that not all large diversified firms are highly decentralized. Hypothesis 15: Increased decentralization will be associated with an improvement in performance. Any efficiency gains achieved through decentralization will improve performance and allow the firm to better service its debt payments. Hitt. and a further 21. This correlation suggests that the two variahles shared only about 9 percent of their variance. Williamson (1975) wrote that many large. Hypothesis 13: Increased debt will be associated with increased decentralization. we controlled for prior level of decentralization in hypothesis testing.28 between the extent of unrelated diversification and the degree of decentralization in a sample of 184 large U. 1988) argument.712 Academy of Management Journal June looking for ways to boost efficiency. This idea is consistent with the spirit of Jensen's (1986. diversified firms are likely to be operating with a decentralized M-form structure. companies.2 percent of the large.4 percent were "centralized multidivisionals characterized by head office involvement in operating decisions" (1988: 72). hut Hill and Pickering (1986) and Hill (1988) noted considerable variation in the extent of decentralization within multidivisionals. implying considerable room for tbe existence of relatively centralized unrelated diversified firms. and increasing decentralization presents itself as one such option. Hill. However. Third. Hypothesis 14: Increased management holdings will be associated with increased decentralization. 1972). Hypothesis 11: Increased emphasis on efficiency goals will be associated with increased decentralization. most firms are too centralized. Williamson recognized the possibility that within some multidivisionals many operating decisions may be centralized and referred to such firms as "corrupted M-form" organizations (Williamson & Bhargava. Thus.

bierarchical complexity is likely to de- . Moreover. 1950b) seminal work. Sage.. building on Worthy's (1950a. 1987). Given tbat large middle manager cadres are expensive to maintain. resulting in a bigher "head count. there will be a tendency to add personnel and bierarcbical layers. will increase efficiency. and improvement in tbe quality of information sbould lead to better decisions. Improvement in tbe capacity of information channels should lead to more comprehensive decision making. and smaller spans of control than are optimal. The theoretical foundation for this argument can be found in Williamson's (1964) work. Cbild added that. For ail of the reasons mentioned earlier. A related way of Increasing organizational efficiencies below the level of top management is to reduce hierarchical complexity. Easterwood et al. Most important. we would expect tbis waste to exhibit itself in excessive organizational slack." a "taller" (Child. First shorter lines of communication and tbe removal of "gatekeepers" between lower and upper levels in a hierarcby should enhance tbe capacity. As with decentralization. If LBO targets are characterized by organizational waste and inefficiency. unless held in check by external competitive forces. such reduction. the shift to a flatter organization sbould result in a reduction in the number of an organization's middle managers. Scott. 1989. slow to respond to market demands. and speed of information flows (Baker & Wruck. Third. Cbild. further decentralization would be in order.Phan and Hill 7X3 tralization of operating decisions to quasi-autonomous operating units. organizations tend to add more layers ibtin necessary. 1980. More effective decision making and greater flexibility both imply better utilization of resources. organization theorists have argued that hierarchies that are taller tban necessary can be a major source of bureaucratic inefficiency (e. a sbift to a flatter organization can reinforce a policy of decentralization. so long as effective operations are not compromised.g. Hage. Similarly. Reduced hierarchical complexity. lacking in accountability. managers tend to increase the size of the departments under their control. quality. Second. A shift to a flatter organization might bring a number of efficiency gains. in wbicb he suggested tbat. Child (1984) gathered extensive empirical evidence suggesting tbat organizations bave a natural tendency to respond to the coordination problems created by growtb by adding layers to tbeir bierarcbies. 1984). freed from profit pressures. Doing away witb middle management layers forces increased accountability. tbis can be expected to increase efficiency. An improvement in the speed of information flows should increase flexibility and speed response to market demands. with regard to decentralization. 1984. For sucb firms. and capable of deliberately or accidentally stifling communication (Child.. Hierarchical complexity can give rise to a bureaucracy tbat is resistant to change. 1994) structure. If Jensen's (1986) arguments concerning organizational waste and inefficiencies witbin LBO targets are correct. they may well have adopted tbe inefficient and overly centralized Mform structures identified by Hill and Williamson. 1989. 1981).

Hypothesis 18: Increased debt will be associated with decreased hierarchical complexity. increase in management stockholdings increases the incentive to look for ways of increasing efficiency. after a leveraged huyout Hypothesis 16: Increased emphasis on efficiency goals will be associated with decreased hierarchical complexity. Hoskisson & Hitt.. & Ireland. The emphasis on financial criteria is argued to encourage dysfunctional hehavior at the di- . 1990. Hoskisson & Hitt. Hitt. 1988).g.714 Academy of Management Journal June crease for three reasons following an LBO. Another counterargument concerns the financial and strategic control thesis of Hoskisson. If that is the case. Hoskisson & Turk. In one of the most comprehensive tests of this argument. together with the resulting change in goal emphasis. Hoskisson. the increase in debt that accompanies an LBO gives managers an additional incentive to look for ways of hoosting efficiency. 1990). First. Hypothesis 20: A reduction in hierarchical complexity will be associated with an improvement in performance. neglecting strategic criteria. Hypothesis 19: Increased management holdings will be associated with decreased hierarchical complexity. We have argued that the change in governance structure that follows an LBO. when controlling their divisions. and their associates (Hitt. Hypothesis 17: Decreased emphasis on growth goals will be associated with decreased hierarchical complexity. Second. An alternative argument is that the financial strains caused by an LBO force managers to focus on short-term efficiency and to slash investments that are necessary for long-term efficiency (Reich. motivates managers to look for efficiencies. a result that again supports the short-term view. widely viewed as an index of a firm's commitment to the long term (e. 1989). reduced complexity will present itself as a way to meet a newly important efficiency goal. who have argued that large diversified firms overemphasize financial criteria. we present arguments that suggest relationships opposite to those given in the above hypotheses. Third. Some Counterarguments Before moving on. Long and Ravenscraft (1993b) found that LBOs were associated with a decline in long-term profitability. we might expect an LBO to eventually lead to a decline in firm performance. Long and Ravenscraft found that firms' R&D intensity declined by an average 40 percent after buyouts. 1988. Also. Thus. Long and Ravenscraft (1993a) looked at the impact of LBOs on R&D spending. which would seem to support the short-term argument.

wbich regres. although often large and diversified. However. Singh. we examined the impact ofthe independent variables upon a change in performance over two longer time periods. Hypothesis 1 was tested by a (-test. Model 3. we were only able to undertake this longer-term analysis for the subset of firms that continued to trade a minority of their stock or bonds on a public exchange after tbeir buyouts or that returned to the public domain several years later. and tbe changes in strategy and structure. Model 2. In addition. Such cases therefore call for increased emphasis on financial controls. Maupin. we argue that LBO targets are bloated and inefficient organizations that have been suffering from considerable organizational slack and a lack of attention to profitability. in which we regressed the change in an organizational characteristic (a measure of strategy or structure) against the change in the level of debt. our arguments suggest that the reduction in diversification following an LBO leads to an increased emphasis upon financial criteria. Lehn SE Poulsen. such as short-term profit maximization and risk aversion. and 20. Following Jensen's thesis and a growing body of empirical evidence (e. as Hoskisson and Hitt (1988) argued. one extending from one year prior to the LBO to three years after it and the other from one year prior to five years after. management holdings. for LBO firms the problem is not that financial controls are too tight. where. This model was used to test Hypotheses 2 to 5. was used to test Hypotheses 10. .g. This situation differs from that found in tbe average extensively diversified firm. these two apparently contradictory arguments can be reconciled. and goals. the change in goals. was used to test Hypotheses 6 through 9. 1990). 1989. a reduction in diversification is likely to result in less reliance on financial criteria and a greater utilization of strategic criteria. we assessed the relative importance of debt and management holdings in leading to improvement in efficiency. and 16 through 19. we thus observed three-year periods.. A solution lies in recognizing that LBO targets. whicb we refer to as efficiency goals. In model 1. 1987. primarily because they have been able to live off of their substantial free cash flow. are also inefficient. financial controls may well be too tight. In contrast. 11 through 14. In an attempt to explore the longer-run effects of LBO on firm performance. If one accepts the agency theory line of reasoning. we regressed tbe change in the goals of a firm against the change in its level of debt and management holdings.Phan and Hill 715 visional level. using a path analytic approach. but that they are not tight enough. 15. According to this reasoning. METHODS Tbe models used to test the above hypotheses compared the situation in a firm one year prior to its leveraged buyout to that existing one year after the LBO. In our view.sed tbe change in performance against the change in debt and management holdings.

a questionnaire survey presented itself as the only feasible way of collecting detailed data for a large enough sample of LBO firms to undertake statistical hypothesis testing. Standard Industrial Classification (SIC) codes put 57 percent of these in manufacturing. Some COMPUSTAT data were available for 66 firms.716 Academy of Management Journal June Data Sources Detailed publicly available data pertaining to tbe performance and strategy of LBO targets is not always available because most LBOs result in firms going 100 percent private. representing 47. insurance companies. Clayton & Dubilier. savings and loans associations. The final survey was sent out in mid 1991. such as decentralization and hierarchical complexity. financial statements. CS First Boston. Wasserstein Perella. We interviewed senior executives from tbe following: Kohlberg. Maybelline. The surveys were sent to CEOs and chief financial officers (CFOs) of the firms. We excluded banks. Tbe . Kravis & Roberts. The Marley Co. and GAF Corp. detailed information relating to internal organizational dimensions. The results of the tests for nonresponse and data source bias. The database defined an LBO as a merger deal of wbich 80 percent or more of the total value was debt-financed. 1988). Tbe construction of the survey was guided by theoretical considerations. BW/IP International. Additional private data (internal memos.survey population consisted of 450 LBOs completed between 1986 and 1989. Multiple responses were received from 17 firms whose CEO and CFO responded separately. data services. which are summarized in . The wording of questions was partly shaped by interviews and survey pretests with the CEOs of a number of LBO firms and with the general partners of a number of LBO-sponsoring companies. either because a minority of their stock or bonds had continued to be traded upon the open market. 20 percent in wholesale and retail trade. We obtained the survey population from the Mergers and Aquisitions Database supplied by MLR Publishing to Automatic Database Processing Inc. cannot be gleaned from public databases. Goldman Sachs. Survey population and response bias. or because tbey had returned to the public domain after a few years as private firms. and strategic plans) were also obtained from Levi Strauss. investment houses. and 7 percent in other industries. 16 percent in services. We also conducted pretests of the survey witb organizational scbolars.6 percent of the survey population. Thus. and Collins & Aikman. Forstmann Little. Safeway.. We received responses from 214 firms. Moreover. and real estate firms because tbeir financial statements were incompatible with those of tbe manufacturing find service firms that formed the majority of LBO targets for this period. We were able to obtain public data for 107 nonrespondent firms and used the stringent Kolmogorow-Smirnov two-sample test to determine if systematic differences existed between respondent and nonrespondent companies along key firm characteristics (Siegei & Castellan. inclusive. Survey construction.

rather than for the items themselves as we had only 17 firms to work with.69 0.lit 1995 • Phan and Hill 717 Table 1. we expected the results of this test to be generalizable to the rest of the sample.90 2. = .90 32.260 18.93 -6.7 13.64 Range 246.291 167.65 1. In our sample. As can be seen.56 3. groups. Incomplete recall may seriously confoimd the results of surveys based upon the recall of past events (Golden.6 330. suggesting strongly that the two groups were drawn from the same distribution.3 Respondents Nonrespondents " For respondents. As two individnals would not be likely to have the same type of faulty recall.66 -2. We calculated kappas for scales composed of individual items in our surveys. we compared the answers of the two respondents for the 17 firms in which two people Independently filled out the questionnaire.334.21 2. positions that at least ensured that they had full access to the pertinent data.50 8.82 3. '' All D^^ statistics were nonsignificant.78 3.817 2. To test for interrater reliability. D is the maximum deviation of tbe frequency distributions of two samples. N = 104. The construction of the scales themselves is discussed later in this section. the kappas range from a high of 1.1 298.6 3.70 0. indicating no nonresponse bias. kappa was chosen because it corrects for the chance correlation between raters and measures ratings based on categorical scales. suggested that there were no significant differences in the distributions of the respondent and nonrespondenl. The statistic tests the statistical significance of the differences between these distributions to determine if they were drawn from the same population.n Sales'Respondents Nonrespondents Employees Respondents Nonrespondents Productivity Respondents Nonrespondents ROI 0. As a check on accuracy.7 268 289 s.3 2. which TABLE 1 'i^-. m and n. 624.5 5. Data reliability. 1992).6 576. in Table 2. the most common measure of interrater agreement (Fleiss.B Skewness 1.0. good results for interrater reliability would increase confidence in the accuracy of the survey responses. An adjusted correlation coefficient that should be interpreted as a correlation coefficient.14 D ^ m.903 15. over 86 percent of the respondents held top management posts in the pre-LBO firms. As we could think of no systematic ex ante reason why these 17 companies would differ from the others.d.0 4.680.50 48.66 0.20 6.^9 56. • In millions of dollars. we used kappa (k). "^' Results of Test for Distribution Differences Between Respondents and Nonrespondents^ V'ariables Median 261.88 1. 1981: 213-237). N = 214: for nonrespondents.

75) witb a 90 percent confidence interval of 0. For tbe quantitative questions.36 2.50 0. Examples are as follows: To assess decentralization.p^q. to a low of 0. Testing tbe hypothe. whore a.44 0. from COMPUSTAT. As can be seen. 1978. With the exception of the items on changes in debt.50 0. p^.88 0.00 [k (-1.c. The Appendix gives the multi-item questions from which the scales were constructed. all of the measures were based upon scales that we constructed from multi-item questions following Cacciopo and Petty's (1982) model for construct development.and post-LBO approval of sucb matters as major investments and marketing .35 0.83.46 0.76 0.88 1. Measures The data to calculate most measures were taken from the survey. obtaining a high overall reliability coefficient of 0. diversification.64.. signifies perfect agreement between raters.50 0.be] -* niimerator/p.36 Denominator 0.gj -i.38 0.776 [p < . a kappa of greater tban 0.Numerator 0.89 to a low of .961. q.77 0. We tested but rejected the hypothesis tbat the overall kappa of 0.00 t). and performance. wben it was available. witb k as the sum of the individual k numerators divided by the sum of tbe individual k denominators.51 0.76.718 Academy of Management Journal TABLE 2 Interrater Agreement for Multiple Respondent Firms* Factors Strategic scope Hierarcbv Operational decentralization Strategic decentralization Growtb goals Efficiency goals Ovorall .^ -• denominator. k ^ 2[ad . in tbe case of the longer-term performance measures. which leads us to conclude tbat there was a high degree of accuracy. According to Landis and Kocb (1977).b.36 k 0. are the proportions of cbance expected joint ratings. We calculated overall reliability coefficient (Nunnally. Table 3 gives the bivariate correlation coefficients calculated for such data.80 indicates a level of agreement beyond chance. we found at i = 1 that z = 0.83 significantly differed from 1.s normally distributed). management boldings. and q. Data for performance measures came from the survey or..76 0.83 is not statistically significantly different from I: = 1 (i: i. we asked respondents about pre. Tbe overall kappa was . 209-212) to determine the accuracy of the two sets of data.d are the proportions of joint ratings and p^. This result is bigber than the lower limit Landis and Kocb (1977) set for excellent agreement beyond cbance. we determined the validity of our survey data by comparing tbe information provided by respondents to the same information on the COMPUSTAT tapes.H3 " N = 17.62 < J: < 1.39 0.1)1.sis that k = 0. Tbe value used to represent each scale was tbe mean score for al! items it included.0. correlations between survey and COMPUSTAT data ranged from a bigh of .44 0.

LBO preposi •LBO t-LBO r-LBO it-LBO pre. cq UJ 0} o o CD "TO J 'S* " f t S C O •3 CO Q Q U U m ft o xl M H 01 a. 1-4 ft ft o ft ft d ft sod in O ft Q Q h. .^ C Q in h. .2 3 op 0) u£ 6 o 6m cq CQ pre-1 post.LBO -LBO re-LBO 0 03 -4 •a _ XI 'i: a.Phan and HUI 719 CO a _ > * • ' ca a a a o «l CQ ' S XI .

however. (Some observers have argued that such estimations are inflated in any case since it is in the interests of the target to overestimate its value.) Tbe data were obtained from respondent reports of the percentages one year before and one year after the LBO. The multi-item questions were designed to elicit specific response patterns. The change in management stockholdings was measured as the difference between the ratio of the value of management-owned shares or share equivalents (sometimes referred to as "shadow stock") to total capitalization (total debt plus total equity) one year after and one year prior to an LBO.50 were excluded from the construction of scales to remove ambiguity. Change in management holdings. We used total capitalization ratber tban total equity since a majority of equity is swapped for debt in a leveraged buyout. To assess hierarchical complexity. the magnitude ofthe increase does vary significantly from case to case. Finally. the number of corporate human resotirces managers and the firm's size relative to its competitors'. so any residual must be included to account for the total value of a firm at the time of a buyout. we generated normal probability plots and histograms that confirmed that the variables were distributed normally. 5. Change in performance. All scale coefficient alphas were . Factor analysis was applied to each multi-item question to confirm that the actual response patterns were in accordance with expectations.720 Academy of Management JoumaJ June strategy decisions. and 6). We used labor costs ratber than number of employees as the denominator in order to . the factors had eigenvalues greater than 1. We decided to use this measure instead of total market value (although the latter conceptualization of firm value is richer) because error in estimating the correct discount rate will compound any unreliability inherent in the estimation of book value at the time ofthe buyout.70 or greater (Tables 4. we used total debt to reflect these facts. Thus. we asked about change in. Items that loaded on more than one factor or that loaded lower than 0. In many instances. Labor productivity was measured by earnings before interest and tax (EBIT) over total labor costs. Change in debt. Previous researcb on leverage has focused on long-term debt. Overall. Not all firms withdraw 100 percent of their equity. such a foctts may be misleading because a portion of tbe debt structure may consist of very short-term (3-6 month) bridge loans. the strategic decisions regarding downsizing may be driven by these loans as much as by long-term debt obligations. We used a productivity measure to capture performance primarily because changes in productivity are likely to show up sooner than changes in profitability.0. It is also important to note that although all LBOs involve an increase in debt-to-equity ratio. and visual inspection of the individual scale scree plots confirmed the loadings were appropriate. In tbe case of LBOs. for instance. Change in performance was measured by the difference between tlie labor productivity of a firm one year after and one year prior to its LBO. The cbange in debt was measured as the difference between the total debt-to-equity ratio of a firm one year after its LBO and one year prior to it.

This scale contained seven items: the number of hierarchical levels in a firm. and tbe number of departments. We then measured change in diversified scope as the absolute cbange in the valne of the Herfindabl index between ( . tbe number of employees in the corporate personnel department. Change in decentralization. thus covering four. 1986. the number of departments in the executive office. Change in goals. tbe number of staff employees. data on 58 firms were available for tbe tbree-year measure. ROS was used rather than ROI or ROE since equity is typically reduced drastically in an LBO firm. We constructed two scales to measure the extent of decentralization witbin a firm (see Table 6). Two scales measured the goals of a firm (see Table 4). Tbe first scale contained two items. The change in emphasis on different goals was then calculated by subtracting the one-year-prior score from tbe one-year-after score. measur- . a high. the number of levels in the corporate personnel department. 1984. which contained three items—profitability. The second scale. To account for effects not captured by productivity changes. Tbe data were extracted from COMPUSTAT for tbe firms remaining in tbe public domain. Tbus. and data for 33 firms were available for tbe fiveyear measure. defined as EBIT/total sales. positive result on efficiency goals would tell us that efficiency goals became more important to a firm after its LBO. We looked at the difference between the performance of a firm one year prior to its LBO. Crilicbes. The long-run change in performance was also measured using productivity and ROS data. Hill & Sneli. and three and five years after. We entered these measures in separate regression equations to test for tbe persistence of short-term performance improvements. We measured tbe change in tbe diversified scope of a firm using a Herfindahl index of diversification. profit growth. A negative score indicated a decrease in hierarchical complexity (see Table 5). Change in hierarchical complexity. One scale. defined as Diversification.1 and t + 1. tbe greater tbe importance of these criteria as goals. is the share of firm i's total sales from tbe /th four-digit SIC industry group. for example. = where (is the year of firm i's LBO and S. Change in diversified scope. The survey data allowed us to calculate a value for each scale for one year prior to an LBO and one year after it.and six-year periods. The data required to calculate this measure were from the survey.1995 Phan and Hill 721 account for variations among firms' salary structures (Clark. Tbe higher the score on this scale. 1989). and cash flow— measured efficiency goals. sales growtb and market share. we also measured the change in return on sales (ROS). the average number of managerial levels in operating companies. We refer to this scale as measuring growth goals.

093 .308 -. production decisions. buying decisions.145 . ing the extent to which operating decisions were decentralized.823 .21 Post-LBO Efficiency Growth JHB jm . be enhanced by involving lower-level managers wbo can better interpret opportunities and threats that are salient to corporate strategic decisions hecause of their day-to-day interaction with the environment.17 .678 . the argument here is that after an LBO. The effectiveness of such decisions may.557 .814 .802 .764 1.7Cffi . marketing strategy. i Results of Confirmatory Factor Analysis for Change in Goals" Items Profitability Profit growth Cash flow Market share Sales growth Alpha EigenvaluH Pre-LBO Efficiency Growth . strategic decentralization.685 . acquisition strategy. and decisions regarding financial goals.722 Academy of Management Journal TABLE 4 -. The second scale.765 1.034 -. Changes in decentralization were calculated in the same way as the cbange in goals. and business unit strategy.543 . there is a shift toward ''^ TABLE 5 Results of Confirmatory Factor Analysis for Change in Hierarchical Complexity Items Levels in IIRM department Corporate HRM personnel Levels in whole Departments in executive office Departments in whole firm Staff employees Levels of unit management Alpha Hierarchy .057 .868 . with higher values indicating higher decentralization.32 -. however. contained four items: strategic decisions. pricing decisions. product mix decisions.610 .t^ . capital investment decisions.764 2. The strategic decentralization scale used here captures the extent to which corporate decisions are shared with lower-level managers after an LBO. contained seven items: advertising decisions.B32 .054 .076 .797 .873 firm .013 «78» l. measuring tbe extent to which strategic decisions were decentralized.SO " Boldface indicates items that loaded on factors.S91 .832 .097 . It may seem unlikely thai corporate strategy decisions will he decentralized to operating divisions after an LBO because sucb decisions are the preserve of a firm's corporate head office.

Tbe industrial organization literature suggests that tbe attractiveness of the industry in wbicb a firm competes often dictates its performance (Porter. .56 .075 .788 2. Control Variables First.218 .120 . we used pre-LBO size as a proxy for degree of hierarcbical complexity.813 .871 . TABLE 6 Results of Confirmatory Factor Analysis for Change in Decentralization^ Items Advertising decisions Marketing strategy Production decisions Pricing decisions Buying decisions Product mix decisions Business unit strategy Overall firm strategy Acquisition strategy Major investment decisions Major financial objectives Alpha Eigenvalue Pre-LBO Strategic Operating .15 " Boldface indicates items that loaded on factors.207 . We also controlled for change in firm size.204 -.875 .48 .Phan and Hill 723 more participative decision making with regard to acquisitions. and diversification that existed in a firm prior to its LBO.98 -.270 . hierarchical complexity.1)18 . we also used changes in the profitability and productivity of a firm's primary four-digit industry to control for the effect of systematic industry-wide influences on firm performance.and eight-firm industry concentration at the four-digit SIC level and including it as a control variable in our analyses.374 6.764 .766 .SIS .722 .924 5.089 . but controlling for bierarchical complexity was more problematic because the survey simply asked respondents to indicate the change in hierarcbical complexity tbat accompanied tbe LBO and did not solicit data tliat enabled us to measure tbe absolute level of bierarcbical complexity one year prior to an LBO (see the Appendix). the data came from the COMPUSTAT Business Segments Database. To get around this limitation. we controlled for the levels of decentralization.289 .799 . and the like.750 . measured as number of employees.588 .258 .797 2.182 .287 .019 .672 .266 .280 -.223 .791 .764 .752 .1S4 .276 . 1980). Controlling for decentralization and diversification was relatively straightforward because tbe survey instrument collected relevant information. We allowed for industry effects by measuring the cbange in four. capital investments.286 -.801 .BIB Post -LBO Operating Strategic . Similarly.778 .728 .773 .131 .145 .71S JWl .824 .

10]. indicating support for Hypothesis 1 (p < . Consistent with Hypothesis 11. This result held when decentralization was measured by operating decentralization (p < .724 Academy of Management fournal RESULTS Table 7 reports correlations and summary statistics. an increased emphasis on efficiency goals was weakly associated with a reduction in scope (p < . Consistent with Hypothesis 2. We regressed the changes in debt and management stockholding against the changes in emphasis on efficiency and growth goals.01). although this result only held for strategic decentralization (p < .05) and strategic decentralization (p < . Hypotheses 11 through 14 deal with the impact on decentralization of changes in debt. . on the average. management holdings. This association is not a trivial finding because it demonstrates owners' cognizance of the agency problem and an a priori attempt to address it. As Hypothesis 14 predicts. 11 through 14. mean management stockholdings increased from 14. and 16 through 19. We did not find any evidence that a decreased emphasis on growth goals was associated with a decrease in diversified scope. Table 9 reports the results of tests of Hypotheses 6 through 9. management holdings. scope. Nor was there any evidence that increased debt was associated with a reduction in scope. and size. the results suggest that a change in strategic goal emphasis does take place after an LBO. and goals on diversified scope.01) and a decreased emphasis upon growth goals (p < .01).01} but not when it was measured by strategic decentralization.61. We found that. Hypotheses 6 through 9 deal with the impact of changes in debt. so Hypothesis 8 is not supported. consistent with Hypothesis 9. so Hypothesis 13 received some support.01). an increased emphasis upon efficiency goals was associated with increased decentralization. there was evidence that increases in management stockholdings were associated with a reduction in diversified scope (p < . Hypothesis 1 was tested by a (-test. The f-statistic for the difference between means was 6.01). a decreased emphasis on growth goals was associated with increased decentralization. so Hypothesis 7 is not supported. and goals. increased debt was associated with increased emphasis on efficiency goals (p < . increased management stockholdings were associated with an increased emphasis upon efficiency goals (p < . Consistent with Hypothesis 12. Consistent with Hypothesis 6. consistent with Hypotheses 4 and 5. Table 8 reports results of the tests of Hypotheses 2 and 5. Previous studies that ignore this aspect of the post-LBO situation may have missed an important explanatory variable.2 to 35. We found no evidence that increased debt was associated with a decreased emphasis on growth goals.000).05). Increased debt was weakly associated with increased operating decentralization (p < .10). However. in which we controlled for pre-LBO diversity.7 percent after an LBO. so Hypothesis 3 is not supported. Thus. However. increased management holdings were associated with both increased operating (p < .

1995 Phan and Hill 725 OC .

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324 0. Hypothesis 15 was confirmed when the dependent variable was the change in productivity [p < . changes in the levels of debt and management holdings were not related to change in hierarchical complexity. Table 10 reports results of the tests for the performance hypotheses (Hypotheses 10. We found no evidence that an increased emphasis on efficiency goals was associated with reduced hierarchical complexity.01) or the change in profitability (p < .66'** 0.66** 3. Support for Hypothesis 10 must be tempered by this fact.001 Hypotheses 16 through 19 deal with the impact on hierarchical complexity of changes in debt.72'* 4. so Hypothesis 16 was not supported.162 214 ' D. which predicts that increased decentralization will be associated with improved firm performance.01) and profitability (p < .211 214 Change in Emphasis on Growth Goals Independent Variables Change in debt Change in management holdings F Adjusted fi^ P -0. There was support for Hypothesis 15.001). We found some support for Hypothesis 10.01) but found no support when it was the change in productivity. increased debt and management holdings have both direct and indirect impacts upon firm performance.072 -0.05). Given the curreut findings and the secondary role accorded to managerial ownership in previous LBO studies. There was support for Hypothesis 20.06** N "*p<.10). with reduction in hierarchical complexity associated with performance improvement for both change in productivity {p < . fol- . we considered it important to explore the relative strengths of these effects. Decreased emphasis on growth goals was associated with reduced hierarchical complexity (p < .01 '**p< .81*** 0. which predicts that a reduction in diversified scope will be associated with performance improvement when the dependent variable was change in profitability [p < . so Hypothesis 17 was supported. and 20). In our model [Figure 1). However. it did not hold when decentralization was measured by operating decentralization and the dependent variable was the change in profitability.tn 4. 15. However.05).381 9. We did so by means of a path analysis. management holdings. and goals.366 13. When decentralization was measured by strategic decentralization.1995 Phan and Hill 727 TABLE 8 "• Results of Regression Analysis for Goals Change in Emphasis on EfUciency Goals t P 0. so Hypothesis 18 and 19 were not supported. This result also held when decentralization was measured by operating decentralization and the dependent variable was the change in productivity (p < .

S P -^ . d) a> ' ' ' a> DO OO oo DO OT to a O C P p C <0 O (D ~- U U C tj < J .PB 0! eo a. R u C a.g -° s ic o 6.728 Academy of Management Joumal June n e _o '"5 c 6 «H Cn Q "to . 00—1 CM o o o o o I I I CA 0) BO 01 0 O PA «4-l o (fi d d d d d 00 fl B U M . 1^ ^ ^ OOO nO !c tn O 2 <" ^ • a G G V V V V CQ CQ CQ ^ CQ ^ J J J " J -^ fl flj a. O JS Q u I I C c — o 00 a: n u T3 — c • ^ B n (D t CO d 1 d d d d d 1 o o o « in o tM i n T-4 T-l B u a.

and performance of an LBO firm.343 0. & Brett.97 1. 1982). with the change in debt accounting for the remainder.239 -0. rather than increase in deht.71 0.04 1.95** 2.09* 2.35 1. we recomputed the regression analyses reported in Tahle 10 using performance data for three and five .75*** 214 t 2.92" 3.083 0. The change in management holdings accounts for 69. increase in management holdings.92* 2.28*** 1.028 0.019 -0.20 0.25 0.05 **p<. Mulaik. has the more important impact upon the goals.463 0.042 0.302 -0.07* 3.89 2.211 -0.33*' 4.91 0.40 0. on the average.38* 5.71 0.751 0.099 -0.352 -0. management holdings have a larger impact than deht upon change in performance.322 2.73 0.011 0.3 percent of the explained variance in profitahility.094 -0.07"* 1. summarized in Tahle 11.and Hill 729 TABLE 10 Results Regression Analysis for Performance Change in Productivity Independent Variables Pre-LBO size Pre-LBO diversified scope Pre-LBO operating decentralization Pre-LBO strategic decentralization Change in size Change in 4-finn concentration ratio Change in 8-Rrm concentration ratio Change in industry profitability Change in industry productivity Change in debt Change in management holdings Change in efficiency goals Change in growth goals Change in operating decentralization Change in strategic decentralization Change in hierarchical complexity Change in diversified scope Adjusted R^ F N Change in Profitability P 0.84** 214 0.566 0.52 2.149 0. We then decomposed the variance in firm performance hrotight ahout hy a change in deht and management holdings into direct and indirect effects.045 0.38 0.373 0.262 -0.27** +p < . we assumed coefficients not significant at the 5 percent level or hetter to he equal to zero and excluded them from the final estimation of path coefficients.001 lowing the theory-trimming approach (James.75 0.07 1.31*** 0.045 0.13 0.71** 0. Finally.60 0.095 -0.245 0.035 0.10 0.186 0. show that when both direct and indirect effects are considered.448 4. strategy.343 -0.119 -0.10 *p < .101 -0.6fl** 1.70+ 2.113 0.102 -0. structure. to assess longer-term effects.267 -0.01 ***p< .23a 0. The results of this exercise.193 0. This result suggests that.5 percent of the explained variance in productivity and 74.

industry performance.218)(.343)-(-(.218)(.2n2)(..366(. However.319 .343) + (.366(. This conclusion is consistent with event study evidence (DeAngelo et ah.381) Debt and productivity Debt and profitability (-. Second. Results.373) . diversified scope and hierarchical complexity diminish.281)(. Efficiency receives more emphasis. and firm size) account for much ofthe variance.202) (.262) + (-. Third. these changes in goals. are less supportive ofthe performance hypotheses than the results reported in Table 10. and structure foster greater efficiency.13)(-. LBOs are associated with an increase in management holdings. and structure than deht.343) + (. in addition to an increase in debt. 1989. Figure 2 summarizes results. hut we did find some limited evidence in support of Hypothesis 15: an increase in strategic decentralizalion was associated with an improvement in productivity five years after an LBO (p < .728 Management holdings and profitability 0 .324(. 1984.262) + (.245 . as demonstrated by increases in productivity and profitability. As was noted. a comparison of the size of tbe betas reveals that the control variables (industry concentration. On the hasis of these results. the results derived from this exercise are still instructive.262) . Lieheskind el al. Fourth.343) 0 . management holdings seem to have a greater impact upon goals..324)(-. these data were only available for small subsamples. 1990) and with other ex post studies of LBO performance [Kaplan.366)(-. We did not find evidence in support of Hypotheses 10 and 20. the change in governance structure that occurs with an LBO does affect firm goals.730 Academy of Management Journal June TABLE 11 Summary Decomposition Table Bivariate Relationships Management holdings and productivity Direct Effect . whose beta weights may be unstable. strategy. and decentralization increases.218)(.144)(. as hypothesized. and structure. reported in Table 12.187)(-. strategy. 1992.01). DISCUSSION AND CONCLUSIONS In sum.267) + (-. Although the variance explained by all four models was high. Madden et al.566 Indirect Effect .38l)(-.343) + (-. which suggest the following: First. Ravens- .146 years after the LBOs.324)(.428 + (.324(. strategy.343) Total Effect .381)(. and growth less emphasis.239) + (.31) (.13)(-.343) + (-.366l(. we cannot reject either the free cash flow or agency theory assertions tiiat leveraged buyouts lead to an increase in enterprise efficiency.343) + . 14 of the 20 hypotheses received some support.239} + (.

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However. which suggests that both the level of R&D investments and the profitability of LBOs tend to decline over the long run. Decreased Emphasis on Growth Goals H17 craft. Taken together. a reduction in complexity and scope. and an increase in decentralization. 1993a. Our study also suggests tbat Jensen's (1986) exclusive focus upon the importance of debt in the LBO process may be misplaced. Such a pattern may be interpreted as supporting those who claim that LBOs have a damaging impact upon the long-term performance of the firms involved. Table 12 does not reveal much in the way of a positive impact either. The results reported in Table 12 suggest that the performance impact of an LBO is far less dramatic over longer time periods. 1993b: Singh. Our work shows with greater precision than previous research has employed where this performance improvement might be coming from—a change in goals. tbe failure of most of the positive performance effects identified in Table 10 to hold up over a longer time period should set off some alarms. 1990). Although we cannot say for sure whether post-LBO firms suffer from myopic shortterm behavior. We not only .732 Academy of Management Journal )tme FIGURE 2 Summary of Results H2 Increased Emphasis on Efficiency Goals H4 Hn Hi 4 Increased Decentralization H15 Increased Management Holdings HI Decreased Diversified Scope H12 HIO Increased Performance Increased Deht Decreased Hierarchical Complexity H20 nr. It is also roughly consistent with the work of Long and Ravenscraft (1993a. as tbeir detractors claim. neitber can we deny this possibility. only to decline somewhat thereafter. which generally suggest that LBOs do lead to an increase in efficiency in the short run. 1993b). Although we found no evidence that LBOs actually decreased performance over the longer term. the two sets of results suggest that performance improves immediately following an LBO. Further studies of the long-run impact of LBOs will have to be undertaken before this issue can be resolved.

nor was Hypothesis 18. as they suggest a direct association between management holdings and performance three and five years after an LBO. when no association existed one year after the event. Another cautionary point concerns the accuracy of our variahle mea- . Moreover. Our study is vulnerable to all of the standard criticisms leveled at studies that use survey data. survey data were the only way to test the hypotheses for a large sample of Firms. concerning social desirability effects. Second. which links increased deht to decreased hierarchical complexity. This pattern of results again suggests that increases in debt may be les. rather than the increase in deht.Phan and Hill 733 found that LBOs are associated with marked increases in management stockholdings. We have two replies to this potential criticism. we were careful in constructing the survey. Like Hypotheses 3. which predicts an association hetween increased deht and increased decentralization. The long-term regression analyses for performance seem to point to this conclusion. was only weakly supported. hut in the long run the changes associated with management stockholdings may have the most enduring impact upon firm efficiency. inherent amhiguity. and nonresponse bias. was not supported. Although these variables were weakly correlated. Hypothesis 8. First. that was correlated with substantive changes in strategy and structure (see Figure 2 and Tahle 9). In closing. It is notable that it was the increase in management stockholdings. are incorrect. In contrast. Alternatively. it would seem that the variance here was captured by the change in efficiency goals. increased debt was not associated with a reduced emphasis on growth goals (Hypothesis 3).s important in hringing ahout changes in the strategy and structure of firms that have experienced leveraged buyouts than increases in management stockholdings. One possihle explanation for this pattern is that our measure of hierarchical complexity wasn't discriminating enough to pick up the required effects. 8. a few words of caution are appropriate. hut also that this increase may he just as important as the increase in debt for explaining suhsequent efficiency gains. Moreover. it is possihle that the theoretical arguments. checking the reliability of both recall and accuracy. three other hypotheses found no support: A decreased emphasis upon growth goals had no impact on diversification (Hypothesis 7). much of the effect of deht upon firm performance was direct. as reported earlier. consulting with those involved in LBOs and pilot-testing with a small sample before settling on a final design. common method variance. which links increased debt to reduced diversification. We also found no evidence that an increased emphasis on efficiency goals led to a reduction in hierarchical complexity (Hypothesis 16) or that increased management holdings led to a reduction in hierarchical complexity (Hypothesis 19). hut Hypothesis 13. and 18. We are thus as confident as is possihle that our survey measured what it was intended to measure hut also recognize that social desirability effects may hias our sample toward better performers. we conducted all the standard tests for nonresponse hias and reliahility. derived from agency theory. Debt plays an important role.

Similarly. In particular. however. In particular. It is worth emphasizing yet again that our strongest results focused primarily upon the short-run impact of LBOs upon firm efficiency. 1988).734 Academy of Management Journal June suring increase in deht load. we have downplayed their impact on certain stakeholder groups. which shows that the industry-adjusted performance effects of LBOs do not extend over more than three years. on the hasis of our study we have to he reticent ahout making definitive statements as to the positive long-run impact of LBOs on efficiency. we may have understated the size of the increase hecause some firms might have reduced their deht loads in the LBO year hy quick asset sales. hut there may he a numher of methodological reasons for the findings. In addition. is consistent with Long and Ravenscraft's (1993h] study. For example. This relationship would naturally hias our data in favor of better performers. other stakeholders do not reap similar henefits. LBO firms that chose to return to the puhlic markets might he systematically different from those that did not. . our conclusions are limited at this point. This lack of support. their original decision lo purchase the firm's debt is tied directly to information provided by the firm about Us riskiness. as opposed to stot:kholders. If this were the case. we think it unlikely that many firms dramatically paid down their deht levels within one year of their LBOs. one consequence of an LBO may he to destroy a firm's implicit contracts with hondholders^ and with employees outside of the senior management group {Shleifer & Summers. In an LBO. with a certain degree of implicit trust involved In the transaction. it is important to emphasize that by focusing on the impact of LBOs on firm performance. hut our data provided only very weak support for these conjectures. These results may demonstrate that LBOs' effects are short-term. We feel reasonahly confident that LBOs are associated with substantive organizational changes of the type likely in firms trying to improve efficiency. Thus. However. By focusing upon the increase in the dehtto-equity ratio of a firm from one year prior to an LBO to one year after. There is an argument that although LBOs ultimately henefit the organizations that sponsor them and the senior managers whose equity positions are dramatically increased. Employees frequently lose out hecause increased debt may reduce ^ Bondholders. which would make tbem a significant stakeholder in the LBO decision. initial public offerings are usually executed hy firms that can maximize stock price by demonstrating improved performance and strong potential for continued efficiencies. Finally. are giiaranleed their claims to lhe returns promised by the firm. the results are consistent with past ex ante and ex post research. employees wbo have invested high amounts of human capital in exchange for employment security would also have that implicit contract broken in an LBO. Although we tried to include long-run performance data in our study. In this regard. the financial risk level of a Rrm increases substantially because more debt has been issued. bondholders do not get to vote on whether the LBO deal should be done. This degrades the stability of bondholders' claims on the firm. However. our conclusion that the motivational impact of an increase in deht is not as important as Jensen suggests might he misplaced.

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"always an executive office responsibility. Y. & Bhargava. the degree the following bave cbanged 1 year AFTER the LBO:" (1 = increased hy 66-100%. Strategic Management Joumal. 8: 149-168. . A. Auerbach tEd. September 20: 38-50.]. C.. ]. London: Grey Mills. 1950b.). In A. C. 11: 111-130. A." Approving annual financial objective. Shleifer. Harvard Business Review. J. 1950a. 7 = decreased by 66-100%). 14: 251-273. Williamson. C. The real key to creating wealth. business level conduct and risk.. In K. Factors influencing employee morale.. Strategic Management Jaumal. S. S. 4 = no change." to 5. & Summers. American Sociological Review. Strategic Management Journal. New York: Free Pres. O. 1972. 15: 169-178. 1988. to the nearest percentage. Williamson. Breach of trust in hostile takeovers. N. Woo. & Easterwood. "responsibility shared with lower level managers." througb 3. 28(1}: 51-73. "never an executive office responsibility. Siegel. APPENDIX Survey Questions Decentralization "Tbese questions measure how decision making has cbanged in tbe executive office. Organizational structure and employee morale. Nonparametric statistics for the behavioral sciences (2d ed. 1\illy. 1987. New York: McGraw-Hill. Worthy. 1993. Jr. 1975.s. 1993. E. H. Strategic redirection in large management buyouts: The evidence from post-buyout restructuring activity. Cowling (Ed.sifying the internal control apparatus of the modern corporation. The economics af discretionary behavior: Managerial in a tbeory of tbe firm.). N. 1990. NI: Prentice-Hall. 1964. Englewood Cliffs. O. Chicago: University of Chicago Press. Please try to recall. E." Responses ranged from 1. 1988. Singh. E. O. I. Path analysis of the relationship between market share. Markets and hierarchies: Analysis and antitrust implications. Management buyouts: Distinguishing characteristics and operating changes > prior to public offering. Assessing and clas. Worthy.. objectives Williamson. Corporate takeovers: Causes and consequences: 33-56.s for tbe wbote firm Approving major investments Overall strategic direction of tbe firm Formulating or undertaking acquisition strategies Production decisions Buying decisions Advertising decisions Marketing strategy decisions Pricing decisions Product mix or new product launcb decisions Determination of R&D budgets Hierarchical Complexity "These questions measure the degree of cbange in organization design. L.738 Academy of Management Joumal June Seth. Market structure and corporate behavior: 125-148. Please indicate tbc degree tbe following decisions are tbe SOLE responsibility of tbe executive office BEFORE AND AFTER the LBO was formalized. Fortune. ]. & Cnsteilan.

L. and governance in interfirm alliances and networks. University of Washington. Phan is an assistant professor of strategic management at York Universily. tn particular. degree from the University of Washington in 1992.D. . H(i ructjived his Ph.IMS Phan and Hill 739 Number of departments in executive office Number of hierarchical levels in the whole firm Number of levels in corporate personnel department Numher of employees in corporate personnel department Amount of contact hetween operating companies or departments Average number of managerial levels in operating companies or departments Frequency operating companies or departments report to executive office Size of your company relative lo compelitors Number of people authorized (o make capital purchases Number of products and services sold Number of supplier contracts Number of staff (not line) employees Number of departments or operating companies Performance "The following are performance criteria a board of directors may use to evaluate executive management. His research interests center on applying economic theory to problems of business and corporate strategy. Mark the importance of each before and after the LBO was completed:" (1 = most important. his studies deal with the control and monitoring of managerial at:tion and strategic choice in post-takeover firms. top management compensalion. Charles W. Hill is a professor of strategic management at the School of Business. degree in industrial organization economics from the University of Manchester Institute of Science and Technology in England. Sales growth Profit growth Stock returns Cash flows Profitability Productivity Innovativeneas in management Market share Phillip H. 5 = irrelevant). His current research and teaching interests are in the areas of corporate governance and mergers. He holds a Ph.D.

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