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Leveraged Buyouts and Financial Distress

Brian Ayash , Mahdi Rastad

PII: S1544-6123(20)30154-9
DOI: https://doi.org/10.1016/j.frl.2020.101452
Reference: FRL 101452

To appear in: Finance Research Letters

Received date: 23 May 2019

Revised date: 31 October 2019
Accepted date: 2 February 2020

Please cite this article as: Brian Ayash , Mahdi Rastad , Leveraged Buyouts and Financial Distress,
Finance Research Letters (2020), doi: https://doi.org/10.1016/j.frl.2020.101452

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 Leveraged Buyouts and Financial Distress

Brian Ayash† and Mahdi Rastad‡

October 31, 2019

Abstract
Do leveraged buyout transactions increase the chance of bankruptcy? While corporate finance
theory predicts that such sharp changes in capital structure increase financial distress costs by
raising the probability of bankruptcy, previous studies fail to measure the effect. In this letter,
we provide evidence that is consistent with the prediction of the theory. Tracking a sample of
484 leveraged buyouts and propensity score matched control firms for 10 years, we find that
these transaction increase the probability of bankruptcy for the target firm by approximately
18%.

Keywords: Leveraged Buyouts, Private Equity, Financial Distress, Bankruptcy

JEL classification: G33; G34; G38; G32; J08

________________________________________________
†Corresponding author. 1 Grand Avenue, Orfalea College of Business, California Polytechnic State
University, San Luis Obispo, CA 93407. Email is bayash@calpoly.edu. Data are available at the Ayash
Leveraged Buyout Research Database.

‡Orfalea College of Business, California Polytechnic State University, San Luis Obispo, CA
93407. Email is mrastad@calpoly.edu.

∗We thank research assistants Madeline Wilson, Austin Nall, Kennedy Whalen and Dale Chang.
1 Introduction

Our understanding of leveraged buyouts (LBOs) is expanding with the increased visibility into these

typically private transactions. However, there remains limited study of the long-term outcomes in large

samples of LBO target firms and measurement of financial distress. So while corporate finance theory

predicts that such sharp changes in capital structure increase financial distress costs by raising the

probability of bankruptcy (Merton, 1974), surprisingly there is little empirical evidence supporting these

predictions or measurement of the change in the probability of bankruptcy surrounding these transactions.

Therefore, our goal in this letter is to study long-term outcomes and measure the effect of an LBO on
financial distress, measured as the probability of bankruptcy. In our empirical approach, we compare LBO
outcomes with propensity score matched control firm outcomes for the identification of a causal effect. Our
results show a sharp contrast between the bankruptcy rate of LBO target firms and control firms. We find
that an LBO increases the probability of bankruptcy for the target firm by approximately 18%. Our research
design makes our analysis robust to macroeconomic and industry shocks and does not require private
information since outcomes are observable.

This is an important distinction in our research design and allows us to present results for a sample of

484 large public to private LBOs. For instance, in studies that use regulatory data, many LBOs cannot be

studied after the LBO because as now private firms, regulatory filings are no longer a requirement. For

example, Kaplan (1989) identifies 76 LBOs and only 48 with regulatory filings post-LBO, while Ayash

and Schutt (2016) study 183 LBOs with financial statements post-LBO of 521 LBOs identified. Likewise,

Smith (1990), Kaplan and Stein (1993), Guo, Hotchkiss, and Song (2011) and Ayash, Bartlett, and Poulsen

(2017) experience similar difficulties and significant sample attrition. The LBOs that do not disap-pear and

are studied in these articles are typically the larger buyouts that use public debt
in financing the takeover or become public again via an initial public offering (IPO). Our research design

is similar in spirit to Cohn, Mills, and Towery (2014), who uniquely observe U.S. Internal Revenue Service

tax data to study 353 public to private LBOs post-buyout.

Policymakers are trying to enact initiatives to address the perceived harms of private equity. For

example, Senator Elizabeth Warren introduced the “Stop Wall Street Looting Act” to broadly regulate

private equity partly as a result of the frequent bankruptcies associated with LBOs. Our research illustrates

that there is justification for concern, given the bankruptcy rate of LBO target firms is ten times that of an

arguably reasonable control group.

2 Literature Review

Economics literature has long been interested in financial distress and its costs. However, the study of

long-term outcomes of firms acquired in leveraged buyouts is limited. For instance, Tykvova and Borell

(2012) investigates financial distress and bankruptcy outcomes in a sample of 1842 buyouts from the EU-

15 countries. Their sample covers the period 2000-2008, with 64% of the buyouts occurring between 2006-

2008. Firms were then followed until 2010, only allowing for a short-term analysis. In addition, as noted in

Boucly, Sraer, and Thesmar (2011), French buyouts experience a less than 3% increase in leverage post-

buyout, and therefore the majority French sample presented in Tykvova and Borell (2012) is not

representative of leveraged buyouts.

Ayash and Schutt (2016) illustrate that the bankruptcy rate of the 231 LBOs identified from the 1980s
is 27%, while the bankruptcy rate of LBOs from 1990-2006 is 17%, with 30% of target firms still private
equity controlled. Cohn et al. (2014) document that of the 353 LBOs they studied, only 224 have exited
private equity control, and of these 49 firms (22%) had bankruptcy exits. Finally, Kaplan and Stromberg
(2009) document that 6% of global buyouts exit private equity ownership via bankruptcy. However, only
40% of the sample had an “exit” event. More importantly, all of these studies fail to investigate
bankruptcy using a control group.

3 Data and Sample Construction

 The transactions studied herein consist of U.S. publicly traded firms where controlling ownership was
acquired by private equity funds in leveraged buyouts between January 1, 1980 and December 31, 2006,
with a total transaction value in excess of $50 million1. This produces a list of 484 LBOs linked to
COMPUSTAT and SEC Edgar to collect financial statements pre-LBO. We then use news sources to follow
the history of the LBO target firms and specifically determine how and when the companies “exit” private
equity ownership. The possible exit strategies are initial public offering (IPO), sale to a strategic buyer, sale
to another financial buyer, and bankruptcy or out of court restructuring2.
For the LBO sample, we record the outcome as bankruptcy if the LBO company goes bankrupt within
the 10-year window after the transaction date. Otherwise, the outcome is recorded as non-bankruptcy if
either (a) a non-bankruptcy exit occurs within the 10-year window, or (b) there is no exit within 10-year
window. For the control sample, we track each control company for 10 years after the transaction date. We
record the outcome as non-bankruptcy if there is an active record for the company in COMPUSTAT
indicating that the company is still publicly traded or if the company is acquired or merged. We record the
outcome as bankruptcy if the reason for delisting from the exchange is recorded as bankruptcy by the CRSP
database. Otherwise, for other delisting reasons, i.e., delisted for delinquent non-payment of fees, still being
publicly traded but on a different exchange, or when it cannot be found on the CRSP Delisting database we
use multiple sources such as LexisNexis, FactSet, local newspapers, Wikipedia, etc. to find out whether a
bankruptcy happens within the 10-year window following the transaction date.

1
Sources used to identify LBOs include the SDC Platinum database, Kaplan (1989), Guo et al. (2011), Ayash and
Schütt (2016) and Ayash et al. (2017).
2
Out of court restructuring is defined specifically as a debt for equity conversion where the private equity funds’
equity is essentially eliminated.
 Our estimates for the bankruptcy rate is potentially impacted by classical censoring problems that
typically exist in this kind of survival analysis. While this methodology results in a relatively fair assessment
for the bankruptcy rate of the control sample simply because there is more publicly available information
on public companies, it gives a lower bound for the bankruptcy rate for the LBO sample. This is because
an LBO company may still go bankrupt even after it is off our radar. For example, a company with an early
non-bankruptcy exit (less than 10 years) which we count as non-bankruptcy outcome may experience
another LBO during which a bankruptcy occurs. Another example would be a bankruptcy outcome for an
LBO company with a late exit (more than 10 years), which we do not count as bankruptcy within the 10-
year window. Specifically, in our case 14 out of 75 exits that occurred after year 10 are bankruptcy exit,
which increases the bankruptcy rate in LBO sample from 20% to 23%.

4 Methodology and Results

4.1 Empirical Test Setup

In order to provide new evidence regarding the financial risk surrounding LBOs, we specifically track
LBO outcomes for 10 years post-acquisition. We match target firms in the year prior to the LBO based on
both industry classifications and a propensity score generated from financial data when constructing an
arguably appropriate benchmark of the counterfactual. Our tests compare outcomes for LBO target firms
with the matched control group.
4.1.1 Construction of the Control Group

To be included in the candidate set, the non-LBO must be publicly traded and in the same industry (3-
digit Standard Industrial Classification (SIC)). We then use the following covariates observed in the year
prior to the LBO (or the respective matching year for candidate firms) to control for selection bias and other
confounding effects by estimating a propensity score for being an LBO target: the logarithm of sales;
Leverage, defined as debt scaled by assets; CFSales, defined as the ratio of EBITDA to sales; ROA, defined
as EBITDA scaled by assets; and InvInt, defined as capital expenditures scaled by plant, property and
equipment. The variables selected are based on the literature (Lehn and Poulsen, 1989, Boucly et al., 2011
and Ayash and Schutt, 2016), but exclude market variables in order to limit attrition.

We estimate a propensity score for being an LBO target using a probit model. We then select the non-
LBO firm in the same industry with the closest propensity score to the LBO firm’s propensity score.
Matched firms are selected from the candidate set with replacement.3 Table 1, Panel A shows the results
of the probit regression used to compute the propensity score matched control group. Table 1, Panel B

depicts differences in mean scores for all covariates between the LBO firms and the propensity matched
control group. Overall, with the exception of Leverage, we observe no statistically significant differences
in means between the two groups pre-LBO. Table 1, Panel C reports test statistics of multivariate

differences in means tests. Overall, the results in Table 1 suggest that the propensity score matched control
group mirrors the LBO group reasonably well, given the covariates.

We then use news sources to follow the history of the matched control firms and specifically determine

bankruptcy outcomes. Panel A in Figure 1 provides a graphical analysis of the cumulative bankruptcy rates.
The figure shows a dramatic contrast in bankruptcy rates between LBO target firms and control firms.

While in 10 years after LBO transactions, the bankruptcy rate reaches about 20% (92 out of 467), it only

reaches about 2% (11 out 467, with replacement) in the control sample. Panel B in Figure 1 presents the

hazard rate for the LBO and control samples. While for the control sample the declining trend in hazard

rate never reaches 1%, for the LBO sample it follows a hump-shape pattern with a peak at above 5% in

3
The propensity score matching method, with replacement, maps the 467 LBO companies into 412 unique public
companies that form the control sample.
year 3. This is consistent with the finding of Altman and Kishore (1995) on “aging effect”, in which they

show that low-rated bonds are most likely to default three years after issuance.

4.2 Empirical Model

Given that the outcome variable is binary we use a probit model as illustrated in equation (1).
Bankruptcy is an indicator variable that switches on if a firm goes bankrupt within the 10-year window
following an LBO transaction (or the respective matching years for control firms); LBO is an indicator
variable for treatment, being an LBO target firm; and X is a vector of control variables measured in the year
prior to the LBO transaction that could potentially impact the bankruptcy outcome. λj is industry fixed
effect and ei is the error term. We do not add year fixed effects because the timing of the bankruptcy is
ignored in this analysis.

Prob(Bankruptcyi ) = Φ(β0 + β1LBOi + β2Xi + λj + ei ) (1)

We hypothesize that firms targeted in an LBO transaction are more likely to be financially distressed
than similar firms that are not LBO targets.
4.3 Results

Table 2 reports the probit estimation results for Equation (1). Results in the first (last) two columns
report the estimated coefficients without (with) controls. Industry fixed effects are added in columns (2)
and (4). Overall, the estimation results indicate a positive β1, which is highly statistically significant. The
difference in the bankruptcy rates is both economically and statistically highly significant with t-statistics
that are in the 8 to 9 range. As reported in columns (3) and (4), this result is robust to adding controls for
other factors that could potentially impact the exit outcome.
To interpret the coefficient of the LBO term, β1, presented in Table 1 (focusing on model

(3)), we use the average values of all the dependent variables for each of the LBO and control samples in
Table 2, panel B. Using the Normal CDF function, this results in an estimated probability of bankruptcy of
19.9% for the LBO firms and 2.0% for the control firms, an additional 17.9% for the LBO target firms.
This result is consistent with our earlier observation in Figure 1 and unreported OLS estimates.

Whether private equity funds acquire distress firms in an attempt to restructure them and improve their
operations, or target healthy firms with leveraged capital structures resulting in an increased incidence of
financial distress is an important economic question that policy makers are trying to understand. In a recent
letter to Kohlberg, Kravis & Roberts (KKR), lawmakers ask: “Was this a deliberate policy by your firms
to load the company with debt? If so, what is your justification?” KKR responded saying, “Toys R Us’s
troubles were caused by market forces...” Using a difference-in-differences approach to address issues of
causality, our research illustrates that there is justification for concern, given the bankruptcy rate of LBO
target firms is ten times that of an arguably reasonable control group, controlling for ‘market forces’.
5 Conclusion

We use a propensity score matching algorithm to match a sample of 467 large U.S. public to private
leveraged buyout transactions to similar publicly traded firms. Comparing the bankruptcy outcomes for the
LBO group with an arguably acceptable counterfactual control group, we find that the 10-year bankruptcy
rate for LBO target firms is 18% greater than controls. These results are timely and germane given Senator
Elizabeth Warren recently introduced the “Stop Wall Street Looting Act” to broadly regulate private equity
in the United States.
References

Altman, E. I. and V. Kishore (1995). The NYU Salomon Center’s Report on Defaults and Returns on High
Yield Bonds: Analysis Through 1994. New York University Salomon Center.

Ayash, B., R. P. Bartlett, and A. B. Poulsen (2017). The Determinants of Buyout Returns: Does Transaction
Strategy Matter? Journal of Corporate Finance 46, 342-360.

Ayash, B. and H. Schütt (2016). Does going private add value through operating improvements? Journal
of Corporate Finance 40, 192-215.

Boucly, Q., D. Sraer, and D. Thesmar (2011). Growth LBOs. Journal of Financial Economics 102 (2), 432-
453.

Cohn, J. B., L. F. Mills, and E. M. Towery (2014). The evolution of capital structure and operating
performance after leveraged buyouts: Evidence from U.S. corporate tax returns. Journal of Financial
Economics 111 (2), 469-494.

Guo, S., E. S. Hotchkiss, and W. Song (2011). Do Buyouts (Still) Create Value? The Journal of Finance 66
(2), 479-517.

Kaplan, S. N. (1989). The effects of management buyouts on operating performance and value. Journal of
Financial Economics 24 (2), 217-254.

Kaplan, S. N. and J. C. Stein (1993). The Evolution of Buyout Pricing and Financial Structure in the 1980s.
The Quarterly Journal of Economics 108 (2), 313 - 57.

Kaplan, S. N. and P. Strömberg (2009). Leveraged Buyouts and Private Equity. Journal of Economic
Perspectives 23 (1), 121-146.

Lehn, K. and A. Poulsen (1989). Free cash ow and stockholder gains in going private transactions. The
Journal of Finance 44 (3), 771.

Merton, R. C. (1974). On the pricing of corporate debt: The risk structure of interest rates. The Journal of
Finance 29 (2), 449-470.

Smith, A. J. (1990). Corporate Ownership Structure and Performance: The Case of Man-agement Buyouts.
Journal of Financial Economics 27 (1), 143-164.

Tykvová, T. and M. Borell (2012). Do private equity owners increase risk of financial distress and
bankruptcy? Journal of Corporate Finance 18 (1), 138-150.
 25.0%

20.0%

15.0%

10.0%

5.0%

0.0%
-2 -1 0 1 2 3 4 5 6 7 8 9 10 11
LBO Sample Control Sample
(a) Bankruptcy Rate

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
-2 -1 0 1 2 3 4 5 6 7 8 9 10 11
LBO Sample Control Sample
(b) Hazard Rate

Figure 1: Comparison of Bankruptcy and Hazard Rates between LBO and Control Samples
Figure 1, panel (a) presents a comparison of the cumulative bankruptcy rate for LBO target firms versus
control firms over the 10-year period following an LBO event (or the respective matching period for the
peer firms). Each period after the LBO, the bankruptcy rate is calculated as the ratio of the total number of
bankruptcies since going private (t = 0) to the sample size. Figure 1, panel (b) presents a comparison of the
hazard rate in period t that is the ratio of the number of LBO bankruptcies in period t to the total number of
non-bankrupt LBO firms in period t. Both sample sizes are 467 firms matched in the year before LBO (t =
-1), with replacement.
 Table 1: Probit Regression for Propensity Score Matching

***p<0.01; **p<0.05; *p<0.10 based on Wald χ2 values. Panel A presents the results of the probit model
run to compute the matching score. The covariates used are: the log of sales; Leverage; CFSales; ROA;
and InvInt. All variables are measured in the period before the LBO (or the respective matching year for
peer rms). Panel B presents differences in Means between LBOs and control firms in the period before the
LBO. PScore is propensity score. Employees is in thousands. Panel C provides the results of the test of the
hypothesis that the differences in means of the covariates between LBOs and control firms are not
significantly different from zero.

Panel A: Probit regression used for propensity score matching

Parameter Intercept log(sales) Leverage CFSales ROA InvInt

Estimate -2.226 0.082 0.434 0.006 1.061 -1.143

Standard Error (-26.85) (7.11) (5.66) (0.22) (5.82) (-8.60)
*** *** *** *** ***
Model χ2 349.80 p < .01 Ps. R2 8.34% N 15108

Panel B: Comparison of LBO sample to control sample

Treatment (LBO) Control Group Mean Comparison Test

Variable Mean Median Mean Median N Diff t-stat P-value

log(sales) 6.0389 5.9363 6.0282 5.9864 467 0.0107 0.1044 0.9169

ROA 0.1486 0.1487 0.1521 0.1479 467 -0.0035 -0.6008 0.5481
CFSales 0.1387 0.1180 0.1442 0.1271 467 -0.0055 -0.7381 0.4607
Leverage 0.3019 0.2840 0.2695 0.2460 467 0.0324 2.2359 0.0256
InvInt 0.2110 0.1832 0.2133 0.1970 467 -0.0023 -0.2337 0.8153

Employees 8.1539 8.1619 8.1144 8.2397 437 0.0395 0.3491 0.7271

PScore 0.0509 0.0486 0.0489 0.0472 467 0.0020 1.4254 0.1544

Panel C: Test of equal means in LBO and control group

Propensity matched control group test of H0: “No overall LBO effect”
Statistics Value F-value NumDF DenDF Pr > F
Wilks’ lambda 0.9932 1.28 5 928 0.2707
 Table 2: The Impact of LBO on Bankruptcy Using a Probit Model

***p<0.01; **p<0.05; *p<0.10 based on Wald χ2 values. Table 2 presents the results of the probit model
based on a control group constructed with replacement. The dependent variable is a dummy variable that
switches on if the firm goes bankrupt within 10 years after LBO. The covariates are measured in the period
before the LBO.

Dependent Variable: Bankruptcy Dummy

(1) (2) (3) (4)

LBO 1.156*** 1.543***1.169*** 1.639***

(8.12) (8.55) (7.92) (8.34)
log(sales) -0.003 0.03
(-0.08) (0.44)
ROA 1.339 -0.761
(1.56) (-0.56)
CFSales -1.335* -0.656
(-1.92) (-0.55)
Leverage 1.069*** 1.717***
(3.88) (3.99)
InvInt -0.263 0.219
(-0.61) (0.30)
Constant -1.985*** -2.057*** -2.279*** -2.753***
(-15.73) (-2.89) (-6.73) (-3.07)

Industry FE No Yes No Yes

pseudo - R2 0.1284 0.2895 0.1556 0.33
N 934 600 934 600

14