* 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).


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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.

The model includes direct and indirect effects.1995 Phan and Hill 707 lie supports this assumption (Lehn & Poulsen. Thus. This change in emphasis leads to changes in the strategy and structure of the firm. These changes in strategy and structure are all predicted to have a beneficial effect npon firm performance.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. 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 . Specifically. Maupin. Since the model does not fully specify all mediating variables. Singh. reduction in scope will occur as the firm divests itself of diversified activities and refocnses on its strategic core. . 19B9. 1990). 1987. 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. 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. we expected that significant effects would he left uncaptured by the variables addressed in this study.

1989. Kaplan. 1988. managers can. a leveraged buyout is associated with an increase in debt. automatic. subject to tbe firm's achieving a satisfactory level of profit. as principals in the relationship with managers and as major stockholders in the post-LBO firm. An increase in management stockholdings is not. Tbe implicit argument is that the main components of managerial utility are status. 1992. Because of tbese increases. 1993). Nonetbeless. unless tbe buyout was undertaken by management. tbe proportion of equity held by management will increase. Tully. managers will emphasize sales growtb. after an LBO tbe goals of top managers sbift from those consistent with growtb maximization toward those consistent with maximizing firm efficiency (Garvey. 1964). 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. 1992. market share. 1980). be expected to emphasize profitability. To the extent that the value of a firm's equity reflects its potential for creating longterm efficiency gains. and job security. insist on top managers taking a significant equity stake in a firm. 1991). and the like (Aoki. Firm size is in turn maximized by emphasizing growtb in sales and market sbare. theorized to be a function of firm size. an agency perspective suggests that managerial ownership of a leveraged firm's equity may help ensure that managers maintain a long-run focus. Consistent with tbis argument are Garvey's (1992) and Singh's (1990) findings that in most LBOs management stockholdings increase. 1986. at least in the context of an LBO. The managerial hegemony and agency theory literature thus suggests that under a pre-LBO governance structure. power. 1976. Hypothesis 2: Increased debt will be associated with an increased emphasis on efficiency goals. By change in governance structure. agency theorists mean increases in both debt and management stockholdings. Thus. Most LBO sponsors. 1990). Williamson. Hypothesis 1: Following a leveraged buyout.708 Academy of Management Journal June Increased Management Holdings By definition. and the like (Jensen. Jensen. 1988). The logic is that managers' stockholdings align their interests witb those of tbe principals (Fama. Alternatively^ if efficiency maximization has priority. Thus. Marris. 19B6. casb flow. 1964. as was noted. Jensen & Meckling. income. bowever. 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. . after a leveraged buyout. researcbers have argued that in most cases an increase in management stockholdings accompanies an LBO (Garvey. 1984: Fama. 1980. Singh.

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

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

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

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

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

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

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

16 percent in services. CS First Boston. 20 percent in wholesale and retail trade. Maybelline. savings and loans associations. detailed information relating to internal organizational dimensions. BW/IP International. or because tbey had returned to the public domain after a few years as private firms. Tbe . representing 47. insurance companies. The final survey was sent out in mid 1991. which are summarized in . cannot be gleaned from public databases. The database defined an LBO as a merger deal of wbich 80 percent or more of the total value was debt-financed. 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. 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. and Collins & Aikman. We received responses from 214 firms.survey population consisted of 450 LBOs completed between 1986 and 1989. Goldman Sachs. Some COMPUSTAT data were available for 66 firms. investment houses. The Marley Co. Clayton & Dubilier. We excluded banks. We obtained the survey population from the Mergers and Aquisitions Database supplied by MLR Publishing to Automatic Database Processing Inc. financial statements. Safeway. Standard Industrial Classification (SIC) codes put 57 percent of these in manufacturing. inclusive. either because a minority of their stock or bonds had continued to be traded upon the open market. and GAF Corp. 1988). and strategic plans) were also obtained from Levi Strauss. Multiple responses were received from 17 firms whose CEO and CFO responded separately. We interviewed senior executives from tbe following: Kohlberg. Survey construction. The surveys were sent to CEOs and chief financial officers (CFOs) of the firms. We also conducted pretests of the survey witb organizational scbolars. Additional private data (internal memos.6 percent of the survey population. Survey population and response bias. 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. such as decentralization and hierarchical complexity. Tbe construction of the survey was guided by theoretical considerations.. The results of the tests for nonresponse and data source bias. Wasserstein Perella. 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. Kravis & Roberts. data services. Thus. Forstmann Little.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. Moreover. and 7 percent in other industries.

We calculated kappas for scales composed of individual items in our surveys. suggesting strongly that the two groups were drawn from the same distribution. 1981: 213-237). we expected the results of this test to be generalizable to the rest of the sample.1 298.50 8. • In millions of dollars.21 2. = . As can be seen. which TABLE 1 'i^-.0 4. To test for interrater reliability.291 167. As we could think of no systematic ex ante reason why these 17 companies would differ from the others.90 32.3 2. An adjusted correlation coefficient that should be interpreted as a correlation coefficient. suggested that there were no significant differences in the distributions of the respondent and nonrespondenl.817 2. 1992).5 5. groups. positions that at least ensured that they had full access to the pertinent data. m and n. the kappas range from a high of 1. Incomplete recall may seriously confoimd the results of surveys based upon the recall of past events (Golden.6 3.82 3.6 330. The statistic tests the statistical significance of the differences between these distributions to determine if they were drawn from the same population.903 15. The construction of the scales themselves is discussed later in this section.93 -6. kappa was chosen because it corrects for the chance correlation between raters and measures ratings based on categorical scales.66 -2.50 48.260 18. over 86 percent of the respondents held top management posts in the pre-LBO firms. In our sample.70 0.90 2.69 0. we used kappa (k).64 Range 246.334.88 1.7 268 289 s. good results for interrater reliability would increase confidence in the accuracy of the survey responses.7 13.56 3. N = 104. rather than for the items themselves as we had only 17 firms to work with.680. 624. '' All D^^ statistics were nonsignificant. the most common measure of interrater agreement (Fleiss.65 1. "^' Results of Test for Distribution Differences Between Respondents and Nonrespondents^ V'ariables Median 261. D is the maximum deviation of tbe frequency distributions of two samples.n Sales'Respondents Nonrespondents Employees Respondents Nonrespondents Productivity Respondents Nonrespondents ROI 0.d.14 D ^ m.6 576.B Skewness 1. we compared the answers of the two respondents for the 17 firms in which two people Independently filled out the questionnaire.20 6.78 3. As a check on accuracy.3 Respondents Nonrespondents " For respondents. As two individnals would not be likely to have the same type of faulty recall. in Table 2. Data reliability. N = 214: for nonrespondents.0. indicating no nonresponse bias.^9 56.66 0.lit 1995 • Phan and Hill 717 Table 1.

77 0.776 [p < . management boldings.76 0.62 < J: < 1. 209-212) to determine the accuracy of the two sets of data.50 0.76 0.75) witb a 90 percent confidence interval of 0. we asked respondents about pre. Tbe value used to represent each scale was tbe mean score for al! items it included.89 to a low of .961.50 0. 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.0.s normally distributed). wben it was available. Measures The data to calculate most measures were taken from the survey.gj -i.H3 " N = 17.44 0.36 k 0. to a low of 0. We calculated overall reliability coefficient (Nunnally.c.and post-LBO approval of sucb matters as major investments and marketing .be] -* niimerator/p. we found at i = 1 that z = 0.1)1.44 0.88 0. obtaining a high overall reliability coefficient of 0.80 indicates a level of agreement beyond chance. from COMPUSTAT. whore a. diversification. a kappa of greater tban 0.36 Denominator 0.35 0. For tbe quantitative questions.00 t). We tested but rejected the hypothesis tbat the overall kappa of 0. signifies perfect agreement between raters.00 [k (-1.36 2. The Appendix gives the multi-item questions from which the scales were constructed.76.38 0. With the exception of the items on changes in debt. q.64. Table 3 gives the bivariate correlation coefficients calculated for such data.46 0. p^.b.50 0.39 0. which leads us to conclude tbat there was a high degree of accuracy.. correlations between survey and COMPUSTAT data ranged from a bigh of . Data for performance measures came from the survey or.^ -• denominator.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 . in tbe case of the longer-term performance measures. we determined the validity of our survey data by comparing tbe information provided by respondents to the same information on the COMPUSTAT tapes.88 1. 1978.Numerator 0. k ^ 2[ad . Tbe overall kappa was . As can be seen.p^q. Examples are as follows: To assess decentralization.. and q. According to Landis and Kocb (1977).d are the proportions of joint ratings and p^.83.83 significantly differed from 1. are the proportions of cbance expected joint ratings.51 0.sis that k = 0. witb k as the sum of the individual k numerators divided by the sum of tbe individual k denominators. Testing tbe hypothe. and performance. This result is bigber than the lower limit Landis and Kocb (1977) set for excellent agreement beyond cbance.83 is not statistically significantly different from I: = 1 (i: i.

2 3 op 0) u£ 6 o 6m cq CQ pre-1 post. .LBO preposi •LBO t-LBO r-LBO it-LBO pre. 1-4 ft ft o ft ft d ft sod in O ft Q Q h.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 . 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.^ C Q in h. .

(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. In many instances. 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.50 were excluded from the construction of scales to remove ambiguity. We used labor costs ratber than number of employees as the denominator in order to . Previous researcb on leverage has focused on long-term debt. and 6). We used a productivity measure to capture performance primarily because changes in productivity are likely to show up sooner than changes in profitability. To assess hierarchical complexity. Not all firms withdraw 100 percent of their equity. the magnitude ofthe increase does vary significantly from case to case. 5. The multi-item questions were designed to elicit specific response patterns. Change in performance.) Tbe data were obtained from respondent reports of the percentages one year before and one year after the LBO. so any residual must be included to account for the total value of a firm at the time of a buyout. Thus. for instance. Factor analysis was applied to each multi-item question to confirm that the actual response patterns were in accordance with expectations. Items that loaded on more than one factor or that loaded lower than 0. and visual inspection of the individual scale scree plots confirmed the loadings were appropriate. It is also important to note that although all LBOs involve an increase in debt-to-equity ratio. the factors had eigenvalues greater than 1. however.70 or greater (Tables 4. we used total debt to reflect these facts. we generated normal probability plots and histograms that confirmed that the variables were distributed normally. 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 number of corporate human resotirces managers and the firm's size relative to its competitors'. All scale coefficient alphas were . the strategic decisions regarding downsizing may be driven by these loans as much as by long-term debt obligations. Labor productivity was measured by earnings before interest and tax (EBIT) over total labor costs. 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. In tbe case of LBOs. Change in management holdings. we asked about change in. Finally. 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. We used total capitalization ratber tban total equity since a majority of equity is swapped for debt in a leveraged buyout.0. 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. Overall. Change in debt.720 Academy of Management JoumaJ June strategy decisions.

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

32 -. with higher values indicating higher decentralization.722 Academy of Management Journal TABLE 4 -.t^ .543 . and decisions regarding financial goals.057 . Changes in decentralization were calculated in the same way as the cbange in goals.145 .054 .832 . The second scale.764 1.076 . capital investment decisions.21 Post-LBO Efficiency Growth JHB jm . 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. marketing strategy. The effectiveness of such decisions may. the argument here is that after an LBO.823 .093 .SO " Boldface indicates items that loaded on factors.802 . 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 .765 1. acquisition strategy.610 . measuring tbe extent to which strategic decisions were decentralized.685 . however.557 .B32 . The strategic decentralization scale used here captures the extent to which corporate decisions are shared with lower-level managers after an LBO. strategic decentralization. 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 . contained four items: strategic decisions.013 «78» l.17 .308 -.7Cffi .797 . production decisions. pricing decisions.868 . and business unit strategy.034 -.S91 .764 2.097 .814 . ing the extent to which operating decisions were decentralized.873 firm . buying decisions.678 . contained seven items: advertising decisions. 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. product mix decisions.

the data came from the COMPUSTAT Business Segments Database.875 .131 . Controlling for decentralization and diversification was relatively straightforward because tbe survey instrument collected relevant information.824 .1S4 .588 .374 6. and diversification that existed in a firm prior to its LBO.223 .797 2. we controlled for the levels of decentralization. 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).799 .204 -. .98 -. measured as number of employees.773 .266 .728 .and eight-firm industry concentration at the four-digit SIC level and including it as a control variable in our analyses.791 .287 .752 .788 2. Similarly.764 .56 .766 .075 .722 . To get around this limitation.71S JWl . We allowed for industry effects by measuring the cbange in four.145 . Control Variables First. 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 .764 .924 5. Tbe industrial organization literature suggests that tbe attractiveness of the industry in wbicb a firm competes often dictates its performance (Porter.289 . we used pre-LBO size as a proxy for degree of hierarcbical complexity. hierarchical complexity.778 . 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.207 . capital investments.750 .218 .120 .672 .871 .BIB Post -LBO Operating Strategic .15 " Boldface indicates items that loaded on factors.270 .089 .1)18 .813 . 1980).019 . We also controlled for change in firm size. and the like.48 .280 -.Phan and Hill 723 more participative decision making with regard to acquisitions.801 .182 .276 .258 .SIS .286 -.

01} but not when it was measured by strategic decentralization. and goals on diversified scope. in which we controlled for pre-LBO diversity. and goals. on the average. indicating support for Hypothesis 1 (p < . the results suggest that a change in strategic goal emphasis does take place after an LBO. As Hypothesis 14 predicts. Consistent with Hypothesis 11. increased management holdings were associated with both increased operating (p < .01) and a decreased emphasis upon growth goals (p < . so Hypothesis 13 received some support. and size.61. increased management stockholdings were associated with an increased emphasis upon efficiency goals (p < . Consistent with Hypothesis 6. although this result only held for strategic decentralization (p < . Hypothesis 1 was tested by a (-test.01). We regressed the changes in debt and management stockholding against the changes in emphasis on efficiency and growth goals. an increased emphasis on efficiency goals was weakly associated with a reduction in scope (p < . consistent with Hypotheses 4 and 5.10]. there was evidence that increases in management stockholdings were associated with a reduction in diversified scope (p < . management holdings. Increased debt was weakly associated with increased operating decentralization (p < . We did not find any evidence that a decreased emphasis on growth goals was associated with a decrease in diversified scope. increased debt was associated with increased emphasis on efficiency goals (p < . This association is not a trivial finding because it demonstrates owners' cognizance of the agency problem and an a priori attempt to address it. 11 through 14. consistent with Hypothesis 9.724 Academy of Management fournal RESULTS Table 7 reports correlations and summary statistics. Nor was there any evidence that increased debt was associated with a reduction in scope. a decreased emphasis on growth goals was associated with increased decentralization. Consistent with Hypothesis 2. However.10).01). . However.2 to 35. Thus. so Hypothesis 7 is not supported. management holdings. Table 9 reports the results of tests of Hypotheses 6 through 9. and 16 through 19. mean management stockholdings increased from 14. Hypotheses 11 through 14 deal with the impact on decentralization of changes in debt.05) and strategic decentralization (p < . Hypotheses 6 through 9 deal with the impact of changes in debt. so Hypothesis 8 is not supported. scope. Table 8 reports results of the tests of Hypotheses 2 and 5.7 percent after an LBO. We found no evidence that increased debt was associated with a decreased emphasis on growth goals. We found that.01). The f-statistic for the difference between means was 6. This result held when decentralization was measured by operating decentralization (p < .01). so Hypothesis 3 is not supported. an increased emphasis upon efficiency goals was associated with increased decentralization. Previous studies that ignore this aspect of the post-LBO situation may have missed an important explanatory variable. Consistent with Hypothesis 12.000).05).

1995 Phan and Hill 725 OC .

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changes in the levels of debt and management holdings were not related to change in hierarchical complexity. which predicts that increased decentralization will be associated with improved firm performance.10). This result also held when decentralization was measured by operating decentralization and the dependent variable was the change in productivity (p < . so Hypothesis 17 was supported.366 13.05).1995 Phan and Hill 727 TABLE 8 "• Results of Regression Analysis for Goals Change in Emphasis on EfUciency Goals t P 0.001 Hypotheses 16 through 19 deal with the impact on hierarchical complexity of changes in debt.211 214 Change in Emphasis on Growth Goals Independent Variables Change in debt Change in management holdings F Adjusted fi^ P -0. When decentralization was measured by strategic decentralization. it did not hold when decentralization was measured by operating decentralization and the dependent variable was the change in profitability. Decreased emphasis on growth goals was associated with reduced hierarchical complexity (p < .tn 4. which predicts that a reduction in diversified scope will be associated with performance improvement when the dependent variable was change in profitability [p < .001). Given the curreut findings and the secondary role accorded to managerial ownership in previous LBO studies.324 0.381 9.72'* 4.162 214 ' D. management holdings. and 20).01) and profitability (p < . and goals.01) but found no support when it was the change in productivity.81*** 0. 15. fol- . Table 10 reports results of the tests for the performance hypotheses (Hypotheses 10. we considered it important to explore the relative strengths of these effects. We found some support for Hypothesis 10.05). so Hypothesis 16 was not supported. In our model [Figure 1). We did so by means of a path analysis. so Hypothesis 18 and 19 were not supported.01) or the change in profitability (p < . There was support for Hypothesis 15. There was support for Hypothesis 20. with reduction in hierarchical complexity associated with performance improvement for both change in productivity {p < . However. We found no evidence that an increased emphasis on efficiency goals was associated with reduced hierarchical complexity.072 -0.66** 3. However. increased debt and management holdings have both direct and indirect impacts upon firm performance. Support for Hypothesis 10 must be tempered by this fact. Hypothesis 15 was confirmed when the dependent variable was the change in productivity [p < .06** N "*p<.01 '**p< .66'** 0.

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25 0.07* 3.343 0. structure.35 1.042 0.28*** 1.099 -0. This result suggests that.045 0.20 0.07"* 1. summarized in Tahle 11.322 2.92* 2.094 -0. The change in management holdings accounts for 69.13 0.463 0.31*** 0.095 -0.75 0.566 0.23a 0. and performance of an LBO firm.045 0.89 2.04 1.10 *p < .119 -0. The results of this exercise.71 0.5 percent of the explained variance in productivity and 74.70+ 2.27** +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. we recomputed the regression analyses reported in Tahle 10 using performance data for three and five . rather than increase in deht.3 percent of the explained variance in profitahility.75*** 214 t 2.60 0. on the average.10 0.73 0.211 -0.186 0.101 -0.102 -0.52 2. & Brett.05 **p<.01 ***p< .91 0. 1982).262 -0.267 -0. management holdings have a larger impact than deht upon change in performance.343 -0.71 0.245 0.40 0. strategy.019 -0.239 -0.07 1.373 0.011 0. to assess longer-term effects.302 -0.6fl** 1.751 0. Finally.001 lowing the theory-trimming approach (James.113 0.083 0.035 0.448 4. with the change in debt accounting for the remainder. show that when both direct and indirect effects are considered.33*' 4.38* 5.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 0.38 0. increase in management holdings.97 1.95** 2.09* 2.84** 214 0.71** 0.193 0.149 0. has the more important impact upon the goals.352 -0.028 0. Mulaik.92" 3. We then decomposed the variance in firm performance hrotight ahout hy a change in deht and management holdings into direct and indirect effects.

.262) + (.187)(-.262) . Ravens- . LBOs are associated with an increase in management holdings.373) . management holdings seem to have a greater impact upon goals. On the hasis of these results.218)(. Fourth. and decentralization increases.381)(.343) + (. are less supportive ofthe performance hypotheses than the results reported in Table 10.281)(. the results derived from this exercise are still instructive.343) + (-.324)(-.262) + (-.324)(. and structure than deht. Second.366)(-.343) 0 .343)-(-(.01).343) + (-. reported in Table 12. these data were only available for small subsamples. strategy. 1992. diversified scope and hierarchical complexity diminish.324(.343) Total Effect . we cannot reject either the free cash flow or agency theory assertions tiiat leveraged buyouts lead to an increase in enterprise efficiency.343) + .38l)(-. and growth less emphasis. as hypothesized.343) + (.267) + (-. strategy.245 . and structure foster greater efficiency. a comparison of the size of tbe betas reveals that the control variables (industry concentration. which suggest the following: First. whose beta weights may be unstable.566 Indirect Effect . 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 < . 1989.202) (. these changes in goals.319 . Although the variance explained by all four models was high. the change in governance structure that occurs with an LBO does affect firm goals. Third. We did not find evidence in support of Hypotheses 10 and 20. strategy. Efficiency receives more emphasis. in addition to an increase in debt. 14 of the 20 hypotheses received some support. as demonstrated by increases in productivity and profitability.239} + (.730 Academy of Management Journal June TABLE 11 Summary Decomposition Table Bivariate Relationships Management holdings and productivity Direct Effect ..366(.146 years after the LBOs.218)(. This conclusion is consistent with event study evidence (DeAngelo et ah. Madden et al.144)(.324(. Results.728 Management holdings and profitability 0 .31) (.428 + (. industry performance. Lieheskind el al.366(.13)(-. and structure. However.13)(-. DISCUSSION AND CONCLUSIONS In sum. 1990) and with other ex post studies of LBO performance [Kaplan. 1984.366l(. Figure 2 summarizes results.218)(. As was noted. and firm size) account for much ofthe variance.239) + (.381) Debt and productivity Debt and profitability (-.2n2)(.

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a reduction in complexity and scope. It is also roughly consistent with the work of Long and Ravenscraft (1993a. Our study also suggests tbat Jensen's (1986) exclusive focus upon the importance of debt in the LBO process may be misplaced. neitber can we deny this possibility. 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. only to decline somewhat thereafter. We not only . Decreased Emphasis on Growth Goals H17 craft. However. 1993b: Singh. the two sets of results suggest that performance improves immediately following an LBO. 1993b). The results reported in Table 12 suggest that the performance impact of an LBO is far less dramatic over longer time periods. Taken together. which suggests that both the level of R&D investments and the profitability of LBOs tend to decline over the long run. 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. 1990). Our work shows with greater precision than previous research has employed where this performance improvement might be coming from—a change in goals. which generally suggest that LBOs do lead to an increase in efficiency in the short run. as tbeir detractors claim. and an increase in decentralization. Although we cannot say for sure whether post-LBO firms suffer from myopic shortterm behavior. Further studies of the long-run impact of LBOs will have to be undertaken before this issue can be resolved. Although we found no evidence that LBOs actually decreased performance over the longer term. Table 12 does not reveal much in the way of a positive impact either. 1993a.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.

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

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

senior managers may stand to reap buge gains from their equity. 1984. the downsizing commonly associated with an LBO obviously negatively affects employees' job security. Clark. Agency prriblenis and the theory of the firm. Easterwood. M. 1983. & Petty. Seth. 32(1): 30-43. Thus. Faroa. F. New York: Free Press. B. A.Academy af Management Review. Organizational changes and value creation in leveraged buyouts: The case ofthe O. Berle. 1989. & Marcus. . But if and when a firm once more becomes a publicly held enterprise. The structure of ownership and the theory of the firm. California Management Review. 62: 777-795. 74: 893-919. Organizations: A guide ta problems and practice. Cambridge. Leveraging the underinvestment problem: How high deht and management holdings solve the agency costs of free cash flow. Bondholders suffer because the increase in debt associated with an LBO increases financial risk and reduces the price of their bonds. & Domsetz. Jaurnal of Financial Research. 26: 378-389. Aoki. & Means. information costs. R. Demsetz.. it could be argued that an LBO is simply a way of enriching senior managers while impoverishing other employees and bondholders. The need for cognition. Working paper. E.. J. R. It was against this background that Shleifer and Summers characterized some LBOs as involving a "hreach of trust" with stakeholders. 1984. & Rice. Fox. A. Cacciopo. The modem corporation and private property. & Gale. 35: 848-860. Oxford: Oxford University Press. DeAngelo. Production. 1992. Baker. REFERENCES Alchian. 1980. Child. B. 1972. 1982. Jaumal of Personality and Social Psychology.. A.. H. 1989. M. H. L. Indeed. New York: Wiley. A. as do LBO sponsors. K. I-. T.J995 Phan and Hill 735 the ability of a firm to fund their pensions. Journal of Political Economy. . Buzzell. The extent to which such breaches of trust negatively affect long-run performance is worthy of future investigation. New York: Macmiltan. G.. Golden. L. The cause. Going private: Minority freeze-outs and stockholder wealth. H. R. 88: 288-298. and economic organization. Fleiss. The past Is the past—Or is it? The use of retrospective accounts as indicators of past strategy. 1981. Harvard University.. American Economic Review. growth and productivity.. K. 27: 367-401. 15:149-166. & Singer. 42: 116-131. G. 1992. 1992. American Economic Review. Unionization and firm performance: The impact of profits. The impact ol* leveraged huyoiits on strategic direction. H.s and consequences of leveraged management buyouts. 17: 62-^5. Journal of Law and Economics. 1984. The vaoperative game theory of the firm. B. 1934. E. J.. we could speculate that our failure to find strong evidence that LBOs improve long-run firm performance reflects such an impact. A. DeAngelo. I. T. MA. Statistical methods for rates and proportions. I. P.. Journal of Law and Economics. Scott and Sons Company. Garvey. B. The PIMS principles: Linking strategy to performance. Moreover. E. T. T. London: Harper & Row. G. & Wruck. 19B4. 1987. M. Academy of Management Journal.

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

tn particular. degree from the University of Washington in 1992. . 5 = irrelevant). his studies deal with the control and monitoring of managerial at:tion and strategic choice in post-takeover firms. Hill is a professor of strategic management at the School of Business. Mark the importance of each before and after the LBO was completed:" (1 = most important. His current research and teaching interests are in the areas of corporate governance and mergers. His research interests center on applying economic theory to problems of business and corporate strategy.D.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. top management compensalion. Charles W. Sales growth Profit growth Stock returns Cash flows Profitability Productivity Innovativeneas in management Market share Phillip H. University of Washington. Phan is an assistant professor of strategic management at York Universily. L. and governance in interfirm alliances and networks. degree in industrial organization economics from the University of Manchester Institute of Science and Technology in England. He holds a Ph.

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