Finance Research Letters xxx (xxxx) xxxx

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Finance Research Letters

journal homepage: www.elsevier.com/locate/frl

Leveraged buyouts and financial distress

Brian Ayash , Mahdi Rastad
⁎

Orfalea College of Business, California Polytechnic State University, San Luis Obispo, CA 93407, United States

ARTICLE INFO ABSTRACT

Keywords: Do leveraged buyout transactions increase the chance of bankruptcy? While corporate finance
Leveraged buyouts theory predicts that such sharp changes in capital structure increase financial distress costs by
Private equity raising the probability of bankruptcy, previous studies fail to measure the effect. In this letter, we
Financial distress provide evidence that is consistent with the prediction of the theory. Tracking a sample of 484
Bankruptcy
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%.
JEL classification:
G33
G34
G38
G32
J08

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 et al. (2011) and Ayash et al. (2017) experience similar difficulties and significant

We thank research assistants Madeline Wilson, Austin Nall, Kennedy Whalen and Dale Chang.
⁎
Corresponding author at: Grand Avenue, Orfalea College of Business, California Polytechnic State University, San Luis Obispo, CA 93407, United
States
E-mail addresses: bayash@calpoly.edu (B. Ayash), mrastad@calpoly.edu (M. Rastad).

https://doi.org/10.1016/j.frl.2020.101452
Received 23 May 2019; Received in revised form 31 October 2019; Accepted 2 February 2020
1544-6123/ © 2020 Elsevier Inc. All rights reserved.

Please cite this article as: Brian Ayash and Mahdi Rastad, Finance Research Letters, https://doi.org/10.1016/j.frl.2020.101452
B. Ayash and M. Rastad Finance Research Letters xxx (xxxx) xxxx

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 et al. (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 et al. (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 to 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 million.1
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 restructuring.2
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.
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.

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.

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B. Ayash and M. Rastad Finance Research Letters xxx (xxxx) xxxx

Table 1
Probit Regression for Propensity Score Matching.
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 < 0.01 Ps. R2 8.34% N 15,108

Panel B: Comparison of LBO sample to control sample

Variable Treatment (LBO) Control Group Mean Comparison Test
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

***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.

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 Fig. 1 provides a graphical analysis of the cumulative bankruptcy rates. The figure shows a dramatic contrast in bank-
ruptcy 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 Fig. 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 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 Eq. (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

3
The propensity score matching method, with replacement, maps the 467 LBO companies into 412 unique public companies that form the control
sample.

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B. Ayash and M. Rastad Finance Research Letters xxx (xxxx) xxxx

Fig. 1. Comparison of Bankruptcy and Hazard Rates between LBO and Control Samples
Fig. 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. Fig. 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.

error term. We do not add year fixed effects because the timing of the bankruptcy is ignored in this analysis.
Prob (Bankruptcyi ) = ( 0 + 1LBOi + 2Xi + j + 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 Eq. (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 Fig. 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’.

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B. Ayash and M. Rastad Finance Research Letters xxx (xxxx) xxxx

Table 2
The Impact of LBO on Bankruptcy Using a Probit Model.
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

***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.

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.

Data for reference

Data are available at the Ayash Leveraged Buyout Research Database.

Supplementary materials

Supplementary material associated with this article can be found, in the online version, at doi:10.1016/j.frl.2020.101452.

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