Journal of Applied Corporate Finance

S P R I N G 19 9 7 V O L U M E 10 . 1

Performance, Leverage, and Ownership Structure in Reverse LBOs

by Robert W. Holthausen and David F. Larcker,
University of Pennsylvania
PERFORMANCE, by Robert W. Holthausen and
David F. Larcker,
LEVERAGE, AND University of Pennsylvania*
OWNERSHIP STRUCTURE
IN REVERSE LBOs

he performance of leveraged buyouts has received considerable

T attention in the finance literature. Michael Jensen has argued that
LBOs and LBO-like organizations add value by reducing incentive
problems faced by more traditional corporate organizations, especially in slow-
growth sectors of the economy. He postulates that high leverage, concentrated
equity ownership by managers, and monitoring by an LBO sponsor firm work
together to create an organizational form with an incentive structure that leads
to value maximization. In particular, increasing the proportion of equity owned
by managers can provide stronger incentives for managers to create shareholder
wealth. In addition, substantial debt service obligations can force managers to
avoid investing in negative net present value (NPV) projects, which is particu-
larly useful in mature industries generating substantial “free cash flows” (that is,
cash in excess of that required to fund all profitable investment opportunities).
Finally, nonmanagement insiders (such as an LBO sponsor firm) typically own
a significant proportion of the outstanding equity and exercise considerable
control over managers through the board of directors, thus improving monitor-
ing within the organization. Given the potentially superior incentive structure
that comes with these changes, Jensen goes so far as to suggest that LBOs, or
public corporations that imitate the incentive structures of LBOs, could supplant
the more typical public corporation in mature industries.1 At the very least,
Jensen argues, many public companies could benefit substantially by adopting
aspects of the LBO form such as higher leverage, larger equity stakes for
managers, and perhaps the participation of large blockholders.

*This article draws heavily on “The Financial Performance of Reverse Leveraged Buyouts,” by Robert W. Holthausen and
David F. Larcker, Journal of Financial Economics 42, 1996, pp. 293-332.
1. See Michael C. Jensen, “The Eclipse of the Public Corporation,” Harvard Business Review 67 (1989), pp. 61-74. Although
supported by G. Bennett Stewart (see “Remaking the Public Corporation from Within,” Harvard Business Review 68 (1990),
pp. 126-137), Jensen’s view of LBO’s is controversial. For example, Alfred Rappaport argues that LBO-like organizations are
inherently transitory in nature and that they are not likely to supplant the public corporation. In particular, Rappaport argues
that concentrated equity ownership and high leverage make it difficult for the organization to be flexible enough to respond
to changing economic conditions and competitive pressures, and that demand for capital, liquidity desires, and risk-sharing
incentives will eventually force the public sale of the LBO organization (see Alfred Rappaport, “The Staying Power of the Public
Corporation,” Harvard Business Review 68 (1990), pp. 96-104).

8
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JOURNAL OF
JOURNAL
APPLIEDOF
CORPORATE
APPLIED CORPORATE
FINANCE FINANCE
 A number of previous empirical studies have
provided convincing evidence of improvements in
the performance of firms that undergo LBOs.2 To our
knowledge, however, no studies have directly ex-
amined the association between the extent of the
change in organizational incentives at the time of
the LBO and the subsequent change in performance.
Nor have researchers documented the performance
of reverse LBOs—those LBO firms that choose to go
public again in an IPO—after they return to public
ownership to see whether such performance im-
provements are sustained under a different organi-
zational structure.
In a study published in 1996, we examined the
performance of reverse LBOs in order to provide
additional evidence about the extent to which
leverage and concentration of ownership provide
desirable incentives within organizations. The premise
of our study was that if the high leverage and
concentrated equity ownership of LBOs motivate
these firms to operate more efficiently while they are
private, we would expect the decline in leverage and
the dispersion of equity ownership to lead to a
decline in performance after they go public. At the
same time, though, we might also expect to find
lingering effects from the LBO; that is, to the extent
that reverse LBOs continue to have higher leverage
and more concentrated ownership than their indus-
try competitors, the reverse LBOs might continue to
outperform their industries.
Notwithstanding the incentive arguments pre-
sented by Jensen, other financial economists have
offered competing predictions about the effects
of changes in leverage and managerial equity
ownership. For example, while increased mana-
gerial ownership of the firm’s common equity
could improve financial performance because the
key officers have a greater stake in any value-
increasing actions that are taken, it is also possible
that increased managerial ownership could hurt
performance because of managers’ risk aversion
and the potential underdiversification of their
wealth. For example, managers with large equity
stakes in highly leveraged firms may reject some
higher-risk but more profitable (higher NPV)
2. See Steven Kaplan, “The Effect of Management Buyouts on Operating
Performance and Value,” Journal of Financial Economics 24 (1989), pp. 217-254,
Chris Muscarella and Michael Vetsuypens, “Efficiency and Organizational Struc-
ture: A Study of Reverse LBOs,” Journal of Finance 45 (1990), pp. 1389-1413, and
Abbie Smith, “Corporate Ownership Structure and Performance: The Case of
Management Buyouts,” Journal of Financial Economics 27 (1990), pp. 143-164. For
9
VOLUME 10 NUMBER 1
projects, and accept lower-risk but less profitable
(lower NPV) projects. Indeed, it seems plausible
that managers in LBOs, faced with the pressure of
servicing a substantial amount of debt, would not
even consider all available projects, concentrat-
ing instead on only those where the payoffs are
relatively assured and immediate.
In our study, we conducted a detailed examina-
tion of the performance and change in organiza-
tional structure (leverage and equity ownership) of
a sample of 90 LBOs that went public between
January 1983 and June 1988. At the time of the IPO,
there was a substantial decline in the mean leverage
ratio and the average equity ownership by insiders
(all officers, directors, and employees). Even so,
equity ownership by managers and other insiders
remained more concentrated and leverage remained
higher than that of typical public corporations. Thus,
when these LBOs returned to public ownership, they
became “hybrid” organizations that retained some of
the important features of the LBO organization.
The key findings of our study are summarized
below:
The operating performance of reverse LBOs, as
measured by operating income/assets and operating
cash flow/assets, is significantly better than that of
the median firm in their industries in the year prior
to and in the year of the IPO. Moreover, the reverse-
LBO firms continue to outperform their industry
competitors for at least the first four fiscal years after
the IPO (though the evidence in the third year is less
strong). Nevertheless, there is some evidence of a
deterioration in the performance of the reverse-LBO
firms after the IPO.
Reverse-LBO firms spend less on capital expen-
ditures than the median firms in their industries
prior to the IPO. After the IPO, their capital
expenditures return to the median level of their
industry counterparts.
Reverse-LBO firms have significantly smaller
amounts of working capital than their industry
counterparts both before and after the reverse LBO.
There is evidence, however, of an increase in the
amount of working capital held by reverse-LBO
firms after they go public.
a case study illustrating improvements in both organizational incentives and
monitoring, see also George Baker and Karen Wruck, “Organizational Changes and
Value Creation in Leveraged Buyouts: The Case of the O.M. Scott & Sons Company”,
Journal of Financial Economics 25 (1989), 163-190. A shorter, less technical version
of this study appears in Vol. 4 No. 1 of this journal.
SPRING 1997
 Changes in operating performance (measured
from one year before to up to four years after the
reverse LBO) are unrelated to the change in leverage
at the time of the reverse LBO. At the same time, we
find that greater declines in the percentage equity
owned by operating management and other insiders
at the time of the reverse LBO are associated with
larger declines in operating performance.
Changes in working capital and capital expendi-
tures are negatively related to the percentage equity
owned by nonmanagement insiders. In particular, as
nonmanagement insider ownership falls, working
capital and capital expenditures increase.
Although these findings are generally consis-
tent with the argument that organizational incentives
affect performance, there is another possible expla-
nation: LBO managers and other owners may believe
either that firm performance has “peaked” or that the
IPO market is willing to pay more than the firm’s
earnings prospects would justify. According to this
explanation, reverse LBOs could thus reflect man-
ager-owners’ attempts to take advantage of a tempo-
rary market mispricing.
To test this possibility, we examined the stock
market performance of reverse LBOs. If managers
were able to issue shares at temporarily inflated
values, we would anticipate negative stock market
performance for reverse LBOs. Our evidence, how-
ever, shows that the stock market returns of LBOs
outperform (or at worst equal) those of the broad
market after the IPO.
CHANGES IN LEVERAGE AND
OWNERSHIP STRUCTURE
Our sample of 90 reverse LBOs comes from an
October 1988 report by Kidder, Peabody & Co.
entitled “Analysis of Initial Public Offerings of Lever-
aged Buyouts.” The data represent all IPOs of LBOs
identified by IDD Information Services, Inc. that
occurred between January 1, 1983 and June 30, 1988
and raised at least $10 million in the common stock
offering. Our sample of LBOs was concentrated in
the 1985 to 1986 period, and the associated IPOs
were concentrated in 1986 and 1987.
Financial information, such as changes in lever-
age and ownership structure at the time of the IPO,
3. Pre-IPO levels refer to the data just prior to the IPO and post-IPO levels refer
to pro forma data for the period immediately after the IPO as described in the
prospectus.
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was obtained from the prospectuses for the public
offering. Stock return data were taken from the files
of the Center for Research in Security Prices (CRSP).
Accounting data were collected from prospectuses
and the Compustat annual industrial, research, and
full coverage files. We obtained information about
the ownership structure and board structure three
years after the IPO from proxy statements.
Using these sources of information, we exam-
ined changes in the financial and organizational
structure (leverage, ownership, and board of direc-
tors) of reverse-LBO firms around the time of the
IPO. The mean leverage ratio (based on book
values) fell from 83% prior to the IPO to 56% after the
IPO, where leverage is defined as the sum of long-
term debt, short-term debt, capitalized leases, and
redeemable preferred stock divided by the sum of all
of the above plus the book value of common equity.3
Debt reduction was the primary use of the proceeds,
with 57% of the firms using 100% of the proceeds to
reduce debt, 28% of the firms using 50% to 99% of
the proceeds to reduce debt, and only 5% of the firms
using none of the proceeds to reduce debt. Other
commonly cited purposes for the proceeds cited in
the prospectuses were working capital, general
corporate purposes, capital expenditures, retire-
ment of preferred stock, and acquisitions.
There were also substantial shifts in the concen-
tration of ownership at the time of the IPOs. The
average ownership of insiders declined from 75%
before the IPO to 49% after the IPO. Insiders include
all officers, directors, employees and their relatives,
and all holdings voted by these people. The equity
ownership of a firm that organizes and/or invests in
LBOs, such as Kohlberg, Kravis and Roberts, would
be included in insiders’ holdings because of its
representation on the board of directors.
The average equity ownership of operating
management fell from 37% of the outstanding eq-
uity prior to the IPO to 24% after the IPO. (Operat-
ing management is defined as operating manage-
ment and other employees (if disclosed) and ex-
cludes directors who have no operating responsi-
bilities.) On average, managers sold 8% of their
stake. Nevertheless, in over half (59%) of the trans-
actions, managers sold none of their equity—and in
some cases their proportional ownership actually
 Interestingly, the period of public trading in the reverse-LBO firms was quite short
for many of them. Through the end of 1993, 36 of the 90 companies had been
acquired by another corporation and eight had completed another LBO.
increased. At the same time, the average equity
ownership by nonmanagement insiders (all officers
and directors who are not considered part of oper-
ating management) fell from 38% before the IPO to
25% after the IPO.
In the process of going public, 34% of the
outstanding equity of the average firm was trans-
ferred to public hands (that is, it was no longer
owned by insiders or other pre-IPO equity holders,
such as private investors, debtholders, or funds
without board representation). Moreover, following
the IPOs, there was a broad range of public owner-
ship in the sample, with the percentage of equity
publicly held by outsiders varying from 4% to 88%
of the outstanding equity.
While the leverage and concentration of equity
ownership decreased substantially when these firms
went public, the leverage and ownership of equity
by managers and other insiders was still large relative
to the leverage and insider equity ownership of the
typical public corporation. For example, median
insider ownership after the IPO was 51.3%, whereas
insider ownership was approximately 5.0% for 1,000
nonfinancial companies followed by Value Line in
1986. Further, the leverage of the reverse-LBO firms
after the IPO was approximately 44% higher, on
average, than for firms in their industry.
Even though the average declines in the own-
ership stake for management and nonmanagement
insiders were approximately the same (–13%), the
changes in ownership for operating management
and nonmanagement insiders were inversely corre-
lated (correlation of –0.404). This suggests that even
though both management and nonmanagement
ownership generally declines, larger declines in
ownership by one group tend to be associated with
more modest declines in ownership by the other.
Further, despite the declines in both leverage and
equity ownership by insiders, the correlation be-
tween the leverage changes and ownership changes
is very small and insignificant.
We also examined the composition of the
board of directors for our sample. There were an
average of seven directors for our sample firms at
the time of the IPO. On average, 34% of the board
of directors were operating managers, while 33% of
the board were nonmanagement capital providers
(such as representatives of leveraged buyout firms,
debtholders, or other investors owning 5% or more
of the equity who are not operating managers).
External board members constituted 27% of the
11
VOLUME 10 NUMBER 1
board, on average, and 6% of the seats were va-
cant. (Nonmanagement board members were clas-
sified as external if they owned less than 5% of the
shares or if they represent an organization that
owned less than 5% of the shares. If the board
member or affiliated organization owns 5% or more,
the board member was classified as a nonmanage-
ment capital provider.)
While there are no well-defined criteria for
judging whether these boards of directors are un-
usual, the size of the boards of reverse-LBO firms is
clearly smaller than the board sizes typically re-
ported in studies of board structure. Moreover, there
is far more representation by nonmanagement capi-
tal providers (active investors) who have a significant
ownership stake in the organization.
There is not much evidence of a significant
change in either management or the board of
directors at the time of the IPO. Of all board members
currently serving, only 12.5% (or about one in eight),
on average, were appointed within six months of the
IPO, and these new board members did not neces-
sarily replace former board members. More likely,
the board size was increased and these were new
appointments. Because the prospectuses rarely dis-
close changes in the size of the board, it was difficult
to obtain information on changes in board structure.
In only one case was a dramatic change in the board
disclosed (in this case, 80% of the board was
replaced). Moreover, only three out of 90 CEOs
changed within six months prior to the IPO date.
Interestingly, the period of public trading in the
reverse-LBO firms was quite short for many of them.
Through the end of 1993, 36 of the 90 companies had
been acquired by another corporation and eight had
completed another LBO. For these 44 acquired firms,
the average time to acquisition was 30 months. Eight
companies had a significant event of default (violat-
ing a covenant, missing an interest or principal
payment, or filing for bankruptcy) and 37 were still
public as of December 31, 1993.
THE OPERATING PERFORMANCE AND
INVESTMENT DECISIONS OF REVERSE LBOs
To assess the relative operating performance of
reverse LBOs, we measured operating performance
using two different (although related) accounting
ratios that are widely used as measures of perfor-
mance: operating income and operating cash flows.
We did not use common stock returns to measure
SPRING 1997
relative operating performance since any expected
decline in the performance of the company attribut-
able to its reversion to a public corporation should
be impounded in the offering price; and, to the
extent this is so, changes in organizational structure
observed at the IPO would be uncorrelated with
subsequent returns.
To avoid the mechanical effect of leverage on
the results, both variables measured flows on a
before-tax and before-interest basis. In addition, we
used several different benchmarks for assessing
expected performance, including “unadjusted” and
“industry-adjusted” benchmarks. Only firms that
were private for the full fiscal year prior to the fiscal
year of the IPO were used in subsequent tests, a
condition that caused us to eliminate eight of the 90
firms from consideration.
The first operating performance measure we
examined was the ratio of operating earnings before
depreciation, interest, and taxes as a percentage of
total assets (denoted “OPINC/assets”). The second
measure was the ratio of operating cash flow before
interest and taxes as a percentage of total assets
(“OCF/assets”). The primary difference between the
OCF measure and the OPINC measure is that the
OCF measure eliminates many accounting accruals.
And, since the accounting accrual process tends to
smooth reported earnings relative to cash flows, the
OCF measure exhibits more variability than the
OPINC measure. OPINC, however, is more highly
correlated with stock returns than OCF. Neverthe-
less, one advantage of the OCF measure is that by
eliminating many accruals (which are at least par-
tially at the discretion of management), the measure
is less susceptible to manipulation. Another advan-
tage of the OCF measure is that it is directly affected
by changes in working capital management.
As mentioned, we assessed the performance of
our sample firms using two different benchmarks.
First, we examined a “raw” or unadjusted measure.
Second, we calculated an industry-adjusted perfor-
mance measure, one that controls for time period
and industry effects by examining the performance
of the reverse-LBO firm after subtracting the contem-
poraneous median performance of the firms with
the same two-digit SIC code as each reverse-LBO firm.
4. While year 0 is the fiscal year of the IPO, we have no control over when
in the fiscal year the IPO occurs. Hence, for some firms, year 0 may be based largely
on the operating results of the firm when it is private and for others the results may
be based largely on a period when the firm is public.
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The Operating Performance of Reverse LBOs
Panel A of Table 1 presents median operating
performance measures from one year before the IPO
(year –1) to four years after the IPO. Year 0 is defined
as the fiscal year that includes the IPO.4 Thus, when
we refer to performance two years after the IPO, we
do not literally mean the performance over the two
years after the company goes public, but rather the
performance over the two fiscal years since the fiscal
year in which the company went public.
Given that a large number of reverse-LBO firms
are later acquired or go bankrupt and that our tests
require the use of accounting data that are not
generally available for those firms, the number of
observations available varies across years. As can be
seen from Panel A of Table 1, the performance of the
reverse LBOs dominates that of their industries in the
year prior to the IPO. In year –1, the median OCF/
assets and OPINC/assets for the reverse-LBO firms
were 19.3% and 19.5%, respectively, as compared to
approximately 10% and 12% for the median firm in
the industry. Reflecting these differences between
our sample firms’ and their competitors’ perfor-
mance, the median industry-adjusted OCF/assets
was 9.2% and the median industry-adjusted OPINC/
assets was 7.7%.5
Results for the years after the IPO suggest that
these firms continue to outperform their industries
for the four years following the IPO, as the median
industry-adjusted performance for OPINC/assets and
OCF/assets is positive (and significantly different
from zero, though the evidence in year +3 is weaker
than in years +1, +2, or +4). But even though the
median reverse-LBO firm continues to outperform its
industry, as we discuss below, the margin of supe-
riority appears to shrink over time.
In Panel B of Table 1, we examine changes in
operating performance for the reverse LBOs. This
analysis is conducted to test the possibility that the level
of a firm’s performance could be significantly better
than its industry throughout the period in question
(years –1, 0, +1, +2, +3, and +4), while the firm also
experiences a significant change (decline or improve-
ment) in its performance relative to its own prior per-
formance or that of its industry. The fiscal year prior to
5. These results should not be interpreted as evidence that LBO firms in general
outperform their industries, because of the potential selection bias associated with
the subset of LBO firms that have a subsequent public offering.
 Median insider ownership after the IPO was 51.3%, whereas insider ownership was
approximately 5.0% for 1,000 nonfinancial companies followed by Value Line in
1986. Further, the leverage of the reverse-LBO firms after the IPO was approximately
44% higher, on average, than for firms in their industry.

TABLE 1 PANEL A: RESULTS ON THE LEVELS OF OPERATING PERFORMANCE

OPERATING Avg Years
PERFORMANCE OF Year –1 Year 0 Year +1 Year +2 Year +3 Year +4 +1 to +4
REVERSE LBOSa
Median level of OCF/assets (%)
Firm 19.3%*** 14.6%*** 11.9%*** 14.3%*** 13.5%*** 15.4%*** 15.0%***
Industry–adjusted 9.2%*** 4.7%*** 1.4% 4.0%*** 2.3% 2.9%** 4.1%***
# observations 54 58 55 45 44 39 37

Median level of OPINC/assets (%)

Firm 19.5%*** 19.8%*** 17.5%*** 17.1%*** 14.7%*** 15.3%*** 16.7%***
Industry–adjusted 7.7%*** 7.9%*** 5.2%*** 5.4%*** 2.9%* 4.3%*** 4.7%***
# observations 62 66 56 47 44 39 38

PANEL B: RESULTS ON THE CHANGES IN OPERATING PERFORMANCE

Year –1 Year –1 Year –1 Year –1 Year –1 Year –1 to
to to to to to Avg Years
Year 0 Year +1 Year +2 Year +3 Year +4 +1 to +4

Median change in OCF/assets (%)

Firm –4.7%*** –6.2%*** –4.4%* –4.5%* –2.1% –2.6%
Industry-adjusted –4.3%** –6.5%*** –4.5%* –5.2%** –3.1% –3.2%
# observations 51 51 42 40 36 35

Median change in OPINC/assets (%)

Firm 0.4% –1.3% –2.2% –4.1%*** –3.4%** –2.0%
Industry-adjusted 0.2% –1.6% –1.9% –3.6%** –2.0%* –1.5%
# observations 62 55 46 43 38 37

a. Year –1 is the fiscal year ending prior to the IPO completion year of Year 0.
*,**,*** — Significantly different from 0 at the 10%, 5% and 1% levels, respectively (two-tailed test).

the fiscal year of the IPO (year –1) was used as the
benchmark in assessing the extent of such changes.
Results using the change in unadjusted firm
performance provide evidence of a significant de-
cline in OCF/assets from the year prior to the IPO to
years 0, +1, +2, and +3, but not to year +4 (although
one should keep in mind that the sample size has
declined to 36 observations by year +4). Using the
OPINC/assets performance measure, we find no
evidence of a statistically significant decline from
year –1 to years 0, +1, or +2, but there are significant
declines in years +3 and +4. At the same time,
however, when using either measure of operating
performance we found no significant differences
between the performance in year –1 and the average
performance from year +1 to +4. The results using
industry-adjusted performance measures parallel
those using the unadjusted measures in terms of the
years in which declines are significant for both
performance measures.
In general, then, the evidence in Table 1 sug-
gests that the operating performance of firms that
complete a reverse LBO exceeds the performance of
their industries at the time of the IPO. Moreover, the
evidence is reasonably consistent with the conclu-
sion that this superior performance lasts for at least
four fiscal years after the fiscal year of the IPO. But
there is also some evidence of a decline in perfor-
mance after the IPO, although this result is sensitive
to the performance measure and benchmark used.6

6. The choice of benchmarks is obviously important for interpreting our
results. In our original paper published in the Journal of Financial Economics, we
also used a performance-matched benchmark that takes the perfomance of the
reverse-LBO firm and subtracts the contemporaneous median performance of all
firms in the same two-digit SIC code whose operating performance was similar to
that of the reverse-LBO firm in the year prior to the IPO. Since firms that are
performing very well or very poorly tend to achieve subsequent performance that
is closer to the norm for their industry, the performance-matched benchmark
allows us to assess whether the performance observed for the reverse-LBO sample
(which undergoes changes in organizational structure) is different from the
performance observed for a sample of firms in the same industry that are chosen
solely on the basis of having performance similar to that of the reverse-LBO firm
in the reverse-LBO firm’s year –1. In general, we find that reverse-LBO firms perform
similarly to the firms in the performance-matched benchmark from years –1 to year
+4. For more detail on this comparison, please refer to the article published in the
Journal of Financial Economics (cited on the first page of this article).

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VOLUME 10 NUMBER 1 SPRING 1997
TABLE 2 PANEL A: RESULTS ON THE LEVEL OF CAPITAL EXPENDITURES AND WORKING CAPITAL
CAPITAL EXPENDITURES Year –1 Year 0 Year +1 Year +2 Year +3 Year +4 +1 to +4
AND WORKING CAPITAL
OF REVERSE LBOSa Median level of capital expenditures/assets (%)
Firm 4.3%*** 4.8%*** 5.3%*** 4.7%*** 5.4%*** 4.4%*** 5.6%***
Industry-adjusted –1.3%** –0.5% 0.0% –0.5% 0.0% –0.4% 0.4%
# observations 61 66 55 47 43 37 36

Median level of working capital/assets (%)

Firm 14.4%*** 14.5%*** 15.0%*** 13.8%*** 13.1%*** 14.5%*** 13.4%***
Industry–adjusted –14.0%*** –13.6%*** –10.1%*** –10.7%*** –12.1%*** –10.6%*** –11.5%***
# observations 54 53 55 45 43 38 37

PANEL B: RESULTS ON THE CHANGES IN CAPITAL EXPENDITURES AND WORKING CAPITAL

Year –1 Year –1 Year –1 Year –1 Year –1 Year –1 to
to to to to to Avg Years
Year 0 Year +1 Year +2 Year +3 Year +4 +1 to +4

Median change in capital expenditures/assets (%)

Firm 0.8%** 0.6% –0.0% 0.7% –0.2% 0.7%
Industry-adjusted 1.2%*** 1.2%* 0.6% 1.4% 1.1% 1.5%
# observations 61 53 45 41 35 34

Median change in working capital/assets (%)

Firm 0.0% 1.5% 0.8% 0.5% 1.3% 0.8%
Industry-adjusted 1.1% 3.4%** 3.8%** 3.6%** 5.1%** 4.3%**
# observations 49 53 43 41 36 35

a. Year –1 is the fiscal year ending prior to the IPO completion year of Year 0.
*,**,*** — Significantly different from 0 at the 10%, 5% and 1% levels, respectively (two–tailed test).

Capital Expenditures and Working Capital
of Reverse LBOs
In addition to investigating operating perfor-
mance, we examined working capital management
and capital expenditures. In particular, we were
interested in determining whether capital expendi-
ture patterns and working capital management of
reverse-LBO firms were significantly different from
those of their industry counterparts, and whether
those patterns changed over time. The previously
cited studies on LBOs found that firms reduce some
of their expenditures on discretionary items and
manage working capital more efficiently after going
private in an LBO. Thus, another potential manifes-
tation of poor performance would be that newly
public firms begin to overinvest in capital expendi-
tures and manage working capital less efficiently.
Panel A of Table 2 provides an analysis of the
unadjusted and industry-adjusted level of capital
expenditures and working capital, both as a percent-
age of total assets. Reverse-LBO firms spent signifi-
cantly less than the industry norm on capital expen-
ditures in the year prior to the IPO, but in later years
there was no difference in capital expenditures
between the reverse-LBO firms and their industry
medians. The industry-adjusted ratio of working
capital to assets was significantly negative in every
year, indicating that the reverse-LBO firms carried
significantly less working capital than other firms in
their industry. Indeed, the reverse-LBO firms carry
approximately half of the working capital carried by
the typical firm in their industry.
Panel B of Table 2 provides an analysis of changes
in capital expenditures and working capital. Unad-
justed changes in capital expenditures showed a
significant increase from year –1 to year 0, but none
of the other differences was significant. Industry-
adjusted changes in capital expenditures increased
significantly between years –1 and 0 and year –1 and
+1; but although subsequent years generally saw
increases relative to year –1, no other observed
changes were statistically significant. Changes in the
level of capital expenditures in years 0 and +1 are

14
JOURNAL OF APPLIED CORPORATE FINANCE
 The operating performance of reverse LBOs is significantly better than that of the
median firm in their industries in the year prior to and in the year of the IPO.
Moreover, the reverse-LBO firms continue to outperform their industry competitors
for at least the first four fiscal years after the IPO.
probably expected, given the infusion of cash into
these firms from the public offering. Further, although
there is no evidence of an increase in the level of
unadjusted working capital for these firms, industry-
adjusted working capital for these firms increased.
LINKING CHANGES IN PERFORMANCE TO
CHANGES IN OWNERSHIP AND LEVERAGE
Up to this point, we have examined the median
levels and changes in performance, capital expendi-
tures, and working capital. While interesting, these
results do not provide evidence on whether the
changes in performance are systematically related to
changes in organizational structure. In order to
provide evidence of a systematic linkage between
incentives and performance, we designed a series of
regressions intended to reveal the relationship be-
tween changes in performance and changes in
leverage and ownership structure.
For purposes of these regressions, our primary
measures of the change in performance were the
changes in OPINC/assets and OCF/assets (measured
in percent) between year –1 and year +1, and the
changes of the same two ratios between year –1 and
the average of years +1 to +4. We also used as
performance measures the changes in working
capital and the changes in capital expenditures over
the same two periods. The variables measuring
change in organizational structure were the change
in leverage and the changes in the percentage of
equity owned by operating management and non-
management insiders.
Moreover, the changes in the organizational
structure variables were measured at the time of the
IPO, regardless of whether we examine the change
in accounting performance between years –1 and +1
or between years –1 and the average of years +1 to
+4. Thus, we effectively assumed that the change in
incentives that occurred in year 0 was related to
subsequent changes in performance. Since we do
not know how quickly a change in performance
arising from a change in incentive structures would
be reflected in the financial statements, we examined
the two alternative intervals.
7. The results reported in Table 3 use the “raw” or “unadjusted” firm
performance measures. In results not reported here, we have also included controls
for industry performance. The coefficients and significance levels are almost
identical to those reported.
8. The F-statistics of the regressions are generally significant and the adjusted-
2
R ’s of the equations range from 6.4% to 33.5%.
15
VOLUME 10 NUMBER 1
If reducing leverage and the concentration of
ownership reduces managers’ incentives to achieve
superior performance, we should expect to find
positive coefficients on the leverage and ownership
variables when OCF/assets and OPINC/assets are
the dependent variables. If, however, very high
leverage and concentrations of ownership constitute
a relatively poor incentive structure, reducing lever-
age and ownership concentration should improve
performance and the coefficients on leverage and
the ownership variables should be negative. More-
over, if reducing leverage and the concentration of
ownership reduces managerial incentives to per-
form, and if increases in working capital and capital
expenditures imply poorer performance because
managers are paying less attention to working
capital management and are relaxing constraints on
capital expenditures, then the signs on leverage and
ownership should be negative.
As presented in Table 3, the results of the first
four regressions7 provide no evidence that changes
in leverage are associated with changes in account-
ing performance. By contrast, the changes in the
percentage ownership by operating management
and nonmanagement insiders are generally signifi-
cant and positively associated with changes in
accounting performance.8 The positive coefficients
on the percentage of equity owned by operating
management and other insiders indicate that the
greater the decline in the percentage of outstanding
equity owned by these groups, the greater the
decline in subsequent accounting performance.9
To get a sense of the economic importance (as
opposed to the statistical significance) of the owner-
ship coefficients, consider the regression of OCF/
assets in Panel A from year –1 to the average of year
+1 to +4, where the estimated coefficients on the
change in the two equity positions are 0.44 for
operating management and 0.35 for nonmanage-
ment insiders. Recall also that the median OCF/assets
in year -1 for this sample was 19.3%. On average, the
firms that enter this regression experienced a 13%
drop in both the percentage of equity owned by
operating management (that is, their average own-
ership fell from 37% to 24%) and in the percentage
9. Note also that the coefficients on the effect of ownership changes are
generally unaffected by the time period used to measure the change, but are
approximately twice as large for the OCF/assets equations than for the OPINC/
assets equations. But, since there is a much smaller change in the OPINC/assets
than the OCF/assets numbers (see Table 1), this is perhaps not surprising.
SPRING 1997
TABLE 3 THE ASSOCIATION BETWEEN OPERATING PERFORMANCE, LEVERAGE, AND OWNERSHIP*, a
Independent variables
Change in Change in Non-
Change in Mgmt. Mgmt. Insider Adj F- No.
Dependent Variable Intercept Debt/Capital % Equity % Equity R2 Stat Obs.

Change in firm OPINC/assets 2.76 0.89 0.13 0.17 7.3% 2.39 54

from year –1 to +1 (0.220) (0.853) (0.042) (0.029) (0.088)

Change in firm OPINC/assets 4.26 –1.87 0.22 0.21 11.9% 2.57 36

from year –1 to the (0.136) (0.776) (0.025) (0.050) (0.071)
average of years +1 to +4

Change in firm OCF/assets 1.73 –7.61 0.38 0.40 22.9% 5.95 51

from year –1 to +1 (0.636) (0.317) (0.001) (0.002) (0.002)

Change in firm OCF/assets 6.25 –3.55 0.44 0.35 33.5% 6.71 35

from year –1 to the (0.065) (0.641) (0.000) (0.006) (0.001)
average of years +1 to +4

Change in firm working capital/ –2.96 3.26 –0.23 –0.24 12.3% 3.37 52
assets from year –1 to +1 (0.297) (0.586) (0.007) (0.017) (0.026)

Change in firm working capital/ –1.34 4.16 –0.07 –0.28 14.2% 2.77 33
assets from year –1 to the (0.611) (0.505) (0.448) (0.008) (0.060)
average of years +1 to +4

Change in firm capital expenditures/ –1.29 –4.40 0.00 –0.08 10.0% 2.88 52
assets from year –1 to +1 (0.292) (0.084) (0.940) (0.054) (0.045)

Change in firm capital expenditures/ –0.95 –1.78 0.01 –0.08 6.4% 1.73 33
assets from year –1 to the (0.454) (0.541) (0.739) (0.095) (0.183)
average of years +1 to +4

* Cross-Sectional Regression Analysis of changes in percentage firm performance after the initial public offering as a function of changes in leverage, change in
the percentage of equity owned by operating management, and change in the percentage of equity owned by non-operating management insiders for 90 reverse-
LBO firms.
a. Year +1 is the fiscal year ending after the IPO completion year of Year 0. The significance levels for each estimated regression coefficient are reported in
parentheses below the estimate. All reported significance levels are two-tailed.

of equity owned by nonmanagement insiders (which
dropped from 38% to 25%). According to our
regression results, a firm experiencing this average
(13%) decline in the percentage equity owned by
management sees its OCF/assets ratio decline by
5.7% (that is, from 19.3% to 13.6%) relative to a firm
whose managers’ percentage equity owned does not
decline, other things equal. And a firm experiencing
the average decline in the percentage equity owned
by nonmanagement insiders (also 13%) loses an
additional 4.55% in OCF/assets, relative to a firm
whose nonmanagement insiders’ percentage equity
owned does not decline, other things equal. Given
the median OCF/assets in year –1 of 19.3%, these
losses each represent about 25% of the ratio’s value
in year –1.
The last four regressions in Panel A use working
capital and capital expenditures as the dependent
variables. Again, there is no evidence that changes
in leverage are associated with changes in working
capital, and only very weak evidence of a negative
association between changes in leverage and changes
in capital expenditures. Further, there is only very
weak evidence of a negative association between
changes in managerial ownership and changes in
working capital, and no evidence of an association
between changes in managerial ownership and
capital expenditures.
However, there is strong evidence of a negative
association between changes in nonmanagement
insider ownership and both working capital and
capital expenditures. That is, as nonmanagement

16
JOURNAL OF APPLIED CORPORATE FINANCE
 There is strong evidence of a negative association between changes in
nonmanagement insider ownership and both working capital and capital
expenditures. That is, as nonmanagement insiders’ equity decreases, working capital
and capital expenditures increase.
insiders’ equity decreases, working capital and capi-
tal expenditures increase. The coefficients on non-
management insider ownership in the working
capital regressions (which range from –0.24 to –0.28)
suggest that a firm experiencing the average decline
in the percentage equity owned by nonmanagement
insiders (13%) sees its working capital/assets ratio
increase by about three percentage points relative to
a firm whose nonmanagers’ percentage equity did
not decline. Given the median working capital/
assets in year –1 of 14.4%, this represents more than
a 20% increase in working capital relative to the value
in year –1. A similar calculation using the nonman-
agement insider ownership coefficient from the
capital expenditure regressions of –0.08 implies an
increase in capital expenditures/assets of 1.04%,
which approximates a 25% increase in the level of
capital expenditures relative to year –1.10
THE STOCK MARKET PERFORMANCE
OF REVERSE LBOs
Overall, Table 3 provides evidence that changes
in accounting performance observed after the re-
verse LBO are related to changes in the concentra-
tion of ownership by operating management and
nonmanagement insiders. One interpretation of the
evidence is that reductions in the concentration of
ownership lead to an inferior incentive structure and
therefore performance deteriorates. An alternative
interpretation, however, is that managers optimally
choose the timing of the IPO transaction to take
advantage of an information “asymmetry”—that is, a
significant disparity between their private informa-
tion and the information known to the market that
might cause public investors to overpay in an IPO.
According to this interpretation, managers reduce
their ownership stake more as their expectation of
performance falls. (Of course, examining the rela-
tion between changes in equity ownership and
10. One difficulty associated with interpreting the working capital and capital
expenditure regressions is that many firms explicitly indicate that they are going
public in order to raise funds for the purposes of increasing working capital and
capital expenditures. Of interest to us is the effect of the incentive structure on
capital expenditures and working capital. We are not interested in the effects of
an infusion of cash on working capital and capital expenditures if that was the
purpose of the equity offering, assuming that the effects of that infusion do not
represent incentive problems. As the ownership stakes of the managers and
nonmanager insiders fall, more capital is likely to be raised by the firm, and thus
the negative association between ownership and both working capital and capital
expenditures may be due to the cash infusion. To see whether our results on
leverage and ownership are sensitive to controlling for the capital infusion into the
firm, we reran all of the working capital and capital expenditure regressions with
an additional control variable for the net proceeds of the offering less the amount
17
VOLUME 10 NUMBER 1
operating performance is only tangentially related to
this timing explanation because it does not directly
relate to changes in shareholder wealth.) In this
section, we examine the stock market performance
of reverse LBOs to determine if there is any evidence
that managers act opportunistically.
If managers take advantage of their private
information to sell their shares at an inflated offer-
ing price, we would anticipate significantly nega-
tive shareholder returns following the IPO. Previ-
ous studies have documented that the stock price
performance of IPOs in the 1975-1984 period (not
reverse LBOs) underperforms the value-weighted
New York and American Stock Exchange Index by
approximately 25% over the first three years of
listing (excluding the day of listing). A similar
finding in the reverse-LBO data would be consis-
tent with managers’ taking advantage of an infor-
mational asymmetry.
The mean opening-day raw return for the 89
reverse-LBO firms for which opening-day closing
price data was available on the CRSP tapes was
2.03%. Of these, 43 had a positive return, 24 had a
negative return, and 22 had a zero return. Previous
studies on IPOs (excluding reverse LBOs) generally
document mean first-day returns above 10%. Thus,
the initial day’s return is much smaller for the sample
of reverse LBOs than for IPOs in general.
To examine this issue further, we investigated
longer holding periods beginning with the closing
price on the opening-day. In assessing the longer-
term stock market performance of reverse LBOs, we
used three different metrics: buy-and-hold returns;
buy-and-hold returns in excess of the buy-and-hold
returns for the value-weighted New York and Ameri-
can Stock Exchange Index (market-adjusted re-
turns); and Jensen alphas.11 The three different
measures were calculated for 12-, 24-, 36-, and 48-
month holding periods beginning with the closing
price on the date of the IPO.
used to retire debt (deflated by assets). The regression results were not sensitive
to the inclusion of this variable. Therefore, the associations between ownership and
working capital and capital expenditure do not appear to be mechanically induced
by the IPO.
11. Jensen alphas assume that the Capital Asset Pricing Model is correctly
specified. The Jensen alpha for each firm is the intercept from estimating a firm-
specific time series regression of monthly firm excess returns (the firm’s returns in
excess of one-month U.S. Treasury Bill returns) on the value-weighted NYSE/
AMEX excess returns (the value-weighted NYSE/AMEX return in excess of one-
month U.S. Treasury Bill returns). Regressions use the maximum number of
observations available up to the number of months in the reported holding period.
(The mean and median betas for the reverse LBOs vary between 1.3 and 1.5
depending on the time period examined.)
SPRING 1997
 Our examination of longer-term performance
yielded no evidence of negative returns subsequent
to the reverse LBO. In particular, mean and median
returns, market-adjusted returns, and Jensen alphas
at 12 months were all insignificantly different from
zero. At 24, 36, and 48 months, mean and median raw
returns were positive and significantly different from
zero. Mean and median market-adjusted returns
were positive at 24, 36, and 48 months, but only the
24-month return was significant at conventional
levels. For the Jensen alphas, the means at 24, 36, and
48 months were all positive and also significant at the
10% or better level at 24 and 36 months, while the
medians were always negative but never signifi-
cantly different from zero at conventional levels.
Overall, then, the market performance of the
reverse LBOs after their public offerings was either
positive or insignificantly different from zero, de-
pending on the time period and performance metric
chosen. Since there was no evidence of statistically
negative excess returns, there is no support at the
overall sample level for the hypothesis that managers
were able to take advantage of an information
asymmetry to enrich themselves. Moreover, the
pricing of reverse LBOs seems quite rational relative
to the pricing of other IPOs, for reverse LBOs
experience neither a large increase in value on the
offering date nor a large decline in value over the
subsequent three years.
We also examined the extent to which cross-
sectional variation in excess returns can be ex-
plained by the change in leverage and ownership
structure. If the initial public offering market is
efficient, we would not anticipate that the change in
organizational structure variables would explain any
of the cross-sectional variation in subsequent market
performance, since those variables are known at the
time of the offering. While the amount that insiders
sell in the offering or by which they reduce their
percentage ownership of the firm would likely affect
the offering price, it should not affect subsequent
market performance in an efficient market. If subse-
quent market performance is found to be uncorrelated
with the organizational structure variables—in par-
ticular, with the change in the percentage equity
owned by operating management and nonmanage-
12. If the reverse LBOs are generally constrained in their ability to make
investments, this sample of firms is unlikely to exhibit the positive incentive effects
associated with debt, since those effects are typically discussed in the context of
firms with free cash flow generating ability and no profitable investment oppor-
18
JOURNAL OF APPLIED CORPORATE FINANCE
ment insiders—that would be additional evidence
that is inconsistent with the information asymmetry
explanation for the observed association between
operating performance measures and ownership.
In a series of tests whose findings are not
reported here, we found no association between
stock market performance and either changes in
leverage or changes in the percentage equity owned
by managers and other insiders. Thus, there is no
evidence that operating management and other
insiders were able to use an information asymme-
try to increase their wealth. The offering price
appears to have reflected any change in perfor-
mance arising from the change in the leverage and
ownership structure.
INTERPRETATION AND SUBSEQUENT
CHANGES IN ORGANIZATIONAL STRUCTURE
Our major findings, then, are that reverse-LBO
firms outperform their industries for the four years
following the IPO. At the same time, however, there
is some evidence of a decline in performance in that
period. Further, reverse LBOs both increase capital
expenditures and levels of working capital after the
public offering. Most important, cross-sectional tests
indicate that firm performance decreases with de-
clines in the concentration of equity ownership by
operating management and other insiders, but is
unrelated to changes in leverage. Finally, both
capital expenditures and working capital appear to
increase with declines in the concentration of equity
ownership by nonmanagement insiders.
One interpretation of our findings is that there
are positive incentive effects associated with more
concentrated ownership by managers and active
investors who monitor management, and that these
organizational changes contribute to superior per-
formance. At the same time, we find no evidence
of positive incentive effects associated with greater
leverage in the sense that post-IPO performance is
unrelated to changes in leverage at the time of the
IPO.12
These results leave us with a bit of a puzzle,
however. If LBOs are value-increasing events when
undertaken, can reverse LBOs also be value-increas-
tunities. Moreover, evidence from our sample indicates that capital expenditures
increase after the reverse LBO which is consistent with these firms being cash
constrained prior to the reverse LBO.
 The pricing of reverse LBOs seems quite rational relative to the pricing of other IPOs,
for reverse LBOs experience neither a large increase in value on the offering date
nor a large decline in value over the subsequent three years.
ing? If reverse LBOs are not value-increasing, why
are they undertaken? One possibility is that, as the
value of the firm increases with improved perfor-
mance, the owners of the LBO firm begin to place a
higher value on having more marketable claims and
more diversified holdings. And, so, even if their
decision to sell is expected to cause performance to
decline somewhat after going public, the managers
still prefer to hold claims that are marketable.
Another potential answer to the puzzle, how-
ever, is that the change in organizational structure
occurs because of some major change in the external
business environment that affects, say, the firm’s
investment opportunities. For example, suppose
that profitable investments become available to the
firm on a larger scale than had been available
previously, but that the firm’s current owners are
reluctant to provide more funding because of their
lack of diversification. Moreover, financing the new
investment with debt is precluded by the already
high leverage levels. In this case, the shift to a public
firm could be optimal, and the fundamental cause of
such a shift would be the underlying change in the
firm’s investment opportunities. It is in this sense that
the organizational structure of the reverse-LBO firm
may well have been optimal both when the firm was
private, and when it returned to public ownership.13
Since our tests provide at least some evidence
that changes in performance subsequent to the
reverse LBO are related to the change in the owner-
ship structure, it is interesting to examine changes in
organizational structure after the reverse LBO. If the
change in organizational structure that occurs at the
time of the reverse LBO is less efficient than the LBO
structure, we would expect firms to switch back
towards their LBO-like structure.
To see whether the board and ownership
structure of the reverse-LBO firms changes after
the reverse LBO, we obtained proxy statements for
the 44 firms in our sample that were still publicly
listed three years after the reverse LBO. Our analy-
sis indicates that these firms were still hybrid orga-
nizations—that is, they retained some of the own-
13. One possibility that we cannot rule out is that the association between
ownership and performance detected by our tests is not caused by the incentive
effects associated with increased ownership, but rather that the shifts in the firm’s
investment opportunities are driving both the changes in ownership and the
positive correlation between ownership and performance. In many cases, low
profitability and the presence of few promising investment opportunities might
have been responsible for the initial decision to lever up and concentrate
ownership through an LBO. However, after capturing the gains from the LBO, these
firms may may have faced expanded investment opportunities with positive-NPVs,
19
VOLUME 10 NUMBER 1
ership and board structure characteristics of the
leverage buyout. At the same time, they also ap-
peared to be continuing to evolve toward the
board and ownership structure of a more typical
U.S. corporation, as opposed to moving back to-
ward an LBO-like structure.
In particular, we found that for the firms that
were still public three years after the reverse LBO,
the mean and median percentages of equity owned
by operating managers were 22.4% and 12.6%,
respectively. For nonmanagement insiders, the mean
and median ownership percentages were 16.4%
and 5.3%, respectively. Thus, although ownership
by operating managers and nonmanagement insid-
ers was still more concentrated than for the typical
corporation, the ownership positions of these orga-
nizations had become much less concentrated than
they were immediately after the IPO. (The median
declines in ownership for management and non-
management insiders were –14.9% and –24.1%,
respectively.)
We also found that the board structure of
these companies was evolving toward a more stan-
dard corporate structure. In particular, three years
after the IPO, approximately 46% of the board
members were external members with no signifi-
cant equity stakes (less than 5% of the equity), 35%
of the board members were internal board mem-
bers, and the remaining 19% of the board members
were significant investors (representatives of LBO
buyout firms, debtholders, and other significant
investors). Of the external members with no signifi-
cant equity stakes, approximately 7% were signifi-
cant investors immediately after the IPO but were
no longer significant investors.
Thus, the major shift that occurred in the board
structure in the three years after the IPO was away
from nonmanagement capital providers to external
directors with limited equity stakes. Though the
median board size did not increase (and average
board size increases by less than one person),
approximately one-third of the board members were
new since the reverse LBO.
but with lower operating performance ratios than those taken while the firm was
private. High leverage and concentrated ownership are likely to have constrainted
the firm from making such investments. To the extent this is so, it would be the
company’s new investment opportunities (with positive NPVs, but lower rates of
return) that are effectively driving management’s decision to return to less
concentrated public ownership and cause the reduction in operating performance.
Thus, it would be these new investment opportunities, as opposed to the changes
in incentives, that are driving the association we document between ownership and
performance.
SPRING 1997
 Overall, the results in this paper add some between performance and managerial ownership
intriguing evidence on the link between perfor- and ownership by active investors (monitors). More-
mance and organizational incentives. In particular, over, the results provide further insights on the
there is strong evidence of a positive association transition from the LBO form.

ROBERT HOLTHAUSEN DAVID LARCKER

is Nomura Securities Professor of Accounting and Finance at the is the Ernst & Young Professor of Accounting at the University
University of Pennsylvania’s Wharton School. of Pennsylvania’s Wharton School.

20
JOURNAL OF APPLIED CORPORATE FINANCE
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