i An update to this article is included at the end

JOURNAL OF
Bnancial
ELSEVIER Journal of Financial Economics 42 (1996) 293 332
ECONOMICS

The financial performance of reverse leveraged buyouts

Robert W. Holthausen*, David F. Larcker
The Wharton School, University of Pennsylvania, Philadelphia, PA 19104, USA

(Received June 1992; final version received June 1996)

Abstract

We examine the accounting and market performance of reverse leveraged buyouts (i.e.,
firms making their first public offering after previously completing a leveraged buyout).
On average, the accounting performance of these firms is significantly better than their
industries at the time of the initial public offering (IPO) and for at least the following four
years, though there is some evidence of a decline in performance. Cross-sectional
variation in accounting performance subsequent to the IPO is related to changes in the
equity ownership of both operating management and other insiders, and is unrelated to
changes in leverage. Finally, there is no evidence of abnormal common stock perfor-
mance after the reverse leveraged buyout.

Key' words: Reverse leveraged buyouts; Capital structure; Equity ownership; Financial
performance
J E L classification: G32; G34

1. Introduction

The performance of leveraged b u y o u t s (hereafter, LBOs) has received

considerable a t t e n t i o n in the finance literature. Jensen (1989) argues that LBO-
like o r g a n i z a t i o n s mitigate the incentive problems faced by more t r a d i t i o n a l

* Corresponding author.
The comments of Terrence O'Keefe, Wayne Mikkelson, Michael Jensen (the editor}, Karen Wruck
(the referee}, and workshop participants at the University of Oregon and the University of
Pennsylvania are gratefully acknowledged. We would like to thank Kidder, Peabody & Co. who
granted us permission to use data they collected for a study of reverse LBOs. We would also like to
thank John Core for his help as a research assistant on this project. Finally, the financial support of
Coopers and Lybrand, Ernst & Young, and Nomura Securities is gratefully acknowledged.

0304-405X/96/$15.00 ~C' 1996 Elsevier Science S.A. All rights reserved

PII S 0 3 0 4 - 4 0 5 X ( 9 6 ) 0 0 8 8 4 - 7
294 R.W. Holthausen. D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332

corporate organizations, especially in nongrowth sectors of the economy. He

postulates that high leverage, concentrated equity ownership by managers, and
monitoring by an LBO sponsor firm create an organizational form whose
incentive structure leads to value maximization. In particular, increasing the
proportion of equity owned by managers can provide increased incentives for
managers to create shareholder wealth. In addition, substantial debt service
obligations can force managers to avoid investing in negative net present value
projects, which is particularly useful in industries generating free cash flows in
excess of that required to fund all profitable investment opportunities. Finally,
nonmanagement insiders (such as an LBO sponsor firm) typically own a signifi-
cant proportion of the outstanding equity and exercise considerable control
over managers through the board of directors, thus enhancing monitoring
within the organization. Jensen concludes that LBOs, or public corporations
that mimic the incentive structures of LBOs, could supplant the more typical
public corporation because of their superior incentive structures. 1
In prior empirical studies, Kaplan (1989), Smith (1990), and Muscarella and
Vetsuypens (1990) document an improvement in the accounting performance of
firms that undergo an LBO. Similarly, Baker and Wruck (1989) document
improved performance and the changes in incentives and monitoring for the
LBO completed by O.M. Scott. These authors suggest that the explanation for
the improved performance is the change in organizational incentives. To our
knowledge, however, there are no studies that directly examine the association
between the extent o f the change in organizational incentives at the time of the
LBO and the subsequent change in performance.
While the accounting performance and valuation implications of leveraged
buyouts have been studied in numerous academic articles, the performance of
reverse leveraged buyouts, firms that issue shares publicly after having pre-
viously gone private, is a largely unanswered question. Examination of reverse
LBOs can provide additional evidence about the extent to which leverage and
concentration of ownership provide desirable incentives within organizations. 2

1Although supported by Stewart (1990), Jensen's view of LBO's is controversial. Rappaport (1990)
argues that LBO-likeorganizations are inherently transitory in nature and that they are not likelyto
supplant the public corporation. In particular, Rappaport argues that concentrated equity owner-
ship 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.
ZDegeorge and Zeckhauser (1993) examine the performance of reverse LBOs subsequent to their
1PO, but dismiss the possibility that the change in incentivescould explain changes in performance
and consequently do not empirically examine that question. Mian and Rosenfeld (1993) find
evidence that reverse LBOs have positive abnormal stock returns in the 36 months subsequent to
going public, but they do not examine the effects of incentives on offering prices or subsequent
returns.
 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 295

If the high leverage and concentrated equity ownership of LBOs motivate these
firms to operate more efficiently while they are private, we might anticipate that
the decline in leverage and the dispersion of equity ownership would result in
a decline in the performance of these firms after they go public. However, to the
extent that they continue to have higher leverage and more concentrated
ownership than firms in their industries, these firms might continue to outper-
form their industries.
Despite the intuition of the incentive arguments presented by Jensen and
others, there are competing economic predictions regarding the effects of cha-
nges in leverage and managerial equity ownership. For example, while increased
managerial ownership of the firm's common equity could increase financial
performance because the key officers have a greater stake in any value-increas-
ing actions that are taken (e.g., Jensen and Meckling, 1976), it is also possible
that increased managerial ownership could decrease financial performance due
to managerial risk aversion and the potential underdiversification of the man-
agers' wealth (see Fama and Jensen, 1985; Morck, Shleifer, and Vishny, 1988).
Thus, managers could reject higher-risk but more profitable (higher net present
value) projects, and accept lower-risk but less profitable (lower net present
value) projects due to managerial risk aversion. In effect, managers might not
even consider the entire distribution of available projects, concentrating instead
on only those of lower total risk. In addition, Demsetz (1983) and Fama and
Jensen (1983) argue that if managerial equity ownership is concentrated, the
manager may have effective control over the organization and disciplining
mechanisms such as the market for corporate control and managerial labor
markets may be rendered ineffective, resulting in a decline in performance. |f
either the managerial risk aversion argument or the management entrenchment
argument is correct, declines in managerial equity ownership could lead to
increases in the performance of reverse LBOs.
Similarly, while leverage has potentially positive incentive effects because of
the discipline imposed by the requirement to continually generate sufficient cash
to meet principal and interest payments, there is also the potential for negative
incentive effects. For example, conflicts of interest between shareholders and
debtholders could cause managers to choose projects that reduce firm value but
that make shareholders better off vis-a-vis the debtholders (e.g., Jensen and
Meckling, 1976). In addition, leverage could affect project selection by managers
due to managerial risk aversion. |n particular, managers might avoid high net
present value projects that are very risky and instead take lower-risk projects
with potentially lower net present values (again effectively truncating the distri-
bution of projects that they consider). Managers alter their project selection by
choosing less risky projects in order to avoid the potential loss of their firms or
jobs that could arise when the firm cannot meet its debt repayment schedule,
which is more likely if the manager has chosen risky projects. Thus, high
leverage could cause risk-averse managers to alter their investment decisions in
296 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293-332

such a way as to decrease the riskiness of the assets of the firm in order to reduce
the likelihood of default. Coupling high leverage with high managerial equity
ownership makes the manager's equity claim more risky than it would be with
lower leverage, thus providing an indirect effect of increased leverage on a man-
ager's willingness to take risky projects. Whether increased leverage and more
concentrated equity ownership provide positive incentive effects is, therefore, an
empirical issue.
This paper provides a detailed examination of the performance and change in
organizational 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 initial
public offering (hereafter, IPO), there is a decline in the mean leverage ratio and
the average equity ownership by insiders (all officers, directors, and employees).
However, equity ownership by managers and other insiders remains concen-
trated and leverage remains high relative to typical public corporations. Thus,
when these LBOs go public, they are hybrid organizations that retain some of
the characteristics of the LBO organization.
We find that the accounting 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 perform better than
their industries for at least the four full fiscal years after the IPO (though the
evidence in the third year is less strong). While these firms continue to outperform
their industries, there is also some evidence of a deterioration in the performance
of the reverse-LBO firms subsequent to the IPO, though the strength of this
evidence is somewhat dependent on the specific accounting performance metric
analyzed and the benchmark portfolio used for assessing expected performance.
We also examine the expenditure decisions of the reverse-LBO firms with
respect to capital expenditures, advertising, and research and development. We
find evidence that prior to the IPO, reverse-LBO firms spend less on capital
expenditures than the median firms in their industries, and that subsequent to
the IPO, their capital expenditures return to the median level of their industry
counterparts. Advertising expenditures by reverse-LBO firms exceed the level of
industry expenditures both before and after the IPO and do not appear to
change. The evidence on R&D expenditures suggests a decline in R&D spending
subsequent to the IPO.
With regard to working capital management, we find that reversc-LBO firms
have significantly smaller amounts of working capital than their industry
counterparts both before and after the reverse LBO. There is, however, evidence
of an increase in the amount of working capital held by reverse-LBO firms after
they go public. With respect to employment decisions, we find no evidence that
the staffing levels of reverse-LBO firms are different from their industries either
before or after the reverse LBO.
We also document the extent to which changes in performance are associated
with changes in organizational incentives. The results indicate that the change in
 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 297

accounting performance (measured from one year before to up to four years

after the reverse LBO) is unrelated to the change in leverage and is positively
related to the change in the percentage of equity owned by the operating
management and other insiders that occurs at the time of the reverse LBO.
Specifically, greater declines in the percentage equity owned by operating
management and other insiders is associated with greater declines in accounting
performance. We also demonstrate that changes in working capital and capital
expenditures are negatively related to the percentage equity owned by non-
management insiders. In particular, as nonmanagement insider owner-
ship falls, working capital levels and capital expenditures increase. These
results are consistent with changes in organizational incentives affecting
performance.
The evidence linking accounting performance with changes in organizational
incentives is also consistent, albeit superficially, with managers taking advan-
tage of an information asymmetry to optimally time the IPO to maximize their
wealth. Evidence on the stock market performance of reverse LBOs provides
a more direct test of that issue, as we would anticipate negative stock market
performance for reverse LBOs if managers were able to issue shares at tempor-
arily inflated values. The evidence on the stock market performance of reverse
LBOs is not consistent with managers exploiting an information advantage. We
find evidence of either zero or positive excess returns depending on the return
metric and holding period examined.
The results in this paper are largely consistent with prior findings
on leveraged buyouts in Kaplan (1989), Smith (1990), and Muscarella and
Vetsuypens (1990), who document increases in operating efficiency at the time
firms go private. Moreover, our results are generally consistent with Morck,
Shleifer, and Vishny (1988) and Wruck (1989), at least to the extent that they also
find an association between equity ownership and performance. Our paper, like
Wruck (1989), differs from Morck, Shleifer, and Vishny (1988) in that we
examine the effect of a change in organizational structure on the change in
financial performance, whereas Morck, Shleifer, and Vishny (1988) examine the
level of performance and the ownership structure at a point in time. However,
we do not attempt to estimate the specific nonmonotonic form of the relation
between performance and ownership, described in Morck, Shleifer, and Vishny
or in Wruck, as the percentage of the equity owned by managers and non-
management board members in our sample is much larger, on average.
The interpretation of the results in our paper depends on whether the changes
in organizational incentives are considered to be exogenous or endogenous.
If we assume that the shifts in leverage and ownership are exooenous, then
the results in our paper are consistent with Jensen (1989), Stewart (1990), and
others who have argued that LBOs have favorable incentive consequences. In
particular, increases in managerial equity ownership and/or increases in equity
ownership by active investors (monitors) lead to improved organizational
298 R. 14A Holthausen, D.F. Larc'ker/Journal of Financial Economics 42 (1996) 293 332

performance. However, if we assume that the changes in organizational incen-

tives are endogenous, this interpretation of the results may not be appropriate. In
particular, it is possible that the changes in ownership and leverage are optimal
responses to shifts in the economic environment facing the firm (for example,
exogenous changes in the investment opportunity set change the optimal levels
of equity ownership by managers and nonmanagement insiders). Thus, the
observed association between ownership and performance may not be a causal
relation, but could arise because of a change in the exogenous economic
environment correlated with both optimal ownership structure and perform-
ance. Unfortunately, due to the general lack of knowledge regarding the deter-
minants of optimal organizational structure, it is difficult to estimate a system of
equations that could distinguish between these alternative interpretations.
Moreover, we are hampered by our small sample size. As such, our paper adds
intriguing evidence to the debates regarding incentives and performance, but
does not unambiguously resolve the interpretation of these results.
The remainder of the paper proceeds as follows. Section 2 describes the
sample of reverse LBOs and provides some selected descriptive statistics. Sec-
tion 3 documents the accounting performance, investment decisions, and work-
ing capital management of the sample. Section 4 reports regressions linking
cross-sectional variation in accounting performance measures with measures of
the change in the firm's organizational structure. Section 5 presents an analysis
of the stock market performance of reverse LBOs subsequent to their IPO, to
investigate the validity of the information asymmetry argument. Concluding
comments are in Section 6.

2. Data

Our sample of 90 reverse LBOs comes from an October 1988 report by

Kidder, Peabody & Co. entitled 'Analysis of Initial Public Offerings of
Leveraged 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 that raised at least $10 million in the common stock offering. To
ensure that these were in fact reverse LBOs, we checked the sample against the
Dow Jones News Service for a story about both the LBO and the IPO, and
against the prospectuses. As described in Table 1, our sample of LBOs is
concentrated in the 1985 to 1986 period, and the associated IPOs are concen-
trated in 1986 and 1987.
Financial information, such as changes in leverage and ownership structure at
the time of the IPO, is obtained from the prospectuses for the public offering.
Stock return data are from the files of the Center for Research in Security Prices
(CRSP) with data available through December 31, 1993. Accounting data are
from prospectuses and the Compustat annual industrial, research, and full
 R. W Holthausen, DF. Larcker/Journal of Financial Economics 42 (J996) 293 332 299

Table 1
Distribution of calendar years for the original
leveraged buyout (LBO) transaction and the
subsequent initial public offering (IPO) for
a sample of 90 LBOs that went public between
1983 and 1988

Calendar year LBO IPO

1976 1 0
1977 0 0
1978 2 0
1979 0 0
1980 5 0
1981 9 0
1982 6 0
1983 10 5
1984 11 2
1985 17 4
1986 27 28
1987 2 47
1988 0 4
Total 90 90

Firms included in the sample meet the follow-

ing requirements: (1) the IPO occurred be-
tween January 1, 1983 and June 30, 1988, (2)
the 1PO raised at least 10 million dollars, and
(3) the IPO was included in the IDD Informa-
tion Services Inc. database. The sample was
obtained from the Kidder, Peabody & Co.
study entitled 'Analysis of lnitial Public Offer-
ings of Leveraged Buyouts'.

coverage files with d a t a available t h r o u g h fiscal years ending M a y 31, 1994.

I n f o r m a t i o n a b o u t the o w n e r s h i p structure a n d b o a r d structure three years after
the I P O is o b t a i n e d from p r o x y statements.
T a b l e 2 p r o v i d e s descriptive statistics c o n c e r n i n g changes in the o r g a n i z a -
tional structure (leverage, ownership, a n d b o a r d of directors) a r o u n d the time of
the I P O ( p r e - I P O levels refer to the d a t a j u s t p r i o r to the I P O a n d p o s t - I P O
levels refer to p r o f o r m a d a t a for the p e r i o d i m m e d i a t e l y after the I P O as
d e s c r i b e d in the prospectus). The m e a n leverage ratio (based on b o o k values)
falls from 83% p r i o r to the I P O to 56% after the I P O , where leverage is defined
as the s u m of l o n g - t e r m debt, s h o r t - t e r m debt, capitalized leases, a n d redeem-
able preferred stock divided by the s u m of l o n g - t e r m debt, s h o r t - t e r m debt,
c a p i t a l i z e d leases, r e d e e m a b l e preferred stock, a n d the b o o k value of c o m m o n
equity. D e b t r e d u c t i o n is the p r i m a r y (stated) use of the proceeds, with 57% of
300 R.W. Holthausen, D.b: Larcker/Journal of Financial Economics 42 (1996) 293 332

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302 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293-332

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 not using any
proceeds to reduce debt (other commonly cited purposes for the proceeds cited
in the prospectuses included working capital, general corporate purposes, capi-
tal expenditures, retirement of preferred stock, and acquisitions). Post-IPO
leverage measures based on market capitalization are much lower in general.
For example, the median debt-to-market capitalization (market value of equity
plus book value of debt) is 33.2% for the sample. Pre-IPO leverage measures
based on market values would presumably be lower than the book values as
well, but we cannot observe the pre-IPO market values.
There are also substantial shifts in the concentration of ownership at the time
of the IPO. The average ownership of insiders declines 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
which organizes and/or invests in LBOs, such as Kohlberg, Kravis, and Roberts,
would be included in insiders' holdings because of their representation on the
board of directors. Average operating management equity ownership falls from
36% of the outstanding equity prior to the IPO to 24% after the IPO.
Operating management is defined as operating management and other em-
ployees (if disclosed) and excludes directors who have no operating responsibili-
ties. On average, managers sell 8% of their stake. In 59% of the transactions
managers sell none of their equity, and in some cases their proportionate
ownership actually increases. Average equity ownership by nonmanagement
insiders (all officers and directors who are not considered part of operating
management) falls from 39% before the IPO to 25% after the IPO. Again, in
some cases, the proportionate ownership of the nonmanagement insiders in-
creases. When these firms go public, 34% of the outstanding equity of the
average firm is in public hands (not owned by insiders or other pre-IPO equity
holders, such as private investors, debtholders, or funds without board repre-
sentation). Moreover, there is a broad range of public ownership 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 decreases substan-
tially when these firms go public, the leverage and ownership of equity by
managers and other insiders is still large relative to the leverage and insider
equity ownership of the typical public corporation. For example, median (mean)
insider ownership after the IPO is 51.3% (48.8%), whereas McConnell and
Servaes (1990) report median (mean) insider ownership of 5.0% (11.8%) for
approximately 1,000 nonfinancial companies followed by Value Line in 1986.
Further, the mean difference between the leverage ratio for the reverse-LBO firm
and the median leverage for firms in the same two-digit SIC code industry is
0.17, which is approximately 44% higher than the median industry leverage.
This difference is statistically significant at the 0.001 level (two-tail).
 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293-332 303

Despite the decline in both leverage and equity ownership by insiders, the
correlation between the leverage changes and ownership changes is quite small.
For example, the correlation between the change in leverage and the change in
equity ownership of operating management and nonmanagement insiders is
0.137 and 0.045, respectively, and neither correlation is significant at conven-
tional levels. Thus, less than 2% of the variation in leverage can be explained by
changes in equity ownership. This modest correlation is important as it allows
us to disentangle the effects of changes in ownership and changes in leverage on
changes in performance, which would not be possible if ownership and leverage
changes were highly correlated. Despite the fact that the average declines in the
ownership stake for management and nonmanagement insiders are approxi-
mately the same ( - 13%), the changes in ownership for operating management
and nonmanagement insiders are inversely correlated (correlation of - 0.404).
This indicates that, even though both management and nonmanagement owner-
ship generally declines, larger declines in ownership by one group tend to be
associated with more modest declines in ownership by the other group.
Table 2 also reports descriptive statistics on the composition of the board of
directors for our sample. In particular, there are an average of seven directors for
our sample firms at the time of the IPO. On average, 34% of the board of
directors are operating managers, while 33% of the board are 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 constitute 27% of the board, on average,
and 6% of the seats are vacant. Nonmanagement board members are classified
as external if they own less than 5% of the shares or if they represent an
organization that owns less than 5% of the shares. If the board member or
affiliated organization owns 5% or more, the board member is classified as
a nonmanagement capital provider. While it is unclear how to judge whether
these boards of directors are unusual, the board size is smaller than is typically
reported in academic studies, and there is more representation by nonmanage-
ment capital providers (active investors) who have contributed a significant
stake in the organization. For example, Byrd and Hickman (1992) report an
average board size of 12.1, with 37.5% of the board internal and 62.5% external.
Moreover, the percentage of equity owned by nonmanagement directors aver-
ages only 4.1% in their sample, whereas it is approximately 25% in our sample
after the IPO. Similarly, Holthausen and Larcker (1994a) report an average
board size of 13, and the average percentage ownership of the firm by all
nonmanagement directors is 1.06%.
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, on average, only 12.5% have been appointed within the past six months.
These new board members do not necessarily replace former board members.
More likely, the board size has increased and these are new appointments. The
304 R. 144 Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332

prospectuses rarely disclose changes in the size of the board, so it is difficult to

obtain information on changes in board structure. In only one case was a dra-
matic change in the board disclosed, with 80% of the board replaced. Moreover,
only three of 90 CEO's changed within six months prior to the I P O date.
Interestingly, the period of public trading in the reverse-LBO firms is quite
short after they go public. Through the end of 1993, 36 of the 90 companies are
acquired by another corporation and eight complete another LBO. For these 44
acquired firms, the average time to acquisition is 30 months. Eight companies have
a significant event of default (violating a covenant, missing an interest or principal
payment, filing for bankruptcy) and 37 are still public as of December 31, 1993.

3. The accounting performance and investment decisions of reverse LBOs

3.1. Measurement issues

To assess the relative operating performance of reverse LBOs, we measure

accounting performance using two different (although related) accounting ratios
that are widely used as measures of performance, operating income, and operat-
ing cash flows. We do not use c o m m o n stock returns to measure relative
operating performance since any expected decline in the performance of the
company due to its reversion to a public corporation should be impounded in
the offering price, so that changes in organizational structure observed at the
I P O should be uncorrelated with subsequent returns (Section 5 offers a further
discussion of this issue). In order to avoid the mechanical effect of leverage on
the results, both variables measure flows on a before-tax and before-interest basis.
In addition, we report three different benchmarks for assessing expected perfor-
mance; unadjusted, industry-adjusted, and mean-reversion-adjusted benchmarks.
Only firms that are private for the full fiscal year prior to the fiscal year of the 1PO
are used in subsequent tests. This eliminates eight of 90 firms from consideration.
The first accounting performance measure is the ratio of operating earnings
before depreciation, interest, and taxes deflated by total assets (denoted as
OPINC/assets). 3 The second accounting performance measure is the ratio of
operating cash flow before interest and taxes deflated by total assets (denoted as
OCF/assets). 4 The primary difference between the O C F measure and the
O P I N C measure is that the O C F measure eliminates m a n y accounting accruals.

3The precise definition of OPINC is operating income before depreciation (COMPUSTAT data
item # 13).
'*The exact definition of OCF (COMPUSTAT data item numbers in parentheses) is operating
income before depreciation (# 13) plus decrease in accounts receivable (#2) plus decrease in
inventory (#3) plus increase in accounts payable (#70)plus increase in other current liabilities
(# 72) plus decrease in other current assets (# 68).
 R. V¢~Holthausen. D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 305

Thus, the OCF m e a s u r e exhibits more variability t h a n the O P I N C m e a s u r e

since the a c c o u n t i n g accrual process tends to s m o o t h reported earnings relative
to cash flows. Moreover, O P I N C is m o r e highly correlated with stock returns
than is OCF (see Dechow, 1994). However, one a d v a n t a g e of the OCF measure is
that it eliminates m a n y accruals (which are at least partially at the discretion of
m a n a g e m e n t ) , m a k i n g it less susceptible to m a n i p u l a t i o n . However, the evidence
on the extent to which m a n a g e r s adjust accruals a r o u n d the time of c o n t r o l
t r a n s a c t i o n s a n d I P O ' s is mixed (see DeAngelo, 1986, 1988; A h a r o n y , Lin, a n d
Loeb, 1991). A n o t h e r a d v a n t a g e of the O CF m e a s u r e is that it is directly affected
by changes in w o r k i n g capital m a n a g e m e n t .
As indicated, we assess the performance of o u r sample firms using three
different b e n c h m a r k s . First, we e x a m i n e an u n a d j u s t e d m e a s u r e which is simply
the performance of the reverse-LBO firm. Second, we consider an industry-
adjusted performance m e a s u r e which controls for time period a n d i n d u s t r y
effects by e x a m i n i n g the performance of the reverse-LBO firm after s u b t r a c t i n g
the c o n t e m p o r a n e o u s median p e r f o r m a n c e of the firms in the two-digit SIC code
associated with each reverse-LBO firm. Finally, we e x a m i n e a m e a n - r e v e r s i o n -
adjusted performance measure which controls for time period a n d i n d u s t r y
effects as well as for the expected m e a n reversion in a c c o u n t i n g performance
measures when a firm is performing significantly better or worse t h a n its
industry. 5 The m e a n - r e v e r s i o n - a d j u s t e d performance takes the performance of
the reverse-LBO firm a n d subtracts the c o n t e m p o r a n e o u s m e d i a n performance
of all firms in the same two-digit SIC code whose OPINC/assets (OCF/assets) is
within 10% of the reverse-LBO firm's OPINC/assets (OCF/assets) in the year
before the I P O (e.g., if the reverse-LBO firm's OPINC/assets is 0.20 in the year
before the I P O , the b e n c h m a r k w o u l d be the m e d i a n OPINC/assets of all firms
in the same two-digit SIC code whose OPINC/assets in the same c a l e n d a r year
varied between 0.18 a n d 0.22). 6

SA potential problem with the industry-adjusted and mean-reversion-adjusted metrics is the defla-
tion by total assets. LBO firms are likely to have written up their assets or created goodwill to the
extent that the buyout price exceeds the book value of the assets at the time of the transaction, lfthe
write-up of assets and creation of goodwill in the LBO sample exceeds the extent of that activity in
the industry in general, this performance measure is biased toward finding poorer performance by
LBO firms. An alternative would be to deflate by sales instead of total assets in order to avoid the
asset write-up problem in the denominator. However, deflation by sales removes the effects of
efficienciesfrom the performance measure that management might have derived from being able to
increase sales without a commensurate increase in assets. Thus, both measures have flaws. Neverthe-
less, all of the results in the paper have been reestimated by deflating the performance measures by
sales and the results are qualitatively similar to those reported in the text.
OThe median number of firms in the OCF mean reversion benchmark is five, with first and third
quartiles of three and 11. The median number of firms in the OPINC mean reversion benchmark is
eight, with first and third quartiles of five and 15. In order to calculate the median when there are an
even number of firms in the benchmark, we take the average of the two firms tied for the median
position.
306 R.W. Holthausen, D.b2 Larcker/Journal of Financial Economics 42 (1996) 293 332

While industry-adjusted accounting performance benchmarks are common in

the literature, the mean reversion benchmark is not. Accounting performance
measures have been shown to exhibit mean reversion (Brooks and Buckmaster,
1980; Freeman, Ohlson, and Penman, 1982) and this mean reversion is more
easily detected the farther that firms deviate from their mean performance. The
mean reversion can be due to several factors. First, part of the mean reversion
can be due to measurement error in the accounting performance measures, so
that some firms with very good performance this period are firms with positive
measurement error this period. In subsequent periods, the expected measure-
ment error is zero, and hence we will observe mean reversion. Second, there can
be temporary components of earnings that are not sustainable, such as one-time
nonrecurring items. When selecting firms with very good performance, these
temporary components of earnings are likely to be positive, and when they
disappear in a subsequent period, mean reversion will be observed. Finally, due
to competition, it may be very difficult to sustain superior performance for long
periods as competition increases in areas in which performance is superior.
Similarly, exit may take place if performance is poor, potentially improving the
performance of remaining firms.
The purpose of the mean-reversion benchmark is to assess whether the
performance observed for the reverse-LBO sample (which undergoes changes in
organizational structure) is any different than 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. If the mean reversion observed for the reverse-LBO firms is no
different from randomly selected firms with similar performance, then it is more
problematic to argue that the deterioration in performance is related to the shift
in organizational structure.
Barber and Lyon (1996) investigate the empirical power and specification of
accounting performance measures. They find that the size and power of the
mean-reversion-adjusted benchmark (which they refer to as a performance-
matched benchmark) is the most appropriately sized and most powerful test of
nine contenders that they consider. The only exception is when firms are very
small, in which case the most appropriately sized performance benchmark
simply matches on two-digit SIC codes (our industry-adjusted method). Barber
and Lyon (1996) consider such alternatives as a four-digit SIC code match and
a combination two-digit SIC code and size-based match, but neither of these is
superior to either the industry adjustment or mean reversion benchmark that we
use.

3.2. The median level of accounting performance

Panel A of Table 3 presents median accounting performance measures from

one year before the IPO (year - 1) to four years after the IPO. We also examine,
 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293-332 307

but do not report, the mean performance for these firms and obtain very similar
results to the median results reported, both in terms of their point estimates and
the degree of statistical significance. Year 0 is defined as the fiscal year that
includes the IPO. 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.
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 subsequently 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. A Wilcoxon test is used to determine the statistical significance of
the median accounting performance metrics. The Wilcoxon test assumes that
the accounting performance metrics are independent across observations. If
these measures exhibit positive cross-sectional correlation, which is likely be-
cause of the time clustering of the reverse LBOs, the test statistics will be
somewhat overstated.
As can be seen from panel A of Table 3, the performance of the reverse LBOs
dominates that of their industries in the year prior to the IPO. The median
industry-adjusted OCF/assets is 0.092 and the median industry-adjusted
OPINC/assets is 0.077. At year - 1, the median OCF/assetsand OPINC/assets
for the reverse-LBO firms are 0.193 and 0.195, respectively. Thus, the
OCF/assets and OPINC/assetsof the reverse-LBO firms is approximately 92%
and 65% higher than the comparative measure for the median firm in their
industries. However, these results cannot be interpreted as evidence that firms
completing an LBO outperform their industries because of the potential selec-
tion bias associated with the subset of LBO firms that have a subsequent public
offering. The OCF/assets reported here in the year before the reverse LBO is
similar in magnitude to the OCF/assets reported in the second year after the
LBO by Smith (1990).
Results for the years subsequent to the IPO suggest that these firms continue
to outperform their industries for the four years following the 1PO, as the
median industry-adjusted performance for OPINC/assets and OCF/assets is
significantly different from zero (though the evidence at year + 3 is weaker than
at years + 1, + 2, or + 4). However, it does appear that there is a decline in the
performance of the median firm relative to the industry, even though the median
firm continues to outperform its industry. Formal tests of the change in perfor-
mance are contained in panel B.
Results using the mean-reversion-adjusted numbers from panel A of Table
3 indicate that despite the performance-matching procedure at year - 1, the
308 R.W. Holthausen. D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332

~+
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 R.W. Holthausen D.F. Larcker/Journal o f Financial Economics 42 (1996) 293 332 309

o
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310 R. kK Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293-332

mean reversion benchmark sample performs slightly better than the reverse-
LBO firms (the differences for OCF/assets and OPINC/assets are - 0.0021 and
-0.0015). While the differences are statistically significant at the 5% level
(because the standard deviations of the differences are small), the magnitudes of
the differences are trivial, as expected, because of the performance matching in
year - 1. Subsequent to the IPO, there is little evidence that the LBO firms
perform differently than the firms in the mean-reversion-adjusted benchmark,
which implies that the performance patterns for the two groups are similar. The
only reported difference that is statistically significant beyond year - 1 indi-
cates that OCF/assets for the reverse-LBO firms is significantly worse than the
OCF/assets of the mean reversion benchmark in year + 1.

3.3. Median changes in accounting perJbrmance

In panel B of Table 3, we examine changes in accounting performance for the

reverse LBOs. This analysis is conducted because it is conceivable that the level
of a firm's performance could be significantly better than its industry throughout
years - 1, 0, + 1, + 2, + 3, and + 4, but could also experience a significant
change (decline or improvement) in its performance relative to its own prior
performance or relative to its industry. The fiscal year prior to the fiscal year of
the IPO, year - 1 , is used as the benchmark. (Although we would have
preferred to use more than one year as a benchmark, year - 2 is available for
only a very small subset of observations because either the data were never
publicly reported or the firm was not private in year - 2). Note that the data
requirements of panel B are not identical to panel A. Panel A requires only that
data be available for an observation in any given year, while panel B requires
that data be available for year - 1 and another year (year 0, + 1, + 2, + 3, or
+ 4).
Results using the change in unadjusted firm performance provide evidence of
a significant decline in OCF/assets from the year prior to the I P O to year 0, + 1,
+ 2, and + 3, but not to year + 4 (though the sample size has declined to 36
observations by year + 4). Using the OPINC/assets performance measure, no
evidence of a statistically significant decline from year - 1 to year 0, + 1, or
+ 2 is observed, but the differences to year + 3 and + 4 are statistically
significant. In no case is the performance in year - 1 significantly different from
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. The mean-reversion-adjusted numbers provide almost no evidence of
a more significant decline in the reverse-LBO sample than in the mean-reversion
benchmark sample. The results for the mean-reversion-adjusted numbers paral-
lel panel A in that the only significant change uses the OCF/assets measure from
year - 1 to year + 1.
 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 311

The evidence in Table 3 suggests that the accounting 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
conclusion that this superior performance lasts for four fiscal years after the
fiscal year of the IPO. There is also some evidence of a decline in performance
subsequent to the IPO, even though the firms continue to outperform their
industry counterparts. However, there is almost no evidence that the decline
observed for reverse LBOs is any greater than the decline observed for the
mean-reversion-adjusted benchmark.

3.4. Median levels of advertising, capital expenditures, research and development,

working capital, and employment

In addition to investigating accounting performance, we examine expendi-

tures on advertising, capital equipment, and research and development (we refer
to these three items as discretionary expenditures), as well as working capital
management and employment level decisions. In particular, we are interested in
determining whether the expenditure patterns and working capital management
of reverse-LBO firms are significantly different from their industry counterparts
and whether those patterns change over time. For example, Kaplan (1989),
Smith (1990), and Muscarella and Vetsuypens (1990) document that firms
reduce some of their expenditures on discretionary items after an LBO. Thus,
another potential manifestation of poor performance would be that newly
public firms begin to overinvest in discretionary expenditures, manage working
capital more poorly, and become less efficient in the use of their employees.
Panel A of Table 4 provides an analysis of the unadjusted and industry-
adjusted level of capital expenditures, advertising, R&D, working capital, and
employees, all relative to assets. 7 Reverse-LBO firms spend significantly less
than the industry norm on capital expenditures in the year prior to the IPO, but
for later years there is no difference in capital expenditures between the re-
verse-LBO firms and their industry medians. Expenditures on advertising are
higher for the reverse-LBO firms than for their industries in every year. The
industry-adjusted medians of R & D expenditures are never significantly different
from zero. The industry-adjusted working capital/assets ratio is significantly
negative in every year indicating that the reverse-LBO firms carry significantly
less working capital than their industry counterparts. Moreover, the magnitude

;If research and development and advertising expenditures are not disclosed (or are missing from
COMPUSTAT), we eliminate those observations from the analysis. Thus, the results are based on
the set of observationsfor which R&D and advertisingare material enough to be disclosed.All of the
reported results on advertising, capital expenditures, R&D, working capital, and employees have
been replicated using sales as the deflator. In addition, we have analyzed expenditures while treating
missingobservations for R&D and advertisingas zeros.The results are not sensitiveto these choices.
312 R.W. Holthausen, D.F. Larcker/Journal o f Financial Economics 42 (1996) 293 332

~+
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tt~

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tt~ 0
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eq
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 R.W~ Holthausen, D.F. Larcker/'dournal of Financial Economics 42 (1996) 293 332 313

+
tt~

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314 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332

2 %

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 R.W. Holthausen, D.P~ Larcker/Journal of Financial Economics 42 (1996) 293 332 315

of the differences is large, indicating that the reverse-LBO firms carry approxi-
mately half of the working capital carried by their industry counterparts.
Finally, the median industry-adjusted employees/assets ratios are not signifi-
cantly different from zero in any year. Thus, employment levels for the reverse-
LBO firms are similar to employment levels in their industries.

3.5. Median changes in advertising, capital expenditures, research and

development, working capital, and employment

Panel B of Table 4 provides an analysis of changes in discretionary expendi-

tures, working capital, and employees. Unadjusted changes in capital expendi-
tures show a significant increase from year - 1 to year 0, and none of the other
differences are significant. Industry-adjusted changes in capital expenditures
significantly increase between years - 1 and 0 and year - 1 and + 1, and while
subsequent years generally have increases relative to year - 1, no other ob-
served changes are statistically significant. Changes in the level of capital
expenditures in years 0 and + 1 are probably expected given the infusion of
cash into these firms from the public offering. The evidence on firm and
industry-adjusted advertising provides no consistent evidence of a change in
the extent of advertising. Examination of changes in both firm and industry-
adjusted R&D indicates reasonably consistent evidence of a decrease in R&D
relative to year -1, which is somewhat surprising as these firms should be less
constrained by cash shortages subsequent to the public offering. Though there is
no evidence of an increase in the level of unadjusted working capital for these
firms, industry-adjusted working capital for these firms increases. Finally, there
is also evidence of a decline in the number of employees at the firm level, but not
relative to general employment in the industry.

4. Cross-sectional analysis of changes in performance, ownership, and leverage

We have examined the median levels and changes in both performance and
discretionary expenditures. While interesting, these results do not provide in-
formation on the determinants of the cross-sectional variation in the accounting
performance of reverse-LBO firms. Table 5 examines the extent to which
cross-sectional variation in the change in performance of the reverse-LBO firms
can be explained by changes in leverage and ownership structure. The primary
measures of the change in performance are OPINC/assets and OCF/assets
between year - 1 and year + 1, as well as the change between year - 1 and the
average of years + 1 to + 4. We also use as performance measures the change
in working capital and the change in capital expenditures over the same two
periods.
3l6 R.W. Holthausen, D.F. Larcker/'Journal ~ fFinaneial Economies 42 (1996) 293 332

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 R. V~ Holthausen, D.F. Larcker,/Journal of Financial Economics 42 (1996) 293 332 317

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318 R.W. Holthausen, D.F. Larcker/Journal o f Financial Economics 42 (1996) 293-332

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 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 319

The variables measuring the change in organizational structure are the

change in leverage and the changes in the percentage of equity owned by
operating management and nonmanagement insiders. The change in the organ-
izational structure variables is 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
assume that the change in incentives that occurs in year 0 is related to sub-
sequent 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 examine the two alternative intervals. Finally, in
order to control for the expected level of performance for these firms in the
absence of the change in organization structure, we also consider regression
specifications in which we control for either industry performance or the
performance of the mean reversion benchmark (the latter is not used when the
dependent variable is capital expenditures or working capital).
If reducing the leverage and the concentration of ownership reduces man-
agers' incentives to achieve superior performance, we should observe 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 these attributes of organizational structure should increase perfor-
mance and the coefficients on leverage and the ownership variables would be
negative. This interpretation assumes that the optimal organizational structure
is not changing at the time of the reverse LBO (i.e., that we can treat the shift in
organizational incentives as exogenous). 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 if reducing the leverage and concentration of ownership reduces mana-
gerial incentives to achieve superior performance. (Neither advertising nor R&D
are used in these tests because of the lack of sample size associated with those
variables.)
The regression results with no control for industry or mean reversion perform-
ance are presented in panel A of Table 5. The F-statistics of the regressions are
generally significant and the adjusted R2's of the equations range from 6.4% to
33.5%. The first four regressions provide no evidence that changes in leverage
are associated with changes in accounting performance. However, the change in
the percentage ownership by operating management and nonmanagement
insiders is generally significant and positively associated with changes in
accounting performance.
The positive coefficients on the percentage of equity owned by operating
management and other insiders indicates that the greater the decline in the
percentage of outstanding equity owned by these groups, the greater the decline
320 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332

in subsequent accounting performance. 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. Since there is a much smaller
change in the OPINC/assets than the OCF/assets numbers (see Table 3), this is
perhaps not surprising.
To gain some understanding of the economic magnitude of the ownership
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 0.0044 (operating management) and 0.0035
(nonmanagement insiders). Recall that the median OCF/assets in year - 1 for
this sample is 0.193. On average, firms that enter this regression experience
approximately a 13.0% drop in both the percentage of equity owned by
operating management and in the percentage of equity owned by nonmanage-
ment insiders. A firm experiencing the average decline in the percentage equity
owned by management (13 %) loses an additional 0.057 in O CF/assets relative to
a firm whose managers' percentage equity owned does not decline, other things
equal. A firm experiencing the average decline in the percentage equity owned
by nonmanagement insiders (13%) loses an additional 0.0455 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
0.193, 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 expendi-
tures 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. Finally, there is strong evidence of a nega-
tive association between changes in nonmanagement insider ownership and
both working capital and capital expenditures. This significantly negative coef-
ficient implies that as nonmanagement insiders' equity decreases, working
capital and capital expenditures increase.
The magnitudes of the coefficient on nonmanagement insider ownership in
the working capital regressions ( - 0.0024 to -0.0028) indicate that a firm
experiencing the average decline in the percentage equity owned by nonmanage-
ment insiders (13%), gains an additional 0.0312 to 0.0364 in working capi-
tal/assets, relative to a firm whose nonmanagers' percentage equity owned did
not decline, other things equal. Given the median working capital/assets in year
- 1 of 0.144, this represents about a 20% increase in working capital relative to
the value in year - 1. A similar calculation using the nonmanagement insider
ownership coefficient from the capital expenditure regressions of -0.0008
 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 321

implies an increase in capital expenditures~assets of 0.0104, which approximates

a 25% increase in the level of capital expenditures relative to year - 1.
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 improving working capital and
increasing 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, assumin9 that the effects of that
inji~sion 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 expendi-
ture regressions with an additional independent variable that represents the net
proceeds of the offering less the amount used to retire debt (deflated by assets).
The regression results are not sensitive to the inclusion of this variable. There-
fore, the associations between ownership and working capital and capital
expenditure do not appear to be mechanically induced by the IPO.
Panel B of Table 5 reports the same equations as in panel A, but adds
a control for the change in performance from the industry benchmark. The
results are similar to panel A. The coefficients and significance levels for changes
in leverage, management ownership, and nonmanagement insider ownership are
almost identical to those observed in panel A. Thus, changes in leverage remain
an unimportant determinant of performance, while the ownership variables still
retain their significant associations. Surprisingly, the change in industry per-
formance is of limited significance in these regressions.
Panel C contains the estimated OPINC and OCF regressions when the mean
reversion benchmark is included as an additional variable. Including the mean
reversion performance benchmark reduces the significance of the change in
management ownership in the OCF/assets regressions, but not in the
OPINC/asse~s regressions. The significance of the change in ownership for the
nonmanagement insiders is largely unaffected, though the magnitude of the
coefficients in the OCF/assets regressions are reduced by approximately 50%.
The mean reversion performance benchmark is highly significant in the
OCF/assets regressions and more marginally significant in the OPINCi/assets
regressions. The greater significance of the mean reversion benchmark relative
to the industry benchmark in the regression specifications is consistent with
Barber and Lyon (1996).
The cross-sectional regressions reported in Table 5 between accounting per-
formance, leverage, and ownership assume that accounting performance
measures are useful indicators of firm performance. Evidence of the importance
322 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293-332

of accounting performance measures has been thoroughly documented in random

samples by examining the association between changes in prices and changes in
accounting performance measures. However, it is instructive to assess the reliabil-
ity of the accounting performance measures for our sample of reverse-LBO firms
to insure that they are reliable performance measures in this sample. We therefore
estimate the associations between the accounting and stock market measures of
performance for several periods subsequent to the public offering.
We find consistent evidence that subsequent to the IPO, changes in accounting
performance are positively correlated with contemporaneous changes in value.
For example, changes in OPINC/assets (firm, industry-adjusted, or mean-rever-
sion-adjusted) exhibit a statistically significant positive correlation with three
different measures of market performance (raw returns, market-adjusted re-
turns, and Jensen alphas as defined in the next section). The adjusted R2's of
one-year regressions (a one-year return measure regressed on a one-year change
in accounting performance) vary between 15% and 25%, while the adjusted-
RZ's of three-year regressions vary between 38% and 45%. Similar to Dechow
(1994), the positive correlations between return measures and OCF/assets are
less strong than for OPINC/assets, with both one-year and three-year regres-
sions of OCF/assets on market performance measures exhibiting adjusted RZ's
ranging between 5% and 11%. Thus, we conclude that the accounting per-
formance measures for this sample of firms are at least as reliable as those
documented for firms in general.
Overall, we interpret Table 5 as providing evidence that changes in ac-
counting performance observed subsequent to the reverse LBO are related to
changes in the concentration of ownership by operating management and
nonmanagement insiders. 8 Moreover, the results are not sensitive to alternative
specifications such as deflating by sales or controlling for outliers using standard
specification procedures. One interpretation of the evidence is that reductions in
the concentration of ownership lead to an inferior incentive structure and
therefore performance deteriorates. However, an alternative interpretation is
that managers optimally choose the timing of the I P O transaction to take
advantage of an information asymmetry between their private information and
the information known to the market. Under this interpretation, the positive
coefficient on the change in percentage equity owned by managers and
nonmanager insiders arises because managers reduce their ownership stake
more as their expectations of performance falls. However, examining the relation

81n other regression tests, we included the number of months that the firm was private and several
board of director structure variables to explain cross-sectional variation in accounting performance
(the percentage of managers, other capital providers and external board members constituting the
board, as well as the percentage of new board members). As discussed earlier, since these were
private firms, public disclosures do not provide explicit details concerning the change in the board
structure. None of these variables were significant in any regression specification tested.
 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 323

between changes in equity ownership and accoumin9 performance is only tangen-

tially related to this timing explanation because it does not directly relate to changes
in wealth. In the next section, we examine the stock market performance of reverse
LBOs to determine if there is any evidence that managers act opportunistically.

5. Information asymmetry and reverse LBOs

If managers take advantage of an informational asymmetry to sell their shares

at an inflated offering price, we would anticipate significantly negative returns
subsequent to the IPO. Evidence inconsistent with a timing explanation would
be zero or positive excess returns subsequent to the IPO, assuming that we
examine a sufficiently long time period for the market to determine the true
prospects for the firms. Of course, if the initial public offering market is efficient,
we would not expect to see significant excess returns. Ritter (1991) documents
that the stock price performance of I P O s 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). Spiess and Affleck-Graves (1995) document similar
underperformance for the c o m m o n stocks of firms following seasoned equity
offerings. A finding like that of Ritter or Spiess and Attteck-Graves in the
reverse-LBO data would be consistent with managers taking advantage of an
informational asymmetry.
The mean (median) opening-day raw return for 89 reverse-LBO firms for
which opening-day closing price data is available on the CRSP tapes is 2.03%
(0.00%). Of these, 43 have a positive return, 24 have a negative return, and 22
have a zero return. Market-adjusted returns for these firms are very similar. The
mean (median) opening day market-adjusted return for these same firms is
2.12% (0.86%), with the market-adjusted return defined as the firm's return less
the return on the value-weighted portfolio of New York and American Stock
Exchange Companies. Of these, 55 have a positive market-adjusted return and
34 have a negative market-adjusted return. As a comparison, Ibbotson, Sindelar,
and Ritter (1988) report that the mean first-day return for their sample of all
I P O s in the 1983 to 1987 period is 13.3%. Thus, the initial day's return is much
smaller for the sample of reverse LBOs than for I P O s in general and provides no
indication that these offerings are significantly mispriced. To examine this issue
further, we examine longer holding periods. 9

9The analysis in the remainder of this paper excludes the opening-day return and calculates returns
from the closing price on the offeringdate. This is a reasonable procedure for judging the return that
an average investor would obtain from investing in reverse-EBO's,as some have argued (see, for
example, Rock, 1986) that when the stock is underpriced the demand is so high that the offering
becomesrationed. As such, an uninformed investor will be able to invest a relativelysmaller amount
in underpriced offerings than in overpriced offerings.
324 R. ~ Holthausen. D.F. Larcker/'Journal of Financial Economics 42 (1996) 293 332

Longer-term stock market performance of reverse LBOs is reported in

Table 6 using three different metrics: buy-and-hold returns, buy-and-hold re-
turns in excess of the buy-and-hold returns for the value-weighted New York
and American Stock Exchange Index (market-adjusted returns), and
Jensen alphas, which 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 ex-
cess 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 LBO's vary between
1.3 and 1.5 depending on the time period examined.) The three different indi-
vidual firm measures are calculated for 12-, 24-, 36-, and 48-month holding
periods beginning with the closing price on the date of the IPO. We compute
monthly returns from CRSP daily returns assuming that each month has 21
trading days, similar to the approach used by Ritter (1991).
Table 6 reports abnormal return results for the entire sample, for the subset
that is still listed after 48 months, and for the subset that is not listed after 48
months due to an acquisition, another LBO, or an event of financial distress. If
a firm delists, the calculations in the table assume that the subsequent raw
returns, market-adjusted returns, and Jensen alphas are zero. Thus, the portfolio
strategy implicit in the raw return calculation is simply to hold the payout
associated with any delisted security as cash. For the market-adjusted return,
the portfolio strategy implicit in the calculation is that any payout is invested in
the market. For the Jensen alpha, the implicit portfolio strategy is that any
payout earns the equilibrium rate of return given its systematic risk. Statistical
tests for the significance of the mean (median) portfolio returns are implemented
using a one-sample t-test (Wilcoxon test).
Panel A of Table 6 indicates that for the entire sample, mean and median raw
returns, market-adjusted returns, and Jensen alphas at 12 months are insignifi-
cantly different from zero. At 24, 36, and 48 months, mean and median raw
returns are positive and are significantly different from zero. Mean and median
market-adjusted returns are positive at 24, 36, and 48 months, but only the
24-month mean return is significant at conventional levels. For Jensen alphas,
the means at 24, 36, and 48 months are all positive and are significant at the 10%
or better level at 24 and 36 months, while the medians are always negative but
never significantly different from zero at conventional levels. From a portfolio
strategy perspective, the mean return on the portfolio is clearly the relevant
statistic. However, in judging whether these returns are likely to be repeated in
future replications of reverse LBOs, the median provides some information
about the performance of the sample in general. Thus, while the raw returns are
clearly positive, the evidence on the significance of the excess return measures is
 R. 14q Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 325

less clear. Nevertheless, there is no evidence of the significant negative returns

that we would anticipate if managers are taking advantage of an informational
asymmetry with the market in choosing the timing of the IPO.
Panels B and C provide some indication that to the extent there are positive
returns, those returns are coming primarily from the subset of firms that delist,
most of which are acquired. For example, for the sample of reverse LBOs that
delist within 48 months of the reverse LBO (panel C), mean and median raw
returns, market-adjusted returns, and Jensen alphas are all positive and signifi-
cant at 24 months with somewhat weaker significance levels at 36 months. For
the firms still listed 48 months after the reverse LBO (panel B), the mean raw
returns are positive and significantly different from zero at 24 and 36 months.
However, the median raw returns and mean and median market-adjusted
returns and Jensen alphas are not significantly different from zero. Thus, judging
the likelihood that the stock market performance of this sample of reverse LBOs
would be repeated in a future sample of reverse LBOs is contingent, in part, on
whether one believes that the large number of acquisitions evident in this sample
is likely to be repeated.
Overall, the market performance of the reverse LBOs subsequent to their
public offerings is either positive or insignificantly different from zero depending
on the time period and performance metric chosen. Mian and Rosenfeld (1993)
and Degeorge and Zeckhauser also find no evidence of negative excess returns
following reverse LBOs using somewhat different procedures. Since there is no
evidence of statistically negative excess returns, there is no support at the overall
sample level for the hypothesis that managers are able to take advantage of an
information asymmetry to enrich themselves. While Degeorge and Zeckhauser
(1993) do not find evidence of negative excess returns following reverse LBOs,
they still conclude that the accounting performance declines of reverse LBOs are
due to information asymmetries between owners and the market. That con-
clusion is unwarranted given the stock return evidence. Overall, the pricing of
reverse LBOs seems quite rational relative to the pricing of lPOs and the pricing
of seasoned equity offerings, as reverse LBOs do not experience a large increase
in value on the offering date or a large decline in value over the subsequent three
years.
We also examine the extent to which cross-sectional variation in excess
returns can be explained by the change in leverage and ownership structure. If
the initial public offering market is efficient, we would n o t 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 perfor-
mance in an efficient market (see, for example, Leland and Pyle, 1977). Downes
and Heinkel (1982), among others, investigate the pricing of IPOs and find
326 R.W. Holthausen, D.F, Larcker/'Journal of Financial Economics 42 (1996) 293-332

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 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 327

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328 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332

evidence that the offering price is positively related to the percentage ownership
retained by insiders. If subsequent market performance is uncorrelated with the
organizational structure variables, in particular the change in the percentage
equity owned by operating management and nonmanagement insiders, that
would be additional evidence inconsistent with the information asymmetry
explanation for the results reported in Table 5.
Although not reported in tables, we find that cross-sectional variation in
changes in leverage and changes in the percentage of equity owned by managers
and other insiders have no ability to explain cross-sectional variation in either
raw returns, market-adjusted returns, or Jensen alphas for either 12-, 24-, 36-, or
48-month holding periods. Thus, there is no evidence that the change in
organizational structure is correlated with the extent to which the operating
management and other insiders have been able to utilize an information asym-
metry to increase their wealth. This suggests that the offering price includes
expectations of the change in performance arising from the change in the
leverage and ownership structure.

6. Interpretation of the results

In this paper, we examine the accounting and stock price performance of

a sample of reverse LBOs subsequent to their public offering. We relate cross-
sectional variation in changes in accounting performance to variables that
proxy for changes in organizational incentives taking place at the time these
firms go public. The major findings in the paper are that firms outperform their
industries for the four years following the IPO, though there is some weak
evidence of a decline in performance in that period. Further, reverse LBOs
increase capital expenditures subsequent to the public offering while working
capital levels increase. Most importantly, cross-sectional tests indicate that firm
performance decreases with declines in the concentration of equity ownership by
operating management and other insiders and 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 nonmanage-
ment insiders.
If we assume that changes in organizational structure are exogenou~s, then our
results are largely consistent with Jensen (1989) and Stewart (1990), who argue
that there are positive incentive effects associated with more concentrated
ownership by managers and active investors who monitor management, and
that these organizational changes are conducive to superior performance. In the
context of our study, the assumption that organizational structure is exogenous
suggests that the ownership stakes of both the operating management
and nonmanagement insiders are important determinants of organizational
performance.
 R.W. Holthausen, D.F. Larcker/Journal of Financial Economics" 42 H996) 293 332 329

Jensen (1989) and Stewart (1990) also discuss the positive incentive effects
associated with greater leverage, but we find no evidence that performance
subsequent to the I P O is related to changes in leverage at the time of the I P O .
However, if the reverse L B O s are generally constrained in their ability to make
investments, this sample of firms is unlikely to exhibit the positive incentive
effects associated with debt as described by Jensen (1989), since those effects are
discussed in the context of firms with free cash flow generating ability and no
profitable investment opportunities. Moreover, evidence from our sample indi-
cates that capital expenditures increase after the reverse L B O which is consistent
with these firms being cash constrained prior to the reverse LBO. As such, the
leverage effects discussed in Jensen (1989) m a y be unlikely to arise in this sample.
The economic interpretation that ownership, but not leverage, affects perfor-
mance is critically dependent on the assumption that the change in organiza-
tional structure is e x o g e n o u s . However, it is possible that some exogenous shock
(for example, changes in the investment o p p o r t u n i t y set) affects both the firm's
optimal organizational structure and its performance (i.e., both organizational
structure and performance are endogenous). Moreover, given the exogenous
determinants, the organizational structures of the reverse-LBO firms m a y have
been optimal b o t h before a n d after the reverse LBO. Since we have not identified
and do not control for these potential exogenous shocks, it is possible that the
observed relation between changes in performance and organizational structure
is due to the same exogenous shock, and that performance and organizational
structure are not causally related. If changes in organizational structure are
endogenous, there is no reason to believe that increases in the concentration of
ownership will produce increases in performance, unless the exogenous determi-
nants of ownership change in a way that supports the increased ownership
concentration.l°
The limitation in experimental design from treating organizational incentives
as exogenous is also present in most of the research linking performance to
organizational structure, including w o r k which has examined the performance

l°Holthausen and Larcker (1994b) deal directly with the endogeneity issue of organizational
structure on a different and much larger sample of firms. They also find a positive association
between equity ownership and performance, but conclude that the result is driven by managers
increasing their ownership stakes in response to expectations of greater performance, not by greater
equity ownership causally increasing performance. However, that argument is not compelling in this
setting, since we previously demonstrate that the mean and median abnormal common stock returns
subsequent to the reverse LBO are nonnegative and that there is no association between those stock
returns and the changes in ownership structure. Thus, officers and directors appear unable to affect
their wealth, as the performance implications of the change in ownership are priced correctly at the
time of the reverse LBO, regardless of their exact cause. Unfortunately, the number of observations
in the reverse-LBO sample is not sufficiently large to estimate a system-of-equations which would
adequately address the endogeneity issue.
330 R.~L Holthausen, D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332

effects associated with the decision to go private, such as K a p l a n (1989), Smith

(1990), and Muscarella and Vetsuypens (1990). While it is reasonable to con-
clude from that work that the performance of the firms improves when they
perform a leveraged buyout, it is much more problematic to conclude that the
shift in organizational incentives causes the i m p r o v e d performance.
Finally, since our tests provide at least some evidence that there is a decline in
performance subsequent to the reverse L B O and that this is related to the
change in the ownership 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 L B O is n o t o p t i m a l , we would
expect firms to switch back towards their LBO-like structure. To see whether
the b o a r d and ownership structure of the reverse-LBO firms changes after the
reverse LBO, we obtain proxy statements for the firms that are still publicly
listed three years after the reverse LBO. O u r analysis indicates that these firms
are still hybrid organizations, that is, they retain some of the ownership and
b o a r d structure characteristics of the leverage buyout. However, they also
appear to be continuing to evolve toward the b o a r d and ownership structure of
a typical U.S. corporation, as opposed to moving back toward an LBO-like
structure.
In particular, we find that for the firms that are still public three years after the
reverse LBO, the mean and median percentages of equity owned by operating
managers are 22.4% and 12.6%, respectively. F o r n o n m a n a g e m e n t insiders, the
mean and median ownership percentages are 16.4% and 5.3%, respectively.
Thus, ownership by operating managers and n o n m a n a g e m e n t insiders is still
m o r e concentrated than for the typical corporation. Nevertheless, the ownership
positions of these organizations that are still public three years after the I P O are
m u c h less concentrated than they were immediately after the I P O , with the
median decline in ownership for m a n a g e m e n t and n o n m a n a g e m e n t insiders at
- 14.9% and - 24.1%, respectively, tl
We also find that the b o a r d structure is evolving toward a m o r e standard
corporate structure. In particular, three years after the I P O , approximately 46%
of the b o a r d members are external members with no significant equity stakes
(less than 5% of the equity), 35% of the b o a r d members are internal b o a r d
members, and the remaining 19% of the b o a r d members are significant investors

~As discussed previously, 44 of the 90 reverse LBO firms either were acquired or completed another
LBO, with an average time to acquisition of 30 months. Thus, acquisition is one vehicle used for
exiting from the LBO. Mian and Rosenfeld (1993) indicate that the probability of an acquisition
increases with greater equity ownership of an LBO buyout firm. The evidence reported here on the
reverse-LBO firms that are still public provides additional information about exit. As indicated,
both the nonmanagement insiders and management continue to reduce their ownership in the firm.
In addition, 24% of the firms have a different CEO three years after the reverse LBO than they did at
the time of the reverse LBO.
 R.g~ Holthausen. D.F. Larcker/Journal of Financial Economics 42 (1996) 293 332 331

(representatives of L B O b u y o u t firms, d e b t h o l d e r s , a n d o t h e r significant inves-

tors). O f the external m e m b e r s with no significant equity stakes, a p p r o x i m a t e l y
7 % were significant investors i m m e d i a t e l y after the 1PO b u t are n o t significant
investors a n y longer. Thus, the m a j o r shift t h a t occurs in the b o a r d structure in
the three years after the I P O is a w a y from n o n m a n a g e m e n t c a p i t a l p r o v i d e r s
to external directors with limited equity stakes. T h o u g h the m e d i a n b o a r d
size does n o t increase (and average b o a r d size increases by less t h a n one person),
a p p r o x i m a t e l y o n e - t h i r d of the b o a r d m e m b e r s are new since the reverse
LBO.
Overall, the results in this p a p e r a d d s o m e intriguing evidence on the link
between p e r f o r m a n c e a n d o r g a n i z a t i o n a l incentives. In p a r t i c u l a r , there is very
s t r o n g evidence of a positive a s s o c i a t i o n between p e r f o r m a n c e a n d m a n a g e r i a l
o w n e r s h i p a n d o w n e r s h i p by active investors (monitors). At issue, however, is
the a p p r o p r i a t e i n t e r p r e t a t i o n of those results. G i v e n t h a t these firms do n o t
shift b a c k to an L B O - l i k e structure, w h a t e v e r losses they incur from the reverse
L B O m u s t be smaller t h a n the costs of reverting b a c k to the L B O form.
Alternatively, the L B O form is no longer o p t i m a l given the e x o g e n o u s d e t e r m i -
n a n t s of o r g a n i z a t i o n a l structure. F u t u r e research that m o d e l s the d e t e r m i n a n t s
of o r g a n i z a t i o n a l incentives, examines the relation between o r g a n i z a t i o n a l in-
centives a n d performance, a n d treats b o t h as e n d o g e n o u s variables w o u l d be an
i m p o r t a n t a d d i t i o n to the literature.

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 Update
Journal of Financial Economics
Volume 47, Issue 1, January 1998, Page 123

DOI: https://doi.org/10.1016/S0304-405X(97)00040-8
 JOURNALOF
Bnancial
ELSEVIER Journal of Financial Economics 47 (1998) 123
ECONOlVIICS

Erratum
The financial performance of reverse leveraged buyouts
[Journal of Financial Economics 42 (1996) 293-332] 1
R o b e r t W. H o l t h a u s e n * , D a v i d F. L a r c k e r
The Wharton School, University of Pennsylvania, Philadelphia, PA 19104, USA

The following passage from Holthausen and Larcker (1996) (p. 325) is in error
and should be eliminated:

While Degeorge and Zeckhauser (1993) do not find evidence of negative

excess returns following reverse LBOs, they still conclude that the accounting
performance declines of reverse LBOs are due to information asymmetries
between owners and the market. That conclusion is unwarranted given the
stock return evidence.

Degeorge and Zeckhauser (1993) argue that the market should recognize the
presence of information asymmetry, which is consistent with the evidence in
their paper and in Holthausen and Larcker (1996).

References

Degeorge, F., Zeckhauser, R., 1993. The reverse LBO decision and firm performance: theory and
evidence. Journal of Finance 48, 1323-1348.
Holthausen, R., Larcker, D., 1996. The financial performance of reverse leveraged buyouts. Journal
of Financial Economics 42, 293 332.

* Corresponding author.
1 PII of original article: 0304-405X(96)00884-7.

0304-405X/98/$19.00 ~) 1998 Elsevier Science S.A. All rights reserved

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