Operating performance in leveraged buyouts: evidence from 1985-1989 - Leveraged Buyouts Special Issue

Financial Management (Financial Management Association), Spring, 1992 by Tim C. Opler

* This study investigates the consequences of leveraged buyouts (LBOs) on operating performance using a sample of 44 going-private transactions completed in the period 1985-1989. Previous studies have documented increases in before- and after-tax cash flows following LBOs (see Bull [1], Kaplan [7], Kaplan and Stein [8], Kitching [9], Long and Ravenscraft [11], Muscarella and Vetsuypens [12], and Smith [17]).(1) Kaplan [7] and Smith [17] have also shown that capital expenditures decline following LBOs. Kaplan [7] has argued that this decline represents reductions in wasteful investments. These authors have also shown that there are few changes in employment, R&D and maintenance expenditures following LBOs.

The Kaplan and Smith studies have been widely cited as evidence that leveraged buyouts result in efficiency improvements. However, these studies consider leveraged buyouts which occurred in the early and mid-1980s. Several observers have noted that, in the latter half of the 1980s, the leveraged buyout market evolved to the point where pricier and riskier transactions took place (see Kaplan and Stein [8], Jensen [6], and Summers [19]). Quite possibly, the returns from taking firms private declined over time as opportunities dried up for remedying agency problems easily through leverage and increases in management.(2) Thus, real operating gains may have been more difficult to achieve in later deals. Consistent with this account, Long and Ravenscraft [11] find that operating profit margins declined by an average of 2% following 107 leveraged buyouts which occurred in the 1985-1987 period. This suggests that the dramatic operating improvements documented in earlier LBOs were due to an unusual abundance of attractive LBO targets and that "the number and type of firms that can be revitalized through LBOs is limited." (Long and Ravenscraft [11, p. 17]).

Like Long and Ravenscraft [11], this paper documents changes in operating performance following LBOs of the mid- and late 1980s.(3) However, there are several differences between these studies. First, this study examines solely the largest LBOs of the late 1980s. In particular, this study documents changes in operating performance following all but two of the 20 largest LBOs which occurred between 1985 and 1990. The largest LBOs are likely to have the largest impact on the economy and thus are naturally of the most interest to policymakers. Second, this study examines LBOs which occurred through 1989, whereas Long and Ravenscraft studied LBOs through 1987. The last two years, 1988 and 1989, are important in evaluating the LBO phenomenon since many of the largest LBOs (e.g., RJR/Nabisco) occurred in these years.

The main results of this study can be summarized as follows:

* Operating profits/sales rise by an average of 16.5%

from one year before until two years after the LBOs

in the sample. After adjustment for industry trends,

operating profits divided by sales rise by an average

of 11.6%.

* Operating profits per employee rise by an average

of 31.8$ in the two years following the LBOs in the

sample. After industry adjustment, the rise is

40.3%.

* Cash flow net of investment rises even more

significantly.

* LBOs have little impact on R&D, but result in sharp

declines in capital expenditures and income taxes

paid.

The results are broadly comparable with those of Kaplan [7] and Smith [17]. Kaplan finds that operating profits/sales rise by an average of 11.9% in the two years after LBOs. This rise goes to 23.3% after industry adjustment. This study shows a larger rise before industry adjustment and a smaller rise afterwards. Smith [17] shows that industry-adjusted operating cash flows per employee rise significantly after LBOs. The rise documented here is similar. While conclusions about changes in operating performance following LBOs will depend on the sample and the definitions of variables examined, the results presented in this paper suggest that the LBOs of the late 1980s produced positive operating improvements that are roughly the same as those observed by Kaplan [7] and Smith [17]. They are also significantly higher than those reported by Long and Ravenscraft [11] and somewhat higher than those reported in Kaplan and Stein [8].

The remainder of this paper is organized as follows. Section I describes the sample and performance measurement benchmarks. Section II presents results on operating performance and compares the results to those obtained previously. Section III summarizes and concludes.

I. Data and Performance Measurement

The sample consists of 44 large leveraged buyouts completed between 1985 and 1989 (see Exhibit 2). This sample contains all firms listed in the 1990 Forbes Private 400 that completed LBOs in 1985-1989 and had financial information in Compact Disclosure, Moody's Industrial Manual, or the COMPUSTAT II PST, FC and research files for the year prior to the buyout until at least one year afterwards.(4) This financial information is provided by LBO firms because of SEC disclosure requirements associated with their issue of publicly traded bonds, preferred stock or warrants. The remaining 60 LBO firms in the Forbes 400 were not selected because they did not have publicly traded securities, because they had no pre-LBO financials, because they were a division of a larger firm, or because they were taken private in late 1989 or in 1990. Exhibit 1 shows the distribution of sample firms by year. Roughly 75% of the LBOs were completed in 1988 and 1989.