Private Equity, LBOs, and Corporate Governance: International Evidence

Abstract

Private equity is risk capital used in a wide variety of situations, ranging from finance provided to business start-ups to the purchase of family firms, as well as divisions of corporations and even entire mature publicly-traded companies (Gilligan & Wright, 2010). The focus of this special issue is on leveraged buyouts of existing businesses in which private equity investors and a management team pool their own money, usually together with borrowed money to buy a business from its current owners. In recent years, there has been a resurgence of these leveraged buyouts and private equity investment in many nations (Strömberg, 2008; Wright, Amess, Weir, & Girma, 2009a), culminating in a peak worldwide in 2007. The onset of the financial crisis from 2008 resulted in a massive fall in deal value worldwide in 2009 as debt markets closed and private equity firms set about restructuring troubled and over-leveraged portfolio companies. Nevertheless, it is clear that private equity was not just a transitory phenomenon and that private equity firms have adapted to begin to build a new future (Wright, Jackson, & Frobisher, 2010). At the time of writing worldwide private equity shows signs of recovery, as the third quarter of 2010 provided the strongest showing of the market since the financial crisis at an aggregate value of $66.7 billion (Preqin, 2010). These trends have vital global implications for corporate governance and performance. Disclosure and other governance requirements associated with the Sarbanes-Oxley Act have substantially increased regulatory compliance costs for listed corporations (Yoshikawa & Rasheed, 2009). The costs associated with a stock market listing, including the costs of scrutiny by security analysts, have important implications regarding the attractiveness of the stock market for firms. As a result, companies of modest size with growth potential may have great difficulty securing funding. Larger firms may find the regulatory burden and additional scrutiny too severe. An overemphasis on accountability could stifle the ability of firms to realize entrepreneurial opportunities. Under these circumstances, private equity investors can provide funding to realize growth opportunities, as well as active, specialist governance. Pension funds and other institutional investors, including sovereign wealth funds have also been attracted to the private equity market by superior returns. The end result is that private equity funds have become larger, raising the likelihood of additional acquisitions of large corporations. The rise of the private equity market poses critical research questions regarding how these transactions increase private and social value. As evidence by the papers in this special issue, the “performance” effects of these transactions have important implications for corporate governance practices. For instance, private equity firms may need to adopt strategies to secure attractive deals without engaging in public auctions, which have become prevalent. A recent review of the literature in this Journal (Wright et al., 2009a) reported that private equity transactions have resulted in significant gains in “real” performance or productivity (Harris, Siegel, & Wright, 2005; Lichtenberg & Siegel, 1990). However, there may need to be a stronger emphasis on entrepreneurial activity to realize the upside potential of these firms (Wright, Hoskisson, Busenitz, & Dial, 2000). Changes in the stock market and the market for corporate control also raise issues concerning the ability of private equity firms to realize the gains from their investments, especially for modest sized deals in mature sectors, while at the same time meeting investors' expectations of significant returns within a particular time period. The returns from private equity transactions have attracted new types of entrants seeking to reap such returns. In particular, hedge funds have actively entered this market, which raises several concerns, given their transaction-oriented nature and a sense that their ability to add real value (in a managerial sense) to enterprises may be limited. Private equity is also increasingly becoming an international phenomenon. Leveraged and management buy-out activity is on the rise in Europe, Japan, and other Asian nations, as these countries come under increasing pressure to restructure their economies (Wright, Burrows, Ball, Scholes, Meuleman, & Amess, 2007). Public to private leveraged buyouts (LBOs) have been occurring in significant volumes in these countries over the past five years where they were previously absent. The development of these types of organization, in contexts where they were previously absent, adds to the growing interest in the influence of contextual, institutional factors in finance and governance. The actions of multinational private equity firms internationalizing into these markets and the controversy this has generated (especially in Europe) in relation to employment and employee relations also heightens the importance of examining international evidence on this phenomenon. The advent of the international financial crisis from 2008 and its implications for highly leveraged private equity deals has further fuelled interest in the corporate governance implications of private equity. In sum, these developments have salient managerial and policy implications for corporate governance. The papers presented in this special issue address these challenges. Although different in style and research methods used, they have one common element: a strong focus on the governance roles of private equity firms in different contexts. This unique focus makes this special issue an important step towards a better understanding of corporate governance around the world. These papers also help to identify a number of important avenues for future research on the governance implications of private equity investments. Following a general call for papers, we received 19 submissions. Based on the first round of reviews, we invited 10 papers for presentation at a conference held at the University of Albany, State University of New York in June 2010. We then invited authors of the papers presented at the conference to revise their papers and resubmit them for further review. We selected the five best papers that met the standards of the CGIR review process for publication in this special issue. Table 1 contains a summary of these articles. For each paper, Table 1 lists the authors, key research questions, the data and analytical methods, and the key findings relating to corporate governance. There is substantial evidence of significant announcement effects of public to private transactions (henceforth, P2Ps, see, e.g., Renneboog, Simons, & Wright, 2007). These significant increases in stock prices have been found in different institutional contexts, including the US, UK, continental Europe, and Australia (Cumming, Siegel, & Wright, 2007). However, the announcement effects seem to be less in Europe (Andres, Betzer, & Weir, 2007) and Asia (Lee, 2009) than in the US or UK (Renneboog et al., 2007). Explanations of P2P transactions in the US may not hold in Europe and Asia. First, there is heterogeneity between the three continents in terms of capital market development and regulation, legal, and corporate governance frameworks, tax benefits, and the use of debt in funding LBOs. Second, the ownership structure of listed corporations differs, with many continental European corporations, in contrast to the UKand the US, having dominant family shareholders (Geranio & Zanotti, 2011), which is also the case in several Asian countries, including Japan (Wright, Kitamura, & Hoskisson, 2003). This also affects the functioning of the market for corporate control is less active. Third, although there has been some development of corporate governance codes, protection of minority shareholders is generally weaker in continental Europe and Asia. These differences suggest that P2Ps in continental Europe and Asia may have different determinants which impact the wealth gains that are observed. We return to this point in the next section in the context of PE firms' rationales and actions in investing in P2Ps. Evidence suggests that, as in more traditional acquisitions, pre-buyout shareholders obtain a higher price for their stock if outside acquirers compete for control with the proposed MBO (Easterwood, Singer, Seth, & Lang, 1994). Growing attention has, however, been paid to alternatives to the public takeover process, including the roles of private bargaining (Boone & Mulherin, 2007) and irrevocable commitments (Wright et al., 2007). With respect to the latter, acquirers can enhance their chances of success in negotiating a takeover of a listed corporation by seeking irrevocable commitments from significant shareholders to accept their bid before it is made public. Cumming and Li (this issue) add to this literature by examining whether there is evidence of insider trading in public and private acquisitions, including private-equity backed acquisitions. Using international data they find evidence that is consistent with insider trading of acquirer's stock. These findings have important implications for corporate governance research since they point out that insider trading is not associated only with transactions in public market equity and it represents a more general phenomenon that requires further research. PE firms select firms for investment where they perceive that they are underperforming and that their actions can reverse this trend. Various studies of P2Ps have examined the relative importance of different antecedents to the buyout and find, inter alia, that undervaluation is an important factor (Renneboog et al., 2007). However, in continental Europe while undervaluation is important, deals promoted by family owners register higher abnormal returns (Geranio & Zanotti, 2011). Achleitner, Betzerb, Goergen, and Hinterramskogler (2011) also find for continental Europe that since corporate control and ownership in continental Europe tend to be highly concentrated, the incentives of incumbent large shareholders to monitor management and the private benefits of control the latter may derive from the firm affect the likelihood of the firm being taken over by a private equity investor. There is some debate about the role of financial distress as an indicator of the attractiveness of a target corporation for PE firms, with Opler and Titman (1993) in the US arguing that PE firms are deterred from taking companies private that show signs of distress because firm failure is more likely following a buyout, due to the higher debt burden associated with the transaction. Sudarsanam, Wright, and Huang (this issue) challenge this view and extend the argument that private equity can contribute to the general corporate governance literature by extending the market for corporate control beyond traditional acquisitions of companies at risk of bankruptcy. Using a sample of UK P2Ps they find that these firms have a significantly higher default probability than non-acquired firms that remain public. This suggests that PE firms are not deterred by the risk of financial distress, but consider it a value-creating opportunity due to their specialist governance skills. However, they also caution that this view may need to be tempered, given that limited access to information before the deal may mean that serious underlying performance problems are not revealed before the deal is completed. Sudarsanam et al. extend the existing literature on P2Ps, which has tended to cast doubt upon the efficacy or pre-buyout governance mechanisms, by arguing that better governance of the target pre-P2P is associated with lower bankruptcy risk since where the PE investor inherits a strong governance structure, as manifested by the presence of independent boards. These findings, however, raise questions about the ability of private equity governance structures to turnaround troubled former stock market listed corporations. There is growing awareness, particularly in an international context, of the heterogeneity of PE equity and hedge funds. Further, studies have also shown that the effects of PE and hedge funds on the performance of their portfolio companies is closely associated with funds' specialist sector expertise and prior deal experience. Numerous authors have considered the role of traditional takeovers in removing underperforming managers. Most of these papers have reported a higher rate of managerial turnover in the aftermath of a takeover, especially in the case of hostile bids (see, e.g., O'Sullivan & Wong 2005 for a review). The emerging PE literature points to the greater role of PE firms in changing management compared to boards in listed corporations (Acharya, Kehoe, & Reyner, 2009; Cornelli & Karakas, 2008). Gong and Wu (this issue) add to evidence on the role of PE firms in removing incumbent managers. Using a sample of US LBOs, they find that over half of CEOs are changed within two years of LBO. Boards are more likely to replace CEOs in companies with high agency costs and if pre-LBO performance is low. Interestingly, they find that in contrast to boards of directors in public companies, boards in post-LBO companies are likely to replace entrenched CEOs. Again, this finding is very important for corporate governance research in general since it indicates that the types of investors may have a direct impact on other governance factors, such as CEO replacement. As noted earlier, a recent review in this journal (Wright et al., 2009a) identified extensive evidence stretching back to the first wave of private equity backed buyouts in the 1980s of significant performance improvements in portfolio companies, which were associated with improved governance and incentive mechanisms. The effects of private equity backed buyouts on employment in portfolio companies has proven to be a much more controversial issue. Evidence relating to the governance effects on employment resulting from traditional takeovers, has identified substantial reductions (Conyon, Girma, Thompson, & Wright, 2002). The emergence of private equity backed buyouts serves to emphasize the need to recognize the heterogeneity of acquirers and acquirees and their implications for employment. Research has examined the impact of private equity backed LBOs on employment and in portfolio companies (Amess & Wright, 2007, 2010; Davis, Lerner, Haltiwanger, Miranda, & Jarmin, 2008). The available evidence suggests that the negative effects on employment are less for PE deals than for traditional acquisitions (Amess & Wright, 2010). Although the impact of alternative investors such as private equity and hedge funds has attractive considerable policy debate, a growing body of evidence suggests that a more nuanced approach is required that reflects the heterogeneity of the circumstances under which the deal takes place, including whether the deal is an insider driven management buyout or an outsider driven LBO or management buy-in (MBI) (see Wright, Bacon, & Amess, 2009b for a review). While Amess and Wright (2010) focus upon the broad spread of outsider driven MBIs from a range of vendor sources including family firms and divisional sales, Goergen, O'Sullivan, and Wood (this issue) extend recognition of the heterogeneity of acquiree types and their different employment effects to the case of Investor-Led Buyouts (IBOs) of listed corporations. They find that IBOs are accompanied by falls in employment without there being a corresponding increase in productivity and profitability. These findings echo those in Weir, Jones, and Wright (2008) who examine the full scope of public to private buyout transactions. There is an extensive literature concerning the effects of traditional acquisitions on employee relations (see, e.g., Vinten, 1993 for a review). Goergen, Brewster, and Wood (2006) suggest that the cross-country effects of traditional acquisitions are not simply due to simple path dependent institutional differences between countries, but rather to industry and firm specific factors. Attention is also beginning to be given to the link between institutional context and the effects of private equity on employee relations, including the involvement of employees in firm governance, in recognition of the governance impact resulting from the heterogeneity of acquirer types. A first approach to examining this heterogeneity was undertaken by Bacon, Wright, Meuleman, and Scholes (2010b) who, examining a pan-European sample of private equity backed buyouts, find that with respect to the PE firms' country of origin, buy-outs backed by Anglo-Saxon PE firms are as likely to introduce new high performance work practices (HPWP), and are specifically more likely to extend performance-related pay schemes, as those backed by non-Anglo-Saxon PE firms, suggesting some adaptation to the local host country contexts of buy-outs. Interestingly, this study also suggests that the overall impact of PE on (HPWP) is affected more by length of the investment relationship than the countries where PE is going to or is coming from; PE investment results in the increased use of HPWP in buy-outs the longer the anticipated time to exit. Gospel, Pendleton, Vitols and Wilke (this issue) extend this analysis of heterogeneous acquirers by encompassing private equity firms, hedge funds and sovereign wealth funds, each with distinctive corporate governance mechanisms. They find substantial effects of these different forms of alternative acquirer on employees using case studies from three European countries. They note that the effects are heterogeneous. Some consequences such as employment reduction appear to be negative for labour but there are also some benefits in terms of work organisation and employee voice. Their findings that national systems of labour regulation do not seem to impact substantially on the scope for employment reductions but they do affect the extent to which worker representatives receive information after (though not during) the acquisition reinforces the wider evidence from traditional acquisitions. The recent review by Wright et al. (2009a) noted that the evidence on the effects of private equity in different institutional contexts is somewhat fragmented. Further, there has been little attempt to theorize and make empirical comparisons across countries or to analyze the cross-border activities of private equity firms. This has especially been the case for multi-country studies in the finance area, yet evidence from single country studies from countries such as the US, UK, France, and the Netherlands suggests that there may be important differences. Several of the papers in this special issue provide evidence that adds to insights regarding the implications of national institutional differences for the effects of private equity. Sudarsanam et al. provide theoretical argumentation and empirical evidence relating to the UK which stands in contrast to earlier US evidence on the effect of distress costs on the completion of private equity deals. In contrast, the US evidence from Gong and Wu on the extent of CEO replacement is consistent with recent UK studies. With respect to multi-country studies, Cumming and Li examine differences in insider trading in private equity and non-private equity deals in 31 countries, while Gospel et al. provide a specific comparison of the employment effects of different forms of alternative investors in different country contexts. In this section, we identify areas for further research into the international dimensions of the governance aspects of private equity at five levels of analysis: private equity firms compared to other acquirers, private equity firm actions, portfolio company and employee involvement in governance, and private equity and national In Table we the key research que

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