Timing issues in LBO financing: a study of European LBO targets

Timing issues in LBO financing: a study

of European LBO targets

Tjerk van der Kooi

S 1384740

March 14th 2008

Timing Issues in LBO Financing: a Study of

European LBO Targets

TJERK VAN DER KOOI

ABSTRACT

This paper investigates the existence of a timing decision by private equity firms in determining the financial leverage of LBO financing packages. We research whether the financial leverage in buyout financing packages increases due to improvements in economic market conditions. Such a mutual relation implicates that private equity investors time the financial leverage in LBO financing packages. Little previous research has been done on timing issues in private equity LBO deals. We find that increasing money supply and decreasing relative performance of small capitalization stocks raise the financial leverage in private equity LBO deals. These results indicate that private equity investors determine the financial leverage of LBO financing packages by anticipating economic market conditions. The outcomes demonstrate the existence of a timing decision by private equity firms in structuring LBO financing packages. Elaborating on the results of the main study, we find that the existence of timing in financial leverage mainly appears in LBOs with relative small deal values, however. Despite the valuable outcomes of this study further research about the positioning of private equity in global economy should be explored.

I. Introduction

This paper studies the phenomenon of leveraged buyouts (“LBOs”) with a private equity firm as the acquirer. An LBO is a transaction in which a party uses a significant amount of borrowed money to acquire the target company. Private equity firms use mostly debt to finance the buyout. They use mostly debt because debt creates a leverage effect which increases expected return on equity. Economic market conditions that make debt use more attracting positively affect returns of private equity buyouts, the availability of equity financing and the provision of debt. Because returns and availability of capital are the essential parts and value drivers of private equity LBOs, it is intuitive appealing that private equity firms anticipate economic market conditions in financially structuring the deal. The purpose of this paper is to investigate the possible existence of a timing decision by private equity investors in determining the financial structure of an LBO financing package.

The main purpose of private equity firms is realizing capital gains (Jensen 1989; Cumming and Johan, 2007). These capital gains must be achieved through returns on company investments and the avoidance of investment liquidation in the total portfolio (Barry et al., 1990; Cumming and MacIntosh, 2003; Das et al., 2003). To attract the necessary investor funds a high return must be realized on those risky investments. Such a high yield can only be realized by creating a leverage effect through using debt.

The underlying advantages of debt financing have been broadly discussed. According to Jensen’s Free Cash Flow theory (1986, 1989) the use of debt in LBOs creates an improved internal governance system and improves efficiency in operations. Debt reduces the agency costs related to the lack of effectiveness of a governance system. It acts as a substitute for dividends and prohibits company managers to invest available cash inefficiently to avoid bankruptcy. A “control-related” implication is that debt reduces the equity stake in the financing structure. As a result, private equity investors are allowed more easily to control the majority of stock. This concentrated ownership gives private equity firms a large voice in the board of directors. With this large voice, private equity can act as an active investor monitoring and controlling the strategy of the buyout firm (Nikoskelainen and Wright, 2007). Moreover, the large stock ownership by the management of the new company provides by itself a powerful self-monitoring device. Quoting Jensen (1986) “these control effects of debt are a potential determinant of capital structure”. Another powerful implication of debt is that the treat of a potential bankruptcy forces and motivates companies to become more efficient and lean in their operations (Nikoskelainen and Wright, 2007). Also, the tax benefits of debt introduced by Modigliani and Miller (1958) are a serious advantage of LBOs. Interest costs on debt reduce overall tax base and create a tax shield (Lowenstein, 1985).

These main drivers of return in private equity deals can be materialized due to the dramatic nature of the buyout and the high financial leverage in the financing package. Private equity funds use as much debt as possible to strengthen the leverage effect. If the management is capable of generating sufficient cash flows, the return on assets (ROA) lies above cost of debt and raises return on equity (ROE). For maximum benefits and safety, private equity funds focus on firms or divisions with stable business histories, low growth prospects and high potential for generating cash flow (Jensen, 1986). According to Lowenstein (1985) the longevity of LBOs is about three to five years. At that time acquisition debt is paid down and other contractual commitments are fulfilled.

European leveraged loan market during the period January 98- March 07 and the average total debt multiples used in European LBOs during the period January 99-September 07, respectively.

Graph 1: European LBO transaction volumes Graph 2: European Total Debt Leverage Ratio for LBOs

European LBO transaction volumes

0 50 100 150 200 250 1998 1999 2000 2001 2002 2003 2004 2005 2006 Q1 20 07 Year In US D b n

LBO volume Number of deals

Average Total Debt Leverage Ratio for LBO's in Europe

0 1 2 3 4 5 6 7 199 9 200 0 2001 2002 2003 2004 2005 2006 Q3 20 07 Year L eve ra ge rat io

Average total debt/EBITDA

Source: S&P- Leveraged Commentary & Data/Thomson Venture Economics/NVCA/DB

Because the financial leverage effect is the central underlying mechanism of LBOs, it is important to gain insight in which factors determine the financial leverage of private equity LBO financing packages. Despite the significant impact of LBOs on the global economy little academic research exists about the determinants of financial leverage in LBO deal structure. There is even less academic research about the existence of a possible timing issue in determining financial leverage for financing LBOs.

It is intuitively appealing that changes in financial leverage of LBO financing packages can be explained through changes in underlying economic market conditions. Regarding the fact that equity financing is more expensive than debt financing it is, for example expected, that decreasing interest rates raise the financial leverage within LBO financing structure. Such a relation is hypothesized because decreasing interest rates lower the costs of debt financing. With lower costs of debt financing private equity firms are able to use more debt and strengthen the leverage effect.

Swings in other sources of financing like initial public offerings (“IPOs”) and seasonal equity offerings (“SEOs”) are indeed explained by a timing decision. The timing decision is the decision of managers when to issue equity. In case managers believe their stock is overpriced they are more likely to issue equity and create value for their current stockholders. When company managers believe the company stock is undervalued they are likely to delay equity issuing. They expect the stock price to rise to its true value in the future (Ross, Westerfield, Jaffe, 2005).

At least empirical evidence supports the existence of a timing issue in determining the financial deal structure of LBOs. That, for example, rising interest rates influence acquisition decisions of private equity funds is illustrated by the investment vehicle of Qatar, Delta Two. Delta Two has recently decided not to acquire the British department store Sainsbury because of higher debt financing costs¹.

The remainder of this paper is organized as follows. In the next section, we review the literature on timing in equity issuing, the advantages of using debt and the determinants of corporate capital structure. Also other relevant research on the field of private equity is reviewed. In section III and IV the hypotheses and data of the research are discussed, while section V and VI deal with the methodology and results of the Ordinary Least Squares (“OLS”) regression and robustness of the OLS results, respectively. Section VII deals with the results of the difference in means method and section VIII sums and concludes.

II. Literature review

A. Timing in issuing equity and repurchasing shares

similar to the returns of nonissuing firms. They also find similar results for returns following a SEO and returns of nonissuing firms by using time series factor models. They emphasize that many finance literature studies supporting timing ability of managers are based on same return patterns in the data. Brav, Gercy and Gompers (2000) conclude that model specification is an important consideration in testing anomalous returns which strongly influences returns. Eckbo, Masulis and Norli (2000) criticize the matched-firm technique used by Loughran and Ritter (1995) and others by pointing at the fact that the applied technique doesn’t adequately adjust for risk. They state that the new issues puzzle is about proper risk adjustment rather than underreactions due to stock issuing announcements. Their macro factor variables model indicates that although the issuing companies are prone to higher market risk than nonissuing companies, the higher risk is more than offset by risk reducing implications of issuing equity. An explanation can be found in the fact that lower financial leverage lowers the risk of unexpected inflation and default. Besides, equity issuance increases stock liquidity lowering the risk of stock illiquidity. These lower risks lead to a lower expected return relative to matched firms.

B. Disciplining effect of debt

An important contribution to the academic literature about advantages of using debt is made by Jensen (1986, 1989). According to Jensen’s Free Cash Flow theory the debt used in LBOs creates an improved internal governance system and improves efficiency in operations. Lehn and Poulsen (1989), Kaplan (1989) and Bruton et al. (2002) state that an increased financial leverage on the balance sheet has a positive impact on the operating performance of LBO companies and therefore support Jensen’s Free Cash Flow hypothesis. An empirical study by Lehn and Poulsen (1989) obtains a significant positive relation between undistributed cash flow and firms decisions to go private. Opler and Titman (1993) support the FCF theory showing firms undergoing LBOs have low investment opportunities and high free cash flow generation. On the other hand, Maupin, Bidwell and Ortegren (1984) oppose the hypothesis by showing that LBO firms offer high dividends. This is contradictory to the Free Cash Flow hypothesis because dividend is a helpful instrument to limit the free cash flow by itself and strongly reduces the need for an LBO.

C. Tax shield benefits of debt

D. Determinants of capital structure

There exists much academic research about the determinants of capital structure in corporations. Scott (1977) and Myers and Majluf (1984) acknowledge that firms with assets that can be collateralized are expected to issue more debt. They can benefit from the fact that debt with property as collateral avoids the costs of issuing securities. Costs of issuing securities exist because there is an information asymmetry between firms’ managers and outside shareholders. Galai and Masulis (1976), Jensen and Meckling (1976) and Myers (1977) also state that the possibility to collateralize assets is positively related to the use of debt. This can be explained by the fact that stockholders have the tendency to invest suboptimally for the bondholders. This is because the collateralized assets restrict funds available for suboptimal investing. Related to this agency problem is the factor of company growth. When a company has many growth opportunities it has more flexibility in making future investment decisions. This flexibility leads to higher agency costs. Therefore, expected growth must be negatively related with long term debt. DeAngelo and Masulis (1980) argue that tax benefits of debt are substituted by tax deductions related to depreciation and investment tax credits. This implicates that firms with relative large non-debt tax shields use relative less debt in their capital structure. Titman (1984) states stakeholders are very dependent on unique companies. The costs of liquidation due to bankruptcy are very high for these stakeholders. Therefore, unique companies are expected to use less debt in their capital structure to lower the probability of such a costly bankruptcy. Titman also assumes industry classification to be an attribute of capital structure. This is because liquidation of firms that produce products that need special service and spare parts is extremely costly for several stakeholders. To prevent costly bankruptcy relative less debt is attracted. Two important arguments stated by Warner (1977) and Ang, Chua, and McConnell (1982) to explain why debt is positively related to size are that larger firms are more diversified. The diversified portfolio lowers the probability of bankruptcy. Large companies also have lower costs to issue long-term debt. Another well-known attribute of capital structure is the business risk of a firm measured by earnings variability. Bradley, Jarrel and Kim (1984) find a significant relation between financial leverage and earnings variability. When firms have a volatile income they are more prone to bankruptcy. Therefore, these firms use relative less debt.

E. Other relevant research about debt financing

generated by improved incentives. The importance of debt in private equity LBOs is stipulated by Opler and Titman (1993). They conclude that financial distress costs deter LBOs which implies that debt is the driving force of realizing “going private” gains. Opler and Titman conclude that the crucial role for debt is to streamline incentives with the organizational goals. In line with the reasoning of Opler and Titman is the research by Cotter and Peck (2001). They find that the presence of active investors in terms of equity ownership or board presence in the post-LBO firm lowers the use of debt in private equity LBO deals. The results of their study implicate that the main purpose of using debt is the disciplining device. Other studies of Kaplan (1989a and 1989b), Lichtenberg and Siegel (1990), Smith (1990), Kaplan (1991) and Berg and Gottschalg (2005) also stipulate the importance of active monitoring, managing and restructuring the target. All the researchers conclude that the presence of an active investor in the post-LBO company is a key element to LBO success. Groh and Gottschalg (2006) provide insight into the nature of private equity LBOs and drivers of their performance. They state that LBOs differ from public market investments regarding liquidity and information symmetry. Their findings have important implications for comparing returns on LBOs with public market investment returns. Returns can not be measured without thoroughly determining financial leverage ratios, specifying lenders risk and controlling for systematic risk carried by the sponsor. Their analysis also shows that LBOs are mostly executed in low risk industries. They finally conclude that LBOs are more successful if the fund managers can transfer substantial parts of the risk to the lender.

III. Hypotheses

manifests itself in the underestimation of underlying risks. The misunderstanding about the risk of investment leads to more risky investing expressed in higher financial leverage.

The second hypothesis states that decreasing interest rates raise the financial leverage in LBO deal structure. With a lower interest rate private equity investors are able to improve their return on equity by raising debt in the financial structure. Also, declining interest rates lower the net present value of the tax shield. Total volume of debt must be raised to let the tax shield be equal. However, there is no unambiguous view on this point. Studies of Jaffe (1978) and Modigliani and Cohn (1979) state that higher interest rates lead to higher principle compensation resulting in a more valuable tax shield. This implicates that higher interest rates raise debt financing.

The third hypothesis concerns the impact of financial market sentiment on financial leverage. We hypothesize that an improving sentiment raises financial leverage in LBO deal structure. The hypothesis is based on the field of behavioral finance which states that the human decision-making process is subject to limitations. These limitations prohibit investors to make fully rational decisions. This is known as bounded rationality. Quoting March (1994) “The core notion of limited rationality is that individuals are intended rational. Although decision makers try to be rational, they are constrained by limited cognitive capabilities and incomplete information…”. Overconfidence and over optimism are two behavioral phenomena that affect the investing behavior of investors. Overconfident and overoptimistic investors overestimate their returns on investment and underestimate the risks related to the investment (Barber and Odean, 2006). It is expected private equity investors are also prone to this behavioral bias. If private equity investors become more confident they use more debt in their deals due to the underestimation of risks related to debt.

The fourth hypothesis states that improving economic fundamentals in the EU raise financial leverage in LBO deal structure. Firms or divisions of firms are usually initiators of private equity LBO transactions. With good economic conditions private equity firms are able to use more debt in their deals. This is because banks are more positive about the ability of companies to fulfill their debt obligations under positive economic market conditions. The debt service capacity is increased due to improved turnover estimates and relating net profit.

these undervalued large companies to generate higher returns which causes a raise in financial leverage.

The final hypothesis examines the relationship between the control variable of earnings variability and the financial leverage in LBO deal structure. The hypothesis states that decreasing volatility in business income raises financial leverage in LBO deal structure. In academic studies by Bradley, Jarrel and Kim (1984) and Toy, Remmers, Stonehill, Wright and Beekhuisen (1974) about capital structure determinants, volatility in business income is mentioned as an important determinant of capital structure. The underlying rationale is that variable business income raises the probability that firms default on their debt. It can be expected that higher volatility in the market leads to lower financial leverage in private equity financing packages.

IV. Data and variables

This paper studies 288 private equity transactionswith a European target during the period April 99-June 07. The deal multiples have been obtained from Standard & Poor’s Leveraged Commentary & Data. Standard & Poor’s collects quarterly information of the LBO market and provides specific buyout transaction information. Additional specific LBO transaction information is obtained from the Zephyr database. Zephyr is a database with information on mergers and

acquisitions, IPOs and transactions in risky capital.The EURIBOR rates are obtained from the European Banking Federation². The three month EURIBOR rate is chosen as the most validate rate to measure interest rate developmentin the period January 99-March07.The implied volatility of the Dow Jones EURO STOXX 50 index and the implied volatility of the S&P 500 index are provided by Thomson Datastream.Data on European investors’ confidence is provided by State Street Corporation and measured by their Investor Confidence Index which contains historical confidence data.US consumer confidence is provided though Thomson Datastream and is measured by a confidence index. Thomson Datastream also provided the Dow Jones Small and Large Cap indexes over time. With this data the relative performance of small caps against large caps is measured.The money supply in the EU is based on data provided by the European Central Bank³. The data is derived from monthly press releases published by the European Central Bank. The GDP numbers in the EU are provided by the European Central Bank on ecb.int/stat.Table 1 shows the relevant descriptive statistics of the dataset and table 2 gives a detailed specification of the deal sample.

² The European Banking Federation represents the interests of 5000 European banks. The Federation uses their website, www.euribor.org, for specific information about Euribor.

Table 1 Descriptive Statistics

The variable transaction multiple indicates the starting total Debt/EBITDA multiples of LBO. The variable M3 EU is the sum of currency in circulation, overnight deposits, deposits with agreed maturity up to 2 years, deposits redeemable at notice up to 3 months, repurchase agreements and money market fund shares/units and money market paper within the euro zone. Three

month EURIBOR rate is the three month rate at which Euro interbank term deposits within the EU are offered by one prime

bank to another prime bank. The variable GDP EU is the real GDP in the EU and consists of domestic demand + private consumption + government consumption + gross fixed capital formation + change in inventories + net exports. The implied

volatility variables indicate the volatility of the financial market and are derived from option prices at the financial market.

The variable relative return DJ Euro STOXX small cap index is the difference between the DJ Euro STOXX small cap index and the DJ Euro STOXX large cap index. The confidence variables measure the confidence of European investors and U.S. consumers and are represented by an index.

Variable mean median St.dev. min / max Transaction multiple (debt/ebitda multiple) 4.7 5.5 1.082 2.1 / 8.4 M3 EU (€ billion) 5,981 5,901 1,052 4,436 / 8,278 Relative change in M3 (in%) 1,83% 1,78% 1,16% (-)1,43% / 3,85% Three month EURIBOR rate 3.200 3.252 0.909 1.958 / 5.140 Relative change in three month euribor rate (in %) 1,33% 0,44% 9,71% (-)17,77% / 18,69% GDP EU (€ billion) 1,872 1,853 0,172 1,580 / 2,190 Relative change in GDP Euro zone 1,03% 1,01% 0,31% 0,35% / 1,62% Implied volatility S&P 500 (index) 25,26% 23,62% 10,38% 12,38% / 50,82% Relative change in implied volatility S&P 500 2,56% (-)5,48% 30,16% (-)46,18% / 99,81% Implied volatility DJ Euro Europe STOXX 50 (index) 20,35% 19,93% 6,92% 9,97% / 35,82% Relative change in implied volatility DJ Euro STOXX 50 4,71% (-)6,65% 36,56% (-)41,41% / 115,16 % Relative return DJ Euro STOXX small caps (index) (-)1,92% 2,65% 4,98% (-)15,45% / 11,13 Change in relative return DJ Euro STOXX small caps 1,92% 2,65% 4,99% (-)15,45% / 11,13% European investors confidence (index) 92,59 93,47 8,16 77 / 107,23 Relative change in European investors confidence 0,79% 0,55% 8,35% (-)15,87% / 25,43% U.S. consumer confidence (index) 95,99 96,35 12,13 61,4 / 115,9 Relative change in US consumer confidence 0,69% (-)2,60% 16,77% (-)30,31% / 57% Sample size 288

Table 2

Descriptive Statistics of Sample

Dependent variable

The financial leverage in private equity transactions is measured by the Debt/EBITDA multiple in

the LBO deal structure. The Debt/EBITDA multiple measures the financial leverage in the LBO deal structure.

Money supply

M3 is used is to measure money supply because it is the broadest indicator of money. M3 includes M1 which consists of cash and assets that can quickly be converted to currency and M2 which consists of time related deposits, savings deposits and non-institutional money-market funds. Also, large time deposits, institutional money market funds, short term repurchase agreements and other larger liquid assets are included.

Financing costs

The three month EURIBOR rate is taken as a valid indicator of total financing costs. This is due to the fact that in case of a European acquisition underwriting debt is mostly facilitated by a European bank who applies the EURIBOR margin rate.

Sentiment in the financial market

Two different indicators of financial market sentiment are applied. The first indicator contains the US consumer confidence. The US consumer confidence is a valid measure of overall financial market sentiment because the US consumer spending contributes for a very large part to total US economy. US economy forms a large part of total world economy. The second indicator is the European investor sentiment.

Economic fundamentals

GDP is used as an indicator for the condition of the economic market fundamentals. GDP numbers of the EU are a valid measure because only European targets are included into the sample. European companies are for the main part dependent on the European market.

Relative performance of small caps

The relative performance of small caps is measured by the difference in return of large and small capitalization stocks.

Control variable

volatility of 50 large blue chip European companies. The second indicator is the implied volatility of the S&P 500 index which measures the implied volatility of a wide range of S&P 500 index options.

V. Ordinary Least Squares method

To investigate a possible timing decision by private equity firms in determining the financial leverage we use a Classical Linear Regression Model. The Ordinary Least Squares method tests whether changes in several economic market indicators significantly affect changes in the financial leverage of private equity LBOs. If improvements in economic market conditions raise the financial leverage of LBO deal structure the existence of a timing decision in determining financial leverage in private equity LBO deals is demonstrated.

We use the average Debt/EBITDA multiples as a valid measure for the random variable of financial leverage and test the correlation with six independent economic variables to investigate a possible timing issue. The independent economic variables are money supply, financing costs, financial market sentiment, economic growth and relative performance of small caps. Variability of business income acts as the control variable. We start the analysis by running 8 separate univariate time regressions according to a standard sample regression function. For all the independent variables a time lag of 1 quarter is applied because we expect private equity investors adjust quite slowly to changes in economic market conditions. Another relevant reason for building the 1 quarter lag is that private equity firms can only restructure the financial package of the deal when there is sufficient time to the target date of the LBO. In case the investors have committed themselves to the deal and arranged the financing it will be more difficult to adopt for most recent changes in economic market conditions by restructuring the financial package.

By testing whether changes in independent variables statistical significantly relate to changes in financial leverage we measure t-statistic probabilities of changes in each independent variable. Hereby, a 0.10 confidence interval is applied to test for statistical significance. In the case of statistical significance three additional tests are executed. The tests measure whether the data satisfies the implicit assumptions of an OLS model. The Whites test measures the assumption of homoscedasticity in the error terms, Durbin-Watson tests the existence of first order autocorrelation in the error variables and Jarque-Bera tests the existence of a normal distribution. The outcomes of the univariate regressions are presented in table 3.

Money supply

Table 3 Estimate s of Structural C o efficients ( O LS) U n iva riate regre ssions Expla natory varia b le Indicator co efficient t-stat. prob. R ² adj. R ² Money supply M 3 8.81 2.74 0.0102 ** 0.2067 0.1 794 Finan cing costs T hree m onth Euribor rate 0.07 0.17 0.8644 Sentim ent U S consum er confidence 0.19 0.78 0.4434 E uropean in vestors confidence (-)0.48 (-)0.97 0.3382 Econo m ic fundam entals G DP in Euro zone 0.11 0.01 0.9936 R elativ e perform an ce sm all c aps D ifference in la rg e and sm all cap re turn (-)2.20 (-)3.01 0.0053 ** *0.2384 0.2 122 Varia bility of bus iness incom e Im plied v ola tility of D J ST O XX 50 index (-)0.09 (-)0.78 0.4400 Im plied v ola tility of S& P 500 index (-)0.05 (-)0.36 0.7207 * S ignificant a t the 0.10 le vel

**Significant at the 0.05 lev

el

***Significant at the 0.01 lev

the outcome even more powerful. The R-squared statistic indicates that 20.6% of the change in financial leverage levels is explained by changes in money supply within the EU.

Financing costs

According to table 3 we conclude that decreasing financing costs do not statistically significant raise financial leverage in LBO deal structure. Therefore, a test of the hypothesis that decreasing financing costs do not raise financial leverage in LBO deal structure can not be rejected at the 0.10 level.

Financial market sentiment

Table 3 shows that an improvement in financial market sentiment does not statistically significant raise financial leverage. Both improvements in the confidence of US consumers and European investors do not statistically raise financial leverage. Therefore, a test of the hypothesis that an improvement in financial market sentiment does not raise financial leverage in LBO deal structure can not be rejected at the 0.10 level.

Economic growth

The fourth hypothesis which states that an increase in GDP within the EU does not raise financial leverage can not be rejected at the 0.10 level. Table 3 shows that an increase in GDP does not raise financial leverage in LBO deal structure on the statistical significant level.

Relative performance small caps

The hypothesis stating that an increase in the lagged relative performance of small caps does not raise financial leverage can not be rejected on the 0.10 level. The results support an inverse relationship between the relative performance of small stocks and financial leverage, however. Data in table 3 suggests that the marginal effect of a 1% decrease in the relative performance of small caps is statistically related to a 2.20% increase in financial leverage. The results are statistically significant at the 0.10 level and on 0.05 and 0.01 levels. The R-squared statistic indicates that 23.8% of the change in relative leverage levels is explained by changes in relative performance of small caps.

Control variable

Table 5

Estimates o

f Structura

l Coeffic

ients (OLS)

all and lar

ge cap r eturn (-)1 .66 (-)2 ,21 0.0351 ** C ons ta nt (-)0.04 (-)0.62 0.534 9 Mu ltiv ariate reg res si on 0.3250 0.2767 0.6762 2.90 0.5162 M one y suppl y M 3 5.89 1.75 0.0904 * R ela tiv e perf or m ance sm all caps D if fe re nce in sm

all and lar

ge cap r eturn (-)1 .68 (-)2.23 0.0336 ** Variab ilit y o f b us in ess in co m e Im plied v olatil ity o f D J S T O XX 5 0 in de x (-)0 .0 2 (-)0 .2 3 0. 81 47 C ons ta nt (-)0.04 (-)0.52 0.604 5 Mu ltiv ariate reg res si on 0.3260 0.2538 0.4999 2.92 0.5819 M one y suppl y M 3 6.10 1.88 0.0695 * R ela tiv e perf or m ance sm all caps D if fe re nce in sm

all and lar

ge cap r eturn (-)1 .66 (-)2.20 0.0355 ** Variability of business incom e Im plied v olatility of S & P 500 index (-)0.02 (-)0.20 0.841 3 C ons ta nt (-)0.04 (-)0.60 0.547 1 Mu ltiv ariate reg res si on 0.3256 0.2533 0.5762 2.92 0.5739 *

Significant at the 0.10 level

Multivariate regressions

The significant variables from the separate univariate regressions are used to construct a multivariate regression model. By putting the statistical significant variables into the multivariate regression model we construct a model that explains the changes in financial leverage as best as possible. With such a regression model a measure of how well the regression model actually fits the data is developed. The R-squared statistic in the regression model measures how well the sample regression function fits the data.

Besides the regression model with the statistical significant independent variables, we also construct two regression models wherein the control variable of earnings variability is added. Both a model with the implied volatility of DJ STOXX 50 index as an indicator of earnings variability and a model with the implied volatility of the S&P 500 index as an indicator of earnings variability are constructed. These models act as a benchmark against the regression model to compare both models in terms of the goodness of fit to the data. Table 5 shows the outcomes of the regressions.

The outcomes in table 5 show that the adjusted R-squared of the multivariate regression without the control variable is higher than the adjusted R-squared of the multiple regressions with the control variable. Therefore, we conclude that a change in earnings variability is not a determinant in explaining changes in financial leverage in LBO deal structure. The multivariate regression without the control variable explains 32.5% of the change in financial leverage in LBO deal structure.

Cross- sectional study

Elaborating on the results within the overall deal sample we investigate possible differences between the influence of changes in money supply and relative performance of small caps on changes in financial leverage of LBOs with small and large deal values. The purpose of this cross-sectional study is to detect whether the timing issue exists among all LBO deals or that the existence of the timing phenomenon in LBOs is dependent on the size of the deal. Table 6 shows the summary statistics of the sub samples.

Table 6

Descriptive Statistics of Deal Value Sub samples

Group Number of deals Average deal Median deal Min/max deal Average multiple Median multiple Min/max multiple Small deal value < € 386/mn 111 € 214/mn € 205/mn €20/mn / € 386/mn 4,4x 4,5x 2x / 7x Large deal value > € 386/mn 106 € 975/mn € 710/mn €389/mn / € 4.450/mn 4,8x 4,8x 3x / 8x

of deals > € 386 million. We use the OLS method to detect possible differences in the existence of timing issues among two different LBO deal size groups. Table 7 shows the outcomes of the multiple regressions for both the small and large deal value group.

The regression results of the “small deal value” LBO group are statistical significant for both the variables of money supply and relative performance of small caps. Table 7 shows that the coefficient of the change in money supply is comparable with the coefficient of the overall deal sample. The coefficient indicates that the marginal effect of a 1% increase in money supply is statistically related to an 8.45% increase in financial leverage within LBO deal structure. On the other hand, the coefficient of the change in relative performance of small caps shows a contrary direction to the coefficient of the overall deal sample. Table 7 shows that a 1% increase in relative performance of small caps is statistically related to a 2.17% increase in financial leverage within LBO deal structure.

Looking at the results of the “large deal value” LBO group in table 7 it is seen that neither changes in money supply nor changes in the relative performance of small caps are able to explain the changes in financial leverage. Both the hypotheses that an increase in money supply does not raise financial leverage and that an increase in the relative performance of small caps does not raise financial leverage can not be rejected at the 0.10 confidence level.

The cross-sectional regression outcomes show remarkable differences between LBOs with relative small deal values and LBOs with relative large deal values. From the different results we conclude that a timing issue in determining financial leverage does exists in financing LBOs with a relative small deal value but is not present in financing relative large LBOs. Also, the direction of the statistical significant mutual relation between changes in the relative performance of small caps and changes in financial leverage is different between the overall deal sample and the “small deal value” sample. The observed differences create an interesting LBO financing puzzle.

VI. Robustness

Table 7

Coefficient Estimates of

Deal Value Subsamples

rejected at the 0.10 confidence level. Hence, it can be concluded that the results are robust to a coefficient breakdown.

The hypothesis that an improvement in sentiment does not raise financial leverage in LBO deal structure can not be rejected at the 0.10 level. The difference in means test shows contrary evidence, however. Table 8 shows that the mean of the change in European investor confidence for the “below

Financial market sentiment

Table 8 shows that the mean of the variable money supply of the “not below 0% change” group is statistically significant higher than the mean of the “below 0% change” group. The statistical significant difference in means between both groups implicates a positive relation between change in money supply and change in relative leverage used in private equity buyout deals. The hypothesis that increasing money supply does not raise the financial leverage in LBO deal structure must be rejected at the 0.10 level.

Money supply

We use the value of the dependent variable to divide the sample periods into two subgroups. The distribution of periods into subgroups is based on the change in financial leverage. Periods in which changes in leverage are statistically significant below 0 are allocated to the “below 0% change” group whereas periods in which changes are not statistically below 0 or are positive are allocated to the “not below 0% change” group. The probability of the t-statistic is applied to test the existence of a statistical significant difference in means of the explanatory variables between both groups. The confidence interval is set at the 0.10 level. Table 8 shows the outcomes of the separate difference in means tests.

A disadvantage of applying the OLS test on a relative small dataset is the relative low statistical robustness of the results. To overcome the low statistical robustness of the OLS method we apply the difference in means as a second test. The difference in means test is capable to emulate the Ordinary Least Squares test but is not unduly affected by outliers or other small departures from the inherent assumptions of an OLS model. With the difference in means test we are able to draw more rigid conclusions about the general direction of the investigated correlations.

Table 9

Robustness (Chow-Breakdown test) Chow Breakdown Test

STOXX 50 index 0.7302

S&P 500 index 0.7103

prob. F

0% change” group is statistical significant higher than the mean of the change of the “not below 0% change” group. According to table 8, an improving sentiment in the financial market decreases

financial leverage in LBO deal structure. Stated in another way, a worsening sentiment in the financial market raises financial leverage in LBO deal structure. The evidence points on a contra sentimental investing behavior of private equity firms.

Relative performance small caps

Table 8 shows that the mean of the “below 0% change” group is higher than the mean of the “not below 0% change” group. The results show that the relative performance of small stocks is statistical negatively connected to higher financial leverage in private equity LBO deals.

VIII. Summary and concluding remarks

This paper investigated the existence of a timing issue in determining the financial leverage in LBO deal structure. We used changes in six independent variables that were hypothesized to explain the changes in financial leverage as dynamic determinants of financial leverage. The underlying rationale is that managers anticipate positive economic market conditions to improve return on investment. We used both the Ordinary Least Squares method and the difference in means method to investigate the hypothesized existence of a timing decision in determining the financial leverage of private equity LBO transactions. As an elaborating step a cross-sectional research based on LBO deal size was applied to detect possible differences in timing issues among LBO deal size.

The results of the study indicate that private equity firms time the financial leverage in LBO financing packages by which they anticipate positive market conditions. Both the results of the OLS method and the difference in means method support the timing decision of private equity firms. Among other things, changes in money supply are demonstrated to explain changes in financial leverage of LBOs. The results show that a 1% increase in money supply raises financial leverage with 8.81%. The outcome supports worries from economists that a wide monetary policy increases risk taking behavior of banks. The current US sub prime crisis is an example of what possible consequences of such a policy can be.

The cross-sectional study based on LBO deal size shows a statistical significant positive relation between money supply and financial leverage for the “small deal value” sub sample. On the other hand, such a statistical significant relation is not found for the “large deal value” sub sample. A plausible explanation is that, because of the fact that relative small firms are exposed to more downside risks than relative large firms, an underestimation of credit risk by banks will especially raise financial leverage in small LBO deals.

relative performance of small stocks and financial leverage is demonstrated. From the results it is concluded that private equity firms invest relative more in small caps in times of relative strong small cap performance. This result opposes the hypothesized contra cyclical investing behavior of private equity firms.

The results relating to the “small deal value” sub sample show a statistical significant positive relation between the relative performance of small caps and financial leverage, however. The “large deal value” sub sample generates not a statistical significant relation between relative performance of small caps and financial leverage. A possible explanation is that contra cyclical investing in relative small LBOs is relatively more.

Besides the statistical significant relation between money supply and relative performance of small caps and financial leverage the results of the difference in means test show a negative relationship between European investors’ confidence and financial leverage. A possible explanation is that private equity firms anticipate “bargains” as a consequence of a worsening sentiment. Given the undervaluation of targets private equity firms run less risk on debt. Capitalizing on this reduced credit risk private equity firms can achieve higher returns on investment by raising relative debt use.

The results do not provide support that changes in financing costs, economic growth and earnings variability explain changes in financial leverage. Although financial deal structure is intuitively closely related to the capital structure of a firm which is publicly accepted as a determinant of capital structure, this paper does not provide evidence that changes in volatility of business income explain changes in financial leverage of private equity LBO deals. A possible explanation is that private equity firms are focused on securing their equity investment through divesting assets, paying themselves large dividends and make use of sale-and-lease back constructions. With such an aggressive strategy the risk of the investment is lowered significantly in the first years after the LBO. The reduced risk makes volatility in business income relatively less important for those newborn financial companies compared to strategic companies who focus on the long term continuity.

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Other references

Databases

Thomson Datastream Zephyr

Publications

Standard and Poors – Leveraged Commentary & Data/Thomson Venture Economics/NVCA/DB

Papers

Financieel Dagblad, november 6 (2007)

Websites