Empirical Study of Effect of Interest Barrier Rule on Buyout Deals in
Germany and Italy
Zhang Xue
Supervisor: Dr. Jens Martin Student Numnber: 10241353 Master of Business Administration
2013-12-16
Contact email: zhangneve@gmail.com Confidentiality restrictions: no
Abstract:
Leveraged buyouts (LBOs) boomed in the 1980s and have been a hot topic since then. This article explores the role played by taxation system in LBO business. The main discussion is about thin capitalization rules. What do legislators try to achieve with them? From normative perspective, is it fair to exert such particular restrain in free market? Empirically, how effective are certain rules? The analysis takes the buyouts information from 2001 to 2011 in Germany and Italy. It examines the influences on leverage of tax barrier rules, debt market condition, country characteristics, and buyout type.
Introduction
Leveraged buyouts (LBOs) boomed in the 1980s and have been a hot topic since then. This article explores the role played by taxation system in LBO business. The main discussion is about thin capitalization rules. The U.S. federal government first took aim at the perceived tax abuse in mergers and acquisitions with the1989 Revenue Reconciliation Act. Other OECD countries followed the suit. What do legislators try to achieve with them? From normative perspective, is it fair to exert such particular restrain in free market? Empirically, how effective are certain rules?
In this article, I will first review the investment model of LBO and private equity (P.E.) funds. Then, I will describe the implications of LBOs in corporate finance and governance, and in public finance. Next, I will discuss a few well-adopted tax principles and list several common practices related to buyout deals among OECD countries. Afterwards, I will present an empiri-cal study of the effect of tax barrier rule in German and Italian buyout deals from 2001 to 2011. Finally, I will summarize the article with the limits of my study and possible expansions. 1. Buyouts Investment Model and Private Equity Fund
Private equity (P.E.) fund is generally referred to as an entity “formed for the purpose of making investments in securities or other assets that are not readily tradable or that are otherwise known as ‘illiquid’ assets” (Breslow and Schwartz 2013, section 1-2). Limited number of qualified investors purchase unregistered securities in such entity from fund sponsors (also known as general partners and/or fund managers, GPs) under the clauses of “exemptions available for private placement of security” made by financial regulatory authority (SEC in U.S., BaFin in Germany, AMF in France, etc.). These qualified investors (also known as limited partners, LPs) negotiate with GPs to establish fund covenants and provide capital in exchange for an interest. However, LPs do not usually participate in the management of the fund.
P.E. funds are categorized by investment strategies, e.g. buyout funds, mezzanine funds, ven-ture capital funds, real estate funds, distressed funds and funds of funds. Typically, P.E. funds are strictly limited in acquiring publicly traded securities.
Buyout funds gained popularity in the late 1970s. It was spurred by favorable legislation and investors’ calling for managerial improvement. But, buyout funds waned in P.E. business in late 1980s because of high interest rate and a series trading scandals. After the 1990’s economy recession, venture capital funds stepped onto stage with the heat of I.T. industry. However, driven by rapid expansion of market securitization, buyout funds regained its position in the P.E. world in new millennium.
Figure 1 shows the U.S. buyout trends from 1980 to 2011. The bar indicates the deal value (in billion dollars) each year. It is highlighted with four distinctive periods.
Source: Bain and Company Global Private Equity Report 2012, p.1
Figure 2 shows the global buyout trends from 1995 to 2011. The bar indicates the deal value (in billion dollars) each year. Total deal value is listed above the bar.
In a typical transaction, P.E. funds contribute a small portion of cash to full-fill the required amount of “minimum equity contribution of the investors” by company law. This contribution will convert into preferred or common equity in post-LBO entity. P.E. firm also raises a large amount of capital from debt market to gain ownership from pre-LBO shareholders. Part of the debt is obtained from banks or commercial lending companies in the form of senior debt secured by stock or assets. Senior debt bears interest rate floating several points above prime is appraised based on the future cash flow of the new entity. In addition, P.E. firm issues un-secured subordinate debt, known as “Mezzanine debt”. Subordinate debt bears high interest rate, and sometimes is accompanied by stock option or conversion right. Furthermore, P.E. firm may issue high-yield and high-risk bonds subordinated and protected by minimal equity cushion, e.g. “junk bonds”.
Once the buyout takes place, P.E. firm pays cash to public shareholders for their equity inter-ests. These shareholders have to pay capital gain tax in consequence. A big proportion of cash flow generated by the post-leveraged entity is to serve and repay newly incurred debts. Before the buyouts, a company either distributes or defers the dividends. This amount of dividends bears corporate tax. After the buyouts, credit interest payments substitute dividends. Because interest distribution is tax deductible, a company saves a substantial amount of cash, hence the alleged tax arbitrage.
2 Implications of LBOs in corporate finance and governance, and in public finance
A. Capital structure and implications of LBOs in corporate finance and governance
Modigliani and Miller (1958) first proposed that capital structure is irrelevant to the value of the firm in a perfect market. But the assumptions of “perfect market” can hardly hold in real world. Balance between the present value of the benefits and costs of debt financing determines the optimal capital structure. Other factors also influence managerial decision on capital structure. Firm characteristics, such as size, asset tangibility, growth opportunity, and product uniqueness relate to capital structure. Large firms incur more debts because the fixed cost to re-finance is proportionally smaller than that of small firms. And large firms usually have better access to credit markets. Faulkender and Petersen (2006) estimated that rated firms with better access to public debt markets tend to issue 35% more debt than their nonrated counterparties. Tangible assets weigh more as collateral to creditors than intangible assets, as fixed assets present less information asymmetry (assets valuation between managers and investors), and as fixed assets are more easily to be redeployed in default situation. Researches by Marsh (1982), Titman and Wessels (1988), Friend and Lang (1988) and Rajan and Zingales (1995), and Frank and Goyal (2004) all find that leverage is positively related to assets tangibility. Firms with promising
growth opportunities incur less debt, because they invest heavily in projects and generate fewer earnings. As a result, interest tax shield becomes less attractive to them. In addition, firms would maintain financial slack because internal financing costs less than external financing (Myers, 1984). Studies between leverage and market-to-book ratio, a proxy for growth, show evidences of negative relationship between growth and debt (Smith and Watts, 1992, Rajan and Zingales, 1995, Jung et al, 1996, Barclay et al, 2006). Product uniqueness determines lever-age in such way that stakeholders would press the firm to operate less risky if the product is non-substitutable and inimitable.
Debt obligation brings additional risks to firms. A company with volatile cash flow issuing excessive debt exposes itself to higher default risk. Leverage offsets firm’s value as a result. Bradley et al. (1984), Wald (1999), Booth et al. (2001) all found negative relationship between cash flow volatility and leverage. Besides, debt is costly because debt instruments often con-tain restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities
Debts also bring several advantages to firms, such as, less information asymmetry, reduced agency costs of free cash flows by financial and governance engineering (Jensen, 1986), en-hanced performance and a salient effect on work practices (Cumming, Siegel, and Wright, 2007), and increased interest tax deduction (Kaplan, 1989a). Jensen (1989) even argued that leverage buyout organizations, with their post LBO managerial incentives, efficient capital structures and active governance, would eventually become the dominant corporate organizational form. However, buyout deals may not be driven by the usual pubic companies’ pursuit for benefits of debt financing. Evident cyclicality of buyout funds implies that LBO activities may be driven more by credit market conditions. Axelson, Jenkinson, Strömberg, and Weisbach (2012) find “no cross sectional relation between the financial structure of buyouts and matched public firms; instead, price and availability of credit are the main factors that affect the capital structure of buyouts”. The findings suggest that debt financing benefits mentioned-above could be trad-ed-off by excess leverage when available debt is abundant, and that one could have expected more frequent financial distress in later buyouts based on ex ante data. (Kaplan and Stein, 1993)
B. Implications of LBO in public finance
Firms are exposed to complex taxation environment. Tax system molds optimal capital struc-ture and firm’s financing decision. When corporate tax and income tax were added to the irrelevance proposition, they created the benefits for debt in that it shields earnings from taxes (Modigliani and Miller, 1963, & Miller, 1977). Where taxations to debt-holders are relatively less at corporate level than those to shareholders, firm will substitute debt with equity to reduce
its taxable income. Givoly et al (1992) studied the effect of The Tax Reform Act of 1986, which reduced the corporate tax rate and thereby reduce the propensity to use debt tax shield, finding that “debt became less popular after the reduction in tax rates, with highly taxed firms decreas-ing debt the most”. Personal tax also influences the capital structure. But because the diverse rate for different investors, it is hard to estimate the tax effect of leverage. In experience buyout funds often structured as tax-exempt vehicles not to be directly affected by personal taxation. The widely adopted tax code in the U.S. and European countries generally treats interest pay-ments as tax deductible. At firm level debt incurred therefore reduces the tax obligations. But from policy makers’ perspective, granting this kind of tax provision has long been a controver-sial topic since the booming of LBO. It is not justifiable whether to subsidize leverage buyouts by favorable tax regime on neutrality or national finance ground.
Tax savings from debt financing are valuable sources to all investors: pre-LBO shareholders, post-LBO creditors, and P.E. funds. The amount of tax saved is considerably huge. Lowenstein (1985), Frankfurter and Gunnay (1993) even went so far making the assertion that tax benefits in LBOs are too large to give the need to create other real gains. They argued that tax subsidy is the only attributable to use debt in LBO deals. Kaplan (1989) estimated that the median value of in-terest deductions varies from 14.1% to 129.7% of the premium paid to pre-buyout shareholders. Even so, LBOs do not necessarily lead to government tax revenue loss. Part of the ex-ante bene-fits of tax shield accounts for a significant fraction of the premium paid to pre-LBO shareholders (Schipper and Smith, 1989). These shareholders have to pay capital gain tax. Including taxes on operating cash-flow increased from buyout, taxes on interest income from lenders, and taxes on capital gains from post-buyout assets sales, Jensen, Kaplan and Stiglin (1989) estimated that the net effect of buyout increased the present value of the U.S. Treasury tax revenue by 61%. Other than the tax revenue arguments, proponents of regulating leverage recently argued that although leverage distortions did not create in itself the recent financial crisis, they may have aggravated it (Shaviro, 2011, IMF, 2010, Hemmelgarn and Nicodem, 2009).
3. Taxation practices among OECD countries and the effects on LBOs
There are a few well-recognized principles to justify tax rules in market economy. The neutral-ity principle is widely quoted by critics. Musgrave and Musgrave (1976) stated, “Taxes should be chosen so as to minimize the interference with economic decisions in otherwise efficient market.” They asserted that preferential taxation rate due to different capital structure should be limited. Doernberg (2008) discussed, “From an efficiency point of view, the aspirational goal for tax system in general or for the U.S. rules, governing international transactions
specif-ically, is the implementation of a tax-neutral set of rules that neither discourage nor encourage particular activity. The tax system should remain in the background, and business, investment, and consumption decisions should be made for non-tax reasons”. Furthermore, Musgrave and Musgrave (1976) considered that the interest tax shield gives P.E. arbitrage opportunity to take advantage of the system. Many taxation practitioners, such as Brockway, believe that a core objective of any tax reform plan is to reduce tax driven arbitrage (Brockway, 2012).
However, as section 3.A illustrated, interest tax arbitrage under double taxation regime argu-able plays an important role in endorsing LBO activities and influences managerial financial structure choice.
Partly inspired not to endorse LBO transaction with tax-savings, many developed countries began to introduce thin capitalization rules in order to “restrict the implementation of abusive financing structures” (Von Brocke and Perez, 2009). Although thin capitalization rules are not targeting at LBO activities in particular, the objective is to limit the amounts of interest deductions in businesses operations. As a result, one would expect the highly leveraged LBO transactions to be discouraged because of less tax shield afterwards.
So far, countries who limit interest deductibility enclose these three criteria: debt to equity ratio, interest coverage ratio, and, arm’s length principle/interest stripping rule. Tax authorities then benchmark a company and decide whether it is excessively leveraged. The regulations are commonly referred to as “thin capitalization rules”
I. Debt to Equity Ratio:
The following content shows when a company is subjected to a fixed debt-to-equity ratio test. Let this ratio be, µ, the rate of return of debt, i, the amount of debt, D, and the amount of equity, E.
The debt safe harbor for the company is,
H = i•D (1)
(when thin capitalization rule is not applicable)
When the actual debt-to-equity ratio is more than the permitted µ, the safe harbor becomes
H(1) = i•µE (2)
To shareholders of over leveraged company, the amount of interest payable is
iD - i•µE (3)
In a simplified model, when the marginal corporate tax rate is τc, the extra tax burden is Ti = τc •(i•D - i•µE) (4)
The amount Ti decreases both fund-investor and pre-shareholders’ gain, making an LBO trans-action less attractive.
Such concept directing regulation at capital structure seems straightforward. However, perhaps because it is rather easy for companies to circumvent the limit established (Von Brocke and Perez, 2009) or because tax authorities are motivated by capital-import neutrality consideration, many countries recently shifted from this practice to oversee firm’s operation.
II. Interest Coverage Ratio:
This test applies to firm’s interest expense, and it is often called “interest barrier rule or earning stripping rule”. Interest expense is disallowed if the excess net interest expense exceeds certain percent (σ) of taxable earnings before interest, taxes, depreciation and amortization (EBITDA).
σ = iD/EBITDA (5)
H(2) = σ•iD (6)
Ti = τc •(1 - σ)•iD (7)
Directly limiting interest deductions avoids several disadvantages brought about by the pre-viously discussed thin-cap rule. It is arbitrating to enforce a single debt-to-equity ratio for all businesses, since firms of different size operate differently. And, firm can easily decrease the debt-to-equity ratio of the financed subsidiary to push down debt as much as necessary. In addi-tion, development of complex hybrid securities makes extrapolating information from balance sheet more challenging.
III. Arm’s Length Principle:
Under arm’s length principle, taxpayer is “thinly capitalized” whether the amount of the loan is consistent with the amount that would have been granted by a third party. For example, in the U.K., if a firm is thinly capitalized, HMRC (Her Majesty’s Revenue and Customers) would deny the deduction, where a portion of interest expenses is disallowed. In other words, this rule denies an interest deduction if the main purpose is to obtain a tax benefit. There is no definitive formula to determine whether debt is excessive under this approach. The burden of proof either lies with tax authorities or taxpayers.
Often this rule has been criticized for conflicting certainty principle. Because of lack of guid-ance or ratio, it may be difficult for firms to comply with the standard and for regulators to
en-force it. In 2009 the U.K. also passed legislation to limit tax deductibility of interest expenses. There are many more components to thin-capitalization rules than just a ratio. In the past decade OECD countries reformed their tax regime several times to adapt to international tax competition and to accommodate to complex features of financial security. Many of them now take combined codes to regulate interest tax arbitrage and to maximize nation’s tax revenue. Table 1: Practices of regulating thin capitalization in seven countries from year 1989 to 2008
Source: Taxation of Cross-Border Mergers and Acquisitions 2012, KPMG Germany
However, despite the efforts each jurisdiction puts, “It is not possible to create a system that does not have lines providing different treatment for activities defined by the law to be differ-ent but which, as cases get close to the line, do not in substance differs all that much. Because the law generally, and the tax law in particular, is based on relatively crude attempts to com-partmentalize a very complex society and dynamic economic behavior.” (Brockway, 2012)
4. Empirical study of the effect of tax barrier rule in German and Italian buyout deals from 2001 to 2011
Scholes and Wolfson (1990) studied effects of taxation change in the U.S., and they attributed that to certain degree increase of LBOs in 1982-1986 was due to the tax subsidy provided by ERTA (Economic Recovery Tax Act Of 1981). Schipper and Smith (1991) also reasoned that “the surge in acquisition in the fourth quarter of 1986, just before the effective date of the TRA (Tax Reform Act of 1986) and the subsequent decline in acquisition activity is partly due to the reduction in the ERTA subsidy with the enactment of the TRA”.
If any tax law reform to reduce the interest tax subsidy is effective, one may expect to ob-serve one or some of these outcomes: decline of the numbers of buyout proceeds after the effective date; less leveraged re-organization; and, decline of the amount of premium paid for LBOs since interest deduction compromise a median of 14% to 129% of the premium paid to pre-buyout shareholders (Kaplan, 1989). Particularly with interest barrier rule being effective, one may also see the change of debt structure. The higher interest bearing bonds would take less proportion.
Of the seven countries listed in Table 1, Germany and Italy take interest coverage ratio to deem whether a company is excessively leveraged and subsequently to deny its tax subsidy. This tax reform became official in January 1st 2008 in both countries. There are several detailed differences between the two jurisdictions, such as, escape clauses and treatment of interest carry-forwardness.
A. Data description
140 buyouts deals are listed in the database from 2001 to 2011. 106 deals took place in Germa-ny, and 34 in Italy. Forty-four transactions were recorded as secondary leveraged buyouts (SL-BOs) compared to ninety-six as public-to-private leveraged buyouts (L(SL-BOs). Secondary-LBO (SLBO) is leveraged buyouts of which both the buyers and the seller are private equity firms. I took 112 transactions with information on leverage ratio, buyout type, debt amount, and in-dustry. Seventy-seven different P.E. sponsors or sponsor groups managed these deals. The transactions represent 17 industries in Germany and Italy.
Table 2: List of sponsors and corresponding buyout type from 2001 to 2011 in Germany and Italy of the selected 112 samples.
About sixty percent buyouts concentrated in automobile, chemical, media and industrials. Gaming industry presented the highest leverage ratio. Average industry leverage ratio ranges from 4.5 to 6.2. Media and cable industry incurred most average debt amount, whereas enter-tainment and technology industry the least.
The number of buyouts peaked between 2004 and 2008. During these five years secondary buyouts took off as well. Buyout transactions plummeted after 2008 financial crisis, and slight-ly turned up in 2011.
Figure 3: Number of buyout deals from 2001 to 2011 in Germany and Italy of the selected 112-buyout samples. LBOs and secondary-LBOs are illustrated in different shades.
Table 3: List of industry, corresponding average leverage ratio, and average debt amount from 2001 to 2011 in Germany and Italy of the selected 112-buyout samples. It is sorted by average leverage ratio.
Average leverage ratio is higher in SLBOs than in the LBOs. Bonini (2010) suggested that in contrast to LBO, SLBO deals are highly sensitive to debt market condition when studying the buyouts cases in 1998 to 2008. Wang (2010) and Sousa (2010) confirmed that capital market condition motives SLBO deals. Sousa (2013) also showed that firms went through second-ary buyouts have a higher capacity to generate cash flow and to get tax benefits. In contrast, Achleitner and Figger (2011) explained that higher leverage ratio in SLBO could be motivated with reduced information asymmetries in a secondary buyout setting.
Leverage ratio became higher since 2005, but dropped in 2008. This trend may be caused by deteriorating debt market condition, or by the introduction of interest barrier rules in Germany and Italy. In 2009, only one buyout took place and leverage ratio is higher than the average of all samples. The transaction is the privatization of Springer, a Germany based science, tech-nical and medical publisher. Its buyout was predominantly funded with covenant-lite loans that offer investors little protection. And, it was one of the largest leveraged acquisitions in Germany since 2002.
Table 4: Comparison of leverage statistics in LBOs and secondary-LBOs from 2001 to 2011 in Germany and Italy of the selected 112-buyout samples.
Table 5: Statistics of average leverage ratio from 2001 to 2011 in Germany and Italy of the selected 112-buyout samples.
The market timing and agency theories both point that debt market condition affects buyout leverage. I use “Merrill Lynch Option-Adjusted Spread (OAS) - BofA Merrill Lynch Euro High Yield Index” as debt market condition proxy. The index tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. This index fluctuated from 1.98 to 20.13 between 2001 and 2011. It sky-rocketed since the third quarter of 2008 and peaked at the first quarter of 2009. It kept stable and low from 2004 to 2008 when most buyouts occurred.
Figure 4: Trend of BofA Merrill Lynch Euro High Yield Index since 2001 to 2011. Figures of quarterly average leverage ratio are spotted across the trend line.
Quarterly average leverage ratio is calculated from the selected 112 German and Italian buyout samples from 2001 to 2011.
Debt size varied from €100 million to €8,000 million. Half of the sample is below €560 million. Ninety percent is below €1,600 million. Two largest transaction incurred debt over €7,000 million. The largest is the secondary leveraged buyout of a German commercial broad-caster, ProsiebenSat.1. This transaction resulted in a post leverage ratio of 8.5, 2.5 point higher than its average peers in media industry in the sample. The second largest happened in Italy. It is the privatization of Wind Telecomunicazioni S.P.A. This deal resulted in a post leverage ratio of 6.2, 3.4 point higher than its counterparty in telecommunication industry.
B. Determinants of leverage
If barrier rule is effective, leverage will decline. Because the new thin capital regulation limited the tax deduction of debt financing, there should be a negative correlation between leverage and interest barrier. Positive correlation coefficient between leverage and buyout type (sec-ondary LBO is 1) confirms the previous discussion. Positive correlation between leverage and deal size may both be explained by GP-LP conflict theory (Axelson et al, 2009). Axelson et al (2012) showed that bigger deals are significant more levered than smaller ones. For example, if debt is affluent in the market, P.E. fund sponsors might overinvest, aiming at bigger target and overpay premium. However, debt amount is a very rough substitute for actual deal size. Nega-tive relationship between high-yield spread and leverage has been spotted in figure 4. Country factormay play a role in determining leverage ratio because Germany had a long history in regulating interest tax deduction. Germany initially implemented debt-to-equity limitation in 2004. Therefore leverage ratio in German firms could be lower than its counterparties in Italy. Table 7: Correlation coefficient of leverage ratio, interest barrier (the value is 1 if interest barrier code is available, 0 otherwise), buyout type (the value is 1 if it is secondary-LBO, 0 otherwise), debt size (amount of debt), high-yield spread (BofA Merrill Lynch Euro High Yield Index) and country (the value is 1 if it is Germany, 0 otherwise)
Table 6: Statistics of debt size of the selected 112-buyout samples from 2001 to 2011 in Germa-ny and Italy. Two types of buyouts are separately listed to compare the differences.
Model-1 simply regresses leverage ratio on interest barrier rule. Without controlling oth-er factors, buyout levoth-erage ratio decrease 0.77 with the tax code curbing intoth-erest deduction. This model is of little explanatory power. Although the result is significant (robust regression p<0.03), the estimation is biased due to omitting other important explanatory factors.
Model-2 controls the effect of debt market condition using BofA Merrill Lynch Euro High Yield Index. The result shows that interest barrier regulation cuts leverage ratio by 0.33 point. But, the effect is insignificant (robust regression p<0.21). Further White-test revealed het-eroskedasticity bias for model 2. Possible reasons are: differences between SLBOs and LBOs, managers’ risk preferences, and deal size. I assumed non-linear relationship between leverage and high-yield spread. When market is hot, fund managers become risk seeking. Whilst, when market condition is tight, they become risk aversive and get more cautious under the pressure form vigilant investors. Above all, the distribution of BofA Merrill Lynch Euro High Yield Index is skewed. Figure-5 and figure-6 display the distributions of this index and the adjusted index. I used Davidson-MakKinnon Test to compare model-2 with model-3, which assumed non-linear relationship between leverage ratio and high yield index. And the outcome supports the assumption of non-linearity. Explanatory power of model-3 increases significantly after ad-justing debt market condition indicator. But the effect of interest barrier rule became even less. The new tax code only causes 0.03 drop in leverage ratio (robust regression p < 0.96). Although model-3 is superior than model-2, ignoring the effect of buyout type biases the estimations. I use the Ramsey RESET test confirmed missing important variables.
Figure 5: Histogram with normal density plot of BofA Merrill Lynch Euro High Yield Index since 2001 to 2011. Hy_spread indicates the Bofa Index.
Model-4 demonstrates that interest barrier rules reduces firms’ leverage ratio by 0.2 point but the effect is marginal (robust regression p<0.51). Leverage ratio of SLBOs being 0.8 higher than of LBOs confirmed the study by Bonini (2010), Wang (2010), Sousa (2010), and Achleitner and Figger (2011). I also applied buyout type to interact with debt market condition variable to test whether SLBO is also more sensitive to market condition. Model-5 gives evidence (robust re-gression p<0.01) of such sensitive suggested by Bonini (2010), Wang (2010) and Sousa (2010). Model-6 reveals that leverage ratio in Germany is 0.3 point lower than in Italy but this esti-mation is only significant at 80% confidence interval (robust regression p<17.3). The result supports the assumption that leverage in German firms is lower than its counterparties in Italy because Germany has limited debt deductibility since 2004. But both countries enforced inter-est barrier rules at 2008 January capping interinter-est-to-EBITDA at 30%. Therefore, model-7 tries to perceive the effect of interest barrier rules in either jurisdiction. The estimation is biased and insignificant (robust regression p<0.875) due to lack of sample data in Italy after 2008.
Since firms in a given industry have similar proportions of individual assets and liabilities, Har-ris and Raviv (1991) noted that specific industries have a common leverage ratio, which over time is relatively stable. The correlation of capital structure and industry category also received empirical support in Schwartz and Arson (1967), Scott and Martin (1975). DeAngelo and Ma-sulis (1980) and MaMa-sulis (1983) explained that it is the tax code and tax rate differences across industries that cause the intra-industry similarities in leverage ratios. And, individual industry Figure 6: Histogram with normal density plot of adjusted risk indicator. Adjusted indicator is the reciprocal of BofA Merrill Lynch Euro High Yield Index since 2001 to 2011.
may be characterized by growth rate to influence debt levels in its capital structure (Jenson and Mecking, 1976). Model-8 evaluates the effect of industry characteristics. Because Automotive and industrials experienced slow growth in Europe between 2001 and 2011, I speculate firms in the two industries issue relative less debt. The result shows that in automotive and industrials leverage ratio is 0.2 point lower than others, but the estimation is insignificant (robust regres-sion p<0.3). It is possible that leveraged firms are no so much affected by industry characteris-tics compared with public firms.
Table 8: Regression results from model-1 to model-8.
Interest barrier is 1 if it’s applicable. Buyout type is 1 if it is secondary-LBO. High yield spread is the BofA Merrill Lynch Euro High Yield Index. Adjusted spread indicator is the reciprocator of BofA Merrill Lynch Euro High Yield Index. Type*ad.spread represents interaction between buyout type and adjusted spread indicator. Country is 1 if it is Germany. Barrier*Country rep-resents interaction between interest barrier rule and country factor. It is 1 when interest barrier rule became official in Germany. Industry is 1 if firms are listed in media and industrials. Italic formatted figures are standard errors of estimations.
Table 9: Robust regression results from model-1 to model-8.
Interest barrier is 1 if it’s applicable. Buyout type is 1 if it is secondary-LBO. High yield spread is the BofA Merrill Lynch Euro High Yield Index. Adjusted spread indicator is the reciprocator of BofA Merrill Lynch Euro High Yield Index. Type*ad.spread represents interaction between buyout type and adjusted spread indicator. Country is 1 if it is Germany. Barrier*Country rep-resents interaction between interest barrier rule and country factor. It is 1 when interest barrier rule became official in Germany. Industry is 1 if firms are listed in media and industrials. Italic formatted figures are robust standard errors of estimations.
Figure 6-1: Added variable plot of model-4 for interest barrier variable. Leverage ratio is la-beled by the dot.
Figure 6-2: Added variable plot of model-4 for interest barrier variable. The outlier whose leverage ratio is 2.5 is taken out from the model. Leverage ratio is labeled by the dot.
Figure 7: Added variable plot of model-4 for buyout type variable. Leverage ratio is labeled by the dot.
Figure 8: Added variable plot of model-4 for adjusted spread indicator. Leverage ratio is la-beled by the dot.
The above three figures display influences of outliers for model-4. The robust regression is more accurate in the estimation significances.
In summary, all models suffer from sample bias for far fewer buyouts deals since 2008. One can hardly observe significant effect of interest barrier rule on the sample leverage. Model-4 and model-5 bring evidence to support market-timing theory of the leveraged buyout deals and of leverage difference between LBO and SLBO.
5. Conclusion
Taxation plays an important role in managerial decision on firm’s capital structure. It is be-lieved even more influential in leveraged buyout organizations because post-buyout firms are more strongly driven to maximize profit. And, practice of subsidizing buyouts with interest tax shield has long been criticized for many reasons. A number of sovereigns have published special regulations to restrain financial leverage since 1987. These approaches include capping debt-to-equity ratio, administrating arm’s length principle, and limiting interest-to-EBITDA ratio.
This article studies a group of buyouts, including LBO and SLBO, in Germany and Italy from 2001 to 2011. It fails to exhibit convincing evidence to substantiate the effectiveness of the interest barrier rules. However, it supports the market-timing theory for buyout transactions. To further study the effects of the interest barrier rules, it is prudent to look into the underlying debt structure changes triggered by the new rule. For example, P.E. fund may resolve to con-struct less risky borrowings for less interest premium. Separate studying the direct change of interest-to-EBITDA may reveal information on perceived tax revenue savings for the govern-ments.
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