Management buyout effects on a firm’s performance:
Evidence from the small-medium sized companies in the Netherlands
Master thesis
December 2007
Author: V.S. Maslova Student number: S1386298
Faculty of Management and Organization Rijksuniversiteit Groningen
First supervisor: Dr. W. Westerman
Second supervisor: Prof. Dr. F.M. Tempelaar
Mazars Berenschot Corporate Finance Mentor: Ramon Schuitevoerder
Executive summary
In the past fifteen years a lot of research is dedicated to the management buyouts (MBOs) occurred in large organizations. Most studies show that these firms improve their economic results after the management buyout. However a slightly less attention has been paid to the impacts of MBOs on performance of small and medium sized companies. Some observers argue that buy-out managers can exploit the value of the company due to asymmetric information, while others suggest that the buy-out managers can enhance the value of company by implementing changes in internal operating or by strategic positioning of the buyout company.
This paper examines three aspects of small and medium sized management buyouts in the Netherlands. First of all, it analyses the financial performance of 55 firms which experienced the management buyout between 1998 and 2004. Secondly it focuses on changes regarding internal operating and strategic redirection buy-out management implemented after the management buyout. Thirdly, it examines the value drivers which influenced the performance of these companies. The main conclusions of this study are as follows.
It appears that on overall the management buyout firms do not perform better than the companies in the same sector of industry. The results are most of the time not significant except for some operating performance ratios. It is noticeable that management buyout firms perform better than their industry peers regarding return on assets ratio, asset turnover, cash flow to equity ratio and creditor days ratio in year three after the management buyout.
As in comparable studies in the Netherlands and U.K. buy-out managers on the evidence from the survey report an increase in the company’s profitability and increased level of employment after the management buyout. In terms of internal operating, an extensive number of buy-out managers tightened up their control of working capital after the management buyout. Furthermore, it appears that a lot of small medium-sized MBOs appear to undertake a greater level of new product developments than the large MBO counterparts. Overall, the results of the survey indicate support that management implements changes in internal operating and strategy of the company. Motivation is an important aspect of management buyout.
Evidence presented in the survey indicates that most buy-out managers experienced
an increase in their motivation. Motivation to perform is most enhanced by increased financial incentives and to a lesser extent by the financial leverage.
The final part develops a model, based on the answers in the survey, which tests a
set of hypotheses. The study suggests with the evidence of Fisher Exact Probability
Test an associated relationship between the combination of value creative measures
and economic performance. Furthermore it finds evidence that strategic redirection
may enhance economic performance. However no evidence was found that
motivation influence economic performance. However this study finds an associated
relationship between the combination of financial incentives with financial leverage
and motivation. Based on the findings this study cautiously supports value creative,
strategic redirection and agency costs theory.
Preface
The internship at Mazars Berenschot Corporate Finance and the writing of this thesis has been an educational time for me. The internship was an exciting and interesting period with an open working environment, that encourages me further exploit the field of corporate finance.
I wish to express my deep gratitude to my mother and Rob for their unconditional support, believe and patience during my internship and the overall university education program.
Furthermore I would like to pay my gratitude to Ramon Schuitevoerder and especially Daniël Kuyff for the internship possibility at Mazars Berenschot Corporate Finance and for helping me to design the questionnaire.
A special gratitude is for my university supervisor Dr. Westerman for all his support, his knowledge and his broad experience.
I acknowledge with special thanks the Kamer of Koophandel
1in Groningen for providing me excess to their database.
Finally many thanks to my friends, who supported me and believed in me.
Varvara Maslova
Amsterdam, December 2007
1 Chamber of Commerce in the Netherlands
Table of contents
Executive summary ………... 2
Preface……….……… 4
Introduction………. 7
Chapter 1: Research design……… 8
1.1. Problem definition……….... 8
1.1.2. Research objective……… 8
1.1.3. Research question……… 8
1.1.4. Sub questions……… 9
1.1.5. Boundary conditions………. 9
1.2. Type of research………. 9
1.3. Data……… 10
1.3.1. Data sources………. 10
1.3.2. Data gathering……….. 10
1.4. Research method………. 11
1.5. Concept methodology……….. 12
1.6. Scientific relevance……….. 13
1.7. Thesis structure……… 13
Chapter 2: Theoretical Framework………. 15
2.1. Literature……… 15
2.1.1. Asymmetric information theory………... 16
2.1.2. Tax benefits………... 18
2.1.3. Value creative measures……….. 19
2.1.4. Strategic redirection………... 20
2.1.5. Agency costs……… 21
2.2. MBO studies in United States and Europe……… 24
2.3. MBO studies in the Netherlands ……….………... 25
2.3.1. Study of Bruining………. 25
2.3.2. Study of NVP……… 28
2.4. Theoretical model………..……….……… 30
2.5. Summary……….. 32
Chapter 3: Financial performance of Dutch MBOs……… 33
3.1. Research data……… 33
3.1.1. The sample……….. 33
3.1.2. Accounting data……….. 33
3.2. Financial ratio-analysis of MBOs………. 34
3.3. Methodology……… 36
3.4. Research results………... 38
3.4.1. Sign-test results corporate liquidity……… 38
3.4.2. Sign-test results operating performance……….. 40
3.5. Summary……….. 43
Chapter 4: Survey research………. 45
4.1. Survey methodology………... 45
4.1.1. Data……… ……… 45
4.1.2. The letter………. 46
4.1.3. The survey plan……….………... …… 47
4.2. The survey results………... …… 47
4.2.1. Characteristics of MBOs………. 47
4.2.2. Performance………. 47
4.2.3. Post- buyout management developments……… ………... 48
4.2.4. Summary………... 52
4.3. Association test……….. 53
4.3.1. Value creative measures……… 53
4.3.2. Strategic redirection………. 54
4.3.3. Motivation……….. 56
4.3.4. Employment………. 56
4.3.5. Summary………... 56
4.4. Comparison to chapter 3……….. 57
4.5. Summary……….. 58
Chapter 5: Comparison to previous studies……… 60
5.1. Financial performance……….. 60
5.1.1. Corporate liquidity ratios……….. 61
5.1.2. Operating performance ratios………. 61
5.2. Survey results……….. 64
5.2.1. Reason for management buyout……… 64
5.2.2. Performance after the management buyout……… 65
5.2.3. Post-buyout management developments……… 65
5.3. Association test……… 67
5.3.1. Value creative measures……… 68
5.3.2. Post-buyout management developments……… 68
5.4. Summary……….. 69
Chapter 6: Summary and conclusion………. 70
Bibliography……….. 74
Appendices………. .. 78
1. Characteristics of Mazars Berenschot Corporate Finance 2. Sign test
3. The letter 4. The survey
5. Fisher Exact Probability Test
Introduction
Management buyout became a popular instrument of corporate restructuring in the last two decades. Besides the US, where the management buyout is discovered, a substantial growth in buyout deals is also taking place in the Netherlands. According to CMBOR
2the total Netherlands buyout deal value is increased from ! 1 billion in 1996 to ! 10 billion in 2005.
Source: CMBOR, 2006
There is considerable evidence from USA and UK of significant positive improvements in operating performance after the management buyout. According to Dutch studies
3there is also evidence that Dutch management buyouts have major positive effects on firm productivity, new product developments and investments.
Furthermore NVP reports the average revenue growth of 13.4% in three years after the buyout. Many factors are deliberated as the sources of value generations in the buyout. Such as tax advantages, reduction of agency costs or value creation measures. However, the scope of most studies was primarily on subsidiaries which were acquired by their management from large groups and to minor extent on small- medium companies.
The purpose of this study is first to highlight the sources of value generation that are proposed in the literature. Second, it measurers the impact of management buyout on firm’s performance in small-medium sized companies with fresh buyout deals completed in the period 1997-2004. Lastly it uses the findings from own survey to establish a model of associated relationship between the measures management took after the management buyout and the economic performance.
Chapter 1: Research Design
2 Centre for Management Buy-out research
3Bruining, Prestatieverbetering na Management Buy-Out or Performance improvement after Management Buy- Out, Rotterdam, 1992
NVP, Studie naar de economische en sociale effecten van buyouts in Nederland , 2004 Deal value of buy-outs/buy-ins in the Netherlands
0 2000 4000 6000 8000 10000 12000
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
! m
A research design expresses both the structure of research problem and the plan of investigation used to obtain empirical evidence on relations of the problem (Blumberg et al, 2005).
Accordingly the problem definition is introduced in paragraph 1.1. After that the type of research and the data are discussed in sections 1.2 and 1.3. Subsequently the research methods are outlined and linked to the sub questions in paragraph 1.4.
Scientific relevance of this thesis is discussed in section 1.5. Lastly the concept terminology and thesis structure are outlined in section 1.6 and 1.7.
1.1. Problem definition
According to De Leeuw (2003) a problem definition encloses three components:
research objective, research question and boundary conditions. Research objective addresses the purpose of the investigation. Research question flows naturally from the research objective. Research question is further subdivided in sub questions. The boundary conditions provide the limitations to which the research study is subject to.
1.1.2. Research objective
The objectives of this thesis is first to research how the economic performance of Dutch management buyout firms differs with respect to their industry counterparts and secondly to gather information about management interventions after those management buyouts and analyze which of these interventions influenced the firms’
performance.
1.1.3. Research question
What is the post management buyout performance of firms in the Netherlands and which value drivers influenced this performance?
1.1.4. Sub questions
The following sub questions have been formulated to further structure the research:
1. How can management buyouts create value?
2. What is the financial performance of management buyout firms compared to their industry counterparts?
3. What are the measures that have been put in place after the management buyout?
4. Does value creation influence performance?
5. Does strategic redirection influence performance?
6. Does management motivation influence performance?
1.1.5. Boundary conditions
Boundary conditions are subdivided in limiting conditions regarding research results and limiting conditions with respect to the research process (De Leeuw, 2003).
Boundary conditions with respect to the research results include:
- The research is primarily focused on the performance of Dutch management buyout firms.
- This thesis focuses on management buyouts in small-medium sized companies.
- In addition, this research is concentrating on management buyouts, which were completed in the period 1 January 1998 to 31 December 2004.
Boundary conditions with respect to the process:
- The research study will have to comply with general rules and prescriptions for scientific research and thesis as it is set by University of Groningen.
1.2. Type of research
Van der Zwaan (1992) classifies the research in four types; exploratory research,
descriptive research, explanation research and testing research. Exploratory
research tends towards loose structures with the objective to develop the concepts
more clearly. This research is used when the researcher knows little about the
problem. Descriptive study focuses on description of current state and does not test
the theory. Explanation research tests relation between two or more variables and
defines which variables cause the current state of situation. The last type of research
develops clearly stated hypothesis. The researcher verifies whether the developed hypotheses are supported by reality.
Due to the form of the sub questions of this thesis, quantitative test research is most applicable for answering them. The research objective, research question and sub questions of the study are clearly defined. Hypotheses are further outlined in chapter 2.4. This study tests statistically the formulated hypothesis.
1.3. Data
The following paragraph provides an overview of data sources and data gathering.
1.3.1. Data sources
In order to get information, different sources have to be explored. De Leeuw (2003) distinguishes six kinds of sources. The following sources of data are used in this study:
- Documents: such as annual financial reports of the firms and prior research studies about value generation in a management buyout firms.
- Databases: such as Zephyr and Reach.
- Media: newspapers and internet
- Research field: survey sent to firms in order to get information about strategic measures, which have been put in place after the management buyout.
1.3.2. Data gathering
According to Blumberg et al (2005) data can be gathered in different ways, ranging from using existing data to an observation or an interview. In this thesis, data is gathered in two different ways. First, using existing secondary data, the information about the performance of management buyout firms is collected. Kamer van Koophandel
4provides most annual reports of the sample firms in this thesis.
Secondly, data about implemented measures is collected via a survey. This type is classified as a primary data source.
4 Dutch Chamber of Commerce
1.4. Research method
In this section the research methods will be linked to the sub questions.
1. How can management buyout create value?
Many authors have researched the sources of value creation. Sub question 1 is answered by reviewing prior research studies. This type of research is classified as a literature review (De Leeuw, 2003). By investigating the literature a better understanding with respect to value generation in management buyout firms is formed.
2. What is the financial performance of a management buyout firms compared to their industry counterparts?
The financial performance of management buyout firms is empirically analysed using available annual reports of firms. This type of research is classified as a desk research (De Leeuw, 2003). To remove the effects of industry trends, the performance of industry peers is calculated. The methodology will be in more detail explained in chapter 3.
3. What are the measures that have been put in place after the management buyout?
This sub question 3 is answered by using a survey method. This type of research is classified as a field research. The structured questionnaires were sent to the management that initiated and carried out the management buyout.
4. How does strategic redirection, value creation argument and management motivation influence performance?
This question is answered with a Fisher Exact Probability Test. This test measures
the association between two variables. It employs answers which were obtained from
a survey. The methodology will be in more detail explained in chapter 4.
1.5. Concept terminology
According to Verschuren (1999) the definition of concepts is needed to maintain the consistency of what has been researched. During the study the researcher must guard for unnoticed shifting in the meaning of the concepts. In addition, the definition of concepts is necessary to define the boundaries of the study.
Management Buy Out (MBO)
According to Bruining (1992) an MBO involves members of the incumbent management team, which obtain a controlling interest in the firm or division for which they are employed. Besides that, managers make a contribution with their own funds, most of the purchase price will be provided by a combination of equity of investor group and debt. Another tactic of acquiring the company is using a significant amount of debt to meet the cost of acquisition (most often 70% of total capitalization, sometimes 90%-95%). Normally the loans are then repaid either from the company's cash flow, or by selling some of its assets. This is known as leveraged buyout (LBO)
5.
Similarly, CMBOR
6defines an MBO as the purchase of a business by its management, usually in co-operation with outside financiers. Buyouts vary in size, scope and complexity but the key feature is that the managers acquire an equity interest in their business, sometimes a controlling stake, for a relatively modest personal investment. The existing owners sell most or usually all of their investment to the managers and their co-investors.
Small-medium sized companies
The Kamer van Koophandel distinguishes companies with three different criteria’s.
Table 1.1. shows the criteria of the Kamer van Koophandel, these criteria are proposed for financial years after 2006.
Tabel 1.1. The criteria of Chamber of Commerce
5 Centre for Management Buy Out research, located in United Kingdom
6 Centre for Management Buy Out research, located in United Kingdom
Definition Small companies Medium-sized companies
Large companies
Total Assets (! x mln) < ! 4,4 mln > ! 4,4 < ! 17,5 mln < ! 17,5 mln Net profit (! x mln) < ! 8,8 mln > ! 8 < ! 35 mln < ! 35 mln
Employees (! x mln) < 50 > 50 < 250
1.6. Scientific relevance
This study differs in four aspects from prior studies. First of all this thesis focuses only on management buyouts of small-medium sized companies. Prior studies have mainly concentrated on subsidiaries of large companies and in lesser extent on small- medium size businesses. Secondly it tests empirically the operating performance of management buyout firms and afterwards it uses a survey method to observe how the management of these buyout firms thinks about the realized operating performance. Furthermore this study has chosen management buyouts completed between 1998 and 2003. It is interesting to investigate this time period because it includes an economic downturn. This research will give insight in how the management buyout firms perform in contrast to their peer group when the economy is depressed. Finally this study investigates whether measures which were implemented by the management after the buyout can influence the performance of the firms.
1.7. Thesis structure
Chapter 2 provides an overview of theories that have been proposed by researchers.
Furthermore it presents and discusses the outcomes of empirical studies, which were conducted in United States, United Kingdom and in the Netherlands. Finally the theoretical model is derived from the theoretical background and hypotheses are developed.
Chapter 3 describes the methodology, sample data and financial ratios, which are used to answer the sub question 2. Subsequently the found results are presented.
Chapter 4 provides answers to sub questions 3 to 6. This chapter describes the survey methodology, gives response and non-response information. Afterwards it shows the outcomes of the survey, discusses the implemented measures and shows the results of the association test between strategic redirection and performance, value creation measures and performance, motivation and performance.
Chapter 5 summarizes the outcomes found, discusses the differences and
similarities between the found results and prior studies and finally provides a
conclusion.
The structure of this thesis is outlined in the figure below.
Figure 1.1. Thesis structure Research design
Chapter 1.
Theoretical framework Chapter 2.
Desk research Financial performance
Chapter 3.
Survey research Chapter 4.
Chapter 5.
- Problem statement - Data
- Research methods - Concept terminology - Scientific relevance
- Literature review
- Overview of studies in United States and Europe - Research evidence in the Netherlands
- Theoretical model
- Sample data - Financial ratios - Methodology - Results
- Sample data - Methodology - Outcomes survey
- Results Fisher Exact Probability Test
- Reconciliation with theoretical framework
Conclusion
Chapter 6.
Chapter 2: Theoretical Framework
More than fifteen years of research on buyouts has lead to a number of theoretical propositions regarding possible sources of buyout value generation. Several researches found an evidence for the improved operating performance and tried to give a potential explanation for this improvement.
The first part of this chapter will discuss the theories of buyout value generation that have been proposed in the literature. The second part will provide an overview of studies that researched the performance of management buyouts in Europe and United States. The third part presents and discusses two studies that are related to the Netherlands. And at last, the theoretical framework related to this thesis will be presented.
2.1. Literature
After years of research, the written literature on value generation is reviewed by Berg
and Gottschald (2005). They present an overview of potential levers of value
generation as proposed by academic studies and focus on how these levers
contribute to the value generation in management buyout firm. According to the
literature, levers can be divided in value capturing levers and value creation levers. A
value capturing lever has no direct impact on financial performance and influence the
valuation of the company for example in terms of valuation multiples. In this situation
the value of the company can increase without any changes in the financial
performance of the firm. On the other hand, value creation lever has direct impact on
the financial performance of the business. This type of lever is subdivided in primary
lever and secondary lever. Primary lever directly influence value generation. The
value can be created through a tax shield, via the improvements in operational
effectiveness or through the strategic redirection. The changes regarding operational
effectiveness and strategy are initiated by the management and they focus on the
internal operation of the company. A secondary lever does not have a direct impact
on financial performance of the company, but enhances the value indirectly through
improved incentive alignment between the management of target firms and the
owners. Figure 2.1 provides an overview of the theories that will be discussed in this
chapter.
Value capturing lever
Value creation lever
Primary lever
Secondary lever
Figure 2.1. Overview of proposed theories
2.1.1. Asymmetric information theory
Lowenstein (1985) argues that due to information asymmetries between the management and external bidders, the management can take direct advantage of their private information about the company that is not available to other bidders.
This private information about future performance of the company will help managers exploit the firm’s undervaluation in the bidding process.
Furthermore Hite & Vetsuypens (1989) discuss the possibility that the managers could depress or manipulate reported or forecasted earnings in order to buy the company for less. However, DeAngelo (1986) fails to find evidence that managers depress earnings before an MBO.
2.1.5. Agency theory
2.1.3.Value creation measures
2.1.4. Strategic redirection 2.1.2.Tax benefit
2.1.1. Asymmetric information
Value generation
Kaplan (1989) considers indirect evidence concerning the asymmetric information theory and reduced agency cost hypothesis first by looking at the pre- and post buyout equity ownership in 74 MBO companies. The asymmetric information theory expects that if managers know the company is undervalued, they will naturally try to obtain a larger stake in the company. Both above stated hypotheses predict that the percentage of equity held by the management increases after a management buyout.
Kaplan found that the post- buyout managers increase their stake by a median of 16.03%. However, the percentage increase of equity owned by the two top managers is 4.41% whereas the percentage increase for all other managers is 9.96%. This is a strange result if the buyout participants know that the market undervalues the firm.
Kaplan argues that this distribution of equity ownership is more an evidence for the incentive theory than for the asymmetric information theory. This implies that new incentives play a more important role for junior managers. The incentives for managers will be in more detail discussed in section 2.1.5.
Secondly, Kaplan (1989) argues that if the management intentionally mislead public shareholders during the bidding process, the actual performance will exceed the projected performance. Therefore, he compared the pre-buyout operating income projections managers present to shareholders with the actual post- buyout operating income realization. He found that actual operating income in the first and second year is 20.7 % and 25.8 % less than projected operating income. These results are significant at the 1% level. Thus the projections are not too low, they are actually higher than the future realizations and therefore the found results are not consistent with asymmetric information theory. Kaplan concludes that the projection results suggest, but do not prove, that management and public shareholders have similar information about the company.
In addition, Ofek (1994) used 120 unsuccessful management buyouts to test for private information argument. He argues that if the undervaluation is the motive for the MBO, the cumulative abnormal return should remain positive even after the MBO is canceled. However Kaplan did not find any evidence for the underpricing theory.
The cumulative abnormal return between the offer day and the cancellation day was 4% negative for the full sample. Thus, the buyout is not motivated by private information that managers have when they bid for the firm. On the other hand, Ofek argues that it is possible that the emergence of bad news about the firm causes the cancellation of the MBO offer.
The management gain is positive if the premium paid is lower than the difference
between the purchase price and the firm’s intrinsic value (Singh 1990). According to
Singh the improved intrinsic value is “cashed out” through a public offering few years later.
Singh (1990) criticizes the asymmetric information theory by arguing that this theory presumes substantial pre- buyout undervaluation of the company. It is actually possible that the competition in the bidding process can force management to pay out all the potential gains.
Asymmetric information theory is based on the assumption that management benefits only from private information and thus not through their intervention in the internal operating of the firm after buyout. Therefore this theory belongs to value capturing lever.
2.1.2. Tax benefits
Lowenstein (1985) suggests that the post buyout tax savings are the real driving force of value creation in buyout transaction. The buyout management can exploit potential measures to reduce or to avoid the tax. The tax benefit of debt occurs because interest deduction reduces taxable income and creates a tax shield. In addition, an asset write-up following the buyout increases the depreciation deduction.
The increased interest and depreciation following buyout cause lower profits, which lead to lower tax charges.
Kaplan (1989) suggests that the tax benefits are an important source of wealth gains in management buyout. He calculated the value of tax benefits in 76 management buyouts of public companies completed in the period 1980 to 1986. Using data provided to public shareholders at the time of the management buyout, Kaplan calculated a range of the potential tax benefits from increased interest deduction by taking different assumption for the marginal tax advantage and the degree to which debt increases are permanent. He found that the median value of tax benefits varies between 21% and 143% of the premium paid to pre-buyout shareholders. Kaplan also reports a significant correlation between the buyout premiums and estimated tax benefits from buyout. In addition, Kaplan examined the real post-buyout tax and debt repayment for 48 companies of his sample. He finds that the companies in his sample pay little tax in the first two years after buyout. However, in the third year the companies restart to pay tax.
Opler (1992) also found a decline in tax payments. He argues that because of tax
deductibility of interest, 39 leveraged buyout firms in his sample are paying less tax
in the first two years after buyout. The median income taxes decline by 76.7%
adjusted for industry effects after LBO.
In addition, Graham (2000) developed a tax benefit function in order to calculate corporate tax benefits. He estimated that the tax benefit of interest deduction equals 9.7% of market value and 4.3% at the personal level.
The tax benefit argument assumes no significant changes in internal operation of the company. Nevertheless, the found evidence of previous studies presents the tax saving argument as the primary lever of value creation.
2.1.3. Value creation measures
Singh (1990) argues that after the buyout, management can create value through improvements in the internal operating of the company. This focus on internal improvements occurs because of increased level of debt, which asks greater discipline and more appropriate focus on cash generation. Several research papers suggest that internal operating improvements can be realized through numerous restructuring activities such as: more efficient use of capital, sale of unneeded assets or through cost cutting programs.
One common way of improving efficient use of existing capital is through an improved management of working capital. Holthausen and Larcker (1996) found that post-buyout firms have significantly smaller amounts of working capital than their counterparts.
Wright et al (1992) collected information about financial changes in U.K. firms, which experienced buyout between 1983 and 1986. Based on received questionnaires they report that 43.2% of the companies in the sample tight working capital control by reducing debtor days. Moreover 31.1% of questioned sample companies extended creditor days.
In addition, Muscerella and Vetsuypens (1990) gathered information about the restructuring activities that were reported in the prospecti of 72 leveraged buyout firms in the period 1976-1987. They found that 22.2% of the sample reduces production cost. And only 6.9% of the sample report improved inventory control and accounts receivables management.
Other restructuring activity such as unneeded asset sale is also very popular by
buyout firms. Wright et al (1989) reports that 20.8% of the companies in the sample
sold surplus equipment and 17.5% sold the land or buildings that were not more
needed. Muscerella and Vetsuypens (1990) reports an even greater percentage of 43.1% on this restructuring activity.
In addition to the proposed restructuring activities some researches discuss the possibility of the wealth transfer from employees. According to Schleifer et al (1988) and Sliepenbeek (1988) the improved operating performance is a result of wage reduction and job losses after the buyout. Kaplan (1989) rejects this argument in his paper. He finds that for buyout firms those that do not divest after the management buyout: the employment growth by a median of 4.9% and if corrected for sector variation the employment change is negative, but not significant. Unfortunately, Kaplan could not test for wage data.
Muscerella and Vetsuypens (1990) report that for 26 firms with sufficient data the median number of personnel is reduced by 0.6% between LBO and IPO. This can be explained by the sample selection. They find that 12 firms with no acquisition or divesture activity experienced a median employment increase of 17%. The employee wealth transfer theory can be seen as a restructuring activity since there is a likelihood of wage reductions or job losses, which are associated with internal process.
Value creation measures are initiated by the management and have directly impact on the profitability of the company. Therefore this proposed theory could be seen as a primary lever of value creation.
2.1.4. Strategic redirection
Seth and Eastwood (1993) argue that buyouts often lead to a corporate refocusing.
According to them strategic restructuring after the management buyout can lead to the improvement of competitive position of the firm and thus to the improvements in economic performance.
Bruining and Herst (1995) analyzed three management buyout cases. They report that the found improvements in economic performance of these firms can be associated with strategic choice with respect to better market orientation; which products and services to sell, how to approach the (potential) customers.
Melone (1989) approached 56 U.S. companies that completed leveraged buyouts in
the period 1981-1987. Based on received questionnaires he reports that 64% of the
sample increased marketing and sale efforts. Furthermore, 41% and 50% of the
approached firms report the increased level of market and new product development.
The increased focus of buyout firms on new product development is also found by Wright et al (1992). They argue that U.K. firms appear to focus more on new product development than U.S firms. The survey of Wright et al. (1992) shows that 62.3% of the companies had introduced new products, which they would not otherwise have done. With respect to customer relation, Wright et al. (1992) detail that 60% of buyout firms report improvement in customer relation. The level of improvement with respect to relations with suppliers was 37.3%.
As it was proposed, management of the buyout firm can create value and improve performance not only by value creation measures. The redefinition of strategy can also have a clear impact on financial performance of the firm and is therefore presented as a primary lever of value creation.
2.1.5. Agency costs
The value creation argument and the strategic redirection argument explain how the management can create value in the company. The question that many times was proposed is: why are described operating and strategic changes have not been implemented before the buyout? The agency theory addresses this point.
The changes in organizational structure and ownership that become possible due to buyout transaction create the possibility to take advantage of reduced agency cost.
The famous agency theory is proposed by Jensen (1986). Jensen assumes that there is a conflict of interest between the management and the owners. Manager’s objectives might be power, status, consuming perquisites or organization size.
Managers might want to invest free cash flow in wasteful projects because such investments maximize their own utility. On the other hand the owners want to maximize the value of profits. The problem of agency cost is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organizational inefficiencies.
Jensen (1986) argues that when companies undergo management buyouts, a
number of governance mechanisms can limit conflicts between managers and
stockholders. First, he argues that debt can be a more effective instrument than
dividends to limit the waste of free cash flow. He suggests that even though dividend
announcement implies a steady payment, the dividend promise can be weak
because the dividends can be reduced in the future. This is in contrast to debt
obligation where high leverage and increased default risk puts pressure on management to perform and to service debt payments rather than to spend it on wasteful projects. The increased level of debt provides managers with incentive to generate higher cash flow through improved operating performance.
In addition to the leverage, buyout firms can create incentive alignment between the management and the owners through ownership structure. After buyout the management becomes the owner or has an increased equity stake in the firm (Jensen and Meckling, 1976). Smith (1990) argues that increase in the equity stake of the managers directly increases their personal cost of inefficiency like shirking and consuming perquisites. Gottschalg and Zollo (2004) suggest that due to the increased equity stake, management might identify themselves with the company.
This effect positively contributes to incentive alignment. Accordingly, the increased equity stake provides management with strong incentive to generate long-term value.
Jensen and Meckling (1976) argue that this effect is possible only if the managers feel that they can influence the firm’s actions. In addition to direct equity ownership mechanism, Jensen and Murphy (1989) suggest performance based bonuses as an instrument that might enhance incentives of management to perform.
Lastly, buyout changes the governance structure by increasing the concentration of stock ownership of outside board members. This will encourage them to closer monitor the actions of the management. And therefore the monitoring may lead to a reduction of the agency cost.
Opler and Titman (1993) investigated the determinants of leveraged buyout (LBO) activity by comparing firms that have implemented LBOs to those that have not.
Consistent with free cash flow theory, they find LBOs have a combination of unfavorable investment opportunities (low Tobin´s q
7) and a relative high cash flow.
Wright et al. (1996) analyzed the factors, which lead to management buyout failure by using both the financial and non- financial information. They find evidence that the introduction of managerial incentives and the undertaking restructuring activities are associated with reduced probability of failure. However excessive gearing is associated with a higher probability of failure. They did not found evidence for monitoring device.
Also, Phan & Phill (1995) find evidence that the management holdings and debt have a positive impact on productivity. However, management holdings are more correlated with substantial changes in strategy and structure than debt. Phan & Phill argue that debt plays an important role, but in the long run the changes associated
7Tobin´s q: The market value of the firm divided by the replacements costs of its assets. (Chapell and Cheng,1982, Expectations, Tobin´s q and investment: a Note, Journal of Finance 37, 231-235)
with management stockholdings may have the most durable impact upon the firm efficiency.
Holthausen and Larcker (1996) find this result as well. They developed several regressions with operating income, working capital and capital expenditure as the dependent variables and leverage, change in management equity and non- management insider ownership as independent variables. They report that a change in leverage is an unimportant determinant of performance, whereas the ownership variables are mostly significantly and positively associated with operating performance changes. Furthermore they depict a negative relationship between the changes in working capital, capital expenditure and ownership variables. As the equity stake increases, working capital levels and capital expenditure levels falls.
This effect is associated with efficiency improvement of management buyout.
In addition, Amess (2002) empirically investigated the production effects of UK MBO governance structure through the Cobb-Douglas
8production function. He finds that an MBO provides incentive and control systems that lead to an improved productivity via reduced agency costs, debt bonding and monitoring by buyout specialist.
However, there is also a downside of increased managerial ownership and leverage.
Holthausen and Larcker (1996) argue that these mechanisms can create managerial risk aversion. Management might choose for lower-risk project and lower net present value project instead of choosing higher-risk project and higher net present value.
This project choice of management is influenced by the firm’s vulnerability to financial distress. Since there is a likelihood of debt repayment problems, management will choose for less risky projects in order to avoid the possibility of losing their job or a firm. Furthermore, the increased financial leveraged can make a company short-term oriented and this can lead to the reduction in investments. Phan and Phill (1995) argue that this effect could eventually create a decline in firm’s competitiveness.
Agency problems create inefficiencies. The proposed mechanisms improve agency relationship between the management and the owners after the buyout and this effect indirectly motivates management to improve operational effectiveness and strategic distinctiveness of the company. Therefore the reduced agency costs is presented as a secondary lever of value generation. According to Berg and
8 Cobb-Douglas production function:
Q
=AL
aK
be
gt where Q,L, K represent output, labor and capital ande
gtis included to account for trend factor in time series study. (Diwan, 1968, On the Cobb Douglas Production Function, Southern Economic Journal 34,410-414)Gootschalg (2005) this secondary lever can support the three previously described primary levers.
2.2. MBO studies in United States and Europe
This paragraph shows the overview and the conclusions related to the (management) buyout studies of United States and Europe. See table 2.1.
Table 2.1. Overview of empirical studies
Empirical studies have focused particularly on buyout performance in the United States. All studies used financial economic variables to calculate operating performance of the buyout firms. The financial ratios of MBO firms were compared to their industry counterparts. Almost all research papers find positive economic effects on short terms. The operating income is positive and working capital ratios are smaller for management buyout firms.
Desbrières and Schatt (2002) find different results. Return on equity of French management buyout firms falls after the buyout compared to their industry
Author Land # Buyouts Time period Window Variable Effect Researched Hypothesis Effect Holthausen &
Larcker USA 90 LBO 1976-1988 Variable Operating income + Reduced agency cost +
Operating cash flow + Working capital - Capital expenditure -
Kaplan USA 76 LBO 1980-1986 (-1,+2) Operating income + Asymmetric information -
Capital expenditure - Employee wealth transfer -
Cash flow + Reduced agency cost +
Muscarella &
Vetsuypens USA 72 LBO 1976-1987 Variable Operating margin + Reduced agency cost +
Capital expenditure -
Employment +
Ofek USA 120 MBO 1974-1989 Variable Operating performance - Asymmetric information -
Reduced agency cost +
Opler USA 42 LBO 1985-1989 (-1,+2) Operating cash flow +
Taxes -
Investments -
Employees +
Singh USA 130 MBO 1980-1987 Variable Cash flow + Value creation argument +
Working capital - Tax benefit argument - Asymmetric information -
Smith USA 58 MBO 1977-1986 (-1,+2) Operating cash flow + Reduced agency cost +
Working capital - Capital expenditure -
Desbrières
Schatt France 161 LBO 1988- 2004 Variable EBIT - Reduced agency cost +
Net profit -
Cash flow -
Leverage -
Wright et al. UK 979 MBO 1985-2005 n.a. Plants productivity + Reduced agency cost +
(CMBOR)
counterparts. Return on investment and margin ratios also diminish after the buyout but remain significantly higher than the industry average. Desbrières and Schatt argue that even though this ratios are higher for buyout firms compared to their industry counterparts after the buyout, it can not be concluded as in USA or in UK that buyouts improve the performance of the firm due to the found diminishing effect of performance. Desbrières and Schatt propose that this deteriorate effect in financial performance is due to the relative low debt levels of French firms. They think that because of lower leverage there is less pressure on management to perform.
Furthermore, Desbrières and Schatt made distinction between the former subsidiaries of group and the former family business. The subsidiaries appear to be more profitable than family businesses if comparing them with EBIT/sale ratio.
However, family businesses appear to perform better with regard to relative changes in Net profit/ sale and Cash flow/ sale ratios over (-1,+2 window).
2.3. MBO studies in the Netherlands
As stated above a lot of MBO studies were mainly executed in United States and United Kingdom. However a few studies have focused on Dutch MBO market. This paragraph will present two of the main studies which focus on Dutch (management) buyouts. First study is the dissertation study of Bruining
9published in 1992, (Erasmus University in Rotterdam). Second study is initiated by de Nederlandse Vereniging van Participatiemaatschappijen (NVP)
10and Ernst & Young in the collaboration with Center for Management Buyout Research (CMBOR) and Erasmus University Rotterdam.
2.3.1. Study of Bruining
2.3.1.1. Research
The dissertation study is about the economical performance of the management buyout. Bruining researched this area through different methods. In order to find out how MBO firms are performing, he compared the financial ratios of an MBO firm with industry ratios. The sample exist of 73 firms which experienced management buyout in the period 1980-1989.
9 Bruining, Prestatieverbetering na Management Buy-Out or Performance improvement after Management Buy-Out, Rotterdam, 1992
10 NVP, Studie naar de economische en sociale effecten van buyouts in Nederland , 2004
In addition, to learn more about the measures the management took and to research the value creation argument, Bruining analyzed the findings of a NIB (investment bank) survey from 1985 among 49 buyout firms. And at last, he approached 3 firms for a case study.
2.3.1.2. Empirical Results
Bruining (1992) compared 16 firms’ ratios with their industry averages. He divided the ratios in two groups. Three ratios were strongly related to earnings, the other ratios were related to working capital. In his research he recognized that for some small firms it was not possible to calculate all 16 ratios.
The main conclusions:
• Medium sized MBO firms are performing better than the industry in relation to the cash flow ratio, return on investment and return on equity.
• Medium sized MBO firms have a better current ratio than their industry competitors in the first two/ three years after the buyout. The quick ratio is only significant in year=1.
• For small firms the number of usable ratios is constrained due to reporting requirements of KVK.
11However, Bruining found significant positive result in return on investment ratio in year =1 and significant positive result in return on equity in year =4. In other years the results of these ratios are not significant.
• Small firms have a significant worse current ratio and quick ratio compared to the industry in year=1 to year=3 after the management buyout. In other years the results are not significant.
• For medium-sized companies and small-sized companies the solvency ratio is worse compared to the industry ratio in year= 0 to year= 2. After that the ratio is not significant.
2.3.1.3. Survey Results
In the second part of the dissertation study, Bruining (1992) researched the value creation argument that was proposed by Singh (1990). By using the Fisher Exact Probability Test
12he constructed a relationship between the factors that were reported by the management of the NIB survey and the improved economic
11 KVK= Kamer van Koophandel or Dutch Chamber of Commerce
12A test statistic for measures of association that relate two nominal variables. It is used mainly in a 2x2 frequency table. The lower the level of significance P, the stronger the evidence against the null hypothesis.
(Johnstone,1987,Tests of Significance Following R.A. Fisher, Brit.J.Phil.Sci. 38, 481-499)
performance. The main findings are shown in figure 2.2.
Bruining finds a significant relationship between the increased flexibility and improved firm’s performance. This flexibility can be divided in internal flexibility (1) and external flexibility (2). Internal flexibility includes operational, structural (communicational & decisional) changes. External or strategic flexibility is about the ability of the company to change the nature of relationship with the suppliers, customers or ability to change market orientation.
In addition Bruining tests a relationship between the motivation (3) and the firm’s performance. He did not found significant evidence that the motivation of management improves firm’s performance. However, he did find positive relation between the motivation of employees and the firm’s performance. This effect accentuates the important role of employees.
(p. value 0.05) Internal flexibility (1)
(p.value 0.04) Strategic flexibility( 2)
(p. value .58) Motivation (3) management (p. value. 04) Motivation (3) sale employees
(p. value. 02) Motivation (3) administrative employees
H0= There is no association between management measures and improvement of economic performance
Figure 2.2. Fisher Exact Probability test
2.3.1.4. Case study Results
For all three companies Bruining finds a much better economic performance than before the buyout. Several actions were taken by these companies to improve economic performance. These actions were related to operational, structural and strategic flexibility. For example, the three MBO firms increased their operational flexibility by minimizing working capital or cost cutting programs. Structural flexibility is archived by less bureaucracy, shorter lines of communication between
Improved performance
after MBO
management and operations. Regarding strategic actions, firms archived market focus, by identifying customer needs and quickly respond to these needs.
2.3.2. Study of NVP
2.3.2.1. Research
The NVP study was published in 2004 and was implemented through a survey. The goal of this study was to get more insight in the social and economical effects which occurred after the buyout. The first part of NVP study presented the results of performance of Dutch buyout firms, second part discussed the strategies which firms implemented after the buyout. Third part illustrated factors which according to the management create value after the management buyout.
The questionnaires were sent to 274 companies that experienced buyout and were helped by private equity company in the period 1992-2002. About 40% of the sample consists of firms with more than 250 employees. The total response was 46 questionnaires or 16.8%.
2.3.2.2. Results after the buyout
The results of firms after the buyout were positive. The survey asked the management about the revenue growth, EBIT and employment.
Revenue growth
The annual growth after the buyout was 22.0%. The average revenue growth was 13.4% in 3 years after the buyout.
EBIT growth
The average EBIT growth was 9.5% in 3 years after the buyout.
-
- 60 % of the approached firms report that the revenue and EBIT were improved compared to their concurrents after the buyout.- 56 % of approached firms argue that because of the buyout they could develop the business faster.
-
9 % of the sample thinks that without the buyout the company was better off.Employment
In most firms the employment increased after the buyout. According to the management the increase was especially noticeable in marketing, sale and financial department.
2.3.2.3. Strategic redirection
A part of the NVP study focused on product and market development, investments increase and acquisitions/ joint ventures.
Product and market development
The research shows that the companies took strategic actions after the buyout:
In addition, the research shows that after the buyout, the company develops a better focus/ vision regarding the activities:
Increased investments
The research shows that the average expenditures concerning marketing, R&D, education and capital equipment are increased. The largest increase was in education and marketing.
- 54 % of approached firms report an increase in the employment - 23 % reports a decrease in the employment
- 23 % reports no change in the employment
- 65 % of the approached companies developed new products - 59 % of the approached companies invested in new locations - 52 % increased the market field
-
More than 40 % of the sample reports the improved relation with their suppliers- 30 of approached companies disinvested some of their activities where they thought someone else will do better
- 25 % of approached companies reduced the number of products
-
18 % of approached companies reduced the field of served markets- Education expenditure increased with 46 % after the buyout
-
Marketing expenditure increased with 31 % after the buyoutAcquisition and / or joint venture
The research argues that because of the ownership change and financial injection, the companies had the possibility to growth organically or through acquisitions. After the buyout 56% of the approached firms made acquisitions in the Netherlands and 12% were involved in joint ventures. In addition, 45% made acquisitions abroad and 15% closed a joint venture with foreign companies.
2.3.2.4. Factors affecting value creation
According to the management of the approached firms the value is created through the combination of improved control, efficiency and strategic redirection.
The 10 most important factors according to the management are: improved cash flow, cost reduction, improved company efficiency, optimization of capital investments, improved customer service, product development, improved brand reputation, trained work force, geographic expansion and improved marketing techniques.
Incentives
The research shows that about 55% of the approached companies increased the total remuneration of the top management after the buyout.
2.4. Theoretical model
In this section the model tested in this thesis is illustrated in figure 2.3. The relationships shown in this figure have been suggested in the literature. This proposed model has some characteristics of Phan & Phill (1995) model, but the focus lies here on strategic redirection and value creation argument. The theoretical model is based on the assumption of Jensen that prior the buyout, the companies are characterized with inefficiency. Furthermore, as Jensen proposed in the literature, this model assumes that increased equity stake and increased debt improves incentives of the management. Because of increased incentive, the management will focus more on strategic actions and value creation actions. As proposed in chapter 2.1.4 and 2.1.5 these actions have a direct impact on firm’s performance.
The following 6 hypotheses related to the theoretical model are formulated:
First, in this thesis the performance of Dutch management buyout firms will be
empirically tested with secondary data.
Hypothesis 1: There is difference in financial performance between management buyout firms and the medians of their industry peers.
Secondly, the data for testing hypotheses 2- 6 is collected through a survey. This survey is based on the documented on the NVP survey discussed before. And in lesser extent on Wright et al (1992).
Hypothesis 2: There is an association between value creation measures and improvement of economic performance.
Hypothesis 3: There is an association between strategic redirection measurers and improvement of economic performance.
Hypothesis 4: There is an association between motivation and improvement of economic performance.
Hypothesis 5: There is an association between financial incentives and motivation.
Hypothesis 6: There is an association between financial leverage and management motivation.
H5 H3
Motivation
H2 H6
H4
Figure2.3. Theoretical model Increased
Management Holdings
Increased level of debt
Strategic redirection hypothesis
Value creation argument
Economic performance
H1
