LBO_Econ46_AS - Albert Satija Modeling US LBO's a...

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Albert Satija Modeling US LBO’s, a predictive framework I. Introduction: In the past two years, Leveraged buy-outs have generated a level of media exposure unseen since the merger mania of the 1980’s. Aided by low interest rates, high real estate values, greater public expenses and a flood of capital from pension funds and endowments, financial sponsor firms have been snapping up companies at an impressive rate. 1 According to Dealogic, private equity activity totaled $135.7 billion in 2005, the largest total in the last decade with several high profile companies being caught up in the mix. March in 2005 for instance witnessed Toys R Us being purchased for a total of $6.6 billion and Sungard Data Systems for a near record $11.3 billion. 2 In addition to domestic mega-deals, the private equity industry has agitated corporate Europe with a succession of rapid restructurings (usually involving heavy job losses) and unsolicited take over proposals, causing members of the German cabinet to liken the funds to a “pack of locusts.” At the heart of the controversy and, at times, notoriety, is a simple usage of debt to magnify returns on companies. The traditional Leveraged Buyout transaction involves identifying an under-levered company with strong cash flow characteristics and utilizing low grade debt instruments to fund a purchase of the publicly traded shares. By increasing the debt load of the target firm, the financial sponsor’s are presumably optimizing the capital structure and maximizing the tax efficiency of the target. Most LBO transactions last between 3 and 7 years with exit strategies ranging from IPO’s to secondary buyouts by another private equity fund. While the private equity industry has witnessed burgeoning growth in the last decade, academic research on the industry is still in its infancy. To be fair, much of the blame can be apportioned to the clandestine nature of the funds, restricting the potential of many datasets. For example, information involving the specific financial performance of the companies held in fund’s portfolio, and, in some cases, the total purchase price of the firm is available only to the limited partners of the fund. Most of the academic research concerning Leverage Buyouts has followed a case study format and centered on the target firm’s motivations to go private and the stock price premium paid to minority shareholders. 3 Few studies, most notably (notably Evans, Poa and Rath (2005), Eddy, (1996) and Opler and Titman (1993) have sought to define the financial characteristics of public firms that are subject to a leveraged buy out and in general these studies suffer from restricted and out of date data set. Additionally, a surprising dearth of studies focus on LBO activity in the US market. This paper seeks to contribute to the literature by forming a deterministic model of potential LBO firms based on individual financial characteristics using a recent data set of companies formerly traded on the major US stock exchanges.
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