CEO Turnover in Private Equity Sponsored Leveraged Buyouts

• DOI: http://doi.org/10.1111/j.1467-8683.2010.00834.x
• Date: 01 May 2011
• Author: James Jianxin Gong,Steve Yuching Wu
• Published date: 01 May 2011

CEO Turnover in Private Equity Sponsored

Leveraged Buyoutscorg_834195..209

James Jianxin Gong* and Steve Yuching Wu

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We examine the governance role of private equity (PE) f‌irms in post-LBO companies in the US.

We propose and test whether PE f‌irms remove entrenched CEOs or CEOs who cause agency problems.

Research Findings/Insights: Using archival data from a sample of 126 PE sponsored LBOs in the USA between 1990 and

2006, we document a CEO turnover rate of 51 per cent within two years of an LBO announcement. We f‌ind that the boards

of directors replace CEOs in companies with high agency costs, as measured by low leverage and a high level of

undistributed free cash f‌low. In addition, unlike the boards of directors in public companies, the boards in post-LBO

companies tend to replace entrenched CEOs. Finally, the boards are more likely to replace CEOs if pre-LBO return on assets

is low.

Theoretical/Academic Implications: According to the agency theory, a PE-sponsored LBO is a new organizational form that

reduces agency costs by enhancing corporate governance. This study uses CEO turnover as a setting to test that prediction.

We f‌ind that PE f‌irms replace CEOs who can cause agency problems, thus providing empirical support for the proposition

that PE f‌irms improve corporate governance in LBO companies.

Practitioner/Policy Implications: This study offers insights to policy makers who are interested in regulatingPE f‌irms. Our

results suggest that, in the US, PE f‌irms provide effective corporate governance mechanisms by replacing incompetent and

entrenched CEOs. In addition, our results provide a set of factors for PE f‌irms to consider when they make CEO retention

decisions.

Keywords: Corporate Governance, Private Equity, Leveraged Buyout, CEO Turnover

INTRODUCTION

Private equity (PE) sponsored leveraged buyout (LBO) is

a form of investor activism against the public companies

that have incurred agency costs beyond the optimal point

(Jensen, 1989). The last two decades have witnessed an

increase in PE sponsored LBOs. From 2000 through 2007, PE

funds acquired a total of nearly 3,000 companies in the

United States, with a total transaction value exceeding $1

trillion (Government Accountability Off‌ice [GAO], 2008).

Accompanying this development are renewed debates on

whether PE f‌irms and LBOs create value (Cumming, Siegel,

& Wright, 2007; Wright, Amess, Weir, & Girma, 2009). Pro-

ponents argue that PE f‌irms install governance mechanisms

that reduce agency costs and lead to better f‌inancial

performance (Gilligan & Wright, 2008; Jensen, 1989; Kaplan

& Stromberg, 2009; Wruck, 2008). Critics argue that value

created through LBOs is just a wealth transfer from other

stakeholders (Kinsley, 2006; Shleifer & Summers, 1988), such

as bond holders (Travlos & Cornett, 1993), employees via

layoffs (Ippolito & James, 1992), and government via tax

advantages (Scholes & Wolfson, 1990). While academic evi-

dence on the operating performance in post-LBO companies

is largely positive, critics argue that public companies can

achieve performance improvements without undertaking

LBOs (Kaplan, 1989; GAO, 2008). Furthermore, the positive

effect of an LBO on operating performance is subject to

cautious interpretation (Cumming et al., 2007; Kaplan &

Stromberg, 2009). This debate has spurred Wright et al.

(2009) to call for research on PE f‌irms’ contribution to cor-

porate governance in post-LBO companies.

PE f‌irms contribute to corporate governancein three ways.

First, the existence of PE f‌irms presents a threat of takeover,

which provides an incentive for corporate executives to

*Address for correspondence: James Jianxin Gong, Department of Accountancy,

College of Business, University of Illinois at Urbana-Champaign, 1206 South Sixth

Street, Champaign,IL 61820, USA. E-mail: gong@uiuc.edu.

195

Corporate Governance: An International Review, 2011, 19(3): 195–209

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00834.x