Target Bankruptcy Risk and Its Impact on Going Private Buyout Performance and Exit

• Author: Mike Wright,Sudi Sudarsanam,Jian Huang
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00854.x
• Date: 01 May 2011
• Published date: 01 May 2011

Target Bankruptcy Risk and Its Impact on

Going Private Buyout Performance and Exit

Sudi Sudarsanam*, Mike Wright, and Jian Huang

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: What is the impact of bankruptcy risk on whether listed corporations are likely to be bought out

by private equity f‌irms and on the subsequent exit, including bankruptcy, of private equity backed public to private buyouts?

Research Findings/Insights: Using a sample of 246 UK companies that went from public to private (P2P) company status

from 1997 to 2005, we f‌ind that companies going private have a signif‌icantly higher default probability. Private equity f‌irms

sponsoring P2P deals acquire f‌irms with a higher risk of bankruptcy than non-acquired f‌irms that remain public. We f‌ind

evidence that high receivership risk at going private increases the chance that the target will end up in receivership, but

post-P2P bankruptcy likelihood is less when the P2P is a management buyout rather than any other form of buyout.

Independent boards of pre-P2P targets promote P2P deals and reduce the chances of bankruptcy after the buyout,

suggesting a good corporate governance structure makes a positive contribution to bankruptcy avoidance after going

private transactions.corg_854240..258

Theoretical/Academic Implications: Our f‌inding that P2P deals involve targets with a higher risk of bankruptcy adds to

theoretical insights about private equity. In contrast to previous research, it suggests that PE f‌irms are not deterred by the

risk of f‌inancial distress but consider it a value creating opportunity. Our use of the option pricing framework represents a

f‌irst and novel attempt atmeasuring bankruptcy risk and its impact on the ability of private equity f‌irms to achieveeffective

turnaround. We f‌ind a link between better governance of the target pre-P2P and lower bankruptcy risk since where the PE

investor inherits a strong governance structure, manifested in independent boards, chances of subsequent bankruptcy are

reduced. Similarly, where the P2P acquisition is a management buyout, the probability of bankruptcy, post-P2P, is reduced,

suggesting lower informational asymmetries and better alignment of interests between managerial and private equity

investors. Although, due to the small number of receivership exits in our sample of P2P f‌irms, the results are not as strong

as we would like, a more extended analysis involving a larger sample over a longer period, in particular of f‌irms exiting

through bankruptcy is expected to produce stronger results. Our results provide a suff‌icient basis to warrant such further

analysis.

Practitioner/Policy Implications: Private equity backed P2Ps of listed corporations with high bankruptcy risk augment the

market for corporate control as they provide an alternative purchaser to traditional acquirers. Our f‌inding that high

bankruptcy risk at going private increases the chance the target will end up in receivership suggests a need for caution on

the part of private equity f‌irms since the turnaround of P2P targets appears to depend on how seriously distressed they are

at the P2P stage. Private equity f‌irms therefore need to engage in careful due diligence. Private equity f‌irms need to give

attention to the natureof the pre-P2P governance regime when selecting P2P targets, in particular the extent to which better

monitoring by independent directors has been in place and where there is greater alignment of interests between managers

and LBO sponsors since these contribute to bankruptcy avoidance. For listed corporations, our f‌indings suggest that

strengthening of independent boards may contribute to timely decisions to sell troubled corporations.

Keywords: Corporate Governance, Private Equity, Distress, Going Private, LBO, Bankruptcy

INTRODUCTION

Aleveraged buyout (LBO) is an acquisition of a business

mostly with cash, the cash being raised with a prepon-

derance of debt issued by the acquirer. Management

buyouts and management buyins are, respectively, LBOs

where incumbent top managers of the target f‌irms are

*Address for correspondence: Sudi Sudarsanam, Cranf‌ield School of Management,

Finance & Accounting, Cranf‌ield University, Cranf‌ield, MK43 0AL, UK. E-mail:

p.s.sudarsanam@cranf‌ield.ac.uk

Jian Huang’s contribution to this study arose from his doctoral work at Cranf‌ield

School of Management during 2003 to 2007. Thepaper does not in any way ref‌lect the

views, opinions and conclusions of his current employer, GLG Partners.LP. GLG is a

member of the MAN Group.

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© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00854.x

sponsors or co-sponsors of the LBO deal and where such

management is excluded. Going-private is a type of LBO

where the shareholders in the publicly listed target are

bought out, typically supported by private equity f‌irms, and

the company becomes privately owned. It is also known as a

public-to-private (P2P) buyout. P2Ps can be either manage-

ment buyouts or management buyins. In the UK, P2Ps have

become prominent during recent years. P2P transactions on

average account for about 3 per cent in deal number and 20

per cent in value of total LBO activities (CMBOR, 2009). The

increasing importance of P2Ps raises interesting questions

about the motivations and expected sources of valuecreation

that drive these deals (Kaplan & Stromberg, 2008; Wright,

Amess, Weir, & Girma, 2009). Many US studies, principally

relating to the 1980s, have reported substantial gains

for target shareholders when P2P deals are announced

(DeAngelo, DeAngelo, & Rice, 1984; Frankfurter & Gunay,

1992; Kaplan, 1989; Lehn & Poulsen, 1989; Marais, Schipper,

& Smith, 1989; Travlos & Cornett, 1993) and empirically

investigated the value sources. Cumming, Siegel, and

Wright (2007) review the literature on these and provide

evidence that more astute f‌inancial management, labor and

asset productivity improvements, more robust governance

and better managerial incentive alignment contribute to per-

formance improvement and value creation.

Following a P2P deal, the concentrated equity ownership

of the private equity sponsor and the high leverage are said

to provide more effective managerial monitoring, thereby

contributing to greater value creation than in the pre-LBO

period characterised by divorce of management control

from share ownership (Jensen, 1991). This argument is pre-

mised upon corporate governance failure in the pre-P2P

f‌irm. Several other explanations have been put forward as

motivations for P2P LBOs and for their sources of value

(Renneboog, Simons, & Wright, 2007). Among these is the

persistent undervaluation of target f‌irms while being pub-

licly listed. Such undervaluation increases the f‌irm’s cost of

capital and prevents them from pursuing valuable invest-

ment opportunities. Ownership by specialist private equity

f‌irms may allow them to exploit valuable growth opportu-

nities more effectively. This suggests that in the pre-P2P

period the target may have experienced low growth and

poor operating performance (Kim & Lyn, 1991; Lehn &

Poulsen, 1989).

DeAngelo and DeAngelo (1987) argue that the advantages

of going private include improved company performance,

tax savings due to high leverage, and potential improvement

in the f‌irm’s competitive position. Going private deals may

also result in better incentives for managers because of

performance-driven incentive elements, e.g., equity ratchet

and stock options. However, the US and UK empirical evi-

dence on the factors inf‌luencing the going private decision is

mixed (Guo, Hotchkiss, & Song, 2010; Halpern, Kieschnick,

& Rotenberg, 1999; Kaplan, 1989; Lehn & Poulsen, 1989;

Renneboog et al. 2007; Weir, Laing, & Wright, 2005a). We

focus on f‌inancial distress as an aspect of the rationale for

P2Ps that has received limited attention. Opler and Titman

(1993) argue that since f‌irm failure is more likely following a

buyout due to the higher debt burden, the potential for

signif‌icant f‌inancial distress costs will deter P2P buyouts

with high bankruptcy potential. Recent studies have

explored the failure rate of LBOs (Strömberg, 2008; Wilson,

Wright, & Altanlar, 2009). Wilson et al. (2009) f‌ind that

private equity-backed LBOs are less likely to fail than non-

private equity backed LBOs, pointing to the superior gover-

nance skills, resources and capabilities that private equity

f‌irms have compared to listed corporations in managing

companies and avoiding bankruptcy. Acquiring f‌irms with

high bankruptcy potential to turn them around post-buyout

is a challenge of greater magnitude than acquiring relatively

healthy f‌irms and keeping them away from bankruptcy.

There is very little research to date which examines whether

LBO-sponsors in general and private equity f‌irms in particu-

lar successfully meet this challenge. This paper contributes

to the literature by providing evidence on the impact of

bankruptcy risk faced by the P2P targets, an important issue

not addressed directly by prior studies.

We address a specif‌ic question – are private equity f‌irms

able to acquire potentially bankrupt targets and improve

their performance so as to avoid bankruptcy? We seek to

answer this question in the context of the leveraged buyout

(P2P) of publicly listed f‌irms and by relating post-buyout

bankruptcy to this ex ante bankruptcy risk.

We seek to make four contributions to the existing litera-

ture. First, we advance the theoretical arguments concerning

the effect of distress costs on P2P activity by providing a

contrary hypothesis to previous research in which we

suggest distress will be attractive in encouraging P2Ps

because of the turnaroundopportunity it represents. Second,

and related to the f‌irst, we make an important empirical

contribution. Opler and Titman (1993) consider the impact of

f‌inancial distress cost, measured by R&D intensity, on target

shareholder value gains. Research and Development (R&D)

intensity, however, is not a reliable proxy for bankruptcy

risk or distress costs. We employ direct measures of bank-

ruptcy risk–default probability and proximity to defaul–

estimated from stock market data using an option pricing

model. Third,we contribute to the literature on the effective-

ness of the governance mechanisms associated with private

equity f‌irms which has focused upon their role in improving

prof‌itability and reducing costs in portfolio by addressing

the neglected issue concerning whether private equity f‌irms

successfully turn around distressed P2P targets. While a

listed corporation with high bankruptcy risk may present

turnaround potential, this high risk when associated with

the high leverage in P2P deals may increase the chances of

its failure under private equity ownership.In addressing this

issue we also make a policy contribution since regulators

have expressed concern about the potential dangers of P2P

transactions (Financial Services Authority, 2006). However,

to date, there is no evidence to inform this debate. We

provide new evidence on the relationship between bank-

ruptcy risk of P2P targets and their subsequent fate under

private equity ownership. Fourth, we make a contribution to

the general corporate governance literature by highlighting

(1) the role of private equity backed P2Ps in extending the

market for corporate control beyond traditional acquisitions

of companies at risk of bankruptcy and (2) the role of

boards pre-P2P in taking timely decisions to sell troubled

companies.

A study of P2Ps in the UK is especially important for a

number of reasons. First, the UK P2P market is second only

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