BUSI 536 Week 5 Group Discussion Board Forum 2 Example

Group Discussion Board Forum 2: Buyouts, Private Equity and Restructuring

BUSI 536 Mergers & Acquisitions, Group Discussion Board Forum 2 Thread and Replies

Thread by [Student Name]

The forum topic and the two classmates are composites standing in for the course's own topic; the textbook, the research and the Scripture cited are real, and the requirements follow Liberty's public course guide for BUSI 536.

Thread

When a buyout firm acquires a company with mostly borrowed money, what is it really buying? Gaughan (2018) describes how buyouts are financed and how private equity firms organize them, and the description invites three possible answers. The value could come from the debt itself, through tax deductions on interest. It could come from the discipline debt imposes, since managers who must meet large interest payments cannot waste cash. Or it could come from changes in how the business is run. My answer is that the third source matters most, with the first two serving mainly as tools that make operational change happen.

The early evidence came from management buyouts. Kaplan (1989) followed large management buyouts completed in the early 1980s. Over the following three years, operating income rose relative to sales, capital spending fell and net cash flow increased, compared with industry peers. Buyout investors captured much of the gain, but prebuyout shareholders also received large premiums. Kaplan attributed the improvements to better incentives, since managers owned far more of their companies after the deals, rather than to tax savings alone.

Private equity has since changed its methods. Kaplan and Strömberg (2009) describe three kinds of engineering: financial engineering, which aligns incentives through managerial ownership and the discipline of debt; governance engineering, which replaces large, passive public boards with small, active ones; and operational engineering, in which private equity firms bring industry and operating expertise to improve the business itself. They note that operational engineering became more important as buyout firms competed for deals and could no longer earn returns simply from borrowing and cheap prices.

The most complete evidence on the real economy comes from Davis et al. (2014), who tracked 3,200 U.S. buyout targets from 1980 to 2005 and their 150,000 establishments. Buyouts led to modest net job losses, but also to large amounts of both job creation and destruction and to productivity gains, mainly because targets closed less productive plants faster and opened more productive ones. The gains came from reallocating work inside the company, not from the balance sheet.

Proverbs counsels a farmer to prepare his work outside and make his fields ready before building his house (English Standard Version Bible, 2001/2016, Proverbs 24:27). The order matters: income-producing work first, then the structure it will support. A buyout that starts with a plan for the business and uses debt to fund it follows that order; one that starts with the debt and hopes the business will grow into it reverses it. The evidence suggests the first kind creates value and the second often transfers or destroys it.

The question of who receives the value deserves a final word. Davis et al. (2014) found that the job losses were concentrated in some sectors and in deals involving publicly traded targets, while buyouts of private firms often added jobs. Employees, lenders and selling shareholders can therefore fare very differently from one deal to the next. A buyout firm that treats the workforce as a cost to be cut, rather than as part of the business it must improve, may produce a short-term return while weakening the company it will eventually sell, and the next owner will pay for that weakness.

Reply to Grace

Grace, your thread argued that debt is the real engine of buyout returns, because interest is tax deductible and because heavy debt forces managers to run companies efficiently. I agree that both effects are real, and Gaughan (2018) discusses each. But two studies suggest that debt can also be the source of buyout failures, especially when deals are priced aggressively.

Kaplan and Stein (1993) examined how large management buyouts changed over the 1980s. As the decade went on, buyout prices rose relative to cash flow, required bank repayments accelerated so that cash flow covered debt obligations far less comfortably, public junk bonds replaced private subordinated debt, and management teams and dealmakers took more money out of the transactions up front. They interpreted this pattern as overheating in the buyout market, and the late-decade deals were the ones that most often defaulted. Debt did not create discipline in those deals; it created fragility, and the companies had little room to absorb a downturn.

Andrade and Kaplan (1998) studied 31 highly indebted transactions that later became financially distressed. They estimated the costs of financial distress at 10 to 20 percent of firm value. Their more surprising finding was that, measured from before the transaction to the resolution of distress, these deals still increased value slightly on net, which suggests that the operating improvements were real even when the financial structure failed. That supports my thread's argument: the operating gains were the source of value, and excessive debt subtracted from them.

Proverbs makes a similar observation, setting the careful planner, whose plans end in plenty, against the person in a hurry, who ends in want (Proverbs 21:5). The late-1980s buyouts Kaplan and Stein describe were hasty in exactly this sense. Prices were bid up, repayment schedules were compressed and fees were taken early, all in a rush to complete deals while financing was available. The diligent buyout, by contrast, sizes the debt to cash flows that have been carefully tested, leaves room for a bad year or two and pays the participants as value is created rather than at closing.

Your point about tax deductions deserves one more comment, because it is the argument buyout sponsors most often make to their own investors. The tax benefit of debt is real but limited by how much the company can borrow without approaching distress. Once expected distress costs rise faster than tax savings, more debt reduces value. Lenders' willingness to provide credit is not a reliable guide, because in the overheated years Kaplan and Stein describe, lenders and bond buyers competed as eagerly as the buyout firms did. Would you agree that the right amount of debt in a buyout is the amount the business can carry through a recession, rather than the most lenders will provide?

Reply to Dante

Dante, your thread on corporate restructuring argued that spinoffs often create value because they let each business be managed and valued on its own terms. I found your example of an industrial company spinning off its medical device unit persuasive, and the research supports your argument with an important refinement.

Cusatis et al. (1993) studied spinoffs and found that both the spun-off firms and their former parents earned significant positive abnormal returns for up to three years afterward. Much of the gain was concentrated in firms that later became takeover targets, which suggests that spinoffs often create value by making businesses easier for the right buyer to acquire. Daley et al. (1997) asked whether spinoffs improve operating performance, and found that it depends on focus. When the spun-off unit was in a different industry from the parent, the combined firms' return on assets improved after the spinoff; when the unit was in the same industry, there was no improvement. The value, in other words, came from removing an unrelated business that management had not been running well, not from the spinoff transaction itself.

That refinement fits your example well, since medical devices and industrial products share few customers or capabilities. It also connects to the discussion in Gaughan (2018) of why diversified firms sometimes trade at a discount: separating unrelated businesses lets investors and managers concentrate on each one.

Scripture offers an unusual parallel. When the herdsmen of Abram and Lot quarreled because the land could not support both of their flocks, Abram proposed that they separate, so that there would be no strife between them, and let Lot choose his land first (Genesis 13:8-9). The separation was generous, and it allowed both households to prosper in their own territory. A well-planned spinoff can work the same way: rather than forcing two businesses with different needs to compete for the same capital and management attention, it gives each room to grow. Abram's example also suggests that the parent should not keep the best assets for itself and saddle the spun-off unit with debt, a temptation the course readings note in some spinoffs.

Two practical questions follow from the research. The first is whether the spun-off unit receives a capital structure suited to its own business; parents sometimes transfer debt to the new company or pay themselves a large dividend from it just before separation, leaving it weaker than it should be. The second is management: a spun-off firm needs its own leadership with incentives tied to its own performance, which is part of how focus turns into better results. Do you know whether the company in your example gave the spun-off unit a reasonable capital structure, or did the parent load it with debt before the separation?

References

Andrade, G., & Kaplan, S. N. (1998). How costly is financial (not economic) distress? Evidence from highly leveraged transactions that became distressed. The Journal of Finance, 53(5), 1443-1493. https://doi.org/10.1111/0022-1082.00062

Cusatis, P. J., Miles, J. A., & Woolridge, J. R. (1993). Restructuring through spinoffs: The stock market evidence. Journal of Financial Economics, 33(3), 293-311. https://doi.org/10.1016/0304-405X(93)90009-Z

Daley, L., Mehrotra, V., & Sivakumar, R. (1997). Corporate focus and value creation: Evidence from spinoffs. Journal of Financial Economics, 45(2), 257-281. https://doi.org/10.1016/S0304-405X(97)00018-4

Davis, S. J., Haltiwanger, J., Handley, K., Jarmin, R., Lerner, J., & Miranda, J. (2014). Private equity, jobs, and productivity. American Economic Review, 104(12), 3956-3990. https://doi.org/10.1257/aer.104.12.3956

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Gaughan, P. A. (2018). Mergers, acquisitions, and corporate restructurings (7th ed.). Wiley.

Kaplan, S. (1989). The effects of management buyouts on operating performance and value. Journal of Financial Economics, 24(2), 217-254. https://doi.org/10.1016/0304-405X(89)90047-0

Kaplan, S. N., & Stein, J. C. (1993). The evolution of buyout pricing and financial structure in the 1980s. The Quarterly Journal of Economics, 108(2), 313-357. https://doi.org/10.2307/2118334

Kaplan, S. N., & Strömberg, P. (2009). Leveraged buyouts and private equity. Journal of Economic Perspectives, 23(1), 121-146. https://doi.org/10.1257/jep.23.1.121