Private Equity Transactions and the Bankruptcy Rate

Written by Robert K. Rajczewski, LLM; PhD Candidate at Goethe University Frankfurt

Introduction

Private equity (PE) is the business of buying and selling companies and connotes a wide variety of buyouts. The industry has recently risen to particular prominence, moving from the outer fringe of corporate and financial activity to its centre stage,[1] thereby becoming capitalism’s ‘new king’ in the early 2000s.[2] This spectacular transformation over the past three decades renders private equity the Cinderella of the M&A world. The financial crisis has naturally petered out the buyout activity due to the confluence of prevailing economic instability, regulatory shocks, lack of available financing and faltering investor confidence. However, as the dust from the global financial crisis is starting to settle, there are promising signs of resurgence in the industry, as illustrated by recent deals involving Dell and Heinz that arguably put an end to the post-financial crisis lull and pave the way for another private equity ascent.

The spirit of revived deal-making in the corporate world will certainly accentuate the anti-capitalist claptrap that is prevalent in certain corners. Since the Barbarians at the Gate[3] era of the 1980s, the industry has routinely been charged with all kinds of iniquity. However, academic studies of the first and second wave of PE transactions find for the most part positive real effects in respect of a variety of private equity-related variables such as financial performance, productivity and employment. What about the risk of default and the bankruptcy rate of buyouts? What is the magnitude of buyout failures and could this possibly engender a large-scale threat to the stability of the financial system? This will be briefly examined in the following section.

Academic Evidence  

Buyouts, in particular Leveraged Buyouts (LBOs), are characterised by high debt levels secured against a target’s assets. Unsurprisingly, this may increase the risk of financial distress and the likelihood of bankruptcy. At the onset of the recession, many commentators conjectured pessimistic prospects that the days of private equity are numbered and the chances of survival of PE-backed companies are slim. A 2008 BCG report went so far as to suggest that 50% of PE-owned companies would default on their debt by the end of 2011.[4] In 2014, we can say with utmost confidence that this grim prediction has not materialised, even though the global financial crisis resulted in the worst Siberian weather private equity firms had ever experienced. All of the factors that were responsible for pumping up the deal activity collapsed simultaneously[5] and in order to survive fund managers had to implement a variety of contingency measures in their portfolio companies. Despite these unusually challenging conditions only a small number of private equity-backed business failures took place.[6]

It is reasonable to assume that an adverse economic shock can lead to distress and that the high level of leverage commonly employed on LBOs can increase the incidence of defaults, restructurings and formal bankruptcies. A study by Kaplan and Stein (1993)[7] shows that bankruptcy rate varies with the business cycle. The authors analysed 41 US MBOs in the period 1980-1984, finding that only one firm defaulted and, further, that in a sample of 83 deals put together in the period 1985-1989 22 defaulted and nine of these eventually ended up in bankruptcy. The authors attributed the defaults to poorly designed capital and incentive structures. In a later study, Kaplan and Strömberg (2009)[8] examined 17,171 buyouts undertaken on a global scale between 1970 and 2007, finding that only 6% of deals ended up in reorganisation or bankruptcy. The LBO bankruptcy rate in 2006-2007 was a mere 3%. Assuming an average holding period of six years, the annual default rate amounted to 1.2% and was lower than the average default rate of 1.6% for US corporate bond issuers between 1980 and 2002. This low failure rate reflects what Jensen stated in his seminal paper Eclipse of the Public Corporation (1989), that ‘LBOs do get into financial trouble more frequently than public corporations do. But few LBOs ever enter formal bankruptcy.’[9]

Of special significance is the 2012 study by Wilson, Wright, Siegel and Scholes which assesses the economic and financial performance of virtually all UK PE-backed companies between 1995 and 2010.[10] This particular timeframe incorporates three unfavourable economic periods, that is, the recovery from the early 1990s recession, a minor downturn during 2000 and 2003 as well as the global recessionary cycle of 2008-2010. Based on their analysis, the authors reported that private equity transactions experienced higher profitability, productivity and growth relative to comparable non-buyout companies. Even though the study does not specifically deal with the bankruptcy rate, the results evidence that despite recessionary conditions fund managers succeeded in adding value to their portfolio companies, thereby diminishing the likelihood of failure. Moreover, a study of 839 French LBO deals from 1994-2004 by Boucly and co-authors (2011)[11] documented no unusual increase in bankruptcy rates post-buyout as compared to control firms. According to the study, 6.67% of targets and 6.7% of control firms will be bankrupt at some point and 4.17% of targets and 4.58% of control firms will be bankrupt within the three years after the PE transaction. This illustrates that there is only a marginal difference in the failure rate between PE-backed and non-PE-backed companies. A 2013 study by Lopez-de-Silanes, Phalippou and Gottschalg reported that approximately 10% of transactions resulted in bankruptcy.[12] The bankruptcy rate varied from country to country, with 9% in the UK, 12% in the US, 13% in Germany and 8% in France. Deals in Scandinavian countries stood out, with lower bankruptcy rates at 5%. Since the final sample contained 7,453 investments made in 81 countries between 1971 and 2005, the 10% failure rate should not be alarming in view of the extensive time horizon and varied geography, including developing countries.

Tykvova and Borell (2012)[13] investigated whether European buyout companies experience excessive financial distress ending in bankruptcy more frequently than comparable non-buyout firms. The study examined all buyout transactions from 15 countries in the period 2000-2008. The authors found support for the proposition that the private equity-backed companies do not trigger excessive financial distress or suffer from higher mortality rates. It was reported that distress risk increases post-buyout, nevertheless, it does not exceed that of comparable non-buyout companies in the first three years, unless backed by inexperienced private equity investors. Private equity experience shapes the choice of targets and plays a crucial role in reducing the risk of bankruptcy ex post. This is because more experienced private equity investors are better positioned to manage distress risks as contrasted with their inexperienced counterparts – they have superior selection, negotiation skills, information and value-adding abilities, which result in higher success rates, especially as proxied by IPO exits; they can react faster and more effectively when the portfolio company gets into financial difficulties due to their ability to obtain cheaper loans on more favourable conditions; and they are more eager to avoid failures for their reputation vis-à-vis investors and financial institutions is at stake. Inexperienced investors tend to make investments in more risky companies, hoping that impressive success stories will help them improve investor recognition and build good reputation with financial lenders. Perhaps unsurprisingly, this is the reason for a higher risk of financial distress and bankruptcy, which stems from the inability of these less capable investors to guide the acquired company through the restructuring and growth process, especially in recessionary conditions.

The critical role of experience is well documented and can be bifurcated into two investment phases: pre-transaction and post-buyout. Regarding the former, Meuleman and co-authors (2009)[14] reported that experienced investors do better in identifying potentially high performing companies due to superior selection skills and the ability to reduce informational asymmetries. They invest in stable sectors and in companies with low variance in revenues, profits and cash flow. As to the latter situation, more experienced buyout houses do better in the investment monitoring exercise, designing better organisational and strategic changes, identifying and exploiting opportunities for cost efficiencies and growth, as well as capitalising on well-developed business networks and repeated interactions with banks. Accordingly, their portfolio companies are better placed to withstand economic downturns. In this regard, Alperovych, Amess and Wright (2013)[15] have recently found that experience of private equity firms has a positive and significant impact on LBO efficiency levels, especially in the period immediately following the transaction. Further, Demiroglu and James (2010)[16] documented that deals involving reputable private equity groups are less likely to experience financial distress during the five years following the transaction. The authors analysed 180 US public-to-private LBOs between 1997 and 2007, finding that before 2001 ‘ten buyout firms filed for bankruptcy and three firms violated financial covenants but later received waivers’ and that after 2000 ‘only two firms…experienced financial distress, one experienced technical defaults…and another…filed for bankruptcy.’

Concluding Remarks

The crisis has raised relevant concerns regarding the subject matter, but probably more time is needed to obtain a full picture of the effects of the recent downturn on buyouts. As this brief review of academic literature has demonstrated, there is no compelling evidence to suggest that PE transactions significantly increase the bankruptcy rate, even during an economic downturn. The historic evidence of private equity performance as gauged by the mortality rate is rather favourable and does not indicate that PE-backed companies face a significantly higher risk of going bust than non-buyout firms. What is important, given the diverse nature of investments conducted by fund managers in various sectors, it is difficult to imagine systemic consequences for the economy. The likelihood is quite low that a string of highly leveraged buyouts would default and go bankrupt at the same time. Consequently, the systemic failure risk in the private equity industry is basically nonexistent and is quite unlikely to be a cause of future crisis. Naturally, in view of the magnitude of the recent financial upheaval some buyout companies must have flirted with failure and some PE-backed companies went bankrupt. Importantly, these were outliers, with no implications for the fragility of the corporate sector and the entire financial system.

NB, The author refers to bankruptcy as inclusive of insolvency in the UK.