Do Private Equity Firms Acquire Cheaply?

Do Private Equity Firms Acquire Cheaply?

Assignment Seminar Private Equity, December 2011

Group 3

Justyna Urbanska, justyna.urbanska@hotmail.co.uk, 06-30919617

Marleen Damsteegt marleen@damsteegt.eu 06-23890340

Rene den Uijl, 318741, rene_den_uijl@hotmail.com, 06-39218371

Marius Vasiliu 303404, marius@live.nl. 06-14408545

Johan-Paul Verschuure, 283512, JPVerschuure@yahoo.com, 06-41254364

Abstract

This paper studies whether private equity firms acquire cheaply compared to public firms. We investigate whether price premiums paid by private acquirers are lower than those of public acquirers. We performed a literature review to find the potential explanations offered by literature for this difference and focus our quantitative research on whether target and deal characteristics can explain the found differences. Subsequently we try to answer the question whether price premiums, deal and target characteristics change throughout a private equity wave.

To investigate this we used a data sample of 519 takeovers in the US between 2003 until present. These takeovers are for 100% of the shares of the company and financed with 100% cash. We find that private equity firms pay lower premiums than public equity firms. The premium paid changes over the stages of the private equity wave, especially for private equity firms. We find little evidence that deal or target characteristics are causing this premium difference, although we find there are differences in characteristics. We find little evidence that these characteristics change over the private equity wave although this can partially result from the limited size of the data sample.

1 Introduction

In the last decades private equity firms became significantly important M&A players. This led to increased debate among academic researchers and policymakers in addition to high interest by the media. To what extent private equity firms add economic value is often a central theme. This bigger attention was especially triggered by the strong increase in transaction volumes (Cumming, Siegel and Wright, 2007) and the cyclic character of these volumes referred to as private equity waves. Between 2001 and 2007 the leveraged buyout volume in the US$ increased from around 20 bn. US$ to 434 bn. US$ in 2007 (see Figure 1 LBO Transaction Volume in mio US$

). In less than 2 years times the transaction volume dropped in 2009 to levels even below the one of 2001.

Figure 1 LBO Transaction Volume in mio US$1

1 Source: Thomson One Banker

Most of the research has been focused on the sources of the seemingly high returns generated by the private equity. Some of the sources of returns suggested by literature are reduced agency costs by the use of debt (e.g. Jensen 1986), tax shield benefits (Kaplan (1989)), inefficient debt markets and expropriation of lenders (Ivashina, Kovner (2008)), operational improvements and good timing of exit benefiting from improved market circumstances at exit (Guo et al (2009)). Additionally high incentive schemes offered to the management could lead to more efficient running of acquired targets (Jensen (1986)).

Another source of better performance of private equity firms is simply that the premium they pay to the target is much lower when compared to premium paid by public acquires. Potential returns for private equity by acquiring target companies relatively cheap received less attention in literature. Bargaron et al (2009) find that the shareholders of the target company receive a 63% higher premium when a public firm makes the acquisition than when it is taken over by a private equity firm . Comparing the public equity to a private operating firm this premium is 35% higher. Also according to Officer et al (2010) a sole private equity seems to acquire their target companies cheaper than the private operating and public equity acquirers. Private Equity firms pay around 3%-11% less than private operating acquirers depending on which premium measure, significance level and timeframe is chosen. The difference found between sole private equity acquirers and public equity is in the range of 4.7-9.7% (depending on premium measure, significance level and timeframe). Nothing was reported on whether these results depend on the stage of the private equity wave in which the transactions were made.

In literature several explanations are investigated as to why there is a difference in price premiums found. Most article focus on differences in deal and target characteristics, finding that private equity targets are in general high cash flow companies with low growth options more levered, smaller in transaction size and have relatively lower R&D expenses (Bargaron et al (2009), Opler and Titman (1993), Roosenboom (2009)low operational risk (Groh and Gottschalg 2011)

This paper focuses primarily on whether private equity acquires companies cheaper in comparison to their public counterparts. If there are differences this raises questions whether these can be explained by different characteristics in the transaction deals? Or do target companies differ between private and public equity? Or does literature give potential other explanations for this potential difference in price? Second question central in this paper is whether differences between private and public transactions vary over the course of the private equity wave. Are premiums paid in booming phases higher than in the lower activity section of the wave? In their rush to invest in booming periods do private equity parties invest in different type of companies with different deal characteristics than in the more tranquil periods?

This article studies empirically whether the price premium varies between private and public acquirers. In this paper we follow a similar methodology as by Bargaron (2009). The price premium is defined as the transaction price paid in excess of the market prices of the target company before the announcement of the takeover was made. We determine the price premium for the acquisitions in our

sample by determining the buy-and-hold return over three different time frames. We additionally separate premium for the run-up and mark-up period which is consistent with the approach adapted in this article. More explanation of the premium methodology can be found in section 4.1.

Our study is based on a sample of acquisitions in the United States between 2003 ad present. The data sample is obtained from Thomson One Banker and Datastream.