buy-to-sell versus buy-to-keep: a product market theory of buyouts

Buy-to-Sell versus Buy-to-Keep:A Product Market Theory of Buyouts

Pehr-Johan NorbäckLars PerssonJoacim Tåg

Agenda

• Introduction

• General Framework

• A Product Market Theory of Buyouts

• Takeaways

Introduction

Private Equity Buyouts (LBOs)

Institutional Investors Banks

Targets

Private Equity Funds6-10 year

Targets

Private Equity Partners

Advantages

• ”Active” owners– Managerial ownership– Debt– Monitoring

Solve managerial agency problems

Question

Why do not public firms do the same?

Our Contribution

Develop a new framework

• When do buy-to-sell owners emerge in equilibrium?

• How does buying to sell affect strategic investments?

A Product Market Theory of Buyouts

• Why are buyout firms more ”active” owners than public firms?

• Is ”active” ownership a reason for their existance?

• Empirical predictions on differences in behavior

The General Framework

Buying to Sell or Buying to Keep

Stage 1: Acquistion auction

Stage 2: Investment

Stage 3: Exit

Stage 4: Long run

Buy-to-sellBuy-to-keep

k s

s s

k k

k s l

Difference in Investment Incentives

• Stage 2: First order conditions

• Equal investments only if

s k

k k k and

s s s.

# #

Ownership Depends on Investment

• Stage 1: Valuations

• Rankings: Inequality Definition Winner Winning bidI1 vkk vks vs k vkkI2 vkk vs vks k or s vkk or vsI3 vks vkk vs k vkkI4 vks vs vkk k vsI5 vs vkk vks s vsI6 vs vks vkk s vs

vs s , vkk k and vks k , s

Application:A Product Market Theory of Buyouts

Overview

• Public firms buy to keep (have assets)• Buyout firms buy to sell (trade-sale exit)

• Strategic investment is managerial ownership => Restructuring effort

• Debt, monitoring also works (”active”)

Structure and Timing


Stage 2: Compensation contract

Restructuring intensity

Stage 3: Exit auction

Stage 4: Product market interaction

BuyoutIncumbent l k, s

k , s

r k, r s

wkk r s

xAr l,xNAr l

k s

RAr k,RNAr k

RAr s,RNAr s

Stage 4: Product Market Competition

• Firms maximize:

• Nash-Equilibrium :

• Reduced form profits:

ix i,x i, r, z

i x i

x i ,x i ; r, z 0

RAr AxA r,

n 1

xNA r, . . . . ,xNA r, r, and

RNAr NAxNA r,

n 2

xNA r, . . . . ,xNA r,xA r, r.

#

#

Assumption 1

• Restructuring improves competitiveness:

dRArdr 0 and dRNArdr 0








k , s

r k, r s

wkk r s

xAr l,xNAr l

k s

RAr k,RNAr k

RAr s,RNAr s

Stage 3: Exit (Trade Sale)

• First price perfect information auction

• Incumbent valuation:

• General:

Restructured firm is obtained by an incumbent at price wkk r RAr RNAr

wkkr RAr RNAr

kr RAr sr RAr RNAr








k , s

r k, r s

wkk r s

xAr l,xNAr l

k s

RAr k,RNAr k

RAr s,RNAr s


• CARA preferences:

• Linear contract:

• Maximization

uw, r e wb, Cr

wb, b RAr F

r arg maxrEuw, r arg maxrb RAr F Cr

dRAdr Cr dr

d RA,r

RA,rr

C 0

Stage 2: Managerial Ownership

• Participation:

• Costs:

wb, Cr w

lr r F w Cr


• Incumbent:

• Buyout:

k arg max sr r

s arg max kr r

sr k

r dwkk r RAr

d

dRNAr dr

r d 0.

#

#


0

Marginal profit and marginal cost

s Managerial ownership k

d r d

sr

dRAr dr

dRNAr dr

r d

k r

dRAr dr

r d








k , s

r k, r s

wkk r s

xAr l,xNAr l

k s

RAr k,RNAr k

RAr s,RNAr s

Result 1: Buyout firms more ”active”

• Buyout firms more ”active” because they buy to sell

• Stronger incentive contracts:

• More restructuring: r s r k

s k








k , s

r k, r s

wkk r s

xAr l,xNAr l

k s

RAr k,RNAr k

RAr s,RNAr s

Stage 1: Equilibrium Ownership

• Valuations– Buyout

– Incumbent

• Rankings:

vs s wkk r s r s

vkk k RAr k r k RNAr k

vks k , s RAr k r k RNAr s

vks vkkvs vkk

vs vks vkkor vks vs vkk

Stage 1: Equilibrium Ownership

• Ownership depends on the sign of

Inequality Definition Winner Winning bidI1 vkk vks vs k vkkI2 vkk vs vks k or s vkk or vsI3 vks vkk vs k vkkI4 vks vs vkk k vsI5 vs vkk vks s vsI6 vs vks vkk s vs

vs vks

Result 2: Being ”Active” not enough

• Buyout firms need an advantage to emerge in equilibrium (preemption)– Lower restructuring costs; more experience– Tax shield of debt

vs vks wkk r s r s RAr k r k RNAr s RAr s r s RAr k r k .

# #

Since s k , vs vks 0 always hold

0

Marginal profit and marginal cost

s

Managerial ownership

k

d r d

sr

dRAr dr

dRNAr dr

r d

k r

dRAr dr

r d

Net acquisition profits

0 Managerial ownership

RAr r

RNAr

vsvks

vks vs 0

vks RAr k r k RNAr s vs RAr s RNAr s r s

Empirical Predictions

Buyout firms

• give management more intense incentive contracts

• Monitors more and takes on more debt• Does more restructuring => better

operational improvements• Preference for exit through a trade-sale if

IPO costs are large and restructuring not too expensive.

Evidence

• More intense contracts• More debt and board representation• Higher operational and financial

performance

• Leslie and Oyer (2008): debt and m.ownership returns to ”normal”

Other Applications of the Framework

Applications

• Reputational concerns:

• Protecting innovations:

• Asymmetric information:

s k

s T k

s T k

Takeaways

General Framework

• New framework for analysis of buy-to-sell and buy-to-keep ownership

• Maximizing sales price often not the same as maximizing long run value

• Affects investments, which in turn affects equilibrium emergence.

Product Market Theory of Buyouts

• Buyout firms are more ”active” owners because they buy to sell.– Optimal managerial ownership, debt and monitoring

higher than at public firms– Returns to “normal” post exit

• Being ”active” is not enough to outbid incumbents for assets– Preemptive motive– Expertise or tax shield needed

Thank you for your time!

buy-to-sell versus buy-to-keep: a product market theory of buyouts

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