private equity: past, present, and future

8 Journal of Applied Corporate Finance • Volume 19 Number 3 A Morgan Stanley Publication • Summer 2007

Private Equity: Past, Present, and Future

An Interview with Steve Kaplan, University of Chicago, July 26, 2007

Don Chew: Good morning, Steve, and thanks for your will-ingness to share your thoughts on private equity markets. In recent years, private equity has become a global movement, with a large volume of deals in the U.K. and continental Europe, and impressive growth in Asia. Meanwhile here in the U.S., we are now going through what might be viewed as the second great wave of private equity transactions. And with second great wave of private equity transactions. And with secondall the trouble in credit markets this past week, many people are suggesting that the peak of that wave has just passed.

The fi rst wave of U.S. private equity deals was probably nearing its peak when you were back at Harvard in the late 1980s fi nishing your Ph.D. thesis on management buyouts. And as a member of the fi nance faculty at the University of Chicago’s Graduate School of Business since 1989—and now a chaired professor and Director of the school’s Entrepreneur-ship Center—you have been a close observer of private equity markets for well over 20 years now. My plan is to spend the next hour or so drawing on your two decades of thinking and research on these markets to shed light on recent develop-ments, particularly the tightening of credit markets and other challenges and controversies now facing private equity.

More specifi cally, we would like to come up with answers to the following questions:

• How does the current wave of private equity deals compare to the fi rst wave of LBOs back in the 1980s?

• Why is private equity so controversial?• What do private equity transactions really accom-

plish—that is, how do they affect corporate performance, and are they good for the economy?

• How will the recent changes in credit markets affect

the future of private equity? And how will companies and the economy fare in a downturn or market correction?

• Are there lessons for publicly traded companies in the successes of private equity?

The Second Wave of Private EquityChew: Steve, what would you cite as the main accomplish-ments of the current wave of transactions? What are the notable high points, and how do they compare with what we saw 20 years ago?

Steve Kaplan: I think there are two. First is the size of the capi-tal commitments to private equity partnerships by outside investors. During the peak years of the fi rst wave of LBOs, which were 1986 through 1988, the industry was raising about $16-18 billion a year from the limited partners who provide most of the capital. Then, after declining and remain-ing at relatively low levels for the next fi ve or six years, the levels of capital raised by the industry began to rebound in the mid-1990s. After breaking the $20 billion barrier in 1995, capital commitments jumped to $80 billion in 2000. Then, after plunging with the general market decline of 2000-2001, total capital commitments really took off after 2003, exceed-ing $150 billion in 2006.

Now that’s total dollars committed by investors. But what about capital commitments as a fraction of total market capitalization? These too are at an all-time high. By the end of 2006, capital commitments were getting close to 1.2% of the total market cap of U.S. stocks, roughly double the 0.60% peak reached in the ’80s.

Because of the consistency of performance by its best fi rms, private equity

has established itself as a “permanent” asset class; there’s little doubt

in my mind that private equity is here to stay. And this means that

if there’s trouble in their portfolio companies, these fi rms have strong

incentives to work hard to minimize the damage. —Steve Kaplan

9Journal of Applied Corporate Finance • Volume 19 Number 3 A Morgan Stanley Publication • Summer 2007

So, to summarize, we saw large amounts of capital fl owing into private equity in the second half of the 1980s. There was also another major infl ow in the latter half of the 1990s, but that came to an abrupt halt when the market started down in 2000. But these fl ows have been dwarfed by the amounts pouring into the industry in the last three years.

In addition to the large capital commitments, we have also seen an unprecedented volume of public-to-private trans-actions in the last year or so. The peak volume of such deals in the 1980s was reached in 1989, the year of the $30 billion RJR deal. And the record level of private-to-public deals in 1989, which exceeded $50 billion, was not reached again until 2005. Then, in 2006, the volume of such deals jumped to almost $250 billion.

Chew: Why is all this public-to-private activity happening now? And why didn’t it happen in the late 1990s, when there was also a lot of capital coming into the industry?

Kaplan: I think there have been four major factors driving this activity. First, you need to have a lot of capital in the hands of the private equity investors. And as I just mentioned, capital commitments have reach unprecedented levels at present—and they were also very high in the late 1980s, and in the late 1990s as well.

What drives the growth in capital commitments? It gener-ally happens when investors have experienced good returns. In the mid-1980s, the buyout funds produced high returns, which led to lots of capital infl ows. The big buyout funds also had very good returns in 2003, 2004, and 2005, in part because they bought assets in 2001 and 2002 at prices that turned out to have been relatively low. And then, in 2005 and 2006, a huge amount of capital came pouring into the private equity partnerships—and that’s the fi rst necessary condition for public-to-private deals.

Number two, the lenders have to be lending. Lenders in the mid- and late-1980s were very happy to lend, until problems started to surface in 1989. And in the past few years, the lenders have been very happy to lend, at least until this July.

Number three, the relationship between interest rates and stock prices has to be attractive enough that the buyout funds can make money. I’ve calculated “earnings yields”—that is, earnings as a percentage of stock prices—less corporate bond rates since about 1980. These calculations show that earnings relative to bond rates were quite high in the 1987-1988 period, and they’ve been high in the past few years. This means that, during the late 80s and in the last two or three years, interest rates have been low relative to earnings. And this has allowed private equity fi rms to borrow a lot of money to buy public companies at premiums over current values and still be able to make the interest and debt payments. What these ratios also suggest, however, is that when we see a spike up in interest

rates and spreads, as we have just now experienced, or stock prices go up relative to earnings, we’re likely to see a drop in public-to-private activity.

So all three of those conditions that I just mentioned—high private equity capital commitments, easy credit, and attractive spreads between earnings yields and interest rates—were evident in the period 1986 to 1988. And those same three conditions were present from 2005 to mid-2007. Those are the likely reasons we saw the boom in private-to-public deals, and in private equity generally.

But there is one other factor that has likely been at work in the recent boom. Public company CEOs have become more receptive to going private because of recent increases in the regulatory burden of being a public company and because of heightened pressure from both shareholders and the media, all of which are greater today than at any time since the 1980s. In the 1980s, there was consider-able pressure on public company managements, but of a somewhat different kind. In those days, corporate raiders were threatening to take over ineffi cient companies, and going private was a means of escaping—or, in a few cases, teaming up with—the raiders. In the ’90s, by contrast, there was very little hostile takeover activity, CEO pay levels were rising sharply thanks mainly to the granting of stock options, and there was little reason for public company CEOs to consider going private.

Today, though, a part of the rationale for going private is to escape the less constructive effects of regulation and scrutiny by the press and shareholders. At the same time, the buyout fi rms have created a more positive image with CEOs. Among U.S. CEOs today, there is a greater understanding of how private equity works, of how it adds value generally and how the CEOs themselves can benefi t from the process.

Confl icts of InterestChew: That brings us to one of the main sources of contro-versy that now surround private equity: the confl ict of interest faced by CEOs of public companies when selling into a private equity transaction. As a matter of law or fi duciary duty, CEOs in such situations are supposed to seek the highest possi-ble price for their shareholders. But to the extent the CEOs expect to be part of the management team and hold a major equity stake in the new private fi rms, they have an incentive to sell at low prices, thereby shortchanging public sharehold-ers. How big a problem do you think this is?

Kaplan: That’s always a major concern in a public-to-private deal. People were talking about that 20 years ago and they talk about it today. Since the wave of deals in the ’80s, boards receiving offers to take companies private have been required to establish special committees to ensure arm’s-length and fairly valued transactions. And today’s safeguards against such confl icts are strong and getting stronger. There is a tremen-


dous amount pressure today on these special committees to drive deals that are as competitive as they can make them. The work of these committees is being scrutinized by the courts, particularly the Delaware court. Leo Strine, one of the court’s most prominent judges, has criticized a number of these transactions; and as I said, such scrutiny is applying tremendous pressure on managements and boards for these deals to be done at competitive prices.

Shareholders have also objected more vigorously to deals they think are underpriced. There have been a number of instances where highly vocal hedge funds have worked very hard to overturn deals approved by managements and boards. So the shareholders are not just saying, “That’s a 20% premium; let’s take it and go away.” They’re looking at the bids and asking, “Is the price right?”

But to come back to where I started, the confl icts in these transactions are real and worth worrying about. At the same time, it’s important to recognize that there are all kinds of potential confl icts of interest in business—and that, over time, as evidence of confl icts begins to surface, the markets react and companies fi nd ways to manage these confl icts. What we’ve seen lately in public-to-private deals is increased toughness on the part of special committees in scrutinizing the fairness of transactions. We also have pressure from the courts, and from other shareholders, including hedge funds, and from other potential bidders. And I think that’s our best protection against possible confl icts.

As I already mentioned, if you go back to the 1980s, there was also great concern about self-dealing in going private deals. And there are a couple of things we now know about the 1980s that are germane here. In my doctoral thesis, I looked at how the going private deals in the 1980s performed afterward in relation to the forecasts that were made public before the companies went private. What I found was that the companies slightly underperformed the forecasts on average. That is, while the deals of the ’80s did improve operating performance, the operat-ing improvements were not as great as projected in the forecasts. On the basis of these fi ndings, it’s very hard to argue that the companies were hiding something about their true value and prospects to hold down the transaction prices.

It’s also worth mentioning that the self-dealing criticism of 1980s buyouts probably peaked in 1987 and 1988 after the successes of the buyouts in the early and mid 1980s. Many people were saying, “We have a confl ict of interest problem here; these deals are terribly underpriced.” But, as we now know, many of those deals defaulted and returns to buyout investors in those deals were not great.

Chew: When you say these deals turned out badly, are you talking about their operating performance, or their ability to service their debt loads?

Kaplan: I’m talking about their ability to service their debt

and provide adequate returns to investors. The deals I looked at achieved signifi cant operating improvements, on average, but not as much as they were expecting. And that suggests that the main problem with the deals at the very end of the ’80s was that the transaction prices were too high. And if the prices turn out to be too high, that of course means that the selling public shareholders received a good deal, but the buyout investors did not. In other words, there is little evidence of a confl ict-of-interest problem in these cases. Whatever insider information the managers may have had at the time of their deals, it didn’t enable them to transfer value from their own shareholders. In fact, by overpricing these deals, the private equity fi rms ended up transferring value to the public shareholders.

So, this all leads me to conclude that the potential for self-dealing here is not a systemic problem. Yes, you want to think about this confl ict very carefully, but you have safeguards; you have the special committee and you have a shareholder vote. There is a lot of disclosure and there’s oversight from the courts. And market forces also appear to operate in ways that limit the problem.

Chew: There is one other possible solution to this problem, and that’s to ban all management buyouts because of the confl ict of interest. I think that’s Ben Stein’s solution.

Kaplan: That’s right—and that, by the way, was his solution back in 1987. It is worth pointing out that recent events, like those in the late ’80s, provide little support for his view of the world. As in the late ’80s, a number of the larger deals nego-tiated in the fi rst half of 2007 are now looking like very good deals for the selling public shareholders.

Effects on Companies and the EconomyChew: Another controversy that surrounds private equity—and this one has also clearly been around since the ’80s—has to do with their effects on both long-run corporate perfor-mance and on the general economy, including workers and government tax revenues. Critics of private equity, both in the U.S. and abroad, claim that LBOs destroy jobs, create short-term profi ts at the expense of long-run corporate values, and deprive governments of tax revenues through interest tax shields. Can you just talk a bit about these claims, perhaps by talking about what we now know about the earlier wave of U.S. transactions in the 1980s?

Kaplan: The evidence we have on U.S. buyouts in the 1980s is positive on the whole. My Ph.D. thesis found that the LBOs and MBOs done during the period 1981 to 1986 were followed by signifi cant increases in operating margins and cash fl ows, both in absolute terms and relative to their indus-try. And this fi nding has generally been confi rmed in later work by others studying both U.S. markets in the ’80s and


European markets in the ’90s. The evidence also strongly suggests that the transactions created value overall.

We still don’t have much data for U.S. buyouts in the 1990s since most of them were private companies or divisions of public companies. But given the recent fl urry of public-to-private deals, there should be a lot more data from the current wave in the next few years. And I would expect that the current wave, like the previous one, will generate operating gains and effi ciency improvements. That prediction is based on my view of what private equity fi rms do to add value to the companies they buy.

In the ’80s, the process of adding value in LBOs was one of fi nancial and governance engineering. It has three main and governance engineering. It has three main and governancecomponents. One is a strengthening of operating managers’ incentives by giving them—or making them buy—signifi cant equity stakes in their business, and by making these holdings completely illiquid, at least until a good exit opportunity comes along. The second piece is the use of high leverage—the debt of the average LBO fi rm in my sample jumped from 20% to 90% of total capital—to impose operating discipline on mature businesses with limited investment opportunities and ongoing capital requirements. And the third component is active oversight of operating management by the fi rm’s largest investors.

In today’s buyouts, fi nancial and governance engineer-ing continue to be important. However, most buyout fi rms try to augment fi nancial and governance engineering with another discipline—what I call “operational engineering.” In the late 1980s and afterward, with buyout fi rms increasingly bidding against each other to do the fi nancial and governance engineering, more of the value in the deals was going to the sellers. At the same time, incentives and board monitoring at public companies have also improved. The buyout fi rms have responded to such changes by developing industry and operating expertise that they can use to add value to their investments. Many of the fi rms have differentiated themselves by acquiring the industry knowledge to oversee the strategies and operations of their portfolio companies. And they have also created networks of operating executives—in many cases, highly regarded former CEOs—to ensure that their portfolio fi rms have the best managers and advice.

This increased focus on improving operations is a substantial change. My expectation is that the combination of fi nancial and governance engineering with operational engineering will lead to operating improvements and effi ciency gains in the private equity-funded companies of the recent buyout wave.

Chew: What about the effects of private equity on employ-ment?

Kaplan: Most studies that have looked at employment, includ-ing my own, fi nd that employment increases after buyouts,

though generally by less than in the rest of the industry. That shouldn’t come as a surprise because an important part of what buyouts do is to cut costs. Another part, however, is to try to fi nd new sources of profi table growth. And with the increased emphasis on operational engineering that I just mentioned, the search for growth is likely to be a growing part of the equation.

Chew: Could this greater emphasis on growth have something to do with the difference in capital structures between today’s deals and those of the ’80s? Where 90% debt to capital was the norm in the ’80s, today’s deals tend to have equity cush-ions of 20% to 30%. One interpretation of this change is that it represents an adjustment to over-levered capital struc-tures in the 1980s. But another, and perhaps more important, explanation is that the success of today’s PE deals is premised more heavily on growth and investment—and that, in such cases, more equity provides companies with greater assurance of being able to make the investments needed for growth. Does that sound plausible?

Kaplan: I think that’s true of some deals, but certainly not all. In some deals, the private equity fi rms are buying companies with the primary goal of taking out costs initially, and that means operating with fewer people. In such cases, growth could come later, but the fi rst order of business is stream-lining. In other deals, the investment thesis from the start is value added through better management of growth opportu-nities. I suspect today’s deals are a mix of those two types.

Chew: Do private equity fi rms tend to specialize in one of these two different types? In other words, would a fi rm like Clayton, Dubilier & Rice, with its longstanding reputation as an “operations” fi rm, probably be more oriented towards growth, or place a higher value on growth opportunities?

Kaplan: There’s more convergence among fi nancial engineers and operators than there was 20 years ago, with most of the larger fi rms relying on the methods of both disciplines. And, as I said, what makes today different from the ’80s is that most of the big fi rms, though not all, are now committed to operational engineering. That’s why most of them now have a pool of former CEOs or operating executives. They bring them in to advise on where there is fat that can be taken out and where there may be gains from outsourcing—but also on where the company ought to be growing and isn’t.

Why Do Public Companies Go Private…And Then Public Again? Chew: Another facet of private equity that troubles people is the sight of so many public companies going private and then returning to public ownership, with much higher values, often after very short periods of time. After all, if Michael


Jensen is right, and companies without large requirements for outside capital tend to be run better and be more valu-able as private companies, then why would such companies ever return to public ownership?ever return to public ownership?ever

And before I ask you to answer, let me try out on you my own explanation, which goes something like this: The LBOs of the ’80s, and probably later deals as well, added value in part by cutting capital spending on low-return projects in companies that, at least at the time, appeared to have no promising growth opportunities and thus no need for more capital. But in many of these cases, the very act of “pruning” the fi rm after going private could have created new opportunities for profi table growth—or maybe just given management the breathing room to look around and see the opportunities that were already there. Consistent with this idea, academic studies of such “reverse LBOs” have shown that, although capital spending gets cut when the companies go private, their spending returns to normal industry levels after they go public again. The case of Safeway under Peter Magowan is a nice illustration of that. The company cut capital investment after going private, reducing the number of stores, and added a lot of value before returning to public ownership. Then, after going public again, management spent heavily on refurbishing the smaller number of stores, and Safeway has continued to add a lot of value as a public company.

Kaplan: It is true that studies of reverse LBOs show that the companies that return to public ownership perform at least as well as their competitors, which suggests that the cutting process does not reduce their long-run value or impair their future growth potential. In fact, a recent study by Josh Lerner and Jerry Cao of almost 500 reverse LBOs that went public between 1980 and 2002 found that these companies signifi -cantly outperformed both other IPOs and the broad market over a three-to-fi ve-year period.

So, I think your argument about reverse LBOs is a reasonable explanation for many of the deals in the ’80s, and maybe for many after that as well. But I also think the growth component that gets built into today’s private equity deals is greater today than it was 20 years ago. That suggests to me that, in today’s buyouts, the pruning and growth are being thought about all at once, as opposed to the sequential process you just described. I also think that, even after the private equity partnerships realize some of this growth potential, they are still going to look to send their more successful deals back into the public IPO marketplace.

Chew: At the same time, I think it’s important to recognize that not every public company that goes private has plans to return to public ownership. You published a study in this jour-nal about 15 years ago called “The Staying Power of LBOs” that concluded that a little less than half the deals completed

before the end of 1986 had gone public by the end of 1990.

Kaplan: That’s right. And that result I interpreted as suggest-ing that there might be two different kinds of deals. One is where LBOs function as a kind of “shock therapy,” where the companies are improved under private ownership through cost cutting and/or growth, and then returned to public ownership once those changes have been made. The second kind are deals involving what I described as more or less permanent, steady-state, “incentive-intensive” organizations that are designed mainly to preserve effi ciency without much growth or outside capital. But my point here is that even the second type of company will have requirements for liquidity to cash out the private equity investors and individual manag-ers. In such cases, the companies can releverage and pay out a large dividend—or they may choose to sell to another private equity fi rm. In the case of the very large deals, however, a large refi nancing of this kind is going to be diffi cult to do. Instead, I think the logical exit will be to go public again.

Chew: Well, if you believe in the value of concentrated ownership, but would also like at least some of the liquidity associated with public markets, there’s a relatively new exit opportunity for private companies that don’t want to return to full-blown public ownership. And that’s the opportunity promised by recent extensions of the 144A market that are now being promoted by Wall Street to provide liquidity for otherwise private companies. Goldman Sachs has developed this as a fi nancing vehicle for Oaktree, and Apollo is supposed to be set to follow. And there’s likely to be other banks and their clients involved. My understanding is that the banks are encouraging companies to think of this not as a transition stage or fi nancing “half-way” house, but rather as a relatively permanent ownership structure.

Kaplan: Yes, that’s a very interesting development. Rather than releveraging or being sold to another private equity fi rm, companies can achieve a certain amount of liquidity while raising a relatively permanent kind of equity from a smaller group of investors, people who are presumably more sophis-ticated and less concerned about liquidity. We’ll see how that plays out, but I think that’s an interesting middle ground that has valuable elements of being private and being public. And, as you suggest, it could become an important exit opportu-nity.

Effects of High Leverage Chew: As you know, Steve, a lot of people are concerned about the systemic risk from the high leverage. And the recent trou-ble in the credit markets hasn’t done much to reassure people. Can you talk about the damage done by overleveraging in the ’80s, and its relevance if any for the current wave of deals?


Kaplan: Well, let me start by saying that there’s some good news on this front as well. As I already mentioned, the deals in the late 1980s were much more highly leveraged than those done in the ’90s and in recent years. The average debt-to-enterprise value in the ’80s deals was close to 90%; today the average is somewhere between 70% and 80%.

Second, the coverage ratios were substantially lower back then. It now seems hard to believe that, in many of the large deals done at the end of the decade, the EBITDA-to-interest was barely above 1.0X. Today, the average coverage ratio is about 2.0X.

The third important difference between now and then is that, in the case of the senior debt or term loans in the 1980s, companies were required to start repaying principal pretty quickly and typically had to repay all of it in six or seven years. Today the requirements to repay principal are much lower. And, at least through the fi rst half of this year, there were a number of “covenant-lite” deals where the fi rms didn’t have to repay much if any principal for, in some cases, six or seven years.

So, you have less short-term pressure on these companies, making it much less likely that companies won’t be able to make their debt payments, even in a downturn. And this means that we’re less likely to see the big concentration of defaults that we saw in the early ’90s. Now, it’s true that some companies may not be able repay the principal when it comes due six or seven years from now. But the day of reckoning is fi ve, six, or seven years off rather than one or two.

Chew: I’ve heard there’s also a lot of reorganizing of trou-bled companies taking place outside the courts these days. According to Mike Jensen, Drexel reorganized many of its highly leveraged deals in the early and mid-1980s using private exchange offers—and those exchange offers appear to have succeeded in keeping all but a handful of these deals out of Chapter 11, at least until the end of the ’80s. Today I’m told that a lot of hedge funds are taking positions in distressed companies with the aim of reorganizing them and, in some cases, taking control. And all this private workout activity has contributed to the remarkably low default rates on high yield debt that people like Ed Altman have been reporting.

Does it seem plausible to you that these new distressed debt investors are providing a more effi cient way of reorganizing companies outside the courts? And is this a value-preserv-ing process on the whole—or is it just a pushing off of the inevitable?

Kaplan: The evidence of the restructurings from the after-math of the ’80s is that the companies experienced only a modest decline in enterprise value, even if they went through Chapter 11. Since then, it is likely that the distress players have become more adept at reorganizing and restructuring effi ciently. For example, the prepackaged bankruptcy mech-

anism that started in the ’90s seems to incorporate many of the benefi ts of the private workout process into what are at least nominally court-supervised reorganizations.

The FutureChew: Well, the word “bankruptcy” brings us back to where we started—that is, with the current trouble in the credit markets and the growing pipeline of deals waiting for fi nanc-ing. How do you see the current situation playing out?

Kaplan: Well, I have two main scenarios, what I call my “posi-tive story” and my “negative story.” The positive story relies on the fact that the private equity partnerships that have raised the lion’s share of the capital in recent years are the big, well-estab-lished fi rms, many of which now have two decades of successful operation behind them. These are the fi rms that, as shown by my own recent work with Antoinette Schoar and by other studies, have provided investors with above-market returns on a remarkably consistent basis. Because of this consistency of performance by its best fi rms, private equity has established itself as a “permanent” asset class; there’s little doubt in my mind that private equity is here to stay. And this means that if there’s trouble in their portfolio companies, these fi rms have strong incentives to work hard to minimize the damage.

These fi rms are also the ones that, as I mentioned earlier, have committed the most resources toward acquiring a capability in operational engineering. They are the fi rms that have acquired industry expertise and operating executives who can advise their portfolio companies on how both to cut costs and fi nd growth.

The third piece of good news is that today’s deals have capital structures that, as I just said, are more fl exible and so less vulnerable to a downturn than they were in the ’80s. So all three of these elements—control over much of the capital by successful fi rms with a strong interest in the future of the industry, emphasis on operating improvements and growth, and more fl exible capital structures—all this suggests that the most recent wave of private equity will turn out, on balance, to have been good for the economy, in spite of the current troubles in the credit markets. Such transactions are creating more effi cient, better-run companies, and the costs of fi nan-cial trouble are likely to be manageable. And that’s been the verdict of fi nancial economists on the ’80s as well: debtholder losses were dwarfed by the increases in corporate productivity and shareholder value.

So that’s the positive story. What could go wrong? I have two major concerns. First is the possibility that the partners of the buyout fi rms give way to the temptation to make a lot of money even when the returns to their outside investors aren’t very good. Both my paper and the work of others suggest that the average return to private equity, net of fees, over time has average return to private equity, net of fees, over time has averagenot been particularly good; in fact it’s been slightly below that of the S&P 500. In other words, while the best buyout fi rms


consistently outperform, the majority of the other fi rms have failed to match the S&P 500.

How could the best buyout fi rms continue to win when their investors lose? The short answer is high management fees. A 1½% management fee on $20 billion of assets under management is $300 million. If you don’t have too many people to pay, you can do very well with that.

The second big concern has to do with the effect of huge capital infl ows on investor returns. In the past, huge infl ows have led to low returns. And, as I said earlier, this is the period with the largest infl ux of capital we’ve ever seen. And when there’s a fall in returns, the supply of capital will fall with it, lenders will be less willing to lend, and there will be fewer deals. And that, of course, is already happening. The leveraged loan market has clearly had a major readjustment and that will affect any deals that haven’t been fully priced or backstopped. Interest rates are higher, and that may hurt returns on the deals that have been done.

Chew: At the end of the 1980s, Mike Jensen was pointing to a similar “misalignment of incentives” in private equity—the fact that the sponsors weren’t putting in enough equity in relation to the fees they were taking out—as a sign of impending trouble. It was leading to lots of deals that were overpriced and, as a result, overleveraged. But he also argued that the capital markets were starting to adjust to the perceived problems—that is, the lenders were demanding tougher terms and the deal fi rms were putting more equity into the deals—when a wave of new regulation appeared in the form of FIRREA and tougher bank capital require-ments and, the fi nal nail in the coffi n, the LTV bankruptcy court ruling that made debt forgiveness a taxable event for the distressed companies. According to Jensen, it was this misguided wave of new regulation that turned a manageable problem into a fl ood of defaults followed by Chapter 11s. If the legislators and regulators hadn’t intervened, we would have seen far fewer defaults, and the overpriced deals would have gotten worked out in a lower cost way than it did. Do you share that view?

Kaplan: At least part of it. In the end, the deals did get worked out, though some of them ended up in Chapter 11. I agree that the lenders were restricted from doing things that they might have done otherwise because there was a lot of pres-sure from the regulators not to do very much. So, yes, I more or less agree with what Mike says on this. But I also think the costs of Chapter 11 turned out to be lower than most people feared.

Chew: You did a study of Campeau’s acquisition of Federated Stores, which was viewed by the press as one of the worst deals of all time. And as I recall, the bottom line of your study was that although Campeau overpaid by hundreds of millions

of dollars, and the fi rm went into Chapter 11 as a result, the entire process of leveraging the fi rm and running it through Chapter 11 ended up creating a huge amount of value. The debt load ended up driving a quest for effi ciencies prior to the bankruptcy; and when that wasn’t enough to stave off default, there was a change of ownership in Chapter 11 that produced wonderful results.

So, in that case, Chapter 11 accomplished what it is supposed to do—an M&A type transfer of ownership that turned out to be not only value-preserving, but value-increas-ing. But I guess my question is, how representative is the ing. But I guess my question is, how representative is the ingFederated story that you’ve documented?

Kaplan: I think it’s fairly representative. For some kinds of companies, Chapter 11 can be pretty destructive. But for the mature, cash-generating companies that tend to be involved in LBOs, the costs or value loss incurred during a reorganiza-tion are often not very large. Using a bigger sample of HLTs that defaulted, Gregor Andrade and I found that default and Chapter 11 just wasn’t that costly. From the onset of fi nan-cial distress, the companies lost between 10% and 20% of their value—an amount that turned out to be less than the value added by the deals from the time of the buyout bid to the time of distress. That study, along with my own work on Federated, provides a good illustration of the point that overleveraging and bankruptcy are not the end of the world. Companies were reorganized, in many cases ownership changed hands, and life went on.

So from a broad economic standpoint the costs of overle-veraging LBO-type companies are likely to be modest. The debtholders have some losses, some if not most of the private equity investment gets wiped out, and some employees do lose their jobs. But the value of the assets remains largely intact—and, in cases like Federated, even increases.

Lessons for Public Companies?Chew: Steve, you’ve also done a study with Jeremy Stein of MIT of the effects of high leverage on public companies—public companies—publicspecifi cally 12 public U.S. companies that did leveraged recaps—that is, large debt-fi nanced buybacks or special divi-dends—during the 1980s. One of the major fi ndings of that study is that the betas of these companies did not go up nearly as much as might have been predicted from the increases in leverage. And one interpretation is that highly leveraged companies seem to fi nd ways of managing down the risk of the assets after taking on all that fi nancial risk. Do such companies really do a better job of managing risks after lever-ing up; do they operate in a different way?

Kaplan: Well, that’s one interpretation, but there are really two possible stories here. One is that the betas are “noisy,” and so it’s hard to be completely confi dent in what they’re telling us. The other story is that the managers of highly


leveraged companies fi nd ways to reduce fi xed costs, which in turn reduces the companies’ operating leverage and betas. My guess is that both of these interpretations have some explana-tory power; it’s a little bit of both.

Chew: I think your study may be onto something pretty important. If you look at a transaction like IBM’s recent deci-sion to borrow and buy back 10% of its capital, your study seems to go a long way in explaining why the value of the stock went up so much, about 12% in the month after the announcement of the recap—or 8% relative to the gain in the S&P 500. It strikes me that there’s something going on here in terms of the corporate leverage-to-value function that certainly defi es M&M—and, as I said, it’s consistent with what you found in your paper.

There has been another small wave of leveraged recaps in the past few years; and, as we found in the ’80s, the market reaction to these transactions has been predictably positive. And I think your study with Jeremy may get to the heart of what’s going on here: As in the case of the private equity deals, management’s willingness to take on higher leverage is a signal that the company is now being run more effi ciently, or is that is about to be run more effi ciently.

Kaplan: The market reaction to recaps has been consistently positive for decades. When companies do large share repur-chases, their stock prices go up and when companies do large equity offerings, their stock prices go down. I think there are a number of reasons for it, but it’s related to the things we’ve been talking about. When you take on leverage, you reduce your taxes. And you also have a new pressure prodding you on, saying, “You have to make these debt payments, and therefore you’ve got to wring out some fat out of the company or manage it better.” Those two factors, the tax effect and the “feet to the fi re” factor, are at work when you do a large share repurchase. And they operate on an even larger scale when you do an LBO.

Chew: Dave and Diane Denis did an article in this jour-nal about ten years ago that looked at a sample of about 30 large recaps in the 1980s. They found a reduction in major acquisitions and other large investments after the recaps—investments that had received a negative market reaction, on average, when they were fi rst announced. After the recaps, the number of major investments fell, but the market response to the announcements of those fewer deals actually turned positive. So more evidence that high leverage can lead to value-increasing changes in corporate behavior.

Kaplan: That’s right, we now have a number of studies of leveraged recaps, and the results have been consistent across studies, covering different time periods and different coun-tries.

The Convergence of Public and Private Equity MarketsChew: In another recent development, buyout fi rms have arranged to buy majority stakes in companies like Clear Channel Communications, while leaving the public with minority stakes of about 30%. The idea is that such “stub” equity will continue to be traded either in the 144A market or over the counter, thus providing some liquidity for public stockholders along with the opportunity to benefi t from future increases in value.

In such cases, what has effectively been created is a hybrid ownership structure that combines control by a private equity fi rm with minority ownership by a relatively small group of public stockholders. And some people have suggested that this mix of private control and public ownership could provide the best of both worlds: the incentive strength and monitoring skill of a fi nancial sponsor along with the liquidity furnished by diversifi ed shareholders.

In a related development, we have also seen “sponsored” spin-offs in which a private equity fi rm will arrange to buy a large minority stake in a division of a public company that is about to be spun off. Since the remaining shares continue to be owned by the shareholders of the public company, the spun-off division also becomes a public company. One recent example was the purchase by Clayton, Dubilier & Rice of 47.5% of Sally Beauty Holdings, which was spun off by Alberto-Culver.

Kaplan: These are both interesting, and potentially valuable, applications of private equity methods to the governance of public companies. As I said earlier, many of the best private equity fi rms have developed operational capabilities to go along with their traditional fi nance and governance capa-bilities—and they are likely to prove successful in extending those capabilities to the governance of public companies with-out buying complete control. My guess is that we will see more of these transactions over time.

At the same time, we are seeing more of the activist hedge funds playing a role in public company governance, includ-ing determination of whether going private deals are fairly priced. Activist hedge funds, and some private equity funds as well, have been buying large minority stakes in companies and agitating for changes in operations or capital structure. But since they’re not buying control for the most part, I think you could view this kind of activism as another way that private and public equity markets are converging—or maybe “collaborating” is a better description.

But despite this trend toward convergence, I think it’s still true that for some of the changes that private equity fi rms want to make, they very much prefer to do them when the company is private rather than public.

Chew: I’m sure you’re right, but there may be cases where


going private is just not possible. For example, Elevation Part-ners, which is a relatively new buyout fi rm, bought a 25% stake in Palm Computer about six weeks ago. At the same time, they did a leveraged recap and paid a special dividend; and as a result, Palm is carrying a pretty heavy debt load, at least for a technology company. But, somewhat paradoxi-cally perhaps, the presence of a sponsor is said to be giving Palm some leeway, some fl exibility, that they would not have with 100% ownership by the public markets. The company reported fairly poor results about one month ago—and people are saying that the presence of the buyout fi rm gives them a longer time period—say, a two-year investment horizon—to turn things around. In this sense, it may be giving them one of the benefi ts of private ownership—the ability to tune out the distractions caused by market volatility—without actu-ally going private.

Some people have even suggested that public companies should actively seek out large minority investments by private equity fi rms and activist hedge funds. The companies could choose a particular sponsor or hedge fund whose capabili-ties offer a good fi t and say to them, “Can you invest in us? Here’s 25%.” If this were to happen, the public companies would effectively be borrowing the fi nance and governance apparatus of private equity—and perhaps some of the operat-ing expertise as well—to increase their own values. This way much of the value increases would be shared with the public

shareholders; and perhaps more important, the companies could be proactive, taking matters into their own hands, instead of just reacting to demands by hedge funds.

Whether any companies actually will choose to go down that path remains to be seen. But it seems like a logical next step.

Kaplan: I agree that we are likely to see more of this kind of collaboration between private and public equity, particularly if the leveraged loan market remains unsettled.

Chew: That sounds like a good place to end. Thanks again for joining us, Steve, and maybe we can get together in a year’s time to test your predictions.

Kaplan: I’d like to do that.

steve kaplan is the Neubauer Family Professor of Entrepreneurship

and Finance, as well as Faculty Director of the Polsky Entrepreneurship

Center, at the University of Chicago’s Graduate School of Business. Along

with his many published papers on private equity and entrepreneurial

fi nance, and on corporate governance and M&A, Steve has been recog-

nized as one of the top-rated business school teachers in the country. He

also serves on the boards of three companies: Accretive Health, Colum-

bia Acorn Funds, and Morningstar.

private equity: past, present, and future

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