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Roland Cornelius Südhof

TC 660H
Plan II Honors Program
The University of Texas at Austin

May 1, 2010

Michael B. Clement, Ph.D.

Department of Accounting
Supervising Professor

Jonathan Cohn, Ph.D.

Department of Finance
Second Reader

Author: Roland Südhof

Title: Leveraged Buyouts from 1999-2009: Is Bigger Really Better?

Supervising Professor: Michael B. Clement, Ph.D.

As the amount of capital and credit available to private equity surged from 2000 to

2007, many private equity firms dramatically increased the size of their transactions, commonly

referred to as leveraged buyouts (LBOs). What was the rationale behind these increasingly large

LBOs? This paper presents the hypothesis that larger transactions opened up a new group of

potential targets and allowed private equity firms to acquire companies on more favorable

terms due to less competition from other financial buyers. Based on a study of 446 public-to-

private LBOs announced between 1999 and 2009, I conclude that the relationship between size

of the target (measured by the total transaction value of the LBO) and valuation (measured by

Enterprise Value to EBITDA) is different for small and large LBOs. For LBOs with transaction

value ranging from $100 million to around $5 billion, the LBO price tends to increase with the

size of the target. However, evidence suggests that once an LBO exceeds around $5 billion in

transaction value, price remains static as deal value increases. After exceeding $10 billion in

transaction value, price falls substantially with increases in deal size. This result supports my

hypothesis that private equity firms pursue larger deals in pursuit of better deal economics.

Table of Contents

Introduction .......................................................................................................................................... 4
Section 1: The Dynamic Transformation of Private Equity ................................................................ 9
1.1 Private Equity From 1980-1999 ................................................................................................. 9
1.2 Planting the Seeds of the Boom: 1995-2003 ..........................................................................14
1.3 The Fundraising Boom of 2003-2007 ......................................................................................17
1.4 The Role of Credit in LBO Activity............................................................................................20
1.5 Capital and Credit Concentrated in Large Funds....................................................................22
1.6 The Institutionalization of Private Equity ...............................................................................27
Section 2: A Survey of Academic Research on LBO Returns ............................................................30
2.1 Performance Drivers of LBOs...................................................................................................30
2.2 Money Chasing Deals Phenomenon .......................................................................................33
2.3 Buyout Pricing ...........................................................................................................................36
2.4 My Hypothesis ..........................................................................................................................39
Section 3: Study of Public-to-Private LBOs 1999-2009 ....................................................................41
3.1 Methodology ............................................................................................................................41
3.2 Composition of the Dataset .....................................................................................................45
3.3 Regression Results ....................................................................................................................48
Conclusion ...........................................................................................................................................63
Appendix A ..........................................................................................................................................65
Appendix B ..........................................................................................................................................67
Appendix C ..........................................................................................................................................71
Appendix D ..........................................................................................................................................73
Glossary ...............................................................................................................................................77
Bibliography ........................................................................................................................................81
Acknowledgements ............................................................................................................................85
Biography ............................................................................................................................................86


From 1999 to 2009, the deal value of leveraged buyouts (LBOs) 1 increased dramatically

from $39 billion to $518 billion in 2007, only to fall back to $76 billion in 2009.2 This period of

rapid private equity growth was characterized by one phenomenon above all others: steadily

increasing transaction sizes. In fact, average LBO size almost tripled from 1999 to 2007. 3

Why did private equity firms dramatically increase the size of their LBOs during this period? In

this thesis, I present the hypothesis that the ability of a select group of private equity firms to

acquire larger companies opened up new targets that were previously unavailable for buyouts.

Because only a small handful of firms had the buying power to acquire these large targets, large

and established private equity firms faced less competition from other buyers.

The research presented in this thesis provides insight into the economics driving private

equity activity and contributes to the current literature on this topic with a unique and

unusually large dataset. Academia and the media tend to focus exclusively on the conditions

that make large transactions possible, while often overlooking private equity firms’ motivations

behind acquiring increasingly large LBO’s. This thesis gives a unique perspective on private

equity activity by focusing on the incentives driving the private equity firm.

Economic theory states that prices should rise when demand increases and supply stays

constant. There is reason to believe this supply and demand dynamic should apply to private

equity. Theoretically, as the amount of capital committed to private equity increases, so should

For a complete description of terms used in this paper, please see the glossary on page 77.
2008 Preqin Global Private Equity Review, p. 90
Data from Capital IQ, taken from Kaplan and Strömberg (2009)

the competition for deals, thus driving down returns. This hypothesis was put forth by Gompers

and Lerner (2000) and is referred to in academic literature as the “money chasing deals”

phenomenon. 4 If the money chasing deals hypothesis is valid for private equity, then the ability

to buy larger companies should open up a new group of LBO targets and decrease competition

from other private equity firms. According to this hypothesis, the overall favorability of large

deals should therefore be greater than smaller deals conducted during the same period. To

better understand the theoretical underpinnings of this hypothesis, it is necessary to establish a

clear conceptual understanding of how private equity and LBOs function.

Private equity firms gather capital commitments from investors for a specific fund. This

structure operates as a limited partnership, where private equity firms act as the General

Partner (GP) and investors act as the Limited Partner (LP). The mechanism by which investors

commit capital to private equity funds is especially significant. When a fund is raised, investors

do not provide cash to the GP. Investors sign a contract that they will provide a certain amount

of cash, called committed capital, when the GP has found a good investment opportunity. 5 It is

very uncommon for a GP to leave committed capital un-invested. This tendency is largely a

result of the fee structure of private equity funds, which incentivize GPs to invest the capital,

even if the expected return is not very high (see Appendix C).

Gompers and Lerner (2000) study the money chasing deals phenomenon in venture capital firms. However,
research from Ljungqvist, Richardson, and Wolfenzon (2007) and Kaplan and Strömberg (2009) indicate the money
chasing deals hypothesis applies to buyout funds as well.
Private equity funds usually have a life of 10-13 years during which the GPs can continue to draw capital from
investors. The amount of capital that is committed to private equity funds but has not been invested is called “dry
powder” (see Appendix B).

The private equity firm (also referred to as the GP in this paper) uses capital from

investors to invest in corporations following a variety of strategies. 6 The most prevalent

strategy employed by private equity firms is the Leveraged Buyout (LBO). This strategy consists

of investing capital by buying corporations or divisions of corporations using large amounts of

leverage (usually 60-80 percent of the capital structure). The largest and most prominent LBOs

in recent years have been “public-to-private” LBOs, where a private equity firm acquires a large

public corporation and then takes the corporation private. Public-to-private LBOs make up the

overwhelming majority of all LBOs by deal value. In addition, public-to-private LBOs have the

best data available. For these two reasons, I will focus on public-to-private LBOs in this thesis.

Private equity funds usually have strong covenants restricting what type of investments

the GP can make. If a private equity firm does not find any good investment opportunities for

an LBO, it cannot choose a different way to invest the capital. Therefore, given the strong

financial incentive to invest all the capital committed to a private equity fund, it is likely that

private equity firms will continue to execute LBOs even when the transactions are not favorable

to the buyers. Furthermore, there are a limited number of targets because only a few

corporations are good LBO targets. 7

It is plausible therefore, that a private equity firm might seek to escape the inevitable

decrease in general deal favorability when LBO activity increases by acquiring larger targets.

These transactions face less competition from other private equity firms and should be less

affected by the increased competition from other buyers.

More information about these strategies can be found in the Glossary under “Private Equity Firm.”
A good LBO target has very stable cash flows, low debt, growth opportunities, operational inefficiencies, and a
strong asset base.

I directly test this hypothesis through a study of 446 public-to-private LBOs announced

between 1999 and 2009 in the United States and Western Europe. My study focuses on two key

variables of an LBO: size, which refers to the total transaction value of the buyout, and price,

which refers to deal favorability and is independent of size. Price is measured by the valuation

multiple Enterprise Value to EBITDA. My study shows that there is no significant linear

relationship between LBO size and price. The price of LBOs with transaction values from $100

million to around $5 billion increases with the size of the transaction. However, after this point,

price is stable and eventually decreases as transactions get larger, indicating that larger

transactions are more favorable than smaller ones. This result is robust across a variety of

changes to the dataset. However, this study is not meant to be the last word on this subject

because the study only tests pricing and not the ultimate returns of each LBO. At this point,

these LBOs are too recent to make conclusions on their returns.

This research is significant because it presents a new perspective for studying LBOs and

private equity. Past research has largely focused on what made large transactions possible, thus

leading to an emphasis on changes in credit conditions and capital allocation. This thesis

addresses not how the LBO boom was possible but why private equity firms chased the size

that characterized the LBO boom.

The rest of this thesis is organized as follows. Section 1 gives a detailed history of private

equity, drawing heavily on academic research and industry data from Preqin, the alternative

asset research and consulting firm. I use this data to show that private equity has changed

dramatically over the last decade as a tremendous amount of credit and capital was made

available to the largest and most experienced GPs. I argue that these changes have made

certain private equity firms Wall Street institutions rather than mere investment vehicles, and

that their newfound clout is inextricably related to the size of funds and transactions.

Section 2 takes a deeper look at recent research from academia on private equity

performance and valuation. Section 2 establishes the increased role of investment selection

and timing in delivering returns for LBOs, as well as discussing the effect that an increase in

capital committed to private equity has on returns (the so-called “money chasing deals” effect).

Section 2 concludes with a discussion of previous research on LBO pricing.

Section 3 presents my research on the determinants of LBO pricing from a dataset of

446 public-to-private LBOs announced between 1999 and 2009 in the United States and

Western Europe. My analysis concludes that larger LBOs were priced more favorably than

smaller LBOs and that pricing became especially favorable past the $25 billion mark.

Section 1: The Dynamic Transformation of Private Equity

This section gives a brief history of private equity activity since 1980. The history of

private equity is usually divided into two booms: 1986-1989 and 2004-2007. In this section, I

aim to go beyond this distinction by describing how private equity activity adapts to changes in

credit conditions and investor sentiment. This section is organized as follows. First, I discuss

trends in the types of transactions completed by private equity. Then, I outline the underlying

macroeconomic drivers of private equity activity and describe what drove the large increase in

private equity activity from 1999-2009. This discussion is important because it demonstrates

the enormous changes that have occurred in private equity over the last decade and informs

the reader on the historical significance of these changes. This understanding is necessary for

an appreciation of the increased importance of private equity on “Wall Street” as well as the

magnitude of the money chasing deals effect. Beyond this section, Section 2 discusses how

recent academic literature shows that price is an important determinant of LBO returns and

reviews previous research on LBO pricing. Section 3 presents the results of my analysis.

1.1 Private Equity From 1980-1999

The following discussion describes how private equity evolved from the boom of the

late 1980s to a more subdued 1990s.

Michael Jensen’s seminal 1989 paper, “The Eclipse of the Modern Corporation,”

captures the attitude of private equity during the 1980s. Jensen argues the publicly held

corporation has “outlived its usefulness” and that a new type of corporation, privately held with

empowered management and a leveraged capital structure, will inevitably replace publicly held

corporations because they will deliver better returns. These returns are a result of better

governance due to ownership concentration and leverage constraints. Jensen argued the

benefits of this new form of governance are undeniable and will result in organizations

following this governance structure long-term. As reflected in Jensen’s paper, private equity

during this period was seen as a way to arbitrage differences in management and capital


A year later, Jensen’s claims of a new long-term organizational structure seemed

increasingly doubtful as the number of buyouts plunged after the crash of the high yield bond

market. Furthermore, Kaplan (1991) showed the median time for private ownership of LBO

companies was 6.8 years, giving evidence that the LBO structure is not as sustainable over the

long-term as Jensen predicted. But Jensen’s argument contained a kernel of truth. Though LBOs

never became a long-term corporate structure, the values and management ideas

demonstrated in his work predated a revolution in corporate strategy and management over

the next two decades.

Academic research on this period emphasizes three key drivers of LBO returns: financial,

governance, and operational engineering (Kaplan and Strömberg, 2009). Jensen (1989) focuses

on the financial and governance changes private equity firms bring to their portfolio companies.

He argues that increased management ownership, as well as the illiquidity of this ownership,

gives management incentive to perform. Leverage is also valuable because it reduces what

Jensen calls the “free cash flow” problem, in which companies with excess cash allocate capital

inefficiently rather than returning it to shareholders. Operational engineering is also a

fundamental driver of value in an LBO. Today, most large private equity firms employ industry

specialists to enhance operational improvements (Kaplan and Strömberg, 2009). However,

academic research suggests LBOs during the 1980s still benefited from operational

improvements. Kaplan (1989) found that operating income to sales increased by 10 to 20

percent, suggesting significant cost improvements in portfolio companies. Similarly, Lichtenberg

and Siegel (1990) found from a study of 1,100 post-LBO manufacturing plants that total factor

productivity growth is significantly higher in LBO plants than productivity growth in other plants

in the same industry.

The collapse of the high-yield bond market brought large public-to-private LBOs to an

abrupt halt in 1989. But by some measures, overall private equity growth continued. The

number of LBOs from 1990 to 1994 was actually greater than from 1985-1989, though the total

enterprise value of deals was significantly lower (see Figure 1.1).

There is little that suggests the rationale behind private equity from 1990-1999 was

different from before. Private equity turned away from large public-to-private deals and

embraced smaller, less public, and less leveraged acquisitions, focusing on LBOs of private

companies or divisions of public companies (see Figure 1.1). Kester and Luehrman’s study of

Clayton, Dublier, & Rice (1995) as well as Baker and Smith’s book on Kohlberg Kravis Roberts

(1998) suggest private equity was operating as it had in the 1980s, though deals were smaller

and less highly leveraged. The momentous growth of private-to-private deals from 1995 to

1999 shown in Figure 1.1 reflects the increasingly blurry line between venture capital and

private equity during this period as private equity firms increased their activity in the rapidly

growing technology, media, and telecom (TMT) space.

Fig. 1.1: Private Equity Activity 1985-1999 8

1985–1989 1990–1994 1995–1999

All $257,214 $148,614 $553,852
Public-to-Private $126,035 $13,375 $83,078
Transaction Type9 Private-to-Private $79,736 $80,252 $243,695
(Enterprise Value, Divisional $43,726 $46,070 $149,540
in millions USD) Secondary $5,144 $8,917 $72,001
Distressed $0 $1,486 $5,539

In retrospect, Kester and Luehrman’s (1995) argument that the leveraged buyout was

due for a comeback turned out to be remarkably prescient as the number of LBOs surged after

1995 (see Figure 1.2). As evident in Figure 1.2, public-to-private deals account for a small

percentage of the total number of private equity deals but a very large percentage of the total

value of private equity deals. 1995-1999 also saw a renewed interest in pursuing larger targets.

Data from Capital IQ
For a thorough discussion of the different transaction types, please see the Glossary.

Fig. 1.2: Growth of LBO Transaction Types 1980-2007 10

Public-to-private LBOs were rehabilitated in the late 1990s after having lost their

popularity on Wall Street after the 1980s. Main Street had an especially negative view of LBOs,

associating private equity buyout activity with layoffs and liquidation. These views are reflected

in mainstream business articles such as Susan Faludi’s Pulitzer Prize winning article in the Wall

Street Journal, “The Reckoning: LBO Yields Vast Profits but Exacts a Heavy Human Toll.” But

even academic criticism of LBOs picked up after the end of the boom. Rappaport (1990) argued

LBOs are “shock-therapy” that put inefficient firms under intense stress to bring about quick

and not necessarily lasting change, much in line with the Main Street argument that private

equity is the same as “flipping houses.”

Data from Strömberg (2008)

The 1980-1999 period provides a few clear takeaways on the behavior of private equity.

Private equity activity is highly cyclical, especially in the kind of deals that get done. This

cyclicality is grounded in private equity’s ability to quickly adapt to market conditions. Cheap

credit made public-to-private deals especially lucrative in the late 1980s. Enormous growth in

the TMT space during the 1990s fueled a surge in private transactions. It is common to

distinguish private equity into two booms: 1986-1989 and 2004-2007. But this classification

ignores the less public booms that occurred in industries and transaction types. Taken as a

whole, private equity has proven to be incredibly adaptive and persistent. The fundamental

drivers of the business are constantly in flux and range from tax laws to macroeconomic trends

and management theory.

1.2 Planting the Seeds of the Boom: 1995-2003

The late 1990s and early 2000s were important in restoring interest in large public-to-

private LBOs and thus planted the seeds of the 2004-2007 boom. As public-to-private deals

picked up in 1995, reputational differences in the industry started to emerge. Large,

experienced funds received increased attention by the press due to the size of these funds’

transactions. By 2003, there was a perception among investors that large funds outperformed

smaller ones. This perception is reflected in an industry newsletter commending the

outperformance of a select group of these large funds from 1995-2000.11 This perception is also

Preqin PE Spotlight May 2006

evident in the Yale Endowment manager’s (David Swensen) highly influential book on portfolio

management, which recommends investing in private equity funds with experienced GPs. 12

The late 1990s set a precedent that drove private equity fundraising through the rest of

the decade. The heightened reputation of a group of large and experienced buyout firms during

this period was not just perception, but rooted in actual performance. The outperformance of

larger funds from 1995-2003 is supported by a study on LBO performance by Kaplan and Schoar

(2005) as well as data from Preqin (Figure 1.3). Figure 1.3 depicts the average return for a given

vintage year and clearly illustrates the outperformance of the largest private equity firms.

Vintage year refers to the year a private equity fund is created. For example, the average return

of a fund started in mid-1995 is 10 percent for both large and small funds.

Fig. 1.3: Largest Third of Funds vs. All Other Funds 13

David Swensen, Pioneering Portfolio Management
Preqin PE Spotlight June 2007

The outperformance of larger funds from 1995-2003 coincided with an increased

interest in private equity as a viable asset class and investment vehicle. An innovation in

investment management theory (specifically Modern Portfolio Theory) during this time set the

stage for massive increases in private equity fundraising from institutional investors. This

innovation was that increasing allocation to private equity would increase a portfolio’s risk-

adjusted return because private equity returns are historically not strongly correlated with the

returns of other asset classes. The pervasiveness of this new fund management strategy is

reflected by the popularity of Yale University endowment manager David Swenson’s “Yale

Model.” Swenson achieved an annual return of 16.3 percent from June 1998 to June 2008

(during which the S&P 500 returned 2.9 percent annually), partially by increasing his fund’s

stake in private equity from 3.2 percent to 20.2 percent.14 Swensen championed his approach

in speeches and a successful book, Pioneering Portfolio Management (2000). Other

endowments followed suit and either emulated Swensen’s strategy or hired his employees. By

2007, 42 percent of endowments were allocated to alternative investments compared to 23

percent in 2000.15

Other institutional investors have also followed the Yale Model. According to the

European Private Equity & Venture Capital Association, pension funds took the lead as the main

source of capital for private equity deals in 2006, representing 25 percent of the total funds

raised.16 Private equity allocation by pension funds has continued to rise at an astronomical

pace. The Private Equity Analyst reports that by the beginning of 2008, the top four investors in

Golden, Daniel. "Cash Me If You Can." Portfolio Magazine, March 18, 2009.
Commonfund, “Sources of Endowment Growth at Colleges and Universities.” www.commonfund.org
Gilmore, William. “Pension Funds Warm to Private Equity.” Global Investor; May2007, Issue 202, p46-47

private equity were CalPERS (California Public Employees’ Retirement System), CalSTERS

(California State Teachers’ Retirement System), PSERS (Pennsylvania Public School Employees’

Retirement System), and the Washington State Investment Board. 17

1.3 The Fundraising Boom of 2003-2007

The prevalence of the Yale Model among institutional investors brought capital flooding

into private equity. As illustrated in Figure 1.4 below, private equity fundraising grew at an

dramatic rate from 2003-2007, although by the fourth quarter of 2009 quarterly fundraising

had returned to 2003 levels.

Fig 1.4: Quarterly Private Equity Fundraising 2003-200918

Private Equity Analyst. 2008. 2007 Review and 2008 Outlook. New York: Dow Jones.
Preqin Private Equity Spotlight Jan 2010, Vol 6 Issue 1

The growth in private equity assets under management from 2003-2007 far outstrips

any other period in the history of the asset class. By 2007, private equity firms managed more

than $2 trillion in assets.19 The number of LBOs grew from 1,334 in 2004 to 2,556 in 2007.20 But

far greater than the growth in the number of deals is the growth in deal value, reflecting the

trend in private equity to pursue larger targets. The total LBO deal value in 2007 was $579.7

billion. A decade earlier, total LBO deal value was only $39.3 billion, implying an annual growth

rate of 138 percent.21

Capital raised by private equity has increased from $98 billion in 1997 to $518 billion in

2007, growing 43 percent annually. 22 The number of funds raised annually during this period

also increased from 382 to 779, for an annual growth rate of 10 percent.23 The stark differences

between the growth rates of deal value, capital raised, and number of funds (138 percent, 43

percent, and 10 percent, respectively) underscores recent trends in private equity. Deal value

has grown more than capital raised because leverage used in transactions has increased

considerably. The amount of capital raised annually has increased more than the number of

funds because private equity funds have become larger. The difference between the growth in

the number of deals and the value of deals from 1999 to 2009 shown in Figure 1.5 highlights

the trend of increasing transaction values.

2008 Preqin Global Private Equity Review, p. 12
2008 Preqin Global Private Equity Review, p. 90
2008 Preqin Global Private Equity Review, p. 90
2008 Preqin Global Private Equity Review, fig. 3.5, p. 36
2008 Preqin Global Private Equity Review, fig. 3.5, p. 36

Fig 1.5: The Number and Value of Deals by Year 24

As suggested earlier, capital committed to private equity firms were not allocated

evenly across fund sizes. As shown in Figure 1.6, the growth of mega buyout funds was

significantly greater than the growth of middle-market funds. Mega buyout funds 25 raised only

$20 billion in the first half of 2004 but raised more than $100 billion in the first half of 2007,

implying an annual growth rate of 133 percent. Middle market funds 26 raised about $10 billion

in the first half of 2004 and $20 billion in the first half of 2007, for an annual growth rate of only

33 percent.27

Private Equity Spotlight Jan 2010, Vol 6 Issue 1
For 2005-2008, mega buyout fund refers to funds larger than $4,500 million. Due to the smaller fund sizes
before 2005, mega buyout refers to funds larger than $2,000 million for the years 1997 to 2004. This classification
is made by Preqin.
For 2005-2008, a middle market fund is classified as a fund between $501-1,500 million assets under
management. For 1997 to 2004, the middle market classification is applied to funds with assets under
management of $301-750 million. Again, this distinction is made by Preqin.
The fundraising of small and large buyout funds reflect the same trends of mega and middle-market fundraising.
From 2005-2008, Preqin distinguishes small and large buyout as funds with assets under management less than
$500 million and between $1,501-4,500 million, respectively. From 1997-2004, small buyouts refer to funds with

Fig. 1.6: Fundraising for Different Sized Funds 2004-2007 28

Mega Buyout Fundraising Mid-Market Fundraising

1.4 The Role of Credit in LBO Activity

Capital clearly flooded into private equity at unprecedented rates in the 2000s and

favored larger funds. However, capital is only one half of the story. Equally important is the

dramatic increase in the availability of credit. This section describes the role of credit in driving

LBO activity during the late 1980s and 2000s.

Kaplan and Stein (1993) show that cheap debt from high-yield (junk) bonds contributed

to higher leverage and transaction multiples (price to cash flow) during the late 1980s, which

culminated in a significant default rate for LBOs executed in the latter half of the 1980s. 29

Axelson et al. (2008) show that Kaplan’s conclusions on the effect of cheap financing on LBOs

apply to the recent boom as well. Analogous to the 1980s, cheap debt caused more leverage

less than $300 million under management and large buyouts refer to funds with between $751-2,000 million under
Preqin Spotlight Aug 2007, Vol 3 Issue 8
See Appendix A: Private Equity and Financial Distress

and higher transaction prices during the 2000s LBO boom. Axelson et al. (2008) also find that

leverage for their sample of deals from 2004-2006 was 73%, almost as high as their estimate for

1986-1989 (77%). However, it should be noted Kaplan and Stein’s (1993) estimate for leverage

during the late 1980s is notably higher (86%).

An especially interesting study on the impact of credit on LBOs comes from Shivdasani

and Wang (2009), who describe how the “explosion” of structured credit, specifically

Collateralized Debt Obligations (CDOs), increased the supply of bank loans for LBOs. Shivdasani

and Wang found a strong negative correlation between the changes in LBO loan volumes and

the changes in credit spreads of tranches in which CLO vehicles invest, supporting the view that

positive shocks in the supply of credit drove the LBO boom. Figure 1.7 illustrates the strong

correlation between the uses of structured credit and LBO activity.

Fig. 1.7: CDO Issuance vs. LBO Volume 30

Chart from Shivdasani and Wang (2009)

Shivdasani and Wang (2009) also argue CDO funding lowered the cost of debt and

loosened covenants, concluding that an increase of 1 in the standard deviation of CDO funding

of the lead LBO lending bank leads to a 17-20 basis point lower spread on an LBO’s leveraged

loan as well as a 5-12 percent increase in the probability that the LBO debt will have a covenant

light tranche. Shivdasani and Wang convincingly argue that the explosion of structured finance

(and specifically the ability of CDOs to take loans of banks’ books) is intimately related to the

LBO boom. In this sense, credit caused both public-to-private LBO booms, that of the late 1980s

and the mid-2000s. Also, in both booms, availability of credit expanded because LBO debt was

made available to new investors through financial innovation. In the 1980s, LBO debt was

opened up to insurance companies, mutual funds, and other investors through high-yield

bonds. In the 2000s, structured credit allowed these same entities to invest in leveraged loans.

The financial innovation came not from syndicating these loans to other investors, but through

the ability to turn low rated debt to AAA debt through the financial technology of CDOs.

However, Shivdasani and Wang (2009) make an important distinction between the two booms.

They argue increased access to credit did not lead to riskier deals as it did in the late 1980s. 31

1.5 Capital and Credit Concentrated in Large Funds

The enormous resources that flooded into private equity in the 2000s were unequally

distributed, favoring large and experienced private equity firms. This section describes the flow

of capital into private equity during that time period. As shown in Figure 1.6, capital has

This argument will be explored in more detail in Part 2.

disproportionately flooded into a select group of mega buyout funds. To a certain extent, this

consolidation can be viewed as a Darwinian process, with successful funds attracting more

capital and thus growing larger. However, since large funds have historically outperformed

smaller funds, there is a fair degree of endogeneity in this relationship.

Private equity is unique among investment vehicles in that the firms that have

performed well in the past are significantly more likely to perform well in the future. In

contrast, numerous academic papers have shown that mutual fund and hedge fund

outperformance is generally not sustainable and that past performance is not a good indicator

of future success. 32

Kaplan and Schoar (2005) found from a dataset of 746 funds (from the private equity

database Thomson Venture Economics) that a 1 percent increase in past performance is

associated with a 54 basis point increase in performance in subsequent funds. However, his

dataset includes Venture Capital as well as buyout funds. For only buyout funds, a 1 percent

increase in past performance is associated with a 17 basis point increase in the subsequent

fund. Not surprisingly, Kaplan and Schoar (2005) also find that better performing partnerships

are more likely to raise follow-on funds and larger funds.

The results of Kaplan and Schoar (2005) are supported by the work of Diller and Kaserer

(2009), who found from a study of 200 funds from 1980 to 2003 (also from Thomson Venture

Economics) that a 1 percent increase in past performance translates to an increase of 40 to 70

basis points in the subsequent fund.

For examples, see Carhart (1997) or, more recently, Kazemi, Schneeweis, and Pancholi (2003) for research on the
persistence of mutual fund returns. See Kat and Menexe (2002) and Edwards and Cagalyan (2001) for research on
the consistency of hedge fund returns.

Furthermore, Aigner et al. (2008) found from a study of 104 funds (with data from a

large European private equity fund-of-funds) that a top-quartile fund manager has a 33.3 to

41.7 percent probability to place in the top quartile with the manager’s next fund, depending

on the performance measure. Aigner et al.’s findings on subsequent performance of private

equity firms, using PME (Public Market Equivalent) as a performance measure, are presented in

Figure 1.8. Figure 1.8 demonstrates the performance persistence of successful funds.

Fig. 1.8: Return Persistence Statistics by Quartile33

Succeeding Quartile

1st 2nd 3rd 4th

1st 36.40% 18.20% 18.20% 27.30%

2nd 27.80% 33.30% 16.70% 22.20%



3rd 14.30% 35.70% 42.90% 7.10%

4th 0.00% 38.50% 30.80% 30.80%

The results of Kaplan and Schoar (2005), Diller and Kaserer (2009), and Aigner et al.

(2008)34 are significant, though there are some drawbacks to applying their results to the recent

LBO boom. For one, the returns of recent private equity funds are often impossible to measure,

meaning the authors had to rely on older funds. Also, the funds studied include buyout, venture

capital, and mixed funds, while my focus is only on buyout funds. Aigner et al.’s dataset has a

Data from Aigner et al. (2008)
One notable contribution to the study of private equity return persistence unmentioned here is Phalippou and
Gottschalg (2007), whose results are largely in line with those of the authors presented above.

notably higher percentage of buyout funds (58.69 percent) than the databases of Kaplan and

Schoar (22 percent) and Diller and Kaserer (41 percent).

The performance consistency of private equity is clearly reflected in industry trends and

Limited Partner (LP) behavior. As shown in Figure 1.9, LPs have preferred to put their capital in

larger, more prominent buyout funds that have a proven track record. As a result, the percent

of new private equity fund managers to total fund managers has declined from 30 percent in

1990 to 13 percent in 2002 to 7 percent in 2008.35 Also, Figure 1.9 clearly demonstrates how

less capital was allocated to new GPs compared to existing GPs (from 20 percent in 2003 to 10

percent in 2009).

Fig. 1.9: Private Equity Capital Raised for New vs. Existing GPs 36

Preqin Employment Report, Sept. 20, 2009.
Preqin Employment Report, Sept. 20, 2009

It is clear from the academic literature on performance persistence as well as Figures 1.6

and 1.9 that large, experienced private equity firms possessed an advantage in attracting capital

for their funds. However, recent academic work shows these funds enjoyed advantages in

raising debt as well. Demiroglu and James (2010) showed that high reputation private equity

groups (which are coincidentally also shown to be the largest and most experienced GPs) paid

narrower loan spreads, had looser covenants, and borrowed more and at a lower cost from

institutional loan markets. 37

The results of Demiroglu and James are supported by Shivdasani and Wang (2009). High

reputation private equity firms clearly enjoyed preferential access to LBO lenders, who were

also some of the largest CDO underwriters. Shivdasani and Wang (2009) find stark differences

in leverage and cost of debt between CDO-funded deals and non-CDO-funded deals. Not

surprisingly, it was high reputation private equity firms who had access to these CDO-funded

deals. Though not explicitly stated in Shivdasani and Wang’s analysis, this relationship is clearly

apparent in the make-up of their data. 38 Demiroglu and James (2010) even go so far as to

suggest that the dramatic increase in leverage and covenant light from 2004-2007 is applicable

mostly to experienced private equity firms conducting the biggest LBOs, thus distorting the

statistics on leverage for private equity as a whole.

Institutional loans are a great example of the differences in credit available to the mega-buyout firms and
smaller firms. Institutional loans funded 60% of LBO debt during the LBO boom, compared with 44% beforehand.
The largest LBOs also had the greatest proportion of institutional tranches, thus demonstrating the preferential
access of high reputation firms.
The median funding need for a non-CDO deal was $186 million while the median funding need for a CDO deal
was $1.26 billion.

1.6 The Institutionalization of Private Equity

In the following analysis, I will show how the unequal capital and credit allocation of the

2000s has affected the dynamic of the industry within the greater asset management industry.

This section is relevant to my research question because it describes some of the more subtle

implications of the growth of private equity. It is important that the reader understands the

relationship between private equity firms and their stakeholders—the community of

investment banks, other asset management vehicles, and finance professionals, collectively

referred to as “Wall Street” throughout the rest of this paper.

Due to changes in the behavior of institutional investors as well as structured credit

innovations, capital and credit flooded into private equity during the 2000s, causing the sizes of

funds and buyouts to reach new highs. However, the capital and credit flowing into private

equity was clearly not distributed equally. The dominance of existing, established GPs in recent

years has made private equity a more stable industry in the sense that it has discouraged new

entrants and ensured virtually limitless access to capital. As a result, reputation has become a

major barrier of entry into private equity.39

Large and experienced private equity groups have evolved significantly as firms. Large

buyout firms such as Blackstone have completed initial public offerings and now have shares

that are publicly traded on major stock exchanges. Furthermore, their operations have evolved

from traditional private equity to providing investment banking, capital markets, and asset
This effect is especially evident in the work of Ljungqvist, Richardson, and Wolfenzon (2007), who show younger
GPs are more likely to invest in riskier buyouts. After a few periods of good performance, these young GPs become
more conservative. Unfortunately, Ljungqvist et al.’s study only covers buyouts through 2000. It would be useful to
conduct this study on a more recent dataset. I would expect the trend to have strengthened given the increased
barriers to entry.

management services. These large private equity groups have gone from “paper

entrepreneurs” to Wall Street institutions.

Ultimately, the importance of private equity firms on Wall Street depends on their

ability to drive deal activity through large transactions. This relationship was reflected in former

Citigroup CEO Charles Prince’s testimony before the Financial Industry Inquiry Commission. 40

Prince famously told the Financial Times in July 2007 regarding a possible end to the buyout

boom, “When the music stops, in terms of liquidity, things will be complicated. But as long as

the music is playing, you’ve got to get up and dance. We’re still dancing.” 41 Prince was referring

to Citigroup’s role in continuing to provide credit for leveraged buyouts. In his April 2010

testimony, Prince clarified this statement, arguing, “This business [Citigroup] cannot unilaterally

withdraw from the business [lending to LBOs] and maintain its ability to conduct business in the

future … if you are not engaged in business, people leave the institution.” 42

Prince’s statements reflect the commonly held idea on Wall Street during the boom that

a firm had to do business with large private equity firms in order to stay competitive. With

private equity deals accounting for 20 percent of global M&A activity in 2007 (compared to 3.1

percent in 2000) and dominating leveraged capital markets activity, which incidentally pays

significantly higher fees than investment grade issues, an investment bank needed to do

business with private equity to be competitive in overall investment banking fees as reflected in

the “League Tables”, a key source of prestige on Wall Street that measures the market share of

Financial Industry Inquiry Commission Testimony of Charles Price and Robert Rubin, April 8, 2010
Financial Times, “Citigroup Chief Stays Bullish on Buyouts,” July 9, 2007, online.
Sanati, Cyrus. “Prince Finally Explains His Dancing Comment.” The New York Times. April 8, 2010.

investment banks.43 As reflected in Prince’s statement, poor performance in the League Tables

ultimately makes an investment bank a less desirable place to work, hence why firms such as

Goldman Sachs and Morgan Stanley have generally been among the most attractive

employment opportunities for an investment banker. Stronger deal flow means more fees and

higher bonuses for investment bankers.

In the first half of 2006, LBOs reached $500 billion, or 5 percent of the US stock market

and 1.4 percent of global GDP. 44 From a certain perspective, the future of private equity can be

linked to its size, because its size determines its clout on Wall Street, which is simultaneously

related to capital inflows and credit availability. From this perspective, size of transaction value

is a key determinant of the prominence and profitability of private equity firms. This idea is

explored in more detail in the Conclusion.

In the rest of this thesis, I will continue to investigate the importance of transaction size

in LBOs. Section 2 gives a detailed review of academic research on private equity returns and

shows that size and pricing should theoretically be closely related. Section 3 contains the results

of my study of 446 public-to-private LBOs from 1999 to 2009.

Financial Times, January 25, 2007, p. 5.
Archarya, Franks, and Servaes (2007)

Section 2: A Survey of Academic Research on LBO Returns

Section 1 gave a brief history of private equity activity since 1980 and emphasized the

enormous changes that have occurred in the industry in the last ten years. The next section,

Section 2, lays the theoretical foundation of my hypothesis. Section 2.1 concludes from

academic research on the drivers of LBO performance that the price paid during an LBO is

increasingly important to delivering returns. This conclusion justifies using price to evaluate the

favorability of an LBO. Section 2.2 summarizes results from previous studies on the money

chasing deals phenomenon, concluding that there is substantial evidence that an increase in

capital committed to private equity leads to lower returns. This conclusion supports the idea

that private equity firms would seek to escape this effect with larger transactions. Section 2.3

describes previous research on the determinants on LBO pricing and illustrates the differences

between these studies and my study. After Section 2, Section 3 discusses the results of my


2.1 Performance Drivers of LBOs

In this section I review prior academic research on private equity returns and conclude

that pricing has become increasingly important to generating a significant return from an LBO.

Kaplan and Strömberg (2009) identify three general lines of thought in academic literature on

the drivers of returns in LBOs: financial, governance, and operational engineering; tax breaks

and asymmetric information; and market timing. Different studies support a variety of

arguments on the fundamental drivers of LBO returns. From the research, it is safe to conclude

that the performance drivers of LBOs are not static and are at least marginally different for each

period in the history of private equity.

The financial, governance, and operational engineering theory is best demonstrated in

the work of Jensen (1989) and contends that management incentives, leverage constraints on

free cash flows, and closer oversight and governance produce a superior organizational

structure. The studies that show the strongest evidence for this theory are Kaplan (1989),

Jensen (1986), Jensen (1989), and Lichtenberg and Siegel (1990). However, these studies all

focus on 1980s LBOs. Studies after 1990 are much less conclusive and include theories of LBO

drivers beyond financial, governance, and operational engineering.

Guo, Hotchkiss, and Song (2009) performed an important study of 192 public-to-private

buyouts from 1990 to 2006. They find that gains from better operating performance are smaller

than the 1980s and that increases in industry valuation and tax benefits are as important in

generating returns as operating improvements. Guo et al. show the virtues of LBOs as expelled

by Jensen (1989) are valid, but not strong enough themselves to drive the substantial returns

required by private equity (the so-called “hurdle rate.” They suggest successful LBOs ultimately

depend on favorable pricing trends and credit availability.

Several studies support Guo et al.’s findings. Cressy, Munari, and Mallipiero (2007) find

from tracking the performance of 122 UK buyouts from 1995-2002 with non-LBO comparables

that operating profitability of PE-backed firms is 4.5 percent greater than comparables.

However, Cressy ,Munari, and Mallipiero also found that a major determinant of profitability

for buyouts is profitability in the year of the buyout, suggesting “investment selection and

financial engineering techniques may play a more important role than managerial incentives in

raising performance.” Another study on UK public-to-private buyouts by Archarya and Kehoe

(2009) also found only modest improvements in operating performance.

Also consistent with Guo et al.’s findings is the argument found in Kaplan (1997). Kaplan

argues U.S. corporate governance has fundamentally changed since the 1980s, making 1980s

style LBOs and corporate raiders unpractical.45 Corporations have embraced many of the

advantages of LBOs and instilled them into their companies with new management structures.

Kaplan (1997) stresses the importance of such changes as cost of capital based project analysis,

equity compensation, and more active boards and shareholders, which can conceivably be seen

as having taken away much of the low-hanging fruit private equity enjoyed in the 1980s.46

Leslie and Oyer (2008) also strongly support Guo et al.’s research with a fascinating

study of the performance of 144 private equity backed companies after going public. Leslie and

Oyer find no substantial proof that ex-LBO companies are more profitable or operationally

efficient, concluding that private equity firms do not “create value” as much as they “capture


The academic literature described above overwhelmingly shows that private equity

increases operational efficiency but not enough to justify 10-40 percent returns to investors.

Operational improvements, governance gains, and tax benefits can easily be negated by the

impact of fees, which are estimated by Metrick and Yasuda (2007) to equal 19 percent of a

fund’s assets under management. The timing of investments, or in other words, the pricing and
Fitting with my conclusions on the views of the drivers of LBO returns in the 1980s, Kaplan describes the 1980s
takeover wave as capital markets asserting their ascendancy over corporate managers to eliminate waste.
It is reasonable to assume the trend described in Kaplan (1997) has increased over the past decade with the
continued increases in activist investors and management consultants. Brav, Jiang, Partnoy, and Thomas
(forthcoming) describe the substantial increase in shareholder and hedge fund activism.

selection of LBO targets, appears to have become the most important incremental driver of

returns in private equity.

2.2 Money Chasing Deals Phenomenon

The previous section, Section 2.1, established the significance of pricing for LBO returns.

This section builds on this understanding of pricing to describe how competition bids up prices

and thus decreases returns for private equity firms.

Economic theory suggests that as the number of buyers for a product increases, the

price of the product should rise. Since there is a set limit of attractive private equity targets, an

increase in capital to private equity should result in higher prices. Gompers and Lerner (2000)

illustrate this effect, the “money chasing deals” phenomenon, holds true in the venture capital

industry, studying over 4000 venture capital investments from 1987 to 1995. Their research

concludes that a doubling of inflows into venture capital led to a 7-21 percent increase in

valuations. 47 Diller and Kaserer (2009), using a dataset of 777 private equity and venture capital

funds from 1980 to 2003 (dataset is 41 percent buyout funds), have similar results. The “money

chasing deals” hypothesis rests on the assumptions that there are a limited number of

attractive investments, that funds committed to private equity are “sticky” meaning they

cannot be easily retracted, and that funds must invest in private equity (i.e. they are

Conversely, the relationship between valuation and capital inflows could be that improved expectations cause
both valuations and committed capital to rise.

“segmented”). Theoretically, when these assumptions are stronger, the money chasing deals

phenomenon should be stronger as well.

Subsequent research has shown the money chasing deals phenomenon holds true for

buyouts as well as venture capital.48 For example, Aigner et al. (2008) found evidence that the

amount of capital committed to private equity in a given year was negatively related to a fund’s

PME and IRR. The most compelling evidence that the money chasing deals phenomenon applies

to buyouts comes from Ljungqvist, Richardson, and Wolfenzon (2007). These authors show the

investment behavior of a GP depends on the state of the market (cost of debt and competition

for targets). When credit conditions improve or the competition for deals declines, GPs increase

their investments. These investments also have higher returns. Ljungqvist et al. demonstrate

this by using the number of new firms in an industry as a proxy for the investment

opportunities in that industry. Then they show that the number of new firms in an industry is

inversely related with the amount of time it takes to return a given multiple of committed

capital to the LP. Also, the greater the inflow of money into buyout funds, the longer it takes to

return a given multiple of committed capital to the LP, thus implying lower returns in

accordance with the money chasing deals hypothesis.

Although other studies such as Phalippou and Gottschalg (2007) and Diller and Kaserer

(2009) do not completely support the relevance of money chasing deals to buyout firms, the

study of Ljungqvist et al. should be given heightened importance because of the completeness

of their dataset, which covers 35 percent of all buyout capital from 1981 to 2000. While other

Diller and Kaserer (2009) argue that venture capital should exhibit the money chasing deals phenomenon more
than buyout funds because venture capital is thought to be more segmented and stickier. Their research shows the
money chasing deals phenomenon is statistically significant for venture funds but not buyout funds.

studies rely on self-reporting databases such as Thomson Venture Economics, Ljungqvist et al.

obtained their data from one of the largest institutional investors in private equity. This source

means their data is free from self-reporting bias and, more importantly, gives precise

information on the timing of cash flows on over 2,274 portfolio companies by 207 different

private equity funds.

Data on the timing of cash flows allows Ljungqvist to calculate investor behavior, which

is centrally important to testing the money chasing deals hypothesis. Other studies using IRR or

other profitability metrics do not take into account the timing of gains. Studies like Phalippou

and Gottschlag (2007) focus on fund returns while Ljungqvist et al.’s unique dataset allows

them to calculate returns on a portfolio company basis. 49 This allows Ljungqvist et al. to truly

isolate the money chasing deals component from the greater picture. For example, suppose a

fund, raised during a time when there is much competition for deals, holds off on committing

much of its capital until in a few years when it sees better opportunities. 50 This fund will likely

have higher returns. However, the fact that the fund waited to invest would not be reflected in

the results of Phalippou and Gottschlag (2007) and Diller and Kaserer (2009). Furthermore,

Kaplan and Strömberg (2009) conducted a study very similar to Phalippou and Gottschlag

(2007) and Diller and Kaserer (2009) in which they used data from fund returns drawn from

Thomson Venture Economics (the same database used by the previously mentioned authors) to

show there is a strong negative relationship between fundraising and subsequent returns for a

Phalippou and Gottschlag (2007) have cash flow data (amount and timing) only between investors and funds.
Data suggests this was the case in 2003-2009. See Appendix B for a depiction of private equity’s un-deployed
capital, called “dry powder”.

given year.51 I consider the results of Kaplan and Strömberg (2009) more relevant to my

research than comparable studies because their study is more recent and focuses only on

buyout funds.

2.3 Buyout Pricing

Sections 2 and 3 described the importance of pricing for LBO returns and the theoretical

relationship between private equity competition and pricing. This section discusses previous

research on LBO pricing. Previous studies indicate that LBO pricing is cyclical and dependent on

changing business and credit conditions. There is also substantial evidence that the money

chasing deals effect applies to LBO pricing.

My conclusion from surveying academic research is that buyout selection and pricing

has become the primary driver of value in an LBO.52 In the context of the money chasing deals

hypothesis, an increase in capital commitments to private equity funds should significantly

decrease the returns of LBOs by driving up prices and limiting opportunities. This effect should

be especially pronounced for public-to-private transactions since the publicity of takeovers

increases the competition for deals, thus amplifying the money chasing deals effect.

One hypothesis for why deal sizes spiraled to new highs in 2006 and 2007 is that private

equity firms were trying to escape the money chasing deals effect by buying targets out of the

reach of other funds. Larger fund sizes and cheap credit opens up a new group of LBO targets.

The dataset of Kaplan and Strömberg (2009) studies returns of US buyout funds from 1984 to 2004.
This conclusion is analogous to the conclusion of Kaplan and Strömberg (2009) that private equity firms make
returns by buying low and selling high.

Since these resources are only available to experienced firms with a strong track record, some

firms are able to buy targets without much competition from other funds. I intend to test this

hypothesis by determining the relationship between transaction size and the valuation of the

target. Another relevant development is the increased use of “club deals”, where multiple

private equity firms put themselves together to buy one company, especially in larger


Academic research suggests the most important driver of LBO pricing is credit

conditions. Kaplan and Strömberg (2009) estimate a 250 basis point mispricing of debt would

allow a private equity firm to pay an additional 10 percent for a target in an LBO. Kaplan and

Stein (1993) note that cheap debt in the 1980s caused transaction prices to rise to 7-8 times

EBITDA, only to drop to 5-6 times EBITDA when the credit markets collapsed.

Axelson, Jenkinson, Stromberg, and Weisbach (2008) find the conclusions of Kaplan and

Stein (1993) about the 1980s buyout boom relate to the recent boom as well. The cost of

leveraged loans and high-yield debt is strongly correlated with higher leverage and higher

prices.53 Buyout prices also have a strong relationship with overall M&A prices. Axelson et al.

find that transaction value to EBITDA averaged 9.3. Interestingly, Axelson finds that club deals

are actually priced higher than other deals. This finding is in line with the GAO’s 2008 study of

LBOs, which found by analyzing 325 public-to-private LBOs from 1998 through 2007 that there

was no indication club deals paid lower or higher prices. Meuleman and Wright (2007) make

the same conclusion on the effect of club deals on pricing as the GAO report.

Axelson et al. (2009) have two possible explanations for the relationship between the cost of debt and buyout
prices. 1) LBO funds create value by taking on cheap debt while the cost of equity stays the same. 2) GPs have an
option-like stake in the fund with no downside because they get 20% of the returns but lose no capital themselves.

Axelson et al.’s study does not provide evidence on the money chasing deals effect in

the sense that LBO prices did not decouple from broader M&A prices in the mid-2000s. There

are a few reasons to be skeptical about Axelson et al.’s results in this respect. For one, their

dataset excludes most of the large deals of the 2003-2007 boom. Furthermore, they use only

the transactions of five large and highly reputable private equity firms (153 buyouts, only 16%

of which are public-to-private LBOs).

The results of Demiroglu and James (2010) are more relevant to my research question.

The dataset of these authors consists of 181 public-to-private buyouts conducted between

1997 and 2007, 54 of which occurred in 2006 and 2007. Demiroglu and James find that

transaction prices increased in the late 1990s, dipped in the early 2000s, and rose again in 2003.

Unlike the findings of Axelson et al. (2008), Demiroglu and James find that buyout prices after

2003 actually decoupled from market (S&P 500) valuations, suggesting a money chasing deals

effect did occur in the 2000s. Also, prices are shown to be correlated with the number of

buyouts and the reputation of the acquiring private equity group.

An issue with the study of Demiroglu and James is their emphasis on private equity firm

reputation, a subjective quality that is hard to quantify. It would have been more conclusive to

use a more easily observable metric, especially since private equity group reputation seems to

be almost perfectly correlated with size. Demiroglu and James’ conclusions on the high

reputation private equity firms are essentially the same as the conclusions made for large

private equity groups by other authors, such as Kaplan and Stein (1993) and Shivdasani and

Wang (2009).54 Therefore, Demiroglu and James’ conclusion that reputation does not have a

substantial effect on deal valuation is very relevant to this study and consistent with my results.

The results of Shivdasani and Wang (2009) are also relevant to my research. These

authors find that structured credit may have driven the size and number of LBOs but did not

result in higher prices or “overheating,” inconsistent with Demiroglu and James (2010) and

Axelson et al. (2008). Shivdasani and Wang posit that prices stayed reasonable amidst such an

increase in activity because structured credit allowed larger buyouts, which opened up a new

group of desirable targets. My results on the favorability of larger buyouts versus smaller ones

contradict this hypothesis.

2.4 My Hypothesis

Academic research on LBO returns suggests that acquiring a company at a good price is

crucial to delivering returns from the transaction. There is also considerably evidence that

competition among private equity firms drives down returns. These two findings are intricately

related. In fact, the period of lowest historical LBO returns (the late 1980s) is also the period

when prices and transaction sizes were at a historical peak. The infamous 1988 RJR Nabisco

buyout that marked the peak of the 1980s buyout boom was not a bad deal. RJR Nabisco was a

good target. The problem was that the acquiring private equity firm overpaid due to

competition from other financial buyers. The acquiring private equity firm paid a premium of

For example, Demirgolu’s finding that reputation is closely related to buyout leverage and the cost of debt,
meaning high reputation firms use more leverage and have cheaper access to debt.

$10 billion dollars for the company, effectively transferring its return to shareholders (Kaplan

and Strömberg, 2009). The price paid for a transaction can therefore be a good indication of the

likely return.

My hypothesis is that larger transactions were more favorable than comparable smaller

transactions because larger buyouts had less competition from other private equity firms. I test

this hypothesis in section 3 using regression analysis on a large sample of public-to-private

LBOs. In addressing this hypothesis, I hope to shed light on why private equity firms chose to

use the massive amounts of resources made available to them from 1999 to 2009 to buy

increasingly larger companies.

Section 3: Study of Public-to-Private LBOs 1999-2009

Section 1 gave a brief history of private equity activity since 1980 to illustrate how

changes in the allocation of capital and credit transformed the asset class. Section 2 discussed

the relationship between LBO returns and pricing and built the conceptual framework for the

hypothesis that larger deals should be more favorable than smaller ones. This section, Section

3, presents the results of my analysis of a large dataset of public-to-private LBOs from 1999-

2009. Section 3.1 describes how the dataset was compiled and defines the variables used in the

analysis. Section 3.2 provides information on the landscape of the dataset and includes detailed

information on how many deals were announced each year and how valuations changed

overtime. Section 3.3 presents the results of four regressions run on this dataset. Model 1 uses

EV/EBITDA as the price metric. Model 2 uses Premium as the price metric. Model 3 uses

EV/EBITDA as the price metric and looks specifically at the role of club deals and reputation in

LBO pricing. Finally, Model 4 looks at the difference between the pricing of small and large

LBOs. Model 4 concludes that the relationship between size and price is positive for small LBOs

and negative for large LBOs.

3.1 Methodology

The goal of my study is to assess whether larger transactions are priced more favorably

than smaller ones in a competitive private equity environment. If larger transactions are priced

more favorably, then increasing transaction size of an LBO should result in a lower price. My

hypothesis is that prices decline as transaction size increases, thus making mega-buyouts

especially attractive. My research will also contribute to the academic literature on the

determinants of LBO pricing.

To construct my dataset, I took all announced public-to-private deals over $100 million

in transaction value in the Capital IQ database (1,597 LBOs). I focused on public-to-private deals

because they have the best data available. Also, it is difficult to construct a representative

dataset of all LBOs because Capital IQ classifies some LBOs as private placements or ordinary

M&A. Public-to-private LBOs should also theoretically exhibit the money chasing deals

phenomenon more than other transactions (see section 2.2). Lastly, the mega buyouts from

2004-2007 were all public-to-private transactions.

Next, I removed all transactions not announced between 1999 and 2009. Capital IQ was

founded in 1999 and the retroactively added data seems to be more incomplete (Strömberg,

2008). I chose to use the following variables in my analysis:

Fig. 3.11: Definitions of Variables Used in the Analysis

Variable Description
Club Deal A dummy variable used to denote whether the LBO is a club deal.

EBTIDA Earnings Before Interest, Taxes, and Amortization historical three year growth
calculated from historical EBITDA data. EBITDA growth is calculated on a per-company

basis and adjusted to exclude outliers. Using historical EBITDA growth differs from

Demiroglu and James (2010)’s treatment of growth, who uses management’s three

year growth projections from the merger proxy statement. However, given historical

growth is usually used as projected growth when modeling a firm’s performance, the

difference should not be great.

Enterprise A measure of firm value that reflects the market value of the whole business
Value (EV)
regardless of capital structure. EV is calculated as Market Capitalization + Preferred

Stock + Market Value of Debt + Minority Interest - Cash and Cash Equivalents.

Enterprise Calculated as enterprise value at the time of acquisition divided by the last twelve
Value / EBIT
months (LTM) Earnings before Interest and Taxes

Enterprise Calculated as enterprise value at the time of acquisition divided by the LTM Earnings
Value /
EBITDA before Interest, Taxes, Depreciation, and Amortization

EVEG This metric adjusts EV/EBITDA for growth much like the PEG ratio does this for P/E by

dividing the EV/EBITDA multiple by EBITDA growth. A higher EVEG ratio indicates

more was paid for 1 percent of growth than transactions with lower EVEG ratios.

Leverage Calculated as Net Debt/Transaction Value. Net Debt is calculated by subtracting the
before the
Acquisition market capitalization from the transaction value

Mega Buyout An LBO with a transaction value greater than $10 billion. Used as a dummy variable in

the regression analysis.

Net Income Calculated from historical Net Income growth and adjusted for outliers similarly to
EBITDA growth

P/E Gives the price/earnings multiple, calculated by dividing equity value by net income

Premium Calculated as (Price per share - Target's closing price 30 trading days prior to

announcement / Target's closing price 30 trading days prior to announcement)

Reputation of Reputation is assessed on a yes-or-no basis as a dummy variable. Though this is

Partner (GP) significantly different from the methodology of Demiroglu and James (2010), there is

some similarity because reputation is determined by the size of the private equity

firm’s assets under management. The top 10 private equity firms are given the high

reputation distinction.55

Riskiness of Used to assess riskiness of cash flows by taking the standard deviation of EBITDA
Growth growth over a 5 year period.

Riskiness of Used to assess riskiness of cash flows by taking the standard deviation of Net Income
Net Income
Growth growth over a 5 year period.

Sector Describes the target’s sector and consists of Information Technology, Consumer

Discretionary, Consumer Staples, Materials, Industrials, Financials, Healthcare,

Utilities, Telecommunications, and Energy.

Transaction Gives whether the transaction is announced, canceled, or completed

Transaction The sum of the total buyout, which equals the total amount of cash and stock being
paid or the target’s equity and net debt. The transaction value equals the enterprise

value of the target.

After purging the dataset of outliers and transactions with insufficient data, I was left

with a dataset of 446 public-to-private LBOs from 1999 to 2009, which is almost three times as

large as previous studies on pricing by Demiroglu and James (2010) and Axelson et al. (2008).

My dataset is exceptionally large because I included all announced deals rather than only

completed deals. I included announced deals because these deals still give an indication of

pricing by private equity for LBOs. Transactions that were cancelled because a better offer

arose from another private equity firm were eliminated. I also test for differences between

announced and completed deals with no substantial changes in my results.

Size of the private equity firm is taken from Private Equity International’s annual ranking of the world’s 50
largest private equity firms 2008

To make sure my results are robust and are not the product of a bias inherent in the

data from Capital IQ, I performed the same study on a dataset from FactSet. After removing

outliers and transactions with insufficient data, I was left with 371 completed public-to-private

LBOs. My results from the FactSet database were not substantially different from the results of

my Capital IQ dataset.

3.2 Composition of the Dataset

Figure 3.12 illustrates the changes in LBO valuations over time. The number of deals and

total transaction values reflect the LBO boom from 1999 to 2007 as well as the subsequent

decline. Not surprisingly, the average transaction value peaked in 2007 at $3.9 billion compared

to an average of $479 million in 1999. The average premium paid for LBOs seems to be

inversely related to valuation multiples. When multiples such as EV/EBITDA are low, the

average premium paid in an LBO tends to be high. This result is not surprising and reflects

corporations demanding higher premiums in face of depressed public valuations. The rising

EV/EBITDA multiples reflect the overheating of the LBO market as well as rising M&A

valuations. There is a very strong correlation (.79) between EV/EBITDA and LBO volume,

supporting the money chasing deals hypothesis.

Fig. 3.12: LBO Valuation Metrics by Year

(Billion USD) of Deals (Million Premium EBIT EBITDA Growth (%) EV/EBITDA
USD) (%)

2009 23.8 19 1,252 73 22.4 28.5 8.0 6.96 1.15 12.9

2008 32.7 36 907 27 17.5 36.1 11.0 5.55 1.97 14.7

2007 452.5 116 3,901 18 21.9 31.4 12.8 9.68 1.33 15.3

2006 391.9 106 3,697 22 20.0 29.1 11.1 8.34 1.33 14.6

2005 128.1 52 2,464 20 20.9 26.4 9.7 7.06 1.37 16.9

2004 26.9 22 1,223 17 15.5 32.6 9.3 3.90 2.39 14.8

2003 20.4 26 785 20 12.8 29.7 7.6 4.21 1.81 12.5

2002 4.3 9 473 33 23.1 20.2 8.0 4.58 1.75 12.5

2001 3.5 8 434 95 53.2 18.5 8.7 13.68 0.64 12.5

2000 4.3 9 478 36 9.9 12.2 6.1 3.86 1.58 15.6

1999 3.8 8 479 29 11.7 25.8 8.5 6.45 1.32 15.9

Figure 3.13 sorts the data by transaction size and gives further insight into pricing during

this period. The data is divided to reflect the varying degrees of reach for private equity firms

according to the designation of mega, large, middle-market, and small as defined in Section 1.3.

Fig. 3.13: LBO Valuation Metrics by Deal Size

(USD) of Deals (%) Growth (%) Growth STDEV

40B - 10B 28 22.1 23.2 12.9 8.6 32.4 2.0

10B - 3B 61 24.75 19.2 11.8 9.6 33.3 1.9

3B - 1B 115 19.7 19.4 10.9 8.9 56.0 1.9

1B - 500M 67 18.1 19.7 10.4 4.5 73.4 2.3

500M -100M 174 31.5 20.2 9.5 6.2 50.0 1.6

This data is from FactSet MergerStat. The values were computed by taking all non-private equity M&A from 1999
to 2009 and winsorizing the EV/EBITDA multiples for these transactions by 5%. These multiples include deals from
around the world and therefore are not great for direct comparison with LBO multiples. However, they do reflect
worldwide valuation trends.

Figure 3.13 shows EV/EBITDA and EV/EBIT was on average higher for LBOs larger than

$10 billion than smaller LBOs. Small transactions (less than $500 million) had on average the

lowest valuations. The average standard deviation of EBITDA growth is significantly smaller for

larger transactions than smaller ones, indicating a preference of more stable cash flows for

larger transactions. The increase in EV/EBITDA multiples from 2004-2007 is evident in Figure

3.14. Note that EV/EBITDA multiples increased across the board during this period. Larger

transactions were clearly not isolated from the increases in valuation during this time,

consistent with the results of the regression analysis presented below in Section 3.3.

Fig. 3.14: EV/EBITDA and Number of Deals by Buyout Size

EV/EBITDA Number of Deals

2005 2006 2007 2005 2006 2007

40B - 10B 11.21 13.75 13.54 3 11 7

Transaction Size

10B - 5B 8.98 11.13 13.25 4 9 12

5B - 3B 10.89 11.05 14.91 4 8 10

3B - 1B 10.34 10.24 12.08 15 30 43

1B - 500M 10.08 10.88 14.77 8 12 16

500M -100M 8.34 10.99 11.59 17 36 25

3.3 Regression Results

Out of the three valuation multiples present in the dataset, EV/EBITDA is the most

comprehensive estimate of firm value because EBITDA is the best estimate of free cash flow.

Price/Earnings and to a lesser extent, EV/EBIT, have other inputs, such as capital structure and

depreciation, that distort the metric. This quality is evident in Figure 3.12, which shows that

EV/EBITDA is the most consistent and predictable measure of firm value. Using EV/EBITDA as

the dependent variable in the regression is consistent with the studies of Demiroglu et al. and

Acharya and Kehoe. The dependent variables in the regression were EBITDA growth and

standard deviation, sector, announcement year, and transaction size. The following equation

describes Model 1:

(EV/EBITDA) = β0 + β1 (Transaction Value) + β2 (EBITDA Growth) + β3 (1999) + β4

(2000) + β 5 (2001) + β6 (2002) + β7 (2003) + β8 (2004) + β9 (2005) + β10 (2006) +

β1 1 (2007) + β12 (2008) + β13 (Consumer Discretionary) + β 14 (Consumer Staples) (1)

+ β15 (Materials) + β16 (Industrials) + β17 (Financials) + β18 (Healthcare) + β19

(Telecommunications) + β 20 (Energy) + β21 (EBITDA STDEV)

My hypothesis is that larger transaction sizes should result in a lower EV/EBITDA after

adjusting for growth, year, and sector. If my hypothesis is correct, then the regression

coefficient of transaction value (β1) should be negative, indicating that a higher transaction size

lowers the EV/EBITDA. Transaction size should also be a statistically significant explanatory

variable, indicating a p-value less than .05.

The regression results do not support this hypothesis. As indicated in Figure 3.15, the

coefficient of transaction value (β 1) is positive and not statistically significant. This result

suggests that transaction value does not have a negative, linear relationship to EV/EBITDA. In

fact, the results suggest the opposite—that larger transaction values indicate higher multiples

paid. The positive coefficient of transaction value is consistent with the trends for EV/EBITDA

shown in Figures 3.12 and 3.13. The entire regression results are presented below in Figure

3.15. The R-square and adjusted R-square of the regression is .3990 and .3664, respectively.

Fig. 3.15: Regression Results for Model 1

Variables Coefficient Standard Error p-Value

Total Regression 3.97 < 0.0001
Constant 7.36 1.68 < 0.0001
Transaction Value 5.8E-05 3.7E-05 0.115
Year = 1999 0.86 1.91 0.654
Year = 2000 -2.06 1.71 0.227
Year = 2001 1.03 1.72 0.550
Year = 2002 -0.01 1.42 0.994
Year = 2003 -0.37 1.21 0.760
Year = 2004 1.71 1.26 0.176
Year = 2005 1.48 1.11 0.181
Year = 2006 2.34 1.04 0.024
Year = 2007 3.75 1.02 0.000
Year = 2008 2.87 1.16 0.014
Consumer Discretionary -0.70 1.40 0.616
Consumer Staples -1.49 1.56 0.339
Energy 0.80 1.86 0.666
Financials 2.01 1.51 0.183
Healthcare -1.48 1.53 0.334
Industrials -0.67 1.44 0.644
Information Technology -0.18 1.47 0.902
Materials -1.22 1.61 0.448
Telecommunication Services -2.99 1.88 0.112
EBITDA Growth 0.19 0.02 < 0.0001
EBITDA STDEV 9.7E-04 1.8E-03 0.586

The regression results of Model 1 also provide valuable insight into the determinants of

LBO pricing. Consider the coefficients and p-values for the peak of the boom—years 2006 and

2007. The regression coefficients of these two years are statistically significant at the .05 level

and reflect the increasing EV/EBITDA multiples during these years, as shown in Figure 3.12.

Another notable result of this regression is the coefficient of EBITDA Growth: 0.19 (P-value

<.0001). This result indicates that a 1 percent increase in growth by the target company

increases the EV/EBITDA multiple by .19. This result is remarkably robust, staying in the .18-.25

range across many changes to the dataset.

The money chasing deals phenomenon could also be reflected in the premium paid over

the stock price 30 days before the LBO announcement. If a private equity firm faces significant

competition it should end up paying a higher premium for the target. Larger transactions

should therefore have lower premiums because they face less competition from other financial

buyers. If this hypothesis is valid, the regression coefficient of transaction value should be

negative, indicating that an increase in size decreases the premium paid.

(Premium) = β0 + β1 (Transaction Value) + β 2 (Transaction Status) + β3 (1999) +

β4 (2000) + β 5 (2001) + β6 (2002) + β7 (2003) + β8 (2004) + β9 (2005) + β10 (2006)

+ β1 1 (2007) + β12 (2008) + β13 (Consumer Discretionary) + β 14 (Consumer (2)

Staples) + β15 (Materials) + β16 (Industrials) + β17 (Financials) + β18 (Healthcare) +

β19 (Telecommunications) + β 20 (Energy)

The regression results presented in Figure 3.16 for Model 2 are very similar to the

results of the Model 1 regression. The coefficient of transaction value (β1) is positive and

statistically insignificant, indicating there is no strong linear relationship between transaction

value and premium paid. The regression returned an R-square of .2161 an adjusted R-square of


Fig. 3.16: Regression Results for Model 2

Variables Coefficient Standard Error p-Value

Total Regression 31.24 < 0.0001
Constant 67.66 16.34 < 0.0001
Transaction Value 1.3E-04 3.0E-04 0.676
Transaction Status = Cancelled 3.43 11.84 0.772
Transaction Status = Closed 7.41 11.63 0.524
Year = 1999 -42.41 13.51 0.002
Year = 2000 -36.92 12.96 0.005
Year = 2001 20.71 13.36 0.122
Year = 2002 -36.53 13.00 0.005
Year = 2003 -51.83 9.76 < 0.0001
Year = 2004 -53.93 10.09 < 0.0001
Year = 2005 -51.43 8.77 < 0.0001
Year = 2006 -50.24 8.16 < 0.0001
Year = 2007 -54.73 8.05 < 0.0001
Year = 2008 -45.05 9.16 < 0.0001
Consumer Discretionary -3.49 11.01 0.751
Consumer Staples -12.16 12.40 0.327
Energy 0.34 15.32 0.982
Financials -6.57 11.87 0.580
Healthcare 2.00 12.10 0.869
Industrials 2.09 11.35 0.854
Information Technology -1.44 11.46 0.900
Materials 4.58 12.57 0.716
Telecommunication Services 2.10 16.71 0.900

The results for Model 2 in Figure 3.16 indicate that the strongest determinant of

premium paid is the announcement year. Other potential factors such as transaction value,

sector, and transaction status have a negligible and statistically insignificant impact on

premium. Therefore, there is no evidence that larger LBOs enjoy lower premiums.

I also investigated the effect of reputation and club deals on pricing. Figure 3.17

presents the valuation metrics for LBOs done by high reputation firms versus normal reputation

firms and club deals versus non-club deals (as defined in Figure 3.11). Not surprisingly, the

average and median transaction value of high reputation and club deals is much larger than the

mean. The median and average EV/EBITDA paid in these deals is not substantially different

from the mean.

Fig. 3.17: LBO Valuation Metrics for High Reputation and Club Deals

AVG TV (in USD Number of Median TV AVG EV/EBITDA Median

millions) Deals EV/EBITDA

High Reputation 6,311 120 2,790 10.7 10.4

Normal Reputation 1,303 325 479 10.5 9.5

Total 2,654 445 797 10.5 9.7

Club Deal 4,240 61 1,600 9.8 9.7

No Club Deal 1,704 295 491 11.3 10.1

Total 2,138 356 658 11.0 10.0

The relationship between GP reputation, club deals, and pricing was tested in Model 3

below. The regression results are listed in Figure 3.18. The regression again used EV/EBITDA as

the dependent variable.

(EV/EBITDA) = β0 + β1 (High Reputation) + β 2 (Club Deal) + β3 (1999) + β4 (2000)

+ β 5 (2001) + β6 (2002) + β7 (2003) + β8 (2004) + β9 (2005) + β10 (2006) (3)

+ β11 (2007) + β12 (2008) + β13 (Transaction Value)

The R-square and Adjusted R-square were .1044 and .0731, respectively. A negative

value of β1 indicates that higher reputation private equity firms paid lower prices for LBOs. A

negative value of β2 indicates that club deals were also priced lower than similar transactions.

In this example, the relevant coefficients (β1 and β2) were negative, as shown in Figure 3.18.

However, the result of high reputation firms is statistically insignificant. The coefficient of club

deals, on the other hand, is statistically significant, with a p-value of .0183. This finding

indicates that private equity firms can decrease the price paid for a company by teaming up

with other private equity firms. This result is significant because it contradicts the previous

research done on the impact of club deals on prices by Meuleman and Wright (2007) as well as

the Government Accountability Office and indicates the need for more research in this area.

Also, the result that club deals are priced lower even though they are on average three times

larger than other LBOs seems strange given the regression results of Model 1.

Fig. 3.18: Regression Results for Model 3

Variables Coefficient Standard Error p-Value

Total Regression 6.17 0.0001
Constant 10.44 1.50 < 0.0001
High Reputation -0.06 0.87 0.9413
Club Deal = Yes -2.13 0.90 0.0183
Year = 1999 -3.87 2.33 0.0974
Year = 2000 -3.39 2.23 0.1295
Year = 2001 -0.18 2.65 0.9464
Year = 2002 -2.35 2.19 0.2843
Year = 2003 -1.20 2.12 0.5724
Year = 2004 -1.30 2.07 0.5307
Year = 2005 0.13 1.80 0.9440
Year = 2006 2.57 1.67 0.1250
Year = 2007 2.66 1.63 0.1025
Year = 2008 1.50 1.81 0.4092
Transaction Value 7.83 7.62 0.9183

The results shown in Figures 3.15, 3.16, and 3.18 indicate there is not a clear linear

relationship between transaction size and price. However, this result does not necessarily

disprove my hypothesis. There is no reason to believe that the relationship between price and

transaction size is linear. Figure 3.19 charts EV/EBITDA by transaction value for the LBOs in my


Fig. 3.19: Transaction Value vs. Price









0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 50.0

Transaction Value (Billion USD)

The non-linear relationship between price and size suggested in Figure 3.19 also gives a

new explanation for the results of Model 3. Model 3 indicated that club deals are priced

substantially lower than other LBOs. This result was statistically significant at the .05 level. One

explanation for the lower prices of club deals is they decrease competitive bidding by

aggregating private equity firms into one buyer. However, an equally plausible explanation is

that the difference in price between club deals and ordinary deals is a result of the dramatic

difference in size between club deals and ordinary deals — club deals are generally at least 3

times larger than other LBOs (see Figure 3.17).

Figure 3.19 suggests the relationship between price and size is different for smaller and

larger deals. To isolate the relationship of larger deals from smaller deals, the final model of this

paper introduces two new variables: a dummy variable for “Mega Buyouts” and an interaction

term “Mega Buyout × TV.” The Mega Buyout dummy applies to any LBO above a certain

threshold. Due to subjectivity of this threshold, three different values are tested for the

classification of a mega buyout: $5 billion, $10 billion, and $12.5 billion. Mega Buyout × TV is an

interaction term which reflects the difference in the slope coefficients for large and small deals.

These variables will differentiate the slope of larger transactions from the smaller transactions.

(EV/EBITDA) = β0 + β1 (Transaction Value) + β 2 (EBITDA Growth) + β3 (1999) + β4

(2000) + β 5 (2001) + β6 (2002) + β7 (2003) + β8 (2004) + β9 (2005) + β10 (2006) + β1

1 (2007) + β12 (2008) + β13 (Consumer Discretionary) + β 14 (Consumer Staples) + β15 (4)
(Materials) + β16 (Industrials) + β17 (Financials) + β18 (Healthcare) + β19

(Telecommunications) + β 20 (Energy) + β21 (EBITDA STDEV) + β22 (Mega Buyout

Dummy) + β23 (Mega Buyout × TV)

There are three regressions using Model 4. Figure 3.20 presents the regression results

using $5 billion as the threshold for a Mega Buyout. This regression returned an R-square and

adjusted R-square of .4018 and .3663. Figures 3.22 and 3.24 present the regression results

using a Mega Buyout threshold of $10 billion and $12.5 billion, respectively.

Fig. 3.20: Model 4 Regression with Mega Buyout > $5B

Variables Coefficient Standard Error p-Value

Total Regression 3.98 < 0.0001
Constant 7.04 1.72 0.318
Transaction Value 0.0002 0.0002 < 0.0001
EBITDA GROWTH 0.19 0.02 0.527
EBITDA STDEV 0.001 0.002 0.603

Year = 1999 0.99 1.91 0.256
Year = 2000 -1.94 1.71 0.517
Year = 2001 1.11 1.72 0.969
Year = 2002 0.06 1.42 0.810
Year = 2003 -0.29 1.22 0.181
Year = 2004 1.69 1.26 0.193
Year = 2005 1.44 1.11 0.027
Year = 2006 2.31 1.04 0.000
Year = 2007 3.72 1.02 0.011
Year = 2008 2.98 1.16 0.661
Consumer Discretionary -0.62 1.41 0.394
Consumer Staples -1.34 1.57 0.601
Energy 0.97 1.86 0.162
Financials 2.12 1.52 0.360
Healthcare -1.41 1.54 0.716
Industrials -0.53 1.46 0.960
Information Technology -0.07 1.49 0.513
Materials -1.06 1.62 0.119
Telecommunication Services -2.94 1.88 0.345
Mega Buyout × TV -0.0002 0.0002 0.186
Mega Buyout Dummy 1.28 0.97 < 0.0001

The incremental slope of larger transactions almost completely negates the positive

slope of Transaction Value, thus indicating that price is independent of size after exceeding $5


Small y = 7.04 + .0002X

Incremental y = 1.28 – .0002X
Large y = 8.32

This result indicates pricing or large and small LBOs is substantially different. The

relationship between transaction values and price is depicted in Figure 3.21.

Fig. 3.21: Relationship between Price and Transaction Value
Using $5B as the Mega Buyout Value


8 Small LBOs
Large LBOs
0 10 20 30 40 50
Transaction Value (Billion USD)

This relationship implies that pricing becomes more favorable after transaction value

exceeds $6.115 billion. After this point, pricing of large deals is steady and independent of

transaction value. It is likely that a private equity firm still has an incentive to increase deal

value due to economies of scale (see Appendix C), even without a discount for size. However, it

should be noted that this relationship is only marginally statistically significant at the .20 level.

Figure 3.22 contains the regression results of Model 4 using $10 billion as the threshold

for a Mega Buyout. This regression returned an R-square and adjusted R-square of .4088 and

.3737, respectively.

Fig. 3.22: Model 4 Regression with Mega Buyout > $10B

Variables Coefficient Standard Error p-Value

Total Regression 3.96 < 0.0001
Constant 7.43 1.69 < 0.0001
Transaction Value 0.0001 0.00 0.390
EBITDA GROWTH 0.19 0.02 < 0.0001
EBITDA STDEV 0.00 0.00 0.536
Year = 1999 0.86 1.90 0.652
Year = 2000 -2.05 1.70 0.228
Year = 2001 0.99 1.71 0.561
Year = 2002 0.00 1.41 1.000
Year = 2003 -0.46 1.21 0.701
Year = 2004 1.66 1.25 0.184
Year = 2005 1.30 1.10 0.240
Year = 2006 2.20 1.03 0.034
Year = 2007 3.76 1.02 0.000
Year = 2008 2.80 1.16 0.016
Consumer Discretionary -0.82 1.39 0.558
Consumer Staples -1.67 1.56 0.286
Energy 0.87 1.85 0.640
Financials 1.88 1.50 0.211
Healthcare -1.64 1.53 0.286
Industrials -0.73 1.44 0.612
Information Technology -0.28 1.46 0.846
Materials -1.28 1.60 0.425
Telecommunication Services -2.84 1.87 0.129
Mega Buyout × TV -0.0002 0.00 0.089
Mega Buyout Dummy 4.99 1.93 0.010

The incremental slope of large transactions is almost exactly the same for Figures 3.22

and 3.20. However, the resulting relationship is substantially different:

Small y = 7.43 + .0001X

Incremental y = 4.99 – .0002X
Large y = 12.42 – .0001X

This relationship is depicted graphically in Figure 3.23.

Fig. 3.23: Relationship between Price and Transaction Value
Using $10 as the Mega Buyout Value


Small LBOs
Large LBOs
0 10 20 30 40 50 60
Transaction Value (Billion USD)

This relationship indicates that pricing becomes favorable after exceeding $27.55 billion.

After this point, LBOs become dramatically favorable with increases in transaction size. A $1

billion increase in size results in a .133 decrease of EV/EBITDA. The slope of pricing for large

transactions is statistically significant at the .1 level.

Figure 3.24 contains the results for Model 4 using $12.5 billion as the threshold for a

Mega Buyout. The regression returned an R-square of .4102 and an adjusted R-square of .3752.

Fig. 3.24: Model 4 with Mega Buyout > $12.5B

Variables Coefficient Standard Error p-Value

Total Regression 3.56 < 0.0001
Constant 7.72 1.70 < 0.0001
Transaction Value 0.0001 0.0001 0.165
EBITDA GROWTH 0.19 0.02 < 0.0001
EBITDA STDEV 0.00 0.00 0.521
Year = 1999 0.84 1.89 0.657
Year = 2000 -2.01 1.69 0.236

Year = 2001 1.02 1.70 0.549
Year = 2002 0.03 1.41 0.985
Year = 2003 -0.38 1.21 0.756
Year = 2004 1.66 1.25 0.185
Year = 2005 1.35 1.10 0.222
Year = 2006 2.17 1.03 0.036
Year = 2007 3.73 1.01 0.000
Year = 2008 2.88 1.15 0.013
Consumer Discretionary -1.16 1.41 0.412
Consumer Staples -2.06 1.58 0.194
Energy 0.56 1.86 0.765
Financials 1.59 1.51 0.294
Healthcare -1.91 1.54 0.215
Industrials -1.08 1.46 0.458
Information Technology -0.60 1.48 0.686
Materials -1.61 1.62 0.321
Telecommunication Services -3.21 1.87 0.088
Mega Buyout × TV -0.0003 0.0001 0.015
Mega Buyout Dummy 7.05 2.63 0.008

Similar to the results using $5B and $10B as the mega buyout value, the incremental

slope of larger transactions is negative and statistically significant. The relationship between

size and price for larger firms is the following:

Small y = 7.72 + .0001X

Incremental y = 7.05 – .0003X
Large y = 14.77 – .0002X

This relationship is depicted graphically in Figure 3.25.

Fig. 3.25: Relationship between Price and Transaction Value
Using $12.5B as the Mega Buyout Value


8 Small LBOs
6 Large LBOs
0 10 20 30 40 50
Transaction Value (Billion USD)

The slope of large LBO pricing is greatest using $12.5B as the mega buyout threshold.

This slope is -.0002 and indicates a .2 decrease in EV/EBITDA for every $1 billion increase in

transaction value. This slope is also the most statistically significant of the three with a p-value

of .015. This result indicates that deal favorability increases most dramatically with size for

deals exceeding $12.5 billion in transaction value.

Models 1, 2, and 3 clearly show there is no direct linear relationship between

transaction value and price using a variety of metrics and explanatory variables. However,

Model 4 shows the relationship between LBO size and price differs for large and small LBOs.

There is especially strong evidence that the relationship between size and price for large LBOs is

negative. The regression results of Model 4 support my hypothesis and suggest that very large

buyouts enjoy lower prices and become especially favorable after the $25 Billion mark.


My analysis of my dataset of 446 public-to-private LBOs announced from 1999 to 2009

shows that there is no clear linear relationship between transaction size and deal favorability

(also referred to as price). This result indicates the relationship between size and price is not

static across transaction values. For smaller transactions, ranging from $100 million to $5 billion

in value, larger transactions are generally priced higher. However, evidence suggests that once

the size of an LBO exceeds somewhere around $5 billion, this relationship changes and price

stays constant with increases in size. After transaction value exceeds around $10 billion, price

declines as transaction value increases. The rate of change is about a 0.1 to 0.2 decrease in

EV/EBITDA for every $1 billion increase in transaction value. The inverse relationship between

size and price is statistically significant.

This result also explains why club deals—LBOs where private equity firms act in

consortium—were found to be priced lower than other LBOs. Club deals are on average three

times the size of other LBOs and thus benefit from the lower prices of larger deals.

The results of my study support my hypothesis. Regression analysis showed that after a

certain point, larger transactions become more favorable than smaller ones. This result was

statistically significant at the .05 level and robust across three changes to the classification of a

“mega buyout.”

While this study does not prove private equity pursued larger deals because of better

pricing, this study shows there are economic reasons for private equity to pursue larger

transactions. This study shows the relationship between prize and size is different for small and

large LBOs. From the perspective of a private equity firm, a larger transaction will be more
favorable as size increases, thus propelling private equity to increase the size of LBOs. Two

alternate explanations for the increase in transaction size by private equity—fee structure and

clout with lenders, advisors, and employees—are explored in Appendix D.

This study suffers from several limitations that might be addressed in further research.

First, studying price rather than returns is an inherently flawed way to study deal favorability.

There is no way of knowing the returns of the LBOs of the mid-2000s this soon after the

completion of the transactions. Deals that seem favorable from their valuation may still deliver

low returns. There are also a number of intangibles, such as management performance, that

are not included in my analysis of pricing. That being said, there are strong reasons to believe

that price is a good proxy for evaluating the favorability of an LBO. As discussed in detail in

Section 2.1, price has become an increasingly important determinant of LBO returns. Second,

this study includes LBOs that were announced but later cancelled.57 Lastly, in compiling the

dataset, certain transactions were excluded due to data limitations. There might be a bias in

excluding these transactions that mask the true relationship between price and size.

It should be noted that I found no significant difference in results after removing all cancelled deals from the

Appendix A

Private Equity and Financial Distress

Financial distress rates for LBOs vary substantially over time. Andrade and Kaplan (1998)

found that 29 percent of their dataset (LBOs from 1985 to 1989) had defaulted by 1995. Kaplan

and Stein (1993) attribute this high default rate on transactions using less bank debt and fewer

covenants. Guo, Hotchkiss, and Song found a 12 percent financial distress rate for their dataset

of 192 buyouts from 1990 to 2006. Kaplan and Strömberg (2009) found a 7 percent financial

distress rate for his dataset of 17,171 deals from 1970 to 2007.

The high default rate of the late 1980s indicates trouble for LBOs from 2003-2007, when

leverage and pricing peaked similarly to the 1980s (Axelson et al., 2008). Guo, Hotchkiss, and

Song (2007) found that post-buyout performance is positively related to bank financing. This

conclusion is theoretically consistent with past research. Berlin and Mester (1992) and Smith

and Warner (1979) show that the concentration of bank debt makes it easier to negotiate.

Research suggests that ease of negotiating then lowers financial distress costs (Gilson, John and

Lang (1990)).

However, this benefit of bank financing that decreases financial distress has largely been

eliminated in the recent boom due to the role of structured credit. 87 percent of CDOs from

2003 to 2007 were arbitrage CDOs, meaning they were sold off banks’ balance sheets

(Shivdasani and Wang, 2009). The large role of these structures in financing bank loans to

private equity from 2003-2007 implies much of LBO bank debt has been distributed to financial

institutions around the world. Therefore, even though bank debt grew to 81.3 percent of non-

equity financing for LBOs during the LBO boom (Axelson et al., 2008), financial distress is likely

to increase similarly to the 1980s boom. This position contrasts with that of Kaplan and

Strömberg (2009), who argue higher coverage ratios and looser debt covenants will keep

defaults significantly below those of the 1980s. Kaplan and Strömberg’s point is that covenant

light debt will cause less defaults because borrowers will actually have to run out of money

before they can default. However, this claim is contradicted by the work of Demiroglu and

James (2010), who find that buyouts financed by loans with more financial covenants are less

likely to experience financial distress.

I find it strange that Kaplan would underestimate the significance of negotiations for

default rates, especially since Kaplan and Stein (1993) argue that one of the reasons the

majority of LBO defaults in the 1980s ended up in court was due to the difficulty of conducting

private workouts when the debt is widely dispersed. Acharya, Franks, and Servaes (2007) take

an opposing position, arguing coordination problems with hedge funds and other institutions

should be easier. Ultimately, coordination depends on the total dispersion of the syndicated

and securitized debt, which is very difficult to trace.

Appendix B

Mega Buyout Funds: The Next Five Years

Mega buyout funds were hit especially hard by the 2008 credit crisis and ensuing

recession. The disproportionate declines in net asset values (NAV) of mega buyout funds

compared to smaller funds is due to the greater size and increased leverage of mega buyouts.

Fig. B.1: Change In NAV by Buyout Fund Size 58

But even on a proportional basis, the returns of mega buyout funds plunged significantly.

Preqin PE Spotlight Jan 2010, Vol 6 Issue 1

Fig. B.2: Median Buyout Horizon IRRs by Fund Size59

The decreased performance of mega buyouts in recent years could significantly impact

the clout of established private equity institutions on Wall Street if investors reallocate capital

to smaller funds. Lower capital going to mega-buyout funds would mean smaller LBOs, less

M&A fees, and less influence on LBO lenders. A January 2010 survey of LPs indicates investors

are indeed re-evaluating their private equity investments.

Preqin PE Spotlight Jan 2010, Vol 6 Issue 1

Fig. B.3: LP’s Views of Fund Types as of Jan 2010 60

However, I think the LP’s renewed interest in small and mid-market buyouts is

transitory. Mega LBOs have been hit especially hard by the recent crisis because of their high

leverage. Once the economic situation improves, mega buyouts will recover a significant

portion of their value. Furthermore, much of the capital raised from 2003-2007 has not been

invested yet, as evident in Figure B.4). These funds will likely be invested in better priced deals

than the 2003-2007 buyouts and should therefore provide substantial returns to investors. 61

Preqin PE Spotlight Jan 2010, Vol 6 Issue 1
It will be many years, probably a decade, before anyone can make strong conclusions on the return of private
equity from 2003-2007. This is illustrated in Kaplan and Stromberg’s (2009) dataset. Out of 17,171 transactions
going back all the way to 1970, less than 50% had exited.

Fig. B.4: Private Equity Assets Under Management as of June 2008 62

Figure B.4 only depicts deployed capital and dry powder as of June 2008. However,

given that buyout activity has been severely constrained since June 2008, the amount of dry

powder depicted in this chart still applies to the beginning of 2010.

Preqin PE Fundraising Spotlight 2008

Appendix C

Private Equity Fee Structure

The fee structure of private equity traditionally consists of an annual 2 percent

management fee of all assets currently held and managed by the private equity firm and a 20

percent performance fee consisting of 20 percent of the gross profit earned when a portfolio

company is sold. Over time, these fees can add up to substantial amounts. Metrick and Yasuda

(2007) estimate fees to equal 19 cents out of every 1 dollar invested in private equity. Not

surprisingly, fees tend to adjust as the negotiating power of firms and investors fluctuates.

Figure C.1, gives management fees by fund size from 2000-2009. Larger funds tend to have

slightly smaller management fees.

Fig. C.1: Trends in Management Fees by Fund Size and Vintage Year 63

Preqin PE Spotlight Nov 2009, Vol 5 Issue 11

Recently, as the bargaining power of LPs has increased, fees have again become a point

of debate. One of the key new principles of the International Limited Partner Association is

that, “management fees should cover normal operating costs for the firm and its principals and

should not be excessive.” 64 This statement reflects the problem with having management fees

constant across fund sizes. Management fees are supposed to be enough to “keep the lights

on,” but with economies of scale, a large fund can earn a substantial profit merely from the

management fees.

“Private Equity Principles,” Institutional Limited Partners Association, 2009. www.ilpa.org

Appendix D

Two Alternate Theories of the Rationale behind Mega Buyouts

I recognize two alternate theories on why private equity firms embrace size: fee

structure and clout with lenders, advisors, and employees (collectively referred to as Wall

Street). Both of these theories provide alternate explanations for why private equity firms

embraced size over the last decade.

Under the current fee structure of private equity, a GP will earn significantly more from

a larger transaction than a smaller one, even if the larger one is significantly less profitable. 65

From a private equity firm’s perspective, a 10 percent return on a $40 billion LBO is better than

a 40 percent return on a $10 billion LBO. 66 The private equity group will make $800 million on

both LBOs from carried interest. However, management fees will be much greater for the $40

billion LBO. 67 Management fees are supposed to cover operating expenses of the GP, however,

for very large transactions, management fees have become a significant source of profit

because of economies of scale. An example of these economies of scale is the average staff per

assets under management. As depicted in Figure C.1 below, a private equity firm with more

than $10 billion assets under management (AUM) needs almost half as much staff per $1 billion

of AUM as a private equity firm with $1-2.5 billion AUM.

For more information on the fee structure of private equity, refer to Appendix C.
Assuming the firm is using the standard fee structure: 2% management and 20% carried interest
The $40 billion LBO will make $800 million from management fees versus $200 million for the $10 billion LBO.
Even if the management fee is only 1.5 percent, which is true for some large funds, fees from a large LBO are $400
million higher than the smaller one.

Fig. C.1: Average Number of Staff per Firm by Value of AUM 68

Therefore, even though a large target might not be as favorable as a smaller one, a

private equity firm still has an incentive to pursue the larger deal.

The second alternate hypothesis on why private equity firms have incentive to pursue

size is that it increases their clout with Wall Street, which in this case refers to the network of

financial institutions (most importantly, large investment banks) and the professionals at these

firms that control large amounts of capital. Private equity’s new clout on Wall Street is a result

of private equity’s ability to drive deal activity. This idea is well represented in the infamous

statement of Citigroup CEO Chuck Prince that “When the music plays, we’re still dancing.” As

described in detail in Section 1.6, investment banks have a strong incentive to lend to private

Preqin Employment Report, Sept. 20, 2009.

equity firms. In fact, Prince’s statement suggests this incentive is so strong that investment

banks are actually worse off if they choose not to participate. It is not surprising that research

from Demiroglu and James (2010) shows that high reputation firms enjoy preferential access to

lenders, resulting in lower rates and less covenants (see Section 1.5).

Empirical evidence also suggests that executing the biggest deal is prestigious and

desirable for a private equity firm. The timing of the mega LBOs during the buyout boom

supports this theory. 69 According to data from Capital IQ described below in Figure C.2, the

announcement of the five biggest announced LBOs came in a very gradual manner, with 3-4

months separating each subsequently bigger announcement.

Fig. C.2: Timing of the Five Largest Announced LBOs 70

Announcement Date Target Transaction Value Private Equity Sponsors

06/29/2007 BCE, Inc. 46,340.85 Merrill Lynch; Madison Dearborn; Providence

Equity Partners; Teachers' Private Capital

02/25/2007 TXU Corp. 45,236.53 Goldman Sachs; TPG; KKR

11/19/2006 Equity Office Properties 36,924.63 The Blackstone Group

07/24/2006 HCA, Inc. 33,436.11 Merrill Lynch; KKR; Bain Capital

05/28/2006 Kinder Morgan, Inc. 30,456.27 Riverstone; The Carlyle Group; AIG; Goldman Sachs

There is clearly an allure for a private equity firm to execute the largest deal. The almost

rhythmic rise in transaction values could signify a fundamental misalignment of incentives

somewhere in the private equity investment structure. There is reason to believe this
This buildup of transaction value over time is also evident in the 1980s boom, which peaked with the LBO of RJR
Nabisco in 1988.
Data from Capital IQ

misaligned incentive is the GP fee structure, which was not designed with large funds in mind.

As Jensen (1989) presciently warned, “I look with discomfort on the dangerous tendency of LBO

partnerships, bolstered by their success, to take more of their compensation in front-end fees

rather than in back-end profits earned through increased equity value.” There is a strong

argument to be made that the fee structure of private equity misaligns incentives. However,

given the results of my research—that mega buyouts are indeed priced more favorably than

smaller transactions—this incentive for size is not necessarily bad for the Limited Partners.


Definition: Description:
Carried Interest The share of profits given to the General Partner as compensation to

incentivize good performance (usually 20 percent).

Club Deal A buyout where a number of private equity firms pool their resources to

execute the transaction as a consortium.

Collateralized Debt A bundle of fixed-income asset-backed securities that is divided into

Obligation (CDO)
tranches of varying seniority by investment banks and sold to investors.

Collateralized Loan A CDO where the underlying securities are loans, most commonly
Obligations (CLO)
leveraged loans. Arbitrage CLOs are CLOs that are sold off the books of the

underwriting banks to other investors.

Covenant light (Cov-lite) Bank loans that do not carry the usual covenants that restrain risk-taking

by borrowers. The emergence of cov-lite is generally traced back to the

explosion of the structured credit market in the mid-2000s, which made

banks less watchful of covenants since many loans were syndicated or


Distressed Investments Investments in securities that are deeply discounted because the issuers

are in financial distress.

Divisional Buyout An LBO of a division of a larger corporation.

Dry Powder Capital committed to a private equity fund that has not been called up by

the GP.

Financial Sponsor See private equity firm

General Partner (GP) See private equity firm

Institutional Loan Loans that do not amortize over time, indicating they have bullet

maturities. The converse of institutional loans is pro-rata loans, which

consist of revolving credit facilities and amortizing term loans.

Leveraged Buyout (LBO) An acquisition usually conducted by a financial sponsor where a significant

portion of the purchase price, often 75%, is financed by debt. The target of

an LBO is usually a mature company with steady cash flows, a strong asset

base, low debt, and undervalued equity.

Leveraged Loan Loans extended to significantly leveraged companies at higher rates than

other loans and often used to fund LBOs.

Limited Partner (LP) The investors in private equity funds.

Management Fees An annual fee charged by the General Partner to cover the administrative

and operational costs of the private equity firm.

Mezzanine Investments An investment in preferred stock or subordinated debt that is senior only

to common stock. The junior position within the capital structure means

mezzanine debt is more risky and delivers higher returns than other debt.

Money Chasing Deals Hypothesis put forth by Gompers and Lerner (2000) that argues returns
from private equity should be negatively related to capital committed to

private equity because increased competition for deals increases prices

thus diminishing returns.

Portfolio Company A company held and managed by a private equity firm after a buyout.

Private Equity Firm Partnerships or limited liability corporations that make money by investing

and managing capital from investors through leveraged buyouts, venture

capital, and distressed and mezzanine investments. Though firms that

invest in venture capital and distressed and mezzanine opportunities are

often considered private equity firms, for the purposes of this thesis,

private equity firms refers exclusively to firms conducting buyouts. The

capital managed by buyout private equity funds dwarfs the capital

managed by the other forms of private equity. Private equity firms raise

and manage private equity funds.

Private Equity Fund Pools of capital with a fixed life of 10-13 years that are raised and managed

by private equity firms. Private equity funds are organized as limited

partnerships in which the investors are limited partners and the private

equity firm is the general partner. A private equity firm raises multiple

funds over time, depending on how fast it is investing the capital

committed to each fund. Private equity funds are generally closed-end,

meaning funds committed by investors cannot be withdrawn later.

Investors do not provide the capital until the GP finds a suitable

investment. Funds usually have covenants that restrict the possible

investments of the GP.

Private-to-Private LBO A leveraged buyout of a private company. Private companies are usually

smaller than public companies so the transaction values of these deals

tend to be small and are considered middle-market.

Public Market Equivalent Compares private equity returns with the returns of the public market

(introduced by Diller and Kaserer (2004). PME is the ratio of what the

investor receives from an investment in a private equity fund over what

the investor would have earned from an equal investment in the public


Public-to-private LBO An LBO of a public company that results in the financial sponsor taking the

company private.

Secondary Buyout The acquisition of a portfolio company by another private equity firm.

Venture Capital An investment vehicle that invests capital in young companies with high

growth potential.

Vintage Year The year in which a private equity fund is raised by a financial sponsor.

Wall Street This term refers to high finance institutions and the culture of the

professionals at these institutions. Wall Street is dominated by the ability

to generate returns. In this paper, Wall Street generally refers to large

investment banks providing underwriting and advisory services to



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I am heartily thankful to my supervisor, Michael Clement, whose guidance and support

was instrumental to the completion of this thesis. His willingness to entertain my musings and
ability to focus my efforts is greatly appreciated. I am also thankful to my second reader,
Jonathan Cohn, and the other faculty members at the McCombs School of Business who
assisted me in my research. Lastly, I am grateful to my parents for their financial support.


Roland C. Südhof grew up in Dallas, Texas where he attended the Episcopal School of
Dallas. In 2006, he enrolled in the Plan II Honors Program and Business Honors Program at The
University of Texas at Austin, where he also pursued a Masters in Professional Accounting.
Roland first became interested in private equity in the summer of 2009, when he was
introduced to the LBO capital structure while interning in the corporate finance group at Energy
Future Holdings (the $45 billion TXU buyout conducted by KKR, TPG, and Goldman Sachs). After
graduation, Roland will work as an analyst at a bulge-bracket investment bank in New York.