Financing patterns of European Buy-Outs

Table of contents

Table of contents

List of Acronyms

List of Objects

1. Introduction
1.1. Definition of Buy-Outs
1.2. Relevance of Buy-Outs
1.3. Research focus
1.4. Methodology & structure

2. The quest for a theory on optimal capital structure
2.1. Traditionalists
2.1.1. Assumptions made by traditionalists
2.1.2. Irrelevance hypothesis
2.2. Modernists
2.2.1. Tax hypothesis
2.2.1.1. Corporate taxes
2.2.1.2. Corporate and personal taxes
2.2.2. Risky debt hypothesis
2.2.3. Costly contracting hypothesis
2.2.3.1. Assumptions made in Agency Theory
2.2.3.2. Definition of contracting parties
2.2.3.3. Agency conflicts and costs
2.2.3.4. Implications for shareholders and empirical evidence from leveraged Buy-Outs
2.3. An integrated model of capital structure
2.3.1. The case of pure debt and equity
2.3.2. The case of hybrid financing instruments

3. Financing patterns of European Buy-Outs
3.1. Determinants of capital structure choice
3.1.1. Asset characteristics
3.1.2. Liability characteristics
3.1.2.1. Senior debt
3.1.2.2. Mezzanine
3.1.2.3. High Yield
3.1.2.4. Preferred equity
3.1.2.5. Ordinary equity
3.1.2.6. Summary
3.1.3. Availability of funds
3.1.4. Summary
3.2. Evidence from European Buy-Out capitalisation

4. The capitalisation process and other sources of value

5. Summary and outlook

6. References

7. Appendix
7.1. Additional sources of information
7.2. Leverage effect
7.3. Derivation of the Miller Model
7.4. Financial model for capitalisation analysis

List of Acronyms

illustration not visible in this excerpt

List of Objects

Figure 1 European fund in and out-flow of selected asset classes

Figure 2 Five year trend in European private equity investments

Figure 3 Stage model of the Buy-Out process

Figure 4 Graphical representation of the Miller model

Figure 5 Impact of costs of financial distress on firm value

Figure 6 Illustration of the underinvestment problem

Figure 7 Agency costs’ effect on firm value

Figure 8 Illustration of the trade-off theory

Figure 9 Determinants of Buy-Out capital structure

Figure 10 Sources and uses of funds in the European Buy-Out market

Figure 11 European senior debt issuance

Figure 12 European issuances of hybrid products

Figure 13 Funding vs. investment in European equity products

Figure 14 Components of realised returns

Figure 15 Graphical representation of Modigliani and Miller’s proposition II

Table 1 Overview of different Buy-out models

Table 2 Comparison of cash flows from investment in the levered vs. unlevered firm

Table 3 Direct and indirect costs of financial distress

Table 4 Classification of Agency problems

Table 5 Stereotypes of contractual parties

Table 6 Array of Agency problems analysed

Table 7 Agency costs revisited

Table 8 Selection of empirical studies on optimal capital structure

Table 9 Selection of theoretical research on optimal capital structure

Table 10 Selection of empirical studies on optimal capital structure

Table 11 Overview of individual financing instruments’ characteristics

Table 12 Popular covenant types

Table 13 Qualitative evidence from contractual specifications

Table 14 Large cap financial sponsors

Table 15 Levers for value generation in Buy-Outs

Table 16 Interview partners from the investment community

Table 17 Interview partners from academia

1. Introduction

The 1980’s saw the creation of a new form of corporate takeover: Leveraged Buy-Outs.^[2]Extensively discussed, they led to a widespread public debate on corporate governance in the US that culminated in a 1989 congressional hearing on the possible implications of leveraged Buy-Outs for the economy.^[3]

The public picture was clear: The “Barbarians at the Gate“^[4]travelled in pin-striped suits knocking on executives’ doors while asking for their seat in the corporate boardroom. Actions such as, paying for acquisitions with borrowed money, cutting jobs, stealing tax money from the state through increased leverage and selling the firms after a couple of years for a huge profit, all contributed to the image of LBO financiers as corporate raiders. Not only within the public spectre, but moreover, economic literature seriously criticised the one-off gains and zero-sum sources of value^[5]associated with leveraged Buy-Outs. Summers labels the private benefit of LBO shareholders as being achieved at the expense of other stakeholder groups, misevaluations and future growth opportunities.^[6]

Despite this, advocates of this new form of organisation were to be found. Not only did investors searching for higher returns in a low interest environment, welcome the advent of the LBO asset class, but moreover literature began to develop awareness of the benefits of those transactions. The solution to acute incentive problems found in public corporations, which this new form of takeover was able to offer led Jensen to remark: ”The last share of publicly traded common stock will be sold in 2003”^[7].

Knowledge of this new acquisition technique quickly began to reach Europe and by 1989 the total value of Buy-Out transactions undertaken reached €bn 6.5 in the old continent, a 70% year on year increase from 1981.^[8]After a fall in Buy-Out activity in the late 1990’s transactions have recently increased with prominent examples in 2003 including the €bn 1.05 takeover of BertelsmannSpringer, the science and business media publishing unit of Bertelsmann, by UK financial sponsors Cinven and Candover^[9]and the €bn 5.7 takeover of Seat PagineGialle by a consortium of BC Partners, CVC Capital Partners, Investitori Associati, and Permira^[10], Europe’s biggest Buy-Out in 2003.

Of particular interest to both the academic and financial communities, is the aspect of their financing structure. Why are LBOs financed with so much debt? How are the complicated financing structures justified? In the end, what value will be created for the equity investor? These are just some questions that will be touched upon within this research.

The first chapter should give us a first glance of the Buy-Out landscape and the structure of this document by providing:

- A definition of Buy-Outs in general and our research subject in detail.
- A justification of the relevance of the Buy-Out sector to an equity investor.
- Guidance on the focus of our research within the Buy-Out process.
- An introduction to the methodology and structure employed in this research.

1.1. Definition of Buy-Outs

Buy-Out transactions are a sub-segment of the private equity market performed in the latter stages of a company’s life cycle.^[11]“Simply stated, a Buy-Out involves the transfer of ownership of an entity from its current owners to a new set of shareholders […]”^[12], thereby relying on specialised finance companies^[13]. Another characteristic of Buy-Out transactions is the take private of the target company through the buying-up of shares that are consequently removed, at least partially, from publicly traded securities markets.^[14]In practice different kinds of Buy-Outs are distinguished.^[15]

Table 1 Overview of different Buy-out models

illustration not visible in this excerpt^[16]

Notes: † Broader basis then existing management, includes employees from different levels.

‡Financial goals include return on investment, private wealth, etc.; Personal goals include job security, status, etc.; Strategic goals include growth prospectuses for company, platform strategy, etc..

Source: Own analysis i.c.w. Schabert (2000), pp.7-11, BVK (2003), p.36.

A common factor among all types of Buy-Outs is their leveraged financing. This technique requires the target company to support a heavy debt burden. A long standing argument was that, due to the leverage effect^[17]this increase in debt yields higher equity returns and thus benefits equity investors. We will see that additional advantages of increased debt use are tax and incentive benefits.^[18]

Important differences between Buy-Out models exist as well, mostly due to differing information and incentive structures. This research will largely focus on IBOs due to their pronounced economic importance and increased deal size, allowing for the full array of financing instruments to be analysed.^[19]

The long standing mantra of Buy-Outs being limited to stable cash-flow, no growth target companies seems to have been weakened by the advent of the new form of entrepreneurial Buy-Outs undertaken in very dynamic industries.^[20]For the purpose of this research, however, we shall stick to the stereotype of a stable company with a well proven business model to analyze financing behaviour ceteris paribus.

1.2. Relevance of Buy-Outs

Today more than ever, wealth is amassed in private portfolios.^[21]However, in a time of saturated markets with fierce competition and dwindling interest rates, investors are forced to look beyond traditional investment means, such as stocks or bonds, to increase the return of their portfolios.^[22]Whereas other asset classes, like traditional equity or bonds, have seen divestment activity in the past five years private equity has attracted a steady inflow of investments^[23]from asset managers.^[24]This is mainly due to its attractive return^[25], reasonable volatility and portfolio diversification effect.^[26]

Figure 1 European fund in and out-flow of selected asset classes

illustration not visible in this excerpt

Note: Average annual return in % and standard deviation of asset class shown in circle; Period 1994-2003 was used; Indices include JP Morgan European Government Index (Bond), MSCI Europe (Equity), Merrill Lynch Private Equity Index (Private equity);.

Source: EVCA (2004b), p. 24; Merrill Lynch (2004b), p.12; DWS (2004), p.10.

Zooming into the private equity market, a trend towards Buy-Out investments seems to emerge.^[27]Survey results by Goldman Sachs show an increasing optimism for Buy-Out investments in years to come.^[28]

Figure 2 Five year trend in European private equity investments

illustration not visible in this excerpt

Note: Total capital invested shown in circles.

Source: EVCA (2004a), p.13.

The increase of Buy-Out funds raised can be attributed to investors reducing their exposure to highly volatile early stage investments which had to be written off after the burst of the New Economy bubble in the year 2000.^[29]

The following trends can be observed in the European Buy-Out market^[30]:

- The Buy-Out market breaks records in both investments and deal flow. In 2003 €bn 18.4 have been invested in 536 deals.
- High value deals (above €m 250) are on the increase.
- Germany is the number one market after France, measured by deal value.
- Local divestment remains the most common source of Buy-Outs.
- General manufacturing is the most active sector.

To summarise this chapter we can conclude that the private equity asset class, and specifically the Buy-Out sector, are of great importance to the global investor.

1.3. Research focus

After having defined our research subject and justified its importance we come to the question of what specifically will be covered within this paper.

The full Buy-Out cycle includes three different phases: the acquisition, holding and divestment phase.^[31]Within every phase we can distinguish between various tasks that have to be performed by the equity investor to guarantee the success of the transaction.^[32]

Figure 3 Stage model of the Buy-Out process

illustration not visible in this excerpt

Source: Own analysis i.c.w. Berg/Gottschalg (2003), p.5 et seq..

We will concentrate our research efforts on the description of the capitalisation task. In particular we will analyse the value creation potential of adequate leveraged Buy-Out capitalisations in Europe, taking the perspective of an equity investor. This will include both a practical and a theoretical view on the subject.

1.4. Methodology & structure

As stated above our declared goal is the explanation of European LBO capitalisation. To achieve this, we will keep an equity investor’s perspective and ask the question of how value is created for the investor by capital structure alternations.

In the tradition of Decision Theory’s prediction, that “better answers to normative questions are likely to occur when decision makers have a richer set of positive theories”^[33], we will choose a positive research focus, i.e. we will primarily concentrate on explaining capitalisation structures found in the market rather than constructing a normative model on LBO capitalisation.^[34]Historically, corporate finance theory has rather focused on normative questions while neglecting positive theories.^[35]This behaviour bears the risk of drawing conclusions based on a misconception of reality.^[36]

We will look beyond the traditional financing instruments of pure debt and ordinary equity. Present day leveraged transactions are capitalised by employing a wide array of different financing instruments transmitting various effects on firm value. Specifically we will observe the use of senior debt, high yield bonds, mezzanine loans, preferred and ordinary equity in the market.

The evidence provided from this observation is primarily of a qualitative nature. Although this evidence is not able to deliver answers on the absolute strengths of underlying forces, it is able to generate valuable insights on the direction and foundations of these forces. In the social sciences qualitative evidence has been employed frequently and is particularly popular with the Property Rights and Economic Analysis of Law literature.^[37]It even helped shape entire branches of scientific research.^[38]

This research is structured accordingly:

In chapter 2 we will introduce traditionalist and modernist views on optimal capital structure. For the traditionalist view, we identified the irrelevance hypothesis of capital structure for firm value. For the modernist view we will derive and provide empirical evidence for the tax, risky debt and costly contracting hypothesis. On the basis of these hypotheses we will derive a model of optimal capital structure for the case of pure debt and equity. For the case of hybrid financing instruments we will provide a thorough review of state-of-the-art research.

Chapter 3 will introduce the determinants of Buy-Out capitalisation structures. Mainly asset characteristics, liability characteristics and availability of funds are found to have an impact on the final capitalisation of a Buy-Out. Furthermore we will observe financing patterns of European Buy-Outs in the light of those determinants.

Chapter 4 will embed the capitalisation process in a framework for value levers in Buy-Out transactions.

Chapter 5 will summarise our findings and provide the reader with an outlook on further research.

2. The quest for a theory on optimal capital structure

In the following chapter, we will undertake a journey initiated in the late 1930’s, namely the quest for a theory on optimal capital structure. Researchers have long been asking the question whether differences in a firm’s capital structure have an impact on the value of the firm^[39], thereby using two rival views: Traditionalists^[40]argue that markets are efficient, leading to the result of capital structure’s irrelevance for firm value. Moreover, Modernist research suggests that market frictions are existent,^[41]thus obtaining an optimal capital structure. We will discuss both views and their implications for the existence of an optimal capital structure by:

- Presenting the basic assumptions made in the two competing theoretical concepts.
- Deriving the main hypotheses as developed by traditionalists and modernists.

2.1. Traditionalists

Prior to the 1950’s, finance literature largely consisted of ad hoc theories containing little systematic analysis.^[42]Its major concerns were optimal investment and dividend policies, but little consideration was given to the effects of financing decisions and the nature of equilibrium in financial markets. Theories were mostly of a normative nature with little attention to positive questions. In the 1950’s fundamental changes in finance began to occur. Hand in hand with the introduction of traditional analytical methods and techniques to finance problems, came a shift in research focus from normative to positive theories. Being in the tradition of Neoclassic Economic Theory,^[43]early researchers in the field of corporate finance assumed that markets are perfect. Those traditionalists therefore came to the conclusion that a firm’s financing choice does not have an impact on its market value. This chapter will:

- First take a closer look at the assumptions made on perfect markets.
- Secondly build on those assumptions to derive the irrelevance hypothesis of financing choices for firm value as proposed by Modigliani & Miller.

2.1.1. Assumptions made by traditionalists

Traditionalists regarded markets as being perfect, thereby making the following primary assumptions:

- Absence of corporate and personal taxes^[44]

A world without frictions does not include any government intervention, i.e. no taxes are being paid on corporate or personal earnings.

- Debt is risk free^[45]

Debt is always provided to the firm at a constant cost regardless of leverage, i.e. costs of financial distress are not considered.

- Symmetrical information

Asymmetrical information and conflicts of interest between managers and investors are not being recognised^[46], i.e. no Agency costs are imposed on shareholders.

Additionally, the following assumptions have been made:

- All firms are supposed to be in the same risk class^[47]

When formulating their original theory, Modigliani and Miller did not have a tool to allocate a risk profile to a firm. Later, the capital asset pricing model was introduced by Sharpe^[48], Lintner^[49]and Mossin^[50], thus providing a framework for adequate risk evaluation. Integrating the CAPM and capital structure theory, Benninga and Sarig derive the invariance of firm value to leverage.^[51]Hence we can relax this assumption without changing the fundamental insights of Modigliani & Miller.

- The corporate investment plan is determined solely on NPV criteria^[52]

This assumption excludes the fact that the corporate investment plan is determined through financing choices, i.e. the capital structure does not affect cash flows. We will indirectly relax this assumption when discussing market frictions implied by taxes, costs of financial distress and Agency costs. However, three areas of additional research have been identified covering the interdependence of a firm’s financial and product market decisions in the areas of strategy^[53], industry structure^[54]and relationships along the value chain^[55]. As those areas constitute a very new research focus that has neither developed coherent theories nor sufficient empirical tests, we will refrain from covering it in here.

2.1.2. Irrelevance hypothesis

With their ground breaking paper, Modigliani and Miller derived the irrelevance of capital structure for firm value.^[56]

To arrive at that conclusion, they were one of the first to use an arbitrage^[57]argumentation. Their line of reasoning rests on two investment strategies: strategy I involves investing in an unlevered company, and strategy II in a levered company. To buy an unlevered company, the investor has to buy its stocks for the value Abbildung in dieser Leseprobe nicht enthalten^[58]and can claim its expected earnings Abbildung in dieser Leseprobe nicht enthalten.^[59]The alternative, strategy II, is to invest in the levered company, however, the stock investor has to bear the cost of debt financing and consequently receives only Abbildung in dieser Leseprobe nicht enthalten in earnings for its cash layout of Abbildung in dieser Leseprobe nicht enthaltenin period 0.^[60]The total value of the levered company is the sum of the value of stocks plus the value of bonds.^[61]

Formula 2-1 Abbildung in dieser Leseprobe nicht enthalten

Table 2 Comparison of cash flows from investment in the levered vs. unlevered firm

illustration not visible in this excerpt

Note: B = Value of the bonds of a levered company, E[x] = Expected earnings, F = Face value of bonds outstanding, Rf = Cost of risk-free debt, SL = Value of the stocks of a levered company, SU = Value of the stocks of an unlevered company, VL = Value of the levered company, VU = Value of the unlevered company.

Source: Own analysis i.c.w. Ross/Westerfield/Jaffe (1996), p.386 et sqq..

As the stream of earnings of the levered company replicates the stream of earnings of the unlevered company the two initial investments must be equal:

Formula 2-2 Abbildung in dieser Leseprobe nicht enthalten or^[62]

Formula 2-3 Abbildung in dieser Leseprobe nicht enthalten (M&M Proposition I)

Here the arbitrage argument holds. Would the value of the levered company be greater than the value of the unlevered company, i.e. Abbildung in dieser Leseprobe nicht enthalten, an arbitrageur would benefit by borrowing money on his own account and investing in the unlevered company thus replicating the cash flows of the levered company, but having bought in cheaper.^[63]If it holds that Abbildung in dieser Leseprobe nicht enthalten, then an arbitrageur would have to short strategy I and long strategy II to benefit. Acting as an arbitrageur influences prices and thus the arbitrage opportunity vanishes.^[64]It seems that in equilibrium Formula 2-3 holds true.

This model has been labelled as the pie model of capital structure,^[65]due to the fact that the pie, i.e. firm value, stays the same regardless of leverage. Hence, capital structure decisions can be seen to be a mere means of distributing this fixed value to the claimholders, i.e. shareholders and bondholders.

The simplicity of this insight is palpable, however, it is not able to explain capital structure decisions in reality.^[66]Why should shareholders take on debt if they cannot positively affect firm value? Literature soon criticised the restrictive assumptions made by Modigliani & Miller. In the following chapter, we will try to relax those assumptions in order to better align the model to actuality.

2.2. Modernists

As shown in the previous chapter a traditionalist approach towards capital structure research will ultimately lead to the irrelevance hypothesis. Literature soon began to criticise the restrictive assumption of perfect markets made by this approach.^[67]Market inefficiencies began to appear on the radar screen of economic researchers. In particular taxes, costs of financial distress and informational asymmetries made researchers think about how to incorporate those frictions into their capital structure models.

Within this chapter we will present theoretical concepts developed in response to the identified market frictions in a ceteris paribus analysis, i.e. other variables constant, the effect on firm value will be analysed for the following variables:

- Corporate and personal taxes (tax hypothesis)
- Costs of financial distress (risky debt hypothesis)
- Agency costs (costly contracting hypothesis)

2.2.1. Tax hypothesis

Soon after the original paper of Modigliani & Miller, researchers began to realise that a company’s capital structure and its operating environment are not independent^[68], moreover balance sheet and income statement are linked. Suppose, taxes are being introduced and interest payments are tax deductible. As taxes are nothing else than a cost to the firm, firm value should be maximised by minimising those costs. In this way, higher leverage reduces tax costs and maximises firm value.^[69]The following chapter will derive the value generation potential of corporate and personal taxes by presenting the models of Modigliani and Miller (1963) and Miller (1977).

2.2.1.1. Corporate taxes

In a correction to their original paper, Modigliani & Miller react to the critics and derive the value generation potential of corporate tax shields.^[70]They acknowledge that the “deduction of interest in computing taxable profits will prevent the arbitrage process from making the value of all firms in a given asset class proportional to the expected returns generated by their physical assets”^[71]. That means that their Proposition I^[72]has to be restated as:

Formula 2-4 Abbildung in dieser Leseprobe nicht enthalten

The value of the levered company consequently equals the value of the levered company plus the value of corporate tax shields.

The problem with this analysis, however, is that it overstates the tax advantage of debt by considering only the corporate profits tax. As investors in a company care about their after-tax returns^[73], we have to incorporate personal taxes in our discussion.

2.2.1.2. Corporate and personal taxes

Enhancing the results derived by him and his colleague Modigliani, Miller came up with his own model of capital structure, which incorporated both personal and corporate taxes.^[74]If corporate taxes are paid on corporate earnings less interest payments and personal taxes are paid on dividend and interest income received by shareholders, it can be shown that^[75]:

Formula 2-5 Abbildung in dieser Leseprobe nicht enthalten

Figure 4 illustrates this formula.

Figure 4 Graphical representation of the Miller model

illustration not visible in this excerpt^[75]

Note: B = Value of the bonds of a levered company, tB = Personal tax rate on interest, tC = Corporate tax rate, tS = Personal tax rate on dividends and other equity distributions, VL = Value of the levered company, VU = Value of the unlevered company.

Source: Ross/Westerfield/Jaffe (1996), p.436; Keiber (2003), p.8.

If gains on interest income are taxed identical to equity distributions on the personal level, the value of the levered company is equal to the value of the unlevered company plus the tax shield generated through the tax deductibility of interest expenses.^[76]

Formula 2-6 Abbildung in dieser Leseprobe nicht enthalten

Another insight is that in the case of the after-tax dollars to shareholders being equal to the after-tax dollar to bondholders, i.e.Abbildung in dieser Leseprobe nicht enthalten, the value of the levered and the unlevered company are equal.

Consequently, firm value creation potential depends on the relationship of corporate and personal taxes and can be:

- Higher than all-equity firm value plus tax shield (area A)

- Between all-equity firm value and all-equity firm value plus tax shield (area B)
- Lower than all-equity firm value (area C)

In reality, we will find that the average tax rate of shareholders is lower than those of bondholders^[77], for the reason that equity investors receive most of their income through capital gains that are taxed at a lower rate, i.e. Abbildung in dieser Leseprobe nicht enthalten. Additionally, shareholders can postpone taxes by choosing not to realise capital gains, thus earning the time value of money.^[78]However, shareholders are in fact double taxed: once through corporate taxes and again through personal taxes. As a result the after-tax dollars to shareholders should be less than the after-tax dollars to bondholders^[79], i.e. Abbildung in dieser Leseprobe nicht enthalten.

Summarizing our insights on corporate and personal taxation, we can derive a value generation potential of total taxes that is positive, but less than proposed by Modigliani and Miller (1963), i.e. somewhere in area B^[80]. Altogether, shareholder value^[81]will increase modestly.^[82]

Empirical evidence on the tax hypothesis of debt financing has been mixed. Theory predicts that firms with more taxable income or lower non-debt tax shields^[83]should have higher leverage ratios. By regressing non-debt tax shields against companies leverage ratios, early researchers actually found the inverse relation, i.e. more non-debt tax shields meant less debt.^[84]This early research was flawed in two ways. First, the used tax variables were crude proxies for a company’s effective tax rate, and secondly they neglected correlations between variables. For example, companies with high levels of depreciation and other non-debt tax shields tend to have mainly tangible fixed assets. Since fixed assets provide good collateral, high non-debt tax shields may in fact be a proxy not for limited tax benefits, but for low contracting costs associated with debt financing.^[85]More recent research found positive evidence for the tax hypothesis while eliminating shortcomings of early studies by concentrating on incremental financing choices^[86]or by constructing a firm specific tax function^[87]. We conclude that the empirical literature has sufficiently verified the existence of value creation potential in debt implied tax shields.

2.2.2. Risky debt hypothesis

After having introduced taxes to the world of Neoclassic Economic Theory, we will relax another assumption, namely the provision of risk-less debt.^[88]Modigliani & Miller assume in their original paper that debt is provided at a fixed cost regardless of a firm’s leverage.^[89]However, in reality, financial institutions will price bonds according to the expected costs of financial distress, that are calculated by multiplying the discounted costs of financial distress, with the probability of a distressed state being realised.^[90]Let’s take a closer look at the two components of the equation.

Costs of financial distress occur in the case of a levered company not being able to meet its obligation to repay debt or pay interest. We can distinguish between direct and indirect costs of financial distress.^[91]

Table 3 Direct and indirect costs of financial distress

illustration not visible in this excerpt

Source: Ross/Westerfield/Jaffe (1996), p.419 et sqq., Brealey/Myers (2000), p.514 et seq., Kaiser (2002), p.19.

Direct costs are out-of-pocket expenses for the administration of the bankruptcy process. They are of minor importance while accounting for app. 4^[93]to 5^[94]percent of a company’s pre-bankruptcy market value. Of greater importance are indirect costs of financial distress, while accounting for an estimated 20 percent of a company’s pre-bankruptcy market value.^[95]They are induced by the impaired ability to conduct business in a bankruptcy situation, e.g. loss of sales and profits due to lack of confidence in the company^[96].

The probability of a company reaching a bankrupt state rises linearly with leverage.^[97]

With this information, positive discounted costs and linearly rising probability of financial distress, we can derive the following figure.

Figure 5 Impact of costs of financial distress on firm value

illustration not visible in this excerpt

Note: B = Value of the bonds of a levered company, VL = Value of the levered company.

Source: Keiber (2003), p.9.

Hence, firm value is reduced by introducing costs of financial distress. As bondholders rationally assess the present value of the costs of financial distress, they will impose a premium on additional debt financing. This harms shareholders directly and decreases the value of their stocks by the present value of the costs of financial distress.^[98]

Empirical literature proving the risky debt hypothesis is vast and affirmative. A wide array of papers finds evidence on large public corporations^[99]and highly levered transactions^[100]. Consequently, we conclude that the risky debt hypothesis is sufficiently proven.

2.2.3. Costly contracting hypothesis

Within the following section we shall unravel another assumption made by traditionalists: the non-existence of information asymmetries and individual opportunistic behaviour. We will do so by introducing a competing theoretical stream called Agency Theory in the following steps:

- Summarizing the main assumptions made in Agency Theory.
- Characterising the main players of interest in a company’s Agency relationships.
- Discussing Agency problems associated with debt and equity.
- Deriving the implications for shareholders and providing empirical evidence.

2.2.3.1. Assumptions made in Agency Theory

Neoclassic Economic Theory has long seen the firm as a black box^[101]delivering production results, but not allowing for relationships between the acting individuals. Agency Theory tries to overcome those deficiencies while looking at the firm as a “legal fiction which serves as a nexus for a set of contracting relationships among individuals”^[102]. It is important to note that this individualisation of the firm shifts the focus from collectives to individuals and their motivations.^[103]The beginnings of Agency Theory can be traced back to the early 1970’s with papers by Spence and Zeckhauser^[104]and Ross^[105]and led Stiglitz to proclaim a paradigm shift in economic analysis^[106]. Two types of literature can be distinguished that address, “the contracting problem between self-interested maximising parties”^[107].

The Economic Theory of Agency^[108]is a normative, mathematically formalised and less empirically orientated theory. It has traditionally concentrated on the characteristics of contracts between individuals, i.e. preference and informational structure. Analysis is designed towards implications on risk sharing, optimal contract and welfare issues.

In contrast the Financial Theory of Agency focuses on additional aspects of the contracting environment. Monitoring and bonding activities are explained by linking them to factors like capital intensity, degree of specialisation of assets, information costs, etc..^[109]The following paragraph will provide an insight into the fundamentals of both theories.

At the heart of Agency Theory is the Agency relationship between principal and agent. Jensen and Meckling define this relationship as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”^[110]. We can clearly see that this relationship involves direction. Typically the first move, e.g. offering an employment contract, is made by the principal.^[111]The agent can then choose to accept it.

The second assumption made in Agency Theory is that information asymmetries exist between principal and agent. The sources of informational asymmetries can be hidden characteristics, that is to say, the information about personal goals and one’s personality, hidden action, in other words, the inability to monitor the counterparty’s actions, and hidden information, specifically, possession of information that the other counterparty lacks.^[112]Informational asymmetries do not imply bound rationality.^[113]Rather the two contractual parties together would have sufficient information to account for all eventualities that might arise in the contractual relationship. This total information is just distributed unevenly.^[114]As information transfer implies costs we will not observe complete contracts.^[115]Hence the agent’s conduct is not fully discernible by the principal, implying the existence of a discretionary freedom of action.

Linking this discretionary freedom of action to an assumption on human behaviour we can predict possible actions by the principal and agent. Therefore a third assumption in Agency Theory is made on the individual incentive structures. Traditional Agency Theory does not break with the classic model of the homo oeconomicus, i.e. utility maximising human behaviour.^[116]However more recent literature incorporates more complex features in human behaviour.^[117]“The behaviour of the organization is the equilibrium behaviour of a complex contractual system made up of maximizing agents with diverse and conflicting objectives”^[118].

Now it becomes clear that opportunistic behaviour by the contractual parties is possible when using their discretionary freedom of action.^[119]

For the existence of Agency problems a divergence in individual goals has to be present and the discretionary freedom of action has to be exploited to the detriment of the counterparty. Agency problems can be either of ex-ante or ex-post nature with individual or collective organisational reference. Literature has developed a system of classifying the relevant Agency problems.^[120]We will later discuss capital structure specific Agency problems.^[121]

Table 4 Classification of Agency problems

illustration not visible in this excerpt

Source: Jost (2000), p.500.

[...]

^[1]“The average cost of capital on the firm’s existing projects and activities. It is obtained by weighing the cost of each source of funds by its proportion of the total market value of the firm.” [Roos/Westerfield/Jaffe (1996), p.885].

^[2]However, Hoffmann and Ramke find traces of Buy-Out behaviour in the Bible and the Middle Ages [cp. Hoffmann/Ramke (1992), p.31] it were the 1980’s that made this new technique popular.

^[3]US Senate (1989), p.1.

^[4]Title of a book on the LBO of RJR Nabisco that received strong media attention [cp. Burrough/Helyar (1990)].

^[5]Cp. Rappaport (1990), and comment by Summers in DeAngelo (1990), p.415 et seq.

^[6]Cp. DeAngelo (1990), p.416.

^[7]Jensen (1989), p.120.

^[8]Cp. CMBOR (2004), p.38.

^[9]Cp. Meehan/Brewis (2003), p.1.

^[10]Cp. Portanger/Galloni (2003), p.C.5.

^[11]Cp. EVCA (2004c), p.18.

^[12]Wright et al. (1990), p.62 cited in Schabert (2000), p.7.

^[13]Specialised finance companies can be either debt (banks, institutions) or equity providers (financial sponsors).

^[14]Cp. Fox/Marcus (1992), p.63.

^[15]Q.v. Table 1, p.3.

^[16]We introduce this term widely used in the business world to denominate the general partner in a Buy-Out fund. Literature knows several other denominations, e.g. LBO association [cp. Jensen (1989), p.130] or Buy-Out specialist [cp. Cotter/Peck (2001), p.103].

^[17]Q.v. 7.2 Leverage effect, p.77.

^[18]Q.v. 2. The quest for a theory on optimal capital structure, p.8.

^[19]Q.v. 1.3 Research focus, p.6.

^[20]For a discussion of this new form of Buy-Out please refer to Wright/Hoskissen/Busenitz (2001) and Wright/Hoskisson/Busenitz/Dial (2001).

^[21]The leading wealth management consultancy Scorpio Partnership estimates assets under management of the global private banking industry to have reached $trn 4.6 with growth rates of 15% yoy [cp. Scorpio Partnership (2004), p.1].

^[22]Within this research we shall take an equity investor’s perspective, however the Buy-Out topic seems relevant for a broader audience of stakeholder groups, e.g. 60% of companies report an increase in employees post Buy-Out [cp. EVCA (2001), p.14].

^[23]Goldman Sachs estimates that in 2003 4.0% of total European fund assets have been allocated to the private equity asset class compared with just 2.5% in 1999 [cp. Goldman Sachs (2004), p.28.].

^[24]Q.v. Figure 1, p.4.

^[25]Supported by gross performance studies [cp. EVCA (2004b), p.5, Goldman Sachs (2004), p.32], however Kaplan and Schoar find that private equity fund returns are not greater than equity returns net of fees [cp. Kaplan/Schoar (2003), p.2].

^[26]Cp. Merrill Lynch (2004b), p.19 and EVCA (2004c), p.5 as well as Herman, M. (2004), p.1.

^[27]Q.v. Figure 2, p.5.

^[28]The number of respondents rating Buy-Outs as the most attractive private equity investment class over the next three years rose from 28% in 2001 to 61% in 2003 [cp. Goldman Sachs (2004), p.32].

^[29]Source: Interview with Jean-Philippe Maltais (14. June 2004).

^[30]Cp. CMBOR (2004), pp.3-44.

^[31]Cp. Berg/Gottschalg (2003), p.5 et seq.

^[32]Q.v. Figure 3, p.6.

^[33]Smith (1989), p.3.

^[34]Positivism [cp. Schweitzer (1978), p.3] and normative theory [cp. Bea/Dichtl/Schweitzer (2000), p.100] are two specific goals of economic research.

^[35]Cp. Smith (1989), p.3.

^[36]Chmielewicz points out that economic theory and practice are so dynamic that universal validity in the dimensions time, space and object is nearly impossible to achieve. Positive theories can help to understand the interactions of variables that create dynamism [cp. Chmielewicz (1994), p.130 et seq.].

^[37]Cp. Coase (1960), Demsetz (1967), Manne (1967), Alchian/Demsetz (1972), Posner (1972), Cheung (1973).

^[38]Qualitative evidence seems to be instrumental in the development of Natural Sciences [e.g. Darwin (1859)].

^[39]In fact, Williams was the first to argue that a firm’s financing choice does not affect its market value. He calls it the “Law of the conservation of investment value” [cp. Williams (1938), p.73]. Later, Morton derived the same argument [cp. Morton (1954)]. However, none of these works included a proof as sophisticated as Modigliani and Miller’s arbitrage mechanism [cp. Modigliani/Miller (1958), p.269].

^[40]Denomination in analogy to Brealey and Myers [cp. Brealey/Myers (2000), p.484].

^[41]Namely frictions as far as taxes, costs of financial distress and Agency costs are concerned.

^[42]Cp. Smith (1989), p.3.

^[43]For the pros and cons of Neoclassic Economic Theory, please refer to Williamson [cp. Williamson (1988), p.159].

^[44]Cp. Modigliani/Miller (1958), p.273.

^[45]Cp. Modigliani/Miller (1958), p.262.

^[46]Cp. Jensen/Meckling (1976), p.308.

^[47]Cp. Modigliani/Miller (1958), p.266.

^[48]Cp. Sharpe (1961, 1964).

^[49]Cp. Lintner (1965).

^[50]Cp. Mossin (1966).

^[51]Cp. Benninga/Sarig (1998), p.30.

^[52]Idea was originally introduced by Fisher [cp. Fisher (1930)].

^[53]Pioneering research on the interdependency of product market strategy and capital structure, Brander and Lewis protagonised two effects a firm’s financial structure can have on its strategy: The limited liability and the strategic bankruptcy effect [cp. Brander/Lewis (1986), p.956 et sqq.].

^[54]Maksimovic took the interdependency argument of Brander and Lewis further by endogenizing capital structure decisions. He postulated an optimal capital structure depending on the number of firms in an industry and the elasticity of demand [cp. Maksimovic (1988), p.395].

^[55]Includes relationships with a firm’s input suppliers [cp. Sarig (1996)], its workers [cp. Perotti/Spier (1993)] as well as its customers [cp. Titman (1984)].

^[56]Cp. Modigliani/Miller (1958), p.268.

^[57]Arbitrage is defined as a “purchase of one security and the simultaneous sale of another to give a risk-free profit” at no cost [Brealey/Myers (2000), p.1061].

^[58]For acronyms, please refer to the List of Acronyms, p.III.

^[59]Q.v. Table 2 - line (1), p.11.

^[60]Q.v. Table 2 - line (2), p.11.

^[61]Q.v. Table 2 - line (4), p.11.

^[62]With Formula 2-1.

^[63]Cp. Ross/Westerfield/Jaffe (1996), p.388.

^[64]Cp. Modigliani/Miller (1958), p.269.

^[65]Cp. Ross/Westerfield/Jaffe (1996), p.384.

^[66]Cp. Smith (1989), p.9.

^[67]Cp. Rubinstein (2003), p.3.

^[68]Cp. Ross/Westerfield/Jaffe (1996), p.400.

^[69]Cp. Ross/Westerfield/Jaffe (1996), p.402.

^[70]Cp. Modigliani/Miller (1963), p.436.

^[71]Cp. Modigliani/Miller (1963), p.433.

^[72]Q.v. Formula 2-3, p.11.

^[73]Cp. Barclay/Smith (1999), p.10.

^[74]Cp. Miller (1977).

^[75]Cp. Miller (1977), p.267. For a detailed derivation of the formula, please refer to 7.3 Derivation of the Miller Model, p.78.

^[76]Originally derived by Modigliani/Miller (1963), p.436.

^[77]Cp. Barclay/Smith/Watts (1995), p.7.

^[78]Cp. Graham (2003), p.1120.

^[79]Cp. Graham (2003), p.1101.

^[80]Graham estimates the capitalized tax benefit of debt to equal 9.7 percent of firm value [cp. Graham (2000), p.1901 and q.v. Figure 4, p.14].

^[81]Namely the after-tax equity cash flows discounted at the equity cost of capital, less the tax deductible interest payments discounted at the after-tax cost of debt, i.e. .

^[82]Graham estimates shareholder value, created after personal taxes, to be around 4 percent [cp. Graham (2000), p.1901].

^[83]Cordes and Sheffrin suggest that non-debt tax shields, i.e. loss carry forwards, accelerated depreciation, etc., can be quite substantial and may eliminate the need for debt generated tax shields [cp. Cordes/Sheffrin (1983), p.105].

^[84]Cp. Bradley/Jarrel/Kim (1984) and Titman/Wessels (1988).

^[85]Cp. Barclay/Smith (1999), p.18.

^[86]Cp. Mackie-Mason (1990) and Cordes/Sheffrin (1983).

^[87]Cp. Graham (1996, 2000).

^[88]Q.v. 2.1.1 Assumptions made by traditionalists, p.9.

^[89]Cp. Modigliani/Miller (1958), p.262.

^[90]Cp. Myers (1984a), p.580.

^[91]Q.v. Table 3, p.16.

^[92]Some authors count the Agency costs of the underinvestment and asset substitution problem to the indirect costs of financial distress [cp. Jensen/Meckling (1976), p.339, Barclay/Smith/Watts (1995), p.8], however, we will follow Brealey and Myers in their distinction between pure financial distress costs and costs imposed by Agency conflicts [cp. Brealey/Myers (2000), p.511 et sqq.] to better illustrate the gradual relaxation of restrictive assumptions made in classic economic theory.

^[93]Cp. Altman (1984), p.1077.

^[94]Cp. Warner (1977), p.77.

^[95]Cp. Altman (1984), p.1080 and later Lang/Stulz (1992), p.51.

^[96]Cp. Warner (1977), p.72.

^[97]Cp. Keiber (2003), p.9.

^[98]Cp. Ross/Westerfield/Jaffe (1996), p.427.

^[99]Cp. LoPucki/Whitford (1993), Ofek (1993), Opler/Titman (1994), Hotchkiss (1995), and Gilson (1997).

^[100]Cp. Opler/Titman (1993), Asquith/Gertner/Scharfstein (1994), and Andrade/Kaplan (1998).

^[101]Cp. Jensen (1983), p.328.

^[102]This methodological individualism was first mentioned by Schumpeter [cp. Schumpeter (1908), p.90] and later made popular in finance literature by Jensen and Meckling [cp. Jensen/Meckling (1976), p.310].

^[103] Initial research on contractual relationships between and inside firms has been done by Coase
[cp. Coase (1937)] and Alchian and Demsetz [cp. Alchian/Demsetz (1972)].

^[104]Their work concentrated on the analysis of moral hazard in insurance contracts [cp. Spence/Zeckhauser (1971)].

^[105]Ross was the first to coin the term “Principal-Agent-Problem” with one of the first overviews on Agency theory [cp. Ross (1973), p.134].

^[106]Cp. Stiglitz (2003), p.466 et sqq.

^[107]Jensen (1983), p.334.

^[108]Denomination follows Barnea, Haugen and Senbet [cp. Barnea/Haugen/Senbet (1985)], whereas Jensen distinguishes between principal-agent literature and positive Agency literature [cp. Jensen (1983), p.334].

^[109]Cp. Jensen (1983), p.335.

^[110]Jensen/Meckling (1976), p.308.

^[111]Cp. Richter/Furubotn (2003), p.285.

^[112]Cp. Jost (2000), p.475 et seq.

^[113]Cp. Richter/Furubotn (2003), p.238.

^[114]To argue with mathematics: Each individual holds a set of information A respectively B. As A≠B, information asymmetries exist. Full information could be reached through information exchange (AB).

^[115]Cp. Jost (2000), p.477.

^[116]Cp. Richter/Furubotn (2003), p.288.

^[117]The model of the complex man assumes that humans have a hierarchical set of needs which are situation and time dependent as well as humans being versatile and capable of change [cp. Schein (1988), p.93 et sqq.]. For a discussion of alternative models of man please refer to Meckling [cp. Meckling (1976)].

^[118]Jensen (1983), p.327.

^[119]Cp. Jost (2000), p.482.

^[120]Q.v. Table 4, p.20. For a review of traditional Agency problems please refer to Jost (2000), p.492 et sqq.

^[121]Q.v. 2.2.3.3 Agency conflicts and costs, p.22.