Private Equity
Recent Growth in Leveraged Buyouts Exposed Risks That Warrant Continued Attention Gao ID: GAO-08-885 September 9, 2008The increase in leveraged buyouts (LBO) of U.S. companies by private equity funds prior to the slowdown in mid-2007 has raised questions about the potential impact of these deals. Some praise LBOs for creating new governance structures for companies and providing longer term investment opportunities for investors. Others criticize LBOs for causing job losses and burdening companies with too much debt. This report addresses the (1) effect of recent private equity LBOs on acquired companies and employment, (2) impact of LBOs jointly undertaken by two or more private equity funds on competition, (3) Securities and Exchange Commission's (SEC) oversight of private equity funds and their advisers, and (4) regulatory oversight of commercial and investment banks that have financed recent LBOs. GAO reviewed academic research, analyzed recent LBO data, conducted case studies, reviewed regulators' policy documents and examinations, and interviewed regulatory and industry officials, and academics.
Academic research that GAO reviewed generally suggests that recent private equity LBOs have had a positive impact on the financial performance of the acquired companies, but determining whether the impact resulted from the actions taken by the private equity firms versus other factors is difficult. The research also indicates that private equity LBOs are associated with lower employment growth than comparable companies. However, uncertainty remains about the employment effect--in part because, as one study found, target companies had lower employment growth before being acquired. Further research may shed light on the causal relationship between private equity and employment growth, if any. Private equity firms have increasingly joined together to acquire target companies (called "club deals"). In 2007, there were 28 club deals, totaling about $217 billion in value. Club deals could reduce or increase the number of firms bidding on a target company and, thus, affect competition. In analyzing 325 public-to-private LBOs done from 1998 through 2007, GAO generally found no statistical indication that club deals, in aggregate, were associated with lower or higher prices paid for the target companies, after controlling for differences in the targets. However, our results do not rule out the possibility of parties engaging in illegal behavior in any particular LBO. Indeed, according to securities filings and media reports, some large club deals have led to lawsuits and an inquiry into the practice by the Department of Justice. Because private equity funds and their advisers typically claim an exemption from registration as an investment company or investment adviser, respectively, SEC exercises limited oversight of these entities. However, in examining some registered advisers to private equity funds, SEC has found some control weaknesses but generally has not found such funds to pose significant concerns for fund investors. The growth in LBOs has led to greater regulatory scrutiny. SEC, along with other regulators, has identified conflicts of interest arising in LBOs as a potential concern and is analyzing the issue. Before 2007, federal financial regulators generally found that the major institutions that financed LBOs were managing the associated risks. However, after problems with subprime mortgages spilled over to other markets in mid-2007, the institutions were being exposed to greater-than-expected risk. As a result, the regulators reassessed the institutions' risk-management practices and identified some weaknesses. The regulators are monitoring efforts being taken to address weaknesses and considering the need to issue related guidance. While the institutions have taken steps to decrease their risk exposures, the spillover effects from the subprime mortgage problems to leveraged loans illustrate the importance of understanding and monitoring conditions in the broader markets, including connections between them. Failure to do so could limit the effectiveness and ability of regulators to address issues when they occur.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Team: Phone:GAO-08-885, Private Equity: Recent Growth in Leveraged Buyouts Exposed Risks That Warrant Continued Attention
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Report to Congressional Requesters:
United States Government Accountability Office:
GAO:
September 2008:
Private Equity:
Recent Growth in Leveraged Buyouts Exposed Risks That Warrant Continued
Attention:
GAO-08-885:
GAO Highlights:
Highlights of GAO-08-885, a report to congressional requesters.
Why GAO Did This Study:
The increase in leveraged buyouts (LBO) of U.S. companies by private
equity funds prior to the slowdown in mid-2007 has raised questions
about the potential impact of these deals. Some praise LBOs for
creating new governance structures for companies and providing longer
term investment opportunities for investors. Others criticize LBOs for
causing job losses and burdening companies with too much debt. This
report addresses the (1) effect of recent private equity LBOs on
acquired companies and employment, (2) impact of LBOs jointly
undertaken by two or more private equity funds on competition, (3)
Securities and Exchange Commission‘s (SEC) oversight of private equity
funds and their advisers, and (4) regulatory oversight of commercial
and investment banks that have financed recent LBOs. GAO reviewed
academic research, analyzed recent LBO data, conducted case studies,
reviewed regulators‘ policy documents and examinations, and interviewed
regulatory and industry officials, and academics.
What GAO Found:
Academic research that GAO reviewed generally suggests that recent
private equity LBOs have had a positive impact on the financial
performance of the acquired companies, but determining whether the
impact resulted from the actions taken by the private equity firms
versus other factors is difficult. The research also indicates that
private equity LBOs are associated with lower employment growth than
comparable companies. However, uncertainty remains about the employment
effect”in part because, as one study found, target companies had lower
employment growth before being acquired. Further research may shed
light on the causal relationship between private equity and employment
growth, if any.
Private equity firms have increasingly joined together to acquire
target companies (called ’club deals“). In 2007, there were 28 club
deals, totaling about $217 billion in value. Club deals could reduce or
increase the number of firms bidding on a target company and, thus,
affect competition. In analyzing 325 public-to-private LBOs done from
1998 through 2007, GAO generally found no statistical indication that
club deals, in aggregate, were associated with lower or higher prices
paid for the target companies, after controlling for differences in the
targets. However, our results do not rule out the possibility of
parties engaging in illegal behavior in any particular LBO. Indeed,
according to securities filings and media reports, some large club
deals have led to lawsuits and an inquiry into the practice by the
Department of Justice.
Because private equity funds and their advisers typically claim an
exemption from registration as an investment company or investment
adviser, respectively, SEC exercises limited oversight of these
entities. However, in examining some registered advisers to private
equity funds, SEC has found some control weaknesses but generally has
not found such funds to pose significant concerns for fund investors.
The growth in LBOs has led to greater regulatory scrutiny. SEC, along
with other regulators, has identified conflicts of interest arising in
LBOs as a potential concern and is analyzing the issue.
Before 2007, federal financial regulators generally found that the
major institutions that financed LBOs were managing the associated
risks. However, after problems with subprime mortgages spilled over to
other markets in mid-2007, the institutions were being exposed to
greater-than-expected risk. As a result, the regulators reassessed the
institutions‘ risk-management practices and identified some weaknesses.
The regulators are monitoring efforts being taken to address weaknesses
and considering the need to issue related guidance. While the
institutions have taken steps to decrease their risk exposures, the
spillover effects from the subprime mortgage problems to leveraged
loans illustrate the importance of understanding and monitoring
conditions in the broader markets, including connections between them.
Failure to do so could limit the effectiveness and ability of
regulators to address issues when they occur.
What GAO Recommends:
GAO recommends that the federal financial regulators give increased
attention to ensuring that their oversight of leveraged lending at
their regulated institutions takes into consideration systemic risk
implications raised by changes in the broader financial markets. In
line with the recommendation, the regulators acknowledged the need to
factor in such implications into their approach to overseeing their
regulated institutions‘ activities.
To view the full product, including the scope and methodology, click on
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-885]. For more
information, contact Orice M. Williams at (202) 512-8678 or
williamso@gao.gov.
[End of section]
Contents:
Letter1:
Results in Brief:
Background:
Research Suggests Recent LBOs Have Generally Had a Positive Impact on
the Financial Performance of Acquired Companies, but LBOs Were
Associated with Lower Employment Growth:
Club Deals Have Raised Questions about Competition, but Our Analysis of
Such Deals, in the Aggregate, Shows No Negative Effect on Prices Paid:
SEC Exercises Limited Oversight of Private Equity Funds, but It and
Others Have Identified Some Potential Investor-Related Issues:
Recent Credit Events Raised Regulatory Scrutiny about Risk-Management
of Leveraged Lending by Banks:
Conclusions:
Recommendation for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Pension Plan Investments in Private Equity:
Appendix III: Overview of Tax Treatment of Private Equity Firms and
Public Policy Options:
Appendix IV: Case Study Overview:
Appendix V: Neiman Marcus Group, Inc., Case Study:
Appendix VI: Hertz Corp. Case Study:
Appendix VII: ShopKo Stores, Inc., Case Study:
Appendix VIII: Nordco, Inc., Case Study:
Appendix IX: Samsonite Corp. Case Study:
Appendix X: Econometric Analysis of the Price Impact of Club Deals:
Appendix XI: Comments from the Board of Governors of the Federal
Reserve System:
Appendix XII: Comments from the Securities and Exchange Commission:
Appendix XIII: Comments from the Office of the Comptroller of the
Currency:
Appendix XIV: GAO Contact and Staff Acknowledgments:
Bibliography:
Tables:
Table 1: Number and Value of Private Equity LBOs with U.S. Targets,
2000-2007:
Table 2: Number and Value of Club Deals, 2000-2007:
Table 3: The 10 Largest Club Deals and Their Private Equity Firm
Sponsors:
Table 4: Top 10 Commercial and Investment Banks Providing Syndicated
Leveraged Loans for LBOs by Private Equity Funds, U.S. Market, 2005-
2007:
Table 5: Extent of Defined Benefit Plan Investments in Private Equity:
Table 6: Comparison of Income Earned by an Employee and General Partner
by Effort, Capital, and Risk:
Table 7: Companies Selected for Private Equity Buyout Case Studies:
Table 8: Descriptive Statistics of the Sample (Averages), 1998-2007:
Table 9: Primary Variables in the Econometric Analysis:
Table 10: Correlations Between Independent Variables:
Table 11: Multivariate Regression Analysis of Premium, 1998-2007:
Table 12: Multivariate Regression Analysis of Premium, Select
Sensitivity Analyses:
Figures:
Figure 1: The Stages of a Private Equity-Sponsored LBO:
Figure 2: Inflation-Adjusted Capital Commitments to Private Equity
Funds, 1980-2007:
Figure 3: Club Deal Ties among Private Equity Firms Involved in the 50
Largest LBOs, 2000-2007:
Figure 4: Premium Paid for Target Companies in Public-to-Private
Buyouts:
Figure 5: Pension Plans with Investments in Private Equity by Size of
Total Plan Assets:
Figure 6: Overview and Time Line of the LBO of Neiman Marcus:
Figure 7: Overview and Time Line of the LBO of Hertz Corp.
Figure 8: Overview and Time Line of the LBO of ShopKo Stores, Inc.
Figure 9: Overview and Time Line of the LBO of ShopKo Stores, Inc.
Figure 10: Overview and Time Line of the LBO of Samsonite Corp.
Abbreviations:
BDC: business development company:
CDF: cumulative distribution function:
CD&R: Clayton, Dubilier & Rice:
CSE: Consolidated Supervised Entity:
DOJ: Department of Justice:
EU: European Union:
FRBNY: Federal Reserve Bank of New York:
FSA: Financial Services Authority:
IOSCO: International Organization of Securities Commissions:
IPO: initial public offering:
IRS: Internal Revenue Service:
LBO: leveraged buyout:
M&A: Merger and Acquisitions:
ML: maximum likelihood:
NAICS: North American Industry Classification System:
NYSE: New York Stock Exchange:
OCC: Office of the Comptroller of the Currency:
OLS: ordinary least square:
PDF: probability density function:
PWG: President's Working Group on Financial Markets:
SEC: Securities and Exchange Commission:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
September 9, 2008:
The Honorable Byron L. Dorgan:
Chairman:
Subcommittee on Interstate Commerce, Trade, and Tourism:
Committee on Commerce, Science, and Transportation:
United States Senate:
The Honorable Tim Johnson:
Chairman Subcommittee on Financial Institutions:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
Over the past several years, an increase in buyouts of U.S. companies
by private equity funds has rekindled controversy about the potential
impact of these deals. Such funds borrow significant amounts from banks
to finance their deals--increasing the debt-to-equity ratio of the
acquired companies and giving rise to the term "leveraged buyouts"
(LBO).[Footnote 1] From 2000 through 2007, private equity funds
acquired nearly 3,000 companies, with a value totaling more than $1
trillion. Helping to fuel the increase in LBOs has been a strong demand
for private equity investments by pension plans and other institutional
investors and relatively low borrowing rates, according to market
observers. Some academics and others view such LBOs as revolutionizing
corporate ownership by creating new funding options and corporate
governance structures, as well as by providing investors with
attractive, longer term investment opportunities. However, some labor
unions and academics have a less favorable view--criticizing LBOs for
harming workers, such as through job losses and lower benefits;
providing private equity fund managers with, in effect, a tax subsidy;
or burdening companies with too much debt.
The operations of private equity firms and the funds that they manage
generally are subject to limited federal and state regulation, but the
transactions done by the funds may be subject to a number of federal
and state regulations depending on the nature of the transaction.
[Footnote 2] LBOs generally involve the takeover of a corporation.
State corporation statutes impose broad obligations and specific
procedural requirements on a corporation's board of directors with
respect to the sale or change of control of a corporation. For example,
directors have an obligation to act in the best interest of the
corporation's shareholders, and the discharge of that duty may require
taking steps to resist a takeover that they reasonably believe is
contrary to the best interests of the corporation and its shareholders.
Also, in certain circumstances, directors are required to maximize
shareholder value and are precluded from considering the interests of
any groups other than the shareholders.[Footnote 3] Furthermore,
takeover transactions that involve proxy solicitations, tender offers,
or new securities offerings are subject to federal securities laws.
[Footnote 4] Under the Clayton Act, persons contemplating certain large
takeover transactions must give advance notice of the proposed
transaction to the Federal Trade Commission and the Antitrust Division
of the U.S. Department of Justice and wait a designated time before
consummating the transactions.[Footnote 5]
Around mid-2007, the credit markets for LBOs contracted sharply and
brought new LBO activity to a near standstill, especially for larger
deals. This contraction has raised significant challenges for some
banks because of their commitments to help finance pending LBOs but
difficulties in finding investors to buy such debt. Nonetheless, market
participants generally expect private equity-sponsored LBOs to continue
to occur but at slower rate in light of the billions of dollars that
private equity funds raised from investors in 2006 and 2007. Given that
private equity-sponsored LBOs are expected to continue to be an
important part of the U.S. capital markets and your interest in the
oversight of such activity, you asked us to address the following
objectives:
* determine what effect the recent wave of private equity-sponsored
LBOs had on acquired companies and employment, based largely on a
review of recent academic research;
* analyze how the collaboration of two or more private equity firms in
undertaking an LBO (called a club deal) could promote or reduce
competition, and what legal issues have club deals raised;
* review how the Securities and Exchange Commission (SEC) has overseen
private equity firms engaged in LBOs under the federal securities laws;
and:
* review how the federal financial regulators have overseen U.S.
commercial and investment banks that have helped finance the recent
LBOs.
In addition, we provide information on pension plan investments in
private equity in appendix II and information on the tax treatment of
private equity firm profits in appendix III. We also present case
studies to illustrate various aspects of five LBOs in appendixes IV
through IX.
To address these objectives, we reviewed and analyzed relevant
examinations and related guidance and documents from the Board of
Governors of the Federal Reserve System (Federal Reserve), the Federal
Reserve Bank of New York (FRBNY), the Office of the Comptroller of the
Currency (OCC), and SEC. We reviewed academic research that included
analysis of recent LBOs. We also analyzed merger-and-acquisition,
syndicated loan, and related data from Dealogic, which compiles data on
mergers and acquisitions, as well as the debt and equity capital
markets. Dealogic estimates that it captures about 95 percent of
private equity transactions from 1995 forward but is missing the value
of some of the deals when such information is unobtainable. We assessed
the procedures that Dealogic uses to collect and analyze data and
determined that the data were sufficiently reliable for our purposes.
We also analyzed relevant laws and regulations, regulatory filings,
speeches, testimonies, studies, articles, and our reports. We
interviewed staff representing the U.S. regulators identified above and
the Federal Deposit Insurance Corporation, the Department of the
Treasury, and the Department of Justice. We also selected and
interviewed representatives from 2 large commercial banks and 3 large
investment banks based on their significant role in helping to finance
LBOs; 11 private equity firms of various sizes to obtain the views of
small, medium, and large firms; 3 credit rating agencies that have
analyzed leveraged loans or recent LBOs; a trade association
representing private equity firms; 2 associations representing
institutional investors that invest in private equity funds; 4
academics who have done considerable research on LBOs; 2 labor unions
based on their concerns about private equity-sponsored LBOs; and a
consulting firm that analyzed the private equity market. We selected
five LBOs for in-depth case study to illustrate various aspects of such
transactions that ranged in size and scope of the target companies,
level and type of debt used to finance the transaction, or degree to
which the news media focused on the transaction. We conducted this
performance audit from August 2007 to September 2008 in accordance with
generally accepted government auditing standards. Those standards
require that we plan and perform the audit to obtain sufficient,
appropriate evidence to provide a reasonable basis for our findings and
conclusions based on our audit objectives. We believe that the evidence
obtained provides a reasonable basis for our findings and conclusions
based on our audit objectives. Appendix I provides a detailed
description of our objectives, scope, and methodology.
Results in Brief:
Academic research that we reviewed on recent LBOs by private equity
firms suggests that the impact of these transactions on the financial
performance of acquired companies generally has been positive, but
these buyouts have been associated with lower employment growth at the
acquired companies. The research generally shows that private equity-
owned companies outperformed similar companies across certain financial
benchmarks, including profitability and the performance of initial
public offerings (IPO), but determining whether the higher performance
resulted from the actions taken by the private equity firms is often
difficult due to some limitations in the academic literature. While
some observers question whether private equity fund profits result less
from operational improvements made by private equity firms and more
from the use of low-cost debt by the firms, private equity executives
told us that they use various strategies to improve the operations and
financial performance of their acquired companies. Some evidence also
suggests that private equity firms improve efficiency by better
aligning the incentives of management with those of the owners. For
example, private equity firms pay a higher share price premium for
publicly traded companies with lower management ownership--indicating
their expectation of having greater impact on performance in
transactions where existing management may have less incentive to act
in the interest of owners. Regarding the potentially broader impact of
LBOs on public equity markets, a study found that roughly 6 percent of
private equity-sponsored LBOs from 1970 to 2002 involved publicly
traded companies, but 11 percent of private equity-owned companies were
sold through IPOs during this period. This study suggests that the
number of companies going public after an LBO exceeded the number of
companies taken private by an LBO. Some critics contend that buyouts
can lead to job reductions at acquired companies. Two academic studies
found that recent private equity-sponsored LBOs were associated with
lower employment growth than comparable companies. Nonetheless,
uncertainty remains about the impact of such buyouts on employment, in
part because, as one study found, target companies had lower employment
growth than comparable companies before being acquired.
In the past several years, private equity firms increasingly have
joined together to acquire target companies in arrangements called
"club deals," which have included some of the largest LBOs. For
example, of the almost 3,000 private equity-sponsored LBOs we
identified as completed from 2000 through 2007, about 16 percent were
club deals. However, with a value around $463 billion, these club deals
account for about 44 percent of the roughly $1 trillion in total
private equity deal value. Since 2004, club deals have grown
substantially in both number and value, particularly club deals valued
at $1 billion or more. According to various market participants,
private equity-sponsored LBOs are the product of a competitive process.
However, club deals could affect this process and increase or reduce
the level of competition. Club deals could increase competition among
prospective buyers by enabling multiple private equity firms to submit
a joint bid in cases where the firms would not have the resources to
independently submit a bid. Indeed, private equity executives told us
the principal reason they formed clubs was that their funds did not
have sufficient capital to make the purchases alone. Club deals also
could reduce competition and result in lower prices paid for target
companies if the formation of the club led to fewer firms bidding on
target companies or bidder collusion. While club deals can be initiated
by private equity firms, they also can be, and have been, initiated by
the sellers, according to private equity executives we interviewed and
securities filings we reviewed. To examine the potential effect that
club deals may have on competition among private equity firms, we
developed an econometric model to examine prices paid for target
companies. Our analysis of 325 public-to-private LBOs done from 1998
through 2007 generally found no indication that club deals, in the
aggregate, are associated with lower or higher prices for the target
companies, after controlling for differences in targets. However, our
results do not rule out the possibility of parties engaging in illegal
behavior, such as collusion, in any particular LBO. Moreover, our
analysis draws conclusions about the association, not causal
relationship, between club deals and premiums. We also found that
commonly used measures of market concentration generally suggest that
the market for private equity-sponsored LBOs is predisposed to perform
competitively and that single firms do not have the ability to exercise
significant market power. Nevertheless, some large club deals have led
to an inquiry into this practice by the Department of Justice's
Antitrust Division, according to media reports and securities filings,
and several shareholder lawsuits against private equity firms.
Because private equity funds and their advisers (private equity firms)
typically claim an exemption from registration as an investment company
or investment adviser, respectively, SEC exercises limited oversight of
these entities. Private equity funds generally are structured and
operated in a manner that enables the funds and their advisers to
qualify for exemptions from some of the federal statutory restrictions
and most SEC regulations that apply to registered investment pools,
such as mutual funds. Nonetheless, some advisers to private equity
funds are registered and thus are subject to periodic examination by
SEC staff and other regulatory requirements. For example, about half of
the 21 largest U.S. private equity firms have registered as advisers or
are affiliated with registered advisers.[Footnote 6] From 2000 through
2007, SEC staff examined all but one of the private equity firms'
advisers at least once. In the examinations we reviewed, SEC found some
compliance control deficiencies, such as weak controls to prevent the
potential misuse of inside information or to enforce restrictions on
personal trades by employees. Despite such deficiencies, SEC and others
have said that they generally have not found private equity funds to
have posed significant concerns for fund investors. Since 2000, SEC has
brought seven enforcement actions against private equity firms for
fraud--five of which involved a pension plan investing money in private
equity funds in exchange for illegal fees. An SEC official said that
the Division of Investment Management has received more than 500
investor complaints in the last 5 years, but none involved private
equity fund investors. Similarly, officials representing two
institutional investor associations and two bar associations said that
fraud has not been a significant issue with private equity firms.
However, in light of the recent growth in LBOs by private equity funds,
U.S. and foreign regulators, including SEC, have undertaken studies to
assess risks arising from such transactions and have identified some
concerns about potential market abuse and investor protection, which
they are studying further.
Federal banking and securities regulators supervise the commercial and
investment banks that financed the recent LBOs, and recent credit
market problems have raised risk-management concerns. A small number of
major commercial and investment banks have played a key role in
financing recent LBOs: 10 U.S. and foreign commercial and investment
banks originated around 77 percent of the nearly $634 billion in
leveraged loans used to help finance U.S. LBOs from 2005 through 2007.
Of these banks, four are national banks overseen by OCC; four are
investment banks that have elected to be supervised on a consolidated
basis by SEC as a consolidated supervised entity; and two are foreign
banks.[Footnote 7] Before the leveraged loan market began to experience
problems in mid-2007, in the aftermath of problems that originated with
subprime mortgages, OCC and SEC staff found through their examinations
and ongoing monitoring that the major commercial and investment banks,
respectively, generally had adequate controls in place to manage the
risks associated with their leveraged finance activities. However, OCC,
the Federal Reserve, and SEC raised concerns about weakening
underwriting standards from 2005 through 2007. According to OCC and SEC
staff, the major banks generally were able to manage their risk
exposures by syndicating their leveraged loans, whereby a group of
lenders, rather than a single lender, makes the loans. However, after
the problems related to subprime mortgages unexpectedly spread to the
leveraged loan market in mid-2007, the banks found themselves exposed
to greater risk. The banks had committed to provide a large volume of
leveraged loans for pending LBO deals but could no longer syndicate
some of their leveraged loans at prices they originally anticipated.
For example, four commercial banks at the end of May 2007 had more than
$294 billion in leveraged finance commitments, and four major
investment banks at the end of June 2007 had more than $171 billion in
leveraged finance commitments. Since then, the commercial and
investment banks have reduced their total loan commitments and had
commitments at the end of March 2008 of about $34 billion and $14
billion, respectively. However, because the banks could not syndicate
some of the loans as initially planned, the banks held on their balance
sheets a considerable share of the loans they funded when the LBO deals
closed. In light of such challenges, OCC, SEC, and other regulators,
separately or jointly, have reviewed the risk-management practices of
major commercial and investment banks and identified weaknesses at some
banks. The regulators said that they plan to continue monitoring the
efforts being taken by the banks to address risk-management weaknesses
and are continuing to consider the need to issue related guidance.
Given that the financial markets are increasingly interconnected and in
light of the risks that have been highlighted by the financial market
turmoil of the last year, we recommend that the Federal Reserve, OCC,
and SEC give increased attention to ensuring that their oversight of
leveraged lending at their regulated institutions takes into
consideration systemic risk implications raised by changes in the
broader financial markets, as a whole.
We provided a draft of this report to the Federal Reserve, OCC, SEC,
Treasury, and the Department of Justice and a draft of the case studies
to the private equity firms we interviewed for the case studies. The
Federal Reserve, OCC, and SEC provided written comments on a draft of
this report; their comments are included in appendixes XI through XIII.
In their written comments, officials from the three agencies generally
agreed with our conclusions and, consistent with our recommendation,
acknowledged the need to ensure that regulatory and supervisory efforts
take into account the systemic risk implications resulting from the
increasingly interconnected nature of the financial markets. To that
end, they stated that they will continue to work closely with other
regulators to better understand and address such risk. We also received
technical comments from the Federal Reserve, SEC, OCC, Department of
the Treasury, and the private equity firms, which we have incorporated
into this report as appropriate.
Background:
A private equity-sponsored LBO generally is defined as an investment by
a private equity fund in a public or private company (or division of a
company) for majority or complete ownership. Since 2000, the number and
value of LBOs of U.S. target companies completed by private equity
funds have increased significantly, as shown in table 1. According to
market observers, three major factors converged to spur this growth:
(1) the increased interest in private equity investments by pension
plans and other institutional investors; (2) the attractiveness of some
publicly traded companies, owing to relatively low debt and
inexpensively priced shares; and (3) the growth in the global debt
market, permitting borrowing at relatively low rates. As discussed
below, credit market problems surfacing in mid-2007 have led to a
significant slowdown in LBOs by private equity funds.
Table 1: Number and Value of Private Equity LBOs with U.S. Targets,
2000-2007 (Dollars in millions):
Year: 2000;
Number of deals: 203;
Value of deals: $29,019.
Year: 2001;
Number of deals: 113;
Value of deals: 17,050.
Year: 2002;
Number of deals: 143;
Value of deals: 27,811.
Year: 2003;
Number of deals: 209;
Value of deals: 57,093.
Year: 2004;
Number of deals: 326;
Value of deals: 86,491.
Year: 2005;
Number of deals: 615;
Value of deals: 122,715.
Year: 2006;
Number of deals: 804;
Value of deals: 219,052.
Year: 2007;
Number of deals: 581;
Value of deals: 486,090.
Year: Total;
Number of deals: 2,994;
Value of deals: $1,045,321.
Source: GAO analysis of Dealogic data.
Note: Deals that were announced before December 31, 1999, but completed
after that date are excluded from our totals.
[End of table]
As the private equity industry has grown, private equity-sponsored LBOs
have become an increasingly significant subset of all merger-and-
acquisition activity--accounting for about 3 percent of the total value
of U.S. mergers and acquisitions in 2000 but growing to nearly 28
percent in 2007. In recent years, large buyouts of publicly traded
companies, valued in the tens of billions of dollars, have received
considerable public attention. Such deals, however, are not
representative of most private equity-sponsored LBOs. For example,
among nearly 3,000 private equity-sponsored LBOs we identified from
2000 through 2007, the median deal value was $92.3 million, according
to Dealogic data.[Footnote 8] In addition, LBOs of publicly traded
companies (called "public-to-private" buyouts) accounted for about 13
percent of the total number of buyouts during this period but about 58
percent of the total value of the buyouts.
Private Equity-Sponsored LBOs Have Evolved Since the 1980s:
Since the 1980s, private equity-sponsored LBOs have changed in a number
of ways. Some LBOs in the 1980s were called "hostile takeovers,"
because they were done over the objections of a target company's
management or board of directors. Few of the recent LBOs appear to have
been hostile based on available data.[Footnote 9] Two private equity
executives told us that their fund investors, such as pension plans,
typically do not want to be associated with hostile takeovers. In such
cases, the private equity partnership agreements include a provision
prohibiting the fund from undertaking certain acquisitions.[Footnote
10] Another way in which the private equity-sponsored LBOs have changed
is that the scope of LBOs has expanded to include a wider range of
industries--not only manufacturing and retail--but also financial
services, technology, and health care. In addition, private equity
funds have expanded their strategies for enhancing the value of their
acquired companies. In the 1980s, LBO funds sought to create value
through so-called "financial and governance engineering," such as by
restructuring a company's debt-to-equity ratio and changing management
incentives. Later, the acquiring firms sought to improve operations to
increase cash flow or profitability. Today, private equity firms often
use a combination of these strategies. Finally, the size of private
equity funds and buyouts has increased. For example, the 10 largest
funds--ranging in size from about $8 billion to $21 billion--were
created since 2005, according to a news media report. Similarly, 9 of
the 10 largest buyouts in history were completed in 2006 or later.
Overview of an LBO Transaction by a Private Equity Fund:
As illustrated in figure 1, a typical private equity-sponsored LBO of a
target company and subsequent sale of the company takes place in
several stages and over several years.
Figure 1: The Stages of a Private Equity-Sponsored LBO:
[See PDF for image]
This figures provides the following information along with several
illustrations:
A typical private equity buyout involves these stages:
1) A private equity firm creates a fund that obtains capital
commitments from investors; (Investors: pension funds, endowment,
wealthy individuals,etc.)
2) Through its own research or information from intermediaries such as
investment banks, private equity firm identifies ’target“ company for
its buyout fund to acquire.
3) Private equity firm, on behalf of the buyout fund, obtains a loan
commitment which is used, along with the fund‘s capital, to finance the
acquisition. Commercial or investment banks typically provide the
commitment but syndicate the loans–meaning they share the loans among a
group of lenders.
4) After takeover is completed, the buyout fund typically holds the
acquired company for 3 to 5 years. During this time, it seeks to
increase the value of the company, such as through operational and
financial improvements, in hope of realizing a profit when it sells the
company.
5) The buyout fund ’exits“ investment by selling the company, such as
through an IPO of stock, or to a ’strategic“ buyer or another private
equity firm. Profits from the sale, if any, are returned to the fund
and generally distributed to fund investors and private equity firm.
Sources: GAO analysis of information provided by private equity firms,
investment banks, and commercial banks; Art Explosion (images).
[End of figure]
In the first stage, a private equity firm creates a private equity fund
and obtains commitments from investors (limited partners) to provide
capital to its fund. Later, when the firm undertakes buyouts, it calls
on the investors to provide the capital. Investors in private equity
funds typically include public and corporate pension plans, endowments
and foundations, insurance companies, and wealthy individuals. (See
app. II for additional information on the investment in private equity
by pension plans.) As shown in figure 2, private equity funds have
increased their capital commitments from around $0.4 billion (inflation
adjusted) in 1980 to nearly $185 billion (inflation adjusted) in 2007.
Figure 2: Inflation-Adjusted Capital Commitments to Private Equity
Funds, 1980-2007 (dollars in billions, in 2008 dollars):
[See PDF for image]
This figure is a vertical bar graph depicting the following data:
Year: 1981;
Amount: $0.3 billion.
Year: 1982;
Amount: $1.2 billion.
Year: 1983;
Amount: $2.6 billion.
Year: 1984;
Amount: $6.3 billion.
Year: 1985;
Amount: $5.2 billion.
Year: 1986;
Amount: $8.4 billion.
Year: 1987;
Amount: $25.9 billion.
Year: 1988;
Amount: $18.4 billion.
Year: 1989;
Amount: $18.6 billion.
Year: 1990;
Amount: $11.8 billion.
Year: 1991;
Amount: $8.9 billion.
Year: 1992;
Amount: $15.6 billion.
Year: 1993;
Amount: $22.3 billion.
Year: 1994;
Amount: $27.6 billion.
Year: 1995;
Amount: $35 billion.
Year: 1996;
Amount: $37.9 billion.
Year: 1997;
Amount: $52.8 billion.
Year: 1998;
Amount: $77.4 billion.
Year: 1999;
Amount: $66.3 billion.
Year: 2000;
Amount: $92.5 billion.
Year: 2001;
Amount: $54.9 billion.
Year: 2002;
Amount: $28.9 billion.
Year: 2003;
Amount: $33 billion.
Year: 2004;
Amount: $54.8 billion.
Year: 2005;
Amount: $104 billion.
Year: 2006;
Amount: $128.2 billion.
Year: 2007;
Amount: $184.9 billion.
Sources: National Venture Capital Association and Thompson Financial.
Note: Capital commitments are defined as funds that private equity
limited partnerships raise from their limited partners (the investors
in private equity funds). The data include commitments made to buyout
and mezzanine funds but not venture capital funds.
[End of figure]
In the second stage, the private equity firm identifies potential
companies for its fund to acquire. According to private equity
executives, their firms routinely research companies and industries to
stay abreast of developments and to identify potential acquisitions.
Moreover, they make regular contact with managers or owners of both
potential targets and other companies. Two private equity executives
told us it can take years of contacts before managers or owners might
agree to sell. Further, private equity firms can spend significant
amounts of time and money to research potential targets, including
incurring costs for consulting and other professional fees. In addition
to using their own contacts, private equity firms identify potential
targets through investment banks, attorneys, and other such
intermediaries. Companies interested in selling frequently hire
investment banks or other advisers to help them sell their companies.
In the third stage, the private equity firm obtains a loan commitment,
typically from commercial or investment banks, that it then uses to
help finance its fund's acquisition of the target company. A loan
commitment is a promise by the lender to make available in the future a
specified amount of credit under specified terms and conditions. Loans
are an essential component of an LBO because private equity firms
typically contribute through their funds only a fraction of the capital
needed to complete a takeover. The use of borrowed money, or debt
capital, makes up the difference. Importantly, the legal agreements
supporting the debt financing are often between the lender and target
company, not the private equity firm. In 2000, private equity LBOs were
financed, on average, with 41 percent equity and 59 percent debt,
according to a consulting firm report.[Footnote 11] By 2005, LBOs
became more leveraged, with the average deal financed with 34 percent
equity and 66 percent debt.
Private equity executives told us they typically seek offers for loan
commitments from multiple banks in an effort to obtain the best terms
through competition. If its offer to buy a target company is accepted,
a private equity firm will select one of the loan commitment offers,
which the respective bank will fund at the time the acquisition is to
be completed. LBO loans commonly are syndicated loans--meaning that
they are shared by a group of banks and other lenders. The lead bank
finds potential lenders and arranges the terms of the loan on behalf of
the syndicate, which can include commercial or investment banks and
institutional investors, such as mutual and hedge funds and insurance
companies.[Footnote 12] However, each lender has a separate credit
agreement with the borrower for the lender's portion of the syndicated
loan. Further, syndicated loans can be categorized as investment grade
or leveraged loans.[Footnote 13] Syndicated loans for LBOs typically
are leveraged loans, reflecting the lesser creditworthiness of the
borrowers.
In the fourth stage, after completing its buyout of the target company,
the private equity firm seeks to improve the financial and operational
performance of the acquired company. The aim is to increase the value
of the company, so that the private equity firm can sell the company
(fifth stage) at a profit and earn a return for its fund investors. (We
discuss in detail how private equity firms seek to improve the
performance of their acquired companies in the following section of
this report.)
In the fifth stage, the private equity firm exits its fund's investment
by selling its acquired company. Private equity funds typically hold an
acquired company from 3 to 5 years before trying to realize their
return. A private equity fund typically has a fixed life of 10 years,
generally giving the private equity firm 5 years to invest the capital
raised for its fund and 5 years to return the capital and expected
profits to its fund investors. Executives told us they often have an
exit strategy in mind when their firms buy a company. The executives
identified the following options to exit their LBOs:
* make an IPO of stock;
* sell to a "strategic" buyer, or a corporation (as opposed to a
financial firm);
* sell to another private equity firm; or:
* sell to a "special purpose acquisition company," which is a publicly
traded "shell" company that allows its sponsor to raise capital through
an IPO for use in seeking to acquire an operating company within a
fixed time frame.[Footnote 14]
Research Suggests Recent LBOs Have Generally Had a Positive Impact on
the Financial Performance of Acquired Companies, but LBOs Were
Associated with Lower Employment Growth:
Academic research on recent LBOs by private equity firms suggests that
the impact of these transactions on the financial performance of
acquired companies generally has been positive, but these buyouts have
been associated with lower employment growth at the acquired companies.
The research generally shows that private equity-owned companies
outperformed similar companies across certain financial benchmarks, but
it is often difficult to determine whether the higher performance
resulted from the actions taken by the private equity firms. Private
equity executives told us that they seek to improve the operations of
their acquired companies through various strategies, but some observers
question whether such strategies improve performance. Some evidence
suggests that private equity firms improve efficiency by better
aligning the incentives of management with those of owners. We also
found some evidence that recent private equity-sponsored LBOs were
associated with lower employment growth than comparable companies.
However, uncertainty remains about the impact of such buyouts on
employment, in part because, as one study found, target companies had
lower employment growth than their peers before acquisition.
Private Equity-Owned Companies Usually Outperformed Similar Companies
Based on Several Financial Benchmarks:
Academic studies analyzing LBOs done in the 2000s suggest that private
equity-owned companies usually outperformed similar companies not owned
by private equity firms across a number of benchmarks, such as
profitability, innovation, and the returns to investors in IPOs.
[Footnote 15] Recent research finding that private equity-owned
companies generally outperformed other companies is consistent with
prior research analyzing earlier LBOs.[Footnote 16] However, it is
often difficult to determine why the differences in economic
performance occur. Specifically, because private equity firms choose
their buyout targets, it is difficult to determine whether the
performance of the acquired companies after the buyout resulted more
from the characteristics of the chosen companies or actions of the
private equity firms.[Footnote 17] Executives of a private equity trade
group told us that private equity firms typically choose their targets
from among four general categories: (1) underperforming or declining
companies; (2) "orphan" divisions of large corporations--that is, a
division outside a company's core business that may be neglected as a
result; (3) family businesses, where family owners are looking to exit;
and (4) fundamentally sound businesses that nevertheless need an
injection of capital to grow. The executives also said that private
equity firms may specialize by industry. Other common limitations of
academic studies are samples of buyouts that are small or not
representative of all LBOs, resulting from the general lack of
available data on private equity activities. Moreover, most empirical
work on buyouts in the 2000s is based on European data because more
data on privately held companies are available in Europe.[Footnote 18]
Comparing private equity-owned companies to other companies of similar
size in the same industry in the United Kingdom, one study found that
operating profitability was higher at private equity-owned companies.
[Footnote 19] Similarly, two studies, one of U.S. LBOs and the other of
European LBOs, found that growth in profitability was higher at
companies owned by private equity firms.[Footnote 20] A study of U.S.
patents found that private equity-owned companies pursued more
economically important innovations, as measured by how often the
patents are cited by later patent filings, than similar companies.
[Footnote 21] This finding also suggests that private equity-owned
companies are willing to undertake research activities that can require
a large up-front cost but yield benefits in the longer term. An
analysis of 428 IPOs of private equity-owned companies in the United
States between 1980 and 2002 found that they consistently outperformed
other IPOs and the stock market as a whole, over 3-and 5-year time
horizons.[Footnote 22] A study of the IPO market in the United Kingdom,
covering 1992 to 2004, found that returns on the first day of the
offering of 198 private equity-owned IPOs were on average lower than
other IPOs, although 3-year returns (excluding the first day) were
higher than other IPOs.[Footnote 23] Regarding LBOs' potentially
broader impact on public equity markets, critics have expressed concern
about the loss of transparency when public companies are taken private,
since the bought-out companies cease making securities filings required
of publicly held companies.[Footnote 24] However, one study of LBOs and
their exits from 1970 to 2002 found that 6.3 percent of private equity-
sponsored LBOs were public-to-private transactions, but 11 percent of
the exits, or sales, of the acquired companies by private equity firms
were accomplished through an IPO.[Footnote 25] This study suggests that
"reverse LBO" transactions resulted in more companies entering public
markets during this period than exiting following private equity
acquisitions.
Private Equity LBOs Seek to Enhance Performance through Techniques Such
as Improving Management Incentives:
According to the standard economic rationale for buyouts, LBOs enhance
value because, among other things, the debt used to finance the buyout
forces management to operate more efficiently, and private equity
owners vary compensation schemes to better align management incentives
with owners.[Footnote 26] For example, greater debt can limit
management's ability to undertake wasteful investments because free
cash flow is committed to service the debt. Also, providing management
with a higher ownership stake in the company can link its compensation
more closely to shareholder returns.[Footnote 27] Academic research
analyzing the share price premium that private equity firms pay to
shareholders over market prices in public-to-private buyouts is
consistent with this view. Studies have shown that the buyout premium
averages 20-40 percent over stock prices preceding a takeover. In
theory, the premium paid over market prices should reflect the enhanced
value private equity firms expect to realize after a buyout.[Footnote
28] One study of UK buyouts estimated an average premium of 40 percent,
and found that higher premiums were associated with lower recent share
price performance, lower leverage, and lower management equity stakes
at target companies.[Footnote 29] A study of buyouts in European
countries reported an average premium of 36 percent and also found that
higher premiums were associated with lower recent share price
performance at targets, as well as less concentrated ownership among
external shareholders.[Footnote 30] Finally, a study of U.S. buyouts
done from 1995 through 2007 found average premiums of roughly 25
percent in public-to-private LBOs.[Footnote 31] Similarly, our analysis
of public-to-private transactions from the Dealogic database determined
that the average premium paid to shareholders in private equity-
sponsored LBOs in the United States from January 2000 through October
2007 was about 22 percent.[Footnote 32] Our analysis also corroborated
studies of European buyouts in finding that lower premiums were
associated with more concentrated ownership (in the form of management
or external shareholders) in U.S. publicly traded companies prior to
acquisition by private equity firms. On the whole, these results
suggest that private equity buyers anticipate greater value enhancement
in target companies when existing shareholders are more dispersed and
thus have less incentive to monitor or improve performance.
Executives from private equity firms told us that improving the
financial performance of their acquired companies is a key objective.
The intent is to allow the companies, when later sold during the exit
phase of the private equity cycle, to command a price sufficient to
provide the desired returns to a private equity fund's investors. The
executives told us they use strategies that include the following:
* formulating strategic plans to monitor progress and performance;
* retooling of manufacturing or other operations for greater
efficiency;
* reducing the workforce to cut costs;
* acquiring other businesses that complement the acquired company's
operations;
* reducing the cost of goods and supplies by consolidating purchasing;
* selling nonperforming lines of business; and:
* developing new sources of revenue and improving marketing and sales
for good, but under-supported, products.
We found that the private equity firms included in our case studies
used some of these strategies in an effort to improve the financial
performance of their acquired companies. For example, the private
equity owners of Samsonite sought to reinvigorate the company's image
and products, in part by creating a new label for higher priced luggage
and implementing a high-end marketing campaign. (See app. IX for
discussion of this buyout.) As another example, following their buyout
of Hertz, the private equity firms involved sought not only to reduce
costs by buying more cars for the company's fleet, rather than leasing
them, but also to increase the company's share of the leisure car
rental segment partly by creating self-service kiosks for customers.
(See app. VI for discussion of this buyout.) Also, to increase
revenues, the private equity owners of Nordco acquired a competitor as
an add-on acquisition. (See app. VIII for discussion of this buyout.)
According to the private equity executives, they typically do not
become involved in the day-to-day management of the acquired companies;
rather, they exercise influence at the board level, such as by setting
policies and goals. For example, after the Hertz takeover, the lead
private equity firm installed one of its partners as the Chairman of
the board of directors. However, executives said they will replace an
acquired company's senior management, if necessary. As owners of
private companies, the executives said they can make strategic
decisions that might be more difficult for public companies, given
their focus on quarterly earnings performance. ShopKo's new private
equity owners, for instance, planned to spend about $70 million
annually--up from about $35 million in the year before the takeover--to
remodel the stores. (See app. VII for discussion of this buyout.)
Overall, the executives said that boosting their companies' performance
rests more on improving operations and less on financial engineering,
such as the use of debt to leverage returns and the tax deductibility
of interest on such debt.
Altering compensation schemes is another important strategy for
improving financial performance, according to the private equity
executives we interviewed. Executives of one private equity firm told
us that aligning incentives is a primary strategy they use to boost the
performance of their companies. The firm has acquired companies that
were divisions of larger companies, but the incentives of the division
management were tied to the performance of the companies, not to the
divisions. According to the executives, the key is providing management
with equity ownership in a specific area over which managers have
control. They note that when incentives are properly aligned, managers
tend to work harder and improve profitability. Similarly, in the Nordco
buyout, the private equity firm has sought to give the management team
an opportunity to own a significant portion of the company and expects
management to own 30 percent of the company by the time it exits the
investment.
Another area that has received considerable attention has been the use
of debt by private equity firms. Overall, several executives told us
that boosting their companies' performance rests more on improving
operations and less on financial engineering, but we did not
independently assess such assertions. Private equity executives told us
debt financing plays an important role in private equity transactions,
but it is not in their interest to overburden a target company with
debt. According to the executives, if an acquired company cannot meet
its debt payments, it risks bankruptcy; in turn, the private equity
fund risks losing the equity it has invested. If that happens, the
private equity fund will be unable to return profits to its limited
partner investors. Moreover, such a failure would cause reputation
damage to the private equity firm, making it harder for the firm to
attract investors for its successor funds. While default rates on loans
associated with private equity have remained at historically low
levels, one credit rating agency found that being acquired by a private
equity fund increases default risk for some firms.[Footnote 33]
However, the extent to which LBO and other firms will suffer financial
distress under the current credit cycle remains to be seen.
Some market observers question how and the extent to which private
equity firms improve their acquired companies. For example, a credit
rating agency acknowledged that private equity firms are not driven by
the pressure of publicly reporting quarterly earnings but questioned
whether the firms are investing over a longer horizon than public
companies.[Footnote 34] A labor union agreed, saying even if a private
equity firm planned to hold an acquired company from 3 to 5 years, that
period would not be long enough to avoid pressure to forego long-term
investment and improvements. The rating agency also questioned whether
there was sufficient evidence to support claims that private equity
returns were driven by stronger management rather than by the use of
the then readily available, low-cost debt to leverage returns.
Similarly, a recent study estimates that private equity firms do not
earn their income primarily by enhancing the value of their companies.
[Footnote 35] The study, based on one large investor's experience with,
among other investments, 144 private equity buyout funds, estimated
that private equity firms earned about twice as much income from
management fees as from profits realized from acquired companies.
Private Equity-Sponsored LBOs Were Associated with Lower Employment
Growth, but Causation Is Difficult to Establish:
Our review of academic research found that recent private equity LBOs
are associated with lower employment growth than comparable companies,
but a number of factors make causation difficult to establish. Labor
unions have expressed concern about the potential for a buyout to leave
the acquired company financially weakened because of its increased debt
and, in turn, to prompt the private equity firm to cut jobs or slow the
pace of job creation. At the same time, job cuts may be necessary to
improve efficiency. One study of private equity LBOs in the United
Kingdom found that the acquired companies have lower wage and
employment growth than non-LBO companies.[Footnote 36] Research on U.S.
buyouts in the 1980s also found that LBOs were associated with slower
employment growth than their peers.[Footnote 37] In addition, a
comprehensive study of roughly 5,000 U.S. buyouts from 1980 to 2005
found that private equity-owned "establishments" (that is, the physical
locations of companies) had slower job growth than comparable
establishments in the 3 years after an LBO, but slightly higher job
growth in the fourth and fifth years.[Footnote 38] The net effect of
these changes is lower employment growth than comparable establishments
in the 5 years after the LBOs.[Footnote 39] Furthermore, private equity-
owned companies undertake more acquisitions and divestitures and are
more likely to shut down existing establishments and open new ones. The
researchers noted that these results suggest private equity owners have
a greater willingness to restructure the company and disrupt the status
quo in an effort to improve efficiency. However, the study also found
that target establishments were underperforming their peers in
employment growth prior to acquisition. This suggests that LBO targets
are different from non-LBO companies prior to acquisition, making it
difficult to attribute differences in employment outcomes after
acquisition to private equity.[Footnote 40] Further uncertainty is due
to the limited number of academic studies of the impact of recent
buyouts on employment and difficulty faced by the studies in isolating
the specific impact of private equity.
Private equity executives told us that a chief concern generally is
improving efficiency, not necessarily job creation. For example,
executives from one private equity firm said that following an
acquisition, the acquired company eliminated 300 jobs after a $100
million spending reduction in one department. Although jobs were lost,
the executives said it is important to realize that the goal was to
produce an overall stronger company. Executives from another private
equity firm told us that following an acquisition, employment fell when
it closed some outlets. But at the same time, jobs were created
elsewhere when new outlets were opened. One private equity executive
told us that while his firm is sympathetic to calls to do such things
as offer health insurance to workers at acquired companies, "market
economics" sometimes stands as a barrier, because to do so would
produce unacceptably lower investment returns. This challenge, however,
is not unique to private equity-owned companies. As illustrated by our
case studies, strategies implemented after a buyout can lead to either
employment growth or loss. Of the five buyouts we studied, two
experienced job growth, while three experienced job losses (see apps. V
through IX). As noted previously, the LBOs we selected were not
intended to be a representative sample of all LBOs.
Club Deals Have Raised Questions about Competition, but Our Analysis of
Such Deals, in the Aggregate, Shows No Negative Effect on Prices Paid:
In the past several years, private equity firms increasingly have
joined together to acquire target companies in arrangements called club
deals, which have included some of the largest LBOs. Some have
expressed concern that club deals could depress acquisition prices by
reducing the number of firms bidding on target companies. However,
others have posited that club deals could increase the number of
potential buyers by enabling firms that could not individually bid on a
target company to do so through a club. In addition, sellers of target
companies, as well as potential buyers, can initiate club deals. In an
econometric analysis of publicly traded companies acquired by public
equity firms, we generally found no indication that club deals, in the
aggregate, were associated with lower or higher per-share price
premiums paid for the target companies, after controlling for
differences among target companies. (A premium is the amount by which
the per-share acquisition price exceeds the then-current market price;
private equity buyouts of public companies typically take place at a
premium.) We also found that commonly used measures of market
concentration generally suggest that the market for private equity-
sponsored LBOs is predisposed to perform competitively and that single
firms do not have the ability to exercise significant market power.
Nevertheless, some large club deals have been the object of several
recent shareholder lawsuits and, according to media reports and
securities filings, have led to inquiries by the Department of
Justice's Antitrust Division.
Club Deals Have Grown Substantially in Recent Years, Especially Those
Involving Large LBOs:
In recent years, private equity firms increasingly have joined to
acquire companies through LBOs, resulting in some of the largest LBO
transactions in history.[Footnote 41] These club deals involve two or
more private equity firms pooling their resources, including their
expertise and their investment funds' capital, to jointly acquire a
target company. From 2000 through 2007, we identified 2,994 private
equity-sponsored LBOs of U.S. companies, based on Dealogic data, of
which 493, or about 16 percent, were club deals. These club deals
accounted for $463.1 billion, or about 44 percent, of the $1.05
trillion in total LBO deal value we identified. As shown in table 2,
club deals have grown substantially both in number and value since
2004, particularly club deals involving companies valued at $1 billion
or more. Between 2000 and 2007, there were 80 club deals valued at $1
billion or more--accounting for about 16 percent of the total number of
all club deals but almost 90 percent of the total value of the club
deals. These large club deals peaked in 2007, with 28 deals valued at
about $217 billion. Among the club deals we identified, the number of
private equity firms collaborating on a transaction ranged from two to
seven.
Table 2: Number and Value of Club Deals, 2000-2007 (Dollars in
billions):
Year: 2000;
All club deals: Number: 47;
All club deals: Value: $8.8 billion;
Club deals valued at $1 billion or more: Number: 2;
Club deals valued at $1 billion or more: Percentage of all club deals:
4.3%;
Club deals valued at $1 billion or more: Value: $4.2 billion.
Year: 2001;
All club deals: Number: 37;
All club deals: Value: $7.9 billion;
Club deals valued at $1 billion or more: Number: 2;
Club deals valued at $1 billion or more: Percentage of all club deals:
5.4;
Club deals valued at $1 billion or more: Value: $3.0 billion.
Year: 2002;
All club deals: Number: 34;
All club deals: Value: $10.1 billion;
Club deals valued at $1 billion or more: Number: 2;
Club deals valued at $1 billion or more: Percentage of all club deals:
5.9;
Club deals valued at $1 billion or more: Value: $4.4 billion.
Year: 2003;
All club deals: Number: 37;
All club deals: Value: $18.9 billion;
Club deals valued at $1 billion or more: Number: 5;
Club deals valued at $1 billion or more: Percentage of all club deals:
13.5;
Club deals valued at $1 billion or more: Value: $10.4 billion.
Year: 2004;
All club deals: Number: 68;
All club deals: Value: $30.8 billion;
Club deals valued at $1 billion or more: Number: 13;
Club deals valued at $1 billion or more: Percentage of all club deals:
19.1;
Club deals valued at $1 billion or more: Value: $22.4 billion.
Year: 2005;
All club deals: Number: 97;
All club deals: Value: $64.6 billion;
Club deals valued at $1 billion or more: Number: 11;
Club deals valued at $1 billion or more: Percentage of all club deals:
11.3;
Club deals valued at $1 billion or more: Value: $56.1 billion.
Year: 2006;
All club deals: Number: 110;
All club deals: Value: $100.8 billion;
Club deals valued at $1 billion or more: Number: 17;
Club deals valued at $1 billion or more: Percentage of all club deals:
15.5;
Club deals valued at $1 billion or more: Value: $92.9 billion.
Year: 2007;
All club deals: Number: 63;
All club deals: Value: $221.2 billion;
Club deals valued at $1 billion or more: Number: 28;
Club deals valued at $1 billion or more: Percentage of all club deals:
44.4;
Club deals valued at $1 billion or more: Value: $217.4 billion.
Year: Total;
All club deals: Number: 493;
All club deals: Value: $463.1 billion;
Club deals valued at $1 billion or more: Number: 80;
Club deals valued at $1 billion or more: Percentage of all club deals:
16.2%;
Club deals valued at $1 billion or more: Value: $410.8 billion.
Source: GAO analysis of Dealogic data.
[End of table]
According to private equity executives, the principal reason they
formed clubs to buy companies was that their funds did not have
sufficient capital to make the purchase alone or were restricted from
investing more than a specified portion of their capital in a single
deal. For example, an executive of a large private equity firm told us
that, under its agreements with limited partners, the fund may invest
no more than 25 percent of its total capital in any one deal, which
equated to a limit of $750 million for its then-current fund. Another
executive said his firm stops short of such formal limits. For example,
even though its per-investment limit in a recent fund also was $750
million, the executive said, the firm limited its investment in one
acquisition to $500 million because that was thought to be more
prudent. Because of these constraints, the firms needed to partner with
other private equity firms to make recent acquisitions requiring
several billion dollars in equity.[Footnote 42] Other factors leading
private equity firms to pursue club deals, according to executives and
academics, include the benefits of pooling resources for the pre-buyout
due diligence research that private equity firms perform, which can be
costly, and of getting a "second opinion" about the value of a
potential acquisition. Several private equity executives told us that
club deals promote competition because they enable bids to be made that
would not otherwise be possible.
Although more prevalent in recent years, club deals may not always be
the preferred option for private equity firms. According to an academic
we interviewed, this is largely due to control issues. The academic
said that private equity firms joining a club may have to share
authority over such matters as operating decisions, which they
otherwise would prefer not to do. Executives of a large private equity
firm agreed, saying that their firm ordinarily has one of its partners
serve as the Chairman of the board of directors in an acquired company.
They said that in a club deal, this could be a contentious point. An
executive of a midsize private equity firm told us that his firm was
offered, but declined, a minority stake in a technology company buyout
because his firm prefers to be in control. A consultant told us that
private equity firms are finding club deals less attractive and, as a
result, turning more frequently to other arrangements, such as
soliciting additional limited partners, including sovereign investors,
to co-invest in deals, rather than co-investing with another private
equity firm.
Table 3 shows the 10 largest completed club deal LBOs of U.S. target
companies since 2000. As shown, these buyouts have involved companies
in a range of industries. Overall, reflecting their large value, club
deal transactions represent 6 of the 10 largest LBOs done since 2000.
Table 3: The 10 Largest Club Deals and Their Private Equity Firm
Sponsors (Dollars in billions):
Target company (industry): TXU Corp. (utility);
Value: $43.8 billion;
Private equity sponsors: TPG Capital LP (Texas Pacific); Goldman Sachs
Capital Partners; Kohlberg Kravis Roberts & Co.;
Completion date: October 2007.
Target company (industry): HCA Inc. (health care);
Value: $32.7 billion;
Private equity sponsors: Bain Capital Partners LLC; Kohlberg Kravis
Roberts & Co.; Merrill Lynch Private Equity;
Completion date: November 2006.
Target company (industry): Alltel Corp. (communications);
Value: $27.9 billion;
Private equity sponsors: Goldman Sachs Capital Partners; TPG Capital LP
(Texas Pacific);
Completion date: November 2007.
Target company (industry): Harrah's Entertainment Inc. (gaming);
Value: $27.4 billion;
Private equity sponsors: TPG Capital LP (Texas Pacific); Apollo
Advisors LP;
Completion date: January 2008.
Target company (industry): Kinder Morgan Inc. (energy);
Value: $21.6 billion;
Private equity sponsors: AIG Global Investment Group Inc.;
Carlyle/Riverstone Global Energy & Power; Carlyle Group Inc.; Goldman
Sachs Capital Partners;
Completion date: May 2007.
Target company (industry): Freescale Semiconductor Inc.
(electronics/integrated circuits);
Value: $17.6 billion;
Private equity sponsors: Carlyle Group Inc.; TPG Capital LP (Texas
Pacific); Blackstone Group LP; Permira Ltd;
Completion date: December 2006.
Target company (industry): Hertz Corp. (car and equipment rental);
Value: $15.0 billion;
Private equity sponsors: Carlyle Group Inc.; Clayton Dubilier & Rice
Inc.; Merrill Lynch Private Equity;
Completion date: December 2005.
Target company (industry): Univision Communications Inc. (Spanish
language media);
Value: $13.6 billion;
Private equity sponsors: Saban Capital Group Inc.; Thomas H Lee
Partners; Madison Dearborn Partners LLC; TPG Capital LP (Texas
Pacific); Providence Equity Partners Inc.;
Completion date: March 2007.
Target company (industry): SunGard Data Systems Inc. (software and
information technology services);
Value: $1.8 billion;
Private equity sponsors: TPG Capital LP (Texas Pacific); Blackstone
Group LP; Goldman Sachs Capital Partners; Silver Lake Partners LP;
Providence Equity Partners Inc.; Bain Capital Partners LLC; Kohlberg
Kravis Roberts & Co.;
Completion date: August 2005.
Target company (industry): Biomet Inc. (medical products);
Value: $11.4 billion;
Private equity sponsors: TPG Capital LP (Texas Pacific); Blackstone
Group LP; Goldman Sachs Capital Partners; Kohlberg Kravis Roberts &
Co.;
Completion date: September 2007.
Source: GAO analysis of Dealogic data.
Note: Includes transactions completed through first week of April 2008.
[End of table]
The extent to which private equity firms were involved in club deals
for large LBOs is shown in figure 3, which depicts the relationships
among the firms involved in the 50 largest U.S. LBOs from 2000 through
2007. These LBOs had a total value of around $530 billion and involved
33 private equity firms. Of the 50 LBOs, 31 were club deals. Most (31
of the 33) of the private equity firms were involved in these club
deals. For example, as shown in the figure, Goldman Sachs Capital
Partners (upper left corner) entered into club deals that involved 14
other private equity firms, including Apollo Advisors, Blackstone
Group, and CCMP Capital. Moreover, it entered into more than one club
deal with some of the other firms, such as Blackstone Group.
Figure 3: Club Deal Ties among Private Equity Firms Involved in the 50
Largest LBOs, 2000-2007:
[See PDF for image]
This figure is an illustration of club deal ties among private equity
firms involved in the 50 largest LBOs, 2000-2007. Indicated on the
illustration are lines connecting the firms that represent the
following:
One deal between firms;
More than one deal between firms.
Source: GAO analysis of Dealogic data.
[End of figure]
Private equity executives with whom we spoke had differing opinions on
the future trend in club deals. One executive said that private equity
funds will continue to face constraints in acquiring large companies
alone, suggesting a continued role for club deals. Some noted that
private equity firms have been raising larger funds from limited
partner investors and thus should be able to acquire larger target
companies alone. Credit market conditions will also play an important
role, some executives said, because as long as credit is in relatively
tight supply due to the problems in the credit markets, it will be
difficult to get the debt financing necessary to support large club
deals.
LBOs Commonly Involve a Competitive Process and Club Deals Could
Support or Undermine This Process:
Private equity firms commonly acquire target companies through a
competitive process in which interested parties bid on the target
companies, according to academics, executives of private equity firms,
and commercial and investment bank officials.[Footnote 43] For example,
two private equity executives said that selling companies or their
advisers use an auction process to try to increase the companies' sale
price. The nature and formality of the process can vary from deal to
deal, depending on the level of interest in the target company and
other factors. For example, sellers might solicit bids from any
interested buyer or ask only select would-be buyers to bid. After an
initial round of offers, bidders judged to be more capable of working
together or bringing a deal to completion might be invited to submit
revised offers. Additionally, even when the parties have agreed on the
principal terms of a buyout transaction, executives said that the
agreement may include a "go-shop" provision that allows the seller to
seek a better offer from other potential buyers within a certain
period.[Footnote 44]In general, the auction process and go-shop
provision seek to produce higher sales prices for sellers and to allow
sellers to fulfill legal duties to obtain best prices for their
shareholders.[Footnote 45] Those involved in the process also note that
sellers need not ultimately accept even the highest bids for their
companies, if they believe prices offered are inadequate.
For LBOs involving an auction process, club deals can be formed by
either buyers or sellers. First, private equity firms can form clubs on
their own before making an offer to buy a target company. For example,
executives of one firm told us that they might approach other firms
with whom they have dealt effectively in a prior deal or who would
bring advantageous experience or skill to the particular deal. An
executive of another firm cited geographic or industry experience that
a partner could bring. Second, the target company or its advisers can
play a role in organizing private equity firms into clubs to bid on the
company. For instance, in the private equity-sponsored LBO of retailer
Neiman Marcus, the company's adviser organized bidders into four clubs
after receipt of an initial round of proposals. According to the
company, it formed the bidders into clubs because of the size of the
transaction and to maximize competition among the competing groups.
(See app. V for additional details about this LBO.)
Private equity executives said that sellers or their advisers can
influence the formation of bidding clubs by controlling the flow of
information. Before bidding on a target company, potential buyers
typically want detailed information about the company's operations and
finances. Sellers may provide this information under a nondisclosure
agreement, which bars the potential buyers from discussing such
information with others. Executives from private equity firms told us
that by using this control of information as a lever, sellers sometimes
encourage potential buyers to form clubs for several reasons. A seller
may realize that the deal size is too large for one private equity firm
to undertake alone. Also, negotiating the sale of a company can be time-
consuming and distracting, so management of the target company may wish
to limit the number of offers it entertains. Sellers also might
encourage club deals among particular buyers for strategic purposes;
that is, to increase the price paid to acquire their companies. For
example, a seller might pair up a private equity firm offering a lower
bid with another firm offering a higher bid. The expectation is that as
bidding goes forward, prices offered will go up from earlier bids.
Thus, if the starting point for a new round of bids begins at a higher
price, the seller would expect to receive more.
The recent growth of club deals, particularly the larger ones, has
given rise to questions and concerns about joint bidding's potential
effect on buyout competition. If each private equity firm that is part
of a club deal could and would bid independently on a target company,
but instead chooses to bid jointly, this could reduce price
competition. In an auction process, a greater number of bidders, all
else being equal, should lead to a higher purchase price. Thus, if club
deals lead to fewer bidders participating in an auction for target
companies, then such deals could result in lower prices paid for target
companies than would otherwise be true. Even if joint bidding does not
reduce the number of potential bidders for a particular target company,
club deals could still lead to lower prices paid for target companies.
For example, bidders could collude, such as by agreeing on which bidder
will submit the highest offer and potentially win the auction and
allowing the losing bidder to join in later on the LBO.
Our Analysis Indicates That Public-to-Private Club Deals, in Aggregate,
Generally Are Not Associated with Lower or Higher Prices Paid for
Target Companies, and the Private Equity Marketplace Is Predisposed to
Perform Competitively:
To examine the potential effect club deals may have on competition
among private equity firms, we developed an econometric model to
examine prices paid for target companies in a subset of all private
equity deals--that is, those transactions where the target company is
publicly traded.[Footnote 46] We selected these transactions because
pricing and other information necessary for the analysis was publicly
available. We examined these transactions as a group, while
incorporating individual characteristics associated with each
acquisition. The analysis generally found no statistically meaningful
negative or positive relationship between the price paid for a target
company and whether the buyout was the product of a club deal.[Footnote
47]That is, public-to-private club deals, in the aggregate, generally
are not associated with lower or higher per share price premiums, once
important characteristics of target companies are factored into the
analysis. Thus, to the extent that potentially anticompetitive effects
of such club deals would be reflected in the acquisition price, we do
not find evidence of such an effect in the aggregate. However, our
results do not rule out the possibility that, in any particular
transaction, parties involved could seek to engage in illegal behavior,
such as bid-rigging or other collusion. We caution that we draw
conclusions about the association, not casual relationship, between
clubs deals and premiums. Accordingly, our results showing no
association between club deals and price paid should not be read as
establishing that club deals necessarily caused acquisition prices to
be higher or lower. To the extent that the nature of the firms and
transactions we examined differ from the overall population of club
deals, our results may not generalize to the population. (See app. X
for details on our methodological and data limitations.)
For our econometric model, we initially identified 510 "public-to-
private" U.S. buyouts from 1998 through 2007, in which private equity
firms acquired publicly held companies. By number, this type of
transaction represents about 15 percent of all deals but accounts for
about 58 percent of total reported deal value. We examined price paid
using the premium paid over a target company's prebuyout stock price.
Premiums are common in buyouts, because it is the premium over current
stock price that helps persuade current owners to sell. By itself, the
size of this premium can vary significantly among buyouts overall, as
well as for club versus nonclub deals, depending on how it is measured.
For example, comparing a publicly held target company's stock price 1
day before announcement of a buyout to the final price paid shows that
the premium in club deal acquisitions is slightly smaller--by roughly 1
percent--than for other buyouts (fig. 4). On the other hand, using
stock price 1 month before announcement shows that the premium paid in
club deals is significantly larger--about 11 percent higher.[Footnote
48] Neither of these differences is statistically significant in our
econometric models run on the full sample.[Footnote 49]
Figure 4: Premium Paid for Target Companies in Public-to-Private
Buyouts:
[See PDF for image]
This figure is a multiple vertical bar graph depicting the following
data:
Average of premium prior to announcement of buyout: 1 day;
Nonclub deal: 23.2%;
Club deal: 22%.
Average of premium prior to announcement of buyout: 1 week;
Nonclub deal: 25%;
Club deal: 26.1%.
Average of premium prior to announcement of buyout: 1 month;
Nonclub deal: 29.6%;
Club deal: 40.6%.
Note: "Premium, 1 Day" is the premium offered based on a target
company's share price 1 day before announcement of a buyout; "Premium,
1 Week" is the premium offered based on share price 1 week before
announcement; "Premium, 1 Month" is the premium offered share price 1
month before announcement.
[End of figure]
Academic research in this area is limited, but our finding that club
deals are not associated with lower per share price premiums in the
aggregate is consistent with two other studies done on U.S. data.
[Footnote 50] However, our results are inconsistent with another recent
study that found large club deals before 2006 led to lower premiums
paid for target companies.[Footnote 51] This study also found that
target companies with high institutional ownership did not experience
the same effect, suggesting that such institutional investors are able
to counter the potentially negative price effect of club deals.
Moreover, we also found evidence, consistent with the literature, that
larger companies, companies with larger debt burdens, and companies
with large block and managerial holders of equity, received smaller
premiums upon takeover.[Footnote 52].
Given concerns about the potential exercise of market power in private
equity transactions, we also employed two commonly used measures of
market concentration to assess the potential for anticompetitive
behavior in the private equity marketplace generally; that is, among
buyouts of both publicly and privately held target companies. One of
these measures is known as the Four-Firm Concentration Ratio. It is the
sum of the market shares by the four largest participants. A four-firm
concentration ratio of less than 40 percent generally indicates
"effective competition," although it does not guarantee competition
prevails. Markets are considered tight oligopolies if a four-firm
concentration ratio exceeds 60 percent.[Footnote 53] For the private
equity marketplace, we estimate the concentration ratio at about 32
percent, below the 40 percent threshold.
The second measure of market concentration we employed is the
Herfindahl-Hirschman Index, which the Federal Trade Commission and the
U.S. Department of Justice (DOJ) use to assess market concentration and
the potential for firms to exercise market power. The index is
calculated as the sum of the squares of each participant's market
share.[Footnote 54]According to guidelines issued by DOJ, Herfindahl-
Hirschman Index values of below 1,000 indicate an unconcentrated
marketplace, which is more inclined to perform competitively. For the
private equity marketplace, we estimate the index value at 402.
We note that the private equity marketplace is likely even less
concentrated, and more inclined to perform competitively, than our
analyses indicate. Both concentration measures are sensitive to the
definition of the "market," and we have assumed that the marketplace is
comprised only of private equity firms as potential buyers. In
actuality, nonprivate equity buyers, often called "strategic"
purchasers, also can seek to acquire companies. Were such buyers
reflected in our analyses, the market shares of the private equity
firms would be lower, producing lower calculations of market
concentration.
Some Large Club Deals Reportedly Have Attracted the Interest of the
Department of Justice and Have Prompted Lawsuits against Some Private
Equity Firms:
Beginning in October 2006, news media reports said that DOJ's Antitrust
Division sent letters of inquiry to a number of large private equity
firms, asking them to voluntarily provide information about their
practices in recent high-profile club deals.[Footnote 55] As of May
2008, DOJ staff told us they could not disclose any details of their
activities and neither confirmed nor denied the agency's inquiry. At
least one private equity firm, Kohlberg, Kravis, Roberts & Co.,
disclosed receipt of a DOJ letter related to the inquiry in a
registration statement filed with SEC.
Beyond the reported DOJ inquiry, we identified four shareholder
lawsuits that have been filed in connection with private equity firms'
club deals. In their respective complaints, shareholders of target
companies acquired by a consortium of private equity firms alleged
generally that the private equity firms acted in concert to fix the
price paid for the target companies at below competitive prices and in
violation of federal antitrust laws.
One of these cases has been dismissed and, in another, an antitrust
claim stemming from the club deal was dismissed.[Footnote 56]. Two
other cases filed in federal district court, Davidson v. Bain Capital
Partners, LLC, and Dahl v. Bain Capital Partners, LLC, were recently
consolidated into a single action.[Footnote 57] The consolidated case
was pending as we completed this report.
SEC Exercises Limited Oversight of Private Equity Funds, but It and
Others Have Identified Some Potential Investor-Related Issues:
Because private equity funds and their advisers generally have
qualified for exemptions from registration under the federal securities
laws, SEC exercises limited oversight of these entities. Nonetheless,
several advisers to some of the largest private equity funds are
registered, and SEC routinely has examined these advisers and found
some compliance control deficiencies. At the same time, SEC and others
historically have not found private equity funds or their advisers to
raise significant concerns for fund investors--in part evidenced by the
limited number of enforcement actions SEC has brought against such
funds or their advisers. Nonetheless, in light of the growth in LBOs by
private equity funds, U.S. and foreign regulators have undertaken
studies to assess risks posed by such transactions and have identified
some potential market abuse and investor protection concerns that they
are studying further.
Private Equity Funds and Their Advisers Typically Qualify for an
Exemption from Registration with SEC:
Private equity funds typically are organized as limited partnerships
and structured and operated in a manner that enables the funds and
their advisers (private equity firms) to qualify for exemptions from
some of the federal statutory restrictions and most SEC regulations
that apply to registered investment pools, such as mutual funds.
[Footnote 58] For example, SEC staff told us that private equity funds
and their advisers typically claim an exemption from registration as an
investment company or investment adviser, respectively.[Footnote 59]
Although certain private equity fund advisers may be exempt from
registration, they remain subject to antifraud (including insider
trading) provisions of the federal securities laws.[Footnote 60]In
addition, private equity funds typically claim an exemption from
registration of the offer and sale of their partnership interests to
investors.[Footnote 61]
Because private equity funds and their advisers typically claim an
exemption from registration as an investment company or investment
adviser, respectively, SEC exercises limited oversight of private
equity funds and their advisers. SEC's ability to directly oversee
private equity funds or their advisers is limited to those that are
required to register or voluntarily register with SEC. For example,
funds or advisers exempt from registration are not subject to regular
SEC examinations or certain restrictions on the use of leverage and on
compensation based on fund performance and do not have to maintain
their business records in accordance with SEC rules.
A number of investment companies serving to facilitate venture capital
formation also are engaged in LBOs, like traditional private equity
funds. These companies have elected to be regulated under the
Investment Company Act as business development companies (BDC), which
are investment companies, or funds, operated primarily for the purpose
of investing in eligible portfolio companies and that offer to make
significant managerial assistance to such portfolio companies.[Footnote
62] BDCs are permitted greater flexibility than registered investment
companies in dealing with their portfolio companies, issuing
securities, and compensating fund managers.[Footnote 63] However, BDCs
must have a class of their equity securities registered with SEC and
thus are required to file periodic reports with SEC. Moreover, BDCs are
subject to SEC examinations. In 2004, a number of private equity firms
created or planned to create BDCs. For example, Apollo Management
created the most significant BDC during that period, raising around
$900 million. According to data provided by SEC staff, 76 investment
companies had elected to be classified as BDCs as of June 2007.
However, around 50 of them were active, and they held about $19.5
billion in net assets. In comparison, a consulting firm estimated that
U.S. private equity funds had $423 billion of assets under management
at the end of 2006.[Footnote 64]
SEC Examinations of Registered Advisers to Private Equity Funds Have
Identified Deficiencies in Some Compliance Controls:
Private equity fund advisers that are registered with SEC are subject
to the same regulatory requirements as other registered investment
advisers. These advisers are required to maintain books and records and
are subject to periodic examinations by SEC staff. They also must
provide current information to both SEC and their investors about their
business practices, disciplinary history, services, and fees but are
not required to report specifically whether they advise a private
equity fund exempt from registration under the Investment Company Act.
As a result, SEC staff do not know which and, in turn, how many, of the
registered advisers advise exempt private equity funds. The SEC staff
said that they can determine whether a registered adviser advises a
private equity fund when examiners go on-site to do an examination and
through other information sources, such as an adviser's Internet site.
Using publicly available sources, we compiled a list of 21 of the
largest private equity firms based on their assets under management and
amount of capital raised from investors. From this list, SEC staff
identified 11 private equity firms that were registered as investment
advisers or affiliated with registered investment advisers during the
period from 2000 through 2007. During this period, SEC examiners
conducted 19 routine examinations involving 10 of the 11
firms.[Footnote 65] We reviewed 17 of the examinations.[Footnote 66] In
each of these examinations, SEC examiners identified one or more
deficiencies. In 6 examinations, they found internal control weaknesses
related to preventing the potential misuse of material nonpublic or
insider information. In 4 examinations, they found that the adviser had
weak controls related to monitoring or enforcing restrictions on
personal trades by employees. Less commonly found deficiencies included
the adviser using testimonials to endorse its private equity fund,
weaknesses in its marketing materials, or lack of a contingency plan.
These types of deficiencies are not unique to private equity firms that
are registered investment advisers, according to SEC staff, and none of
the deficiencies involved abuses that warranted referring them to SEC's
Division of Enforcement. Nonetheless, SEC examiners sent the advisers a
deficiency letter after completing the examinations, and SEC staff said
that the advisers responded in writing about how they would address the
deficiencies.
From 2000 through 2007, SEC examiners also did 7 "sweep examinations"
that included 4 of the 11 private equity firms' registered advisers,
but it did not conduct any cause examinations of the registered
advisers.[Footnote 67] We reviewed 6 of the sweep examinations.
[Footnote 68] In 4 of the examinations, SEC examiners found
deficiencies concerning internal control weaknesses, including a
failure to obtain clearance for personal trades by employees. In 2 of
these examinations, SEC staff sent the advisers a deficiency letter; in
the other 2 examinations, SEC staff told us that examiners discussed
the deficiencies with the advisers. SEC staff did not find any
deficiencies in its other two sweep examinations.
Growth in Private Equity-Sponsored LBOs Has Led to Greater Regulatory
Scrutiny:
SEC and others generally have not found private equity funds or their
advisers to have posed significant concerns for fund investors. In a
2004 rule release, SEC stated that it had pursued few enforcement
actions against private equity firms registered as investment advisers.
[Footnote 69] In commenting on the 2004 SEC rule, officials from
committees of the American Bar Association and Association of the Bar
of the City of New York noted that enforcement actions involving fraud
and private equity firms have not been significant. In addition, an SEC
official told us that the Division of Investment Management had
received more than 500 investor complaints in the past 5 years but none
involved private equity fund investors. In reviewing SEC enforcement
cases initiated since 2000, we identified seven cases that involved
investments in private equity funds (excluding venture capital funds)
and fraud. Five of the cases involved officials associated with a
pension plan who invested the plan's money in private equity funds in
exchange for illegal fees paid to them by the private equity firms. In
one of the other two cases, SEC alleged that a private equity firm
official misappropriated money that was meant to be invested in the
firm's private equity funds. In the other, SEC alleged that a private
equity firm official engaged in insider trading based on information
received about a potential acquisition.
Officials from a labor union told us that one of their areas of concern
regarding private equity funds was the level of protection provided to
fund investors, particularly pension plans. They said that general
partners (or private equity firms) must be accountable to investors,
particularly in terms of their fiduciary duties to investors and
protections against conflicts of interest. An association representing
private equity fund limited partners, such as pension plans, found that
the vast majority of members responding to an informal survey had not
encountered fraud or other abuse by a general partner and viewed the
funds as treating them fairly. Although the vast majority of survey
respondents viewed themselves as sophisticated and able to protect
their interests, they identified areas where funds needed to improve,
such as fees, valuation of fund assets, and timeliness in reporting
fund performance. An official from another association representing
institutional investors, including public, union, and corporate pension
plans, told us that its members generally do not see a need to subject
private equity funds, or their advisers, to greater regulation.
Additionally, the official was not aware of any cases of a private
equity fund adviser defrauding investors. In a recent report, we found
that pension plans with which we spoke, some of which had been
investing in private equity for more than 20 years, indicated that
these investments had met their expectations and, as of late 2007 and
early 2008, planned to maintain or increase their private equity
allocation.[Footnote 70] Nevertheless, we also found that pension plans
investing in private equity face challenges beyond those associated
with traditional investments, such as stocks and bonds. The challenges
included the variation of performance among private equity funds, which
is greater than for other asset classes, and the difficulty of gaining
access to funds perceived to be top performers, as well as valuation of
the investment, which is difficult to assess before the sale of fund
holdings.
In light of the recent growth in private equity-sponsored LBOs, some
regulators have undertaken efforts to identify potential risks raised
by the activity and assess the need for additional regulation. For
instance, the UK Financial Services Authority (FSA) issued a private
equity study in November 2006, and a technical committee of
International Organization of Securities Commissions (IOSCO), which
included SEC, issued a study in November 2007.[Footnote 71] In its
study, FSA raised concerns about, among other things, the potential for
market abuse (for example, insider trading) to result from the leakage
of price-sensitive information concerning private equity transactions.
It noted that a main cause of the increased potential for information
leaks in the private equity market is the number of institutions and
people involved in private equity deals, especially ones involving
publicly held companies. FSA further noted that the development of
related products traded in different markets, such as credit
derivatives on leveraged loans, increases the potential for this abuse.
[Footnote 72]The IOSCO technical committee also raised concerns about
the potential for market abuse in its study. It stated that market
abuse, such as insider trading, which is not limited to the private
equity industry, remains a key priority for IOSCO and individual
regulators. In that regard, the committee noted that the issue is
relevant to other ongoing work by IOSCO but not to its further work on
private equity.
In their reports, the regulators also identified potential concerns
raised by private equity transactions that related to the protection of
fund investors. FSA stated that conflicts of interest may arise between
fund management and fund investors even though fund management seeks to
align its interests with the interests of fund investors by investing
its capital in the fund. It stated that both sets of interests may
become misaligned in a number of situations, such as if management is
allowed to coinvest with the fund in a particular deal. The IOSCO
technical committee also commented that private equity transactions,
along with other merger-and-acquisition activities, can present
conflicts of interest for a number of parties, including private equity
firms, fund investors, and target companies. For example, it noted that
when management is participating in a buyout, it may not have an
incentive to act in the best interests of existing shareholders by
recommending a sale at the highest possible price. According to the
committee, where public companies are involved, regulators and
investors (including fund investors and public shareholders) emphasize
the controls that firms have in place to ensure that potential
conflicts do not undermine investor confidence. In that regard, the
committee is pursuing additional work to analyze conflicts of interest
that arise in private equity transactions, as they relate to the public
markets, and policies and procedures used to manage such conflicts.
Recent Credit Events Raised Regulatory Scrutiny about Risk-Management
of Leveraged Lending by Banks:
A small number of commercial and investment banks have played a key
role in providing leveraged loans to help finance the recent U.S. LBOs.
Before the problems related to subprime mortgages spread to the
leveraged loan market in mid-2007, the regulators generally found that
the major commercial and investment banks had adequate risk-management
practices but noted some concerns, such as weakening of underwriting
standards and significant growth in leveraged loan commitments. In
general, the major banks managed their risk exposures by providing the
loans through a group of lenders rather than by themselves, but after
the problems surfaced in mid-2007, the banks were no longer able to do
so, exposing them to greater risk. In light of this situation,
regulators have reviewed the risk-management practices of commercial
and investment banks and identified some weaknesses. As the regulators
continue to ensure that their respective institutions correct
identified risk-management weaknesses, it will be important for them to
evaluate periodically whether their guidance responds to such
identified weaknesses and to update their guidance, as appropriate.
Major Commercial and Investment Banks Have Played a Key Role in
Financing U.S. LBOs:
A small number of major commercial and investment banks have helped to
finance the majority of recent LBOs in the United States. Under their
loan commitments, banks usually agree to provide "revolvers" (or
revolving lines of credit) and term loans to private equity funds when
their LBO transactions close.[Footnote 73] A revolver is a line of
credit that allows the borrower to draw down, repay, and reborrow a
specified amount on demand. A term loan is a loan that the borrower
repays in a scheduled series of repayments or a lump-sum payment at
maturity. Although banks fund the term loans when the LBO transactions
are completed, the revolvers usually are not funded at that time but
rather are saved to meet future financing needs. As discussed in the
background, loans issued to finance LBOs are typically syndicated--
provided by a group of lenders--and categorized as leveraged, rather
than investment-grade, loans.
Banks and other lenders provided, in total, nearly $2.7 trillion in
syndicated, leveraged loans in the U.S. market from 2005 through 2007,
according to Dealogic. Of this total, around $1.1 trillion, or 42
percent, was used to finance transactions sponsored by private equity
funds. More specifically, private equity funds used nearly $634
billion, or 56 percent, of the leveraged loans to finance a total of
956 LBOs and the remainder for other purposes, such as the refinancing
of companies held in the funds' investment portfolios.[Footnote 74]
Table 4 shows that 10 commercial and investment banks arranged and
underwrote nearly $489 billion, or 77 percent, of the U.S. syndicated
leveraged loans used to finance 700 private equity-sponsored LBOs from
2005 through 2007[Footnote 75]. Four were U.S. commercial banks--JP
Morgan Chase, Citibank, Bank of America, and Wachovia; four were U.S.
investment banks (or broker-dealers)--Goldman Sachs, Lehman Brothers,
Merrill Lynch, and Morgan Stanley; and two were foreign banks.
Table 4: Top 10 Commercial and Investment Banks Providing Syndicated
Leveraged Loans for LBOs by Private Equity Funds, U.S. Market, 2005-
2007:
Commercial or investment bank: JP Morgan Chase;
Deal value: $95.3 billion;
Number of deals: 272;
Market share based on deal value: 15.0%.
Commercial or investment bank: Goldman Sachs;
Deal value: $58.3 billion;
Number of deals: 129;
Market share based on deal value: 9.2%.
Commercial or investment bank: Citigroup;
Deal value: $56.2 billion;
Number of deals: 107;
Market share based on deal value: 8.9%.
Commercial or investment bank: Credit Suisse;
Deal value: $54.9 billion;
Number of deals: 189;
Market share based on deal value: 8.7%.
Commercial or investment bank: Bank of America;
Deal value: $49.6 billion;
Number of deals: 192;
Market share based on deal value: 7.8%.
Commercial or investment bank: Deutsche Bank;
Deal value: $47.4 billion;
Number of deals: 103;
Market share based on deal value: 7.5%.
Commercial or investment bank: Lehman Brothers;
Deal value: $40.2 billion;
Number of deals: 95;
Market share based on deal value: 6.4%.
Commercial or investment bank: Merrill Lynch;
Deal value: $33.5 billion;
Number of deals: 151;
Market share based on deal value: 5.3%.
Commercial or investment bank: Morgan Stanley;
Deal value: $28.9 billion;
Number of deals: 61;
Market share based on deal value: 4.6%.
Commercial or investment bank: Wachovia;
Deal value: $24.4 billion;
Number of deals: 122;
Market share based on deal value: 3.9%.
Commercial or investment bank: Subtotal;
Deal value: $488.7 billion;
Number of deals: 700;
Market share based on deal value: 77.1%.
Commercial or investment bank: Total;
Deal value: $633.8 billion;
Number of deals: 956;
Market share based on deal value: 100.0%.
Source: GAO analysis of Dealogic data.
[End of table]
Before 2007, Federal Banking Regulators Generally Found Risk Management
for Leveraged Financing to Be Satisfactory:
The banking regulators have been addressing risk-management for
leveraged financing for two decades and, before the credit market
problems in mid-2007, a key concern was underwriting standards. Since
the LBO boom in the 1980s, the Federal Reserve and OCC periodically
have issued regulatory guidance on financing LBOs and other leveraged
transactions. For example, in 1989, the regulators jointly defined the
term "highly leveraged transaction" to establish consistent procedures
for identifying and assessing LBOs and similar transactions.[Footnote
76] In guidance that they jointly issued in 2001, the regulators stated
that banks can engage in leveraged finance in a safe and sound manner,
if pursued within an appropriate risk-management structure.[Footnote
77]According to the guidance, such a risk-management structure should
include a loan policy, underwriting standards, loan limits, a policy on
risk rating transactions, and internal controls.
OCC is responsible for supervising national banks, which include the
four U.S. commercial banks that played a key role in financing recent
LBOs. According to OCC staff, they have continued to supervise the
financing of LBOs by these banks through examinations and ongoing, on-
site monitoring. Moreover, each of these banks is a subsidiary of a
bank or financial holding company supervised by the Federal Reserve.
[Footnote 78] Because of the complexity of leveraged transactions and
restrictions on commercial bank finance activities, various parts of a
leveraged financing package may be arranged through the bank, its
subsidiaries, or its holding company. According to OCC examiners, OCC
works with the Federal Reserve to assess a banking organization's total
participation in and exposure to leveraged finance activities.
OCC examiners told us that each year they have examined the leveraged
lending activities of the four banks as part of their ongoing
supervision. In large banks, most examination-related work is conducted
throughout a 12-month supervisory cycle. The objectives of the
examinations covering the banks' leveraged lending activities included
assessing the quantity of risk and quality of risk management,
reviewing underwriting standards, and testing compliance with
regulatory guidance. To meet these objectives, examiners, among other
things, sampled and reviewed loans and related documentation, reviewed
management reports, and interviewed bank staff. OCC examiners told us
that they also monitor the banks' risk management of their leveraged
lending activities on an ongoing basis throughout the year. For
example, they meet with bank managers from various bank operations on a
regular basis to discuss issues such as portfolio trends, market
conditions, underwriting practices, and emerging risks. In addition,
they periodically review management reports to identify changes in
portfolio performance, composition, and risk and audit reports to
assess the effectiveness of the programs and identify deficiencies
requiring attention.
We reviewed 17 examinations that OCC examiners conducted between 2005
and 2007 that included some aspects of the leveraged finance activities
at two major banks. Each of the examinations generally covered
different portfolios that included leveraged loans, such as special
credits, North American leveraged loans, and syndicated credits. The
examiners found that underwriting standards for leveraged loans had
been easing every year since at least 2005, evidenced by increased
leverage, liberal repayment schedules on term loans, and erosion of
loan covenants.[Footnote 79]However, the examiners generally found the
quality of risk management at the two banks to be satisfactory for the
processes reviewed, at least until mid-2007. For one of the banks,
examiners noted that bank management understood the key risks and
implemented appropriate strategies and controls to manage those risks.
For instance, the bank retained a relatively small percentage of its
leveraged loans. Likewise, examiners at the other bank noted that
underwriting and distribution volume in leveraged loans was significant
and increasing, but the bank retained a small position in leveraged
loans. Nevertheless, in 2006 and 2007 internal documents that outlined
planned examinations and other supervisory activities, examiners at one
bank identified a key risk--the potential for investor demand for
leveraged loans to slow and adversely affect the bank's ability to
syndicate loans and manage risk by retaining only small positions in
leveraged loans. The examiners noted that they would continue to
monitor the bank's leveraged lending activities through ongoing
monitoring and examinations, and they conducted such examinations in
subsequent years.
The Federal Reserve and OCC also supervised the financing of LBOs by
the major banks through other types of reviews and surveys. Each year,
they jointly review shared national credits, which include syndicated
leveraged loans.[Footnote 80] In 2006, the review found that the volume
of leveraged loans rose rapidly, in part because of the rise in mergers
and acquisitions. It also found that strong market competition had led
to an easing of underwriting standards in leveraged loans, evidenced
partly by minimum amortization requirements and fewer maintenance
covenants. The 2007 review continued to find weakened underwriting
standards in leveraged loans, and regulators stated in their joint
press release that banks should ensure that such standards are not
compromised by competitive pressures.[Footnote 81] Furthermore, the
review noted that banks had a backlog of leveraged loan commitments
that could not be distributed without incurring a loss and may need to
be retained by the banks. Similarly, in OCC's 2006 and 2007 survey of
underwriting practices, the regulator also found that banks were easing
their credit standards for leveraged loans and cautioned them about
their weakening standards.[Footnote 82] Finally, in the Federal
Reserve's 2006 and 2007 "Senior Loan Officer Opinion Survey on Bank
Lending Practices," responding banks generally reported that the share
of loans related to mergers and acquisitions, including LBOs, on their
books was fairly small.[Footnote 83] For example, in 2007, around 85
percent of the large banks responding to the survey said that LBO loans
accounted for 20 percent or less of the syndicated loans on their
books.
SEC Began to Supervise Financing of LBOs by Investment Banks around
2005:
As noted earlier, four of the major underwriters of leveraged loans
used to help finance LBOs are investment banks (broker-dealers), all of
which have elected to be supervised by SEC under its Consolidated
Supervised Entity (CSE) program.[Footnote 84] SEC's supervision of CSEs
extends beyond the registered broker-dealers to their unregulated
affiliates and holding companies. SEC staff said that the CSEs usually
originate their leveraged loans in affiliates outside of their
registered broker-dealers to avoid capital charges that otherwise would
be assessed under SEC's capital rules. Between December 2004 and
November 2005, selected broker-dealers agreed to participate in the CSE
program, and SEC has been responsible for reviewing unregulated
affiliates of the broker-dealers.[Footnote 85]
According to SEC staff, they reviewed guidance issued by, and talked
to, federal bank regulators in developing their approach to supervising
the securities firms' leveraged lending. SEC staff said that they focus
on credit, market, and liquidity risks associated with the leveraged
lending activities of the CSEs to gain not only a broad view of the
risks but also insights into each of the different areas, because these
risks are linked. For example, under their approach, SEC staff can
monitor how a firm's credit risk exposure from its leveraged loan
commitments can increase the firm's liquidity risk if the firm cannot
syndicate its leveraged loans as planned. Because management of these
three risks generally involves different departments within a firm, the
staff said that they routinely meet with the various departments within
each firm that are responsible for managing their firm's credit,
market, and liquidity risk exposures. They also said that they review
risk reports and other data generated by the firms.
In fiscal year 2006, SEC reviewed the leveraged lending activities
across each of the CSEs. As part of the review, SEC analyzed the
practices and processes of leveraged lending, management of the risks
associated with leveraged lending, and the calculation of capital
requirements for loan commitments. SEC found that the CSEs, like the
major commercial banks, used loan approval processes and loan
syndications to manage their risks. According to an SEC official, the
review generally found that the firms were in regulatory compliance but
identified areas where capital computation and risk-management
practices could be improved. Moreover, the SEC official said four firms
modified their capital computations as a result of feedback from the
leveraged loan review. Like other consolidated supervisors overseeing
internationally active institutions, SEC requires CSEs to compute
capital adequacy measures consistent with the Basel standards.[Footnote
86]
2007 Market Events Increased Risk Exposures of Banks That Financed LBOs
and Raised Some Concerns about Systemic Risk That Warrant Regulatory
Attention:
Before June 2007, the major commercial and investment banks were able
to use an "originate-to-distribute" model to help manage the risks
associated with their leveraged finance, according to OCC and SEC
staff. Under this model, a bank or group of banks arrange and
underwrite a leveraged loan and then syndicate all or some portion of
the loan to other institutions, rather than holding the loan on their
balance sheets.[Footnote 87] Leading up to June 2007, strong demand by
nonbank institutions (such as collateralized loan obligations,
insurance companies, mutual funds, and hedge funds) that invest in
leveraged loans fostered the growth of the leveraged loan market.
[Footnote 88] According to officials representing four major banks,
they typically were able to syndicate their leveraged loans when the
LBO deals closed. As a result, the banks generally were able to limit
their leveraged loan exposure to the amount that they planned to hold
when they initially committed to make the loans. The bank officials
said that their banks typically held portions of the pro rata loans,
not the longer term and, thus, potentially more risky institutional
loans.[Footnote 89] In addition, the bank officials said that, before
mid-2007, high-yield bond offerings used to help finance some LBOs
normally were completed by the time the deals were closed. This
eliminated the need for the banks to provide bridge loans for those
LBOs, according to the bank officials.
After June 2007, investor concerns about the credit quality of subprime
mortgages spread to other credit markets, leading to a sudden and
significant decline in demand for leveraged loans. Not expecting market
liquidity to change so suddenly, the major banks were left with a large
number of unfunded loan commitments for pending LBO deals. The four
major commercial banks had more than $294 billion in leveraged finance
commitments at the end of May 2007, and the four major investment banks
had more than $171 billion in commitments at the end of June 2007. When
market conditions changed, the banks were no longer able to syndicate
some of their leveraged loans at prices they had anticipated when the
LBO deals closed. The banks also had to fund some of the bridge loans
for such deals. As a result, the banks held on their balance sheets
considerably more loans than originally planned, including leveraged
loans intended to be syndicated to institutional investors. For the
major commercial banks, the amount of leveraged loans that exceeded the
amount that they planned to hold increased from around zero at the end
of May 2007 to around $62 billion at the end of December 2007.
Similarly, the total amount of leveraged loans held by the major
investment banks increased from almost $9 billion to around $59 billion
from June to December 2007. Because the decrease in demand for
syndicated loans caused prices to decline, the banks had to mark down
some of their leveraged loans and loan commitments to reflect the lower
market prices, resulting in substantial reductions to earnings.
[Footnote 90] For example, a credit rating agency estimated that the
major U.S. banks suffered around $8 billion in losses (before fees and
hedges) on their leveraged loans and loan commitments in the third
quarter of 2007.
Since then, the major banks have made progress in reducing the number
of unfunded leveraged loan commitments but continue to face challenges
reducing their loan holdings. First, the major commercial banks have
reduced their leveraged finance commitments from about $294 billion to
about $34 billion from the end of May 2007 through the end of March
2008. Likewise, the major investment banks have reduced their
commitments from about $171 billion to about $14 billion from the end
of June 2007 through the end of March 2008. According to a credit
rating agency, the banks have been able to slowly reduce their
commitment volume, as liquidity gradually has returned to the leveraged
finance market, and as some LBO deals have been cancelled,
restructured, or repriced. Second, the banks are continuing to work to
reduce their holdings of leveraged loans. At year-end 2007, the
commercial banks held about $62 billion more in leveraged loans than
they planned to hold but had reduced the amount to around $53 billion
at the end of March 2008. During the same period, the total amount of
leveraged loans held by the investment banks decreased from around $59
billion to around $56 billion. Bank officials told us that they are
continuing to look for market opportunities to syndicate or otherwise
sell their leveraged loans. Additionally, the banks can, and some do,
manage their leveraged loan risk exposures through hedging, such as
with credit derivatives.
During the third quarter of 2007, federal bank examiners and a credit
rating agency assessed the exposures of banks to their leveraged loans
and commitments under various market scenarios. Such analyses generally
indicated that the banks had sufficient capital to absorb potential
losses. In March 2008, OCC noted that the major commercial banks
continued to be well capitalized, despite adding a sizeable amount of
leveraged loans onto their balance sheets and taking significant write-
downs on these and other assets. Importantly, the default rate for
leveraged loans has remained at a historically low level to the benefit
of banks holding leveraged loans. However, in January 2008, a credit
rating agency forecasted that the default rate for U.S. leveraged loans
will increase to approximately 3 percent from its current 0.1 percent
by the end of 2008, in part driven by the weaker economy.[Footnote 91]
Although the regulators consistently told us that individual banks were
not exposed to significant risk from their leveraged lending
activities, some broader concerns about systemic risk have arisen. In
its June 2006 study on private equity, FSA stated that market
turbulence and substantial losses among private equity investors and
lenders potentially raised systemic risk. It noted that such risk could
be greater if leveraged debt positions were concentrated and could not
be exited during a turbulent market. Although the originate-to-
distribute model has served to disperse risk, it also has made it more
difficult to determine which financial institutions or investors have
concentrated leveraged debt exposures. Federal bank regulators told us
that they know the amount of leveraged loans held by banks and nonbank
investors through their review of shared national credits. However,
they said that although they know the concentrated leveraged debt
exposures of their supervised banks, they lack data to determine
whether, if any, of the nonbank investors have such exposures. The
regulators said that it would be difficult to collect and track such
data because leveraged loans could be traded or securitized, such as
through collateralized loan obligations. Moreover, they said that it is
unclear whether the benefits of collecting such information would
exceed the costs, which could be high--in part because it is unclear
what they could do with the information with respect to nonbank
investors. In its November 2007 report on private equity, an IOSCO
committee highlighted the potential for a large and complex default, or
a number of simultaneous defaults in private equity transactions, to
create systemic risk for the public debt securities markets. To assess
this risk, the committee plans to do a survey of the complexity and
leverage of capital structures employed in LBOs across relevant IOSCO
jurisdictions. Because the survey would include issues of interest to
banking regulators, the technical committee recommended that the survey
be done under the Joint Forum, which postponed making a decision until
a related study on leveraged finance of LBOs was completed (which was
issued in July 2008).
Although the commercial and investment banks have taken steps to
decrease their leveraged lending exposures, the unexpected increase in
risk faced by these banks illustrates one of the ways in which problems
in one financial market can spill over to other financial markets and
adversely affect market participants. Accordingly, it highlights the
importance of understanding and monitoring the conditions in the
broader markets, particularly potential connections between markets.
Should regulators fail to fully understand and consider such
interconnections and their potential systemic risk implications, the
effectiveness of regulatory oversight and the regulators' ability to
address such risk when market disruptions that have potential spillover
effects occur could be limited.
Pursuant to Recent Credit Market Problems, Regulators and Others Have
Raised Concerns about the Risk Management of Leveraged Finance:
As a result of the recent credit market problems, financial regulators
and others have conducted a number of special studies on leveraged
lending or raised specific concerns. Based on a special review of the
leveraged finance activities of four banks, FRBNY examiners reported in
September 2007 that the banks needed to improve their risk-management
practices. Confirming the findings of earlier examinations, FRBNY
examiners found that the banks generally had a robust credit risk
approval process for evaluating individual deals, but underwriting
standards had weakened in response to competitive market conditions.
The examiners noted that the banks used the same standards to
underwrite loans held by banks and loans that the banks traditionally
would syndicate because of their more risky characteristics. According
to the examiners, the banks could have worked through their pipeline of
leveraged finance commitments if liquidity had declined gradually, but
the sudden shock highlighted the negative impact of weakened
underwriting standards and certain risk-management practices. Although
the examiners found that the banks had recently changed some of their
risk-management controls and were continuing to review their controls
for any additional changes that might be appropriate, they concluded
that the banks needed to set or improve limits on their pipeline
commitments and test such exposures under different market scenarios.
Although the examiners noted that such risk-management controls are not
addressed in detail in the 2001 regulatory guidance on leveraged
finance (discussed earlier), they recommended waiting until the
leveraged finance market adjusted to the current market events to
revisit the guidance.
In an October 2007 speech, the Comptroller of the Currency said that he
asked examiners to encourage the major banks to underwrite their
leverage loans in a manner more consistent with the standards they
would use if they held the loans. He said that the originate-to-
distribute model has led banks to move too far away from the
underwriting standards they would have used if the banks held onto the
loans. The Comptroller said that the banks need to strengthen their
standards, but the standards need not be identical to what they would
be if banks held the loans. He noted that there are legitimate
differences in risk tolerances that are useful in matching willing
lenders with risky borrowers. Nonetheless, he said that the banks
should have risk-management systems to measure, monitor, and control
underwriting differences between syndicated loans and loans to be held
in their loan portfolios. In its 2008 survey of underwriting practices,
OCC found that underwriting standards for leveraged loans changed
significantly. According to OCC, since the disruption in financial
markets that began last summer, most banks have responded to investor
concerns and the negative economic outlook by tightening underwriting
terms, particularly those relating to pricing, covenants, and maximum
allowable leverage.
In a March 2008 policy statement, the President's Working Group on
Financial Markets (PWG), working with FRBNY and OCC, issued its
findings on the cause of the recent market turmoil and recommendations
to help avoid a repeat of such events.[Footnote 92] According to PWG,
the financial markets have been in turmoil since mid-2007, which was
triggered by a dramatic weakening of underwriting standards for U.S.
subprime mortgages. This and other developments, such as the erosion of
market discipline on the standards and terms of loans to households and
businesses, revealed serious weaknesses in the risk-management
practices at several large U.S. and European financial institutions.
Such weaknesses included weak controls over balance sheet growth and
inadequate communications within the institutions. These weaknesses
were particularly evident in the risk management of the syndication of
leveraged loans and other business lines. As a result, some
institutions suffered significant losses, and many experienced balance
sheet pressures, according to PWG. For example, some firms were left
holding exposures to leveraged loans that were in the process of being
syndicated. PWG made a broad array of recommendations to reform the
mortgage origination process and certain rating processes, as well as
to strengthen risk-management practices and enhance prudential
regulatory policies. With respect to leveraged finance, the PWG
recommendations included that (1) financial institutions promptly
identify and address any weaknesses in risk-management practices
revealed by the turmoil, (2) regulators closely monitor the efforts of
financial institutions to address risk-management weaknesses, and (3)
regulators enhance guidance related to pipeline risk management for
firms that use an originate-to-distribute model.
Finally, in May 2008, consistent with the PWG recommendation about risk-
management practices, OCC examiners completed a special review of the
leveraged lending activities of four banks, prompted partly by the
large losses from their leveraged loan positions. The review's
objectives included comparing the risk-management practices across the
banks, assessing bank compliance with the 2001 regulatory guidance
(discussed above), and assessing the management systems used by banks
to identify, monitor, and control for underwriting differences between
loans held by the banks and loans sold to other institutions. Based on
their preliminary results, OCC examiners generally found that the banks
needed to improve aspects of their risk-management framework governing
their leveraged finance syndications. In particular, the examiners
found that the banks did not fully comply with the regulatory guidance
for managing the risks associated with their loan syndications. For
example, the banks lacked formal policies for managing syndication
failures. According to the OCC examiners, the banks are documenting
lessons learned to reassess their risk-management practices and making
changes. In turn, OCC is identifying best practices to communicate to
the banks.
In July 2008, Federal Reserve, OCC, and SEC staff told us that they are
continuing to monitor their respective financial institutions and work
with other regulators to address issues raised by the ongoing market
turmoil. The Federal Reserve staff said that they were still reviewing
and analyzing the risk-management weaknesses uncovered over the past
year to ensure that any revised guidance issued was sufficiently
comprehensive and appropriately targeted. OCC staff told us that they
intend to provide additional guidance on leveraged lending through a
supplement to the agency's existing guidance and will work with the
Federal Reserve and others to determine whether the 2001 interagency
guidance on leveraged lending needs to be revised. SEC staff told us
that they do not plan to issue any written guidance, but if the federal
bank regulators develop additional guidance for their commercial banks
or holding companies, SEC will review the guidance and, to the extent
it is relevant to its investment banks, discuss such guidance with the
investment banks.
Conclusions:
Academic research on recent LBOs by private equity funds generally
suggests that these transactions have had a positive impact on the
financial performance of acquired companies. However, it is often
difficult to determine whether the impact resulted from the actions
taken by the private equity firms or other factors, due to some
limitations in academic literature. Research also indicates that
private equity LBOs are associated with lower employment growth, but
uncertainty remains about the employment effect. In that regard,
further research may shed light on the causal relationship between
private equity and employment growth, if any. Our econometric analysis
of a sample of public-to-private LBOs generally found no indication
that club deals, in aggregate, are associated with higher or lower
prices paid for the target companies, after controlling for differences
in targets. But, our analysis does not rule out the possibility of
parties engaging in illegal behavior in any particular LBO.
SEC generally has not found private equity funds to have posed
significant concerns for fund investors. However, in light of the
recent growth in LBOs, U.S. and foreign regulators have undertaken
studies to assess risks arising from such transactions and have
identified some concerns about potential market abuse and investor
protection, which they are studying further. As a result of the recent
financial market turmoil, federal financial regulators reassessed the
risk-management practices for leveraged lending at the major financial
institutions and identified weaknesses. PWG, working with OCC and
FRBNY, has reviewed weaknesses in markets, institutions, and regulatory
and supervisory practices that have contributed to the recent financial
market turmoil. It has developed a broad array of recommendations to
address those weaknesses, some of which apply to leveraged lending. As
U.S. financial regulators continue to seek to ensure that their
respective institutions address risk-management weaknesses associated
with leveraged lending, it will be important for them to continue to
evaluate periodically whether their guidance addresses such weaknesses
and to update their guidance in a timely manner consistent with the PWG
and other relevant recommendations.
Although the leveraged loan market comprises a relatively small segment
of the financial markets and has not raised the systemic risk concerns
raised by subprime mortgages and related structured financial products,
it shares similar characteristics and includes elements that could
contribute to systemic risk. First, the major players in the leveraged
loan market include some of the largest U.S. commercial and investment
banks. Second, the use of the originate-to-distribute model by such
financial institutions played a part in the erosion of market
discipline and easing of underwriting standards for leveraged loans.
Third, the current financial market turmoil--triggered by weakening
underwriting standards for subprime mortgages--revealed risk-
management weaknesses in the leveraged lending activities of the
financial institutions and exposed them to greater-than-expected risk
when market events caused them to hold more leveraged loans on their
balance sheets. This situation increased the vulnerability of these
institutions because of the other challenges they were facing due to
the broader turmoil in the financial markets. Finally, while the
originate-to-distribute model provides a means by which to transfer
risk more widely among investors throughout the system, it can reduce
transparency about where such risk ultimately resides when held outside
regulated financial institutions and whether such risk is concentrated.
Such concentrations could directly or indirectly impact regulated
institutions.
Recent events involving leveraged loans underscore the potential for
systemic risk to arise not only from the disruption at a major
regulated institution but also from the transmission of a disruption in
a financial market to other financial markets. Consequently, it is
important for regulators not to focus solely on the stability of their
financial institutions but also to understand how markets are
interconnected and how potential market changes could ultimately affect
their regulated institutions. While financial institutions have taken
steps to decrease their leveraged lending exposures, the unexpected
increase in such exposures due to the spread of problems with subprime
mortgages to other credit markets illustrates the importance of
understanding and monitoring the conditions in the broader markets,
including potential connections between markets. Failure of regulators
to understand and fully consider such interconnections within the
broader markets and their potential systemic risk implications can
limit their regulatory effectiveness and ability to address issues when
they occur.
Recommendation for Executive Action:
Given that the financial markets are increasingly interconnected and in
light of the risks that have been highlighted by the financial market
turmoil of the last year, we recommend that the heads of the Federal
Reserve, OCC, and SEC give increased attention to ensuring that their
oversight of leveraged lending at their regulated institutions takes
into consideration systemic risk implications raised by changes in the
broader financial markets, as a whole.
Agency Comments and Our Evaluation:
We provided a draft of this report to the Secretary of the U.S.
Department of the Treasury, Chairmen of the Federal Reserve and SEC,
the Comptroller of the Currency, and the U.S. Attorney General for
their review and comment. We also provided draft appendixes on the case
studies to private equity firms we interviewed for our LBO cases
studies: TPG; Clayton, Dubilier & Rice; Carlyle Group; Sun Capital
Partners; Riverside Company; and Ares Management.
We received written comments from the Federal Reserve, SEC, and OCC,
which are presented in appendixes XI, XII, and XIII, respectively. In
their written comments, the three federal financial regulators
generally agreed with our findings and conclusion and, consistent with
our recommendation, acknowledged the need to ensure that regulatory and
supervisory efforts take into account the systemic risk implications
resulting from the increasingly interconnected nature of the financial
markets. Recognizing that no one regulator can effectively address
systemic risk by itself, the regulators said that they will continue to
work closely with other regulators, such as through the PWG, to better
understand and address such risk. They also discussed examinations,
surveys, and other actions that their agencies have taken to address
risks from leveraged financing, many of which we discuss in the report.
Finally, the Federal Reserve noted that it, in coordination with other
U.S. and international regulators, is undertaking a number of
supervisory efforts to address various firmwide risk-management
weaknesses that were identified over the past year through "lessons
learned" exercises. We also received technical comments from staff of
the Federal Reserve, SEC, OCC, the Department of the Treasury, and the
private equity firms, which we have incorporated into this report as
appropriate. The Secretary of the U.S. Department of the Treasury and
the U.S. Attorney General did not provide any written comments.
As agreed with the office of the Chairman, Subcommittee on Interstate
Commerce, Trade, and Tourism, Committee on Commerce, Science, and
Transportation, U.S. Senate, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 30 days
from the report date. At that time, we will send copies of this report
to the other interested members of Congress; the Secretary, U.S.
Department of the Treasury; Attorney General, U.S. Department of
Justice; Chairman, Federal Reserve; Comptroller of the Currency; and
Chairman, SEC. We also will make copies available to others upon
request. In addition, the report will be available at no charge on the
GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staff have any questions regarding this report, please
contact me at (202) 512-8678 or williamso@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. GAO staff who made major contributions
to this report are listed in appendix XIV.
Signed by:
Orice M. Williams:
Director, Financial Markets and Community Investment:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
As agreed with your staff, the report's objectives are to:
* determine, based largely on academic research, what effect the recent
wave of private equity-sponsored leveraged buyouts (LBO) has had on
acquired companies and employment;
* analyze how the collaboration of two or more private equity firms in
undertaking an LBO (called a club deal) could promote or reduce
competition, and what legal issues have club deals raised;
* review how the Securities and Exchange Commission (SEC) has overseen
private equity firms engaged in LBOs under the federal securities laws;
and:
* review how the federal financial regulators have overseen U.S.
commercial and investment banks that have helped finance the recent
LBOs.
Determining the Effect of Recent LBOs on Acquired Firms and Employment:
To analyze what effect the recent wave of private equity-sponsored LBOs
has had on the acquired companies and their employment, we reviewed and
summarized academic studies that included analysis of LBOs completed in
2000 and later. Based on our searches of research databases (EconLit,
Google Scholar, and the Social Science Research Network), we included
17 studies, both published and working papers, all written between 2006
and 2008. Most empirical work on buyouts in the 2000s is based on
European data, as more data on privately held firms are available in
Europe. Due to similar levels of financial development, we included
studies based on European data because they should be instructive for
understanding U.S. buyouts and the private equity market. However,
there are some structural differences between the U.S. and European
economies, such as differences in shareholder rights in the legal
systems of many countries in continental Europe, which may lead to
differences in LBOs. Based on our selection criteria, we determined
that these studies were sufficient for our purposes. However, the
results should not necessarily be considered as definitive, given the
methodological or data limitations contained in the studies
individually and collectively. We also interviewed four academics who
have done research on LBOs by private equity funds and had two
academics review a summary of our literature review. We also reviewed
academic studies analyzing LBOs done before 2000 and other studies on
the subject by trade associations, a labor union, and consultants.
However, we limited our discussion in this report to the academic
literature in an effort to focus our review on independent research. In
addition, we interviewed executives from 11 private equity firms that
ranged from small to large in size, as well as officials from a trade
association representing private equity firms, two labor unions, and a
management consulting firm that analyzed the private equity market. We
reviewed and analyzed regulatory filings and other documents covering
companies recently acquired by private equity funds through LBOs.
Finally, we selected five LBOs for in-depth case study. (See app. IV
for additional information on our case study methodology.)
Assessing the Impact of Club Deals on Competition:
To analyze how the collaboration of two or more private equity funds
jointly engaged in an LBO (called a club deal) may promote or reduce
price competition, we identified and analyzed club deals completed from
2000 through 2007 using data from Dealogic, which compiles data on
mergers and acquisitions, as well as on the debt and equity capital
markets.[Footnote 93] Dealogic estimates that it captures about 95
percent of private equity transactions from 1995 forward but is missing
the value of some of the deals when such information is unobtainable.
We assessed the procedures that Dealogic uses to collect and analyze
data and determined that the data were sufficiently reliable for our
purposes. We also reviewed academic studies on club deals and various
articles on the subject by attorneys and the news media. We reviewed
several complaints filed on behalf of shareholder classes in connection
with club deals and interviewed attorneys in three of the lawsuits. We
also interviewed an antitrust attorney not affiliated with any of the
cases. We did our own analysis of the potential effect that club deals
may have had on competition among private equity firms by using an
econometric model to examine the prices paid for target companies in a
subset of private equity-sponsored LBOs done from 1998 through 2007.
(See app. X for additional information about our econometric analysis
of club deals.) We also employed two commonly used measures of market
concentration to assess competition in the private equity marketplace
generally. We performed data reliability assessments on all the data
used in our analyses. Finally, we interviewed staff from the Department
of Justice's Antitrust Division and SEC, as well as officials
representing seven private equity firms and two academics to discuss
the impact of club deals.
Reviewing SEC's Oversight of Private Equity Fund Advisors and Funds:
To review how SEC has been overseeing private equity firms and funds
engaged in LBOs, we reviewed the federal securities laws and
regulations applicable to such entities, as well as articles on the
subject. We also reviewed and analyzed examinations of registered
advisers to private equity funds conducted by SEC from 2000 through
2007, as well as enforcement actions taken by SEC against private
equity funds or their advisers for fraud over the same period. We also
reviewed various studies conducted by SEC, the U.K. Financial Services
Authority, International Organization of Securities Commissions
(IOSCO), a labor union, and us.[Footnote 94]Finally, we interviewed
staff from SEC's Division of Investment Management and Office of
Compliance, Inspections, and Examinations, as well as officials from
two labor unions, two associations representing institutional
investors, and an association representing private equity funds to
gather information on SEC oversight and investor-related issues.
Reviewing Financial Regulatory Oversight of Bank LBO Lending Activity:
To review how the federal financial regulators have been overseeing
U.S. commercial and investment banks helping to finance the recent
LBOs, we analyzed 2005-2007 data on LBOs, syndicated leveraged loans,
and high-yield bonds from Dealogic. We also analyzed data on leveraged
finance commitments and leveraged loans obtained from the Office of the
Comptroller of the Currency (OCC) and SEC, as well as from regulatory
filings and news releases made by the banks. We reviewed regulatory
guidance and other material, such as speeches, testimonies, or news
releases, issued by the Board of Governors of the Federal Reserve
System, OCC, and SEC covering the leveraged lending activities of
commercial banks and reviewed examinations of such activities conducted
by the Federal Reserve Bank of New York (FRBNY), OCC, and SEC from 2005
to mid-2008. We also reviewed studies on leveraged finance or LBOs by
us, academics, credit rating agencies, and regulators, including the
U.K. Financial Services Authority, President's Working Group on
Financial Markets (PWG),[Footnote 95] Senior Supervisors Group,
[Footnote 96] and IOSCO. Finally, we interviewed officials representing
two commercial banks, three investment banks, three credit rating
agencies, as well as staff from the Federal Deposit Insurance
Corporation, the Board of Governors of the Federal Reserve System,
FRBNY, OCC, and SEC to discuss risk management and regulatory oversight
of leveraged lending.
Addressing Pension Plan Investments and Taxation on Private Equity Fund
Profits:
To address pension plan investments in private equity (discussed in
app. II), we obtained and analyzed survey data of private-sector and
public-sector defined benefit plans on the extent of plan investments
in private equity from three private organizations: Greenwich
Associates, Pensions & Investments, and Pyramis Global Advisors. We
identified the three surveys through our literature review and
interviews with plan representatives and industry experts. The surveys
varied in the number and size of plans surveyed. Although the
information collected by each of the surveys is limited in some ways,
we conducted a data reliability assessment of each survey and
determined that the data were sufficiently reliable for purposes of
this study. These surveys did not specifically define the term private
equity; rather, respondents reported allocations based on their own
classifications. Data from all three surveys are reflective only of the
plans surveyed and cannot be generalized to all plans.
To determine the federal income tax rules generally applicable to
returns paid on partnerships interests in a typical private equity fund
(discussed in app. III), we reviewed and analyzed sections of the
federal tax code applicable to limited partnerships. We also reviewed
and analyzed studies, articles, and material on the subject by
academics, trade associations, private equity firms, federal agencies,
and other interested parties. We identified and reviewed legislative
and other proposals to revise the current tax treatment of private
equity funds or their managers. We also attended various forums
discussing the subject. Finally, we interviewed staff from the
Department of the Treasury, two academics, and two labor unions to
obtain an understanding of the relevant tax issues.
We conducted this performance audit from August 2007 to September 2008
in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe that
the evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.
[End of section]
Appendix II: Pension Plan Investments in Private Equity:
Many pension plans invest in private equity funds, and such investment
is not a recent phenomenon. As we recently reported, the majority of
plans we interviewed began investing in private equity more than 5
years before the economic downturn of 2000 to 2001, and some of these
plans had been investing in private equity for 20 years or more.
[Footnote 97] We also reported that pension plans invest in private
equity primarily to attain long-term returns in excess of returns from
the stock market in exchange for greater risk, and most plans we
interviewed said these investments had met expectations for relatively
high returns. To a lesser degree, pension plans also invest in private
equity to further diversify their portfolios.
Two recent surveys of public-sector and private-sector pension plans
indicated that many plans invest in private equity.[Footnote 98] As
shown in table 5, Greenwich Associates found that about 43 percent of
its surveyed plans invested in private equity in 2006, and Pyramis
found that 41 percent of its surveyed plans had such investments.
[Footnote 99] Both surveys also show that a larger percentage of public-
sector plans than private-sector plans invested in private equity.
Separately, the Greenwich Associates survey found that investment in
private equity was most common among collectively bargained plans
(arrangements between a labor union and employer), with 12 out of 17
such surveyed plans investing in private equity.
Table 5: Extent of Defined Benefit Plan Investments in Private Equity:
Sample: Greenwich Associates (2006): 164 public-sector plans; 420
private-sector plans, including 17 collectively bargained plans; (All
plans had $250 million or more in total assets);
Sample: Pyramis Global Advisors (2006): 90 public-sector plans; 124
private-sector plans; (All plans had greater than $200 million in total
assets.)
Percentage of plans which invest in private equity:
All plans;
Greenwich Associates (2006): 43%;
Pyramis Global Advisors (2006): 41%.
Public sector;
Greenwich Associates (2006): 51%;
Pyramis Global Advisors (2006): 44%.
Private sector;
Greenwich Associates (2006): 40%;
Pyramis Global Advisors (2006): 38%.
Private sector: collectively bargained;
Greenwich Associates (2006): 71%;
Pyramis Global Advisors (2006): n/a.
Sources: Greenwich Associates and Pyramis Global Advisors, 2006.
Note: The total assets of plans surveyed by Greenwich Associates were
$3.6 trillion.
[End of table]
According to Greenwich Associates, the percentage of pension plans
investing in private equity increased from about 39 percent to 43
percent from 2004 through 2006. For larger plans surveyed by Pensions &
Investments, the percentage of plans investing in private equity grew
from 71 percent to 80 percent from 2001 through 2007.
As shown in figure 5, Greenwich Associates survey found that the
percentage of pension plans investing in private equity increased as
the size of the pension plans increased, measured by their total
assets. For example, 16 percent of midsize plans--those with $250 to
$500 million in total assets--invested in private equity, but about 71
percent of the largest plans--those with $5 billion or more in assets-
-invested in private equity. Similarly, the Pensions & Investments
survey found nearly 80 percent of the large funds invested in private
equity in 2007. Survey data on plans with less than $200 million in
assets are not available.[Footnote 100]
Figure 5: Pension Plans with Investments in Private Equity by Size of
Total Plan Assets:
[See PDF for image]
This figure is a vertical bar graph depicting the following data:
Size of plan: $250M - $500M;
Percentage share of plans: 16%.
Size of plan: 250 million (2) N= 159: 0.6194 (3.95)*;
1998-2007: Alternative specification (3) N= 284: 0.7352 (4.54)*;
2000-2007: >100 million (4) N= 183: 0.5625 (5.28)*;
2000-2007: >250 million (5) N= 144: 0.5183 (5.17)*;
2000-2007: Alternative specification (6) N= 236: 0.6541 (5.56)*.
MCAP:
1998-2007: >100 million (1) N= 203: -0.0564 (-3.45)*;
1998-2007: >250 million (2) N= 159: -0.0594 (-3.41)*;
1998-2007: Alternative specification (3) N= 284: -0.0683 (-4.09)*;
2000-2007: >100 million (4) N= 183: -0.0395 (3.26)*;
2000-2007: >250 million (5) N= 144: -0.0384 (-3.07)*;
2000-2007: Alternative specification (6) N= 236: -0.0473 (-3.74)*.
BLOCK:
1998-2007: >100 million (1) N= 203: -0.1368 (-2.07)**;
1998-2007: >250 million (2) N= 159: -0.1268 (-1.79)***;
1998-2007: Alternative specification (3) N= 284: -0.1963 (-2.88)*;
2000-2007: >100 million (4) N= 183: -0.2030 (-3.27)*;
2000-2007: >250 million (5) N= 144: -0.1814 (-2.90)*;
2000-2007: Alternative specification (6) N= 236: -0.2190 (-2.91)*.
STAKE:
1998-2007: >100 million (1) N= 203: -0.1076 (-1.80)***;
1998-2007: >250 million (2) N= 159: -0.2439 (-4.46)*;
1998-2007: Alternative specification (3) N= 284: -0.1416 (-1.789)***;
2000-2007: >100 million (4) N= 183: -0.1087 (-1.70)***;
2000-2007: >250 million (5) N= 144: -0.2623 (-5.10)*;
2000-2007: Alternative specification (6) N= 236: -0.1691 (-2.34)**.
CLUB:
1998-2007: >100 million (1) N= 203: 0.038 (1.72)***;
1998-2007: >250 million (2) N= 159: 0.0316 (1.27);
1998-2007: Alternative specification (3) N= 284: 0.0350 (1.48);
2000-2007: >100 million (4) N= 183: 0.0441 (2.02)**;
2000-2007: >250 million (5) N= 144: 0.0443 (1.91)***;
2000-2007: Alternative specification (6) N= 236: 0.0362 (1.41).
DEBTEQUITY:
1998-2007: >100 million (1) N= 203: -0.0002 (-0.95);
1998-2007: >250 million (2) N= 159: 0.0030 (1.20);
1998-2007: Alternative specification (3) N= 284: [Empty]; [Empty];
2000-2007: >100 million (4) N= 183: -0.0002 (-1.07);
2000-2007: >250 million (5) N= 144: 0.0023 (0.78);
2000-2007: Alternative specification (6) N= 236: [Empty]; [Empty].
PRICE:
1998-2007: >100 million (1) N= 203: -0.0003 (-2.65)*;
1998-2007: >250 million (2) N= 159: 0.0049 (3.39)*;
1998-2007: Alternative specification (3) N= 284: -0.0003 (-3.12)*;
2000-2007: >100 million (4) N= 183: -0.0003 (-3.06)*;
2000-2007: >250 million (5) N= 144: .00058 (5.726);
2000-2007: Alternative specification (6) N= 236: -0.0003 (-2.38)**.
ACCURALS:
1998-2007: >100 million (1) N= 203: [Empty]; [Empty];
1998-2007: >250 million (2) N= 159: [Empty]; [Empty];
1998-2007: Alternative specification (3) N= 284: [Empty]; [Empty];
2000-2007: >100 million (4) N= 183: [Empty]; [Empty];
2000-2007: >250 million (5) N= 144: [Empty]; [Empty];
2000-2007: Alternative specification (6) N= 236: [Empty]; [Empty].
FREECASH:
1998-2007: >100 million (1) N= 203: 0.0915 (1.68)***;
1998-2007: >250 million (2) N= 159: 0.0233 (0.35);
1998-2007: Alternative specification (3) N= 284: [Empty]; [Empty];
2000-2007: >100 million (4) N= 183: 0.0880 (1.54);
2000-2007: >250 million (5) N= 144: 0.0188 (0.31);
2000-2007: Alternative specification (6) N= 236: [Empty]; [Empty]; .
CASHRATIO:
1998-2007: >100 million (1) N= 203: -0.0075 (-5.18)*;
1998-2007: >250 million (2) N= 159: -0.0285 (-1.69)***;
1998-2007: Alternative specification (3) N= 284 [Empty]; [Empty];
2000-2007: >100 million (4) N= 183: -0.008 (-5.66)*;
2000-2007: >250 million (5) N= 144: -0.0345 (-2.22)**;
2000-2007: Alternative specification (6) N= 236 [Empty]; [Empty].
GC:
1998-2007: >100 million (1) N= 203 [Empty]; [Empty];
1998-2007: >250 million (2) N= 159 [Empty]; [Empty];
1998-2007: Alternative specification (3) N= 284 [Empty]; [Empty];
2000-2007: >100 million (4) N= 183: .0038 (0.10);
2000-2007: >250 million (5) N= 144: 0.0977 (2.61)*;
2000-2007: Alternative specification (6) N= 236: -0.0833 (-2.27)**.
MILLS:
1998-2007: >100 million (1) N= 203: -0.0788 (-1.32);
1998-2007: >250 million (2) N= 159: -0.0977 (-1.60);
1998-2007: Alternative specification (3) N= 284: -0.1112 (-1.99)**;
2000-2007: >100 million (4) N= 183: -0.0050 (-0.12);
2000-2007: >250 million (5) N= 144: -0.0187 (-0.53);
2000-2007: Alternative specification (6) N= 236: -0.0329 (-0.77).
Dummy Variables: Time:
1998-2007: >100 million (1) N= 203: Yes;
1998-2007: >250 million (2) N= 159: Yes;
1998-2007: Alternative specification (3) N= 284: Yes;
2000-2007: >100 million (4) N= 183: Yes;
2000-2007: >250 million (5) N= 144: Yes;
2000-2007: Alternative specification (6) N= 236: Yes.
Dummy Variables: Industry:
1998-2007: >100 million (1) N= 203: Food;
1998-2007: >250 million (2) N= 159: Food;
1998-2007: Alternative specification (3) N= 284: Food;
2000-2007: >100 million (4) N= 183: Food;
2000-2007: >250 million (5) N= 144: Food;
2000-2007: Alternative specification (6) N= 236: Food.
Other statistics: óe:
1998-2007: >100 million (1) N= 203: 0.1443;
1998-2007: >250 million (2) N= 159: 0.1329;
1998-2007: Alternative specification (3) N= 284: 0.1825;
2000-2007: >100 million (4) N= 183: 0.1365;
2000-2007: >250 million (5) N= 144: 0.1156;
2000-2007: Alternative specification (6) N= 236: 0.1672.
Other statistics: R[2]:
1998-2007: >100 million (1) N= 203: 0.3501;
1998-2007: >250 million (2) N= 159: 0.3577;
1998-2007: Alternative specification (3) N= 284: 0.2373;
2000-2007: >100 million (4) N= 183: 0.3832;
2000-2007: >250 million (5) N= 144: 0.4357;
2000-2007: Alternative specification (6) N= 236: 0.3035.
Other statistics: Adjusted R[2]:
1998-2007: >100 million (1) N= 203: 0.2827;
1998-2007: >250 million (2) N= 159: 0.2699;
1998-2007: Alternative specification (3) N= 284: 0.1916;
2000-2007: >100 million (4) N= 183: 0.3155;
2000-2007: >250 million (5) N= 144: 0.3544;
2000-2007: Alternative specification (6) N= 236: 0.2560.
Other statistics: F-statistic:
1998-2007: >100 million (1) N= 203: 5.1895;
1998-2007: >250 million (2) N= 159: 4.0744;
1998-2007: Alternative specification (3) N= 284: 5.1912;
2000-2007: >100 million (4) N= 183: 5.6613;
2000-2007: >250 million (5) N= 144: 5.3611;
2000-2007: Alternative specification (6) N= 236: 6.3904.
Sources: GAO analysis of Dealogic, SEC, Audit Analytics, and LexisNexis
data.
Notes: T-statistics are in parentheses, and:
* indicates significance at the 1% level;
**indicates significance at the 5% level, and;
*** indicates significance at the 10% level.
T-statistics are based on White heteroskedasticity-consistent standard
errors and covariance matrix in all specifications.
[End of table]
While our finding that the public-to-private club deals are not
negatively associated with the premium, and the association is positive
when small deals are excluded from the sample, is consistent with
competitive behavior, one should not infer that these results provide
definitive proof of competitive behavior given the modeling and data
limitations. Accordingly, these results should be interpreted with
caution. First, this is an aggregate analysis and, therefore, does not
demonstrate that all shareholders of buyout targets receive a
competitive price. Second, the nonexperimental, cross-sectional design
we employ is among the weakest designs for the examination of causal
relationships and, therefore, omitted variables bias remains a concern.
Moreover, the Heckman-correction approach is imperfect, and some have
raised concerns about the sensitivity of the parameter estimates to the
distributional assumption that underlies the selection model. In that
regard, we draw conclusions about the association, not casual
relationship, between clubs deals and premiums. Additional data and in-
depth case-by-case examinations of club deal transactions may allow for
analysis to address the issue more completely or more validly. Third,
we focused on public-to-private transactions given the availability of
data on prices paid for target companies. We also focused solely on
buyouts involving private equity firms since this sample provides the
cleanest incremental test of the association between club deal private
equity transactions and the premium paid. However, although our public-
to-private sample exceeds the size of many of the samples used in
similar studies, it should be emphasized that we have analyzed only a
small sample of transactions involving club deals. Therefore, the
results may not generalize to other deals involving other types of
companies. Finally, we acknowledge the potential for error in the data
collected on managerial and beneficial ownership. While the recording
of these holdings was straightforward in most cases, it was difficult
to distinguish the managerial holdings from the beneficial holdings in
some cases. We took steps to validate our collection efforts, but some
random errors may remain. Given that the model results are consistent
with prior research, it appears that any errors are minor in the
context of this performance audit.
[End of section]
Appendix XI: Comments from the Board of Governors of the Federal
Reserve System:
Board Of Governors Of The Federal Reserve System:
Randall S. Kroszner, Member Of The Board:
Washington, D.C. 20551:
August 25, 2008:
Ms. Orice M. Williams:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Ms. Williams:
The Federal Reserve appreciates the opportunity to comment on a draft
of the GAO's report entitled "Private Equity--Recent Growth in
Leveraged Buyouts Exposed Risks That Warrant Continued Attention." The
large and episodic waves of leveraged buyouts of U.S. companies, the
most recent of which slowed abruptly in mid-2007, raise a number of
important questions about the potential microeconomic and macroeconomic
effects of such deals. The GAO study provides a balanced and thoughtful
review of the current state of knowledge of leveraged buyouts and their
potential economic impacts, and it also offers a valuable and original
analysis of the effects of "club" deals on the competitive structure of
the leveraged buyout market.
In the report, the GAO recommends that "...federal financial regulators
give increased attention to ensuring that their oversight of leveraged
lending at their regulated institutions take into consideration
systemic risk implications raised by changes in the broader financial
markets, as a whole." This recommendation articulates for the leveraged
lending market a broad and fundamental observation emphasized in a
number of areas over the past year of financial market distress.
Indeed, the need to ensure that regulatory and supervisory efforts take
into account the systemic risk implications of changes in financial
markets has been an important lesson learned across global and domestic
markets, different types of financial institutions, and several
financial products. The heightened awareness of systemic risk and the
interconnectivity of markets and financial institutions are factoring
into the Federal Reserve's approach to its activities and
responsibilities, including the supervision and oversight of leveraged
lending at our regulated institutions. Importantly, by making the
recommendation to multiple U.S. regulators, the GAO recognizes that
coordination among supervisors, along with each regulator's own
targeted efforts and interaction with the private sector, are crucial
to limiting potential systemic risks.
Several "lessons learned" exercises conducted by supervisors and
policymakers over the past year have identified a number of risk-
management weaknesses at major financial institutions. In addition to
the exercise conducted by the President's Working Group on Financial
Markets that is noted in the GAO report, similar efforts have been
conducted by international supervisory groups, such as the Senior
Supervisors Group and the Financial Stability Forum.[Footnote 1]
Together, these efforts--in which the Federal Reserve actively
participated--have identified specific risk-management weaknesses in
leveraged lending business lines along with the need for improvements
in fundamental areas of firmwide risk management that, when addressed,
will help mitigate the possibility that leveraged lending conducted at
regulated institutions might either contribute to, or be affected by,
systemic risk. Federal Reserve supervisors are monitoring efforts to
remedy the risk-management weaknesses identified within specific
institutions' leveraged lending business lines. These efforts include
enhancements to leveraged lending underwriting standards, controls over
leveraged loan pipeline exposures, and approaches in applying the
originate-to-distribute model to leveraged lending. Our monitoring and
review of institutions' remedial efforts, along with continued
supervisory assessments surrounding leveraged lending at supervised
institutions, will be used to determine the need for additional Federal
Reserve or interagency guidance on leveraged tending and to ensure that
any such guidance is sufficiently comprehensive.
From a broader perspective. the Federal Reserve, in coordination with
other U.S. and international regulators, also is undertaking a number
of supervisory efforts to address various firmwide risk-management
weaknesses identified over the past year, initiatives that should help
to better integrate leveraged lending risk exposures. Areas of
particular importance include the need for global, systemically
important institutions to enhance their firmwide stress testing and
balance sheet management processes and to improve the comprehensiveness
of their liquidity risk management and liquidity contingency planning.
Enhancing these key elements of firmwide risk management will enable
institutions to better manage their leveraged lending activities in
coordination with other control functions and risk exposures of the
firm and, thus. provide additional safeguards and shock absorbers in
limiting the potential for leveraged lending activities to possibly
contribute to systemic risk. Supervisory efforts also are under way to
effect improvements in the counterparty credit risk-management
practices of large institutions, including those practices used to
manage exposures to hedge funds and private equity funds. These and
other initiatives being undertaken by the Federal Reserve and other
U.S. and international supervisors in response to market events over
the past year illustrate steps toward a more systemwide focused
approach to supervision. As pointed out in recent remarks by Chairman
Bernanke, efforts to promote a systemwide focus in financial regulation
using guidance and both targeted and horizontal on-site reviews of key
financial institutions have significant potential for contributing to
reducing systemic risk. This includes any such risks that may arise
from, or may affect, leveraged lending--the topic of the GAO report.
[Footnote 2]
A related issue is whether the overall structure of financial
regulation and supervision in the United States could be changed in a
way that would help mitigate systemic risk and improve efficiency.
Indeed, as part of its Blueprint for a Modernized Financial Regulatory
Structure, the Department of the Treasury proposed several legislative
changes to the current financial regulatory structure to achieve these
goals. The Blueprint is an important first step in the longer process
of analyzing the broader issues of how financial market regulation and
supervision may need to be changed to reflect developments in the
markets and recent market turmoil. The Federal Reserve looks forward to
working with the Congress as it considers these important issues.
Again, the Federal Reserve appreciates the opportunity to review and
comment on the GAO's draft report entitled "Private Equity--Recent
Growth in Leveraged Buyouts Exposed Risks That Warrant Continued
Attention."
Sincerely,
Signed by:
Randall S. Kroszner:
Board of Governors:
Footnotes:
[1] See Senior Supervisors Group (2008), Observations on Risk
Management Practices during the Recent Market Turbulence (New York:
SSG, March); and Financial Stability Forum (2008), Report of the
Financial Stability Forum on Enhancing Market and Institutional
Resilience, interim and final reports (Basel: FSF, February 8 and April
7).
[2] Although not addressed by a GAO recommendation, market participants
also have an important role to play in ensuring that various elements
of the leveraged lending market do not contribute to the potential for
systemic risk. To this extent, several industry groups, including the
Counterparty Credit Risk Management Policy Group and the Institute for
International Finance, have issued industry-sponsored sound practices
on counterparty credit risk, liquidity risk management, and other areas
that, when implemented, should help limit the potential for leveraged
lending to contribute to systemic risk in the future. For a more
general discussion of existing and potential methods for addressing
systemic risks, see Ben S. Bernanke (2008), "Reducing Systemic Risk,"
speech delivered at "Maintaining Stability in a Changing Financial
System," a symposium sponsored by the Federal Reserve Bank of Kansas
City, held in Jackson Hole, Wyo., August 21-23.
[End of section]
Appendix XII: Comments from the Securities and Exchange Commission:
United States Securities And Exchange Commission:
Christopher Cox, Chairman:
Headquarters:
100 F Street, NE:
Washington, DC 20549:
chairmanoffice@sec.gov:
[hyperlink, http://www.sec.gov]
Regional Offices:
Atlanta, Boston, Chicago, Denver, Fort Worth, Los Angeles, Miami, New
York, Philadelphia, Salt Lake City, San Francisco:
August 27, 2008
Ms. Orice M. Williams:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Ms. Williams:
We have received and reviewed the draft GAO report "Private Equity:
Recent Growth in Leveraged Buyouts Exposed Risks that Warrant Continued
Attention" (Report). This Report acknowledges that the leveraged loan
market is a relatively small segment of the financial markets, and
while leveraged loans are not, per se, systemically important, they
nonetheless share similar characteristics to subprime mortgages and
structured financial products that could contribute to a systemically
significant event. In the Report, you recommend that federal financial
regulators give increased attention to insuring their oversight of
leveraged lending at their regulated institutions takes into
consideration systemic risk implications raised by changes in the
broader financial markets.
As you know, since 2004, the U.S. Securities and Exchange Commission
has been the consolidated supervisor of certain investment bank holding
companies. The Commission currently supervises the following U.S.
securities firms on a group-wide basis: Goldman Sachs, Lehman Brothers,
Merrill Lynch, and Morgan Stanley. For such firms, referred to as
consolidated supervised entities (CSEs), the Commission oversees not
only the U.S.-registered broker-dealer, but also supervises the holding
company and all affiliates on a consolidated basis, including other
regulated entities and unregulated entities such as derivatives
dealers. The Commission's supervision of CSEs is primarily concerned
with the risks that counterparties and market events potentially pose
to the CSE firms and thereby to the regulated broker-dealers and other
regulated entities. As such, in its daily oversight of CSEs the
Commission is considering and monitoring developments or disruptions in
one financial market for its implications for other financial markets
and for supervised entities in particular.
In 2005, long before leveraged lending became a risk concern generally,
the staff of the CSE program identified leveraged lending by investment
banks as a risk concentration. In 2006, the CSE staff conducted an in
depth review of leveraged lending practices and exposures at each of
the CSEs. This work led to specific changes in certain risk management
practices at some firms, and generated feedback on the range of
practices that informed all CSEs in their efforts to improve control
processes. Thereafter, the CSE staff monitored closely the terms and
exposures of leveraged lending pipelines at each of the CSE for its
impact on liquidity and funding. In this respect the Commission was
diligent about the exposures and risk management of leveraged lending
at CSEs.
While the Commission daily endeavors to identify the potential
transmission of risk by entities or by markets more broadly, it cannot
do so alone. That is why the Commission participates in multilateral
groups to identify and address the interconnections among markets and
the potential cross currents of risk, some of which may be systemically
significant. Specifically, the Commission is an active participant in:
the President's Working Group (PWG); Senior Supervisor's Group (SSG);
Basel Committee on Bank Supervision (BCBS) and Joint Forum (JF). We
also work closely with our supervisory counterparts both domestically
and abroad, including the Federal Reserve Board and Federal Reserve
Bank of New York, the FDIC and OCC and UK FSA, to name a few.
We shall continue to work closely with our supervisory colleagues to
identify and raise awareness about systemically important issues, both
in leveraged lending and in the broader financial markets.
We appreciate the opportunity to comment on the draft Report.
Sincerely,
Signed by:
Christopher Cox:
Chairman:
[End of section]
Appendix XIII: Comments from the Office of the Comptroller of the
Currency:
Comptroller of the Currency:
Administrator of National Banks:
Washington, DC 20219:
August 22, 2008:
Ms. Orice M. Williams:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Ms. Williams:
We have received and reviewed your draft report entitled, "Private
Equity: Recent Growth in Leveraged Buyouts Exposed Risks That Warrant
Continued Attention." Your report responds to a Congressional request
for information concerning the oversight of private equity-sponsored
leveraged buyouts (LBOs).
Among your conclusions, you found that recent credit events raised
regulatory scrutiny about risk-management of leveraged lending by
banks. You recommended that the federal financial regulators give
increased attention to ensuring that their oversight of leveraged
lending at their regulated institutions takes into consideration
systemic risk implications raised by changes in the broader financial
markets as a whole.
The OCC appreciates the importance of the issue raised by the GAO and
the increasingly interconnected nature of the financial markets. As
noted in the GAO report, this interconnectedness has been revealed by
the financial market turmoil of the last year.
As the primary federal regulator for national banks, the OCC is
responsible for ensuring national banks operate in a safe and sound
manner. This is typically done by assessing risk relative to earnings
and capital, and ensuring the quality of risk management systems are
commensurate with the complexity and level of the banks' risk profile.
Nevertheless, the OCC recognizes the need to monitor systemic risk
issues resulting from financial innovation and the interconnectedness
of risks and financial markets. Because systemic risk issues, by their
very nature, span markets and national boundaries, no one regulator can
effectively address systemic risk issues by itself. This is why the OCC
is an active member and participant in the following groups:
President's Working Group, Senior Supervisors' Group, Basel Committee
for Bank Supervision, and Joint Forum. The OCC also collaborates
closely with the Federal Reserve Board, and Federal Reserve Bank of New
York, on matters that may cause concern to the U.S. financial system.
More specific actions the OCC has taken to address risks from leveraged
finance activities conducted by national banks include the following:
* In February of this year, we issued our Leveraged Lending Handbook to
bank CEOs and examining personnel. This handbook provided examiners
with expanded examination procedures; reinforced existing regulatory
guidance issued in 1988, 1999, and 2001; highlighted associated risks;
and, provided risk rating and accounting guidance for leveraged
lending. When applied consistently across the largest national banks
that are the primary participants in the syndicated loan market, such
regulatory policies serve to ensure leveraged lending is conducted in a
prudential manner.
* In 2008, the OCC conducted a leveraged lending horizontal review at
the largest national banks to identify emerging risk issues and risk
management practices requiring attention.
* Prior to the commencement of the Shared National Credit (SNC) review
for 2008, the OCC and Federal Reserve provided examination staff with
clear guidelines that addressed risk identification and risk rating
criteria with a focus on both deal performance and underwriting
structure. We also worked with the Federal Reserve to promote a
consistent risk identification approach to leveraged lending for the
2008 SNC review.
* In 2007 and 2008, the OCC and Federal Reserve collected underwriting
data on leveraged syndicated loans reviewed during the annual
interagency Shared National Credit review. This data collection
provides the OCC and Federal Reserve with specific underwriting
characteristics of leveraged loans originated for distribution.
* The OCC conducts and publishes an underwriting survey that, since
2005, has highlighted to industry participants and to examining
personnel, weakening underwriting standards.
In summary, the OCC will continue to work closely with other regulators
to better understand and address systemic risk issues in the leveraged
loan market. As needed, the OCC will issue guidance to banks and
examiners to ensure leveraged lending is conducted in a prudential
manner across the national banking system.
We appreciate the opportunity to comment on the draft report.
Sincerely,
Signed by: John C. Dugan:
Comptroller of the Currency:
[End of section]
Appendix XIV: GAO Contact and Staff Acknowledgments:
GAO Contact:
Orice Williams, (202) 512-8678, or williamso@gao.gov:
Staff Acknowledgments:
In addition to the individual named above, Karen Tremba, Assistant
Director; Kevin Averyt; Lawrance Evans, Jr.; Sharon Hermes; Michael
Hoffman; Matthew Keeler; Marc Molino; Robert Pollard; Omyra Ramsingh;
Barbara Roesmann; Christopher Schmitt; and Richard Tsuhara made major
contributions to this report.
[End of section]
Bibliography:
To analyze what effect the recent wave of private equity-sponsored LBOs
has had on the acquired companies and their employment, we reviewed and
summarized the following academic articles. Our review of the
literature included academic studies of the impact of private equity
LBOs, using data from industrialized countries, whose sample periods
include LBOs done from 2000 to the present. We do not include in our
bibliography other studies that we reviewed and cited in connection
with our other reporting objectives.
Amess, Kevin and Mike Wright. "The Wage and Employment Effects of
Leveraged Buyouts in the UK." International Journal of the Economics of
Business, vol. 14 (2007).
Amess, Kevin and Mike Wright. "Barbarians at the Gate? Leveraged
Buyouts, Private Equity, and Jobs." Unpublished working paper (2007).
Andres, Christian, André Betzer and Charlie Weir. "Shareholder Wealth
Gains through Better Corporate Governance: The Case of European LBO-
Transactions." Financial Markets and Portfolio Management, vol. 21
(2007).
Bargeron, Leonce, Frederik Schlingemann, Rene M Stulz and Chad Zutter.
"Why Do Private Acquirers Pay So Little Compared to Public Acquirers?"
National Bureau of Economic Research Working Paper, No. 13061 (2007).
Betzer, André. "Why Private Equity Investors Buy Dear or Cheap in
European Leveraged Buyout Transactions." Kredit und Kapital, vol. 39,
no. 3 (2006).
Cao, Jerry X. "A Study of LBO Premium." Unpublished working paper (Nov.
24, 2007).
Cao, Jerry and Josh Lerner. "The Performance of Reverse Leveraged
Buyouts" National Bureau of Economic Research Working Paper, No. 12626
(2006).
Cressy, Robert, Federico Munari and Alessandro Malipiero. "Playing to
Their Strengths: Evidence that Specialization in the Private Equity
Industry Conveys Competitive Advantage." Journal of Corporate Finance,
vol. 13 (2007).
Davis, Steven J., Josh Lerner, John Haltiwanger, Javier Miranda and Ron
Jarmin. "Private Equity and Employment" in The Global Economic Impact
of Private Equity Report 2008, ed. Anuradha Gurung and Josh Lerner
(Geneva, Switzerland: World Economic Forum, 2008).
Gottschalg, Oliver. Private Equity and Leveraged Buy-outs, Study IP/A/
ECON/IC/2007-25, European Parliament, Policy Department, Economic and
Scientific Policy (2007).
Guo, Shourun, Edith Hotchkiss and Weihong Song. Do Buyouts (Still)
Create Value? Unpublished working paper (2007).
Lerner, Josh, Morten Sørenson and Per Strömberg. "Private Equity and
Long-run Investment: The Case of Innovation." in The Global Economic
Impact of Private Equity Report 2008, ed. Anuradha Gurung and Josh
Lerner (Geneva, Switzerland: World Economic Forum, 2008).
Levis, Mario. Private Equity Backed IPOs in UK. Unpublished working
paper (2008).
Meuleman, Miguel and Mike Wright. "Industry Concentration, Syndication
Networks and Competition in the UK Private Equity Market for Management
Buy-Outs." Unpublished working paper (2006).
Renneboog, Luc, Tomas Simons and Mike Wright. "Why Do Public Firms Go
Private in the UK? The Impact of Private Equity Investors, Incentive
Realignment, and Undervaluation." Journal of Corporate Finance, vol. 13
(2007).
Strömberg, Per. "The New Demography of Private Equity" in The Global
Economic Impact of Private Equity Report 2008, ed. Anuradha Gurung and
Josh Lerner (Geneva, Switzerland: World Economic Forum, 2008).
[End of section]
Footnotes:
[1] Although widely used, the term "private equity" investment has no
precise legal or universally accepted definition. Some market
participants and observers define private equity narrowly as LBOs;
others define it more broadly to include venture capital and other
investments. In this report, we focus on private equity funds engaged
in LBOs because this activity has been at the center of the recent
debate and is the focus of our congressional request.
[2] Typically, a private equity firm: (1) creates an entity, usually a
limited partnership, (2) solicits capital from investors in exchange
for limited partnership interests in the partnership, and (3) manages
the limited partnership (commonly referred to as a private equity fund)
as the general partner.
[3] See, e.g., Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506
A.2d 173 (Del. 1986), where the Delaware Supreme Court outlined
directors' fiduciary duties under Delaware law in the context of a
corporate auction.
[4] In general terms, a tender offer is a broad solicitation by a
company or a third party for a limited period of time to purchase a
substantial percentage of a company's registered equity shares.
[5] Act of Oct. 15, 1914, ch. 323, § 7A (as added by the Hart-Scott-
Rodino Antitrust Improvements Act of 1976, Pub. L. No. 94-435, tit. II,
§ 201, 90 Stat. 1383, 1390). The required premerger notification and
waiting period provides the Federal Trade Commission and Antitrust
Division with the opportunity to evaluate the competitive significance
of the proposed transaction and to seek a preliminary injunction to
prevent the consummation of any transaction which, if consummated, may
violate federal antitrust laws.
[6] We compiled a list of the largest private firms using various
publicly available sources and had SEC staff verify which of the firms
were registered as investment advisers or had affiliates that were
registered as investment advisers.
[7] SEC supervision extends to the registered broker-dealer, the
unregulated affiliates of the broker-dealer, and the broker-dealer
holding company itself--provided that the holding company does not
already have a principal regulator. In other words, SEC does not
supervise any entities (such as banks, credit unions, or bank holding
companies) that are a part of the consolidated supervised entity but
otherwise are supervised by a principal regulator.
[8] Deal values were not available for all transactions. The median
value is for transactions for which price information was available.
[9] According to Dealogic data, information on whether a private equity-
sponsored LBO was hostile was available for 686 private equity buyouts
done from 2000 through 2007; of these, none were reported to be
hostile. In 299 of the transactions, the target company's board was
reported "friendly" to the takeover; in the remainder, the board was
reported as "neutral."
[10] A trade journal report recently discussed the possible reemergence
of hostile deals. See "Hostile Bids Could Make a Comeback," Private
Equity Analyst, Dow Jones & Company, Inc. (February 2008).
[11] McKinsey Global Institute, The New Power Brokers: How Oil, Asia,
Hedge Funds, and Private Equity Are Shaping the Global Capital Markets
(October 2007).
[12] Large syndicated loans may involve one or more lead banks.
[13] No standard definition of leveraged loans exists, but leveraged
loans are distinguished from nonleveraged, or investment-grade, loans
based on one of two criteria: (1) the borrower's credit rating or (2)
the loan's initial interest rate spread over the London Interbank
Offered Rate, or LIBOR (the interest rate paid on interbank deposits in
the international money markets).
[14] In analyzing exits of LBOs by private equity funds, a recent study
found that the most common strategies were sales to a strategic buyer,
sales to a financial buyer (e.g., private equity fund), or IPOs. See
Steven N. Kaplan and Per Strömberg, "Leveraged Buyouts and Private
Equity," draft paper (March 2008).
[15] Our review of the literature included academic studies of the
impact of private equity LBOs, using data from industrialized
countries, whose sample periods include LBOs done from 2000 to the
present. These studies include both published papers (5) and working
papers (12), all written between 2006 and 2008. We excluded reports by
trade associations, consulting firms, and labor unions in an effort to
focus our review on independent research. We also note this review does
not include research on the returns to investors (limited partners or
general partners) in private equity funds. The studies of the impact of
recent private equity-sponsored LBOs we reviewed are listed in the
bibliography at the end of the report.
[16] See, for example, Bengt Holmstrom and Steven N. Kaplan, "Corporate
Governance and Merger Activity in the United States: Making Sense of
the 1980s and 1990s," Journal of Economic Perspectives 15, no. 2
(2001), and Mike Wright, Andrew Burrows, Rod Ball, Louise Scholes,
Miguel Meuleman, and Kevin Amess, The Implications of Alternative
Investment Vehicles for Corporate Governance: A Survey of Empirical
Research, Report for the OECD Steering Group on Corporate Governance
(2007).
[17] In other words, there can be "selection bias"--buyouts are not
randomly assigned, as in controlled experiments, where causality is
easier to determine. Some studies used statistical techniques to
account for the nonrandom nature ("endogeneity") of buyout decisions,
but these techniques are imperfect, and most studies do not attempt to
account for this endogeneity. These techniques include instrumental
variables and Heckman-correction for sample selection.
[18] Due to similar levels of financial development, studies based on
European data should be instructive for understanding U.S. buyouts,
although there are some structural differences between the U.S. and
European economies. In particular, differences in shareholder rights in
continental Europe may lead to differences in LBOs.
[19] Robert Cressy, Federico Munari, and Alessandro Malipiero, "Playing
to Their Strengths: Evidence That Specialization in the Private Equity
Industry Conveys Competitive Advantage," Journal of Corporate Finance
13 (2007).
[20] These two studies are based on small samples (89 and 63 buyouts,
respectively) of the post-buyout performance of private firms where
accounting data were available. Shourun Guo, Edith Hotchkiss, and
Weihong Song, Do Buyouts (Still) Create Value? (unpublished working
paper, 2007), and Gottschalg, Oliver, Private Equity and Leveraged Buy-
outs, Study IP/A/ECON/IC/2007-25, European Parliament, Policy
Department, Economic and Scientific Policy (2007).
[21] Josh Lerner, Morten Sørenson, and Per Strömberg, "Private Equity
and Long-run Investment: The Case of Innovation," in The Global
Economic Impact of Private Equity Report 2008, ed. Anuradha Gurung and
Josh Lerner (Geneva, Switzerland: World Economic Forum, 2008).
[22] Jerry Cao and Josh Lerner, "The Performance of Reverse Leveraged
Buyouts," National Bureau of Economic Research Working Paper No. 12626
(2006).
[23] Highlighting the difference between first-day returns and the
longer term performance of IPOs can differentiate initial under-pricing
of the IPO from the long-run performance of the company. Mario Levis,
Private Equity Backed IPOs in UK (unpublished working paper, 2008).
[24] Even after a public-to-private acquisition, a company may still
make securities filings--for instance, if it has publicly traded debt
securities.
[25] Strömberg, Per, "The New Demography of Private Equity" in The
Global Economic Impact of Private Equity Report 2008, ed. Anuradha
Gurung and Josh Lerner (Geneva, Switzerland: World Economic Forum,
2008).
[26] See, for example, Jensen, Michael C., "Agency Costs of Free Cash
Flow, Corporate Finance, and Takeovers," American Economic Review 76,
no. 2 (1986): 323-329, and Holmstrom and Kaplan (2001).
[27] Greater debt also provides tax benefits, via deductibility of
interest payments, which should enhance value for firm owners but may
not result in aggregate economic benefits because of the transfer of
revenue from the government to the firm and the distortion of economic
incentives for financing the firm with debt versus equity.
[28] In a perfectly competitive market, potential buyers would bid up
to their willingness to pay for the target.
[29] Luc Renneboog, Tomas Simons, and Mike Wright, "Why Do Public Firms
Go Private in the UK? The Impact of Private Equity Investors, Incentive
Realignment, and Undervaluation," Journal of Corporate Finance 13
(2007).
[30] Concentrated external shareholders such as institutional investors
should have incentives to monitor performance similar to internal
managers with large equity stakes. See, for example, Jay C. Hartzell
and Laura T. Starks, "Institutional Investors and Executive
Compensation," Journal of Finance 58, no. 6 (2003). Betzer, André, "Why
Private Equity Investors Buy Dear or Cheap in European Leveraged Buyout
Transactions," Kredit und Kapital 39, no. 3 (2006). Christian Andres,
André Betzer, and Charlie Weir, "Shareholder Wealth Gains Through
Better Corporate Governance: The Case of European LBO-transactions,"
Financial Markets and Portfolio Management 21 (2007).
[31] The premium is measured relative to the share price on the day
prior to the deal announcement. Jerry X. Cao, A Study of LBO Premium
(unpublished working paper, Nov. 24, 2007).
[32] The premium is measured relative to the share price on the day
prior to the deal announcement.
[33] However, default risk decreased for target firms whose debt was
already poorly rated. "Default and Migration Rates for Private Equity-
Sponsored Issuers," Special Comment, Moody's Investors Service
(November 2006).
[34] One study of U.S. corporate ownership supports the view that
private owners have a longer time horizon than public owners. In
particular, the study found that private equity funds have longer
holding periods than "blockholders" (external shareholders in public
firms who have more than a 5 percent stake), with 88 percent of
blockholders selling after 5 years, but only 55 percent of private
equity firms selling after 5 years. Gottschalg (2007).
[35] Andrew Metrick and Ayako Yasuda, "The Economics of Private Equity
Funds," Wharton School, University of Pennsylvania (2007).
[36] Kevin Amess and Mike Wright, "The Wage and Employment Effects of
Leveraged Buyouts in the UK," International Journal of the Economics of
Business 14 (2007).
[37] See Steven Kaplan, "The Effects of Management Buyouts on Operating
Performance and Value," Journal of Financial Economics 24 (1989) and
Frank R. Lichtenberg and Donald Siegel, "The Effects of Leveraged
Buyouts on Productivity and Related Aspects of Firm Behavior," Journal
of Financial Economics 27 (1990).
[38] The authors describe establishments as "specific factories,
offices, retail outlets and other distinct physical locations where
business takes place." The lower job growth, relative to peers, results
primarily from differences in layoffs, as new hiring is similar between
private equity and nonprivate equity establishments. Steven J. Davis,
Josh Lerner, John Haltiwanger, Javier Miranda, and Ron Jarmin, "Private
Equity and Employment" in The Global Economic Impact of Private Equity
Report 2008, ed. Anuradha Gurung and Josh Lerner (Geneva, Switzerland:
World Economic Forum, 2008).
[39] Lower employment growth at private equity controlled firms may
shift employment to other firms and sectors of the economy, rather than
reducing the overall level of employment in the economy. However,
economic theory suggests that a greater willingness to restructure
firms could result in temporary "frictional unemployment," as people
moved from job to job more often, or more permanent "structural
unemployment," if rapid innovation increased the rate at which certain
job skills became obsolete. One expert we interviewed suggested that
the unemployment resulting from any job losses was likely to be
temporary in nature.
[40] Furthermore, as one survey of the private equity academic
literature noted, "it cannot be assumed that the pre-buyout employment
levels would have been sustainable." Wright et al. (2007).
[41] Venture capital firms have long pursued a similar strategy.
Venture capital firms are similar to private equity firms, but they
typically invest in early stage companies (whereas private equity firms
invest in more established companies) and acquire less than a
controlling position (whereas private equity firms typically buy all
of, or a controlling position in, the target company).
[42] One study rejects such "benign rationales" for club deals. See
Micah S. Officer, Oguzhan Ozbas, and Berk A. Sensory, Club Deals in
Leveraged Buyouts (unpublished working paper, June 2008). The authors
state that while club deals are larger on average than sole-sponsor
LBOs, only about 19 percent of club deals are larger than the largest
single-firm deal conducted by any of the club members in a 4-year
window around the club deal announcement date. In addition, they state
that club deal targets do not appear to be systematically more risky
than target companies of single-firm deals. "These facts suggest that
capital constraints or diversification returns are unlikely to be [the
major] motivations for club deals." But, see also footnote 51, for a
discussion of limitations of this study.
[43] The less common way, known as "proprietary" deals, is when the
buyer and seller negotiate with each other on an exclusive basis. Such
deals might arise, for example, from relationships developed between
the parties over time. Private equity executives told us that they
maintain regular contacts with companies of interest, even if the
companies are not immediately available for sale. Through such
contacts, a private equity firm might learn of a sale opportunity, and
then pursue it with the target company.
[44] Although some auction deals have included go-shop provisions, they
are more common with proprietary deals. There is some skepticism about
the value of go-shop provisions; for a discussion, see Sautter,
Christina M., "Shopping During Extended Store Hours: From No Shops to
Go-Shops," Brooklyn Law Review 73, no. 2 (2008).
[45] For academic research describing this process, see Audra L. Boone
and J. Harold Mulherin, Do Private Equity Consortiums Impede Takeover
Competition? (unpublished working paper, March 2008). According to the
authors' analysis, in takeovers in which a single private equity firm
is the winning bidder, the target company, on average, contacts 32
potential bidders, signs confidentiality agreements with 13 potential
bidders, receives indications of interest from roughly 4 bidders,
receives binding private offers from 1.5 bidders, and receives formal
public offers from 1.1 bidders.
[46] An econometric model seeks to mathematically examine relationships
among variables and the degree to which changes in "explanatory"
variables are associated with changes in a "dependent" variable, or
variable under study--here, price paid for a buyout, as measured by
premium paid over stock price. Explanatory variables are factors
included in the analysis to adjust for differences among the subjects
being studied. While an econometric model can measure associations
between variables, it cannot by itself establish causation--that is,
the extent to which changes in the explanatory variables cause changes
in the variable under study.
[47] Our analysis is based on data compiled for approximately 325
public companies acquired by private equity firms from 1998 through
2007 for which premium information was available. The data also
permitted us to include several transactions occurring in early 2008.
The data are from Dealogic, Audit Analytics, and company filings with
SEC. To address potential bias in our estimates due to differences
between club deals and nonclub deals, we used Heckman's two-stage
modeling approach. See appendix X for a more complete discussion of our
econometric approach, including model specification, variables used,
data sources, estimation techniques, and limitations. In focusing on
prices paid for target companies, the analysis did not examine
individual deals for specific evidence of anticompetitive behavior.
[48] Differences in the premium at different intervals before
announcement may result from "information leakage." In general, the
buyout premium may be lower closer to the date of the announcement
because of speculation that a deal is imminent or word of a transaction
has leaked out. In such cases, the stock price will adjust to reflect
the takeover possibility. When a single private equity firm engages in
a buyout, it may be easier to keep the transaction confidential until
the time of the announcement. It may be harder to keep a transaction
confidential when two or more private equity firms are involved.
Because price leakage may be more likely for club deals, there may be
greater variance in premium at the 1-month point before the
announcement.
[49] The notable exception to this is our sensitivity test where we
drop small deals from the sample. In these models, we find a positive
statistically significant association between club deals and the
premium.
[50] See, for example, Boone and Mulherin. The authors state: "A
striking result...is that private equity consortiums are...associated
with above-average levels of takeover competition. Indeed, the level of
competition in deals in which private equity consortiums are the
winning bidders is as great or greater than that for single private
equity deals. Although the formation of a consortium would appear to
arithmetically reduce the level of competition, the use of consortiums
actually is associated with more bidding than the average deal. [T]he
data indicate that consortiums are a competitive response by private
equity firms when bidding for larger targets."
[51] See Officer et al. The sample studied included 198 private equity
transactions, of which 59 were club deals. The authors find that 35
deals prior to 2006 drive the negative price impact. The authors
selected club deals after identifying leading private equity firms
through Private Equity International magazine and other sources. To the
extent this selection method categorizes a significant number of
private equity firms' buyouts--whether club deals or single-firm deals-
-as buyouts by other private firms, there could be measurement error
introduced into the model. Also, because the study bases its selection
of transactions on the activities of leading private equity firms, its
sample is likely unrepresentative of the entire population.
[52] Our results also suggests--as relating to which target companies
are more likely to be acquired through a club deal--that large
companies, companies with lower debt ratios and, controlling for size,
companies that do not trade on the New York Stock Exchange had a
greater probability of being taken private in a joint acquisition.
[53] An "oligopoly" is generally defined as a market that is dominated
by a small number of relatively large firms. A tight oligopoly is
generally defined as a market in which four providers hold over 60
percent of the market and other firms face significant barriers to
entry into the market.
[54] For example, if there were 10 companies in a marketplace, and each
held a 10 percent share of the market, the index value would be 1,000-
-for an individual company, the market share of 10 percent, when
squared, is 100; summing the values for all 10 participants would yield
an index value of 1,000.
[55] See, for example, "Private-Equity Firms Face Anticompetitive
Probe; U.S.'s Informal Inquiries Have Gone to Major Players Such as
KKR, Silver Lake," Wall Street Journal (eastern edition), Oct. 10,
2006, A3, and "Merrill Arm Draws U.S. Questions In Informal Probe of
Private Equity," Wall Street Journal (eastern edition), Nov. 6, 2006,
A9.
[56] See Pennsylvania Avenue Funds v. Borey, No. C06-1737RAJ (W.D.
Wash. Nov. 15, 2006); Murphy, et al. v. Kohlberg Kravis Roberts & Co.
(KKR) et al., No. 06-cv-13210-LLS (S.D.N.Y. Nov. 15, 2006). Murphy v.
KKR was voluntarily dismissed by the plaintiff. In Pennsylvania Avenue
Funds v. Borey, the federal district court dismissed the antitrust
claim for failure to state a claim under the Sherman Act. The court
concluded that the plaintiffs had failed to make allegations from which
the court could reasonably infer that the defendant private equity
firms had market power, either in the private equity marketplace at
large or more narrowly in the marketplace for acquiring the target
company.
[57] See Davidson v. Bain Capital Partners, LLC, No. 07-CV-12388 (D.
Mass. Dec. 28, 2007); Dahl v. Bain Capital Partners, LLC, No. 08-CV-
10254 (D. Mass. Feb. 14, 2008). The two cases have been consolidated
under No. 07-CV-12388.
[58] Some private equity funds are organized as limited liability
companies and occasionally as corporations.
[59] Private equity funds typically rely on one of two exclusions from
the definition of an investment company under the Investment Company
Act of 1940 (Investment Company Act). First, section 3(c)(1) of the
Investment Company Act excludes from the definition of investment
company any issuer (1) whose outstanding securities (other than short-
term paper) are beneficially owned by not more than 100 investors and
(2) that is not making, and does not presently propose to make, a
public offering of its securities. 15 U.S.C. § 80a-3c(1). Second,
section 3(c)(7) of the Investment Company Act excludes from the
definition of investment company any issuer (1) whose outstanding
securities are owned exclusively by persons who, at the time of
acquisition of such securities, are "qualified purchasers" and (2) that
is not making, and does not at that time propose to make, a public
offering of its securities. 15 U.S.C. § 80a-3(c)(7). Qualified
purchasers include individuals who own at least $5 million in
investments or companies that own at least $25 million worth of
investments. 15 U.S.C. § 80a-2(a)(51).
Private equity advisers typically satisfy the "private manager"
exemption from registration as an investment adviser under section
203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act). This
section exempts from SEC registration requirements investment advisers
(1) that have had less than 15 clients during the preceding 12 months,
(2) do not hold themselves out generally to the public as an investment
adviser, and (3) are not an investment adviser to a registered
investment company. 15 U.S.C. § 80b-3.
[60] See 15 U.S.C. § 80b-6. In 2007, SEC adopted a rule designed to
clarify its ability to bring enforcement actions against unregistered
advisers that defraud investors or prospective investors in a pooled
investment vehicle, including a private equity fund. See Prohibition of
Fraud by Advisers to Certain Pooled Investment Vehicles, 72 Fed. Reg.
44756 (Aug. 9, 2007) (final rule) (to be codified at 17 C.F.R. §
275.206(4)-8).
[61] Under the Securities Act of 1933, a public offering or sale of
securities must be registered with SEC, unless otherwise exempt. To
exempt from registration the offering or sale of partnership interests
of private equity funds to investors, private equity funds generally
restrict the sale of their partnership interests to accredited
investors in compliance with the safe harbor conditions of Rule 506 of
Regulation D. 15 U.S.C. § 77d and § 77e; 17 C.F.R. § 230.506 (2007).
Accredited investors must meet certain wealth and income thresholds and
include institutional investors such as banks, broker-dealers,
insurance companies, and pension funds, as well as wealthy individuals.
[62] See 15 U.S.C. § 80a-2(a)(48). Generally, eligible portfolio
companies are domestic companies that (1) are not investment companies
under the Investment Company Act and (2) do not have their securities
listed on a national securities exchange or have their securities
listed on a national exchange and a market capitalization of less than
$250 million. 15 U.S.C. § 80(a)(46); 17 C.F.R. § 270.2a-46 (2008).
[63] See 15 U.S.C. §§ 80a-55 - 80a-62. The Small Business Investment
Incentive Act of 1980, Pub. L. No. 96-477, tit. I., 94 Stat. 2278,
among other things, amended the Investment Company Act to establish a
new system of regulation for business development companies as a means
of making capital more readily available to small, developing and
financially troubled companies that do not have access to the public
capital markets or other forms of conventional financing.
[64] McKinsey Global Institute, The New Power Brokers: How Oil, Asia,
Hedge Funds, and Private Equity Are Shaping the Global Capital Markets
(October 2007).
[65] Routine examinations are conducted based on the registrant's
perceived risk. SEC staff seek to examine all firms considered higher
risk once every 3 years. SEC staff select a random sample of firms
designated as lower-risk to routinely examine each year. During a
routine examination, SEC staff assess a firm's process for assessing
and controlling compliance risks. Based on that assessment, examiners
assign advisers a risk rating to indicate whether they are at higher or
lower risk for experiencing compliance problems.
[66] We did not review two examinations because SEC staff did not
prepare reports for these examinations, which covered one firm.
According to SEC staff, the agency has staff monitoring that firm on an
ongoing basis, but the staff do not prepare reports after completing
their examination work.
[67] In a sweep examination, SEC staff probe specific activities of a
sample of firms to identify emerging compliance problems. SEC staff
conduct cause examinations when they have reason to believe something
is wrong at a particular firm.
[68] SEC staff said that a separate report was not prepared for one of
the sweep examinations, since it was part of a larger review.
[69] See Registration under the Advisers Act of Certain Hedge Fund
Advisers, 69 Fed. Reg. 72087 (Dec. 10, 2004). In June 2006, a federal
court vacated the rule. See Goldstein v. Securities and Exchange
Commission, 451 F.3d 873 (D.C. Cir. 2006).
[70] GAO, Defined Benefit Pension Plans: Guidance Needed to Better
Inform Plans of the Challenges and Risks of Investing in Hedge Funds
and Private Equity, [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-
08-692] (Washington, D.C.: Aug. 14, 2008).
[71] IOSCO is an international organization that brings together the
regulators of the world's securities and futures markets. IOSCO and its
sister organizations, the Basel Committee on Banking Supervision and
the International Association of Insurance Supervisors, make up the
Joint Forum of international financial regulators.
[72] FSA stated that it is not just at the time a private equity
transaction is arranged that access to inside information is an issue.
Participation in the debt components of a leveraged finance structure
can give access to significant amounts of data about the ongoing
performance of the company--potentially price-sensitive information.
According to FSA, trading in any related instruments could make them
vulnerable to committing market abuse if price-sensitive information
forms the basis of the decision to trade.
[73] Banks also may agree to provide bridge loans, which serve to
provide temporary financing, until longer term financing can be put in
place. For example, a private equity fund may use a bridge loan to help
finance an LBO, until it can complete a bond offering.
[74] In addition to bank loans, private equity firms may use high-yield
bonds or "mezzanine" debt to help finance their LBOs. High-yield bonds
are debt securities issued by companies with lower-than-investment
grade ratings. Mezzanine debt is a middle level of financing in LBOs--
below bank debt and above equity capital.
[75] Dealogic defines leveraged loans as loans for borrowers rated BB+
or below by Standard and Poor's or Ba1 or below by Moody's. In the case
of a split rating or unrated borrower, pricing at signing is used.
Loans with a margin of (1) between and including 150 and 249 basis
points over LIBOR are classified as leveraged and (2) 250 basis points
or more in the U.S. market are classified as highly leveraged.
[76] The term "highly leveraged transactions" generally was defined as
a type of financing that involves the restructuring of an ongoing
business concern financed primarily with debt. In 1990, the Federal
Reserve required banks to report data on their highly leveraged
transactions, but the definition and reporting requirement were
eliminated in 1992. According to federal banking regulators, the
definition achieved its purposes of focusing attention on the need for
banks to have strong internal controls for highly leveraged
transactions and structure such credits consistent with their risks.
The regulators said that they would continue to scrutinize the
transactions in their examinations.
[77] OCC, Federal Reserve, the Federal Deposit Insurance Corporation,
and Office of Thrift Supervision, "Interagency Statement on Sound Risk
Management Practices for Leveraged Financing," April 9, 2001.
Subsequently, in February 2008, OCC updated its handbook on leveraged
lending, which summarizes leveraged lending risks, discusses how a bank
can manage the risks, and incorporates previous OCC guidance on the
subject.
[78] The Bank Holding Company Act of 1956, as amended, generally
requires that holding companies with bank subsidiaries register with
the Federal Reserve as bank holding companies. The act generally
restricts the activities of bank holding companies to those that the
Federal Reserve determined, as of November 11, 1999, to be closely
related to banking. Under amendments to the act made by the Gramm-
Leach-Bliley Act, a bank holding company that qualifies as a financial
holding company may engage in a broad range of additional financial
activities, such as full-scope securities, insurance underwriting and
merchant banking.
[79] Loan covenants enable lenders to preserve and exercise rights over
collateral value, initiate and manage appropriate courses of action on
a timely basis, and provide lenders with negotiating leverage when the
loans do not perform as expected. "Incurrence" covenants generally
require that if a borrower takes a specified action (such as paying a
dividend or taking on more debt), it must be in compliance with some
specified requirement (such as a minimum debt-to-cash flow ratio).
"Maintenance" covenants are more restrictive than incurrence covenants
and require a borrower to meet certain financial tests continually,
whether the borrower takes an action. If a borrower fails to comply
with loan covenants, it would be in technical default on the loan.
[80] The Shared National Credit Program was established in 1977 by the
Federal Reserve, Federal Deposit Insurance Corporation, and OCC to
provide an efficient and consistent review and classification of any
large syndicated loan. The program covers any loan or loan commitment
of at least $20 million that is shared by three or more supervised
institutions.
[81] Board of Governors of the Federal Reserve System, Joint Press
Release: Shared National Credit Results Reflect Large Increase in
Credit Commitment Volume, and Satisfactory Credit Quality (Sept. 25,
2007) at [hyperlink,
http://www.federalreserve.gov/newsevents/press/bcreg/20070925a.htm].
[82] OCC has been surveying the largest national banks (73 banks in
2006 and 78 banks in 2007) for the past 13 years to identify trends in
lending standards and credit risk for the most common types of
commercial and retail credits. The survey also includes a set of
questions directed at the OCC Examiners-in-Charge of the surveyed
banks.
[83] The Federal Reserve generally conducts the survey quarterly, which
covers a sample selected from the largest banks in each Federal Reserve
district. Questions cover changes in the standards and terms of the
banks' lending and the state of business and household demand for
loans. The survey often includes questions on one or two other topics
of current interest.
[84] If a broker-dealer and its ultimate holding company consent to be
supervised on a consolidated basis by SEC, the broker-dealer may use an
alternative method of calculating its net capital requirement. See 17
C.F.R. § 240.15c3-1 (2007). Generally, this alternative method, the
result of a recent amendment to the SEC net capital rule, permits a
broker-dealer to use certain mathematical models to calculate net
capital requirements for market and derivative-related credit risk. The
amendments to SEC's standard net capital rule, among other things,
respond to international developments. According to SEC, some U.S.
broker-dealers expressed concern that unless the firms can demonstrate
that they are subject to consolidated supervision that is "equivalent"
to that of the European Union (EU), then their affiliate institutions
located in the EU may be subject to more stringent net capital
computations or be required to form a subholding company. See
Alternative Net Capital Requirements for Broker-Dealers that Are Part
of Consolidated Supervised Entities, 69 Fed. Reg. 34428, 34429 (June
21, 2004) (final rule). For a description of the CSE program, see SEC
Holding Company Supervision Program Description at [hyperlink,
http://www.sec.gov/divisions/marketreg/hcsupervision.htm].
[85] GAO, Financial Market Regulation: Agencies Engaged in Consolidated
Supervision Can Strengthen Performance Measurement Collaboration,
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-154] (Washington,
D.C.: March 15, 2007).
[86] Basel regulatory capital standards were developed by the Basel
Committee on Banking Supervision, which consists of central bank and
regulatory officials from 13 member countries. The standards aim to
align minimum capital requirements with enhanced risk measurement
techniques and to encourage internationally active banks to develop a
more disciplined approach to risk management.
[87] The share of a syndicated loan held by a bank varies from deal to
deal, but the major banks generally have a target of holding 10 percent
or less of each leveraged loans they arrange and underwrite, according
to regulators and bank officials.
[88] A collateralized loan obligation is an asset-backed security that
is usually supported by a variety of assets, including whole commercial
loans, revolving credit facilities, letters of credit, or other asset-
backed securities. In a typical transaction, the sponsoring banking
organization transfers the loans and other assets to a bankruptcy-
remote special purpose vehicle, which then issues asset-backed
securities consisting of one or more classes of debt. This type of
transaction represents a "cash flow collateralized loan obligation."
[89] Syndicated leveraged loans issued to finance LBOs generally
include a revolver, term loan A (amortizing term loan), and term loan B
(a term loan that typically carries a longer maturity and slower
amortization than term loan A). The revolver and term loan A often are
packaged together, called the pro rata tranche, and syndicated
primarily to banks, as well as nonbank institutions. Term loan B,
called the institutional tranche, is syndicated typically to nonbank
institutions.
[90] In general, when a commercial bank funds a leveraged loan, it will
record (1) the portion that it plans to retain as a loan held for
investment and (2) the portion that it plans to sell as a loan held for
sale. Held-for-investment loans are recorded at their amortized cost
less any impairment. Held-for-sale loans are recorded at the lower of
cost or market value. When an investment bank funds a leveraged loan,
it generally will record the loan at fair value (such as based on a
quoted market price). According to SEC staff, starting in the third
quarter of 2007, as it became apparent that those commitments that had
not yet closed would not be able to be distributed at par, the
investment banks had write downs not only on the closed loans but also
on the unfunded commitments.
[91] An analysis by Moody's found that LBOs sponsored by private equity
firms generally were associated with an increase in default risk, but
default risk decreased for target firms whose debt was already poorly
rated. "Default and Migration Rates for Private Equity-Sponsored
Issuers." Special Comment, Moody's Investors Service (November 2006).
[92] See President's Working Group on Financial Markets, Policy
Statement on Financial Market Developments (March 13, 2008). PWG was
established by Executive Order 12631, signed on March 18, 1988. The
Secretary of the Treasury chairs PWG, the other members of which are
the Chairpersons of the Board of Governors of the Federal Reserve
System, SEC, and Commodity Futures Trading Commission. The group was
formed in 1988 to enhance the integrity, efficiency, orderliness, and
competitiveness of the U.S. financial markets and maintain the public's
confidence in those markets.
[93] We identified club deals as private equity buyouts with at least
two private equity firms participating in an acquisition, and with at
least one of the two firms participating on an "entry" basis--that is,
making an initial investment in the target company.
[94] IOSCO is an international organization that brings together the
regulators of the world's securities and futures markets. IOSCO and its
sister organizations, the Basel Committee on Banking Supervision and
the International Association of Insurance Supervisors, make up the
Joint Forum of international financial regulators.
[95] PWG was established by Executive Order 12631, signed on March 18,
1988. The Secretary of the Treasury chairs PWG, the other members of
which are the chairpersons of the Board of Governors of the Federal
Reserve System, SEC, and Commodity Futures Trading Commission. The
group was formed in 1988 to enhance the integrity, efficiency,
orderliness, and competitiveness of the U.S. financial markets and
maintain the public's confidence in those markets.
[96] The Senior Supervisors Group is composed of eight supervisory
agencies: France's Banking Commission, Germany's Federal Financial
Supervisory Authority, the Swiss Federal Banking Commission, the
Financial Services Authority, the Board of Governors of the Federal
Reserve System, FRBNY, OCC, and SEC.
[97] [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-692].
[98] We reviewed data from surveys of defined benefit pension plans
conducted by three organizations: (1) Greenwich Associates, covering
midsize to large-size pension plans with $250 million or more in total
assets; (2) Pyramis Global Advisors, covering midsize to large-size
pension plans with $200 million or more in total assets; and (3)
Pensions & Investments, limited to large plans that generally had $1
billion or more in total assets. Greenwich Associates is an
institutional financial services consulting and research firm; Pyramis
Global Advisors, a division of Fidelity Investments, is an
institutional asset management firm; and Pensions & Investments is a
money management industry publication. These data cannot be generalized
to all plans.
[99] The figures reported by these surveys differ somewhat because they
are based on different samples. Comprehensive data on plan investments
in private equity are not available. The federal government collects
information on investment allocations but does not require plan
sponsors to report such information on private equity as a separate
asset class.
[100] According to the Pension Benefits Guaranty Corporation,
individual defined benefit plans with less than $200 million in total
assets comprised about 15 percent of the total assets of all such plans
in 2005.
[101] Pensions & Investments was the only survey GAO reviewed that
reported the allocations of individual plans to private equity. Among
the top 200 pension plans, ranked by combined assets in defined benefit
and defined contribution plans, 133 were defined benefit plans that
completed the survey and provided asset allocation information in 2007.
[102] Private equity firms can also receive other fees, such as
monitoring fees for providing acquired companies with management,
consulting, and other services, or transaction fees for providing
acquired companies with financial advisory and other services in
connection with specific transactions.
[103] Some private equity funds are organized as limited liability
companies, but the tax characteristics of partnerships and limited
liability companies can be the same.
[104] By contrast, income earned by a corporation is subject to two
layers of federal income tax--once at the corporate level, and again at
the shareholder level if dividends are paid.
[105] A related income and taxation issue is treatment of this initial
grant of a "profits interest." Under current law, the grant of carried
interest is not a taxable event, provided that certain conditions are
satisfied. Under proposed Treasury regulations, a partnership and its
partners could elect to use a safe harbor, under which the fair market
value of a partnership interest that is transferred in connection with
the performance of services is treated as being equal to liquidation
value of the interest transferred. Thus, because the liquidation value
of a profits interest on the date of its issuance is zero, the fair
market value of carried interest at the time of its issuance would be
zero.
[106] The discussion in this report of the tax treatment of private
equity firms' compensation is summary in nature. For fuller discussion
and analysis, see, inter alia: "The Taxation of Carried Interest,"
testimony of Peter R. Orszag, director, Congressional Budget Office,
before the Committee on Ways and Means, U.S. House of Representatives,
September 6, 2007; "Present Law and Analysis Relating to Tax Treatment
of Partnership Carried Interests and Related Issues, Part I," prepared
by the staff of the Joint Committee on Taxation, also for the September
6 hearing before the Committee on Ways and Means; "Two and Twenty:
Taxing Partnership Profits in Private Equity Funds," working paper by
Victor Fleischer, associate professor, University of Illinois College
of Law; and testimony of Eric Solomon, assistant secretary for tax
policy, U.S. Treasury Department, before the Committee on Finance, U.S.
Senate, July 11, 2007.
[107] A related, but separate, tax issue for private equity that has
drawn criticism is deductibility of interest as a business expense.
Interest payments are generally deductible as expenses, and critics,
such as labor unions, say that given the significant amount of debt
used to finance private equity buyouts, the interest deduction is a
concern. We note, but do not address, this issue.
[108] Tax avoidance, which is legal, is distinct from tax evasion,
which is not, whereby a taxpayer intentionally avoids true tax
liability. Tax avoidance, while legal, is nevertheless a concern to
some because it can lead to inefficiencies, as entities undertake
transactions they would not otherwise make if not for the tax
advantages.
[109] This bill would also make a number of changes across the tax
spectrum, including modifying the standard deduction, reducing the top
marginal tax rate for corporations, and eliminating the alternative
minimum tax for individuals.
[110] Publicly traded partnerships are generally treated as
corporations for tax purposes and are subject to the corporate income
tax. The primary exception to this rule is that partnerships that
derive at least 90 percent of their income from passive investments and
which, therefore, are not required to register as investment companies
under the Investment Company Act of 1940, do not pay the corporate tax.
[111] This approach would involve altering IRS Rev. Proc. 93-27.
[112] Although our analysis focuses on the 1998-2007 period, we also
included several transactions occurring in early 2008 because such data
was available in Dealogic.
[113] Because we hand-collected the data from company filings in the
EDGAR database, and some companies report statistics differently, we
discuss the possible impact of random error below.
[114] J. Heckman, "The Common Structure of Statistical Models of
Truncation, Sample Selection, and Limited Dependent Variables and a
Simple Estimator for Such Models," Annals of Economic and Social
Measurement 5 (1976).
[115] The inverse Mills ratio is calculated (using the residuals from
the Probit model) as the ratio of the probability density function
(PDF) over the cumulative distribution function (CDF). The
distributional assumption of the error term is the standard normal
distribution; therefore, the ratio of the standard normal PDF and CDF
applied to the residuals for each transaction in the data set is
created. The inclusion of this quantity in the OLS regression mitigates
the potential bias in estimates due to the absence of a variable that
captures potential differences in the companies that would warrant a
different premium even if multiple equity firms did not participate in
some buyouts.
[116] For more information see J. Johnston and Dinardo, Econometric
Methods, 4th edition, 447-450. See also R. J. Willis and S. Rosen,
"Education and self-selection," The Journal of Political Economy 87,
no. 5 (1979).
[117] L. Renneboog et al. (2007) 609.
[118] This must be balanced against our treatment of clubs deals in the
calculating of market shares for each firm--the total value of a given
club deal was split equally among participating private equity firms.
Apportioning deal value equally among private equity firms in a club
deal may bias market share estimates downward because some participants
in the joint transaction actually commit less capital than other
private equity firms in some deals.
[End of section]
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