ORGANIZATIONAL RESTRUCTURING AND ECONOMIC PERFORMANCE IN LEVERAGED BUYOUTS: AN EX POST STUDY

Organizational Restructuring and Economic Performance in Leveraged Buyouts: An Ex PostStudyAuthor(s): Phillip H. Phan and Charles W. L. HillSource: The Academy of Management Journal, Vol. 38, No. 3 (Jun., 1995), pp. 704-739Published by: Academy of ManagementStable URL: http://www.jstor.org/stable/256743Accessed: 01/09/2010 11:57

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o Academy of Management Journal 1995, Vol. 38, No. 3, 704-739.

ORGANIZATIONAL RESTRUCTURING AND ECONOMIC PERFORMANCE IN LEVERAGED

BUYOUTS: AN EX POST STUDY

PHILLIP H. PHAN York University

CHARLES W. L. HILL

University of Washington

This article reports the results of an ex post study of the effects of

leveraged buyouts (LBOs) upon the goals, strategy, structure, and performance of firms. Our study was designed to test arguments that can be logically derived from agency theory. We used a survey to collect data on pre- and post-LBO goals, strategy, structure, and productivity for a sample of 214 firms that underwent buyouts between 1986 and 1989. Our results do not enable us to reject hypotheses based upon agency theory.

One of the most notable trends of the 1980s was the explosion in leveraged buyout activity; the total value of leveraged buyouts (LBOs) ex- ceeded $250 billion in the 1980s. A leveraged buyout involves a swap of equity for debt. The group undertaking an LBO typically raises cash by is- suing bonds and then uses that cash to buy the firm's stock. In effect, in an LBO a firm replaces its stockholders with bondholders and, in the process, transforms the firm from a public to a private entity. Although the boom in such activity is now largely over, debate still rages as to the competitive consequences of LBOs. Some authors have claimed that the high level of debt associated with a buyout forces firms to cut needed capital and R&D investments in order to service debt payments, thereby damaging their long-run efficiency and competitive position (e.g., Reich, 1989). Others have used agency theory to argue that LBOs improve firm efficiency (e.g., Jensen, 1986, 1988).

Currently, researchers lack the empirical evidence required to make a strong judgment with regard to the impact of leveraged buyouts on efficiency (Jacobs, 1991). Although a number of ex ante event studies of buyouts have been undertaken, they only offer evidence as to expected consequences, as measured by the stock market's reaction to buyout an- nouncements (e.g., DeAngelo, DeAngelo, & Rice, 1984; Madden, Marples,

We would like to thank Michael Hitt and the two anonymous reviewers for this journal for their very helpful comments on and thoughtful analyses of a previous version of this article.

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& Chung, 1990). Although these studies suggest that LBOs do increase efficiency, as predicted by agency theory, such a conclusion must be tempered by the fact that expectations do not always match outcomes. Given the very real possibility that LBOs might lead to a decline in efficiency, there is a need for ex post studies of the relationship between a leveraged buyout and the efficiency of an enterprise (Palepu 1990). Such studies are now beginning to appear (Kaplan, 1989; Kaplan & Stein, 1993; Lichtenberg & Siegel, 1990; Liebeskind, Wiersema, & Hansen, 1992; Long & Ravenscraft, 1993a, 1993b; Seth & Easterwood, 1993; Singh, 1990), and they have generated mixed results. For example, the work by Lichtenberg and Siegel indicates that LBOs realize efficiencies and productivity gains, but the studies by Long and Ravenscraft suggest that they lead to a long-term decline in R&D spending and profitability.

Drawing on agency theory, we try herein to articulate with more precision than hitherto the mechanism by which an LBO might improve the efficiency of a firm. Although agency theorists talk about the incentive alignment effects of the increase in debt and management stockholdings associated with buyout (e.g., Garvey, 1992; Jensen, 1986), they tend to gloss over the nature of the changes in strategy and structure that are required to bring about an improvement in firm performance. We try to specify the form those changes will take.

AGENCY THEORY AND LBOS

Our reason for testing the agency theory perspective is that the debate about the efficiency effects of leveraged buyouts has largely been waged between those who take an agency theory perspective (e.g., Jensen, 1986, 1988) and those who argue that such an interpretation is wrong and that LBOs harm efficiency (Reich, 1989). Thus, the theory is important in this context and deserves to be put through the rigors of serious empirical testing.

Agency theorists argue that within public corporations a conflict aris- es between the goals of professional managers and those of stockholders (Berle & Means, 1934; Fama, 1980; Jensen & Meckling, 1976). Building on that basis, Jensen (1986) argued that a serious source of conflict between management and stockholders is the utilization of free cash flow, defined as cash flow in excess of that required to fund all investment projects whose forecasted financial return is positive when discounted at the relevant cost of capital. Since free cash flow cannot be profitably reinvested within a company, Jensen argued that it should be distributed to stockholders in the form of dividends or stock buybacks. However, managers may resist distributing surplus cash resources to stockholders and may instead invest them in growth-maximizing or empire-building projects that yield low or negative returns and involve excess staff and indulgent perquisites. Managers do this, according to agency arguments, because such investments maximize their own utility (Aoki, 1984; Jensen & Meck- ling, 1976; Marris, 1964; Williamson, 1964).

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According to agency theory, a number of governance mechanisms can limit conflict between managers and stockholders. These mechanisms include boards of directors, the market for corporate control, the managerial labor market, concentrated ownership, managerial stock ownership, and various incentive alignment devices such as stock option plans and golden parachutes1 (Demsetz, 1983; Fama, 1980; Jensen, 1988). However, according to Jensen (1986), in firms generating significant free cash flow, such governance mechanisms are not always sufficient to attenuate the conflict between management and stockholders over the payout of free cash. In such situations, Jensen argued an LBO may be appropriate.

Jensen focused primarily on the role of debt in limiting managerial dis- cretion, noting that the debt used to finance an LBO helps to limit the waste of free cash by compelling managers to use it to service debt payments rather than spend it inefficiently within the firm. Further, Jensen emphasized that debt motivates managers to look for efficiencies. The need to service high debt payments forces them to slash unsound investment programs, reduce overhead, dispose of assets that are more valuable outside of the company, and restructure an organization to increase accountability and control. The proceeds generated by these restructurings can then be used to reduce debt to sustainable levels, creating a leaner, more efficient, and more competitive organization.

Other authors have pointed out that an LBO also frequently involves giving incumbent managers significant equity stakes in a firm (Garvey, 1992; Kaplan & Stein, 1993; Singh, 1990). The result is to transform managers into owners, thereby giving them positive incentives to look for efficiency gains that will increase the value of their stockholdings. Thus, increase in management stockholdings may be just as important as increase in debt as a stimulus to efficiency following a buyout. By focusing upon the role of debt, Jensen presented us with a unduly pessimistic view of management, ignoring the possibility that managers will respond positively to the right kind of incentives.

MODEL AND HYPOTHESES

Figure 1 illustrates the model tested herein. Some of the relationships shown in Figure 1 have already been suggested in the literature (Easter- wood, Seth, & Singer, 1989; Jensen, 1986). A central assumption underlying this model and built on Jensen's arguments is that prior to being bought out, LBO firms are characterized by inefficiency and waste. Consequent- ly, there is considerable scope for improving their efficiency through proactive changes in strategy and structure. A body of empirical work indicating that LBO targets are characterized by higher cash flows, lower growth prospects, and greater inefficiencies than firms that remained pub-

1 Golden parachutes are severance contracts that handsomely compensate top-level man-

agers for the loss of their jobs in the event of a takeover.

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lic supports this assumption (Lehn & Poulsen, 1989; Maupin, 1987; Singh, 1990).

The model includes direct and indirect effects. One postulated indirect effect is that the change in governance structure that follows an LBO- as captured by the increase in management holdings and debt-will lead managers away from an emphasis on growth goals and toward efficiency goals. This change in emphasis leads to changes in the strategy and structure of the firm. Specifically, reduction in scope will occur as the firm di- vests itself of diversified activities and refocuses on its strategic core. The model also predicts increased decentralization and decreased hierarchical complexity as management pushes operating responsibility to lower levels in an attempt to increase profit accountability. These changes in

strategy and structure are all predicted to have a beneficial effect upon firm

performance. Since the model does not fully specify all mediating variables, we ex-

pected that significant effects would be left uncaptured by the variables addressed in this study. Thus, the model specifies a number of direct effects between (1) the changed governance structure and firm performance and (2) the change in goal emphasis and performance.

FIGURE 1 Impact of Strategy and Structure on Post-LBO Firm Perfomance

reased _ _ _ __------------------------------------------ I rphasis on lphasis on

1 emphasls on Growth Goals ---------------------------------------- J

L____-______-___-_-___-__-____----___-___-- ______-- __-- _--_-_

---- Direct Effects - (Hypothesized) Indirect Effects

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Increased Management Holdings

By definition, a leveraged buyout is associated with an increase in debt. An increase in management stockholdings is not, however, automatic, unless the buyout was undertaken by management. Nonetheless, researchers have argued that in most cases an increase in management stockholdings accompanies an LBO (Garvey, 1992; Kaplan, 1989; Singh, 1990). Most LBO sponsors, as principals in the relationship with managers and as major stockholders in the post-LBO firm, insist on top managers taking a significant equity stake in a firm. The logic is that managers' stock-

holdings align their interests with those of the principals (Fama, 1980). Consistent with this argument are Garvey's (1992) and Singh's (1990) findings that in most LBOs management stockholdings increase. This is an im-

portant point because it addresses a major criticism of free cash flow the-

ory-that an extreme debt load forces managers to make cuts that lead to short-term gain but cripple long-term efficiency (Jacobs, 1991). To the extent that the value of a firm's equity reflects its potential for creating long- term efficiency gains, an agency perspective suggests that managerial own-

ership of a leveraged firm's equity may help ensure that managers maintain a long-run focus. Thus,

Hypothesis 1: Following a leveraged buyout, the pro- portion of equity held by management will increase.

Impact of an LBO on Corporate Goals

A central assertion of agency theory is that the change in the governance structure of a firm that accompanies an LBO motivates managers to look for efficiencies. By change in governance structure, agency theorists mean increases in both debt and management stockholdings. Because of these increases, after an LBO the goals of top managers shift from those consistent with growth maximization toward those consistent with maximizing firm efficiency (Garvey, 1992; Jensen, 1986, 1988), as was noted.

The managerial hegemony and agency theory literature thus suggests that under a pre-LBO governance structure, managers will emphasize sales growth, market share, and the like (Aoki, 1984; Fama, 1980; Jensen & Meckling, 1976; Marris, 1964; Williamson, 1964). The implicit argument is that the main components of managerial utility are status, power, in- come, and job security, theorized to be a function of firm size. Firm size is in turn maximized by emphasizing growth in sales and market share, subject to the firm's achieving a satisfactory level of profit. Alternatively, if efficiency maximization has priority, managers can, at least in the context of an LBO, be expected to emphasize profitability, cash flow, and the like (Jensen, 1986, 1988; Tully, 1993). Thus, after a leveraged buyout,

Hypothesis 2: Increased debt will be associated with an increased emphasis on efficiency goals.

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Hypothesis 3: Increased debt will be associated with a decreased emphasis on growth and market share goals.

Hypothesis 4: Increased management stockholdings will be associated with an increased emphasis on efficiency goals.

Hypothesis 5: Increased management stockholdings will be associated with a decreased emphasis on growth and market share goals.

At this point, a counterargument should be recognized. Work on the Profit Impact of Market Strategies (PIMS) database seems to suggest a positive correlation between market share and firm performance (Buzzell & Gale, 1987). If that is the case, managers looking for efficiencies should not ignore market share goals but instead emphasize them. The issue, however, is not clear-cut. On the one hand, evidence supports the PIMS position (e.g., Mueller, 1985; Scherer, 1980). On the other hand, empirical work using refined statistical techniques has contradicted it: Rumelt and Wensley (1980), Jacobsen and Aaker (1985), and Jacobsen (1988) suggested that the market share effects found in PIMS studies are spurious and due to failure to control for unobservable factors. Once these are controlled for, market share effects disappear. Prescott, Kohli, and Venkatraman (1986) and Woo (1987) found similar results. Moreover, the work by Buzzell and Gale (1987), which was cross-sectional, begs the question of causality. Does an emphasis on efficiency give rise to market share, or does an emphasis on market share give rise to greater efficiency? We suspect that the former is more likely to be the case.

Impact of LBOs on Diversified Scope and Performance

At the heart of Jensen's (1986, 1988) argument is the hypothesis that, prior to their LBOs, many firms waste free cash flow by diversifying beyond the point optimal from an efficiency perspective (Hoskisson & Turk, 1990; Marris, 1964; Ravenscraft & Scherer, 1987). The changes in governance structure that accompany an LBO are argued to give managers an incentive to reevaluate diversification moves and to look for assets that might be sold off or closed down. This effect might arise for three reasons.

First, the renewed emphasis on efficiency that follows a buyout and the reduced emphasis on market share and growth goals should lead managers to question the value of diversification moves made in a prior period of empire building.

Hypothesis 6: After a leveraged buyout, increased emphasis on efficiency goals will be associated with a reduction in the diversified scope of a firm.

Hypothesis 7: Decreased emphasis on market share and

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growth goals will be associated with a reduction in the diversified scope of a firm after a leveraged buyout.

Second, the need to pay down the debt associated with an LBO may motivate managers to divest diversified assets in order to raise capital. In- deed, one of Jensen's main arguments is that the need to service high debt payments forces management to sell off assets acquired through empire building and to focus its attention upon improving the efficiency of the businesses that remain. Thus,

Hypothesis 8: An increase in debt after a leveraged buyout will be associated with a reduction in the diversified scope of a firm.

Third, to the extent that managers increase their stake in the equity of the firm after an LBO, they will be motivated to sell assets and pay down debt in order to shift the capital structure of the firm away from debt, thereby increasing the value of their equity holdings. Moreover, their increased stockholdings give managers a strong incentive to look for ways of increasing efficiency, since that will ultimately increase the value of their equity stakes. If a firm subsequently relists its stock on the equity markets, as often occurs after a number of years, managers can reap substantial gains from any increase in the value of the firm's equity achieved while it was leveraged. Thus,

Hypothesis 9: An increase in management holdings after a leveraged buyout will be associated with a reduction in the diversified scope of a firm.

If many leveraged firms previously engaged in unprofitable diversification, as Jensen (1986, 1988) suggested, the hypothesized disposal of non-value-adding diversified assets should improve performance. In addition, reduction in scope will reduce the information-processing demands on top management, thereby allowing them to devote more time to increasing the efficiency of the assets that remain (Hill & Hoskisson, 1987). Other things being equal, this too should improve the performance of the firm. Thus,

Hypothesis 10: After a leveraged buyout, a reduction in the diversified scope of a firm will be associated with an improvement in firm performance.

There is already a fair amount of evidence broadly consistent with Hy- potheses 6-10. Seth and Easterwood (1993) found that after management buyouts, firms did refocus their activities toward core sets of related businesses. This trend was particularly notable for the more extensively diversified unrelated firms in their sample. Similarly, Liebeskind and col- leagues (1992) found some evidence of post-LBO downsizing. Moreover, Hypothesis 10 is largely congruent with the thrust of empirical research on the diversification-performance relationship. In general, reviews of

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this large body of research have suggested a negative relationship between extensive diversification, particularly of the unrelated variety, and

performance (Hoskisson & Hitt, 1990; Ramanujam & Varadarajan, 1989). Thus, one might expect that reduced diversification will have a positive impact on firm performance. Indeed, Markides (1992) suggested that a strategy of reducing diversification enhances stockholder wealth. Similarly, in longitudinal work, Hill and Hansen (1991) found evidence that reduced diversification was positively associated with performance improvement.

Impact of an LBO on Structure and Performance

A strong, although underdeveloped, theme in Jensen's theory is the idea that after a leveraged buyout occurs, management undertakes changes in organizational structure that boost organizational efficiency. Underly- ing this theme is the belief that prior to LBOs, target firms are characterized by organizational waste and inefficiency (Fox & Marcus, 1992; Singh, 1990). Such waste might exhibit itself in a high number of employees, a large head office staff, and overly bureaucratic internal control systems. We argue that after an LBO managers will attempt (1) to achieve greater decentralization and (2) to reduce hierarchical complexity.

Increased decentralization. Decentralization, one way of releasing organizational efficiencies below the level of top management, can improve efficiency in a number of ways (Child, 1984; Hill & Pickering, 1986; Hu- ber, Miller, & Glick, 1990). First, it allows individuals who are close to operations and the market to make decisions. In so far as such individuals are better informed than managers further up in a hierarchy, the result should be more effective decision making, which in turn implies better use of resources and improved efficiency.

Second, decentralization has long been argued to have beneficial motivational effects. Giving lower-level managers and workers more responsibility increases their job satisfaction, improves their performance, and thus can be expected to improve the performance of a firm (Child, 1984). Third, decentralization can be viewed as a strategy for tightening control within an organization (Child, 1984; Williamson, 1975). Quasi-autonomous subunits, such as work groups, departments, and divisions can be controlled by monitoring their output and holding members accountable for

poor performance (Ouchi, 1980). Put another way, decentralization increases task visibility, which makes it more difficult for individuals to in- dulge in "free riding," shirking, or any form of on-the-job consumption and reduces the need for top managers to conduct costly extensive information searches and time-consuming audits (Alchian & Demsetz, 1972; Jones, 1984).

After an LBO, we postulate that decentralization will increase and will have a positive effect upon performance. Decentralization will increase for three reasons: First, the shift toward efficiency seeking that has already been argued to accompany an LBO can be expected to result in managers

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looking for ways to boost efficiency, and increasing decentralization pre- sents itself as one such option. Second, the increase in debt that accompanies an LBO also gives managers an incentive to look for ways of boosting efficiency. Any efficiency gains achieved through decentralization will improve performance and allow the firm to better service its debt payments. Third, the increase in management stockholdings that has been argued to accompany an LBO gives managers another strong incentive to look for ways of increasing efficiency. Thus, after a leveraged buyout,

Hypothesis 11: Increased emphasis on efficiency goals will be associated with increased decentralization.

Hypothesis 12: Decreased emphasis on growth goals will be associated with increased decentralization.

Hypothesis 13: Increased debt will be associated with increased decentralization.

Hypothesis 14: Increased management holdings will be associated with increased decentralization.

Hypothesis 15: Increased decentralization will be associated with an improvement in performance.

Implicit in the above hypotheses is the idea that prior to an LBO, most firms are too centralized. This idea is consistent with the spirit of Jensen's (1986, 1988) argument. However, in reality it may not always be the case: some LBO firms may already be very decentralized, particularly highly diversified firms. In such firms, there will be less scope for increasing decentralization and thus improving performance. To take these effects into account, we controlled for prior level of decentralization in hypothesis testing.

At the same time, we should note that there is evidence to suggest that not all large diversified firms are highly decentralized. Williamson (1975) wrote that many large, diversified firms are likely to be operating with a decentralized M-form structure, but Hill and Pickering (1986) and Hill (1988) noted considerable variation in the extent of decentralization within multidivisionals. Only 35.2 percent of the large, diverse firms in Hill's sample employed an M-form, and a further 21.4 percent were "centralized multidivisionals characterized by head office involvement in operating decisions" (1988: 72). Similarly, Williamson recognized the possibility that within some multidivisionals many operating decisions may be centralized and referred to such firms as "corrupted M-form" organizations (Williamson & Bhargava, 1972). Moreover, Hill, Hitt, and Hoskisson (1992) found a correlation of only .28 between the extent of unrelated diversification and the degree of decentralization in a sample of 184 large U.S. companies. This correlation suggests that the two variables shared only about 9 percent of their variance, implying considerable room for the existence of relatively centralized unrelated diversified firms. It follows that such "centralized multidivisionals" might encompass scope for further decen-

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tralization of operating decisions to quasi-autonomous operating units. If LBO targets are characterized by organizational waste and inefficiency, they may well have adopted the inefficient and overly centralized M- form structures identified by Hill and Williamson. For such firms, further decentralization would be in order.

Reduced hierarchical complexity. A related way of increasing organizational efficiencies below the level of top management is to reduce hierarchical complexity. If Jensen's (1986) arguments concerning organizational waste and inefficiencies within LBO targets are correct, we would expect this waste to exhibit itself in excessive organizational slack. Most important, there will be a tendency to add personnel and hierarchical layers, resulting in a higher "head count," a "taller" (Child, 1994) structure, and smaller spans of control than are optimal. The theoretical foundation for this argument can be found in Williamson's (1964) work, in which he suggested that, freed from profit pressures, managers tend to increase the size of the departments under their control. Similarly, Child (1984) gath- ered extensive empirical evidence suggesting that organizations have a nat- ural tendency to respond to the coordination problems created by growth by adding layers to their hierarchies. Child added that, unless held in check by external competitive forces, organizations tend to add more layers than necessary. Moreover, building on Worthy's (1950a, 1950b) semi- nal work, organization theorists have argued that hierarchies that are taller than necessary can be a major source of bureaucratic inefficiency (e.g., Child, 1984; Hage, 1980; Scott, 1987). Hierarchical complexity can give rise to a bureaucracy that is resistant to change, lacking in accountability, slow to respond to market demands, and capable of deliberately or accidentally stifling communication (Child, 1984).

A shift to a flatter organization might bring a number of efficiency gains. First shorter lines of communication and the removal of "gate- keepers" between lower and upper levels in a hierarchy should enhance the capacity, quality, and speed of information flows (Baker & Wruck, 1989; Easterwood et al., 1989; Sage, 1981). Improvement in the capacity of information channels should lead to more comprehensive decision making, and improvement in the quality of information should lead to better decisions. An improvement in the speed of information flows should increase flexibility and speed response to market demands. More effective decision making and greater flexibility both imply better utilization of resources.

Second, the shift to a flatter organization should result in a reduction in the number of an organization's middle managers. Given that large middle manager cadres are expensive to maintain, such reduction, so long as effective operations are not compromised, will increase efficiency. Third, a shift to a flatter organization can reinforce a policy of decentralization. Doing away with middle management layers forces increased accountability. For all of the reasons mentioned earlier, with regard to decentralization, this can be expected to increase efficiency.

As with decentralization, hierarchical complexity is likely to de-

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crease for three reasons following an LBO. First, reduced complexity will present itself as a way to meet a newly important efficiency goal. Second, the increase in debt that accompanies an LBO gives managers an additional incentive to look for ways of boosting efficiency. Third, increase in management stockholdings increases the incentive to look for ways of in-

creasing efficiency. Thus, after a leveraged buyout

Hypothesis 16: Increased emphasis on efficiency goals will be associated with decreased hierarchical complexity.

Hypothesis 17: Decreased emphasis on growth goals will be associated with decreased hierarchical complexity.

Hypothesis 18: Increased debt will be associated with decreased hierarchical complexity.

Hypothesis 19: Increased management holdings will be associated with decreased hierarchical complexity.

Hypothesis 20: A reduction in hierarchical complexity will be associated with an improvement in performance.

Some Counterarguments

Before moving on, we present arguments that suggest relationships op- posite to those given in the above hypotheses. We have argued that the change in governance structure that follows an LBO, together with the resulting change in goal emphasis, motivates managers to look for efficiencies. An alternative argument is that the financial strains caused by an LBO force managers to focus on short-term efficiency and to slash investments that are necessary for long-term efficiency (Reich, 1989). If that is the case, we might expect an LBO to eventually lead to a decline in firm performance.

In one of the most comprehensive tests of this argument, Long and Ravenscraft (1993a) looked at the impact of LBOs on R&D spending, wide- ly viewed as an index of a firm's commitment to the long term (e.g., Hoskisson & Hitt, 1988). Long and Ravenscraft found that firms' R&D intensity declined by an average 40 percent after buyouts, which would seem to support the short-term argument. Also, Long and Ravenscraft (1993b) found that LBOs were associated with a decline in long-term profitability, a result that again supports the short-term view.

Another counterargument concerns the financial and strategic control thesis of Hoskisson, Hitt, and their associates (Hitt, Hoskisson, & Ireland, 1990; Hoskisson & Hitt, 1988; Hoskisson & Turk, 1990), who have argued that large diversified firms overemphasize financial criteria, neglecting strategic criteria, when controlling their divisions. The emphasis on financial criteria is argued to encourage dysfunctional behavior at the di-

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visional level, such as short-term profit maximization and risk aversion. According to this reasoning, a reduction in diversification is likely to result in less reliance on financial criteria and a greater utilization of strategic criteria. In contrast, our arguments suggest that the reduction in diversification following an LBO leads to an increased emphasis upon financial criteria, which we refer to as efficiency goals.

In our view, these two apparently contradictory arguments can be rec- onciled. A solution lies in recognizing that LBO targets, although often large and diversified, are also inefficient. Following Jensen's thesis and a growing body of empirical evidence (e.g., Lehn & Poulsen, 1989; Maupin, 1987; Singh, 1990), we argue that LBO targets are bloated and inefficient organizations that have been suffering from considerable organizational slack and a lack of attention to profitability, primarily because they have been able to live off of their substantial free cash flow. If one accepts the agency theory line of reasoning, for LBO firms the problem is not that financial controls are too tight, but that they are not tight enough. Such cases therefore call for increased emphasis on financial controls. This situation differs from that found in the average extensively diversified firm, where, as Hoskisson and Hitt (1988) argued, financial controls may well be too tight.

METHODS

The models used to test the above hypotheses compared the situation in a firm one year prior to its leveraged buyout to that existing one year after the LBO, we thus observed three-year periods. In model 1, we regressed the change in the goals of a firm against the change in its level of debt and management holdings. This model was used to test Hypotheses 2 to 5. Model 2, in which we regressed the change in an organizational characteristic (a measure of strategy or structure) against the change in the level of debt, management holdings, and goals, was used to test Hy- potheses 6 through 9, 11 through 14, and 16 through 19. Model 3, which regressed the change in performance against the change in debt and management holdings, the change in goals, and the changes in strategy and structure, was used to test Hypotheses 10, 15, and 20. Hypothesis 1 was tested by a t-test.

In addition, using a path analytic approach, we assessed the relative

importance of debt and management holdings in leading to improvement in efficiency. In an attempt to explore the longer-run effects of LBO on firm

performance, we examined the impact of the independent variables upon a change in performance over two longer time periods, one extending from one year prior to the LBO to three years after it and the other from one year prior to five years after. However, we were only able to undertake this longer-term analysis for the subset of firms that continued to trade a minority of their stock or bonds on a public exchange after their buyouts or that returned to the public domain several years later.

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Data Sources

Detailed publicly available data pertaining to the performance and strategy of LBO targets is not always available because most LBOs result in firms going 100 percent private. Moreover, detailed information relat- ing to internal organizational dimensions, such as decentralization and hierarchical complexity, cannot be gleaned from public databases. Thus, a

questionnaire survey presented itself as the only feasible way of collect- ing detailed data for a large enough sample of LBO firms to undertake statistical hypothesis testing.

Survey construction. The construction of the survey was guided by theoretical considerations. The wording of questions was partly shaped by interviews and survey pretests with the CEOs of a number of LBO firms and with the general partners of a number of LBO-sponsoring companies. We interviewed senior executives from the following: Kohlberg, Kravis & Roberts, Clayton & Dubilier, Wasserstein Perella, Forstmann Little, Gold- man Sachs, CS First Boston, The Marley Co., Maybelline, BW/IP Interna- tional, and Collins & Aikman. Additional private data (internal memos, financial statements, and strategic plans) were also obtained from Levi Strauss, Safeway, and GAF Corp. We also conducted pretests of the survey with organizational scholars. The final survey was sent out in mid 1991.

Survey population and response bias. We obtained the survey population from the Mergers and Aquisitions Database supplied by MLR Pub- lishing to Automatic Database Processing Inc. data services. The database defined an LBO as a merger deal of which 80 percent or more of the total value was debt-financed. The survey population consisted of 450 LBOs completed between 1986 and 1989, inclusive. We excluded banks, savings and loans associations, insurance companies, investment houses, and real estate firms because their financial statements were incompatible with those of the manufacturing and service firms that formed the majority of LBO targets for this period. The surveys were sent to CEOs and chief financial officers (CFOs) of the firms. We received responses from 214 firms, representing 47.6 percent of the survey population. Standard In- dustrial Classification (SIC) codes put 57 percent of these in manufacturing, 20 percent in wholesale and retail trade, 16 percent in services, and 7 percent in other industries. Some COMPUSTAT data were available for 66 firms, either because a minority of their stock or bonds had continued to be traded upon the open market, or because they had returned to the public domain after a few years as private firms. Multiple responses were received from 17 firms whose CEO and CFO responded separately. We were able to obtain public data for 107 nonrespondent firms and used the stringent Kolmogorow-Smirnov two-sample test to determine if systematic differences existed between respondent and nonrespondent companies along key firm characteristics (Siegel & Castellan, 1988). The results of the tests for nonresponse and data source bias, which are summarized in

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Table 1, suggested that there were no significant differences in the distributions of the respondent and nonrespondent groups.

Data reliability. Incomplete recall may seriously confound the results of surveys based upon the recall of past events (Golden, 1992). In our sample, over 86 percent of the respondents held top management posts in the pre-LBO firms, positions that at least ensured that they had full access to the pertinent data. As a check on accuracy, we compared the answers of the two respondents for the 17 firms in which two people independently filled out the questionnaire. As two individuals would not be likely to have the same type of faulty recall, good results for interrater reliability would increase confidence in the accuracy of the survey responses. As we could think of no systematic ex ante reason why these 17 companies would dif- fer from the others, we expected the results of this test to be generalizable to the rest of the sample.

To test for interrater reliability, we used kappa (k), the most common measure of interrater agreement (Fleiss, 1981: 213-237). An adjusted correlation coefficient that should be interpreted as a correlation coefficient, kappa was chosen because it corrects for the chance correlation between raters and measures ratings based on categorical scales. We calculated kappas for scales composed of individual items in our surveys, rather than for the items themselves as we had only 17 firms to work with. The construction of the scales themselves is discussed later in this section.

As can be seen, in Table 2, the kappas range from a high of 1.0, which

TABLE 1 Results of Test for Distribution Differences Between Respondents

and Nonrespondentsa

Variables Median s.d. Range Skewness Dmnb Salesc

Respondents 261.1 624.90 246.7 1.56

Nonrespondents 298.7 2,334.20 13,680.3 3.65 0.69

Employees Respondents 268 6,817 2,903 1.78

Nonrespondents 289 2,260 15,291 3.88 0.66

Productivity Respondents 3.6 18.50 167.6 1.91

Nonrespondents 3.0 48.50 576.9 -6.66 0.70 ROI

Respondents 4.5 8.90 56.6 -2.21

Nonrespondents 5.3 32.64 330.8 2.14 0.82

a For respondents, N = 214; for nonrespondents, N = 104. b All Dm,n statistics were nonsignificant, suggesting strongly that the two groups were

drawn from the same distribution, indicating no nonresponse bias. D is the maximum devi- ation of the frequency distributions of two samples, m and n. The statistic tests the statistical significance of the differences between these distributions to determine if they were drawn from the same population.

c In millions of dollars.

1995 717


TABLE 2 Interrater Agreement for Multiple Respondent Firmsa

Factors Numerator Denominator k

Strategic scope 0.39 0.51 0.77

Hierarchy 0.44 0.50 0.88

Operational decentralization 0.35 0.46 0.76

Strategic decentralization 0.38 0.50 0.76 Growth goals 0.44 0.50 0.88

Efficiency goals 0.36 0.36 1.00 Overall k 2.36 2.83 0.83

a N = 17. Testing the hypothesis that k = 0.83 is not statistically significantly different from k = 1 (k is normally distributed), we found at k = 1 that z = 0.776 (p < .75) with a 90

percent confidence interval of 0.62 < k < 1.00 [k (-1,1)]. This result is higher than the lower limit Landis and Koch (1977) set for excellent agreement beyond chance. k = 2(ad - bc) -*

numerator/plql + p2q2 ~- denominator, where a,b,c,d are the proportions of joint ratings and

P1, P2, q1, and q2 are the proportions of chance expected joint ratings, with k as the sum of the individual k numerators divided by the sum of the individual k denominators.

signifies perfect agreement between raters, to a low of 0.76. The overall

kappa was .83. According to Landis and Koch (1977), a kappa of greater than 0.80 indicates a level of agreement beyond chance. We tested but re-

jected the hypothesis that the overall kappa of 0.83 significantly differed from 1.0.

For the quantitative questions, we determined the validity of our sur-

vey data by comparing the information provided by respondents to the same information on the COMPUSTAT tapes, when it was available. Table 3 gives the bivariate correlation coefficients calculated for such data. As can be seen, correlations between survey and COMPUSTAT data ranged from a high of .89 to a low of .64. We calculated overall reliability coefficient (Nunnally, 1978: 209-212) to determine the accuracy of the two sets of data, obtaining a high overall reliability coefficient of 0.981, which leads us to conclude that there was a high degree of accuracy.

Measures

The data to calculate most measures were taken from the survey. Da- ta for performance measures came from the survey or, in the case of the

longer-term performance measures, from COMPUSTAT. With the exception of the items on changes in debt, management holdings, diversification, and

performance, all of the measures were based upon scales that we constructed from multi-item questions following Cacciopo and Petty's (1982) model for construct development. The value used to represent each scale was the mean score for all items it included. The Appendix gives the multi-item questions from which the scales were constructed. Examples are as follows: To assess decentralization, we asked respondents about pre- and

post-LBO approval of such matters as major investments and marketing

718 June

TABLE 3 Results of Reliability Analysis for Sources of Quantitative Dataa

COMPUSTATb

Respondents 1 2 3 4 5 6 7 8 9 10 11 12

1. Size pre-LBO .89 2. Size post-LBO .82 3. EBIT pre-LBOG .87 4. EBIT post-LBOc .82 5. Sales pre-LBO .88 6. Sales post-LBO .86 7. Labor pre-LBO .79 8. Labor post-LBO .75 9. Debt pre-LBO .84

10. Debt post-LBO .84 11. Capital pre-LBO .72 12. Capital post-LBO .64

a The overall reliability coefficient for the quantitative data responses is rkk = 0.981, with rkk given by the general form of the Spearman- Brown Phophecy formula (Nunnally, 1978):

rkk + (k- 1)] j

where k is the number of items and ri is the average of the correlations on the diagonal in the matrix. Numbers in cells are bivariate Pearson correlations. Off-diagonal items are excluded since this is only a subset. Full correlations are in Table 7. There were 66 firms with available one year pre- and post-LBO COMPUSTAT data.

b All correlations are significant at p < .001. c EBIT = earnings before interest and tax.


strategy decisions. To assess hierarchical complexity, we asked about change in, for instance, the number of corporate human resources managers and the firm's size relative to its competitors'.

The multi-item questions were designed to elicit specific response patterns. Factor analysis was applied to each multi-item question to confirm that the actual response patterns were in accordance with expectations. Items that loaded on more than one factor or that loaded lower than 0.50 were excluded from the construction of scales to remove ambiguity. Over- all, the factors had eigenvalues greater than 1.0, and visual inspection of the individual scale scree plots confirmed the loadings were appropriate. All scale coefficient alphas were .70 or greater (Tables 4, 5, and 6). Final- ly, we generated normal probability plots and histograms that confirmed that the variables were distributed normally.

Change in debt. The change in debt was measured as the difference between the total debt-to-equity ratio of a firm one year after its LBO and one year prior to it. Previous research on leverage has focused on long-term debt. In the case of LBOs, such a focus may be misleading because a portion of the debt structure may consist of very short-term (3-6 month) bridge loans. In many instances, the strategic decisions regarding downsizing may be driven by these loans as much as by long-term debt obliga- tions. Thus, we used total debt to reflect these facts. It is also important to note that although all LBOs involve an increase in debt-to-equity ratio, the magnitude of the increase does vary significantly from case to case.

Change in management holdings. The change in management stockholdings was measured as the difference between the ratio of the value of management-owned shares or share equivalents (sometimes referred to as "shadow stock") to total capitalization (total debt plus total equity) one year after and one year prior to an LBO. We used total capitalization rather than total equity since a majority of equity is swapped for debt in a leveraged buyout. Not all firms withdraw 100 percent of their equity, however, so any residual must be included to account for the total value of a firm at the time of a buyout. We decided to use this measure instead of total market value (although the latter conceptualization of firm value is richer) because error in estimating the correct discount rate will com- pound any unreliability inherent in the estimation of book value at the time of the buyout. (Some observers have argued that such estimations are in- flated in any case since it is in the interests of the target to overestimate its value.) The data were obtained from respondent reports of the per- centages one year before and one year after the LBO.

Change in performance. Change in performance was measured by the difference between the labor productivity of a firm one year after and one year prior to its LBO. We used a productivity measure to capture performance primarily because changes in productivity are likely to show up sooner than changes in profitability. Labor productivity was measured by earnings before interest and tax (EBIT) over total labor costs. We used labor costs rather than number of employees as the denominator in order to

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account for variations among firms' salary structures (Clark, 1984; Grilich- es, 1986; Hill & Snell, 1989). To account for effects not captured by productivity changes, we also measured the change in return on sales (ROS), defined as EBIT/total sales. ROS was used rather than ROI or ROE since equity is typically reduced drastically in an LBO firm.

The long-run change in performance was also measured using productivity and ROS data. We looked at the difference between the performance of a firm one year prior to its LBO, and three and five years after, thus covering four- and six-year periods. We entered these measures in sep- arate regression equations to test for the persistence of short-term performance improvements. The data were extracted from COMPUSTAT for the firms remaining in the public domain; data on 58 firms were available for the three-year measure, and data for 33 firms were available for the five- year measure.

Change in goals. Two scales measured the goals of a firm (see Table 4). The first scale contained two items, sales growth and market share. The higher the score on this scale, the greater the importance of these criteria as goals. We refer to this scale as measuring growth goals. The second scale, which contained three items-profitability, profit growth, and cash flow- measured efficiency goals. The survey data allowed us to calculate a value for each scale for one year prior to an LBO and one year after it. The change in emphasis on different goals was then calculated by subtracting the one-year-prior score from the one-year-after score. Thus, for example, a high, positive result on efficiency goals would tell us that efficiency goals became more important to a firm after its LBO.

Change in diversified scope. We measured the change in the diversified scope of a firm using a Herfindahl index of diversification, defined as

(1 - jS )t-1 (1 -X Sj)t+l

Diversification/= (1 -- ES)2t_l (1 - EjSj)2t+l'

where t is the year of firm i's LBO and Sj is the share of firm i's total sales from the jth four-digit SIC industry group. The data required to calculate this measure were from the survey. We then measured change in diversified scope as the absolute change in the value of the Herfindahl index between t - 1 and t + 1.

Change in hierarchical complexity. This scale contained seven items: the number of hierarchical levels in a firm, the average number of managerial levels in operating companies, the number of departments in the executive office, the number of levels in the corporate personnel department, the number of employees in the corporate personnel department, the number of staff employees, and the number of departments. A negative score indicated a decrease in hierarchical complexity (see Table 5).

Change in decentralization. We constructed two scales to measure the extent of decentralization within a firm (see Table 6). One scale, measur-

1995 721


TABLE 4 Results of Confirmatory Factor Analysis for Change in Goalsa

Pre-LBO Post-LBO

Items Efficiency Growth Efficiency Growth

Profitability .832 .145 .837 .040 Profit growth .797 .308 .805 .094 Cash flow .685 -.097 .691 -.054 Market share .093 .814 .057 .823 Sales growth .076 .802 -.013 .810

Alpha .764 .765 .785 .764

Eigenvalue 2.17 1.21 1.90 1.32

a Boldface indicates items that loaded on factors.

ing the extent to which operating decisions were decentralized, contained seven items: advertising decisions, marketing strategy, production decisions, pricing decisions, buying decisions, product mix decisions, and business unit strategy. The second scale, strategic decentralization, measuring the extent to which strategic decisions were decentralized, contained four items: strategic decisions, acquisition strategy, capital investment decisions, and decisions regarding financial goals. Changes in decentralization were calculated in the same way as the change in goals, with higher values indicating higher decentralization.

It may seem unlikely that corporate strategy decisions will be decentralized to operating divisions after an LBO because such decisions are the preserve of a firm's corporate head office. The effectiveness of such decisions may, however, be enhanced by involving lower-level managers who can better interpret opportunities and threats that are salient to corporate strategic decisions because of their day-to-day interaction with the envi- ronment. The strategic decentralization scale used here captures the extent to which corporate decisions are shared with lower-level managers after an LBO; the argument here is that after an LBO, there is a shift toward

TABLE 5 Results of Confirmatory Factor Analysis for Change in

Hierarchical Complexity

Items Hierarchy

Levels in HRM department .868

Corporate HRM personnel .851 Levels in whole firm .705

Departments in executive office .632

Departments in whole firm .678 Staff employees .557 Levels of unit management .543

Alpha .873

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more participative decision making with regard to acquisitions, capital investments, and the like.

Control Variables

First, we controlled for the levels of decentralization, hierarchical complexity, and diversification that existed in a firm prior to its LBO. Con- trolling for decentralization and diversification was relatively straightfor- ward because the survey instrument collected relevant information, but controlling for hierarchical complexity was more problematic because the survey simply asked respondents to indicate the change in hierarchical complexity that accompanied the LBO and did not solicit data that enabled us to measure the absolute level of hierarchical complexity one year pri- or to an LBO (see the Appendix). To get around this limitation, we used pre-LBO size as a proxy for degree of hierarchical complexity.

The industrial organization literature suggests that the attractiveness of the industry in which a firm competes often dictates its performance (Porter, 1980). We allowed for industry effects by measuring the change in four- and eight-firm industry concentration at the four-digit SIC level and including it as a control variable in our analyses. Similarly, we also used changes in the profitability and productivity of a firm's primary four-digit industry to control for the effect of systematic industry-wide influences on firm performance; the data came from the COMPUSTAT Business Seg- ments Database. We also controlled for change in firm size, measured as number of employees.

TABLE 6 Results of Confirmatory Factor Analysis for

Change in Decentralizationa

Pre-LBO Post-LBO

Items Operating Strategic Operating Strategic

Advertising decisions .816 .289 .871 -.018

Marketing strategy .815 .204 .799 .120 Production decisions .813 -.145 .778 .207

Pricing decisions .801 .131 .750 .266

Buying decisions .773 .280 .728 .287 Product mix decisions .718 -.270 .722 .286 Business unit strategy .661 .276 .588 -.223 Overall firm strategy .259 .791 .089 .824

Acquisition strategy .154 .766 .182 .752

Major investment .019 .764 .075 .875 decisions

Major financial objectives .374 .672 .218 .764

Alpha .931 .788 .924 .797

Eigenvalue 6.48 2.15 5.98 2.56

a Boldface indicates items that loaded on factors.

1995 723


RESULTS

Table 7 reports correlations and summary statistics. Hypothesis 1 was tested by a t-test. We found that, on the average,

mean management stockholdings increased from 14.2 to 35.7 percent after an LBO. The t-statistic for the difference between means was 6.61, indicating support for Hypothesis 1 (p < .000). This association is not a triv- ial finding because it demonstrates owners' cognizance of the agency problem and an a priori attempt to address it. Previous studies that ignore this aspect of the post-LBO situation may have missed an important ex-

planatory variable. Table 8 reports results of the tests of Hypotheses 2 and 5. We regressed

the changes in debt and management stockholding against the changes in

emphasis on efficiency and growth goals. Consistent with Hypothesis 2, increased debt was associated with increased emphasis on efficiency goals (p < .01). We found no evidence that increased debt was associated with a decreased emphasis on growth goals, so Hypothesis 3 is not supported. However, consistent with Hypotheses 4 and 5, increased management stockholdings were associated with an increased emphasis upon efficiency goals (p < .01) and a decreased emphasis upon growth goals (p < .01). Thus, the results suggest that a change in strategic goal emphasis does take place after an LBO.

Table 9 reports the results of tests of Hypotheses 6 through 9, 11 through 14, and 16 through 19, in which we controlled for pre-LBO di- versity, scope, and size. Hypotheses 6 through 9 deal with the impact of changes in debt, management holdings, and goals on diversified scope. Consistent with Hypothesis 6, an increased emphasis on efficiency goals was weakly associated with a reduction in scope (p < .10). We did not find any evidence that a decreased emphasis on growth goals was associated with a decrease in diversified scope, so Hypothesis 7 is not supported. Nor was there any evidence that increased debt was associated with a reduction in scope, so Hypothesis 8 is not supported. However, consistent with Hypothesis 9, there was evidence that increases in management stockholdings were associated with a reduction in diversified scope (p < .01).

Hypotheses 11 through 14 deal with the impact on decentralization of changes in debt, management holdings, and goals. Consistent with Hy- pothesis 11, an increased emphasis upon efficiency goals was associated with increased decentralization. This result held when decentralization was measured by operating decentralization (p < .01) but not when it was measured by strategic decentralization. Consistent with Hypothesis 12, a decreased emphasis on growth goals was associated with increased decentralization, although this result only held for strategic decentralization (p < .05). Increased debt was weakly associated with increased operating decentralization (p < .10), so Hypothesis 13 received some support. As Hy- pothesis 14 predicts, increased management holdings were associated with both increased operating (p < .05) and strategic decentralization (p < .01).

June 724

1- co

TABLE 7 Correlations and Summary Statisticsa

Mean 3-Year

Variables Change s.d. 1 2 3

1. Management holdings 21.50% 40.00

2. Debt 6.44 14.21 .13* 3. Efficiency

goals 0.67 0.91 .30*** .29*** 4. Growth goals -0.17 1.09 .35*** .15* -.14* 5. Operating

decentralization 0.28 0.78 .33*** .04 .43*

6. Strategic decentralization 0.21 0.95 .21** .06 .14*

7. Diversified

scope -0.15 1.56 .16* .02 .28* 8. Hierarchial

complexity -4.33 0.70 .12 .12 .14* 9. 4-firm concen-

trationb -1.96 9.68 .12 .04 .17* 10. 8-firm concen-

trationb 4.38 6.59 .43***-.03 .18* 11. Industry

profitabilityb 0.12 0.60 .01 .06 -.11 12. Industry

productivityb 0.22 0.39 .12 -.01 .23*

4 5 6 7 8 9 10 11 12 13 14 15

**.06

.12 .38***

* .18* .42*** .25**

.31***-.03 -.04 .09

-.05 .21** .04 .19* .15*

-.07 .02 -.05 .03 -.05 .08

-.07 -.18* .13* .03 .09 .15* .42***

*-.14* -.09 -.23** .10 -.14* .16* .23** .31***

TABLE 7 (continued)

Mean 3-Year

Variables Change s.d. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

13. Firm size -0.27 8.19 -.08 .05 .09 .01 .13* .03 .12 -.03 .01 .00 .21** .05 14. Profitability 0.25 0.42 .32*** .51*** .27***-.38*** .17* .45***-.35***-.25** .09 .10 .07 .08 -.03 15. Productivity 0.69 0.59 .47*** .41*** .17* -.38*** .13* .30***-.19* -.10 .13* .07 .13* .17* -.04 .80*** 16. Pre-LBO size 3,057 656 -.02 .14* -.03 .24***-.09 -.03 -.03 .16* .07 -.06 -.19* -.02 -.17* .01 -.17*

17. Pre-LBOscope 0.32 0.67 .09 -.11 -.01 .04 -.25**-.23** -.64*** .10 -.06 .03 -.09 -.11 -.21**-.27** .23**

18. Pre-LBO operating decentralization

19. Pre-LBO stra-

tegic decentralization

20. Profitability, 3 year

21. Productivity, 3 year

22. Profitability, 5 year

23. Productivity, 5 year

0.21 0.92 -.04 .05 .03 .15* -.19**-.17* .15* .30*** .03 .11 -.12 -.12 .06 .02 .26**

C)

n 0 M-,

0

Cb

n 0

0 0 m

t

'k3

0.18 0.88 .07 -.05 -.12 -.10 -.23**-.58***-.11 -.03 .01 .02 .10 .12 -.17* .31*** .11

0.63 0.92 .03 .02 .38***-.20* .09 .12 .05 .01 .31*** .28* .02 .18* -.24**

0.73 4.88 .24* .02 .03 .01 -.06 .00 .00 -.08 .07 -.03 .04 .62*** -.08

2.56 2.32 .28***-.04 .01 -.09 .02 .01 -.03 .03 .24** .32*** .09 .08 .24'

9.16 0.37 .09 -.00 .34***-.24** -.05 .46***-.09 -.18* .20** .22** .10 .13 -.07

a N 214. b The appropriate 3- and 5-year values are used for the correlations between these variables and the long-term performance variables.

*p < .05

**p < .01

***p < .001 '-

CD

Phan and Hill

TABLE 8 Results of Regression Analysis for Goals

Change in Emphasis Change in Emphasis on Efficiency Goals on Growth Goals

Independent Variables t t , t

Change in debt 0.324 3.72** -0.072 0.81

Change in management holdings 0.366 4.06** -0.381 4.86** F 13.66*** 9.81***

Adjusted R2 0.211 0.162 N 214 214

**p < .01 ***p < .001

Hypotheses 16 through 19 deal with the impact on hierarchical complexity of changes in debt, management holdings, and goals. We found no evidence that an increased emphasis on efficiency goals was associated with reduced hierarchical complexity, so Hypothesis 16 was not supported. Decreased emphasis on growth goals was associated with reduced hierarchical complexity (p < .001), so Hypothesis 17 was supported. How- ever, changes in the levels of debt and management holdings were not related to change in hierarchical complexity, so Hypothesis 18 and 19 were not supported.

Table 10 reports results of the tests for the performance hypotheses (Hypotheses 10, 15, and 20). We found some support for Hypothesis 10, which predicts that a reduction in diversified scope will be associated with

performance improvement when the dependent variable was change in

profitability (p < .01) but found no support when it was the change in productivity. Support for Hypothesis 10 must be tempered by this fact. There was support for Hypothesis 15, which predicts that increased decentralization will be associated with improved firm performance. When decentralization was measured by strategic decentralization, Hypothesis 15 was confirmed when the dependent variable was the change in productivity (p < .01) or the change in profitability (p < .05). This result also held when decentralization was measured by operating decentralization and the de-

pendent variable was the change in productivity (p < .10). However, it did not hold when decentralization was measured by operating decentralization and the dependent variable was the change in profitability. There was

support for Hypothesis 20, with reduction in hierarchical complexity associated with performance improvement for both change in productivity (p < .01) and profitability (p < .05).

In our model (Figure 1), increased debt and management holdings have both direct and indirect impacts upon firm performance. Given the current findings and the secondary role accorded to managerial ownership in previous LBO studies, we considered it important to explore the relative strengths of these effects. We did so by means of a path analysis; fol-

1995 727

TABLE 9 Results of Regression Analysis for Structure and Strategy

Change in Change in Change in Operating Change in Strategic Diversified Scope Hierarchical Complexity Decentralization Decentralization

Independent Variables P t t 3 t P t

Pre-LBO scope 0.247 3.19** Pre-LBO size 0.177 2.33* Pre-LBO operating

decentralization -0.164 2.14* Pre-LBO strategic

decentralization -0.563 8.89*** Change in debt 0.025 0.32 -0.093 1.26 0.144 1.83t -0.047 0.75 Change in management holdings -0.187 2.42** -0.051 0.70 0.176 2.28* 0.202 3.21** Change in efficiency goals -0.130 1.67t -0.031 0.42 0.218 2.73** -0.027 0.43 Change in growth goals 0.018 0.28 0.310 4.07*** -0.004 0.05 -0.124 1.93* Adjusted R2 0.090 0.133 0.250 0.375 F 4.07*** 5.96*** 11.50*** 20.42*** N 214 214 214 214

tp < .10

*p < .05 **p < .01

***p < .001

00 03

a

C')

CD

0

a a

Z-

a

a

a p a)

Phan and Hill

TABLE 10 Results Regression Analysis for Performance

Change in Productivity Change in Profitability Independent Variables , t p t

Pre-LBO size 0.302 2.68** 0.099 0.75 Pre-LBO diversified scope -0.119 1.04 -0.102 0.71 Pre-LBO operating decentralization -0.211 1.60 -0.019 0.13 Pre-LBO strategic decentralization -0.101 0.89 -0.094 0.73

Change in size -0.238 2.07* -0.045 0.38

Change in 4-firm concentration ratio 0.463 3.33** 0.011 0.10

Change in 8-firm concentration ratio 0.751 4.28*** 0.035 0.25

Change in industry profitability 0.028 0.20

Change in industry productivity 0.193 1.52

Change in debt 0.245 2.38* 0.083 0.71

Change in management holdings 0.566 5.31*** 0.045 0.35

Change in efficiency goals 0.095 0.91 0.239 1.92*

Change in growth goals -0.113 0.97 -0.373 3.07**

Change in operating decentralization 0.186 1.70t 0.149 1.07

Change in strategic decentralization 0.343 2.95 ** 0.262 1.92*

Change in hierarchical complexity -0.352 2.71** -0.267 2.09*

Change in diversified scope -0.042 0.40 -0.343 2.27**

Adjusted R2 0.448 0.322 F 4.75*** 2.84** N 214 214

tp < .10

*p < .05

**p < .01

***p < .001

lowing the theory-trimming approach (James, Mulaik, & Brett, 1982), we assumed coefficients not significant at the 5 percent level or better to be equal to zero and excluded them from the final estimation of path coefficients. We then decomposed the variance in firm performance brought about by a change in debt and management holdings into direct and indirect effects. The results of this exercise, summarized in Table 11, show that when both direct and indirect effects are considered, management holdings have a larger impact than debt upon change in performance. The change in management holdings accounts for 69.5 percent of the explained variance in productivity and 74.3 percent of the explained variance in profitability, with the change in debt accounting for the remainder. This result suggests that, on the average, increase in management holdings, rather than increase in debt, has the more important impact upon the goals, strategy, structure, and performance of an LBO firm.

Finally, to assess longer-term effects, we recomputed the regression analyses reported in Table 10 using performance data for three and five

1995 729


TABLE 11 Summary Decomposition Table

Direct Indirect Total Bivariate Relationships Effect Effect Effect

Management holdings and productivity .566 .366(.281)(.343) + (-.381)(.31) .728 (-.352) + (-.381)(-.124) (.343) + (.202)(.343)

Management holdings and profitability 0 .366(.239) + (.366)(.218)(.262) .428 + (.366)(-.13)(-.343) + (.202) (.262) + (-.187)(-.343) + (-.381) (-.124)(.262) + (-.381)(.31) (-.267) + (-.381)(-.373)

Debt and productivity .245 .324(.218)(.343) + (.144)(.343) .319 Debt and profitability 0 .324(.239) + (.324)(.218)(.262) + .148

(.324)(-.13)(-.343) + (.144)(.262)

years after the LBOs. As was noted, these data were only available for small subsamples, whose beta weights may be unstable. However, the results derived from this exercise are still instructive.

Results, reported in Table 12, are less supportive of the performance hypotheses than the results reported in Table 10. We did not find evidence in support of Hypotheses 10 and 20, but we did find some limited evidence in support of Hypothesis 15: an increase in strategic decentralization was associated with an improvement in productivity five years after an LBO (p < .01). Although the variance explained by all four models was high, a comparison of the size of the betas reveals that the control variables (industry concentration, industry performance, and firm size) account for much of the variance.

DISCUSSION AND CONCLUSIONS

In sum, 14 of the 20 hypotheses received some support. Figure 2 summarizes results, which suggest the following: First, in addition to an increase in debt, LBOs are associated with an increase in management holdings. Second, the change in governance structure that occurs with an LBO does affect firm goals, strategy, and structure. Efficiency receives more emphasis, and growth less emphasis; diversified scope and hierarchical complexity diminish, and decentralization increases. Third, as hypothesized, these changes in goals, strategy, and structure foster greater efficiency, as demonstrated by increases in productivity and profitability. Fourth, management holdings seem to have a greater impact upon goals, strategy, and structure than debt.

On the basis of these results, we cannot reject either the free cash flow or agency theory assertions that leveraged buyouts lead to an increase in enterprise efficiency. This conclusion is consistent with event study evidence (DeAngelo et al., 1984; Madden et al., 1990) and with other ex post studies of LBO performance (Kaplan, 1989; Liebeskind et al., 1992; Ravens-

730 June

TABLE 12

Impact of Strategic and Structural Variables on Post-LBO Firm Three- and-Five Year Performancea

Change in Productivity Change in Profitability Independent Variables 3 Years After LBO 5 Years After LBO 3 Years After LBO 5 Years After LBO

Pre-LBO size 0.003 (0.03) 0.011 (0.09) 0.106 (0.87) 0.020 (0.14) Pre-LBO diversified scope -0.106 (0.94) -0.055 (0.44) -0.027 (0.21) -0.039 (0.35) Pre-LBO operating decentralization -0.728 (0.64) -0.023 (0.18) -0.038 (0.29) -0.002 (0.01) Pre-LBO strategic decentralization -0.019 (0.19) -0.150 (1.47) -0.021 (0.20) -0.003 (0.03) Change in size -0.039 (0.44) -0.074 (0.70) -0.157 (1.53) -0.210 (1.83)t Change in 4-firm concentration ratio 0.057 (0.46) 0.255 (2.13)* 0.701 (4.79)**** 0.365 (2.25)* Change in 8-firm concentration ratio 0.015 (0.12) 0.208 (1.81)t 0.658 (4.41)**** 0.441 (2.98)** Change in industry profitability 0.188 (1.83)t 0.053 (0.44) Change in industry productivity 0.690 (7.53)**** 0.060 (0.56) Change in debt 0.019 (0.21) 0.036 (0.37) 0.050 (0.48) 0.036 (0.32) Change in management holdings 0.370 (4.10)**** 0.145 (0.14) 0.003 (0.03) 0.266 (2.35)* Change in efficiency goals 0.060 (0.65) 0.234 (2.12)* 0.128 (1.14) 0.064 (0.51) Change in growth goals -0.054 (0.57) -0.198 (1.88)t -0.151 (1.40) -0.014 (0.11) Change in operating decentralization 0.140 (1.37) 0.140 (1.22) 0.053 (0.46) 0.108 (0.86) Change in strategic decentralization 0.011 (0.11) 0.350 (3.18)** 0.168 (1.46) 0.022 (0.18) Change in hierarchical complexity -0.059 (0.63) -0.150 (1.33) -0.054 (0.50) -0.103 (0.85) Change in diversified scope -0.148 (1.25) -0.055 (0.43) -0.031 (0.23) -0.155 (1.23) Adjusted R2 0.440 0.326 0.225 0.162 F 5.08**** 3.51*** 2.56** 2.36**

Sample size 58 33 58 33

a Parentheses contain t's. tp < .10

*p < .05

**p < .01 ***p < .001

****p < .0001

CC Uc

Q

0-

5


FIGURE 2 Summary of Results

H2 Increased H11 Emphasis on

Efficiency Goals

H14 H4 nl H1 - Increased H15

Increased Management H9 Decen

'Holdings / [Decreased . . .'.

T Hi /T41 /-"' Diversified - : T g H13 / Performance Hi- ~ H1 - ~~~~Scoepe Increased Debt

/H12

Decreased H20 [Hierarchical

.... Complexity

H5 ~ Decreased H17 3 Emphasis on Growth Goals

craft, 1993a, 1993b; Singh, 1990), which generally suggest that LBOs do lead to an increase in efficiency in the short run. Our work shows with greater precision than previous research has employed where this performance improvement might be coming from-a change in goals, a reduction in complexity and scope, and an increase in decentralization.

However, the failure of most of the positive performance effects identified in Table 10 to hold up over a longer time period should set off some alarms. The results reported in Table 12 suggest that the performance im-

pact of an LBO is far less dramatic over longer time periods. Although we found no evidence that LBOs actually decreased performance over the longer term, Table 12 does not reveal much in the way of a positive impact either. Taken together, the two sets of results suggest that performance improves immediately following an LBO, only to decline somewhat there- after. Such a pattern may be interpreted as supporting those who claim that LBOs have a damaging impact upon the long-term performance of the firms involved. It is also roughly consistent with the work of Long and Ravens- craft (1993a, 1993b), which suggests that both the level of R&D investments and the profitability of LBOs tend to decline over the long run. Although we cannot say for sure whether post-LBO firms suffer from myopic short- term behavior, as their detractors claim, neither can we deny this possibility. Further studies of the long-run impact of LBOs will have to be undertaken before this issue can be resolved.

Our study also suggests that Jensen's (1986) exclusive focus upon the importance of debt in the LBO process may be misplaced. We not only

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found that LBOs are associated with marked increases in management stockholdings, but also that this increase may be just as important as the increase in debt for explaining subsequent efficiency gains. It is notable that it was the increase in management stockholdings, rather than the increase in debt, that was correlated with substantive changes in strategy and structure (see Figure 2 and Table 9). In contrast, much of the effect of debt upon firm performance was direct. Hypothesis 8, which links increased debt to reduced diversification, was not supported, nor was Hypothesis 18, which links increased debt to decreased hierarchical complexity, but Hy- pothesis 13, which predicts an association between increased debt and increased decentralization, was only weakly supported. Moreover, increased debt was not associated with a reduced emphasis on growth goals (Hy- pothesis 3). This pattern of results again suggests that increases in debt may be less important in bringing about changes in the strategy and structure of firms that have experienced leveraged buyouts than increases in man-

agement stockholdings. Debt plays an important role, but in the long run the changes associated with management stockholdings may have the most enduring impact upon firm efficiency. The long-term regression analyses for performance seem to point to this conclusion, as they suggest a direct association between management holdings and performance three and five years after an LBO, when no association existed one year after the event.

Like Hypotheses 3, 8, and 18, three other hypotheses found no support: A decreased emphasis upon growth goals had no impact on diversification (Hypothesis 7). Although these variables were weakly correlated, it would seem that the variance here was captured by the change in efficiency goals. We also found no evidence that an increased emphasis on efficiency goals led to a reduction in hierarchical complexity (Hypothesis 16) or that increased management holdings led to a reduction in hierarchical complexity (Hypothesis 19). One possible explanation for this pattern is that our measure of hierarchical complexity wasn't discriminating enough to pick up the required effects. Alternatively, it is possible that the theoretical arguments, derived from agency theory, are incorrect.

In closing, a few words of caution are appropriate. Our study is vul- nerable to all of the standard criticisms leveled at studies that use survey data, concerning social desirability effects, common method variance, inherent ambiguity, and nonresponse bias. We have two replies to this potential criticism. First, survey data were the only way to test the hypotheses for a large sample of firms. Second, we were careful in con- structing the survey, consulting with those involved in LBOs and pilot-testing with a small sample before settling on a final design. More- over, as reported earlier, we conducted all the standard tests for nonresponse bias and reliability, checking the reliability of both recall and accuracy. We are thus as confident as is possible that our survey measured what it was intended to measure but also recognize that social desirability effects may bias our sample toward better performers.

Another cautionary point concerns the accuracy of our variable mea-

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suring increase in debt load. By focusing upon the increase in the debt- to-equity ratio of a firm from one year prior to an LBO to one year after, we may have understated the size of the increase because some firms might have reduced their debt loads in the LBO year by quick asset sales. If this were the case, our conclusion that the motivational impact of an increase in debt is not as important as Jensen suggests might be misplaced. How- ever, we think it unlikely that many firms dramatically paid down their debt levels within one year of their LBOs.

It is worth emphasizing yet again that our strongest results focused primarily upon the short-run impact of LBOs upon firm efficiency. In this regard, the results are consistent with past ex ante and ex post research. Al-

though we tried to include long-run performance data in our study, our conclusions are limited at this point. We feel reasonably confident that LBOs are associated with substantive organizational changes of the type likely in firms trying to improve efficiency, but our data provided only very weak support for these conjectures. This lack of support, however, is consistent with Long and Ravenscraft's (1993b) study, which shows that the industry-adjusted performance effects of LBOs do not extend over more than three years. These results may demonstrate that LBOs' effects are short-term, but there may be a number of methodological reasons for the findings. In particular, LBO firms that chose to return to the public markets might be systematically different from those that did not. For example, initial public offerings are usually executed by firms that can maximize stock price by demonstrating improved performance and strong potential for continued efficiencies. This relationship would naturally bias our data in favor of better performers. Thus, on the basis of our study we have to be reticent about making definitive statements as to the positive long-run impact of LBOs on efficiency.

Finally, it is important to emphasize that by focusing on the impact of LBOs on firm performance, we have downplayed their impact on certain stakeholder groups. There is an argument that although LBOs ultimately benefit the organizations that sponsor them and the senior managers whose equity positions are dramatically increased, other stakeholders do not reap similar benefits. In particular, one consequence of an LBO may be to destroy a firm's implicit contracts with bondholders2 and with employees outside of the senior management group (Shleifer & Summers, 1988). Employees frequently lose out because increased debt may reduce

2 Bondholders, as opposed to stockholders, are guaranteed their claims to the returns

promised by the firm. In addition, their original decision to purchase the firm's debt is tied

directly to information provided by the firm about its riskiness, with a certain degree of im-

plicit trust involved in the transaction. In an LBO, the financial risk level of a firm increases substantially because more debt has been issued. This degrades the stability of bondholders' claims on the firm, which would make them a significant stakeholder in the LBO decision. However, bondholders do not get to vote on whether the LBO deal should be done.

Similarly, employees who have invested high amounts of human capital in exchange for em-

ployment security would also have that implicit contract broken in an LBO.

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the ability of a firm to fund their pensions. Moreover, the downsizing com- monly associated with an LBO obviously negatively affects employees' job security. Bondholders suffer because the increase in debt associated with an LBO increases financial risk and reduces the price of their bonds. But if and when a firm once more becomes a publicly held enterprise, senior managers may stand to reap huge gains from their equity, as do LBO sponsors. Thus, it could be argued that an LBO is simply a way of enriching senior managers while impoverishing other employees and bondholders. It was against this background that Shleifer and Summers characterized some LBOs as involving a "breach of trust" with stakeholders. The extent to which such breaches of trust negatively affect long-run performance is worthy of future investigation. Indeed, we could speculate that our failure to find strong evidence that LBOs improve long-run firm performance reflects such an impact.

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APPENDIX Survey Questions

Decentralization

"These questions measure how decision making has changed in the executive office. Please indicate the degree the following decisions are the SOLE responsibility of the executive office BEFORE AND AFTER the LBO was formalized:" Responses ranged from 1, "always an executive office responsibility," through 3, "responsibility shared with lower level

managers," to 5, "never an executive office responsibility." Approving annual financial objectives for the whole firm

Approving major investments Overall strategic direction of the firm

Formulating or undertaking acquisition strategies Production decisions

Buying decisions

Advertising decisions

Marketing strategy decisions

Pricing decisions Product mix or new product launch decisions Determination of R&D budgets

Hierarchical Complexity

"These questions measure the degree of change in organization design. Please try to recall, to the nearest percentage, the degree the following have changed 1 year AFTER the LBO:" (1 = increased by 66-100%, 4 = no change, 7 = decreased by 66-100%).

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Number of departments in executive office Number of hierarchical levels in the whole firm Number of levels in corporate personnel department Number of employees in corporate personnel department Amount of contact between operating companies or departments Average number of managerial levels in operating companies or departments Frequency operating companies or departments report to executive office Size of your company relative to competitors Number of people authorized to make capital purchases Number of products and services sold Number of supplier contracts Number of staff (not line) employees Number of departments or operating companies

Performance

"The following are performance criteria a board of directors may use to evaluate executive management. Mark the importance of each before and after the LBO was completed:" (1 = most important, 5 = irrelevant).

Sales growth Profit growth Stock returns Cash flows

Profitability Productivity Innovativeness in management Market share

Phillip H. Phan is an assistant professor of strategic management at York Universi-

ty. He received his Ph.D. degree from the University of Washington in 1992. His current research and teaching interests are in the areas of corporate governance and mergers. In particular, his studies deal with the control and monitoring of managerial action and strategic choice in post-takeover firms, top management compensation, and governance in interfirm alliances and networks.

Charles W. L. Hill is a professor of strategic management at the School of Business, University of Washington. He holds a Ph.D. degree in industrial organization economics from the University of Manchester Institute of Science and Technology in Eng- land. His research interests center on applying economic theory to problems of business and corporate strategy.

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ORGANIZATIONAL RESTRUCTURING AND ECONOMIC PERFORMANCE IN LEVERAGED BUYOUTS: AN EX POST STUDY

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