Bank Affiliation in Private Equity Firms: Distortions in Investment Selection

ABSTRACT Private equity firms that are affiliated with banks have become major players in the leveraged buyout (LBO) market, raising billions of dollars in funds. In this paper, I investigate value creation of these LBOs through operating performance, leverage, and pricing. I find that bank-affiliated LBOs fail to create operating performance gains, on average. Moreover, I find that targets of bank-affiliated and independent LBOs are systematically different. While I find no difference in operating performance gains between bank-affiliated and independent LBOs with matched target characteristics, all firms that share the target characteristics of bank-affiliated LBOs show worse post-buyout operating performance. Combined with no difference in leverage and deal pricing, the overall results suggest that bank affiliation negatively affects the economic benefit of LBOs due to differing objectives that result in distortions in investment selection. JEL Classifications: G23, G24, G34 Keywords: private equity; banks; leveraged buyout I. INTRODUCTION The past three decades have seen significant changes in the role banks play in financial markets. Banks have expanded their activities from being financial intermediaries to directly participating in the market. The recent financial crisis, in particular, has sparked a heightened interest on the part of policy-makers in understanding the involvement of traditional financial institutions in alternative investment assets. Take the leveraged buyout (LBO) market for example. Banks, through their asset management divisions, have carried out a large volume of LBOs. LBOs sponsored by private equity firms affiliated with banks account for up to 30% of all buyouts, annually (see Figure 1), and some of the largest private equity firms are investment arms of banks. For example, Goldman Sachs, JP Morgan, HSBC, and Citigroup have together raised over $180.6 billion in private equity funds since 1990. (1) Despite banks' direct involvement in the private equity market, we have only a limited understanding of their impact on subsidiary private equity firms. In general, being part of a large financial conglomerate provides an information advantage to associated firms (Massa and Rehman, 2008; Ritter and Zhang, 2007; Bodnaruk et al., 2009) and can potentially reduce conflicts of interest between debt and equity holders (Fang et al., 2013). However, a parent-subsidiary structure also creates distortions (e.g. distortions in incentives and objectives), which may lead to problems in selecting or managing portfolio companies (Gompers and Lerner, 1998). Fang et al. (2013) provide more specific arguments on the distorted objectives of bank-affiliated LBOs. Using a U.S. LBO sample on deal financing and exits, they find that bank-affiliation influences deal financing terms but have worse exits if deals are carried out at the peak of the market. Industry observers seem to share these concerns about the impact of having a parent bank. According to some practitioners, investors are overwhelmingly cautious about bank-affiliated private equity firms. This paper expands the negative view of bank-affiliated LBOs that was first reported by Fang et al. (2013). First, I highlight real economic problems with bank-affiliated LBOs by studying value creation through operating performance, leverage changes, and deal pricing, instead of deal exits. Second, having detailed accounting data, I further identify target selection as the source of the performance difference between bank-affiliated and independent LBOs. Third, I confirm the negative view of bank-affiliated LBOs in a U.K. sample, which is free of the selection problem a U.S. sample may face. The U.K. is the second largest buyout market worldwide, and unlike U.S. firms, all U.K. firms are required to submit annual financial information. Using this U.K. sample, I first examine target characteristics, using univariate tests and Probit regressions to identify characteristics associated with targets of each type of LBO. …