Private Equity: Recent Growth in Leveraged Buyouts Exposed Risks That Warrant Continued Attention
Published: 2008-09-09T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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.

section_title: Letter
paragraphs: 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). 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. 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. Furthermore,  takeover transactions that involve proxy solicitations, tender offers, or  new securities offerings are subject to federal securities laws. 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.
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.
subsections: section_title: Background
paragraphs: 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.
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. 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.
subsections: section_title: Private Equity-Sponsored LBOs Have Evolved Since the 1980s
paragraphs: 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. 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. 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.
section_title: Overview of an LBO Transaction by a Private Equity Fund
paragraphs: 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.
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.
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.  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. 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. 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    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.
section_title: 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
paragraphs: 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.
subsections: section_title: Private Equity-Owned Companies Usually Outperformed Similar Companies Based on Several Financial Benchmarks
paragraphs: 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. Recent  research finding that private equity-owned companies generally  outperformed other companies is consistent with prior research analyzing  earlier LBOs. 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. 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.
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.  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. 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. 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. 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. 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. 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. This study suggests that “reverse LBO” transactions  resulted in more companies entering public markets during this period  than exiting following private equity acquisitions.
section_title: Private Equity LBOs Seek to Enhance Performance through Techniques Such as Improving Management Incentives
paragraphs: 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. 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. 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. 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. 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. Finally, a study of U.S. buyouts done from 1995  through 2007 found average premiums of roughly 25 percent in public-to- private LBOs. 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. 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  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. 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. 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. 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.
section_title: Private Equity-Sponsored LBOs Were Associated with Lower Employment Growth, but Causation Is Difficult to Establish
paragraphs: 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. Research on U.S. buyouts  in the 1980s also found that LBOs were associated with slower  employment growth than their peers. 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. The net  effect of these changes is lower employment growth than comparable  establishments in the 5 years after the LBOs. 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. 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.
section_title: Club Deals Have Raised Questions about Competition, but Our Analysis of Such Deals, in the Aggregate, Shows No Negative Effect on Prices Paid
paragraphs: 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.
subsections: section_title: Club Deals Have Grown Substantially in Recent Years, Especially Those Involving Large LBOs
paragraphs: In recent years, private equity firms increasingly have joined to acquire  companies through LBOs, resulting in some of the largest LBO  transactions in history. 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.
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. 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  coinvest in deals, rather than coinvesting 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.
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.
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.
section_title: LBOs Commonly Involve a Competitive Process and Club Deals Could Support or Undermine This Process
paragraphs: 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. 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.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. 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.
section_title: 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
paragraphs: 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. 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.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. Neither of these differences  is statistically significant in our econometric models run on the full  sample.
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. However, our results  are inconsistent with another recent study that found large club deals  before 2006 led to lower premiums paid for target companies. 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.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. For the  private equity marketplace, we estimate the concentration ratio at about  32 percent, below the 40 percent threshold.
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. 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.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.
section_title: Some Large Club Deals Reportedly Have Attracted the Interest of the Department of Justice and Have Prompted Lawsuits against Some Private Equity Firms
paragraphs: 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. 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.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. The consolidated case was pending as we completed this report.
section_title: SEC Exercises Limited Oversight of Private Equity Funds, but It and Others Have Identified Some Potential Investor- Related Issues
paragraphs: 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.
subsections: section_title: Private Equity Funds and Their Advisers Typically Qualify for an Exemption from Registration with SEC
paragraphs: 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. exemption from registration as an investment company or investment  adviser, respectively. 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.In addition,  private equity funds typically claim an exemption from registration of the  offer and sale of their partnership interests to investors.
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. BDCs are permitted  greater flexibility than registered investment companies in dealing with  their portfolio companies, issuing securities, and compensating fund  managers. 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.
section_title: SEC Examinations of Registered Advisers to Private Equity Funds Have Identified Deficiencies in Some Compliance Controls
paragraphs: 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. We reviewed 17 of the  examinations. 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. We  reviewed 6 of the sweep examinations. 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.
section_title: Growth in Private Equity- Sponsored LBOs Has Led to Greater Regulatory Scrutiny
paragraphs: 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. 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.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. 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.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.
section_title: Recent Credit Events Raised Regulatory Scrutiny about Risk- Management of Leveraged Lending by Banks
paragraphs: 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.
subsections: section_title: Major Commercial and Investment Banks Have Played a Key Role in Financing U.S. LBOs
paragraphs: 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.  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. 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 200775. 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.
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.
section_title: Before 2007, Federal Banking Regulators Generally Found Risk Management for Leveraged Financing to Be Satisfactory
paragraphs: 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. 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.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. 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.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.  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. 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. 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. 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.
section_title: SEC Began to Supervise Financing of LBOs by Investment Banks around 2005
paragraphs: 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. 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.
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.
section_title: 2007 Market Events Increased Risk Exposures of Banks That Financed LBOs and Raised Some Concerns about Systemic Risk That Warrant Regulatory Attention
paragraphs: 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. 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.  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.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. 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.
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.
section_title: Pursuant to Recent Credit Market Problems, Regulators and Others Have Raised Concerns about the Risk Management of Leveraged Finance
paragraphs: 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. 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.
section_title: Conclusions
paragraphs: 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.
section_title: Recommendation for Executive Action
paragraphs: 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.
section_title: Agency Comments and Our Evaluation
paragraphs: 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 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.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: 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.
subsections: section_title: Determining the Effect of Recent LBOs on Acquired Firms and Employment
paragraphs: 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.)
section_title: Assessing the Impact of Club Deals on Competition
paragraphs: 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. 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.
section_title: Reviewing SEC’s Oversight of Private Equity Fund Advisors and Funds
paragraphs: 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.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.
section_title: Reviewing Financial Regulatory Oversight of Bank LBO Lending Activity
paragraphs: 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), Senior Supervisors Group, 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.
section_title: Addressing Pension Plan Investments and Taxation on Private Equity Fund Profits
paragraphs: 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.
section_title: Appendix II: Pension Plan Investments in Private Equity
paragraphs: 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. 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. 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. 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.
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.
Although many public-sector and private-sector pension plans invest in  private equity, such plans typically have allocated a small percentage of  their total assets to private equity. According to the Pensions &  Investments survey, large pension plans allocated, on average, 5 percent of  their total plan assets to private equity in 2007. Likewise, the Pyramis  survey, which included midsize to large-size plans, found plans allocated,  on average, 5 percent of their total plan assets to private equity in 2006.  Although the majority of plans investing in private equity have small  allocations to such assets, a few plans have relatively large allocations,  according to the Pensions & Investments survey. Of the 106 plans that  reported investing in private equity in 2007, 11 of them had allocations of  10 percent or more; of those, only 1 plan had an allocation of about 20  percent.
For a more complete discussion of pension plan investments and private  equity, see Defined Benefit Pension Plans: Guidance Needed to Better  Inform Plans of the Challenges and Risks of Investing in Hedge Funds  and Private Equity (GAO-08-692).
section_title: Appendix III: Overview of Tax Treatment of Private Equity Firms and Public Policy Options
paragraphs: The tax treatment of private equity fund profits received by private equity  firms has raised a number of public policy questions. For managing private  equity funds, private equity firms generally receive an annual management  fee and a share of fund profits. Under current law, the management fee  typically is taxed as “ordinary” income for the performance of services.  The share of fund profits typically is taxed at a preferential rate for long- term capital gains. Some argue that the share of profits should be taxed as  ordinary income for the performance of services. Others, however,  maintain that the current approach is appropriate. Reflecting the debate,  there have been a number of congressional and other proposals to change  the tax treatment.
subsections: section_title: Private Equity Firms Receive Two Types of Income, and They Are Taxed Differently
paragraphs: Private equity firms generally receive two types of income for managing  the funds they establish to undertake buyouts of target companies. These  two types of income are taxed differently, so how income is classified is a  significant driver of tax liability. First, in serving as general partners, firms  receive an annual management fee based on the amount of fund assets  under management. According to an industry trade group, firms  historically have set their management fee at 2 percent of the assets under  management but recently have been lowering the fee, as the size of private  equity funds has grown and raising fund capital has become more  competitive. Private equity firms receive the fee for performing services  for the fund partnership (not in their capacity as partners), and the fee is  intended to finance their day-to-day operations. The management fee  received by a private equity firm generally is taxed as ordinary income and  subject to a federal marginal tax rate ranging up to 35 percent.
Second, private equity firms, as the general partners of the funds, also  receive a share of the funds’ profits, called carried interest. This carried  interest typically represents a right, as a partner, to share in 20 percent of  the future profits of the fund.The concept of carried interest is not new; it  has been employed since at least the 1930s in a number of industries.  Because private equity funds typically are organized as partnerships,  partnership tax rules determine the tax treatment of the distributive share  of the income from the carried interest. Under current tax law,  partnerships are “pass-through entities,” meaning that income passes  through the partnership to the partners without being taxed at the  partnership level. When income earned by a partnership is passed through  to the individual partners, it is taxed based on the nature of the income  from the underlying activity. While taxation of private equity profits may  be a new issue today, partnership taxation rules are well established. Upon  receipt of carried interest—that is, the grant of the right to a share of  future profits—a private equity firm becomes a partner in the fund and  pays tax in the same manner as other fund partners on its distributive  share of the fund’s taxable income. Thus, if the fund earns ordinary  income, or a short- or long-term capital gain, each partner’s distributive  share includes a portion of that income. In other words, carried interest is  not automatically subject to long-term capital gains treatment. But the  typical nature of private equity firms’ activities—selling investment assets  held for several years—means carried interest received by private equity  firms commonly is taxed as a long-term capital gain. As such, it is subject  to a preferential federal tax rate of 15 percent.
section_title: Tax Treatment of Carried Interest as a Capital Gain Is Subject to Debate
paragraphs: According to academics and others, categorizing carried interest as  entirely ordinary income or capital gains can be difficult, especially as it  reflects a combination of capital assets and labor in the form of expertise  applied to those assets. In short, private equity firm managers use investor  capital to acquire assets in the form of portfolio companies and then apply  their expertise to increase the value of the companies. Table 6 highlights  conceptual difficulties in making clear distinctions among types of  income, by comparing income earned by a traditional employee and a  fund’s general partner, based on characteristics such as effort, capital  contributed, and compensation risk.
Whether the private equity firm’s distributive share from the carried  interest should be viewed as ordinary income for the performance of  services, and hence subject to a higher tax rate, has been the subject of  debate. Some academics and others, including labor union executives and  some in the private equity and venture capital industries, have criticized  allowing capital gains treatment to carried interest on a number of  grounds. These reasons include that such treatment  is inconsistent with the theory of capital gains because private equity firms  provide services similar to asset management when they select, acquire,  and oversee acquired companies; therefore, income from these activities  should be treated like that of an ordinary employee performing services; represents an unfair subsidy to wealthy individuals because it allows  private equity managers whose earnings can be millions of dollars per year  to pay a lower marginal rate than many lower-income workers earning  ordinary income; is inappropriate to the extent that private equity involves risking of time  and effort, but not money, since private equity firms contribute only a  small portion of total capital invested in a buyout fund; and is inconsistent with the nature of the private equity business because the  general partners are sophisticated enterprises that compete for the same  employee talent as investment banks and provide services analogous to  investment banking/financial services, where income is taxed as ordinary  income.
By contrast, private equity executives and others, including some  academics and other business executives, say capital gains treatment is  appropriate and thus oppose treating carried interest as ordinary income  because    carried interest represents an ownership interest in assets held for long- term investment that involves risk-taking by private equity firms; because  risk-taking is a goal of the preferential treatment for capital gains, it is  appropriate for carried interest to be taxed at the lower rate;   private equity firms are creating new ventures and not being compensated    private equity firms’ portfolio companies hold capital assets and pass their  gains to the private equity partnerships, which is not a performance of  services; the notion of capital gains taxation is not based on separating returns to  labor and returns to capital; instead, if there is a capital asset, and its value  grows through someone’s effort, then that is a capital gain. For example,  the owner of a business may supply labor to the venture, causing the value  of the business to grow and upon sale of the business, any gains generally  would be entitled to capital gains treatment; and    capital gains treatment mitigates effects of “double taxation” of private  equity activities, because portfolio companies already pay corporate taxes  before passing any gains to the private equity partnerships owning them.  Supporters of the capital gains approach also say that changing the  treatment would have negative consequences. They said that investment  and innovation will be discouraged, the supply of capital would decline,  productivity would suffer, U.S. competitiveness in international capital  markets would be undermined, and tax avoidance activities will increase.  Tax avoidance occurs when the nature of activity is changed to lessen or  eliminate tax liability.
section_title: Several Bills Have Been Introduced and Other Ideas Suggested to Change the Tax Treatment of Private Equity Firms’ Income
paragraphs: As the taxation of carried interest became a higher profile issue beginning  in 2007, a number of legislative proposals to change the tax treatment of  private equity firms’ income were introduced in the 110th Congress. These  proposals fall into two categories: Tax treatment of carried interest, and  treatment of the limited case in which a private equity firm is a publicly  traded partnership.
The carried interest proposals generally have similar provisions. H.R. 2834  (introduced June 22, 2007) would eliminate capital gains treatment in  favor of an ordinary income approach. Specifically, this bill would treat  income received by a partner from an “investment services partnership  interest” as ordinary income. It would define “investment services  partnership interest” as any partnership interest held by a person who  provides services to the partnership by    advising as to the value of specified assets, such as real estate,  commodities, or options or derivative contracts;   advising as to investing in, purchasing, or selling specified assets;    managing, acquiring, or disposing of specified assets; or    arranging financing with respect to acquiring specified assets.
The sponsor of the legislation said that he and others were concerned that  capital gains treatment is inappropriately being substituted for the tax rate  applicable to wages and earnings. He added that investment managers are  essentially able to pay a lower tax rate on their income because of the  structure of their investment firm. Under this proposed legislation, the  capital gains rate would continue to apply to the extent that the managers’  income represents a reasonable return on capital they have actually  invested in a partnership.
H.R. 3970 (introduced October 25, 2007) would also treat carried interest  as ordinary income; specifically, it would treat partnership income earned  for providing investment management services as ordinary income. H.R.  6275 (introduced June 17, 2008) would, among other things, treat net  income and losses from investment services partnership interests as  ordinary income and losses. The Joint Committee on Taxation estimated  the ordinary income treatment would raise $25.6 billion from 2008 through  2017.
Bills addressing publicly traded partnerships arise from a limited number  of private equity firms and hedge funds that have made initial public  offerings of stock. They would change the tax treatment of such  partnerships that provide investment advisory and related asset  management services. S. 1624 (introduced June 14, 2007) would treat as a  corporation for income tax purposes publicly traded partnerships that  derive income or gains from providing services as investment advisers (as  defined by the Investment Advisers Act of 1940) or asset management  services. That is, they would pay the corporate income tax on their  earnings, rather than pass those earnings through to be taxed only as the  partners’ individual income.
The sponsor and another senator said that, if a publicly traded partnership  earns profits by providing financial services, that kind of business should  be taxed as a corporation. Otherwise, creative new structures for  investment vehicles may blur the lines for tax treatment of income. The  sponsor said that the law must be clear and applied fairly, or there is risk  of eroding the corporate tax base.
Another bill, H.R. 2785 (introduced June 20, 2007), is identical to S. 1624.  According to the sponsor, the proposal is a matter of fairness. He said that  a loophole in current law allows some of the richest partnerships in the  world to take advantage of American taxpayers. Also, such partnerships  enjoy a competitive advantage over corporations that pay taxes.
There has been some concern expressed about legislative proposals to  change the current tax treatment of private equity profits. For example,  some senators have questioned targeting carried interest, according to  news reports. Likewise, a leading national business association has said  that a change in private equity taxation, as part of a larger change in  partnership taxation in general, would reduce the productivity of  American workers and the ability of U.S. companies to compete in global  markets.
In addition to formal legislative proposals, others, in seminars and during  congressional testimony, have cited other possible ways to tax carried  interest. Such ideas include the following:    Taxing carried interest when granted. Under current law, when a person  receives a profits interest in the partnership—such as, when the private  equity firm general partner receives a 20 percent share of the fund’s  profits—the Internal Revenue Service (IRS) does not treat receipt of that  interest as a taxable event to the extent the firm received the profits  interest for providing services to the fund in a partner capacity or in  anticipation of becoming a partner.Under the proposal, the initial grant  of the carried interest to the general partner would be assigned a value and  that value would be subject to taxation as ordinary income. However,  according to commentary we reviewed, it can be difficult to value a profit  interest in a partnership when it is received, and the process is vulnerable  to manipulation.
An election method, in which the general partner would choose between  the loan method or all profits being taxed as ordinary income.
section_title: Appendix IV: Case Study Overview
paragraphs: To illustrate various aspects of private equity buyouts, we created case  studies of five private equity transactions, ranging from small to large and  covering a variety of industries. The purpose of this appendix is to explain  how the case studies are structured and what information is being  provided. Each of the cases discussed in appendixes V through IX  provides information on the following:    a summary of the transaction;    a time line of significant events;    an overview of notable aspects of the acquisition;    background on the target company and the private equity firms involved;    details of the takeover;    post-buyout strategy and implementation;  results following the buyout; and   as available, details of the private equity firm(s)’ exit, or sale of interest in  the acquired company.
Table 7 lists the private equity buyouts we selected for these case studies.
These transactions are intended to be illustrative of various features of  private equity transactions, and not representative of all such buyouts. We  judgmentally selected these cases from among 2,994 buyouts we identified  for the 2000-07 period from Dealogic data. We selected five LBOs for in- depth case study based on the size and scope of the target company,  amount and type of debt used to finance the transaction, or degree to  which the news media focused on the transaction. These case studies  illustrate, among other factors: post-buyout changes in employment;  financing methods and extent of borrowings; pre-buyout competition  among bidders; formation of “clubs” among bidders to make joint  acquisitions; strategies for improving operations post-buyout; and methods  by which private equity firms exit, or divest, their investments.
Our analysis is based on publicly available information, including company  news releases, news articles, and filings with SEC, as well as interviews  with private equity firm executives. We requested comments on the case  studies from private equity firms involved in the transactions, and  incorporated technical comments received, as appropriate.
section_title: Appendix V: Neiman Marcus Group, Inc., Case Study
paragraphs: Overview: The Neiman Marcus buyout illustrates a number of aspects of  how private equity deals can work: a target company that, after evaluating  its business, sought out a buyer itself; an acquisition in which the new  owners have not made significant operational changes; use of a financing  method in which the company may pay interest that it owes or take on  additional debt; and creation of bidding teams of potential buyers at the  behest of the seller. Figure 6 provides an overview of the LBO transaction,  including a time line of key events.
Background: As of July 2005, just before the buyout, Neiman Marcus  operated 35 Neiman Marcus department stores, 2 Bergdorf Goodman  department stores, and 17 Last Call clearance centers. The retailer also  sells by catalog and online.
TPG is a Forth Worth, Texas-based, private investment firm with more  than $50 billion under management. TPG typically looks to invest in  companies that are market leaders and have a defensible competitive  position, long-term growth potential, and experienced management. Other  TPG investments include J. Crew Group, Burger King, MGM, and Harrah’s  Entertainment. New York-based Warburg Pincus, with $19 billion invested  in nearly 500 companies, says it looks to invest in companies with strong  management and then work with them to formulate strategy, implement  better financing, and recruit talented executives. Previous Warburg Pincus  investments include BEA Systems, Coventry Health Care, and Knoll.
The acquisition: In late 2004, Neiman Marcus stock was trading at all- time highs. Given improved operating results and relative strength of the  financial markets at the time, the Neiman Marcus board decided to explore  options for the company’s future. This was part of a regular evaluation of  long-term alternatives, including whether the company should remain  independent. At the time, some directors believed there might be an  uncommon opportunity for stockholders to realize significant investment  gains, so the board engaged Goldman Sachs as an adviser to assist in  considering alternatives. In early 2005, the board authorized Goldman  Sachs to contact potential buyers, based on demonstrated ability to  complete large transactions, ability to preserve confidentiality, and  interest in the retail industry. Seven private equity firms responded. Given  the size of any potential buyout transaction, the board asked Goldman  Sachs to arrange the bidders into teams, or “clubs,” as they are sometimes  known, to make joint offers. After an eighth firm entered the mix,  Goldman Sachs formed four teams of private equity firms. The company’s  board evaluated bids from the teams on factors such as price, strength of  financing commitment letters, and advantages or disadvantages to Neiman  Marcus shareholders. A ninth bidder eventually joined the process as well.
The team of TPG and Warburg Pincus won the auction with a $100 per  share bid, valuing the company at about $5.1 billion. The $100 bid was an  almost 34 percent premium over the closing price of Neiman Marcus stock  on the last trading day before the company announced it was exploring  strategic alternatives. At the time, the buyout was the third-largest deal  done since 2000. TPG executives said that several factors made Neiman  Marcus an attractive acquisition. TPG believed Neiman Marcus  management to be exceptional, with a stellar track record. TPG also  believed Neiman Marcus to be a unique asset—having prime locations in  all major metropolitan areas, a widely known and respected brand name, a  highly loyal customer base, and a leadership position in the luxury retail  industry. TPG saw Neiman Marcus as having superior customer service,  good relationships with top designers, and a disciplined growth strategy.  From the customer side, TPG thought demographic trends among Neiman  Marcus’s affluent customer base showed potential for significant growth.  TPG executives were confident that Neiman Marcus’s sales force could  continue to produce higher average transaction sizes, repeat visits, and  increased customer loyalty. Finally, TPG saw Neiman Marcus’s Internet  and direct sales businesses, which were fast-growing and highly profitable,  as channels to tap into affluent customers beyond the geographic range of  its traditional stores. (Warburg Pincus executives did not respond to GAO  requests for comment.)
Strategy and implementation: Based on the company’s attributes, TPG  viewed Neiman Marcus as an investment that would not require major  changes in strategy or operations but instead would rely on the growth  strategy and operating plans already in place. TPG executives said they  plan to increase value by increasing the company’s earnings and repaying  debt by using free cash flow. TPG and Warburg Pincus have kept Neiman  Marcus’s pre-buyout management in place and are not involved in day-to- day management of the company.
Results: Revenues are up, profits are down, and the company has  expanded since the buyout. Neiman Marcus has opened five Neiman  Marcus stores, and it has also opened seven additional Last Call clearance  centers. The company has launched a new brand of store, called CUSP,  aimed at younger, fashion-savvy customers. Employment has increased by  about 11 percent since the buyout, from 16,100 to 17,900 employees.
As part of its expansion, Neiman Marcus’s capital expenditures reached  $502 million during fiscal years 2005 through 2007, compared with $369.2  for fiscal years 2001 through 2003. New store construction, store  renovations, and the expansion of distribution facilities account for the  bulk of these expenditures. The company has also pared some of its  operations, selling its credit card business, as was planned before the  buyout, and also divesting its interest in two private companies—Kate  Spade for $121.5 million and Gurwitch Products for $40.8 million.
Revenues reached a record $4.4 billion for fiscal 2007, an increase of 8.9  percent from fiscal 2006. Comparable store revenues increased 6.7 percent  in fiscal year 2007, following an increase in comparable revenues of 7.3  percent in fiscal year 2006.
Meanwhile, although the company has moved to pay down debt used to  finance the buyout, Neiman Marcus says it remains highly leveraged. In  fiscal year 2005, before the buyout, net interest expense was $12.4 million.  Post-buyout, for fiscal year 2007, net interest expense increased more than  20-fold, to $259.8 million. At the end of 2007, outstanding debt was almost  $3 billion. Net income fell from $248.8 million in fiscal year 2005, before  the acquisition, to $56.7 million the following fiscal year and $111.9 million  for fiscal year 2007. Earnings from operations, however, are up, the  company said.
The Neiman Marcus deal also featured a $700 million financing feature  known as a payment-in-kind, high-yield bond. This arrangement allows the  company to make a choice each quarter: pay interest to its bondholders in  cash or in the form of additional bonds. But if the company decides to  exercise the payment-in-kind option, it pays a higher interest rate—three- quarters of a percentage point—payable in additional bonds for that  interest period. This gives the company the ability to ease its debt  servicing burden in the short-term but at the cost of greater overall  indebtedness. To date, Neiman Marcus has not used this feature. To  protect itself against debt costs, Neiman Marcus has entered into interest  rate swaps, which have the effect of fixing the interest rate on a portion of  its variable rate debt.
Exit: The private equity firms continue to own the company, and TPG  executives declined to discuss specifics of any exit strategy.
section_title: Appendix VI: Hertz Corp. Case Study
paragraphs: Overview: The Hertz buyout is one of the largest private equity deals. It  drew criticism in the media and from union members, after the company’s  new owners paid themselves $1.3 billion in dividends not long after the  transaction closed and ultimately financed the payments by selling stock  to the public. The company has realized hundreds of millions of dollars in  improved financial results annually, but also has cut thousands of jobs as  it has sought to make operations more efficient. Figure 7 provides an  overview of the LBO transaction, including a time line of key events.
Background: Hertz says it is the world’s largest general use car rental  company, with approximately 8,100 locations in about 145 countries. Hertz  also operates an equipment rental company with about 380 locations  worldwide, although car rentals accounted for 80 percent of 2007  revenues. Ford Motor Co. had purchased an ownership stake in Hertz in  1987 and purchased the company outright in 1994.
CD&R executives said that the firm emphasizes making operational  improvements in companies it acquires. The firm has long had an interest  in multilocation service businesses, they said, as evidenced by investments  including Kinko’s and ServiceMaster. The Carlyle Group is one of the  biggest private equity firms and says it has demonstrated expertise in the  automotive and transportation sectors. Its investments include Dunkin’  Brands, AMC Entertainment, Inc., and Grand Vehicle Works, which  provides products and services to truck fleets and recreational vehicle  users. Merrill Lynch Global Private Equity is the private equity arm of  Merrill Lynch & Co.
The acquisition: In 2000, CD&R began exploring acquisition targets in the  car rental industry. It analyzed a number of firms before targeting Hertz  because of its industry-leading position. In addition to having strong brand  recognition, Hertz was the leader in airport rentals, and its equipment  rental division provided diversification. CD&R also had an interest in  “corporate orphans,” that is, units of large corporations that are not part of  the company’s core operations, and thus may not receive sufficient  management attention. CD&R viewed Hertz as such an orphan, with  significant room for improvement as a result.
Beginning in 2002, CD&R regularly approached Ford about acquiring  Hertz, CD&R executives said. They explained that Ford was skeptical  about CD&R’s ability to finance the acquisition and operation of Hertz,  which is capital-intensive due to its large holdings of cars and equipment.  By 2005, Ford was experiencing difficulty in its core auto manufacturing  business and decided to divest Hertz. Ford took a two-track approach to  doing that, simultaneously pursuing an initial public offering (IPO) of  Hertz, as well as a bidding process for the outright sale of the company.
Given the size of the potential deal, CD&R needed partners, executives  said. Like many other private equity firms, CD&R has restrictions on how  much it can invest in a single entity and buying Hertz on its own would  have meant exceeding this “concentration” limit. Thus, CD&R partnered  with two other firms—the Carlyle Group and Merrill Lynch Global Private  Equity. Carlyle officials said they too had been interested in Hertz for  some time and were attracted by the strong brand and orphan status. The  two firms agreed to a partnership, with CD&R as the lead firm with  operational control. Both firms had worked previously with Merrill  Lynch’s private equity fund, and they invited the company to join the two  firms.
In September 2005, after several rounds of bidding, Ford agreed to sell  Hertz to the consortium. CD&R executives described the bidding process  as difficult and competitive, with two other groups of leading private  equity firms participating. Ford’s investment bankers managed the process  and pitted the competing bidders not only against each other but also  against the prospect of an IPO. During bidding, CD&R stressed to Ford  that a direct sale would provide a higher price, more certainty, and more  cash than an IPO. Eventually, Ford went for the private sale, in a deal  valued at $14.9 billion, which included $5.8 billion of corporate debt and  $6.8 billion of debt secured by the company’s vehicle fleet. At the time, it  was the second largest leveraged buyout ever done. The private equity  firms invested $2.3 billion, with each contributing an approximately equal  amount, to acquire ownership of all of Hertz’s common stock.
Strategy and implementation: Even before acquiring Hertz, CD&R had  identified three main areas for improving Hertz’s operations: the off- airport market segment, high expenses in European rental car operations,  and widely varying performance among individual branch locations.  According to CD&R executives, Hertz had significantly increased its  number of off-airport locations, for example, but was losing money. So the  firm decided to close some poorly performing offices. In Europe, CD&R  identified overhead expenses, such as sales and administrative costs,  which were several times higher than in the United States and thus would  be a target for change.
After the buyout, the consortium helped Hertz management develop  operational and strategic plans and implemented a new management  compensation method, according to Carlyle executives. The plans  included, for example, efforts to increase market share in the leisure  segment and to improve buying and managing of vehicles. Carlyle  executives said hiring a new chief executive in mid-2006 was critical to  implementing the plans. The new Chief Executive Officer came to Hertz  with a background in process improvement and industrial management  after working at General Electric Co. and serving as the Chief Executive of  auto parts supplier Tenneco.
To target price-sensitive and leisure customers, Hertz began offering  discounts to customers making online reservations and using self-service  kiosks. Carlyle executives said that to reduce the cost of its fleet, Hertz  increased the share of cars that it buys, rather than leases, from  manufacturers. (Owning is cheaper, because with a lease, the  manufacturer must be compensated for the residual risk of disposing of a  rental car once its service lifetime is up.) As part of efforts to increase  efficiency, Hertz relied on employees to generate ideas. For example,  workers identified ways to improve cleaning and processing of rental cars  upon their return, Carlyle executives said. Changes in compensation were  designed to better align the interests of management and shareholders.  For example, Hertz provided more than 300 employees an opportunity to  own stock in the company, based on revenue growth, pretax income, and  return on capital.
Results: Hertz’s financial performance has improved in some areas since  the buyout. Revenues have continued to grow steadily, as they did under  Ford’s ownership, with an increase of 16 percent from 2005 to 2007. Cash  flow, as measured by a common industry benchmark of earnings before  interest, taxes, depreciation, and amortization, grew by about 25 percent,  from $2.8 billion in 2005 to $3.5 billion in 2007. Hertz’s operational  improvements can be seen in its direct operating expenses as a percentage  of revenues, which declined from 56 percent in 2005 to 53 percent in 2007.
Net income, however, fell below preacquisition levels, although it is  growing. In 2005, net income was $350 million, but this declined to $116  million in 2006, before improving to $265 million in 2007. The lower  earnings reflect higher interest payments stemming from debt used to  finance the acquisition. In September 2005, before the acquisition was  completed, Hertz’s total debt was $10.6 billion, and this balance increased  to $12.5 billion by the end of 2005, after the deal closed. Consequently, net  interest expense rose from $500 million in 2005 to $901 million in 2006 and  $875 million in 2007. These amounts represented 6.7 percent, 11.2 percent,  and 10.1 percent of revenue, respectively. At the same time, however,  Hertz’s new owners have used the increased cash flow to pay down the  debt. As a result, total debt decreased by $555 million from 2005 to 2007.
To help cut costs, Hertz has reduced its workforce by about 9 percent  since the end of 2005. After the private equity consortium acquired Hertz  in late 2005, the company had about 32,100 employees, with 22,700 in the  United States. By the end of 2007, total employment had decreased to  about 29,350, with 20,550 in the United States. Most of the reduction came  following job cuts announced in 2007 that the company said were aimed at  improving competitiveness. It said the reductions were aimed at  eliminating unnecessary layers of management and streamlining decision  making. According to CD&R, 40 percent of the lost jobs came in the  equipment rental business, which fluctuates with the construction cycle.  Further workforce cuts are planned, as Hertz has said the company has  completed agreements to outsource functions including procurement and  information technology by the end of the third quarter of 2008.
In June 2006, 6 months after the acquisition, Hertz borrowed $1 billion to  pay its private equity firm owners a dividend. Five months later, Hertz  made an IPO of stock, raising $1.3 billion, and used the proceeds to repay  the $1 billion loan and to make another $260 million dividend payment to  the private equity firms. The dividends drew criticism, such as in the media  and from union members, for their size, and the IPO, coming less than a  year after the acquisition, drew criticism as a “quick flip” transaction. For  example, Business Week magazine, in an article describing what it called  private equity firms’ “slick new tricks to gorge on corporate assets,”  singled out dividend payments as a “glaring” sign of excess and cited the  $1 billion Hertz dividend.
Carlyle and CD&R executives said a desire to return funds to the private  equity firms’ limited partners and uncertainty whether the IPO would  actually be completed as planned, spurred the June dividend. Banks were  willing to loan money at attractive rates to fund the dividend, they said. As  for the timing of the IPO, the executives explained that Hertz’s  performance turned out to be better than expected, while at the same  time, market conditions were attractive. It can often take 3 years or more  to exit a buyout through an IPO and subsequent secondary equity  offerings, one executive said, because public investors are often unable or  unwilling to purchase more than a portion of the shares held by private  equity owners in a single offering. This long horizon, coupled with Hertz’s  financial performance, convinced the private equity firms to proceed with  the IPO.
Hertz’s stock debuted at $15 per share, peaked near $27, and more recently  has been in the $13 range. The decline has generally been in line with the  performance of other large, publicly traded car rental companies.
Exit: After the IPO, the three firms retained an ownership stake in the  company of 72 percent, which Carlyle and CD&R executives said  demonstrated that there was no “quick flip.” In June 2007, the firms  completed a secondary offering of their Hertz shares, selling $1.2 billion  worth of shares, and leaving them with a 55 percent ownership stake.  Executives of one of the firms said three or four more such offerings are  likely.
section_title: Appendix VII: ShopKo Stores, Inc., Case Study
paragraphs: Overview: The ShopKo transaction is a deal involving a relatively large  employer, a competitive bidding process that produced a significantly  higher purchase price, and insider ties that forced the Chairman of the  board to not participate in the sale. Figure 8 provides an overview of the  LBO transaction, including a time line of key events.
Background: ShopKo is a Green Bay, Wisconsin-based discount retail  chain in the same category as Kohl’s, Target, or Wal-Mart. At the time the  deal closed, ShopKo had 356 stores under its ShopKo, Pamida, and  ShopKo Express Rx brand names in 22 states in the Midwest, Mountain,  and Pacific Northwest regions. Founded in 1961, ShopKo merged into  SuperValue, a wholesale grocer, in 1971. In 1991, SuperValue divested  ShopKo via an IPO of stock, and ShopKo became an independent public  company. In fiscal year 2000, ShopKo sales reached $3.5 billion, and the  company was on the Fortune 500 list. Four years later, however, sales had  fallen to $3.2 billion, and the company was experiencing its fourth straight  year of declining same-store sales. (Same-store sales are a common  benchmark for retail sales comparisons, so that the baseline of  comparison remains the same.)
Sun Capital, with about $10 billion in equity capital, targets its buyout  efforts on companies that are important in their markets but which are  underperforming or distressed. Other Sun Capital acquisitions include  Bruegger’s Bagels, Wickes Furniture, and Mervyn’s department stores.
The acquisition: Several factors contributed to ShopKo’s declining sales  and set the stage for the Sun Capital buyout. In January 2001, ShopKo had  begun a reorganization that closed 23 stores and associated distribution  centers. ShopKo also faced heavy competition from national retailers. For  fiscal year 2004, ShopKo reported that Wal-Mart was a direct competitor in  97 percent of ShopKo’s markets; for Target, the figure was 75 percent, and  for Kmart, 70 percent. In addition, ShopKo was testing alternative store  layouts in remodeled stores and attempting to identify its core customer— which it came to define as mothers with family income between $45,000  and $50,000 a year—and to develop a merchandising strategy around that  customer.
In late 2003, the private equity firm Goldner-Hawn approached ShopKo  about buying the company, and an agreement was reached in April 2005.  But some shareholders objected, saying ShopKo’s board had not fully  investigated its options and that the proposed deal undervalued the  company. These other options considered by ShopKo’s board, included  continuing current operations, seeking out strategic buyer(s), and  recapitalizing the company but keeping it publicly owned. Amidst the  controversy, two large shareholders—a hedge fund and a real estate  investment firm—individually approached Sun Capital about possible  interest in participating in a ShopKo buyout.
ShopKo fit Sun Capital’s focus on underperforming companies. Sun  Capital also believed ShopKo had shown resilience in the face of its  competition, primarily from Target and Wal-Mart. In addition, Sun Capital  thought that ShopKo had strength in its pharmacy and optical business  lines; that the chain had strong brand recognition and loyalty among its  customers, and that it was beginning to see success in shifting its  merchandise mix. However, Sun Capital executives said they were initially  hesitant to participate in bidding for ShopKo because the company had  already agreed to a buyout with Goldner-Hawn. In the end, Sun Capital  executives said they decided to join the bidding for ShopKo because it  appeared Sun Capital could pay more, for a deal it judged to be worth  more, and because the Goldner-Hawn deal appeared to have what Sun  Capital executives called an “insider flavor.” This was because ShopKo’s  nonexecutive Chairman had talked with Goldner-Hawn about potentially  becoming an investor in the private equity fund purchasing ShopKo and  about post-buyout employment at ShopKo as well. (This conflict caused  the Chairman, as well as another director, to recuse themselves from  lengthy deliberations on sale of the company.) After the shareholder  complaints raised in opposition to the Goldner-Hawn deal, Sun Capital  believed the ShopKo board would welcome its offer. Sun Capital’s winning  bid of $29 per share was 21 percent better than Goldner-Hawn’s initially  accepted offer of $24 per share, and it boosted the deal value by $160.8  million.
Strategy and implementation: Following the buyout, Sun Capital began  a makeover of ShopKo operations. Sun Capital describes its approach to  managing its portfolio companies as more hands-on than most private  equity firms. It designates an operating partner who holds weekly calls and  monthly meetings with company management. According to Sun Capital  executives, these meetings help to monitor the acquired company’s health,  coach its management, and identify areas for efficiencies and cost savings.
ShopKo consolidated its vendors, making it a more important customer to  each vendor. In addition, Sun leveraged its portfolio’s purchasing power to  acquire higher quality goods at a lower cost with better credit terms, Sun  Capital executives said. For example, ShopKo was able to realize what  executives said were large savings in the cost of prescription drugs. The  company overhauled its marketing, launching a broadcast television and  radio advertising campaign that included back-to-school ads for the first  time in many years. Before the buyout, ShopKo’s promotions revolved  around local newspaper circulars. To capitalize on its in-store pharmacies,  which executives say is a key strength, ShopKo began buying small,  independent drugstores and transferring their business to ShopKo.
Sun Capital executives say they plan to spend approximately $70 million  annually—up from about $35 million planned for fiscal year 2005, before  the takeover—to continue the remodeling of ShopKo and Pamida stores,  an initiative started before the buyout. In addition, ShopKo is opening its  first new store in 6 years. These moves bring capital expenditures back up  to 2004 levels.
Operationally, ShopKo reorganized its five regional management offices  into 14 district groups. The aim was to provide better and faster  communication between store managers and field management. Sun  Capital recruited a new Chief Executive Officer but retained most ShopKo  management. In addition, Sun Capital decided to operate ShopKo and  Pamida as separate entities. This was because Sun Capital believed the  ShopKo and Pamida customer bases were sufficiently different —chiefly,  with Pamida’s being more rural. Shortly after the acquisition, Sun Capital  sold off ShopKo’s real estate holdings, leasing the properties back from  the new owners, in an $815.3 million deal that at the time was the biggest  retail sale-leaseback in U.S. history. Previously, ShopKo owned both the  land and buildings at about half its stores. Sun Capital executives said the  real estate deal allowed Sun Capital to retire debt used to finance the  buyout and to operate ShopKo with reasonable debt ratios and ample  liquidity. Using the real estate proceeds to pay down initial debt was  planned at the time of the buyout, Sun Capital executives said.
Results: Sun Capital executives declined to provide information on post- buyout revenue and income, but they said that revenue has been relatively  level, after being on the decline before the takeover. Sun Capital  executives say they believe they have put ShopKo in a better position to  compete against national competitors like Target and Wal-Mart, by  leveraging Sun Capital’s retailing experience and sourcing capabilities, and  by allowing ShopKo to focus on improving the business away from the  demands of the public marketplace. ShopKo is expanding again, and  remodeling efforts are paying off, with sales at remodeled stores up 5  percent compared with a base level for stores that have not been  remodeled, which executives say is a significant difference.
Given pre-buyout store closings, Sun Capital judged corporate and  administrative staffing to be excessive when it took control. As a result,  there were a small number of layoffs in these areas after the deal closed.  Overall, before the buyout, the company employed approximately 22,800— 17,000 at ShopKo stores and 5,800 at Pamida stores. Today, ShopKo  employs approximately 16,000. Sun Capital executives declined to provide  a figure for Pamida. Overall, jobs have been lost due to store closures but  are being added as new stores open. Given the geographic spread of  ShopKo stores, company employment is dispersed as well, and generally,  no single store is a major employer within its market area.
Exit: Sun Capital plans to hold ShopKo in its portfolio for the immediate  future. Eventually, according to executives, an IPO of stock is the most  probable exit strategy, as there does not appear to be a strategic buyer.  Sun Capital executives believe the Pamida division, which has been  established as a separate internal unit, will have more exit options than the  ShopKo division because of Pamida’s particular customer base.
section_title: Appendix VIII: Nordco, Inc., Case Study
paragraphs: Overview: The Nordco buyout illustrates several elements of the private  equity market: a smaller deal; a buyout in which the seller was another  private equity firm; and pursuit of an add-on strategy in which the acquired  firm serves as a platform for subsequent purchases that build the size of  the company. Figure 9 provides an overview of the LBO transaction,  including a time line of key events.
Background: When acquired by the Riverside Company (Riverside),  Nordco designed and built railroad “maintenance-of-way” equipment for  the North American freight, transit, and passenger railroad markets, such  as equipment used for tie and rail replacement and right-of-way clearing.  Although a supplier of heavy machinery, Nordco’s strategy is to avoid  burdensome capital expenditures by outsourcing component production  and then doing only assembly work itself.
Riverside makes acquisitions in what it calls the small end of the middle  market, focusing on industry-leading companies valued at under $150  million. Riverside has about $2 billion under management, and its previous  investments include American Hospice, a Florida-based hospice care  provider with centers in four states; GreenLine Foods, an Ohio provider of  packaged green beans; and Momentum Textiles, a California contract  textile supplier.
The acquisition: As a smaller firm, Riverside executives said that it does  not rely on referrals from prominent Wall Street firms to identify its  buyout targets. Instead, it works with a variety of sources, including  smaller investment banks and brokers. Among Riverside’s contacts was a  Minneapolis investment bank that alerted Riverside executives, among  others, that Nordco’s then-current owners, another private equity firm,  were selling. Riverside executives met with Nordco management before  Riverside decided to submit a bid. Because of the investment bank’s  promotional efforts, there was strong competition for the acquisition,  Riverside executives said. Although small, Riverside considers thousands  of buyout opportunities. In 2007, the company reviewed 3,500  opportunities, which executives said they quickly reduced to only about  1,200. Riverside personnel visited 400 would-be targets, with the company  ultimately buying 28 of them, or 0.8 percent of the original group.  Financing for the Nordco deal included a feature where one lender  receives some of the interest it was due as an increase in its outstanding  balance rather than cash. This allowed Riverside to offer a higher overall  return, which the lender demanded, but without diverting cash from  earnings to pay the interest due.
Strategy and implementation: While considering Nordco an attractive  acquisition target, Riverside executives nonetheless had some concerns  about Nordco’s ability to increase revenues internally. For instance,  Nordco management had been projecting revenue growth of about 5  percent to 6 percent annually, which a Riverside executive told us was  “kind of underwhelming.” Thus, from the beginning, Riverside’s strategy in  acquiring Nordco was to boost revenue by using Nordco as a vehicle for  making add-on acquisitions that would increase the size of the company.
In line with this strategy, Riverside acquired J.E.R. Overhaul Inc., another  maintenance-of-way company, in September 2006 as an add-on to Nordco  in a $12 million deal. J.E.R. makes replacement parts used to rebuild  equipment, which can then be rented out. Nordco was already in the  replacement-part business, and J.E.R. copied parts made by Nordco and  others. Besides expanding Nordco’s business, the J.E.R. deal also allowed  Nordco to eliminate the copying of its parts by a competitor. J.E.R. also  had expertise in rebuilding equipment made by Nordco competitors,  meaning that Nordco could thus gain intelligence about other makers’  machines. In March 2007, Riverside made a second add-on acquisition:  $14.1 million for Dapco Industries, Inc., and Dapco Technologies, LLC, two  related companies active in rail inspection, including ultrasonic testing of  rails. With the Dapco companies holding 10 patents, Riverside found their  technology to be attractive. In April 2008, Riverside announced its third  add-on buyout for Nordco: $45.5 million for Central Power Products, Inc.,  one of only three U.S. makers of railcar movers, and whose innovation is  the use of rubber tires for traction instead of steel wheels.
While the initial acquisition of Nordco was highly competitive, Riverside  approached the smaller, add-on companies directly. Beyond building the  core business, the add-on acquisitions were part of another post-takeover  strategy for Nordco: build revenues by providing services, in an effort to  achieve a more diversified, and hence steadier, stream of sales as a way to  buffer the cyclicality of the capital equipment marketplace, executives  said.
Riverside’s strategy for Nordco has also included emphasizing new  product development, which had lagged, and making manufacturing more  efficient. According to Riverside executives, apart from seeking to  improve operational efficiency, a key element has been to give the  management team an opportunity to own a significant portion of the  company, on the theory of aligning managers’ interests with the  company’s. Riverside executives said they expect that by the time the  company sells Nordco, management will own about 30 percent of the  business.
Results: Revenue and employment have grown steadily since the  acquisition, even after factoring out the growth attributable to the  acquisitions. Excluding the most recent add-on acquisition, combined  revenues grew from $39.1 million in 2002 to $100.2 million in 2007, with  net income up from $2.6 million to $4.2 million For the same period,  employment more than doubled, from 106 to 283. For only Nordco,  revenues grew from $39.1 million in 2002 to $77.8 million in 2007, with net  income level at about $2.6 million. Employment increased from 106 to 158.  Riverside’s initial concern about Nordco’s internal growth turned out to be  unfounded, because actual sales growth has been about 20 percent  annually in recent years, versus the 5 percent to 6 percent once forecast.
Riverside executives say they are pleased by the developments, which they  say have relied upon standard practices, such as planning and executing  well, rather than novel or unique methods. A union representing many  employees complimented the new owners for the job they have done. A  union official told us that new management has invested significantly;  been hands-off on daily operations; hired new managers without purging  the old; and negotiated a contract with comparatively generous benefits.  The official added that in contract negotiations, the company initially  made aggressive antiunion proposals on such matters as organizing  activity and insurance benefits but quickly withdrew most of them.  Overall, union members, who are affiliated with the United Steelworkers,  traded off changes in work rules in return for an otherwise favorable  contract that won overwhelming approval. The official said that if the  union is concerned about anything, it is that the company still has room to  improve its efficiency, which is something workers want for the sake of  long-run job security.
Exit: Riverside executives said they do not yet have a definite exit  strategy. But in this case, a “strategic” buyer, that is, one interested in the  company specifically for what it does, versus another private equity firm,  seems more likely, they said. The railroad industry is large, and a number  of players would have the necessary capital, the executives said. Riverside  had identified several possible buyers even before it closed on the Nordco  deal.
section_title: Appendix IX: Samsonite Corp. Case Study
paragraphs: Overview: The Samsonite transaction illustrates the use of a  recapitalization—an alternate financing structure for LBOs—by a team of  three private equity firms to acquire a controlling interest in the company.  After owning the company for 4 years, the team sold out to another private  equity firm. Figure 10 provides an overview of the LBO transaction,  including a time line of key events.
Background: In 2003, Samsonite had a well-known brand name but was  on the verge of bankruptcy, as the company sought to save a business  burdened by debt and hurt by a post-9/11 travel slowdown. Samsonite was  best known for its hard-sided, durable suitcases and was responsible for  innovations including lightweight luggage and wheeled suitcases. Today,  Samsonite generates most of its revenues from outside North America,  with Europe accounting for more than 40 percent of its $1.07 billion in  sales for fiscal year 2007.
Ares Management was the lead private equity firm in the acquisition.  Based in Los Angeles, Ares Management was founded in 1997 and has  offices in New York and London. The firm has invested in a number of  retail and consumer product companies, including General Nutrition  Centers, Maidenform Brands, and National Bedding (Serta). Bain Capital is  an investment firm whose activities include private equity, venture capital,  and hedge funds. Its private equity investments include Toys “R” Us,  Burger King, Dunkin’ Brands, and Staples. Teachers’ Private Capital is the  private equity arm of the Ontario Teachers’ Pension Plan, which invests  pension fund assets of 271,000 active and retired teachers in Ontario,  Canada. Its investments include General Nutrition Centers, Shoppers Drug  Mart Corp., and Easton-Bell Sports.
The acquisition: In 2002, Samsonite directors were trying to find a  solution to growing financial pressure stemming from indebtedness. In a  1998 recapitalization, Samsonite had issued $350 million of notes at 10.75  percent interest and $175 million of preferred stock at a dividend rate of  almost 14 percent, in order to buy back common stock and refinance  existing debt. As a result, large, debt-related and dividend payments were  burdening the company. In October 2002, a potential investment deal  proposed several months earlier fell apart. In February 2003, Samsonite  announced it was pursuing a new recapitalization investment from the  Ares Management-led group. Ares Management executives said that they  became interested in the travel industry after its downturn following the  9/11 attacks and also were aware of Samsonite because of a prior  investment in the company. Samsonite’s brand was attractive to Ares  Management, executives said, but the firm was also aware of the  company’s debt service burden and potential for bankruptcy.
Ares Management formed a three-firm team and offered Samsonite a cash  investment in conjunction with a restructuring of Samsonite’s debt and  preferred stock. Ares Management executives said they brought in  partners because the deal was too large to handle alone. Ares Management  first approached the largest investor in its private equity fund, the private  equity arm of the Ontario Teachers’ Pension Plan, which agreed to join.  Because a large portion of Samsonite’s sales came from Europe, Ares  Management sought to include an investor located in that region. To that  end, executives brought in a fund managed by the European private equity  group of the investment firm Bain Capital.
After several months of negotiations, Samsonite announced in May 2003  that an agreement had been reached. The three private equity firms  invested $106 million (with each firm investing a little over $35 million), in  return for a new series of Samsonite preferred stock. Samsonite used the  proceeds, in part, to repay existing debt. Samsonite also exchanged its  existing preferred stock for a combination of the new preferred stock and  common stock. Building on a prior investment stake held by Ares  Management, the three-firm consortium used this transaction to gain  control of about 56 percent of the company’s outstanding voting shares.
Holdings of existing common shareholders, who approved the deal, were  diluted from 100 percent to about a 3 percent stake of outstanding voting  shares. Ares Management executives said that common shareholders had  faced losing everything in a bankruptcy, while the recapitalization left  them with a smaller share of a more valuable company.
Strategy and implementation: The consortium’s revitalization strategy  was to focus on reducing the debt load while seeking to improve  marketing and product quality. According to Ares Management executives,  troubled businesses struggling to service high debt loads often reduce  spending on marketing and product development in favor of simply  focusing on survival. Samsonite’s restructuring of its finances lowered its  interest and dividend payments, providing more cash for marketing and  other activities, the executives said. Other efforts focused on improving  product sourcing and distribution.
In early 2004, Samsonite’s new owners hired the former President and  Chief Executive of luxury goods maker Louis Vuitton to reinvigorate the  company’s image and products. He moved to reposition Samsonite as a  premium lifestyle brand, rather than simply as a commodity provider of  luggage. Especially in the United States, the Samsonite brand had suffered  in recent years, although it was still strong in Europe and Asia.
The company created a new label—the Samsonite Black Label—for the  higher-priced, and higher-margin, segment of the market, while  establishing a sister brand, American Tourister, as the company’s lower- priced product. The new Chief Executive also focused on a high-end  marketing campaign by using business and entertainment celebrities to  sell the products. The company hired a noted designer to produce a new  line of luggage. Another element of the strategy was an expansion of retail  activities by opening stores in fashionable locations such as Bond Street in  London and Madison Avenue in New York City. Spending on advertising  grew steadily from $37 million in the company’s 2004 fiscal year to $67.5  million in the 2007 fiscal year.
Results: Since the acquisition, Ares Management achieved its goals of  boosting revenues and margins, with both measures steadily improving  from fiscal year 2003, before the acquisition, through fiscal year 2007.  Annual revenue grew by about 42 percent, from $752 million to $1.07  billion, and gross profit margin widened from 43 percent to 51 percent.  Over the same period, the company was profitable in fiscal years 2004 and  2006. But it suffered losses in fiscal years 2005 and 2007, due in part to  higher expenses in redeeming preferred shares and retiring debt. Ares  Management executives said net income has been hurt by one-time  charges, such as for restructuring and a computer system, that did not  reflect Samsonite’s operating performance.
Although Ares Management executives said they wanted to cut  Samsonite’s debt burden, it went up. Six months before the three private  equity firms acquired Samsonite, the company had $423 million in long- term debt. This amount declined to $298 million at January 2006 but then  increased to $490 million for 2007.
While owned by the group of private equity firms, Samsonite’s global  employment dropped by about 7 percent, as the company laid off workers  following factory closings and relocations. In January 2003, 6 months  before the firms acquired the company, Samsonite employed 5,400 people.  In each year since then, according to federal securities filings, the  employment level has been at about 5,000. In 2007, about 1,300 of those  employees were in North America. Ares Management executives said they  could not provide figures for U.S. employment. They also said Samsonite’s  mix of workers has changed, as manufacturing employees were reduced in  number, largely in Europe, but employees were added in marketing,  distribution, product development, and retail.
In recent years, Samsonite has continued a pre-buyout trend to outsource  its manufacturing from company-owned factories to third-party vendors in  lower-cost regions, mostly in Asia. In fiscal year 2007, Samsonite  purchased 90 percent of its soft-sided luggage and related products from  vendors in Asia, while most of its hard-sided luggage was manufactured in  company-owned facilities. Because of the shift, Samsonite has sold or  closed several of its remaining manufacturing facilities, in France,  Belgium, Slovakia, Spain, and Mexico. Samsonite has also revamped  domestic operations. In May 2006, the company announced it would close  its former headquarters in Denver, Colorado; relocate Denver distribution  functions to Jacksonville, Florida; and consolidate corporate functions in a  Mansfield, Massachusetts, headquarters office.
Exit: Initially, the three firms in the consortium were looking to exit their  Samsonite investment through an IPO of stock, but eventually pursued  another option. In early 2006, Samsonite, whose stock had been delisted  from the Nasdaq exchange in 2002, began exploring a listing on the  London Stock Exchange. In 2007, Samsonite began marketing the planned  offering in Europe. But, in May 2007, several private equity firms  approached one of Samsonite’s private equity owners, Bain Capital, about  acquiring the company. As a result, Samsonite’s consortium of owners  decided to open up an auction for the company, while still continuing with  plans for the stock offering. The auction attracted a number of bidders,  with CVC Capital Partners, a Luxembourg-based private equity firm,  emerging as the winning bidder.
The buyout was completed in October 2007. Terms of the deal were $1.1  billion in cash, plus assumption of debt that valued the transaction at $1.7  billion. Samsonite directors and the three private equity owners, whose  holdings had grown to about 85 percent of the company, approved the deal  unanimously. The private equity firms received about $950 million,  according to a securities filing. An Ares Management executive said the  company believed it had re-energized the Samsonite brand.
section_title: Appendix X: Econometric Analysis of the Price Impact of Club Deals
paragraphs: The presence of club deals (collaboration of two or more private equity  firms in a buyout) in the leveraged buyout market has raised concerns  about the potential for anticompetitive pricing. For example, the  Department of Justice’s Antitrust Division has reportedly launched an  inquiry into this practice by some large private equity firms. While club  deals could enhance competition by enabling private equity firms to bid  together for companies they otherwise could not buy on their own, these  deals could also reduce competition by reducing the number of firms  bidding on target companies and fostering a collusive environment. If joint  bidding by private equity firms facilitates collusion, the share price  premium over market prices that private equity firms pay to shareholders  should be lower in club deals than in nonclub deals. To investigate the  relationship between club deals and the premium, we constructed a  sample of public-to-private U.S. buyouts by private equity firms using  Dealogic’s Merger and Acquisitions (M&A) database. The sample initially  contained observations on 510 public-to-private transactions involving U.S.  target companies from 1998 through 2007. Of these transactions, 325 had  the requisite premium data for further analysis. We employed standard  econometric modeling techniques, including Heckman’s two-stage  modeling approach to address potential selection bias issues. While the  results suggest that, in general, club deals are not associated with lower or  higher premiums, we caution that our results should not be taken as  causal: that is, they 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. This appendix provides additional information on the  construction of our database, econometric model, additional descriptive  statistics, and limitations of the analysis.
subsections: section_title: Data Sample Was Created Using the Dealogic Database with Additional Fields from SEC’s Edgar, LexisNexis and Audit Analytics
paragraphs: identify 510 buyouts of publicly traded, U.S. companies by private equity  firms—some of which were transactions undertaken by a consortium of  firms (club deals). Because each transaction included financial  information on the target company and private equity acquirer(s), as well  as other details regarding the deal, we were able to construct a set of  variables to explain the variation in the premium across transactions. We  augmented our set of variables with information from SEC’s Edgar  database, Audit Analytics, and LexisNexis. We used the Edgar database to  collect data on managerial and beneficial holdings of equity for each of  the target companies in our sample since the existing literature has shown  that the presence of these shareholders is associated with the premium  paid by buyout firms. Similarly we used Audit Analytics—an online  intelligence service maintained by Ives Group, Incorporated—to extract  data on audit opinions dating back to 2000. As a result, we were able to  include information on the risk characteristics (going concern opinions) of  the target companies as an additional control variable in the resultant  econometric model focusing on the 2000-2007 period. Finally, we included  stock price data for the target firms using the Historical Stock Quote  database in LexisNexis. Company filings with SEC are the principal source  for data on managerial and beneficial equity holdings. Moreover, we have  used Audit Analytics data in recent reports and, as a result, have  performed various checks to verify the reliability of the data. For this  performance audit, we also conducted a limited check of the accuracy of  the LexisNexis data by ensuring that the stock prices for a random subset  of the companies matched the stock price data contained in the Dealogic  database. the resultant sample and illustrates that club deals, on average, are larger  and can differ from single private equity deals along a number of other  dimensions.
Because some transactions in our sample resulted in the private equity  firm holding less than 100 percent of the target company, we identified  whether the target company filed a Form 15 (which notifies SEC of a  company’s intent to terminate its registration) to determine whether the  company actually went private. Transactions that resulted in the private  equity firm(s) holding less than a 100 percent stake in the company, and  where no Form 15 was filed for the company around the time the  transaction was completed, were excluded from the econometric model.
section_title: Econometric Modeling Procedures
paragraphs: Our econometric methodology exploits standard ordinary least squares  (OLS) and maximum likelihood (ML) procedures to investigate the  following questions:    What attributes of the target company or deal characteristics increase the  probability that the transaction will be a club deal (multiple private equity  firms will join together to acquire the target company)?
When other important factors influencing shareholder premiums are  accounted for—including controlling for differences in club and nonclub  deals—are companies taken private in club deals associated with lower  premiums than those paid to shareholders of companies that are taken  private by a single firm? share premium regression estimated by OLS. The Heckman selection  model is estimated as follows:  (1) Probit:  z = θ + Mβ + ε1i the dependent variable (a dummy variable   indicating whether or not the transaction is a club  deal).  a matrix of explanatory variables that varies across   transactions. These are variables that help capture  the characteristics of the public target company,  characteristics of the deal as well as time and  industry dummies.  constant term.  a random disturbance term (residual). (2) OLS:yi = θ + Xβ + Cδ + λα + ε2i the dependent variable (premium paid to   shareholders of the target company).  a dummy variable indicating whether or not the   transaction is a club deal.  a matrix of explanatory variables that varies across   transactions. These are variables that help capture   the characteristics of the public target company,  characteristics of the deal as well as time and  industry dummies.  the inverse Mills ratio constructed from equation  (1). variables, they are nonlinear functions of the measured variables, given  the assumption of normality in the Probit model. In our case, in addition  to variables specific to equation 2 required for identification, we were also  able to exploit variables unique to equation 1 as well.
section_title: Variables Included in the Model
paragraphs: As shown in table 9, the dependent variable in all of our OLS econometric  models is the shareholder premium, which is calculated as the logarithm  of the final price offered by the acquiring firm(s) divided by the target  company’s share price 1 day before the announcement. Published research  suggests that under this specification, the premium incorporates the  informational value of any announcement made during the going-private  process, such as amended bid prices, bidder competition, and the  identification of the acquiring party. We use the premium based on the  price 1 day before the announcement since this measure is lower for club  deals than for single private equity transactions. However, we also use the  premium calculated as the logarithm of the final price offered by the  acquiring firm(s) divided by the share price 1 month before the  announcement in some models as a sensitivity test. companies, the estimates may overstate the degree of concentration for  each transaction.
Additionally, we included a number of control variables in the OLS and  Probit ML models in attempt to explain the variation in the shareholder  premium across transactions or—for the Probit model—the probability  that an acquisition involves more than one private equity firm. These  variables are related to the characteristics of the target company and/or  the deal. As indicated in the body of this report, recent research suggests  that private equity firms pay a higher premium for target companies with  lower valuations, lower leverage, poorer management incentives  (measured by management’s ownership share), and less concentrated  ownership among external shareholders. We include variables that capture  these insights, as well as additional controls based on our audit work.  Table 9 includes a listing of the primary variables included in the  econometric models, ranging from company size (market capitalization)  and financial leverage and liquidity ratios to indicators of a going concern  opinion and variables thought to capture the potential for incentive  realignment. As some of these variables may also be related to the club  dummy variable, controlling for them along with the inverse Mills ratio  from the first stage of the Probit model also enhances the internal validity  of the OLS parameter estimates. We also include time period fixed effects  and dummy variables for some industries in our principal specifications.
subsections: section_title: Industry dummy variables (defined by two-digit NAICS codes).
paragraphs: With the exception of the deal value (DEALVAL) and the market  capitalization (MCAP), the variables are not highly correlated, minimizing  our concern over multicollinearity (see table 10). While the correlation  between the deal value and the market capitalization of the target  company is roughly .97, none of the other correlations exceed .38 for  variables we include simultaneously in a regression, and most fall below  .20. (We of course do not include Float in regressions where Stake and  Block are included since it is a linear combination of the other two  variables.) The liquidity and debt ratios all show very little correlation in  our sample.
section_title: Results
paragraphs: insignificant in the primary models. Although not reported, we also found  that share of the market held by the firms undertaking the transaction did  not affect the size of the premium paid to shareholders of the target  company. We also found evidence, consistent with the literature, that  larger companies, companies with larger debt burdens, and companies  with large beneficial and managerial holders of equity, received smaller  premiums, while companies with poorer market-adjusted stock price  performance received higher premiums. Moreover, shareholders of  companies where doubt was raised about their ability to continue as a  going concern received a lower premium over the 2000-2007 period. In all  specifications reported we maintained a dummy variable for target  companies only in the accommodation and food services sector, since the  dummy variables for all other industries were insignificant.
The first-stage Probit model suggests that large companies, companies  with lower debt ratios, and companies not trading on NYSE, controlling  for size, have a greater probability of being taken private in a joint  acquisition. Initially, we ran the first-stage Probit model with a larger  number of independent variables but dropped those variables that were  insignificant and then used the more parsimonious model represented in  table 11 to estimate the inverse Mills ratio included in stage two. The  insignificance of the Mills ratio for the 2000-2007 regression suggests that  selection bias is not a problem given our control variables, while its  marginal significance for the 1998-2007 regression indicates that selection  bias is more likely an issue. To be conservative, we included the Mills ratio  in the consequent regressions exploring the sensitivity of our results.
Table 12 presents the results of selected sensitivity models we employed  to check the robustness of our main econometric results. We present the  results of an alternative specification in which we drop the financial and  leverage ratios to maximize the number of transactions included in the  model. The results corroborate the findings of our less restrictive models  suggesting that club deals are not associated with lower premiums paid to  shareholders. Also, we estimated models where we considered only  transactions with deal values greater than $100 million and $250 million.  While some of the variables show instability, the club dummy remains  positive and, in fact, becomes statistically significant at the 5 percent level  in the 2000-2007 period for deals greater than $100 million. 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.
section_title: Appendix XI: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix XII: Comments from the Securities and Exchange Commission
section_title: Appendix XIII: Comments from the Office of the Comptroller of the Currency
section_title: Appendix XIV: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: 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.
section_title: Bibliography
paragraphs: 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.
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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).
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