CONTROLLING FINANCIAL DISTRESS COSTS IN LEVERAGED BUYOUTS WITH FINANCIAL INNOVATIONS

This study investigates imovative methods used to reduce the cost of financial distress in leveraged buyouts. These methods include strip financing, where debt and equity are shared by the same investors, the use of LBO specialist sponsors, who represent both equityholders and debtholders, and debt provisions which allow the postponement of cash outflows. In theory, methods like these encourage stockholders and debtholders to reallocate their claims to a firm's cash flow with minimum rancor (see Jensen [21] and Wruck [44]). Thus, they have the potential to significantly reduce the direct and indirect costs of financial distress. This study offers evidence on whether such innovative financing mediods reduce the expected costsof financial distress in LBOs. I document the prevalence of these financing techniques in a sample of 63 LBOs and ascertain whether they are associated with lower risk-adjusted financing costs. Other things being equal, firms which control die deadweight costs of debt financing should have a lower cost of capital. Evidence on the impact of LBO financing techniques addresses the broader argument that highly levered firms have become more sophisticated in managing the deadweight costs of debt. Such evidence is also relevant in addressing policymaker concems about the potential adverse macroeconomic consequences of LBO debt. Alan Greenspan [19], Chairman of the Federal Reserve Board, testified in 1989 that ''. . . the worrisome and possibly excessive degree of leveraging associated with [corporate restructuring] could create a new set of problems for the financial system.''l Greenspan and others continued to express these types of concems throughout the 1990-1992 recession.2 To the extent that LBOs are successfully engineered to avoid the deadweight costs of fmancial distress, their potential adverse impact on the stability of the financial system is ameliorated. Section I of this study discusses the role that LBO financing methods may play in reducing the expected costs of financial distress. Section II documents the prevalence of various financing methods in a sample of 63 LBOs. Section III describes the empirical methods and risk-adjustment procedure used to study the impact of these methods on financing costs. Section IV describes the results, and Section V draws several conclusions.