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Bondholder wealth effects of management buyouts.

* A principal feature of the financial landscape during the 1980s has been the increasing frequency with which U.S. corporations have undergone leveraged buyouts (LBOs). These transactions involve the substitution of debt for equity and the elimination of publicly held equity. The post-buyout firms frequently have debt to asset ratios of 90% or greater. The new debt issued against the firm's existing assets usually consists of senior bank loans and subordinated public debt. The end result can be a dramatic change in the risk profile of the LBO firm's outstanding debt.

In this paper, we study the impact of 29 management buyouts (MBOs), announced during the years 1981-1989, on the value of the firms' outstanding nonconvertible bonds. An MBO is simply a leveraged buyout in which the incumbent managers participate in the equity ownership of the post-buyout firm. Earlier studies have provided mixed results about whether bondholders of firms that are taken private via leveraged buyouts suffer significant losses when debt increases so dramatically. The results for the MBO announcements studied in this paper indicate that, on average, bondholders lose about three percent of the market value of the bonds with a range of returns of about [-19%.sup.1] to +13%. In addition, we found that the extent of these losses depends importantly on the presence of restrictive covenants.

I. Previous Research

For discussion purposes, it is useful to dichotomize previous research concerning bondholder wealth effects of takeovers, in general, and leveraged buyouts, in particular, into two groups. The first contains the early research which attempted to replicate stockholder wealth effect studies. These studies utilized daily bond returns, a two-day event window (days -1 and 0), and generally failed to account for the potential effect of differences in bond indentures. Examples of this research include Asquith and Kim [1], Denis and McConnell [4], Lehn and Poulsen [6], and Cook and Martin [3]. Much of this work included various types of acquisition activity which further obscures bondholder wealth effects. These studies produced evidence of zero or very modest negative returns. However, Cook and Martin [3] did find that bond returns varied inversely with the use of debt to finance the acquisition and a significant market-adjusted return of -1.73% was reported for the quartile of firms having the largest increase in leverage.

The failure of these early studies to uncover evidence of bondholder wealth losses of the magnitudes reported in the financial press during the latter half of the 1980s (including widely publicized cases such as RJR Nabisco) has given rise to a second surge of interest in researching the bondholder wealth effects of leveraged buyouts. These studies have attempted to refine the research methodology to account for the data limitations inherent in studying bond returns and to account for differences in bond indenture that could lead to differential bondholder wealth effects. The present study represents an addition to this literature.

Marais, Schipper, and Smith [7] modified the standard event study methodology to examine abnormal returns to equity and debt securities of corporations that announced a buyout proposal during the period January 1974 through November 1985. Their final sample of 30 nonconvertible bonds included bonds issued by firms involved in both successful and unsuccessful buyout proposals. Daily bond returns were examined for an event window around days -1 and 0. Since the sample bonds did not always trade on these days, they calculated multiple-day returns utilizing the smallest possible period of time that spanned the event. If the multiple-day return spanned a period longer than one month, then the bond was excluded from the analysis of abnormal returns. Abnormal returns were computed based on expected bond returns generated from a two-index model using the CRSP stock index and the Dow Jones Bond Index.

Marais, Schipper, and Smith found that abnormal bond returns were negative but not significantly different from zero. They concluded that leveraged buyouts did not redistribute wealth from bondholders to the buyout group or the pre-buyout stockholders. Although they did not directly examine the issue, their evidence is consistent with the view that bondholders satisfactorily protect themselves using protective covenants. Alternatively, their findings are consistent with the view that the effects of increased leverage are offset by improvements in the firm's expected cash flows (e.g., the consequence of better use of tax shields, operating efficiency gains, or reductions in agency costs).

The selection of the proper event date is particularly crucial when evaluating bondholder wealth effects of leveraged buyouts, since MBOs are frequently preceded by another takeover attempt by an outsider. That is, outside offers may also rely heavily on leverage to finance the proposed acquisition such that the target firm's bonds may have already suffered a decline in value due to the anticipated effects of added debt financing. Although it is not completely clear from their discussion, it appears that Marais, Schipper and Smith did not adjust for the influence of prior takeover activity. For example, in their discussion of Revlon, they referred to the hostile bid by Pantry Pride and attempted defensive recapitalization of Revlon in August of 1985, but analyzed the MBO wealth effects for this firm's bonds using the October 2, 1985 MBO announcement. Note also that Pantry Pride's hostile offer eventually defeated the MBO.

Asquith and Wizman [2] examined a sample of 214 nonconvertible bonds issued by 65 leveraged buyout targets during the period 1980-1988. Their sample included 47 successful and 18 unsuccessful buyouts. To be included in their sample, the proposed transaction had to involve a complete purchase of the target firm by a private investor group. Partial purchases and purchases by firms with existing operations were excluded. Event windows of one month, two months, and a period spanning the two months prior to the buyout announcement through two months after the final outcome were analyzed. The buyout announcement date appeared to be the earlier of either the leveraged buyout announcement date or the date on which the Wall Street Journal first reported that an individual, publicly traded firm, or private investment group expressed interest in acquiring the target for any purpose (this includes the possibility of a merger with an outsider). Standard & Poor's Bond Guide was the source of their bond prices. The actual price listed in the Bond Guide is, in order of availability, the sales price, the bid price, the asked price, and finally, the desk price (the price at which the desk trader says he would have traded if orders had come in). They calculated abnormal bond returns as the difference in the corporate bond return and the return on a Treasury index of the same maturity class. Note that this measure has a positive bias because it includes both the abnormal event-related return and the normal default risk premium on the corporate bonds.

Asquith and Wizman found evidence of negative abnormal returns. In addition, the size and significance of these findings was larger for the longer time intervals that included the completion date. They also classified their sample into three groups based on the presence and strength of covenant protection, and found that the greatest losses were concentrated in the bonds with the weakest covenant protection.

Warga and Welch [8] studied bond reactions to successful buyouts by 16 companies with 43 noncovertible bonds from 1985-1989. In contrast with previous studies, they used dealer price quotes provided by Shearson-Lehman-Hutton (SLH). This data source limited the size of their sample and restricted the composition of their sample to largely investment-grade issues. Abnormal monthly bond returns were calculated as the difference in the individual bond return and a comparably rated SLH corporate bond index (SLH have eight such indices: Aaa, Aa, A and Baa, and both long- and intermediate-term indices). The closest matching rating/duration market index was chosen to proxy expected bond returns.

Warga and Welch were not clear as to whether they controlled for other contaminating events in their selection of event dates. They did indicate that they accounted for prior takeover activity for one firm (Burlington Industries), but apparently did not for three others (Borg-Warner, Fruehauf, and Lear-Siegler). However, they chose a sufficiently long event window to incorporate much of the impact of other accompanying restructuring activities.

They found evidence of significant bondholder losses using an event window spanning the period beginning two months prior to the announcement and ending one month afterwards. The average raw return for their 43 bonds was -4%, and the average abnormal return was -8%. They also found that the magnitude of wealth losses was larger for higher rated debt and larger for longer maturity debt.

II. Description of the Test Sample and Data Collection Procedures

A. Sample Selection

The initial list of MBO firms selected for possible inclusion in this study was compiled using a multi-stage process. Specifically, the following sources and procedures were used:

(i) The Wall Street Journal Index was searched for the years 1981 through 1989 under the topics "Going Private" and "Mergers and Acquisitions" for firms that received management buyout proposals.

(ii) The Wall Street Journal Index was reviewed under the names of well-known buyout specialists for firms that received management buyout proposals and included one of these specialists.

(iii) Mergers & Acquisitions list of completed transactions was surveyed for management buyouts.

(iv) Selected issues of W.T. Grimm's Mergerstat Review were searched for firms that completed management buyouts.

(v) The resulting sample was compared to that of Lehn and Poulsen [6A] for transactions that were overlooked by the above procedures.

Finally, to qualify for inclusion in the sample we imposed the following restrictions: (i) there must have been an identifiable buyout proposal with a stated offer price, and (ii) some or all of the incumbent management must have been a particular in the buyout proposal. In some cases, management initiated the proposal. In other cases, a buyout specialist initiated the proposal and included incumbent management as part owners of the proposed post-buyout corporation. Finally, offers to purchase firms, where a private or public operating company would have participated in the ownership of the post-buyout firm, were excluded.

The sample of MBO firms was then screened for nonconvertible public debt outstanding at the date of the buyout announcement. Since we use exchange price data, the sample was reduced further by the requirement that the bonds be listed on the NYSE or AMEX. Finally, there had to be at least one available price in the 15 weeks prior to the buyout announcement, as well as one price in the five weeks following the announcement, so that bond returns could be computed. The final sample consists of 29 MBO firms with 62 noncovertible bonds. A listing of these firms and their respective bond issues is presented in the Appendix.

Of these 29 MBO firms, 18 successful completed their buyouts, and these 18 firms had 32 outstanding bonds. The remaining 11 buyout targets (which had 30 outstanding bond issues) were not taken private by management. In six of these 11 unsuccessful MBOs (with 16 bond issues), the management buyout group was outbid by an outsider. The remaining five unsuccessful MBOs (with 14 bond issues) were disposed of as follows: two proposals were withdrawn and the firm was acquired later by an outsider, one firm changed its buyout proposal to a liquidation program, and the other two firms withdrew their proposals without a subsequent takeover or restructuring of the firm. Thus, only two of the 29 firms in the sample were not eventually restructured.

An important characteristic of MBO firms is the presence of other takeover activity preceding or following the announcement of the buyout proposal. Nine firms (14 bonds) had an outstanding offer by an outsider at the date of the MBO announcement.(2) Ten firms (31 bonds) received an outside offer following management's offer. Finally, the remaining ten firms (17 bonds) experienced no other takeover activity within the year preceding or following the announcement of the buyout proposal.

Exhibit 1 contains selected descriptive characteristics for the bonds in our sample. Panel A shows that 21 bond issues (34%) are senior debt of the target firms and 41 bonds (66%) are senior subordinated or subordinated debt. Thus, the bonds in the sample are heavily weighted towards lower priority claims. Panel B contains the bond ratings of the sample bonds and indicates that none of the bonds in the sample were rated Aaa or Aa immediately prior to the buyout announcement. Thirty-six bonds (58%) in our sample were rated investment grade prior to the buyout announcement, 11 bonds were not rated prior to the announcement and the remaining 15 bonds were rated speculative.(3) Our sample has proportionately more lower rated debt than that of Warga and Welch [8].

Panel C of Exhibit 1 shows the status of the bonds one year after the outcome of the buyout proposal became known, to determine the status of the bonds, the following procedure was employed. First, we checked Moody's Industrial Manual for the year of and year after completion of the MBO to see whether the post-buyout firm was still listed. If so, we checked to see whether the bond was still outstanding. If it was not outstanding, we looked to see whether it had been retired and at what price. If Moody's did not provide the necessary information, we checked Standard & Poor's Bond Guide to see whether the bond continued to trade (or to be followed) one year after the completion date. If the bond disappeared from the Bond Guide's coverage of outstanding public debt, we checked the list of calls. This procedure resolved the status of all but four bonds. Moody's provided information on the status of those four.

Panel C of Exhibit 1 indicates that 17 bonds (27%) had been redeemed by the target firms and 38 bonds (61%) remained outstanding. One bond matured within this time frame and was paid in full. This status is not applicable for the six bonds issued by the two firms that did not complete their buyout proposal, were not subsequently acquired by an outsider, or did not undertake a fundamental restructuring. Panel D shows the maturity spectrum of the sample bonds. Maturities at the announcement date ranged from a little more than one year up to 27 years with an average of 12 years.

Panels E and F of Exhibit 1 indicate the presence of restrictive covenants that might protect bondholders from wealth transfers. These covenants provide protection because they can lead to repurchase of a bond or alteration of its terms. Panel E classifies the bonds into three groups according to the strength of any leverage restrictions in the bond indentures as indicated in Moody's Industrial Manual from the year preceding the buyout.

Bonds are classified as having strong leverage restrictions if the covenants limit funded debt as a proportion of total assets. For example, the covenants might require that total assets exceed 250% of funded debt. Eleven of the bonds in the sample contained strong leverage restrictions. Bonds are classified as having weak leverage restrictions if they contain covenants that preserve the priority of outstanding debt but do not limit the amount of total debt. These covenants are considerably less restrictive, but might still lead to a restructuring or repurchase of the outstanding bonds if the particular financing arrangement for the MBO relied heavily on senior bank debt. Seventeen bonds in the sample had weak leverage restrictions. Finally, 34 of the 62 bonds had no restrictions on the firm's use of debt.

Panel F of Exhibit 1 classifies the sample according to the presence or absence of restrictions on dividend payments. Twenty-seven of the bonds in the sample contained covenants that limit the firm's ability to pay dividends to the extent of current income and/or permit payment of dividends only if the book value of equity exceeds a prescribed minimum value. These restrictions may pose an inconvenience for the post-buyout firm with its heavy reliance on debt. To avoid potential problems, bonds with provisions like these, which could function as de facto leverage constraints, may be restructured or repurchased. In such cases, large losses for bondholders are unlikely. The remaining bonds in the sample did not contain dividend restrictions.
Exhibit 1. Selected Characteristics of Sample Bonds
 Panel A. Priority
 Senior 21
 Senior subordinated 7
 Subordinated 34
Panel b. Bond Rating Prior to the Buyout Announcement
 A 14
 Baa 22
 Ba 4
 B 11
 Not rated 11
 Panel C. Status One Year After Completion
 Redeemed 17
 Still outstanding 38
 Matured 1
 Not applicable 6
 Panel D. Maturity Class at Announcement Date
 One to five years 7
 Six to ten years 17
 Eleven to fifteen years 23
 Sixteen to twenty years 11
 Greater than twenty years 4
 Panel E. Leverage Restrictions
 Strong 11
 Weak 17
 None 34
 Panel F. Dividend Restrictions
 Yes 27
 No 35

B. Bond Price Data

Weekly transaction prices for the sample bonds were obtained from the Commercial and Financial Chronicle, when available, and from the Wall Street Journal, otherwise. Throughout most of the period, the Chronicle provided only the last price from Friday's trading. For the last two years of data, daily prices were published in the Chronicle. To maintain uniformity, Friday prices were collected throughout the sample period. When a bond did not trade on Friday, a Thursday price was collected, if available. The choice of a week as the interval was based on the trade-off between attempting to get a precise measurement of the event-related return and manageability of the data collection task. Recall that both Asquith and Wizman [2] and Warga and Welch [8] used monthly price data, while Marais, Schipper, and Smith [7] used daily data.

Bond prices was collected from 31 weeks prior to the MBO announcement through five weeks after the announcement. If an outside offer accompanied the MBO, then this rule was amended to 31 weeks before the arrival of the first bidder through five weeks after the arrival of the second bidder. The average bond had 17 prices in the pre-event period.

C. Computation of Bondholder Returns

Corporate bonds are traded and interest such that the seller receives the trade price of the bond plus interest accrued from the last coupon date. Thus, bond returns were calculated as follows: (1) [R.sub.i,t] = ([F.sub.i,t] + [C.sub.i,t] / [F.sub.i,t-1]) - 1, where [R.sub.i,t] is the rate of return for the ith bond between the close of trade at week (t - 1) and the close on week (t); [C.sub.i,t] is the coupon payment (if any) paid to the holders of record of the bond at the end of week (t - 1); and [F.sub.i,t] is that flat price of the bond at the end of week (t). We calculated [F.sub.i,t] as follows: (2) [F.sub.i,t] = [T.sub.i,t] + ([C.sub.i] / 180) [N.sub.i], where [T.sub.i,t] is the last trade price of the bond for week (t) and [N.sub.i] is the number of days (based on each month having an even thirty days) which have passed since the last coupon payment for the bond.

D. Defining Abnormal Performance

Abnormal returns are computed using two different approaches: market-adjusted and mean-adjusted returns. The market-adjusted return is calculated as the difference in the corporate bond's return and a Treasury Index return. To proxy market returns, we used the Shearson-Lehman-Hutton Intermediate- and Long-Term Treasury Indices. The corporate return is matched with the intermediate-term index if the bond's maturity is ten or fewer years. The long-term index is used if the bond's maturity is eleven or more years. This procedure adjusts for the impact of interest rate and term structure changes. The event window for the market-adjusted returns approach spans the period beginning with the first announcement of an offer to acquire the firm by either management or an outside party and ends with the last acquisition announcement. If the firm received only an MBO offer, then the event window would begin the Friday preceding the announcement and end on Friday the week of the announcement.[4] The return interval ranged from one to 23 weeks.[5]

The market-adjusted return approach was utilized by Asquith and Wizman [2], and Warga and Welch [8]. However, this measure provides a biased estimate of the true abnormal return because it includes both the event-related return and the normal risk premium on the bond.[6] This problem is likely to be small for investment-grade bonds and return intervals of one week, but grows in importance for lower grade debt and longer return intervals.

To correct for this problem, a second calculation is performed. The market-adjusted return for each pre-event week is computed and averaged to provide an estimate of the normal difference between the corporate and Treasury return. The abnormal return is then defined to be the market-adjusted return around the event window minus the normal difference calculated for the pre-event period. For a detailed discussion of this approach, see Handjinicolaou and Kalay (5). We will refer to this measure of abnormal return as the mean-adjusted return. The event window is defined in the same manner for both the market-adjusted and mean-adjusted return approaches.

III. Bondholder Wealth Effects

A. Tests Involving the Entire Sample of Firms and Bond Issues

The results in Exhibit 2 provide strong evidence for the rejection of the null hypothesis of no wealth effects for bondholders of MBO firms. Panel A contains statistics for the market-adjusted returns approach, while Panel B contains similar results for the mean-adjusted returns methodology. Looking first at the results in Panel A, the entire sample of 62 bonds realized an average buyout loss of -2.56%, the sample of 56 bonds, for which restructuring occurred, lost an average of -3.31%, and the sample of 32 bonds, for which an MBO was successful, experienced an average loss of -3.35%. All of these abnormal returns are significantly different than zero at the 0.01 level. To investigate the impact of outliers, we also performed a sign test to see if the number of bonds that experienced negative abnormal returns was statistically different than the number with positive abnormal returns. For the complete sample of 62 bonds, there were 42 negative abnormal returns; for the sample of 56 bonds issued by firms that ultimately restructured, there were 41 negative abnormal returns; and for the 32 bond sample of successful MBOs, there were 24 negative abnormal returns. A sign test indicated that, in all these cases, the number of negative abnormal returns was significantly greater than the number of positive abnormal returns at the 0.01 level. As can be seen from Panel B, the mean-adjusted returns approach yielded similar results (i.e., -2.93% for the entire sample,(7) -3.77% for the bonds of firms which were ultimately restructured, and -4.32% for the bonds of successful MBOs). The range of returns was -16.9% to +11.5% under the market-adjusted returns approach and -18.7% to +12.9% using the mean-adjusted returns approach.

The preceding analysis was based on individual bond issues and assumes that the bond returns are uncorrelated. However, since some firms had multiple bond issues, this assumption is highly questionable. To get around this problem, we also investigated the presence of bondholder wealth transfers where the unit of analysis was the firm. Here, we calculated an equally weighted average of the bond returns for each firm's bonds.[8] We analyzed three samples and applied the two methodologies for evaluating abnormal returns. For the market-adjusted returns approach, the first sample was comprised of the entire set of 29 companies, the second included the 27 firms which were eventually restructured, and the third contained the 18 firms for which an MBO was successful. From Panel A of Exhibit 2, we see that the average wealth effect for the entire sample was -2.19%, for the 27 firms that were eventually restructured it was -2.68%, and for the successful MBO firms it was -2.60%. These abnormal returns were all statistically different from zero at the 0.05 level. The sign test statistics for the 29, 27 and 18 firm samples were -2.04, -2.50 and -2.36, and all were significant at the 0.05 level. For the mean-adjusted returns approach, the entire sample produced an average wealth effect of -2.40%, for the firms that were eventually restructured it was -3.77%, and for the successful MBO firms it was -3.16%. These abnormal returns were also significantly different than zero at the 0.05 level.

B. Bond Covenant Features and Wealth Transfers From MBO Announcements

Bond price reactions to MBO announcements potentially depend upon factors specific to the bond indenture. In this section, we investigate the possibility that bond covenant provisions lead to differential price effects across individual bond issues. Specifically, we conjecture that leverage and dividend restrictions contained in the bond indenture can force the redemption of a particular bond issue following a highly levered and unfavorable MBO transaction, thus protecting the holders of that bond issue from wealth losses. The value of such restrictive covenants may depend on the remaining maturity of the bond with the covenants being particularly valuable for longer term debt. The cost of not having protection is likely to increase with maturity, because the price sensitivity to increases in required return rises with maturity. Similarly, the price sensitivity of protected bonds to declines in required yield rises with maturity.

We used the categorical variable LR to denote the presence of leverage restrictions in the bond indenture. Restrictions were designated to be strong, weak, or non-existent to correspond with the description in Moody's. Dividend restrictions, denoted by the dummy variable DR, were simply classified as to whether or not they existed. Abnormal announcement returns were hypothesized to be positvely related to both LR and DR.

The outstanding maturity variable poses a problem because bond return is not a strict function of outstanding maturity. Longer maturity bonds make negative abnormal returns more negative and positive abnormal returns more positive. In order that we might capture this differential response, a categorical variable MAT(9) is constructed from the four pairwise combinations of positive and negative price reactions to the MBO announcement, as well as from the outstanding maturity being greater than ten years, or less than or equal to ten years.(10) To test for the impact of leverage and dividend restrictions, as well as outstanding maturity on the observed abnormal returns, we performed an analysis of variance using the classification variables LR, DR, and MAT.

Exhibit 3 contains the results of the analysis of variance on the market-adjusted abnormal bond returns. Since the results are similar when the mean-adjusted returns approach is used, these results are omitted. Panel A reveals the [R.sup.2] of the model to be 0.56 and the equation F-statistic to be significant at the 0.0001 level. The independent effects are measured based on Type III sums of squares (partial sums of squares).(11) From Panel A, dividend restrictions appear to be more helpful than leverage restrictions in explaining market-adjusted abnormal bond returns. The F-value on DR of 6.98 is significant at the 0.01 level, whereas the F-value of 0.31 on LR is insignificant. The weak independent effects on leverage suggest that the joint distribution of leverage and dividend restrictions should be analyzed.

Panel B of Exhibit 3 contains a table of differential mean abnormal returns jointly classified by leverage and dividend restrictions. As suggested above, the joint distribution exhibits a pronounced lack of balance. For example, 21 of the 29 firms which had no dividend restriction also had no leverage restriction and only one had a strong leverage restriction. Panel B also shows the gradient of abnormal returns in the direction of dividend and leverage restrictions. With no dividend or leverage restrictions, the average market-adjusted return in -6.45%, whereas bonds with both a dividend and strong leverage restriction produce an average market-adjusted return of 0.74%. The "totals" row and column show the marginal, though not independent, effects of leverage and dividend restrictions.

The F-value for MAT is equal to 10.13, significant at the 0.0001 level. In order to test the univariate impact of MAT, avoid nonfunctionality and possible estimator problems,(12) we regressed the square of the abnormal announcement returns on MAT. From Exhibit 4, as expected, the coefficient on MAT is positive with a T-statistic of 1.86, significant at the 0.07 level. The squaring of the abnormal announcement returns addresses the problem described above; namely, that longer maturity bonds make negative abnormal returns more negative and positive abnormal returns more positive. The positive coefficient of MAT is consistent with this hypothesis.

IV. Qualitative Analyses of Bonds With Positive Abnormal Returns and Redemptions

The preceding results established that, on average, bondholders lose when firms undertake management buyouts and that the wealth effect of an MBO on a particular bond depends on the specific covenant protection. Protected bonds do not lose when MBOs occur, but unprotected bonds do, on average, suffer losses of about six percent. This section presents some qualitative analyses of bond outcomes that further clarify the influence of covenant protection on bondholder wealth effects. Section IV.A examines the bonds with positive announcement week returns and Section IV.B investigates the bonds that had negative announcement week returns, but which were eventually redeemed.

A. Bonds With Positive Announcement Returns

As reported in Exhibit 2, 20 of the bonds in the sample experienced positive market-adjusted returns.(13) Exhibit 5 presents a descriptive analysis of these bonds. This analysis does not make statistical inferences, but simply examines the characteristics of the bond issues to determine whether there are common attributes that could explain the positive returns.

The first row of Exhibit 5 shows that six of the 20 bonds that had positive returns were later redeemed. All six of these bonds contained both leverage and dividend restrictions. Bondholders may well have anticipated the retirement of these bonds and revised their prices upwards at announcement. One would expect prices to rise for these bonds, because a more certain call price at (or above) par will be paid in the near future and will be substituted for a less certain maturity payment and coupon stream spread over a longer time. Note that five of these six bonds were trading at discounts before the buyout announcement and had prices well below their call prices; the sixth bond had both a market price and a call price at par. By implication, 11 of the 17 bonds that were eventually redeemed experienced negative reactions to the buyout announcement. These bonds are discussed below.

The second row of Exhibit 5 shows that another five of the bonds that experienced positive abnormal returns had extensive protection, but were not redeemed because the MBO was defeated by an outside bid. An examination of the financing arrangements for these outside bids indicates that they did not rely exclusively on the issue of debt against target assets and were not required to redeem the bonds. To the extent that the bond market could have anticipated either redemption, if the MBO prevailed, or no wealth loss, if the outsider won, these five bonds should have gained in value.

The third row of Exhibit 5 indicates that five of six bonds issued by the two firms that did not eventually restructure also experienced positive returns. Surprisingly, none of these bonds contained protective covenants. One of these firms, whose three bonds experienced positive returns, filed for Chapter 11 protection nine months after the MBO failed.

The two bond issues contained in the fourth row of Exhibit 5 are problematic. In both cases, the bonds contained only weak leverage restrictions and were not redeemed following completion of the buyout. It is not apparent why these bonds would experience a positive abnormal return. Finally, the one bond found in the fifth row of Exhibit 5 was scheduled to mature about a year following the buyout announcement. This impending maturity may have limited the exposure of the bondholders to any adverse effects from the MBO.
Exhibit 5. Qualitative Analysis of the 20 Bonds With
 Positive Announcement Week Market-Adjusted
Number of Bonds Characteristics
 6 MBO completed and bonds redeemed;
 both dividend and leverage restrictions.(a)
 5 MBO defeated by outside offer and
 bonds not redeemed; bonds contain
 dividend and leverage restrictions.(b)
 5 MBO withdrawn and firm not
 restructured; no restrictive covenants.
 2(c) MBO completed but bonds not redeemed;
 contain a weak leverage restriction.
 1 Bond matured within approximately
 one year of announcement.
 1(d) No obvious explanation.
(a)There was one weak and five strong leverage restrictions.
(b)There were two weak and three strong leverage restrictions.
(c)There was one bond in this group under the mean-adjusted returns
(d)There were two bonds in this group under the mean-adjusted returns

B. Bonds With Negative Announcement Returns That Were Redeemed

Exhibit 6 examines the price path between the date of the first post-announcement price and the call date for ten of the bonds that were redeemed but experienced negative announcement reactions.(14) This exhibit shows the course of month-end price quotes from Standard & Poor's Bond Guide.(15) Call dates were obtained from Moody's Investor Services and confirmed in Standard & Poor's Bond Guide whenever possible. The last price for each bond is the call price. The ten bonds were issued by Beatrice, City Investing, Lear-Siegler, and Jim Walter.

Panels A, C and D of Exhibit 6 display the price paths for Beatrice, Jim Walter, and Lear-Siegler. These three firms successfully completed proposed buyouts within six months of the initial announcement. In the weeks following the initial buyout announcement, Standard & Poor's Moody's or both downgraded the relevant issues by these firms. The negative announcement reaction and the downgrade indicate that both the market and the rating agencies did not expect these bonds to be redeemed. However, the eight bonds issued by these three firms were called within four months of the downgrade. The price paths displayed in Exhibit 6 show that prices were generally flat in the post-event period until the month of call. An examination of Wall Street Journal articles in this time frame did not reveal any explanation of the redemptions for any of the three firms.

City Investing's price path is displayed in Panel B of Exhibit 6. City Investing's board elected to liquidate the firm rather than sell the whole firm to a management buyout group or a rival outside bidder.(16) The ratings of these City Investing bonds were affirmed by Standard & Poor's eight months after the buyout was proposed and five months after the liquidation plan was adopted. Redemption occurred about one year after the initial buyout announcement. The decisions by the firm to redeem the bonds and by the rating agencies to affirm the company's ratings were most likely based on different considerations than the types of covenant protection analyzed in this paper. Thus, the eventual redemption of this bond and the negative price reaction to the buyout announcement may be consistent for these two bonds.

V. Concluding Comments

Using two methodologies -- market-adjusted returns and mean-adjusted returns -- we provide evidence confirming the presence of significant bondholder wealth losses of about three percent associated with the announcement of MBOs. This evidence is in conflict with that provided by Marais, Schipper, and Smith [7], but is consistent with the results of the recent studies by Asquith and Wizman [2], and Warga and Welch [8]. The magnitude of the losses in our study is similar to that reported by Asquith and Wizman [2]. For example, the set of our firms which contained no dividend and leverage restrictions experienced an average loss of 6.5%, whereas, for a similar partition, Asquith and Wizman [2] reported an average loss of 5.2%. Our findings are not sensitive to the choice of methodology employed. Furthermore, our findings indicate that bond price reactions are sensitive to the presence of restrictive covenants and maturity.

Appendix. Sample of MBOs and Their Bonds
Company Name Coupon (%) Maturity Rating
 Allegheny International 9.00 1989 NR
 10.75 1999 NR
 10.40 2002 B3
 American Medical 11.00 1998 Baa3
 11.75 1999 Baa3
 Beatrice 7.875 1994 A3
 8.50 2008 A3
 10.875 2010 A3
 9.25 2000 Baa1
 6.00 1998 Baa2
 7.70 1996 Baa1
 9.50 1999 Baa1
 Best Products 12.625 1996 B1
 Borg-Warner 5.50 1996 A1
 Burlington Industries 9.00 1995 Baa3
 CCI 12.75 1998 B1
 City Investing 8.00 1991 NR
 8.125 1991 NR
 9.00 1996 NR
 9.125 1997 NR
 Cole National 14.50 2000 B2
 Colt Industries 11.25 2015 Ba3
 10.125 1995 Ba3
 12.50 2001 B1
 Freuhauf 6.00 1987 Baa2
 9.70 1996 Baa2
 Fuqua 7.00 1988 B
 9.50 1988 NR
 9.875 1997 B
 GAF 11.375 1995 Ba3
 Jim Walter 8.00 1998 Baa2
 9.50 1996 Baa1
 Lear-Siegler 10.00 2004 NR
 11.50 1998 Baa1
 11.25 1998 Baa1
 Metromedia 9.50 1998 Baa2
 Midland Ross 5.75 1992 Baa2
 Norton Simon 6.00 1998 Baa2
 7.70 1996 Baa1
 9.50 1999 Baa1
 Owens-Illinois 7.625 2001 A3
 9.35 1999 A3
 Reliance Group 9.875 1998 NR
 9.875 1999 NR
 Revlon 10.875 2010 A1
 RJR Nabisco 7.375 2001 A1
 8.00 2007 A1
 7.75 2001 A1
 7.75 2003 A1
 6.75 1993 A1
 Safeway 7.40 1997 A3
 SCM Corporation 5.75 1987 Baa2
 7.25 1988 Baa2
 9.25 1990 Baa2
 Scott Fetzer 9.25 1985 A3
 Storer Communications 10.00 2003 Ba2
 Sybron 7.40 1994 Baa3
 Western Pacific 10.00 2001 NR
 Wickes Companies 12.00 1994 B2
 7.50 2005 B2
 15.00 1995 B3
Note: NR means not rated.

(1)Although the RJR Nabisco case has received considerable publicity, none of the RJR Nabisco bonds were among the six largest negative returns. (2)Included in this group was one firm that had a group of shareholders waging a proxy fight to force liquidation of the firm. (3)Of the 11 bonds not rated by Moody's, eight were rated speculative grade by Standard & Poor's, two were not rated by Standard & Poor's, and one was rated investment grade. (4)When an announcement occurred on a Friday, we extended the event window a week. (5)Some bonds had short return intervals of three of four weeks due to nontrading of the bond in weeks -1 or 0. The longer intervals were largely for bonds of firms that had more than one bidder (i.e., management and at least one outsider). (6)This is less of a problem for Warga and Welch because they matched the bonds of the LBO target with an index of comparably rated bonds. Asquith and Wizman and the present study, however, both used Treasury indices. (7)There was insufficient pre-event period data to calculate a mean return for one RJR bond and for the Midland Ross bond. (8)We also constructed a weighted average bond return for each firm based on the par value of each bond issue. For the market-adjusted returns methodology, this produced an average wealth loss of -2.21% for the entire sample, -2.62% for the restructured subset, and -2.46% for the successful MBO. For the mean-adjusted returns approach, average wealth losses occurred equal to -2.29% for the entire sample, -2.75% for the restructured subset, and -3.01% for the successful MBOs. These returns were also statistically significant. (9)One of the referees pointed out that these estimators may not exhibit asymptotic convergence properties. Omitting the maturity variable would, however, subject the results to a missing variable criticism. With the maturity variable omitted, the equation F-value was 4.10, with a significance level of 0.0035, and the resulting [R.sup.2] was equal to 0.29. (10)Asquith and Wizman included a maturity variable in their analysis of the cross-examination abnormal bond returns. Although they did not attempt to control for the differential sign effect that maturity has for bonds that increase versus decrease in value following a buyout announcement, their regressions involving maturity included only the sample of bonds still outstanding. The returns for these bonds are likely to be negative. They found that the coefficient was negative and statistically significant. (11)Thus, the hypotheses to be tested are invariant to the ordering of effects in the model. (12)See footnote 9. (13)Using the mean-adjusted returns methodology, 19 of the same 20 bonds had positive abnormal returns. One of the bonds in the fourth row of Exhibit 5 had a negative mean-adjusted return. One other bond had a negative market-adjusted return but positive mean-adjusted return. This bond would appear in the last row of Exhibit 5. (14)No prices were available from this period for the eleventh bond that was redeemed but experienced a negative announcement reaction. (15)These prices have not been adjusted for coupon accruals or movements in the general level of interest rates. (16)Several divisions of the firm were, however, purchased by division managers.


[1]P. Asquith and E.H. Kim, "The Impact of Merger Bids on the Participating Firms' Security Holders," Journal of Finance (December 1982), pp 1209-1228. [2]P. Asquith and T.A. Wizman, "Event Risk, Covenants, and Bondholder Returns in Leveraged Buyouts," Journal of Financial Economics (September 1990), pp. 195-213. [3]D.O. Cook and J.D. Martin, "The Co-Insurance and Leverage Effects on Target Firm Bondholder Wealth," in Research in Finance, Vol. 9, A. Chen (ed.), Greenwich CT, JAI Press, 1990, pp. 107-129. [4]D.K. Denis and J.J. McConnell, "Corporate Mergers and Security Returns," Journal of Financial Economics (June 1986), pp. 143-187. [5]G. Handjinicolaou and A. Kalay, "Wealth Redistributions or Changes in Firm Value: An Analysis of Returns to Bondholders and Stockholders Around Dividend Announcements," Journal of Financial Economics (March 1984), pp 35-63. [6]K. Lehn and A. Poulsen, "Sources of Value in Leveraged Buyouts," in Public Policy Towards Corporate Takeovers, Transition Books, 1988. [6A]K. Lehn and A. Poulsen, "Free Cash Flow and Stockholder Gains in Going Private Transactions," Journal of Finance (July 1989), pp. 771-787. [7]L. Marais, K. Schipper, and A. Smith, "Wealth Effects of Going Private for Senior Securities," Journal of Financial Economics (June 1989), pp. 151-191. [8]A. Warga and I. Welch, "Bondholder Losses in Leveraged Buyouts," Working Paper, Columbia University, 1991. Douglas O. Cook is a Senior Financial Economist at the Office at Thrift Supervision, Department of the Treasury, Washington, D.C. John C. Easterwood is an Assistant Professor of Finance at Virginia Tech, Blacksburg, Virginia, and the University of Houston, Houston, Texas. John D. Martin is the McDermott Professor of Banking and Finance at the University of Texas, Austin, Texas.
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Title Annotation:Leveraged Buyouts Special Issue; includes appendix
Author:Cook, Douglas O.; Easterwood, John C.; Martin, John D.
Publication:Financial Management
Date:Mar 22, 1992
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