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On the Capital Structure of Leveraged Buyouts

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  • Enrique R. Arzac

Abstract

A signalling hypothesis of LBO capital structure is examined, wherein the promoters of an LBO unambiguously convey their commitment to generate and distribute free cash flow to investors by assuming debt service obligations high enough to exhaust free cash flow during the initial phase of the LBO operation. The signalling equilibrium results in an equity value consistent with the promoters' expectations concerning free cash flow and permits them to keep the value released by the LBO. The model admits positive probability of default in equilibrium, but equity values are shielded from the costs of financial distress by the adoption of a strip financing arrangement. The promoters have an incentive to adopt strip financing and investors find it not optimal to unbundle the securities making up the strip. Properties similar to those of strip financing are identified in a number of common financial structures and instruments.

Suggested Citation

  • Enrique R. Arzac, 1992. "On the Capital Structure of Leveraged Buyouts," Financial Management, Financial Management Association, vol. 21(1), Spring.
  • Handle: RePEc:fma:fmanag:arzac92
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    Cited by:

    1. Catherine Crapsky & Lionel Escaffre, 2009. "De la hiérarchisation des créances à la titrisation économique : les apports de la norme comptable à l'évolution du financement d'une opération de LBO," Post-Print hal-00769388, HAL.
    2. Kenneth Carow & Dianne Roden, 1997. "Determinants of the stock price reaction to leveraged buyouts," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 21(3), pages 49-59, September.
    3. Groh, Alexander P., 2004. "Risikoadjustierte Performance von Private Equity-Investitionen," Publications of Darmstadt Technical University, Institute for Business Studies (BWL) 21382, Darmstadt Technical University, Department of Business Administration, Economics and Law, Institute for Business Studies (BWL).
    4. Lloyd Blenman & Nischala Reddy, 2014. "Leveraged Buyout Activity: A Tale of Developed and Developing Economies," Journal of Financial Management, Markets and Institutions, Società editrice il Mulino, issue 2, pages 157-184, December.

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