Do agency costs of free cash flow impact private equity acquisitions : an empirical analysis of the free cash flow hypothesis’ impact on US private equity transactions

Abstract

The bidders in the acquisition market can be divided into two groups, strategic and financial acquirers, where the majority of the latter group consists of private equity firms. The two groups have different purposes for performing acquisitions. While strategic bidders typically intend to acquire targets to incorporate them in their businesses, the incentives of private equity firms are more financially driven as their main objective is to generate a return for their investors over a relatively short time-horizon. Consequently, different target characteristics appeal to the two bidder groups, where one possible explanation for this segmentation is the free cash flow hypothesis. Jensen (1989) states that the private equity company has a unique ability to mitigate agency costs of free cash flow. If the market is convinced that this is the case, private equity firms should be able to make a return by reducing agency costs of free cash flow before exiting. Previous literature provides inconsistent evidence concerning whether private equity firms acquire targets prone to agency costs of free cash flow, leaving unclear interpretations of the relationships proposed by Jensen. We argue that the inconsistent evidence in literature could potentially be a consequence of not studying the relationships in a way consistent with Jensen’s theory. Hence, we constrain our analysis to public low growth firms. Our findings provide robust evidence in line with Jensen’s (1989) hypothesis, indicating that private equity companies target firms prone to agency costs of free cash flow. Furthermore, if private equity companies expect they can obtain a return through mitigation of agency costs of free cash flow, we assume this to be reflected in their willingness to pay relative to that of the market. However, if the market does not believe that the reduction of agency costs of free cash flow is sustainable, the private equity companies should not be able to make a return on these targets, and hence the proposed relations might not be present. We test this connection by applying the acquisition premium as a proxy for excess willingness to pay above the market. While our main analysis provides evidence for this relationship, our further research does not show an unambiguous picture. We believe this to be a result of the lack of competition in the transactions studied and that consequently, using the acquisition premium as a proxy for willingness to pay in excess of the market valuation does not allow us to capture the relationship we intend to examine.