dc.description.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. | en_US |