Pre-privatization capital investment trend of public firms targeted for leverage buyouts

Abstract

This research examines the capital allocation behavior of listed companies during the period before they become targets for public-to-private transactions. This study aims to fill an academic gap by focusing on pre-buyout behavior, specifically testing agency conflicts in the case of Management Buyouts (MBOs), which feature two conflicting theories: the hypothesis that managers might use capital excessively to expand the asset base (empire-building), and the theory that managers might intentionally reduce investment to depress the firm's valuation (undervaluation hypothesis). Furthermore, the study tests whether such investment behavior is driven by conditions under the Free Cash Flow theory or Financial Distress. The researcher utilizes firm-year panel data, excluding the financial and utilities industries due to capital structure constraints. The study employs Propensity Score Matching (PSM) to mitigate selection bias and uses the "Capital Expenditures to Depreciation ratio" as a proxy to measure organic capital replacement. The regression analysis reveals three key findings. First, the models provide conditional evidence that target firms have an organic capital replacement rate approximately 0.19 units lower than that of their matched control group in the years preceding the buyout. Second, this severe underinvestment behavior is a unique characteristic of target firms and cannot be fully explained by operating cash flow factors or excessive debt conditions under normal market environments. Finally, the empirical evidence finds no statistically significant difference in capital allocation between the MBO and IBO groups, a result that contradicts the hypothesis of excessive managerial empire-building prior to MBOs. Overall, rather than supporting intentional managerial undervaluation, these findings point toward a universal sponsor selection mechanism. They demonstrate that whether the acquirers are incumbent managers or external financial institutions, the transition to a private company frequently occurs after a period during which the target firm falls into a state of capital depletion and its physical assets are continuously allowed to deteriorate. These findings hold significant policy and practical implications for corporate boards and investors, highlighting the need to recognize that both internal and external sponsors systematically target firms with historically neglected asset bases, positioning them as prime candidates for privatization and subsequent operational restructuring.