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Journal of Financial Economics 23 (1989) 155-191.

North-

Laurentius atherine SCNI


Universiry of Chicago, Chicago. IL 606~7, USA

Received November 1987, final revision received January 1989

This paper investigates effects of going-private buyout proposals made from 1974 to 1986 on the
value and default risk of convertible and nonconvertible debt and preferred stock securities.
Positive average price reactions are documented for public convertible securities and nonconvert-
ible preferred stock; many of these issues are redeemed as part of the buyout. Most nonconvert-
ible debt securities remain outstanding without renegotiation after buyouts. and minimal average
price reactions are documented for public nonconvertible debt. Following successful buyouts the
proportion of debt in the capital structure more than triples on average, and most rated debt
securities experience downgradings in Moodys ratings.

Our objective is to investigate the effect of going-private buyouts of pubk


corporations on the value and default risk of the existing senior securities.
Allegations that these securities (particularly nonconvertible debt) are im-
paired by increases in default risk induced by buyout-related financing have
appeared in the financial press and elsewhere with supporting anecdotal
evidence.2 Whether recapitalizations that involve unanticipated increases in
borrowing - such as those that frequently accompany going-private buy-
outs - do indeed affect senior securities adversely is unresolved in the finance
literature.

*We appreciate useful conversations with Linda and Harry DeAngelo and comments fro.n
seminar participants at Baruch College, Duke University, Harvard University, Yale University,
the Stanford Summer Accounting Workshop, and the Universities of Alberta, Chicago, Illino%,
Minnesota, Oregon, Rochester, and Texas. Particularly helpful suggestions were provided by
Gailen Hite (the referee). This research was supported by the Center for Research in Security
Prices, by the Institute of Professional Accounting, and by th: Executive Program Research Fund.
all at the Graduate School of Business of the University of Chicago.
We use the terms going-private buyout, going-private transaction, and buyout to refer to a
tran;action in which public common stock ownership is extinguished and incumbent managcmcnt
retains control (i.e., the firm is not purchased by another firm with different managers). There is
management equity participation in all our sample buyouts. We include convertibie and I~OIKO~-
vertible debt and preferred stock in the terms senior securities or securities and refer only to
common sock as stock.
*Most but not all of our sample buyouts involve leverage increases.
156 L. Marais et al., Effects of going prioare on senior securities

e implications of going-private buyouts for the values of senior securities


are ~omFlicat~d by at least two issues. First, the existing securities face a
necessarily apect ;he wealth of differ
e way. Securities may remain o~tsta~di
converted into other securiiies, or renegoti-
protect fixed payments on securities that
in terms if, for example, total operating
cash flows increase after the buyout because of the incentive effects of the
n of equity claims and the buyout financing. Our primary motiva-
ument the net effect of any such factors on the existing securities.
e provide three types of evidence regar ing the impact of buyouts on
securities. The first is descriptive evidence leverage increases associated
sample buyout firms. The evidence includes comparisons of the average
r the buyout, af various classes of senior securities,
e also document the sample frequency of outcomes
, redeemed for cash, exchanged for other securities, or
ese outcomes indicate the relevance of the increases in

For 113 sample firms, there is 4.5 times as much private as public long-term
debt (measured by book values) before the buyout. In additicn, more than
80% (by book value) of this private debt is nonconvertible and has no
ummarized in Moods) restricting additional borrowing with
r seniority. Buyout-related borrowing increases the value-
e leverage ratio from 0.265 before the buyout to 0.894 after-
ase in leverage may aflectmore of the private than the public
nonconvertible debt, because a higher proportion of private debt (6% versus
ook value) remains outstanding without renegotiation after the

he second type of evidence is the change in price of public securities at


initial buyout announcements of firms with sufficient available price data to
compute security returns. Both nonconvertible preferred stock and convertible
securities earn significant positive abnormal returns on average. The gains to
enerally arise from idiosyncratic features of
uts, whereas for our sample of convertible
xplainable by gains available from conver-
bonds on average earn zero abnormal re-

oodys debt ratings around


effects of these buyouts on
crease in the risk of default

clebt)/(book value of long-term debt + kook


implies a decrease in secusit
ings (and radings) of
IpropOSalS.
change bchavior~
irect comparison cf this bond-rating-change evidence with desists on
rice reactions to buyout announcements is not possi ost of our
sample. Specifically, sufficient price data to permit inclusion in the returns
analysis are available for only seven of the 36 nonconver;ible
ratings data. For this small subsample, the evidence is row
that six of the seven bonds experienced 0th negative r-g
downgrades. It is not clear, however, whether this result wo
larger samples or later time periods.
The paper is organized as follows. Section 2 motivates the stlrdy in light of
prior research. Section 3 describes the sample. Section 4 explains our empirical
procedures and reports both estimates of wealth effects on public set
and evidence concerning changes in Moodys debt ratings associated wit
management buyouts. Section 5 contains conclusions.

Research to date has documented effects of going-private buyouts on


common stock values, income taxes, and (to a lesser extent) bond and
preferred stock values. DeAngelo, DeAngelo, and Rice (1984) and Lehn and
Poulsen (1988) report abnormal gains to common stockholders averaging
9% respectively. Lehn and Paulsen (1988) Schipper and Smith
aplan (1987) provide various measures of the effects of buyouts
on the value of corporate-income-tax Biabilities resulting from a change in
interest and depreciation deductions following the buyout. Their results sug-
gest a marked decline in the tax liability following some buyouts. Finally,
Lehn and Poulsen compare bond and preferred stock prices 10 days before
and after leveraged buyout announcements. They find minimal price changes
for 13 bonds and positive price changes for 10 preferred stocks.
We examine the impact of buyouts on debt and preferred stock. Our main
interest is in whether a decline in the value and an increase m the defautt risk
of such fixed claims are associated with the leverage-increasing
capital structure that often accompany going-private buy0
quency and dollar size of leveraged buyout transac~ior~s h
recent years, attention has been called in the fina
effects on corporate bondholders4 er losses arc ahe

4See, for exarnptc, Forsythe, Bad Gradw Taitcovers Tcac


Borrm 3. Febnmy 24, 195;; Farrell. Ttieoverc and Bu~ou
Busitress Weeh. November II. 1985; Forsythe, Current Yield
ilyouts. Barmu s, October 28, 1%. Andes3
158 L. Marais et al.. Efecrs o,fgohg privare on senior seru,ilies

be at least partially responsible for the stockholder gains associated with


recent leverage-increasing corporate restructurings. McDaniel (4986, 1988)
summarizes a number of stories from the financial press as well as semi: of the
related academic research and provides 20 case studies that he describes as
corporate restructurings in which senior security holders complained thalt
stockholders were infringing on their rights.
ocumenting such an expropriation of bondholder wealth would have
implications for the theory of corporate finance as it relates to the effects of
conflicts of interest (among, say, bondholders, stockholders, and managers) on
the firms capital structure, its market. value, and ias various securities. In a
review of the research into such conflicts, Jensen and Smith (1985) identify
three primary means of transferring wealth from bondholders to stockhnders:
(1) unexpected increase in risk of investment projects, (2) unexpected increase
in dividends, and (3) unexpected issuance of additional debt of the same or
higher priority. Although covenants often are included in debt contracts to
reduce bondholders exposure to expropriation by such unexpected investment
and financing decisions, the effective degree of protection is an empirical
issue.5
Several recent empirical studies in the finance literature test for wealth
effects for bondholders of corporate restructurings that affect leverage. For
example, researchers have tested for a reduction in bond price and/or bond
rating associated with an increase in cash dividends [Hancijinicolaou and
alay (1984)], stock repurchases [Dann (1981) and Vermaclen (1981)], debt for
stock exsha offers {Masulis (1980)], and voluntary spin-offs of corporate
subsidiaries ite and Owers (1983) and Schipper and Smith (1983)]. The
results largely fail to demonstrate the expropriation of bondholder wealth.h

Bondholders Can Take a Terrific Beating, Heard on the Street, Wa11 Street Journal, June 1, 1987:
and Sandier. Owens-Illinois, in Going Private, Limits Right of Junior Bondholders to Gzt Money
Back, Heard on the Street, Will Srreer Journal, June 9, 1987. An example often mentioned in
these stories is the n&es issued by Revlon in the summer of 1985 in a defensive recapitalization.
Subsequently, management proposed a leveraged buyout of Revlon (the Wull Sweet Jourttul
carried a story on Qctober 2 cies&oing board consideration on October 1 of a management
buyout proposal). Closiltg prices of Revlon notes in the days surrounding October 1 and 2 are as
fQllOWS.
nurr 9,26 9/27 9/30 10/l iO/2 10/3 lO/4 10/7
Price 100.0 market 99.0 92.75 93.5 94.5 90.0 87.875
closed
Thus. k)vcr the seven trading day!; centcrcd on October 2. the notes lost 12.125%.
See Smith and Warner (1979) end McDanrell (1986) for a discussion and analysis of bond
covenants.
i\n exception is Masulis (1980). which documents significant average abnormal losses of - 0.3%
co~ve~tib!e bonds upon the announcement of debt for stock exchange oilers,
asses for holders of ~~,~co~vc~ti~~edebt without covenant protect against the
ti~a9 debt of equal or senior sIanding ( -0.843 ), No significa losses were
ers of convertible debt.
L. Marah et al., cts 01 going priuate ma sefh= securities 159

The view that in a levera


uced systematically by a
senior status ignores the
factors.
firms cash flows may decline as aresult of the buyout. For e
ing the firms pension plan or cut
claims. An increase in interest tax
an increase in depreciation deductions from a step-up in the
existing assets may reduce the federal co
in tax and compensation liabilities will
leverage resulting from buyout fin
cash flows because of the incent
claims and the buyout financing may tend to protect the fixed payments
original securityholders. Third, an insider groups offer to buy the
held common stock at a substantial premium may convey favorable inside
information about the distribution of futtire returns on the firms assets. If so.
the buyout offer will raise the capital markets expectations of the cash flows
available to service securities. The net effect of these forces on the value and
default risk of debt and preferred stock is the empirical issue addressed here.

Our final sample contains 290 buyout proposals made by 26


Stock Exchange (NYSE), American Stock Exchange (AMEX), and NASDA
firms from January 1974 to November 1985. Mor:t of this sample was identl-
iied by searching the Dow Jones News Retrieval Service under key phrases
related to going-private and leveraged buyouts. Stories about 551 proposals
were located in two Dow Jones sources: The Wall Street J~r~rab FulP Text
from January 1984 to November 1985 and Dow Jones News (w
the Broadtape and selected stories from Barron s and the Wall Street Jourml)
from June 1979 to November 1985. In addition, a search of the financial press
and the Wall Street Journal Index under the names of well-known buyout
specialists added 20 proposals made by 19 firms during 1974-1978, for a
total of 571.R

See Jensen (1986) for a discussion of the implications of debt for corporate efficiency and
Smith (1988) for related empirical evidence.
RIn addition to these sources, we used the WSY Index to obtain daily observations of tkc DC)N
Jones Bond ctive Data Corporation data bases and
MorUdal and Id Record for prices, face value. interest ts.
covenant pr conversion features of debt; Center fsa
(CRSP) daily stock returns files daily stock returns of NYSE, A
Pro statements and other publi e Capital Changes Rep0
for scripions of leverage cha Ption of securities. and changes in ownership struc-
tures.
160 L. Marais et al., Efects of going private on setlior securities

he following announcements were eliminated: (1) 109 proposed buyouts


that did not involve the whole firm, (2) 27 buyouts that were proposed b
existing businesses with operating assets, (3) 1Ogbuyouts that were rnentione
as a restructuring possibility with no subsequent proposal, (4) 9 annuunce-
ents that were rejections by the boar s in a buyout
that would naturally fo s involving Ii
traded on the NYSE, A for one year before the proposal,
(6) 1 proposal made by a firm in bankruptcy proceedings.
Seventy-three sample firms had at least one public debt or preferred stock
security outstanding at their buyout announcements, but not all the securities
have enough returns available for computation of abnormal returns. In addi-
tion, some firms have multiple securities outstanding at multiple buyout
announcements. We therefore distinguish between an observation* and an
event as follows. An observation is a single security at a given announcement,
whereas an event is a distinct buyout announcement. Although multiple
securities of a given type for a single firm are combined at an announcement
to count as one event, the number of events for a given type of security may
exceed the number of firms because of multiple announcements by some firms.
Table 1 summarizes the year-by-year frequency of announcements by the
totall sample and by firms with public securities. There is substantial time
clustering, with between 45% and 50% of announcements drawn from 1984
1985. The announcements by firms with public securities are more likely
e defensive (39% versus 24% overall) and less likely to be successful (46%
versus 57% overallj. The 73 firms with public debt or preferred stock are
somewhat larger as measured by market value of common equity: $410.6
million on average, cornpared with $?80.5 mi!lion for the sample as a whole.
This difference becomes more pronounced in the later years of the sample and
resent in every sample year starting with 1978. In addition, only three of 80
a~nounccments (about 4%) made by firms with public debt and preferred
stock are krnade by NASDAQ firms, while 92 of 290 total announcements
(about 32%j involve NASDAQ firms. The total market value of the senior
public securities associated with these 80 announcements is less than one-half
(about 42%) of :he associated market value of equity.

s associated with going-private transactions can


efault risk of senior securities. Table 2 summarizes

Dcfcnsivc ~U~VIJPproposals are made in response to a takeover bid or the threat of ore (as
e filing of form 13D, by published rumors in the financial press, or by the firms
aving rejected a takeover offer within the last year). Successful buyout proposals are those that
ulminate in a ~cccs~ful tender oKer. w that the stock of the buyout firm is
is c;mtrolled by the rn~~~~erne~~buyout group.
L. Marais et al., Effects of going prime on seuior securities 161

leverage ratios for 113 sa s a mea~rc o Str se lxfore

ratio is 0.263, and no

n leverage rat10 is 0. 3 firms ratios excee


0.90. Eighteen firms, or about 16% of tain ratios less than

leverage, indicating that the m n increase in leve

following characteristics: debt or preferred stock, public or private, convertible


or not, and, for debt, protected or not.
Dollar book values of securities in each of 14 categories are presented as
proportions of the book value of long-term debt plus stockholders equity.
value-weighted proportions are computed by dividing the sample-wide t
dollar book value in each category by the sum of the book values of long-term
debt plus stockholders equity sample-wide. Thus, each firm is effectively
weighted by its size, as measured by the book value of long-term debt plus
stockholders equity. In contrast, the equal-wei ted proportions are simple
averages of the ratio of book value of each tegory to each firms own
long-term debt plus stockholders equity.
The results in table 3 suggest that, using book value measures, private
long-term debt dominates the other nonequity categories of our sample firms
capital structures. Public long-term debt as a proportion of total capital
(long-term debt plus stockholders equity) before the announcement averages
just 0.039 (0.031) on an equal-(value-)weighted basis. The average dollar book
value is $8.2 million per sample firm. In contrast. average private long-term
debt before the announcement is $37.3 million per firm, or 0.211 (0.140) of
iota1 capital on an equal-(value-)weighted basis, respectively. ore than 80%
of this debt is nonconvertible debt without covenants restricting the issuance

The leverage ratio is computed, using book values, as: (long-term debtj/(long-term debt + Iota!
stockholders equity). Prebuyout levera&_ ratios arc computed using data from the balance sheet
immediately preceding the buyout announcement; postbuyout ratios are computed from the
expected capitalization as disclosed in public buyout filings (such as proxy statements). We were
able to obtain sufficient data to compute leverage ratios for 113 of the 165 successful buyouts in
our sample.
Private securities are not registered with the SEC, whereas public securities are. We categorize
a debt security as protected if its description in M&Vs indicates there are covenants rcstricllng
the issuance of debt with equal or higher seniority. Francis (1988) provides evidence that the
information in Moodvs is a good description of the actual covenants. Specifically, she c
the Mooc$s descripiion with the actual indenture ements for 45 public industrial
and found that the covenants were reporte
classifcations that Franciss results apply to our sa jzublic debt securities.
Table 1
Characteristics of 290 going-private buyout announcements by 264 NYSE, AMEX, and NASDAQ firms, 1974-1985.
-
Panel A: 290 announcements made by 264#rms, selected without regard to capitul st; ucture

No. of announcements Market value of common equityr


NY/AM NASD Total Defensivea SuccessfuP Total - M& yilledian MaX I1
___---

1974 3 0 3 0 0 108.9 9.0 36.8 63.1 3


197s 0 0 0 0 0 0 0 0 0 0
1976 3 1 4 0 4 65.1 6.9 12.4 33.3 4
1977 9 0 9 0 7 117.7 6.9 14.2 25.2 8
1978 3 c) 5 1 5 467.8 8.4 17.6 270.4 5
1979 10 i 18 : 9 L668.5 2.7 25.9 380.5 18
1980 12 6 18 14 1.286.2 2.6 18.1 323.2 18
1981 18 8 26 5 14 1,924.O 4.3 21.8 284.2 26
1982 22 13 35 8 27 2.377.9 1.5 25.1 330.6 35
1933 29 11 40 11 24 6,636.9 1.4 70.9 747.2 40
1984 214 24 78 21 36 17,895.6 4.8 110.0 L891.9 78
1985 35 19 54 15 25 19,@42.1 9.4 68.5 3.872.4 53
Total 198 92 290 69 165 SL990.6 288

.-- --- --.l._ - ._. - _, .-. - -..- s --- . .. _- __- _ - _ -


Panel B: 80 announcements made by 73jirms, with public debt and/or public preferred stock in the capital structure
No. of announcements Market value of equityC Market value of senior securitiesC
NY/AM NASD Total Defensive Successfulb Total Min Median Max II Total Min Median Max n
--
1974 2 0 2 0 0 72.1 9.0 36.0 63.1 2 452.6 452.6 452.6 452.6 1
1975 0 0 0 3 0 0 0 0 60.0 0 0 0 0 0 0
1976 0 0 0 0 0 0 0 0 60.0 0 0 0 0 0 0
1977 1 0 1 0 1 6.9 6.9 6.9 6.9 1 0 0 0 0 0
1978 1 1 2 1 2 431.4 161.0 215.7 270.4 2 137.3 7.6 68.6 129.7 2
1979 4 0 4 2 1 800.3 26.4 199.2 375.6 4 174.1 10.1 33.1 97.8 4
1980 3 0 3 2 2 443.7 95.6 168.4 179.7 3 555.6 13.3 37.3 505.0 3
1981 5 1 6 1 2 823.8 13.8 153.9 270.4 6 667.9 6.9 42.4 450.8 6
1982 7 0 7 3 5 767.3 25.1 95.4 289.0 7 176.1 1.4 2.9 81.3 7
1983 15 0 15 7 7 3.897.5 25.3 114.3 747.2 15 472.8 3.3 14.9 114.9 13
1984 24 1 25 10 9 11,894.5 19.2 298.0 1.891.9 25 1.636.4 5.7 29.3 643.9 23
1985 15 0 15 5 7 13.709.8 20.0 511.5 3.872.4 15 9,6OQ.3 2.3 55.7 7,857.l 14
Total 77 3 80 31 36 32.847.5 80 13,gg2.1 73

Defensive announcements are those made in response to a takeover bid or the threat of one (as indicated by the fifing of form 13D, by published
rumors in the financial press, or by the firms having rejected a takeover otler within the preceding year).
bSuccessful buyout proposals are those that lead to a merger or successful tender offer, so that the common stock is delisted and the firm is
controlled by the buyout group.
Market values are measured in millions of dollars at the most recent available price at least two days before the buyout-announcement date.
NY/AM means listed on the New York and American Stock Exchanges. Senior securities refer to public debt and preferred stock; for senior
securities, total market value is: (number of shares or bonds outstanding at the fiscal year-end preceding the buyout announcement) * (most recent
available price at least two days preceding the announcement). n is the number of events with sufficient available data for computing a market value; n
is less than or equal to the given total number of announcements. Mm, median*, and max are the minimum, median, and maximum of the n
market values.
164 L. Muruis et al., Efects of going prirwte 011 setoior securities

Table 2
Sample distribution of leverage ratio? before and after 113 going-private buyouts undertaken by
AMEX, NOSE, and NASDAQ firms. 1974-1985!

Before buyout After buyout Change at buyout


__--___
Interval for level or No. of No. of &CLof
change in leverage ratio firms Percent firms Percent firms Percent

x=1.00 0 0.0 4 3.5 1 0.9


0.90 I x c 1.00 0 0.0 39 34.5 1 0.9
0.80 < x c 0.90 4 3.5 18 15.9 10 8.8
0.70 I x c 0.80 3 2.7 15 13.3 13 11.5
0.60 5 x < 0.70 6 5.3 11 9.7 17 15.1
0.50 < x -z 0.60 9 8.0 8 7.1 i4 12.4
0.40 I x < 0.50 12 10.6 7 6.2 12 10.6
0.30 I: x < 0.40 20 17 7 2 1.8 8 7.1
0.20 I x -z 0.30 14 12.4 0 0.0 10 8.8
0.10 d s < 0.20 ld 15.9 3 2.7 9 8.0
0.00 I x < 0.10 27 23.9 6 5.3 13 11.5
.Y< 0.00 NA NA NA NA 5 4.4
Total 113 100.0 113 100.0 113 100.0
Median 0.263 0.845 0.499

Tine ieverage ratio is computed as: (book value of long-term debt)j(book value of long-term
debt + book value of total stockholders equity). The ratio before the buyout is computed from the
balance sheet for the fiscal year end immediately preceding the buyout announcement. The ratio
after the buyout is computed from the pro forma capitalization information given in SEC filings
related to the buyout.
These are 30 NASDAQ firms and 83 AMEX and NYSE firms for which leverage measures are
available from proxies or other SEC filings related to the buyout, annual reports, and 10-K
reports.
x refers to the /erfel of leverage ratio before and after the buyout and to the c/rarrge in leverage
ratio upon the buyout.

of additional debt of equal or higher seniority.* The results in table 3 also


show that buyouts on average reduce common stockholders equity as a
proportion of total capital. The decline is from 0.722 to 0.043 on a value-
ted basis and from 0.696 to 0.253 on an equal-weighted basis. In dollars,
the average decline in the book value of common stock is $178.4 million (from
$192.3 million of prebuyo public equity to $13.9 million of common equity
uyou t particip s). This reduction is accompanied by a dollar
increase in the average book value of long-term debt from $70.5 million to

*?The potential importance of the protection clause is illustrated by the 9.59, debentures of
Metromedia. On December 6, 1983 a management team proposed a management buyout, to be
financed by over $1 billion in bank debt and the issuance of new debentures that would rank
debentures. The price of these debentures dropped from 90% of par about
announcement to 85% of par two days after the announcement and 82% of
the announcement. After the buyout, both Moodys and .Y
s) and from BB + to B - (S&P). Both rating
the changes.
L. Muruis et al.. Efects of goittg prirwe ott setmr stwcrirres 165

Table 3
Capital structure of 113 AM and NADAQ firms before and after g~in~-~~~~te
011ts.
1974-1985.
Value-weighted (a) and equal-weighted (bj average book value of long-term debt, preferred stock.
and common equity as a proportion of long-term debt plus stockholders equity by security type.

efore buyout After buyout Ckange at buyout


Security type 71, (b) (a) (b) - (a) (b)
-~
Private long-term debt
Nonconvertible with protectionb 0.0825 0.026 0.184 0.262 0.158
Nonconvertible without protection 0.114 0.182 0.462 0.361 0.280
Convertible with protection 0.000 0.001 0.000 0.000 0.000 (;.OD;)
Convertible without protection 0.001 0.002 0.002 0.008 0.001
Subtotal EZ 0.21.1 0.764 0.654 0.624 0.443
Public long-term debt
Nonconvertible with protection 0.009 0.011 0.042 0.023 0.033 0.012
Nonconvertible without protection 0.014 0.02!2 0.031 0.017 0.017
Convertible with protection 0.002 0.001 0.000 0.000 $~:~
Convertible without protection 0.0106
s- 0.005 0.000 0.000 $?E{ (o:OOs>
Subtotal 0.031 0.039 0.073 0.040 8.042 0.001
Other long-term debt 0.094 0.050 0.057 0.044 (0.037) (0.006)
Pritwte preferred stock
Nonconvertible 0.000 0.022 0.014 0.022 0.014
Convertible 0.003
-- 0.008 0.009 0.005 0.009
Subtotal 0.003 0.030 0.023 0.027 0.023
Public preferred stock
Nonconvertible 0.004 0.003 0.026 0.002 0.022
Convertible 0.006
-- 0.001
-. 0.007 0.002 0.001
Subtotal 0.010 0.004 0.033 0.004 0.023

Common stock 0.122 0.696 0.043 0.235 (0.679) (0.461)

Public securities are registered with the SEC, while private securities are not.
bProtection here means that Moodrs indicates there are covenants restricting the issuance of
debt with equal or higher seniority.
Other long-term debt includes deferred taxes, deferred investment tax credits. and other
b!ance-sheet items, and excludes unfur&d pension obligations.
Common stockholders equity includes the par value of common stock, additional paid-in
capital, and retained earnings, and excludes tmasury stock.

$291.2 million. These changes are reflected in ta le 3 as an incre


ted average leverage ratio frosn 0.265 before t uyout to 0.

y far the largest leverage i


nonconvertible debt. After the buyo
166 L. Marais et al., Effects of going private 011senior securities

with going private can be viewed on average as a substitution of private


nonconvertible debt for common equity.13
Table 4 presents direct evidence on the disposition of debt and preferred
stock in 113 buyouts. All sample securities outstanding at the balance sheet
date immediately preceding the buyout announcement experienced one of four
outcomes: (1) partly or completely redeemed for cash, (2) exchanged for other
securities, (3) no change, or (4) timing of payments renegotiate<& Results are
presented for the number of securities and total book value in the first three
categories.14
Among the 404 securities in this subsample (387 debt and 17 preferred stock
securities), the largest proportion (275 or 68%) experience no change in the
explicit terms of their contracts. Within this group, 227 securities are private
nonconvertible debt securities without protection against the issuance of
additional debt of equal or higher seniority. With one exception - a private
debt issue for which the timing of payments was rescheduled - the remaining
sample securities are at least partially redeemed for cash or exchanged for
other securities. The effect of the buyout on their value depends on the value
of the cash or securities received in relation to the value of the original
securities before the buyout announcement.
More than half of all public debt and preferred stock is at least partially
redeemed or exchanged at buyouts; 10 of 12 public preferred issues are fully
redeemed, as are 2 of 5 private preferred issues.15 PropSortionally more public
debt securities (about 60% or 25 of 42 issues) are at least partially redeemed or
exchanged than are private debt securities (about 26% or 90 of 354 issues).
This difference may be due to differences in restrictive covenants between
public and private debt or to a preference for retiring all public securities
when the common stock becomes privately held.

13Acomparison of the equal-weighted and value-weighted averages in table 3 suggests potential


differences in capital structure changes associated with firm size (as measured by the book value of
long-term debt plus stockholders equity). Specifically, preferred stock and public debt account for
6.3% and 7.3%. respectively, of the average post buyout capital structure on a value-weighted
basis, but 2.7% and 4.0% on an equal-weighted basis. Before the buyout, however, the value-
weighted and equal-weighted proportions were more similar (3.1% versw 3.9% for public debt and
1.3% versus 0.4% for preferred stock). Thus larger firms, which are more heavily weighted in the
value-weighted proportions, appear to make relatively greater use of public debt and preferred
stock in financing management buyouts. These indications, which are based on point estimates
without regard to dispersions, should be viewed as merely suggestive of the potential for
diKerences.
*The fourth category contains just one private nonconvertible deb: issue (book value $3.1
million).
If al1 pubhc securities and common stock are redeemed, the firm is no longer subject to SEC
uirements. Avoiding t.Fe costs of such reports is sometimes mentioned as a motiva-
tion for going private.
L. Marais et al.. Qfects of going prir*ate or8seniw srcm-ilies 167

Table 4
Outcomes to holders of debt securities and preferred stock associated xith 113 goi~~~~~v~~~
buyouts by AMEX. NYSE, and NASDAQ firms. 1974-198s.
Book value of debt and preferred stock in thousands of dollars. followed by number of issues
in parentheses.

Nonconvertible Nonconvertible Convertible Convertible


with without with wirhol:
Outcome protectio# protection protection protertion

Panel A : Private debt securitiesh

Fully redeemed for cash 98,138 (6) 1,052.480 (72) 1.500 (1) 3.790 (3)
Partially redeemed for cash 52,312 (5) 89.604 (6) 0 (0) 0 (0)
Exchanged for other securities 0 (0) 0 (0) 0 (0) 1,539 (1)
Remain outstanding without
renegotiationc 603,081 (23) 2.284.010 (227) 9.120 (1) 18,223 (3)
Total 753,531 (30) 3,429,197 (3061 10.620 (2) 23,551, (7)

Panel B: Public debn ;mrities

Fully redeemed for cash 6,762 (1) 191,205 (11) 46,518 (1) 166,976 (9)
Partially redeemed for cash 0 (0) 10.512 (1) 0 (0) 0 (0)
Exchanged for other securities 0 (0) 132.W (2) 0 (0) 0 (0)
Remain outstanding without
renegotiation 278,083 (8) 94,818 (8) 0 (0) 1.4% (1)
Total 284,845 (9) 42X.535 (22) 46,518 (1) 168,424 (10)
Panel C: Preferred stock

Private Public
-~ -
Nonconvertible Convertible Nonconvertible Convertible

Fully redeemed for cash 7,749 (2) 0 (0) 68,218 (5) 20.518 (5)
Partially redeemed for cash 0 (0) 0 (0) 0 (0) 0 KU
Exchanged for other securities 0 (0) 2 (1) 0 (0) 0 (0)
Remain outstanding without
renegotiation 0 (0) 75,100 (2) 65.109 (1) 168,000 (1)
Total 7,749 (2) 75,102 (3) 133,327 (6) 188,518 (6)

Protection here means that Moodys indicates there are covenants restricting the issuance of
debt with egual to higher seniority.
bPtlblic securities are registered w&h the SEC, while private securities are not.
The timing of payments was rescheduled for one nonconvertible private security with a book
value of $3.1 million.

ecuri er

4.4. Index models

We estimate the wealth effects on the common stock and senior securities of
firms that armounce buyou
returns into estimates of
168 L. Muruis et ~1.. Eec 15 qf going prime m settior securiries

common stock our index model is the familiar market model, conditioned on
returns tc the CRSP equal-weighted NYS stock index for
EX securities and on the equal-weighted N index for
issues. For debt and preferred stock we use dex model
on both CRSP stock index returns and returns to the Dow Jones
nd Index.16 Our purpose in including the latter is to attempt to compensate
r interest-rate movements in our estimaics of abnormal returns to fixed
income securities.17
Owing to the infrequent trading of several of the senior securities in our
sample, our data contain numerous multi-day returns. We interpret each such
multi-day return as the sum of a corresponding set of unobserved single-day
returns, each of which is generated by the single-day index model. Therefore
the appropriate index model for a multi-day return has the same coefficients as
that for e-day return, but these coefficients multiply the sum of the
correspo dex returns. Similarly, the intercept coefficient multiplies n,
tL .-l..rnt:.3
U& UUI~UU~ Gf t he iR*dti- day return, instead of 1. The error term in the
equation for the n-day index model has n times the variance of the single-day

Single- or multi-index models for bond returns are less well established in the empirical
finance literature than those fo- stock returns. Several theoretical and empirical difficulties %i:jfh
such models are unresolved, e.g., the choice of an appropriate index and the potential nonstation-
arity of the beta coefficient. Our specification of the two-index model is justified on the pragmatic
ground that several alternative specifications. including the single-index market model and simple
mean adjustment, yield qualitatively identical conclusions. See Alexander (1980) and Elton and
Gruber (1987. ch. 19) for further details regarding index models for bonds.
There are several theoretical grounds for skepticism about our implicit assumptiull of
stationarity of the heta coefficient that measures the sensitivity of bond returns to movements in
the index portfolio of bonds. Elton and Gruber (1987, ch. 19) discuss one such consideration,
which implies that the bond beta equals the ratio of t:. ,Macauley) duration of the bond to that
of the index portfolio. This implies, in turn. that beta decreases with time and that the decrease
becomes steepei as the bond approaches maturity. The average time 10 maturity of our sample
bonds is over twelve years. A!1 but seven of our sample bonds have at least five years to maturity,
and for each of these the theoretically implied variation in beta over the relevant period is small
compared with its standard error of estimation. For the remaining seven short-maturity bonds
the time io maturity ranges from seven to 28 months. None of these seven bonds experienced an
abnormal return greater than 0.9% in magnitude at 7 buyout announcement. and no associated
r-statistic exceeds 0.9 in magnitude. Moreover, a replication of our event study using a simple
mean adjustment instead of the bond-index mod4 does not materially alter these statistics fgr the
individual securities involved or our aggregate conclu ions.
tiOur treatment of multi-day returns for sparsely traded securities implicitly assumes that the
prosess that governs when trades occur is indepetdetrt of the underlying return-generating process.
(The same assumption underlies the Scholes and Williams (1977) procedure for correcting
estimates of beta for nonsynchronicity.] One concern about this assumption is the possibility that
circumstances that trigger trading also tend to have economic content that drives unusual returns.
eriod the observed returns arc not necessarilv drawn from an
g returns process. as we assume. We make &is observation& 3s
do not have an econometric scutiun.
Table 5
Summary statistics fm d least square5 estimate5 of index models for common stock, debt,
and preferred stock se of AMEX. NISE. and NASDAQ firms proposing going-private
transactions, 1974-1985.
The index model for the jth common stock or security is
~tra,rl,,+P,r,,,+~,~d,phr+~,/I~
where 5, is the return to the j th common stock or security;
AMEX market return for fisted stock and the equal-wei NAS~AQ market return for
NASDAQ stock: rh, is the return to the Dow Jones bond index: d, is a dummy variable equal to
0 if security j is common stock and 1 otherwise; a,, fi,, and /I$ are intercept and slope
coefficients: q,, is the duration of 5, (i.e., v,, = 1 for a single-day return): and P,, is an error term.
-- - --
Quartiles
Security type &VO Median Range 0.25 li.75

Punel A : fi
NYSti and AMEX common stock 197 0.85 - 0.26 to 3.59 US4 1.14
NASDAQ common stock 90 0.63 - 0.19 to 2.34 0.34 1.19
Convertibl, debt 30 0.31 -0.19 to 1.61 0.18 0.47
Convertible preferred stock 24 0.56 - 0.08 to 1.17 0.39 0.75
Nonconvertrble debt 68 0.06 - 0.98 to 0.49 - G.05 0.21
Nonconvertible preferred stock 12 0.30 -0.07 to I.11 0.13 0.39

Pmel B: 8
Convertible debt :; 0.13 - 0.68 to 1.47 - 0.03 0.35
Convertible preferred stock 0.31 - 1.24 to 5.49 - 0.04 0.96
Nonconvertible debt 68 0.39 -0.G to 2.70 0.17 0.70
Nonconvertibie preferred stock 12 0.31 -0.23 to 1.23 0.04 0.64

Punei C; R (unudjusted)
NYSE and AMEX common stock 197 0.08 0.00 tbzt3.34 0.03 0.13
NASDAQ common stock 90 0.03 0.00 to 0.28 0.01 0.07
Convertible debt 30 0.05 0.00 to 0.25 0.02 0.11
Convertible preferred stock 25 0.10 0.01 to 0.26 0.07 0.14
Nonconvertible debt 68 0.06 0.01 to 0.40 0.02 0.12
Ncnconvertibie preferred stock 1& 0.02 0.W to 0.17 0.01 r)O5

Panel D: Corre!otionss mrrong uhnorrrzol returm to debt und


pre,ferred stock securitie.7 uf
u sirrglejm
Convertiue debt 5 0.17 0.10 to 0.50 0.12 0.37
Convertibre tjreferred stock 4 0.55 O.:!3 to 0.64 0.44 0.60
Nonconvertible 1+? 101 0.12 - 0.99 to 0.99 - 0.01 0.23
Nonconvertibfc preferred stock 3 0.06 - 0.05 to 0.08 0.00 0.07
_--~__-..- _ .- .~____. -~-- - ---
N is the number oi observations.
These are estimated con:emporaneous c,.l-n.rs-sectinnalcorrelations x~~ong the cxcw WIYI.\ i,, of
the index models for different ?icuritics of the same firm.
190 L Marais et al., EJthcts of going private on senior securities

error term.19 Therefore we estimate the index models by weighted leas


S) to account for this source of heterosked~st~city. (Further
of the index models are provided in the a
Summary statistics for the index-model regression n k table 5. In
the estimates of 8, the
y to movements in a stoc
stocks in our sample have relatively low market se
common stocks is 0.85, and t
.63. Although the maximum for common stocks in our
sample exceed 2.0, most less than 1.2. For debt and preferred stock the
estimates of /I in panel A icate that convertible @sues are more sensitive to
the market index than nonconvertibles (median /3s equal to 0.31 and 0.56
and 0.30, respective1 but less sensitive than common stock.
shows estimates of the slope coefficient measuring security-
sensitivity to movements the bond index. The median and quartile
resuhs indicate that returns to nonconvertible bonds are more sensitive to
movements in the bond index than are returns to convertible bonds. For
referred stock the in&cations are inconclusive. The cross-sectional distribu-
tions of t-statistics for the coe%cients (not reported here) confirm that returns
to the convertible securities are indeed related to the stock index and provide
modest confirmation of a relation between returns to nonconvertibles and the
bond index.
The explanatory power of the WES regressions, as measured by R2, is
shown in panel C of table 5. For all classes of securities, the median R2 values
do not exceed 0.10. The lowest median explanatory power (0.02) is associated
with ~o~c~~vertible preferred stock. The highest median R2 values are those
for common stock (0.08) and convertible preferred stock
(8.1 these securities the explanatory power of the index model
is modest in absolute terms.

timation of abnormal retmu

edicticn errors computed using the fitted


ma1 return is computed for each sample
riods defined relative to the associated
reannouncement, announcement, a,ad F9rten-
~Q~~cernen~pcrioi: is defined for most securities
e day the announcement appezrs in the
ces of going pric pate on serhr securiries 171

II Street Journal. nnouncement period starts at tra


relative to the a % day and ends on the last d
announcement peri anning approximately three
the announcement. The postannouncement period begins o
after the announcement period and ends when the buymt proposal is resolved,
which we define operationally as follows. For s buyouts the period
ends at the earhest of the days the stockholders a e merger into a new
private corporation, a going-private tender offer is successfully complete
the common stock is delisted. For going-private proposals that fail
because of a competing outside bid) the postannouncement period e
the proposal is withdrawn and/or rejected by the board or stockho
going-private proposals that lose to a higher outside bid the period
the higher outside offer is announced.
Studies that include multiple securities of sample firms must take account of
the potential covariance among returns of a given firms securities m assessing
the overall significance of abnormal returns. This is easily accomplished if
different securities of a given type can be combined into a single value-weighted
portfolio. The relatively sparse nonsynchronously-observed returns to many
senior securities make it difficult to compute portfolio returns, however.
Therefore some studies [e.g., Eger (1983) and Handjinicolaou and Kalay
(1984)] select one bond per firm (on the basis of trading frequency) and
exclude the other senior securities from the sample. An alternative approach,
which we follow, is to estimate the covariances and to incorporate them in our
assessments of significance. (Details are provided in the appendix.) Panel
table 5 summarizes our estimates of cross-sectional correlations among se
ties of a given type for a single firm. Not surprisingly, most of the estimated
correlations are positive.
The following example illustrates the potential consequences of these dif-
ferent ways of accounting for cross-sectional covariance. One of our sample
buyout announcements is associated with eight distinct nonconvertible debt
issues. The announcement-period abnormal returns for these securities range
from 0.08% to 6.09%, with associated t-statistics ranging from 0.06 to 3277.
Using the criterion of trading frequency to select a single
security for this event [as in Eger (1983)] yields four possible
abnormal returns and t-statistics ran
to 1.40. Using our a
among returns to the

with an associai
Table 6
Abnormal returns for public securities at 80 announcements 01 going-private proposals by 73 AMEX, NYSE, and NASDAQ firms, January 1974 to
November 1985.
-_
Abnormal returns ,--statiHics
- -___
Quartiles Quartiles
No. of
announcements Mean Median Range 0.25 0.75 Aggregatea Median Range 0.25 0.75

Panel A; Period preceding the unnmxementh


Common stock 80 0.09 0.08 - 0.53 to 0.74 -0.00 0.20 5.07 0.40 - 2.75 to 5.31 -0.01 1.14
Convertillrle debt 24 0.03 0.04 - 0.50 to 0.29 -0.u2 0.09 2.46 0.40 - 1.34 to 3.88 -0.12 0.91
Convertible
preferred stock 21 0.12 0.13 - O.u/ ro 0.39 -0.00 0.18 3.28 0.70 - 0.73 to 3.01 -0.00 1.07
Nonconvertible debt 33 - 0.00 - 0.02 - 0.09 to 0.19 -a.03 0.01 0.23 - 0.28 -- 1.27 to 8.82 -0.78 0.17
Nonconvertible
preferred stock 10 - 0.00 - 0.01 -0.12 to 0.10 -0.04 0.03 0.20 c).O4 - 0.41 to 0.66 -0.18 0.31

Panel B: Announcement periodC


Common stock 80 0.13 0.13 - 0.04 to 0.37 0.03 0.22 42.33 3.96 - 1.95 to 18.57 0.74 8.33
Convertible debt 22 0.06 0.04 - 0.01 to 0.33 0.02 0.09 11.01 11.64 -0.25 to 10.34 0.43 2.99
Convertible
preferred stock 20 0.08 0.06 - 0.09 to 0.21 0.02 0.18 11.81 1.76 - 3.92 to 10.24 0.55 5.31
Nonconvertible debt 30 - o.Ono3 - 0.001 - 0.07 to 0.05 -0.02 0.01 1.05 -0.16 _- 5.29 to 1.92 -0.58 0.35
Nonconvertible
preferred stock 10 0.11 0.07 - 0.01 to 0.35 0.00 0.21 9.12 2.80 - 0.41 t,o 7.80 0.32 4.18
__-

_ -_ _ _ ._ - - . -. - ._. ._ - ~. . __ _~ - . . -.- - - - -~.- - . - .-


Punel C: Period following successfrrlpropost&
Common stock 33 0.09 0.06 - 0.41 to I.21 -0.01 0.13 1.64 0.23 - 1.59 to 2.35 -0.03 0.49
Convertible debt 7 - 0.00 0.04 - 0.20 to 0.09 -0.04 0.06 -0.17 0.29 - 1.69 to 0.71 -0.38 0.51
Convertible
preferred stock 4 0.08 -0.10 - 0.20 to 0.71 -0.16 0.32 0.87 - 0.36 - 0.42 to 2.87 -0.40 1.26
Nonconvertible debt 10 - 0.01 - 0.02 -0.19 to 0.14 -0.07 0.05 1.15 - 0.22 - 1.Ol to 5.41 -0.71 0.40
Nonconvertible
preferred stork 6 - 0.04 - 0.01 - 0.39 to 0.18 -0.11 0.11 - 0.25 - 0.06 -0.80 to 0.51 - 0.64 0.45

Pane/ D: PeriodJollowing unsuccessful proposalsc


Common stock 15 -0.15 -0.16 - 0.48 to 0.25 - 0.30 - 0.01 - 3.29 - 1.28 - 2.88 to 3.33 - 1.86 - 0.08
Convertible debt 7 -0.11 - 0.06 - 0.27 to 0.00 -0.19 -0.03 -2.87 - 0.77 - 2.12 to 0.01 - 1.69 -0.67
Convertible
preferred stock 3 -0.16 -0.16 - 0.34 to 0.01 -0.25 -0.07 -1.77 - 0.90 - 2.24 to 0.08 - 1.57 -0.41
Nonconvertible debt 4 - 0.08 -- 0.05 - 0.20 to - 0.02 -0.13 -0.03 - 2.27 - 0.63 -2.76 to -0.54 - 1.71 -0.57
Nonconvertible
preferred stock 2 - 0.01 - 0.01 - 0.08 to 0.06 -0.08 0.06 - 0.38 - 0.27 - 0.94 to 0.40 -0.94 0.40
- __.
This is the sum of the z-statistics for- mdividual securities divided by the square root of the number of terms. Individual security z-statistics are
computed using the procedures described in the appendix.
hThe period preceding the announcement is determined in part by the availability of data. For most securities it begins 69 days before the WSJ
announcement of the proposal. For some securities, the preannouncement period begins 23 days before the WSJ announcement.
The announcement period is the day of the WSJ announcement and the preceding day.
This postarnouncement period extends from the day after the announcement period until the offer is consummated. The total of panel C events
(successful buyouts) plus panel D events (unsuccessful buyouts) is less than 80 because we were unable to identify definitive outcomes for 32 of 80
announcement events.
This postannouncement period extends from the day after the announcement period until the offer is withdrawn.

rl
w
174 L. Marais et al., E$pcts oi going privute on senior securities

iions yields a r-statistic of 2.44, while assuming that aI correlations equal one
yields 1.13.) Thus a selected representative debt security may not yield the
same conclusion about abnormal returns as an anaiysis of a firms entire
portfolio of public debt issues.
Our econometric procedure provides r-statistics far the abnormal returns
associated with the subperiods of interest, thus standardizing them for differ-
ent residual variances and for varying numbers of estimation-period ob-
servations. Under the nukl hypothesis of zero announcement effects the
distributions of these ts still differ cross-sectionally because of their varying
degrees of freedom. To facilitate cross-sectional aggregation of evidence from
our sample, we further standardize each t-statistic by dividing it by its
theoretical standard deviation under the null; we refer to the standardized ts
as z-statistics. In table 6 we also report aggregate z-statistics equal to the sum
of the individual zs divided by the square root of the number of terms. Under
the null hypothesis both the individual and the aggregate z-statistics are
distributed approximately as standard normal variables.

4 3. Measures of abnormal per,cbrmance


Table 6 summarizes estimates of abnormal returns to common stock, as well
as debt and preferred stock securities, before, at, and after buyout announce-
ments-21 For a given type of security and subperiod, each distinct buyout
an-ouncement in our sample is associated with zero, one, or more securities
having enough data available to estimate an abnormal return. Each event with
at least one corresponding security is represented in table 6 by a single
value-weighted portfolio abnormal return for each subperiod and by the
associated z-statistic as described in section 4.2,

4.3.1. A bnorma! returns before buyout announcements

Panel A of table 6 presents results for the 6%day period preceding the
pearance of t e buyout announcement in the Wall Sireet Journal. In this
preannouncement period commolL 7 stock, convertible debt, and convertible
referred stock earn abnormal returr-1?3averaging 9%, 3%, and 12%. respec-
vely. Under the null hypot esis of no abnormal performance for any an-
sample, the corresponding individual z-statistics should
om sample from a standard normal distribution. In addi-
ctional distribution, we report an aggregate z-statistic for

The event study reported in table 6 was replicated for all 286 stocks with sufficient returns
data. While results for this larger sample were very similar to those reported in table 6, it is not
clear whether such results would be observed for samp!es drawn from other time periods.
L. Marais et al., Efecrs ofgoing prioore on settior securities 175

the hypothesis that the in ual zs are ce


z-statistics indicate si ficance of the abnormal retu
probability level (two-Me ) in all three cases.
z-statistics for nonconvertible debt and preferred stock do not indicate a
systematic shift of abnormal returns away from zero in the preannouncement
period.

4.3.2. Abnormal returns to common stock and convertible securities at


buyout announcements
Panel B of table 6 presents results for the ~Rou~~rnent
aggregate evidence for each class of public securities except no
debt shows that abnormal returns are significantly positive at be
0.0001 probability level. The average abnormal returns range from 6% for
convertible debt to 13% for common stock. Furthermore, the median z-statis-
tic for the securities within each class indicates significance at the 0.10
probability level or better (two-tailed). The average abnormal gains do not,
therefore, appear to be due to a small subsample of securities within each
class.
For convertible securities, the average abnormal retunrnsreported in
of table 6 are at least partly attributable to the gains available to
holders from conversion. Table 7 provides descriptive evidence for 21 conver-
tible bonds (representing 19 firms, one of which made two buyout anneunce-
ments) and 18 convertible preferred stocks ,$epresenting 15 fir
which made two buyout announcements) for which full information was
available concerning a cash GTcash-equivalent ofFer price for common stock,
conversion terms, and prices for convertible securities at leas: two days
preceding the buyout announcement. We used this information to
conversion premiums as In[(number of shares of common stock into
security is convertible * cash offer price to common stock)/(most re
price for security)].
For these 39 securities, eight conversion premiums are negative: two for
preferred stocks (both associated with unsuccessful offers) and six for bonds
(four associated with unsuccessful o
returns on the 31 positive premiums y
bonds and preferred sto
relation between abnormal rzturln a
adjusted for the probs
cients in the regressions sf
176 L. Marais et (11. Efects of going private on serlior securities

Table 7
Abnormal returns and conversion premi ms for 39 convertible debt and convertible preferred
stock securitiesa at announc tnents of going-private Buyouts. 1974 1985.
-_
Convertible debt Convertible preferred stock

No. of securities 21 18
No. of firms 19 15
Abnormal returnb
Average 0.06 0.09
Range - 0.008 to 0.33 - 0.09 to 0.26
Median 0.04 0.05
Conversion premiumC
Average 0.09 0.18
Range - 0.88 to 0.70 - 0.04 to 0.50
Median 0.13 0.17
Regression of abnormal returns
on positive conversion premiums
.\D2 ~~uj~Skd)
/*A, 0.68 0.60
Slope coefficient 0.53 0.55
Standard error of slope 0.10 0.12
No. of observations 15 16

a We were able to find a cash or cash-equivalent offer price as well as conversion terms for 39
securities of 30 distinct firms. (Four firms have both convertible debt and convertible preferred
stock in the subsample.)
bAbnormal returns are computed using the procedures described in the appendix.
The conversion premium for a given security is computed as: ln[(number of shares of common
stock into which the security is convertible*cash oiler price to common stock) + (most recent
trade price)].

43.3. Abnormal returns to nonconuertible preferred stock at


buyout announcements

The positive abnormal returns averaging 0.11 to nonconvertible preferred


in table 6 are not, of course, attributable to conversion
or these I2 securities (representing 10 firms) we investigated call
values, voting power, and ultimate outcomes to attempt
e apparent systematic gains. Negative abnormal returns of less
than 1.0% in magnitude are associated with three buyout offers. In one case
her case a successful buyout was challenged in
olders on the grounds that the buyout was
e third negative return is associated with a
was not redeemed. The smallest
or less) are associated with four securities
the stock was not redeemed or the buyout failed.
with the largest abnormal returns consists of
urns ranging fro
pre urn and protected by voting rig
tion.

4.3.4. Abnormal returns to nonconvertible debt securities at


buyout announcements
In contrast to the results for other classes of securities, the mea
median abnormal returns to nonconvertible debt are approximately zero
announcement period, with 50% of this sample of 30 abnormal returns fallin
between - 2% and + 1%. These results do not suggest a pattern of
wealth gains or losses to nonconvertible public debt securities u
announcements. However, the nonconvertible public debt set
firms in this sample do experience statistically significant abn
losses, ranging from -7% to +5% with z-statistics ranging
+ 1.9. Although the aggregate z-statistic of - 1.05 does not i
center of the cross-sectional distribution of individual z-statistics is nonzero,
the &i-squared statistic for the hypothesis that they have unit variance equals
51.5, which is significant at the 0.01 level. This is evi
values among the 30 abnormal returns than is c
hypothesis.
Although our sample-wide statistical analysis is consistent
wealth effects on nonconvertible debt at buyout announce
cases of negative effects have been reported in the financial press and else-
where. Therefore in the five subsections below we examine several characteris-
tics of the individual securities and announcements in our sa
prior research and the anecdota
disaggregate the 30 announcement
debt securities (section 4.3.
defensive proposals (section .3.4b). We define a defensive
response to an existing or atened takeover offer. In sect
exarnine outcomes for ofIers (i.e.,
bonds (e.g., retirement). Finally,
leverage ratios before and after successful buy

4.34~. Abnormal returns to i~divid~~~debt securities

based on the combination of all none


178 L. Murais et al.. Eflecrs of going priuate on senior securities

abnormal return for these 55 observations is OBO3and the range is -0.07 to


0.06; 27 ablrormal returns are positive. The range of individual z-statistics is
- 5.3 to 3.9; nine z-statistics exceed 1.6 in magnitude (five positive and four
negative).
Interpretation of these results is complicated by the presence of five events
that account for 28 of the 55 individual abnormal returns. A single firm, Rapid
American, made two buyout offers (in 1974 and 1980) that account for two
events and 12 security returns. The first buyout offer was withdrawn atter the
SEC questioned its terms and a bondholder group objected to the terms.
Abnormal returns to all four of this firms bonds in our sample at the 1974
announcement are negative (ranging from - 0.02 to -0.04 with z-statistics
from - 2.5 to - 0.7). as is the abnormal return to stock ( - 0.03). At the 1980
buyout offer, however, the stock-price reaction is +0.07, and all eight bond
returns in the sample are positive as wel! (ranging from 0.008 to 3.06 with
z-statistics from 0.1 to 3.9).
The buyout was structured as a debt-for-stock exchange ofPer followed by a
merger; the public minority interest (about 42%) was extinguished and the
leverage-ratio increase was 0.13. There was no change in bond rating associ-
ated with the buyout and no debt was retired. The leverage ratio before the
buyout was 0.803, and all rated bonds in our sample were rated B2 by
Moodys. Thus this firm was aiready highly leveraged, and the buyout-related
le\*erage increase was relatively small. The agreement of the signs of the
abnormal bond returns at each of these two events is consistent with our
method of aggregatirrg abnormal returns into a single portfolio return ir each
event. The interpretation of such a portfolio return would be complicated if it
combined statistically significant individual abnormal returns of opposite signs
at a single event.
Three other sample firms with unsuccessful buyout proposals account for
seven, six, and three security returns apiece. At its 1984 buyout announcement,
the stock-price reaction crCity Investing is 0.14, while the average bond-price
reaction for its seven bonds in the sstmp!e is -0.02 (the individual returns
range from -0.04 to 0.03 with z-statistics from - 2.0 to 1.8; five are negative).
City Investing was liquidated about 18 morlths after its buyout proposal failed.
Fuqua Industries stock-price reaction at its 1981 buyout announcement is just
er 6.13, and ah1three sample bond reactions are Zero or positive. Finally,
Ams 1985 buyout proposal is associated with a stock-price reaction of
0.003; three of its six bonds experience statistically insignificant negative
rle the other three reactions are positive an
are defensive, compared with 69 of 290 in the total sample (about 24%
IO defensive p osals account for of the 55 totai bond ouse
defensive mane er, buyout prop Is met with succes., only twice; bond
returns ar9 0.0 d -0.068 (the most negative return in
these two announcements. ** Defensive proposals, however, are n
associated with lower bond returns: a two-s ple test for di
abnormal bond returns at defensive and no fe~sive buyout
a I-statistic of - I.23 (for 55 o servations, not significan
levels).

4.3.4~. Qummes PObuyout proposals and to individual securitia


The success rate is lower in the subsample of 30 events included in &e
security-returns analysis reported in table 6 than in the 290 announcements in
the total sample. Specifically, 11 buyout proposals (about 37%~ involving
public nonconvertible debt succeed and I65 proposals (about 57%) in the total
sample succeed. A &i-squared test for homogeneous proportions yields in
rejection of the null hypcthesis at the 0.018 level.
We find no evidence of a systematic pattern of bond redemption associated
with this subsample of buyouts. Bonds are called at or soon after the buyout in
four successful buyouts. (one firm calls two bonds.) Returns at the buyout
announcements are negative for all five called bonds. In addition, seven bonds
are repaid as part of the City Investing liquidation described earlier, and five
sample bonds have matured since their firms buyout announcements.
Among the 27 positive returns to nonconvertible debt, 11 are associated
with successful buyouts. Of these 11 returns, eight are associated with Ra
Americans 1980 buyout, as described earlier. Two of the other three successful
buyouts with positive abnormal returns to nonconvertible debt are associated
with a relatively mo est leverage increase (0.109, Soundesign) or a leverage
decrease (-0.045, I-Iunt International). The third firm, CCI Corporation,
experiences the largest leverage increase in this subsample (0.5
bond-rating decrease from Bl to B3. The bond return is, un
positive (0.014, t = 0.20). An examination of the specific characteristics of this
bond and this buyout uncovered no explanation for this result; the debt
remained outstanding with no nnnounced c
nated to all buyout financing. Thus, if the e
ated with a single buyout are removed, only
suc~es&l buyouts an

ZIt doe5 not appear that these different reactions are associated with leverage changes. The
positive bond reaction is associated with a leverage increase of 0.597 and a bond-rating decrease
3; the nr;ative reaction is associated with a leverage increase of 0.093 and a
bond-rating decrease ft.xn Ba2 to B2.
kinder the null hypothesis that the probability is 3.5 that a buyout prr~pnsmlwith ;i positive
return will succeed, a binomial test based on three successes out of 19 proposals yields a =-statistic
of - 2.98. sigtificrnt at bettec than the 0.05 ievel.
18C L. Marais er al., ETfects of poittg privure ott settior securilies

We conjecture that the apper:nt average lack of bond-price reaction to buyout


announcements for this subslmple is partly due to the rather low success rate
(about 37%) of these offers.

4.3.4d. Leverage changes


The preannouncement leverage ratios for this subsample of 30 proposed
buyouts all lie above the sample median of 0.263 reported in table 2. They
range from 0.302 to 0.803. With one exception, however, the increases in
leverage at the buyout all lie below the median leverage increase of 0.499
reported in table 2. It appears, therefore, that these firms were already more
highly leveraged th.an the typical buyout firm in our sample, and their
buyout-related financing was proportionately smaller.24 The apparent relative
unimportance of leverage changes is confirmed by a zero estimated correlation
between abnormai returns and leverage changes for the POcases with available
data.

4.3.4e. Rating changes


I3ond-rating decreases (probably arising at least in part from the leverage
increases) are observed for seven of the 11 successful buyouts included in the
returns analysis reported in table 6. One firm experiences no rating change;
cne firm calls its rated debt at the buyout; and three firms have no rated deb:.
In addition, one rating decrease follows an unsuccessful buyout proposal. We
perform a two-sample t-test on the subsample of 35 bonds with both abnormal
returns and bond ratings (eight bond ratings decline and 27 do not e:hange).
The resulting t-statistic is -2.03, indicating that bonds that later experience
ratings decreases tend to earn more negative returns at buyout announce-
ments. Six of the seven rating decreases after successful buyouts are associated
with negative bond returns at buyout announcements; positive returns are
associated with the no-change firm, one firm with a rating decrease, and two of
the three firms with no ratings.
Overall, we find no systematic pattern of gains or losses to our sample of
public nonconvertible debt at uyout announcements. This result contrasts
with the results for three other classes of securities, in which systematic gains
are observed, and found to be at least partiy attribu?able to the frequent
participative of these securities in the buyouts, either through a conversion
feature or through redemption. Nonconvertible debt, however, in general is
not redeemed at the buyout,

For example, s Services had completed a debt-for-stock exchange offer that replaced
one-third of its out ing common stock with deh about a year before its 1982 buyout offer. At
the buyout a~~ou~ceme~t, the debt issues . .. the exck offer experienced a - 0.053 return (the
stock return was 0.?6.
nea debenture, eventn
43.5. Abnormal returns after buyout announcenzents
After the announcement period., there are generally insignificant abncrmal
returns to common stock and public securities in successful buyouts. Although
both posittile and negative abnormal returns are documented in panel C of
table 6, the only aggregate t-statistic that that approaches significance at
conventional levels is that for common stock (1.54), and the median z-statistic
for common stock (0.23) does not indicate signiicance. These results are
consistent with the QW that ultimately successful buyout proposals are
followed, on average, by minimal revisions in expect;ations. In contrast, almost
uniformly negative abnormal returns are observed in the period following
buyout proposals that ultimately fail (panel D o f table 6).* The largest sample
size in this panel, however, is 15, and most sample sizes are less than 10, so
these results should be interpreted cautiously.

4.4. Gains to shareholders compared withpublic and private de&holders


exposure to potential losses
Potential wealth effects of buyout announcements are not, of course, limited
to the public securities considered in section 4.3. Since private debtholders are
the predominant creditors in terms of book values prior to the buyout,
consideration of public securities alone does not finally dispose of the conjec-
ure that losses to debtholders might substantially offset shareholder gains. It
is not possible to extend the tests underlying results reported in table 6 to the
publicly unobservable changes in the value of priTate debt.26 We can, however,
compute indirect measures of bondholder exposure to wealth losses.
To gain perspective on the plausibility of bondholder expropriation as the
sole source of stockbolder gains, we first corrsider the following question: if all

Given that the overall success rate of the 290 buyout proposals in our sample is about 55%
the asymmetry of the results in panels C and D of table 7 may appear anomalous. Partitioning the
preannouncement- and announcement-period abnormal rettims to common stock by ultimate
success cr failure yields no evidence that the market is able to discriminate the two classes of
events at the time of the announcement. Nevertheless, the outcomes that we label success or
failure are not a simple dichotomy. fn particular, the information content of falure varies
substantially depending, for example, on whether the buyout failed because of a competing
outside bid.
26The covenant protection of private debt may differ systematically from that of public debt.
Although they do not consider private-debt agreements explicitly, Smith and Warner (1979) report
that their analysis suggests that private debt has both higher risk and more detailed covenant
restrictions than does public debt, Leftwich (1983) reports that variations from generally accepted
accounting principles are found more frequently in private debt covenants, and that these
variations generally restrict managements ability to choose accounting rules that favor stockhold-
ers over bondholders. Our own evidence on differences in covenants for public and private debt is
c<Mned IO the covenant protecting against the i~~ance of debt cf equal or greater seniority. AS
indicated in table 30 of 306 (about 10%) of our sample private ~o~co~v~~~tib~edebt issues have
the protection covenant, and 9 of 22 public debt issues (about 40%) have this covenant.
182 L. Marais et al., Efects oj going privare on senior securities

nonconvertible debt experienced extreme (100%) hses in book value, or more


@usible losses roughly similar to the greatest percentage negative abnormal
return for a public debt security (about 7%), tc what extent would these losses
offset dollar gains to shareholders? Our analysis is based on 103 buyouts with
both positive abnormal returns to stockholders at buyout announcements and
sufficient data to compute book values of debt at the balance-sheet date
preceding the announcement.
For 35 of the 103 buyouts (about 34%) we find that our estimated dollar
gains to shareholders exceed even our extreme (100% loss of book value)
measure of debtholder exposure. The results of the event study suggest that
10% of book value may be a more plausible bound on total debtholder
exposure to wealth loss. Estimated dollar gains to stockholders exceed 10% of
total book value of debt for 84 of the 103 buyouts (about 81%). There are thus
only 19 buyouts, which together account for less than 2% of the total dollar
gains to stockholders, for which plausible debtholder losses - on the order of
10% of book value - can account fully for stockholder gains.
The preceding comparisons of stockholder gains with bounds on potential
bondholder losses provide evidence on the plausibility of wealth transfers from
debtholders as the sole source of stockholder gains. An alternative view is that
such wealth transfers may be an important source of stockholder gains, but
not the only one. If ivealth transfers are a factor in going-private buyouts, they
should be moie il-+crLy I nt zs the proportion of debt in the prebuyout capital
structure increaaspd. GM ir,, l;diger ratios of prebuyout debt to equity should
yield greater percenlage gains io siockholders through debtholder expropria-
tion. Such a relation shoz1.i *- 7
...A& h ii positive cross-sectional correlation
between percentage abnormal rerurns to common stock and the prebuyout
debt-equity ratio. In the subsample of 103 buyouts, however, the rank
correlation between abnormal returns and debt-equity ratios is less than 0.01
and is not significant at conventional levels. A cross-sectional regression of
abnormal returns on debt-equity ratios, weighted to account for the standard
errors of the estimated abnormal returns, yieids an estimated slope coefficient
of 0.006, with an associated t-statistic of 0.71. Thus our sampie evidence does
not suggest that expropriation of debtholders IS an important source of
stockholder gains.

oodys ratings of sample debt

Section 4.3 documented bond-rating decreases for six firms with negative
abnormal returns, and one fir with positive ahnormal returns, to noncor-.ver-
tible debt following buyout ~~~o~nce~nen~.s. expand the
analysis to ir~iude all sibt,& sciur oorjys. The
ose is to i~vcstigate w ~yo~t-related increases in leverage impair
L. Marais et al., Effects oj going pricate on senior securities 183

existing securities by increasing their default risk, as measured by oodys.


Without other offsetting changes, such as changes in the terms oi a bond, a
true increase in default risk is expected to be associated with a decline in
value. Such a decline would occur when the default-risk increase became
known to the market.2s
Moodys Bond Record was searched for each sample firm with a successful
buyout proposal in the month preceding the buyout announcement in the
sections listing ratings of nonconvertible debt, convertible debt, and preferred
stock.29 Subsequent issues of Moodys Bond Record were searched fsr each
rated sample security until the earlier of tws events: (1) a change in rating ant
(2) one year after the buyout-resolution date. The buyout-resolution date is
defined as the earliest of: stockholder approval of the merger into a nevV
private corporation, successful completion of a going-private tender offer,
delisting of the common stock. Moodys ratings were found for 36 nonconver-
tible debt securities of 19 firms, 17 convertible debt securities of 14 firms, and
no preferred stock securities before and after successful buyout proposals.
A transition matrix of noncoiivertible debt ratings before and after success-
ful buyout proposals is presented in table 8, panel A. In the month preceding
successfui buyout proposals, 22 of 36 nonconvertible debt securities (61%) are
rated as investment grade (Baa3 or above). In contrast, after the buyout is
completed, none is rated as investment grade. Rating decreases are pervasive,
affecting 30 (83%) of the 36 nonconvertible debt securities. In many cases,
ratings drop several categories.
The transition matrix of ratings of convertible debt securities before and
after successful buyout proposals is reported in panel B of table 8. Forty-one
percent of this sample (7 of 17 securities) was rated as investment grade before
the buyout announcement, but only one security retained this rating. As
reported in panel A of table 8, 41% of the sample experienced a rating

It is not clear how Moodys determines default risk. Previous research [e.g., Belkaoui (1983)]
has documented that linear models that include leverage measures and subordination status havs
substantial explanatory power for bond ratings. To the extent that Moodys decision rules are
influenced heavily by increases in leverage ratios, rating decrcases following leveraged buyouts
seem highly likely. Some support for this conjecture is found in Wall Strser Journal stories
announcing rating decreases for our sample securities, Moodys officials are often quoted as
referring to the buyout-related ieverage increase as a primary reason for the change.
28We do not investigate timing issues, for example, whether bond-rating change announcements
fo,!owing major ieverage increases r&ax ii<w inf~i~ia*rion about the effects of the leverage
increase. The purpose of our analysis is to supplement the results obtained in :he e Jent study in
section 4.3. For a test of stock-price effects of bond-rating change announcements, sr.e f-fohhausen
and Leftwich (1986).
29None of the sample firms that co,mpleted a buyout ad preferred stock with a Moodys rating
in the month preceding the buyout announcement. Five f the firms that announced an unsuccess-
ftiabtiyoilt propC& had preferred stock [uiPe nCinconV ribie and four conver?ib]e pferrc+ c@+
Au,$ iii i6,id) iJi& by MGX!~S zs Of the montb prece e at-mouncement. No preferred stock
ratings changed between the buyout-announcement and buyout-resolution dates.
184 L. Marais et ul.. Effects of going priLBate on senior securities

Table 7
Transtion matrix of Moodys debt ratings before and after 33 successful going-private
transactions. 1974-1985.
@ells above the diagonal are downgrades; the diagonal is indicated in boldface.

Panei A : P.onconvertibie debt

Revised rating
Prior rating Bal Ba3 Ba3 Bl B2 B3 Total

Aa 0 0 0 0 0 4
Al 0 0 0 ii 0 0 0
A2 0 1 0 0 0 0 1
A3 c) 0 9 0 0 0 9
Baa1 1 0 1 0 0 0 2
Baa2 0 0 3 0 1 0 4
Baa3 0 0 1 0 1 0 2
Bal 0 0 0 0 0 0
Ba2 0 ii 0 1 1 0 2
Ba3 0 0 0 0 1 1 2
Bl 0 0 0 0 3 3
B2 0 0 0 0 : 1 6
B3 0 0 0 0 0 1 1
Total no. of
securities 1 1 13 5 9 6 36

Panei B: Conoertihle debt

Revised rating
Prior rating Baa1 Baa2 Baa3 Bal Ba2 iia3 Bl B2 B3 Total
-__
Baa1 0 0 0 9 0 4 0 5
Baa2 0 0 0 0 9 1 0 1
Baa.3 0 0 0 0 0 1 0 1
Bal 0 1 0 0 0 0 0 1
Ba2 0 0 7 0 0 0 0
Ba3 0 0 0 0 0 0 0 ;
B: 0 0 0 0 1 0 1 2
Total no. of
securities 1 0 0 1 7 0 1 6 1 17

Prior ratings are taken from Moodys Bond Record one month before the buyout announce-
ment. Subsequent ratings are taken from Moodys Bond Record in the earlier of the resolution
date (the date of shareholder approval, completion of tender offer. or common-stock dehsting) and
the most recent month for which a bond rating is available.

ade; as with nonconvertible debt, several downgrades crossed several


L. Marais et al., Efjects of going privute on senior secunties 185

Table 9
Summary of Moodys debt-rating changes for 146 debt securities of AMEX. NYSE, and
NASDAQ firms making going-private buyout proposals and for all rated securities, 1974-1983.
I-
Pane/ A : Afoo~vs rating changes Pr I CS debt securities of jrms making going-private proposals

Successful proposals Unsuccessful proposals


--
Convertible Nonconvertible Convertib!e Nonconvertible
-
No. of
securities 17 36 27 66
Proportion
downgraded 0.41 0.83 0.037 0.015
-
Panel B: Rating changes for all debt securities rated ly Moodys during periods
represented by going-private proposals b-yfirms with rated debt securities

Number of Moodys
rated securities Number of changes
Year of Rating
announcement Buyout sample Totalb Upgrades Downgrades change score

1974 5 4760 65 97 - 0.007


1979 7 5648 50 61 - 0.002
1980 5 5719 83 136 - 0.009
1981 6 6079 72 152 -0.013
1982 10 5808 60 552 - 0.085
1983 19 6580 360 288 +0.011
1984 41 6683 276 420 - 0.022
1985 53 7534 528 492 - 0.005
Total 146 48,811 1,494 2.198 - 0.010

The proportion downgraded is the fraction with rating downgrades. The sample includes no
rat+ upgrades.
This is the total number of debt securities rated by Moodys as of June in a given year.
In a given year, each upgrade (downgrade) is assigned a score of + 1.0 ( - 1.0). regardless of the
number of categories across which the rating is changed The sum of the scores in a given
year is divided by the number of debt securities with Moodys ratings as of June of that year.

year for a debt security is assigned a score of - 1.0 (+ 1.0). A security with no
rating change during the year is assigned a score of 0.0. The total score for all
rated debt securities is divided by the total number of ebt securities with
Moody. .atings as of June of that year. A score is regorte
9 for each year in which buyout p posals were annou
debt ratings are available before a after the buyout ahi
annual scores are then weighted by the proportion of all
whose firms annouuced buyouts during that year. The result
indicates a slight ten
186 I.. Marais et al. Eflects of going p: ;wte on senior securities

rating declines associate e successful buyout proposals do not appear

nts pervasive increases in


nt study in section 4.3 reports
little or no impact on bond values on average. This difference stems in part
from differences in the samples considered; the event study contains only
seven of the 36 rated nonconvertible debt issues (and six of these experienced
statistically insignificant negative returns as well as rating downgrades).
In addition, bond-rating changes and the event study may not be capturing
all the same phenomena in all cases. For example, the event study fails to
capture any effects of a change in default risk that is anticipated before the
announcement period (which for most bonds is two or a few days) or that is
resolved by information released after the announcement period. The rating-
change analysis, however, covers the period from the month preceding the
buyout announcement through a year after the resolution date. Those making
the rating decisions have access to actual information about the amount and
terms of buyout financing, whereas the event reaction will reflect expectations
about these matters.
Bond ratings also have a relativelv narrow scope, in that they are intended
(according to Moodys) to capture only default risk. The price reaction at the
buyout announcement, on the other hand, reflects what is known at the time
about changes in default risk, expectations about redemption, expectations
about whether the buyout offer will succeed or fail, what the circumstances of
success or failure might be, and what effects, if any, a successful buyout might
have on the value of all the firms claims.

This paper investigates the effects of going-private buyout proposals made


from 1974 to 1985 on debt securities and preferred stock. A buyout may
terminate existing debt and preferled stock contracts by early redemption or
conv on, or these contracts may remain outstanding with or without revi-
sion. &in our sample, over two-thirds of these securities (primarily private
nonconvertible debt) remain outstanding following the buyout without any
d revisions in the explicit terms of the contract.
e also measure price reaction; for public securities at anr_Juncements of
buyout proposals. The only class of securities that does not gain on average is
ericnces statistically insignificant negative aver-
emselves, these price reactions do not support the

We also collected the ratings of debt securities of firms which announced unsuccessiui buyour
proposals. These ratings were largely unchanged. Only one convertible and one nonconvertible
debt security had a rating downgrade, and the raiing was reduced by only one rating category in
each case.
L. Marais et al, Eflects of going private on senior securities i87

view that bond values were generally reduced during our sample period
g0ingprivate transactions. hether this evidence would generalize to the large
buyouts of 1986--1988rem s an open question. Additional analysis produces
weak evidence, ,within our sample of nonconvertible debt, that more negative
abnormal returns are associated with successful buyout proposals d propos-
als followed by bond-rating decreases. (Our sample is characteriz by perva-
sive downgradings of Moodys debt ratings following successfu! buyout
proposals.

A ix: a s es

A.i. Returns data


We take raw common-stock returns for NYSE, A
firms from the daily returns tapes of the Center for Research in Securit
(CRSP) at the University of Chicago and transform them to continuously
compounded form by taking the natural logarithms of the raw returns plus
one. Returns for securities other than common stock are computed as in (A.l):

where
Rj, = return to security j between the close of trading on trading day t - k
and day t; if k > 1 this is a multi-day return,
'j* = closing price plus accrued interest (in the case of bonds) or closing price
(in the case of preferred stock) for security j on day t; if no trade
occurred on day t then a bid--ask average is used, if available,
Cj, = coupon or dividend payment to holders of record of security j during the
interval between day t - k and day t.
Because most senior securities do not trade publicly every trading day, many
of the returns computed as in (X.1) cover several trading days.

A.2. Estimation period for index mcdels


For most securities we estimate the index models Lsing all available returns
between event time - 400 days and event time - 70 days, excluding multi-day
returns whose duration exceeds
estimation-period returns for some securities,
securities this specification does not yiel
estimation observations.
188 L. Marais et al., Eflects of going prkate on senior securities

shorter preannouncement periods are included in panel A of table 6: omitting


these returns from panel A does not qualitatively affect the results.

A.3. Specifkation of the announcement period

As in prior research, we define the announcement period a


annocncement appeared in the Wall Street Journal and the prece
days - 1 and 0 in event time. Clean announcement-period data consist of
two one-day returns on days -1 and 0 or one two-day return on day 0.
Because of infrequent trading such clean data are unavailable for several
senior securities. In each such case we take the shortest possible combination
of one or two multi-day returns that covers days - 1 and 0, and include it in
our sample of announcement-period returns if its total duration is no more
than one month. For example, if a security traded on days - 4, - 3, - 2, + 1,
+ 2, and + 3 rellative to the announcement day 0, the three-day roturn for day
+ 1 only would be included.
This rule allows us to increase considerably the number of securities
included in announcement-period tests over those with clean announcement-
period returns. We interpret such multi-day returns as the sum of an unob-
served clean announcement-period return and several single-day returns from
outside the announcement period, which cannot be observed separately. Un-
der the maintained hypothesis that single-day returns outside the announce-
ment period follow the same index model as in the estimation period, the
excess single-day returns contribute only noise of known varia
observed multi-day announcement-period return. Our econome.tri
accounts for this additional variance as outlined in section A.4.3

A.4. Variances and covariances of abnormal returns

Under the null hypothesis of no announcement effect, the returns corre-


sponding to event dates -1 and 0 come from the same index model that
governs the estimation-period data. Therefore the relevant variance for testing
an observed announcement-period return (of duration n, possibly greater than
23 fog an announcement effect is simply n times the single-day return variance.
Similarly, the relevant covariance between two sush returns is simply m times
the sing!e-day covariance, where m (possibly greater than 2) is the number of
days of overlap between them.32

An alternative to our approach is a somewhat arbitrary allocation of a p, ~JI of the


multi-day return to the clean announcement period. as in Eger (iYK3!.
The dchcription in se&on A.4 is written ;as if (:w variuncca and kII. clnancc5 of I(: turns are
of interest, rather than those of index-l,k~dcl prediction errors Ada;lting the di+ s..--n 10 the
latter tax iiltroduces algebraic complications wi:hout, however, adlllng conceptu;ll .irity. See
Marais (1986) for the omitted details.
L. Marais et at, Efects of going prime on senior securities 189

-x----=x X X * Security 1
trades

Security 1
returns
0-x -x X X-a

Security 2
R 24 R21 R 29 returns

Trading
1 2 3 4 5 6 7 8 9 days

Fig. 1. Illustrative price series and overlapping multi-day returns for two hypothetical securities.
x indicates a price observation: R,, denotes the observed return to secur+ _i at time t. The
estimation period begins on day 1.

If the estimation data for diKerent securities of the same firm were contem-
poraneous and included no multi-day returns, the required variances and
covariances could easily be estimated from lthe parallel time series, as is done
in the well-known seemingly unrelated regressions procedure. With tstimation
data that include multi-day return observations, such as those depicted in fig.
1, the estimation problem is more complicsted. Although the returns of the
two securities in the figure overlap, they are nonsynchronous. For example, the
first return of security 1 ( R12) overlaps the first return of security 2 ( RZ4) by
one day. The second return of security 1 (R,,) overlaps R,, by two days and
R 27, the second return of security 2, by one day. These overlaps can be
exploited to estimate the covariance between the two series.
We use the following generalization of the estimator used in the seemingly
unrelated regressions procedure. 33 Define matrices Iii containing the number
of days by which return observations for the ith sectirity overlap with return
observations for the jth security. In the two-secu+ity example shown in fig. 1,
for example, the (2,3) cell contains the number c8f days b!l which the second
return observation for security 1 overlaps the t:tird return observation for
security 2, while the (3,2) cell contains the overla:3 (in days) between security
ls third return and security 2s second return. If a return lo security 1 does
not wrnrln
.,,,,p a given return to security 2 at all, the corrtSpunding element of
Eij equals zero. Zjj need not be a square matrix because diKerent securities
can have different numbers of available returns.
In the special case of a single security i, each return tiverla s itself for its
entire duration. Tht result is a diagonal 0s~ elements are sim

The covariancc estimator described here is unbiased and fairly easy to compute: it is not the
maximum-likelihood estimator, however, and may he ineftkient.
190 L, Marais et al., Effects of going private on senior securities

the durations of the observed returns for security i an which is proportional


to the covariance matrix of the return vector. Generaked least-squares estima-
tion of the index model using this diagonal covariance matrix reduces to
weighted least squares, as described in section 4.2.
For two disti \ct securities 1 an 2, the covariance atrix of the two return
vectors e, and e2 is o&&, wh e & is as defin above and cri2 is the
one-day contemporaneous covariance. It can be shown34 that the following
expression gives an unbiased estimate of Q:

(A-2)

where

e^,,e^,= observed return vectors for securities 1 and 2,35


2; = Mocre-Penrose generalized inverse of the matrix Z,, described earlier,
4, = rank of Z,, adjusted for degrees of freedom.

We require that Di,be at least 12. In several cases the estimation periods used
in the WLS estimation of the index models do not overlap sufficiently for two
securities of the same firm to meet this requirement. In these cases we reduce
the preannor Icement subperiod to one month as described in section A.2.
This procedure provides estimates of the single period, contemporaneous
disturbance covariances for all of a given firms securities. Marais (1986) shows
in detail how to compute the derived estimates of the variances and covari-
antes between the multi-day abnormal returns for related securities, consistent
with the description in the first paragraph of this section.

Alexander, G.J., 1980, Applying the market model to long-term corporate ionds, Journal of
Financial and Quantitative Analysis 15, 1063-1050.
Belkaoui, A., 1983, Industrial bonds and the rating process (Quorum Books. Westport, CN).
Dann. L., 1981, Common stock repurchases: An analysis of returns to bondholders and stockhold-
ers, Journal of Financial Economics 9, 113-138.
&Angelo, I-I., L. DeAngelo, and E. Rice, 1984, Going private: Minority freezeouts and share-
holder wealth, Journal of Law and Economics 27, 367-401.
Eger, C.. 1983, An empirical test of the redistribution effect in pure exchange mergers, Journal of
Financial and Quantitative Analysis 4, 547-571.

etails are available from tke authors; see also arais (1986).
3SIn reality we are intcreste e variaaccs and covariances of the index model disturbances,
Of e raw re s. Therefore we apply estimator in (A.2) to vectors of residuals from
fitr index m s instead. There is a c quent adjustment fcr degrees of freedom in the
sor I?.
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