Apparently selling buggy whips paper for newspapers, magazines and coupons is not as profitable as – wait, who thought it was profitable? Cerberus? Sadly, that did not work out for them:

NewPage Corp., the largest North American maker of coated papers, filed for bankruptcy six years after being bought by Cerberus Capital Management LP.

NewPage had $3.4 billion in assets and $4.2 billion in debt as of June 30, according to today’s Chapter 11 filing in Wilmington, Delaware. The Miamisburg, Ohio-based company was bought by New York-based Cerberus for $2.3 billion in January 2005, and issued $900 million in junk bonds to fund the purchase. It has been unprofitable since 2006.

A 2005-vintage leveraged buyout company crushed by an unsustainable debt load and operational failure is a good excuse to mention a neat paper posted today on Harvard Law School’s Forum on Corporate Governance and Financial Regulation. The authors, three UT-Austin business professors, use tax return data to examine what happens to 1995-2007 vintage U.S. LBO targets. And they are pretty confident that they can dismiss many of the traditional explanations for how private equity firms make money – both the flattering and the unflattering ones. From the paper:

In summary, the results of our analysis are most consistent with LBOs being driven primarily by the desire to affect a one-time, sustained shift in a firm’s capital structure. We also find some support for the argument that private equity acquirers are skilled at turning around underperforming companies, though LBOs do not lead to operating performance improvements in general. We do not find support for Jensen’s (1989) free cash flow argument for the role of LBOs. And it does not appear that private equity firms loot their targets, as some commentators have argued.

To unpack that a bit:

1. LBOs do not discipline management and improve performance by reducing free cash hoarding – they don’t seem to reduce free cash flow or improve performance.

2. There’s some operational improvement for companies that are unprofitable pre-IPO, but not for the broader universe of LBO companies. Not for NewPage, either – Yves Smith is particularly unimpressed by Cerberus’s operational wizardry there.

3. On the plus side, there’s not much evidence that private equity firms are particularly rapacious in paying themselves dividends:

The median LBO firm pays out no dividends in the two years after an LBO and only a minimal amount in the third year after the LBO. Even the 90th percentile of dividends divided by transaction value is only 0.1% in the first year after the LBO and 1.7% in the second year after the LBO. These payout rates are actually lower than payout rates in the years prior to the LBO. These results hold when we look only at firms that generate excess cash flow post-buyout and therefore have the capacity to pay dividends.

4. But the main effect of an LBO is to permanently lever up the target, increasing return on equity and reducing the tax bill:

Another explanation for LBOs is that some publicly-traded firms are underlevered, and that the LBO allows the firm to move towards its optimal capital structure. This would create value for investors by, for example, allowing the firm to generate more interest tax shields. Our results do appear to support this argument. … Consistent with the increased tax shields afforded by debt, the number of firms paying tax drops dramatically in the year of the LBO and remains low even up to five years after the LBO. … The change in debt levels and leverage ratios accompanying an LBO are long-lived, and if anything debt tends to continue to increase after a buyout. Moreover, even those firms that generate excess cash flow post-LBO, and therefore have the capacity to pay down debt, do not do so.

Graphically, debt jumps up and stays there:

That explanation seems consistent with NewPage, whose LBO was funded with $900mm in debt and which filed for bankruptcy with $4.2bn. Though the tax shield is probably cold comfort to Cerberus and NewPage now.

The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts [Harvard Law, full paper on SSRN]

NewPage, Cerberus-Owned Papermaker, Files for Bankruptcy [BW]