Several testable hypotheses on the financial characteristics of firms
that undergo leveraged buyouts (LBOs) are presented. The hypotheses ar
e based on arguments of modern financial theory. Empirical results sup
port Jensen's (1986) free cash flow hypothesis. Contrary to expectatio
ns, LBO firms have higher average levels of debt and operating efficie
ncy before the buyout than do other firms. An attempt is also made, us
ing a binary logit model, to predict which firm will undergo a LBO, on
the basis of the firm's financial characteristics. Using a conditiona
l maximum likelihood method, a split-sample technique, and a refined c
utoff probability estimation, the prediction effort is generally succe
ssful.