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Why are Buyouts Levered: The Financial Structure of Private Equity Funds

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  • Ulf Axelson
  • Per Stromberg
  • Michael S. Weisbach

Abstract

This paper presents a model of the financial structure of private equity firms. In the model, the general partner of the firm encounters a sequence of deals over time where the exact quality of each deal cannot be credibly communicated to investors. We show that the optimal financing arrangement is consistent with a number of characteristics of the private equity industry. First, the firm should be financed by a combination of fund capital raised before deals are encountered, and capital that is raised to finance a specific deal. Second, the fund investors' claim on fund cash flow is a combination of debt and levered equity, while the general partner receives a claim similar to the carry contracts received by real-world practitioners. Third, the fund will be set up in a manner similar to that observed in practice, with investments pooled within a fund, decision rights over investments held by the general partner, and limits set in partnership agreements on the size of particular investments. Fourth, the model suggests that incentives will lead to overinvestment in good states of the world and underinvestment in bad states, so that the natural industry cycles will be multiplied. Fifth, investments made in recessions will on average outperform investments made in booms.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12826.

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Date of creation: Jan 2007
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Handle: RePEc:nbr:nberwo:12826

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Citations

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Cited by:
  1. Cohn, Jonathan B. & Mills, Lillian F. & Towery, Erin M., 2014. "The evolution of capital structure and operating performance after leveraged buyouts: Evidence from U.S. corporate tax returns," Journal of Financial Economics, Elsevier, vol. 111(2), pages 469-494.
  2. Fedyk, Yuriy & Walden, Johan, 2007. "High-Speed Natural Selection in Financial Markets with Large State Spaces," SIFR Research Report Series 52, Institute for Financial Research.
  3. Alexander Ljungqvist & Matthew Richardson & Daniel Wolfenzon, 2008. "The Investment Behavior of Buyout Funds: Theory and Evidence," NBER Working Papers 14180, National Bureau of Economic Research, Inc.
  4. L. Bottazzi & M. Da Rin & T. Hellmann, 2007. "What is the Role of Legal Systems in Financial Intermediation? Theory and Evidence ," Working Papers 613, Dipartimento Scienze Economiche, Universita' di Bologna.
  5. Axelson, Ulf & Stromberg, Per & Weisbach, Michael S., 2008. "Why Are Buyouts Levered? The Financial Structure of Private Equity Funds," Working Paper Series 2008-15, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  6. Lahr, Henry & Kaserer, Christoph, 2009. "Net asset value discounts in listed private equity funds," CEFS Working Paper Series 2009-12, Center for Entrepreneurial and Financial Studies (CEFS), Technische Universität München.
  7. Baran, Lindsay C. & King, Tao-Hsien Dolly, 2010. "Going private transactions, bondholder returns, and wealth transfer effects," Journal of Banking & Finance, Elsevier, vol. 34(8), pages 1856-1872, August.
  8. Axelson, Ulf & Baliga, Sandeep, 2007. "Liquidity and Manipulation of Executive Compensation Schemes," SIFR Research Report Series 54, Institute for Financial Research.
  9. Joseph McCahery & Erik Vermeulen, 2012. "Private equity regulation: a comparative analysis," Journal of Management and Governance, Springer, vol. 16(2), pages 197-233, May.
  10. David T. Robinson & Berk A. Sensoy, 2011. "Cyclicality, Performance Measurement, and Cash Flow Liquidity in Private Equity," NBER Working Papers 17428, National Bureau of Economic Research, Inc.
  11. Gregory, David, 2013. "Private equity and financial stability," Bank of England Quarterly Bulletin, Bank of England, vol. 53(1), pages 38-47.
  12. Edmans, Alex, 2011. "Short-term termination without deterring long-term investment: A theory of debt and buyouts," Journal of Financial Economics, Elsevier, vol. 102(1), pages 81-101, October.
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  14. Demiroglu, Cem & James, Christopher M., 2010. "The role of private equity group reputation in LBO financing," Journal of Financial Economics, Elsevier, vol. 96(2), pages 306-330, May.
  15. Inderst, Roman & Vladimirov, Vladimir, 2012. "Preserving "Debt Capacity" or "Equity Capacity": A Dynamic Theory of Security Design under Asymmetric Information," MPRA Paper 53840, University Library of Munich, Germany.
  16. Andrew Metrick, 2010. "The Economics of Private Equity Funds," Review of Financial Studies, Society for Financial Studies, vol. 23(6), pages 2303-2341, June.

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