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

Ulf Axelson (), Per Stromberg and Michael Weisbach
Additional contact information
Ulf Axelson: Swedish Institute for Financial Research, Postal: Swedish Institute for Financial Research, Saltmätargatan 19A, SE-113 59 Stockholm, Sweden, http://www.sifr.org

No 49, SIFR Research Report Series from Institute for Financial Research

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.

Keywords: LBO funds; capital structure; private equity; ex ante financing; ex post financing; incentives in private equity (search for similar items in EconPapers)
JEL-codes: G23 G32 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2007-02-15
New Economics Papers: this item is included in nep-cfn
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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Related works:
Journal Article: Why Are Buyouts Levered? The Financial Structure of Private Equity Funds (2009)
Working Paper: Why Are Buyouts Levered? The Financial Structure of Private Equity Funds (2008)
Working Paper: Why are Buyouts Levered: The Financial Structure of Private Equity Funds (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:hhs:sifrwp:0049

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