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

51 Pages Posted: 12 Jan 2007 Last revised: 20 Jul 2022

See all articles by Michael S. Weisbach

Michael S. Weisbach

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Ulf Axelson

London School of Economics; Swedish Institute for Financial Research (SIFR)

Per Strömberg

Swedish House of Finance; ECGI; CEPR

Date Written: January 2007

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.

Suggested Citation

Weisbach, Michael S. and Axelson, Ulf and Stromberg, Per, Why are Buyouts Levered: The Financial Structure of Private Equity Funds (January 2007). NBER Working Paper No. w12826, Available at SSRN: https://ssrn.com/abstract=956865

Michael S. Weisbach (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

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Ulf Axelson

London School of Economics ( email )

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Per Stromberg

Swedish House of Finance ( email )

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