Abstract

http://ssrn.com/abstract=956865
 
 

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


Michael S. Weisbach


Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER)

Ulf Axelson


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

Per Strömberg


Swedish House of Finance

January 2007

NBER Working Paper No. w12826

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.

Number of Pages in PDF File: 51

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Date posted: January 12, 2007  

Suggested Citation

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

Contact Information

Michael S. Weisbach (Contact Author)
Ohio State University (OSU) - Department of Finance ( email )
2100 Neil Avenue
Columbus, OH 43210-1144
United States

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Ulf Axelson
London School of Economics ( email )
United Kingdom
Swedish Institute for Financial Research (SIFR) ( email )
Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden
Per Stromberg
Swedish House of Finance ( email )
Drottninggatan 98
111 60 Stockholm
Sweden

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