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Why are Buyouts Leveraged? The Financial Structure of Private Equity Firms

53 Pages Posted: 19 May 2008  

Ulf Axelson

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

Per Strömberg

Swedish House of Finance

Michael S. Weisbach

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

Date Written: February 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.

Keywords: Capital structure, leveraged buyouts, private equity

JEL Classification: G24, G32, G34

Suggested Citation

Axelson, Ulf and Strömberg, Per and Weisbach, Michael S., Why are Buyouts Leveraged? The Financial Structure of Private Equity Firms (February 2007). , Vol. , pp. -, 2007. Available at SSRN: https://ssrn.com/abstract=1133778

Ulf Axelson (Contact Author)

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

Michael S. Weisbach

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

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