The Financial Structure of Private Equity Funds

Professor Michael S. Weisbach

University of Illinois

Facts about the Private Equity Industry

Responsible for enormous quantity of investment. Buyouts Venture Deals

Rollups/Consolidations PIPEs

Firms share common organizational structure:  Finite-Lived Limited Partnerships.

GPs raise money from LPs to fund series of future investments. GPs get:

Rights to pick future investments. Management fee (1 – 2 %) plus ‘Carry’ (20%) All decision rights about managing investments

How does a venture capital investment work?

Venture Investor (Kleiner Perkins, Sequoia, Illinois Ventures) invests in startup.

Financed partly by fund’s own money which is used as equity, partly with equity they syndicate from other investors.

Typically an investment has multiple rounds before exiting, also usually syndicated.

Fund holds firm for 2-10 years, then must sell it (exit):– IPO– Acquisition

How does a leveraged buyout work?

Financial buyer like LBO fund (KKR, Blackstone, Madison Dearborn) takes over public or private firm.– Synergies?

Financed partly by fund’s own money which is used as equity, partly with large amounts of debt:– Bank debt– Junk bonds

Fund holds firm for 2-10 years, then must sell it (exit):– IPO– Trade sale– Secondary (sell to other LBO fund)

A Typical Conversation about Leverage

Practitioner: "Things are really tough because the banks are only lending 4 times cashflow, when they used to lend 6 times cashflow. We can't make our deals profitable anymore.“

Academic: "Why do you care if banks will not lend you as much as they used to? If you are unable to lever up as much as before, your limited partners will receive lower expected returns on any given deal, but the risk to them will have gone down proportionately."

  Practitioner: "Ah yes, the Modigliani-Miller theorem. I learned about

that in business school. We don't think that way at our firm. Our philosophy is to lever our deals as much as we can, to give the highest returns to our limited partners."

Goal of This Research It tries to ‘reconcile’ the way that academics think about

private equity partnerships with what my coauthors and I have learned from listening to practitioners.– Provides a framework for understanding the contractual nature of

private equity partnerships.– Potentially affects the way that academics think about these

organizations (maybe not so important) and the way we teach students about them (probably more important).

I’ll give short, hopefully intuitive discussion of some of the ideas in the paper.

The longer paper can be downloaded from my website: www.business.uiuc.edu/weisbach

Organizational structure

Funds are organized as Limited Partnerships with finite life.

Managers at the funds are General Partners, investors are Limited Partners– LPs = pension funds, foundations, wealthy individuals.

LPs commit to contribute capital for “pool” of future investments– Investment objects unknown when capital is raised

GP’s are restricted in amount of fund capital invested in each deal, rest has to be borrowed from banks

Investments must be exited within 8-12 years.

Structure of Compensation GP gets:

– ”carry”: 20% of excess return on fund.– ”management fee”: 1-2% of invested capital.– All decision rights.

The same compensation structure as the Venetian Merchants from the 13th century!!

Invested amount

0

LP

Fund cash flow

GP

Why do 13th Century Venetian Merchants and GPs have the same Compensation System?

Our answer: Corporate Governance Consider the ‘governance nightmare’ in public

corporations:– Information on companies is publicly available– Shareholders have the right to sell stock– Corporate control market can replace managers

Limited Partners in Private Equity firms have even fewer rights than shareholders in public firms.

The reason why LPs are willing to invest with PE firms is their institutional features to a large extent, mitigate governance problems.

Institutions common to Private Equity Firms that help resolve Governance Problems

The compensation structure for GPs. The GPs’ equity contribution to the fund. The comingling of investments within a fund. The implicit requirement that partnerships

raise additional financing for each investment. The funds’ finite lives. The decision right allocation, giving GPs

virtually all rights to pick investments. The desire of GPs to raise funds in the future.

A common observation about the PE Industry: The market is incredibly cyclical

High returns High inflow of capital to new funds Low returns Low inflow of capital High returns etc.

In booms/low interest environments investment discipline seems ”too loose”– Signs of overinvestment: Deals have worse returns

In busts/high interest environments investment discipline seems ”too strict”:– Signs of ”underinvestment”:

» GPs complain that banks don’t lend even when they have good deals

» Deals that do get made have high returns

Unresolved Questions

Why does the organizational structure seem so succesful?

Why are investments contingent on access to debt capital?– Why don’t they use less more of the fund capital

when debt is unavailable?

What can explain the cycles in returns and fundraising?– Is the market crazy?

Existing research Focus has been on the relation between GP and

portfolio firm:

– Taxshields, incentive benefits of debt, management expertise.

– Has been shown that LBOs add value. Can’t explain cycles and organizational structure Explaining the existence of LBOs with DTS and

incentive benefits of debt runs into problems.– You can lever public firm, restructure incentives and get tax

benefits anyway.

Portfolio firmGP

A new approach Focus on relation between GP and his investors, LP’s:

GP is the expert – knows the most about the potential of portfolio companies.

But he gambles with other people’s money. The contracts must be structured to alleviate the

concerns about governance by LPs and to give the GP incentives to choose the right deals to invest in.

Portfolio firmGPInvestor

Why is capital commited to a fund before investments are found?

Alternative: Do one investment at a time.– Experiments with this structure was made early on

without success.

Problem: The GP has little to lose in one deal– he gambles with other people’s money. – If he would not raise money for the deal, he earns

nothing.– If he raises money for a deal that looks less than

great to him, he has a chance of getting lucky.

Invested amount0

LP

Fund cashflow

GP

The GP has nothing to lose

By tying deals together in a fund the incentives are improved.– GP can now lose something in a bad deal – it eats

up his carry on past or future good deals.– This also explains why no new funds can be raised

before the fund capital is (mostly) used up, or why investors are not allowed to exit the fund whenever they want to.

Pooling creates internal screening

Other explanations

Transaction costs: It’s cumbersome to go out and raise capital all the time.– But if you know the GP is great a phone call

should be enough

Diversify risks across pool of firms:– Investors can diversify on their own– A typical fund still relies on one or two major hits.

How can we Explain the Implicit Requirement for Subsequent Additional Financing?

Contracts only allow a certain amount of fund capital invested in each deal.

Alternative: Raise enough capital to start with to be capable of financing all deals without debt.

Problem: Marginal investments will be undertaken if:– too few good deals have been found and the fund life is

approaching its end.– Economy is bad and most deals are expected to be

unprofitable.

How subsequent financing can improve the quality of investments.

Additional financiers will provide capital only if there is an expectation of a high return.

This process improves the quality of investments that eventually get undertaken.

The Bank or potential partners serve as a check. Less willing to supply enough debt capital if times are bad.

Forced leverage creates external screening.

Alternative explanation for the use of leverage

Leverage mechanically increases returns. But if that was all that was going on, one

could simply lever the S&P 500 and with enough leverage, have extraordinarily high expected returns.

Risk increases mechanically with return when leverage is added to a capital structure.

To affect economic value, leverage has to improve the quality of investments.

How can cycles be explained? Combination of internal screening (from comingling

investments) and external screening (from the need for additional financing) works most of the time but not always.

Problem with the investment horizon:– The internal screening disappears if there is too much uninvested

capital left at the end.– In bad times/high interest environments the external bank screening

takes over.– But in good times the GP can get access to bank financing even

when he has no discipline: ”Mediocre deal” enough to cover the loan.

» Even if not enough to cover the opportunity cost of Limited Partners

Overinvestment in good times, underinvestment in bad times (but the deals made are good!)

Implications for cyclicality

Overinvestment in good times – some mediocre deals get taken.

Underinvestment in bad times – some good deals cannot get financed.

Average deal made in bad times is actually better quality than the average deal in good times.

But this is not because the market is crazy. Rather it is a necessary ’loss’.

Private equity can finance many valuable deals but financing imperfections lead to some mistakes.

Why don’t LPs have veto rights over individual investments? Wouldn’t this help to solve the

governance problems?

If LPs were given veto rights over individual investments, they would use them whenever they are concerned about governance, especially when there have been few investments earlier in the fund and the GP has incentives to invest, even if potential investments are poor quality.

This would dilute the positive incentive effects of comingling investments within funds.

Third party financing (bank, syndication from other investors) is critical.

Why does the deal have to be exited within a fixed time frame?

Further check on the GP– Desire to raise next fund improves incentives for existing

ones.– Cost: Some investments require more time, sometimes the

exit market (IPO) is cold. Secondaries (selling to another LBO firm) have

become a more and more common alternative.– Is this just passing around a hot potato or is it good practice?– Michael Jensen predicted ”The Eclipse of the Public

Corporation” 20 years ago. – Does Sarbanes/Oxley imply that some firms should always

be private?

Conclusion The financial / organizational structure of private equity

firms (LBO’s, Venture capital) appears successful and robust.– Strong evidence that they contribute value to the world

Frictions between GPs and LPs seem crucial for explaining organizational structure and investment behavior.

Boom/Bust cycles in the private equity industry are a natural consequence of this investment process.– Not necessarily ’behavioral’.– Likely are an unavoidable outcome of the investment process that

nonetheless allows for investments that could not be undertaken by other types of organizations like public corporations.

Ongoing Empirical Study of LBO Capital Structure

We are collecting a database of large buyouts in both the US and Europe.

What determines capital structures of portfolio firms? Does it appear to be something like the ‘traditional tradeoff model’ from corporate finance, or the newer theory based on financing cycles proposed here?

Can we measure the effect of debt cycles on the quantity, pricing, and ultimate performance of deals?

What other factors affect deals? Early vs. late in a fund? Geographic differences?