Working Paper: CEPR ID: DP6133
Authors: Ulf Axelson; Per Johan Strömberg; Michael Weisbach
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 Codes: G24; G32; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| The structure of private equity funds, which combines ex ante and ex post financing (G23) | governance problems that arise from GPs having more information about deal quality than LPs (D82) |
| The financial structure of private equity firms (G32) | overinvestment occurs in good times (G31) |
| The financial structure of private equity firms (G32) | underinvestment happens in bad times (G31) |
| The financial structure of private equity firms (G32) | cyclicality multiplier in investment behavior (E22) |
| Investments made during economic downturns (G31) | outperform those made during booms (E32) |
| The timing of investments is influenced by the financial structure and the economic environment (G31) | counter-cyclical performance (E32) |
| The structure of compensation for GPs (J33) | mitigate excessive risk-taking (G28) |
| The structure of compensation for GPs (J33) | align the interests of GPs with those of LPs (L20) |