The Financial Structure of Private Equity Funds

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The Financial Structure of Private Equity Funds

• Professor Michael S. Weisbach
• University of Illinois

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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

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How does a venture capital investment work?

• Venture Investor (Kleiner Perkins, Sequoia,
  Illinois Ventures) invests in startup.
• Financed partly by funds 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

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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 funds 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)

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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."

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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).
• Ill 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

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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
• GPs 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.

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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!!

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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.

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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.

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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 dont lend even when
  they have good deals
• Deals that do get made have high returns

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Unresolved Questions

• Why does the organizational structure seem so
  succesful?
• Why are investments contingent on access to debt
  capital?
• Why dont 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?

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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.
• Cant 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.

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A new approach

• Focus on relation between GP and his investors,
  LPs
• GP is the expert knows the most about the
  potential of portfolio companies.
• But he gambles with other peoples 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.

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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 peoples 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.

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• The GP has nothing to lose

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• 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

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Other explanations

• Transaction costs Its 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.

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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.

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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.

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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 SP 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.

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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!)

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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.

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Why dont LPs have veto rights over individual
investments? Wouldnt 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.

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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?

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Conclusion

• The financial / organizational structure of
  private equity firms (LBOs, 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.

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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?