Why are buyouts levered: The financial structure of private equity funds

Private equity funds have become important actors in the economy, yet there has been little analysis explaining their financial structure. We present a model where the financial structure minimizes agency conflicts between fund managers and investors. Relative to financing each deal separately, raising a fund where the manager receives a fraction of aggregate excess returns improves incentives to avoid bad investments. Efficiency is further improved by requiring funds to also use deal-by-deal debt financing, which becomes unavailable in states where internal discipline fails. Nevertheless, investment is overly cyclical, and investments in bad states outperform investments in good states. Practitioner: “Things are really tough because the banks are only lending 4 times cash flow, when they used to lend 6 times cash flow. 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.” 1