Understanding Leveraged Buyouts and Private Equity
here are many reasons why private equity firms— particularly leveraged buyout (LBO) transactions—have been so controversial. Private equity is often associated with job losses when private equity investors take over companies; large amounts of debt used to finance these deals; large sums that partners seem to make; and a veil of secrecy that surrounds running their portfolio of companies. The crucial question is whether private equity firms indeed leave the businesses they buy and sell better off in the long-run.
Given the criticisms, many people might be surprised that academic research has found that the answer is largely yes, suggesting that there is a lot about private equity that is not well understood. To separate facts from opinions, University of Chicago Booth School of Business professor Steven N. Kaplan and Per Strömberg of the Stockholm School of Economics were asked by the Journal of Economic Perspectives to write a paper to shed light on this somewhat mysterious business. “We wanted to summarize what we know about leveraged buyouts and private equity in a logical, systematic, and balanced way, which you rarely get in the popular press,” Kaplan says.
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In their study, Kaplan and Strömberg demystify private equity by describing how the industry works, how fundraising and transaction characteristics have varied over time, the changes that private equity investors make to a company, and the effects of these changes on operating performance, employment, and fund returns.
Kaplan and Strömberg also explain the factors that drive the recurring boom and bust cycles of the industry. This feast and famine aspect of private equity suggests that the industry will undoubtedly contract after a phenomenal run just a few years ago. At the same time, they conclude that reports that the private equity industry is dead are exaggerated. Just like the previous waves of the late 1980s and 1990s, the industry will come back. Moreover, Kaplan and Strömberg believe that a substantial part of private equity’s growth is unrelated to cyclical factors, but rather to the techniques that firms have refined over so many deals which add value to the companies they buy.
What Is Private Equity?
A private equity firm invests in companies using money raised through a fund. The fund’s limited partners, which can include corporate and public pension funds, endowments, insurance companies, and wealthy individuals, provide most of the capital. The private equity firm, also called the general partner, usually puts in at least one percent of the total capital. The fund typically has a fixed life of about 10 to 13 years. General partners manage the fund’s investments on behalf of the limited partners. They are compensated by charging management fees usually equal to two percent of the committed capital and a “carried interest” or profit shares that is usually 20 percent of the fund’s profits.
In a typical buyout, the private equity firm agrees to buy a company with 60 to 90 percent debt—hence the term “leveraged buyout.” The fund covers the remaining 10 to 40 percent, with the managers of the purchased company contributing an additional small fraction of the equity.
LBOs of large public companies in such mature industries as manufacturing and retail dominated the first buyout wave of the mid- to late 1980s. However, public-to-private deals dropped significantly following the fall of the junk bond market in the late 1980s. Instead, in the 1990s, “middle-market” buyouts of private rather than public companies became the most common type of LBO transaction. Buyout activity also spread to such new industries as information technology, financial services, and health care.
The private equity landscape changed again in the most recent wave when public-to-private deals surged in 2005 to mid-2007, accounting for about one-third of LBO transaction value during this period. With the return of public-to- private transactions, the size of the average deal almost tripled between 2001 and 2006.
Private equity firms restructure the companies they buy and hope to sell them or “exit” at a much higher price, either by selling the business to another company or private equity firm, or through an initial public offering. The median holding period is roughly six years, but has varied over time.
A common criticism is that private equity funds increasingly “flip” their investments quickly rather than hold on to them long enough to make valuable changes. But Kaplan and Strömberg see no evidence that “quick flips” have become more common. Of the deals that were sold since 1970, only 12 percent were exited within 24 months of the LBO acquisition date. Moreover, because of the popularity in recent years of secondary buyouts, which are buyouts of companies owned by other private equity groups, LBOs actually stay longer in the hands of private equity firms.
Is Private Equity a Better Organizational Form?
As LBO activity increased in the 1980s, Harvard University professor Michael Jensen predicted that LBO organizations would eventually become the dominant organizational form. Ownership stakes of portfolio companies are much more concentrated compared to a public company’s dispersed shareholders, and the private equity firm itself is an efficiently run organization that gives strong financial incentives to its investment professionals.
Moreover, private equity firms typically give the management team of a portfolio company a large equity upside through stocks and options—a practice that was unusual among public firms in the early 1980s. Private equity firms also require management to make a meaningful investment in the company so that it participates in the downside as well. Managers cannot sell equity or exercise options until the company exits, thus reducing the incentive to manipulate short-term performance. Even though stocks and options have become more widely used in public corporations, Kaplan and Strömberg say that management’s ownership percentages are still greater in LBO companies than in public companies.
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