TY - JOUR AU - Axelson,Ulf AU - Stromberg,Per AU - Weisbach,Michael S. TI - Why are Buyouts Levered: The Financial Structure of Private Equity Funds JF - National Bureau of Economic Research Working Paper Series VL - No. 12826 PY - 2007 Y2 - January 2007 UR - http://www.nber.org/papers/w12826 L1 - http://www.nber.org/papers/w12826.pdf N1 - Author contact info: Ulf Axelson London School of Economics Houghton Street London WC2A 2AE Tel: +44 (0)20 7107 5070 Fax: +44 (0)20 7849 4647 E-Mail: u.axelson@lse.ac.uk Per Stromberg Institute for Financial Research (SIFR) Drottninggatan 89 SE-113 60 Stockholm Sweden Tel: +46 8 728-5128 Fax: +46 8 728 5130 E-Mail: per.stromberg@sifr.org Michael Weisbach Department of Finance Fisher College of Business Ohio State University 2100 Neil Ave. Columbus, OH 43210 Tel: 614/292-3264 E-Mail: weisbach.2@osu.edu AB - 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. ER -