Essays In Private Equity

Abstract: This first essay studies the motivations and the consequences of leveraged buyouts of privately held companies. Over the last two decades, the number (enterprise value) of leveraged buyout transactions involving privately held targets totals 10,013 ($855 billion), accounting for 46% (21%) of the worldwide leveraged buyout market. Yet the vast majority of academic studies focus on the buyouts of publicly held targets. This chapter investigates the effects of leveraged buyouts on privately held targets. I find that, unlike the corporate restructuring process of public firms after the buyouts, private targets sponsored by private equity firms grow substantially after the buyouts. The overall evidence suggests that private equity firms, through leveraged buyouts, facilitate private targets' growth by alleviating targets' investment constraints. In the second essay which is co-authored with Berk Sensoy, Lea Stern, and Mike Weisbach, we study model and estimate the total incentives facing private equity general partners. Incentives from the explicit fee structure ("two and twenty") of private equity funds understate the actual incentives facing private equity general partners because they ignore the rewards stemming from the effect of current performance on the ability to raise larger funds in the future. We evaluate the importance of these implicit incentives in the context of a learning model in which investors use current performance to update their assessments of a general partner's ability, and, in turn, decide how much capital to allocate to the partners' next fund. Our estimates suggest that implicit incentives from expected future fundraising are about as large as explicit incentives from carried interest in the current fund. This implies that the performance-sensitive component of revenue is about twice as large as suggested by previous estimates based only on explicit fees. Consistent with the model, we find that these implicit incentives are stronger when abilities are more scalable and weaker when current performance is less informative about ability. Overall, the results suggest that implicit incentives from future fundraising have a substantial impact on general partners' welfare and are likely to be an important factor in the success of private equity firms. In the last chapter, I study performance persistence in the private equity industry. Contrary to what has been known in the literature, I find that performance persistence in private equity is short-living. Current fund performance is positively and significantly associated with the first follow-on fund performance, but not with the second or third follow-on funds. Even the statistically significant association between two consecutive funds' performance is not economically large. The returns of the best performing quartile portfolio drops by about half, and those of the worst performing portfolio improve substantially from one fund to the next fund. There is no difference in the performance of the second (and after) follow-on funds of current top and bottom performing quartile portfolios. Performance converges in the long run. The commonality of relevant market conditions between two consecutive funds largely explains performance persistence. Also, excessive fund growth conditional on past performance erodes performance and reduces persistence.