Buyouts: A Primer

Tim Jenkinson is Professor of Finance at the University of Oxford Said Business School; Hyeik Kim is a Ph.D Candidate in Finance at The Ohio State University; and Michael Weisbach is Professor and Ralph W. Kurtz Chair in Finance at The Ohio State University. This post is based on their recent paper.

This paper provides an introduction to buyouts and the academic literature about them. Buyouts are initiated by “buyout funds”, which are limited partnerships raised from mostly institutional investors. Buyout funds have grown substantially and currently raise more than $400 billion annually in capital commitments. The funds earn returns for their investors by improving the operations of the firms they acquire and exiting them for a profit.

Intellectually, the buyout sector provides a plethora of questions to study. There are theoretical questions: How should funds be set up and managers compensated? To what extent does private contracting allow for more efficient resource allocations than a reliance on public markets? There are questions related to portfolio theory and capital markets: Private equity is a huge part of most institutional portfolios, how much capital should be allocated to this asset class, and how should it be split between various subsectors (buyouts, VC, real estate, etc)? How does one go about measuring the risk and return of a fund that makes only around 10 investments, many of which have only one cash outflow and one cash inflow over a 12 to 15 year period? To what extent do LPs and/or GPs have measurable skills? Corporate finance questions abound: How much value is created by the highly leveraged financial structure of most buyouts? What do GPs do to their portfolio firms to increase their values? Do they transfer wealth from other parties (workers, governments), or do they improve the efficiencies of operations? And perhaps the most important questions concern management and leadership, since at the end of the day, most of the increases in the value of the portfolio firms are likely to come from better managerial decisions. How do private equity funds decide on the managerial teams of their portfolio firms? What do they do to motivate and monitor these teams?

The academic literature has just scratched the surface in its understanding of these and related questions. To make things more complicated (and more fun to study), buyout funds constantly innovate and come up with new types of investments and organizational structures. The private capital market has matured to the point that most major firms today have relied on private capital markets at some point, and this trend is likely to continue. A useful mantra for those of us who study the private equity industry is that: Private capital markets are at least as important and far more interesting than public capital markets in the Twenty-First Century economy.

We begin our discussion of buyouts by explaining in Section 2 how buyout funds are structured and exactly how they work. We discuss the relationship between three broad questions in this section: (1) how is capital intermediated from investors to buyout funds, (2) how do buyout funds structure investments into portfolio companies, and (3) how are the management of portfolio companies incentivized by the buyout fund owners?

While Section 2 discusses the nuts and bolts of the way in which buyouts are structured, Section 3 focuses on why they occur in the first place. Buyouts deliver returns to investors by improving the performance of the companies that they buy. It is the expectation of these performance improvements that drive the growth of the industry. The ability of a buyout fund to secure capital commitments depends on investors’ expectations of its return relative to their relatively high hurdle because of the buyout sector’s risk, fees, profit shares, and illiquidity.

Section 4 provides facts about buyouts which starts with a brief history describing the evolution of the sector. Buyout markets tend to be correlated with the credit cycle. Purchase price multiples and debt contributions tend to go up (down) during economic booms (busts) but returns show a counter-cyclical pattern: years when relatively little capital is raised tend, ultimately, to produce the best returns. While in the past, trade sales to corporate acquirers was the dominant exit types, secondary transactions whereby one buyout fund sells to another became increasingly common recently. Fund fees have deviated surprising little from the 2 and 20 model—a 2% annual management fee and 20% profit share, or ‘carried interest’—even as buyout funds have increased dramatically in size.

Section 5 surveys academic research on buyouts. Such research on buyouts, and on private capital markets more generally, faces two major hurdles. First, the firms that are acquired in buyouts are private after they are acquired, and the majority are private prior to being acquired as well. Consequently, the quality of data that is available to researchers is far lower than for research on public firms. Furthermore, data on private equity funds themselves—in particular fund cash-flows, fees, details of limited partnership agreements etc.—are difficult to obtain. Data availability is, in general, improving and there have been some important initiatives that have made research-quality data more readily available for researchers (In particular we would highlight the role played by the Private Equity Research Consortium (PERC), which provides access to Burgiss data and programming support to analyse the data. PERC also runs conferences encouraging interaction between academics and practitioners working, or investing, in private equity. More information on PERC is available at Second, even if all private data were available publicly, much data that is commonly used for public firms and markets simply do not exist for private firms and markets. In particular, there are no market prices for firms or funds that are not publicly traded (a few are). And funds receive cash flows from their portfolio companies only at the time of acquisitions portfolio firms, exists, as well as the occasional dividend.

The complete paper is available for download here.

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