LBO in practice: structuring and modeling

Readings Volume 2:
Further elements

Marc-Elie Bernard

HEC – Academic Year 2015/16

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LBO in practice: structuring and modeling
Readings
1. Technical notes on LBOs
2. Vernimmen Letter articles on LBOs
3. McKinsey articles on PE
4. LBO in question
LBO in practice: structuring and modeling
Readings
• Technical notes on LBOs
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Journal of Economic Perspectives—Volume 22, Number 4 —Season 2008 —Pages 000 – 000

Leveraged Buyouts and Private Equity

Steven N. Kaplan and Per Strömberg

I n a leveraged buyout, a company is acquired by a specialized investment firm

using a relatively small portion of equity and a relatively large portion of
outside debt financing. The leveraged buyout investment firms today refer to
themselves (and are generally referred to) as private equity firms. In a typical
leveraged buyout transaction, the private equity firm buys majority control of an
existing or mature firm. This arrangement is distinct from venture capital firms that
typically invest in young or emerging companies, and typically do not obtain
majority control. In this paper, we focus specifically on private equity firms and the
leveraged buyouts in which they invest, and we will use the terms private equity and
leveraged buyout interchangeably.
Leveraged buyouts first emerged as an important phenomenon in the
1980s. As leveraged buyout activity increased in that decade, Jensen (1989)
predicted that the leveraged buyout organizations would eventually become the
dominant corporate organizational form. He argued that the private equity firm
itself combined concentrated ownership stakes in its portfolio companies,
high-powered incentives for the private equity firm professionals, and a lean,
efficient organization with minimal overhead costs. The private equity firm then
applied performance-based managerial compensation, highly leveraged capital
structures (often relying on junk bond financing), and active governance to the
companies in which it invested. According to Jensen, these structures were

y Steven N. Kaplan is Neubauer Family Professor of Entrepreneurship and Finance, Uni-

versity of Chicago Graduate School of Business, Chicago, Illinois. Per Strömberg is Professor
of Finance at the Stockholm School of Economics and Director of the Swedish Institute of
Financial Research (SIFR), both in Stockholm, Sweden. Both authors are also Research
Associates, National Bureau of Economic Research, Cambridge, Massachusetts. Their e-mail
addresses are ^[email protected]&.
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2 Journal of Economic Perspectives

superior to those of the typical public corporation with dispersed shareholders,

low leverage, and weak corporate governance. A few years later, this prediction
seemed premature. The junk bond market crashed; a large number of high-
profile leveraged buyouts resulted in default and bankruptcy; and leveraged
buyouts of public companies (so called public-to-private transactions) virtually
disappeared by the early 1990s.
But the leveraged buyout market had not died—it was only in hiding. While
leveraged buyouts of public companies were relatively scarce during the 1990s
and early 2000s, leveraged buyout firms continued to purchase private compa-
nies and divisions. In the mid-2000s, public-to-private transactions reappeared
when the U.S. (and the rest of the world) experienced a second leveraged
buyout boom.
In 2006 and 2007, a record amount of capital was committed to private equity,
both in nominal terms and as a fraction of the overall stock market. Private equity
commitments and transactions rivaled, if not overtook the activity of the first wave
in the late 1980s that reached its peak with the buyout of RJR Nabisco in 1988.
However, in 2008, with the turmoil in the debt markets, private equity appears to
have declined again.
We start the paper by describing how the private equity industry works. We
describe private equity organizations such as Blackstone, Carlyle, and KKR, and
the components of a typical leveraged buyout transaction, such as the buyout of
RJR Nabisco or SunGard Data Systems. We present evidence on how private
equity fundraising, activity, and transaction characteristics have varied over
time.
The article then considers the effects of private equity. We describe the
changes in capital structures, management incentives, and corporate governance
that private equity investors introduce, and then review the empirical evidence on
the effects of these changes. This evidence suggests that private equity activity
creates economic value on average. At the same time, there is also evidence
consistent with private equity investors taking advantage of market timing (and
market mispricing) between debt and equity markets particularly in the public-to-
private transactions of the last 15 years.
We also review the empirical evidence on the economics and returns to private
equity at the fund level. Private equity activity appears to experience recurring
boom and bust cycles that are related to past returns and to the level of interest
rates relative to earnings. Given that the unprecedented boom of 2005 to 2007
has just ended, it seems likely that there will be a decline in private equity
investment and fundraising in the next several years. While the recent market
boom may eventually lead to some defaults and investor losses, the magnitude
is likely to be less severe than after the 1980s boom because capital structures
are less fragile and private equity firms are more sophisticated. Accordingly, we
expect that a significant part of the growth in private equity activity and
institutions is permanent.
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Steven N. Kaplan and Per Strömberg 3

Private Equity Firms, Funds, and Transactions

Private Equity Firms

The typical private equity firm is organized as a partnership or limited liability
corporation. Blackstone, Carlyle, and KKR are three of the most prominent private
equity firms. In the late 1980s, Jensen (1989) described these organizations as lean,
decentralized organizations with relatively few investment professionals and em-
ployees. In his survey of seven large leveraged buyout partnerships, Jensen found an
average of 13 investment professionals, who tended to come from an investment
banking background. Today, the large private equity firms are substantially larger,
although they are still small relative to the firms in which they invest. KKR’s S-1 (a
form filed with the Securities and Exchange Commission in preparation for KKR’s
initial public offering) reported 139 investment professionals in 2007. At least four
other large private equity firms appear to have more than 100 investment profes-
sionals. In addition, private equity firms now appear to employ professionals with a
wider variety of skills and experience than was true 20 years ago.

Private Equity Funds

A private equity firm raises equity capital through a private equity fund. Most
private equity funds are “closed-end” vehicles in which investors commit to provide
a certain amount of money to pay for investments in companies as well as man-
Fn1 agement fees to the private equity firm.1 Legally, private equity funds are organized
as limited partnerships in which the general partners manage the fund and the
limited partners provide most of the capital. The limited partners typically include
institutional investors, such as corporate and public pension funds, endowments,
and insurance companies, as well as wealthy individuals. The private equity firm
serves as the fund’s general partner. It is customary for the general partner to
provide at least 1 percent of the total capital.
The fund typically has a fixed life, usually ten years, but can be extended for
up to three additional years. The private equity firm normally has up to five years
to invest the fund’s capital committed into companies, and then has an additional
five to eight years to return the capital to its investors. After committing their
capital, the limited partners have little say in how the general partner deploys the
investment funds, as long as the basic covenants of the fund agreement are
followed. Common covenants include restrictions on how much fund capital can be
invested in one company, on types of securities a fund can invest in, and on debt
at the fund level (as opposed to debt at the portfolio company level, which is
unrestricted). Sahlman (1990), Gompers and Lerner (1996), and Axelson, Ström-
berg, and Weisbach. (forthcoming) discuss the economic rationale for these fund
structures.

1
In a “closed-end” fund, investors cannot withdraw their funds until the fund is terminated. This
contrasts with mutual funds, for example, where investors can withdraw their funds whenever they like.
See Stein (2005) for an economic analysis of closed- vs. open-end funds.
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4 Journal of Economic Perspectives

The private equity firm or general partner is compensated in three ways. First,
the general partner earns an annual management fee, usually a percentage of
capital committed, and then, as investments are realized, a percentage of capital
employed. Second, the general partner earns a share of the profits of the fund,
referred to as “carried interest,” that almost always equals 20 percent. Finally, some
general partners charge deal and monitoring fees to the companies in which they
invest. Metrick and Yasuda (2007) describe the structure of fees in detail and
provide empirical evidence on those fees.
For example, assume that a private equity firm, ABC partners, raises a private
equity fund, ABC I, with $2 billion of capital commitments from limited partners.
At a 2 percent management fee, ABC partners would receive $40 million per year
for the five-year investment period. This would decline over the following five years
as ABC exited or sold its investments. The management fees typically end after ten
years, although the fund can be extended thereafter. ABC would invest the differ-
ence between the $2 billion and the cumulative management fees into companies.
If ABC’s investments turned out to be successful and ABC was able to realize
$6 billion from its investments—a profit of $4 billion—ABC would be entitled to a
carried interest or profit share of $800 million (or 20 percent of the $4 billion
profit). Added to management fees of $300 to $400 million, ABC partners would
have received a total of up to $1.2 billion over the fund’s life.
In addition, general partners sometimes charge deal and monitoring fees that
are paid by the portfolio companies. The extent to which these fees are shared with
the limited partners is a somewhat contentious issue in fundraising negotiations.
These fees are commonly split 50 –50 between general and limited partners.
The Private Equity Analyst (2008) lists 33 global private equity firms (22 U.S.-
based) with more than $10 billion of assets under management at the end of 2007.
The same publication lists the top 25 investors in private equity. Those investors are
dominated by public pension funds, with CalPERS (California Public Employees’
Retirement System), CasSTERS (California State Teachers’ Retirement System),
PSERS (Public School Employees’ Retirement System), and the Washington State
Investment Board occupying the top four slots.

Private Equity Transactions

In a typical private equity transaction, the private equity firm agrees to buy a
company. If the company is public, the private equity firm typically pays a premium
of 15 to 50 percent over the current stock price (Kaplan, 1989b; Bargeron,
Schlingemann, Stulz, and Zutter, 2007). The buyout is typically financed with 60 to
90 percent debt— hence the term, leveraged buyout. The debt almost always
includes a loan portion that is senior and secured, and is arranged by a bank or an
investment bank. In the 1980s and 1990s, banks were also the primary investors in
these loans. More recently, however, institutional investors purchased a large
fraction of the senior and secured loans. Those investors include hedge fund
investors and “collateralized loan obligation” managers, who combine a number of
term loans into a pool and then carve the pool into different pieces (with different
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Leveraged Buyouts and Private Equity 5

seniority) to sell to institutional investors. The debt in leveraged buyouts also

often includes a junior, unsecured portion that is financed by either high-yield
bonds or “mezzanine debt” (that is, debt that is subordinated to the senior debt).
Demiroglu and James (2007) and Standard and Poor’s (2008) provide more
detailed descriptions.
The private equity firm invests funds from its investors as equity to cover the
remaining 10 to 40 percent of the purchase price. The new management team of
the purchased company (which may or may not be identical to the pre-buyout
management team) typically also contributes to the new equity, although the
amount is usually a small fraction of the equity dollars contributed.
Kaplan (2005) describes a large leveraged buyout—the 2005 buyout of Sun-
Gard Data Systems—in detail. Axelson, Jenkinson, Strömberg, and Weisbach
(2008) provide a detailed description of capital structures in these kinds of lever-
aged buyouts.

Commitments to Private Equity Funds

Private equity funds first emerged in the early 1980s. Nominal dollars commit-
ted each year to U.S. private equity funds have increased exponentially since then,
from $0.2 billion in 1980 to over $200 billion in 2007. Given the large increase in
firm market values over this period, it is more appropriate to measure committed
capital as a percentage of the total value of the U.S. stock market. The deflated
F1 series, presented in Figure 1, suggests that private equity commitments are cyclical.
They increased in the 1980s, peaked in 1988, declined in the early 1990s, increased
through the late 1990s, peaked in 1998, declined again in the early 2000s, and then
began climbing in 2003. By 2006 and 2007, private equity commitments appeared
extremely high by historical standards, exceeding 1 percent of the U.S. stock
market’s value. One caveat to this observation is that many of the large U.S. private
equity firms have only recently become global in scope. Foreign investments by U.S.
private equity firms were much smaller 20 years ago, so the comparisons are not
exactly apples to apples.
Although we do not have comparable information on capital commitments to
non-U.S. funds, it is clear that they also have grown substantially. In 2007, the Private
Equity Analyst lists three non-U.S. private equity firms among the twelve largest in
the world in assets under management.

Private Equity Transactions

F2 Figure 2 shows the number and combined transaction value of worldwide
leveraged buyout transactions backed by a private equity fund sponsor based on
data from CapitalIQ. In total, 17,171 private equity-sponsored buyout transactions
occurred from January 1, 1970, to June 30, 2007. (This excludes transactions
announced but not completed by November 1, 2007.) Transaction values equal the
enterprise value (market value of equity plus book value of debt minus cash) of the
acquired firms, converted into 2007 U.S. dollars. When transaction values are not
recorded (generally smaller, private-to-private deals), we impute values as a func-
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6 Journal of Economic Perspectives

Figure 1
U.S. Private Equity Fundraising and Transaction Values as a Percentage of Total
U.S. Stock Market Value from 1985 to 2007

3.50%
Private Equity Fundraising
3.00% Private Equity Transactions

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%
19
19

19
19

19
19
19

20
20
20

20
20
19
19
19

19
19

19
19

19

20
20

20
88
89

92
93

96
97
98

00
01
02

05
06
86
87

90
91

94
95

99

03
04

07
85

Sources: Private Equity Analyst, CapitalIQ, Strömberg (2008), authors’ calculations.

Figure 2
Global Private Equity Transaction Volume, 1985–2006

2500 900
Number of LBO transactions (Left axis)
800
Combined equity value of transactions (2007 billions of $)
2000 (Right axis)
700

600
2007 $ (Billions)

1500
Number

500

400
1000
300

200
500
100

0 0
20
20
20
20
20
20
19

20
19
19

19
19
19
19
19
19
19
19
19
19
19
19

01
02
03
04
05
06
85

00
87
86

92
93
94
95
96
97
98
99
91
88
89
90

Sources: CapitalIQ, Strömberg (2008), authors’ calculations.

Note: “LBO” is “leveraged buyout.”
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Steven N. Kaplan and Per Strömberg 7

tion of various deal and sponsor characteristics. Figure 1 also uses the CapitalIQ
data to report the combined transaction value of U.S. leveraged buyouts backed by
a private equity fund sponsor as a fraction of total U.S. stock market value.
Strömberg (2008) describes the sampling methodology and discusses potential
biases. The most important qualification is that CapitalIQ may underreport private
equity transactions before the mid-1990s, particularly smaller transactions.
Overall buyout transaction activity mirrors the patterns in private equity fund-
raising. Transaction and fundraising volumes exhibit a similar cyclicality. Transac-
tion values peaked in 1988; dropped during the early 1990s, rose and peaked in the
later 1990s, dropped in the early 2000s; and increased dramatically from 2004 to
2006. A huge fraction of historic buyout activity has taken place within the last few
years. From 2005 through June 2007, CapitalIQ recorded 5,188 buyout transactions
at a combined estimated enterprise value of over $1.6 trillion (in 2007 dollars), with
those 21⁄2 years accounting for 30 percent of the transactions from 1984 to 2007 and
43 percent of the total real transaction value, respectively.
Although Figure 2 only includes deals announced through December 2006
(and closed by November 2007), the number of announced leveraged buyouts
continued to increase until June 2007 when a record number of 322 deals were
announced. After that, deal activity decreased substantially in the wake of the
turmoil in credit markets. In January 2008, only 133 new buyouts were announced.
As the private equity market has grown, transaction characteristics also have
T1 evolved, as summarized in Table 1; Strömberg (2008) presents a more detailed
analysis. The first, late 1980s buyout wave was primarily a U.S., Canadian, and to
some extent a U.K., phenomenon. From 1985– 89, these three countries accounted
for 89 percent of worldwide leveraged buyout transactions and 93 percent of
worldwide transaction value. The leveraged buyout business was dominated by
relatively large transactions, in mature industries (such as manufacturing and
retail); public-to-private deals accounted for almost half of the value of the trans-
actions. These transactions in the first buyout wave helped form the perception of
private equity that persisted for many years: leveraged buyouts equal going-private
transactions of large firms in mature industries.
Following the fall of the junk bond market in the late 1980s, public-to-private
activity declined significantly, dropping to less than 10 percent of transaction value,
while the average enterprise value of companies acquired dropped from $401
million to $132 million (both in 2007 dollars). Instead, “middle-market” buyouts of
non–publicly traded firms— either independent companies or divisions of larger
corporations— grew significantly and accounted for the bulk of private equity
activity. Buyout activity spread to new industries such as information technology/
media/telecommunications, financial services, and health care while manufactur-
ing and retail firms became less dominant as buyout targets. Although aggregate
transaction value fell, twice as many deals were undertaken in 1990 –94 versus
1985– 89.
As private equity activity experienced steady growth over the following period
from 1995–2004 (except for a dip in 2000 –2001), the market continued to evolve.
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8 Journal of Economic Perspectives

Table 1
Global Leveraged Buyout Transaction Characteristics across Time

2005–6/ 1970–6/
1985–1989 1990–1994 1995–1999 2000–2004 30/2007 30/2007

Combined enterprise value $257,214 $148,614 $553,852 $1,055,070 $1,563,250 $3,616,787

Number of transactions 642 1,123 4,348 5,673 5,188 17,171
LBOs by type:
(% of combined
enterprise value)
Public to private 49% 9% 15% 18% 34% 27%
Independent private 31% 54% 44% 19% 14% 23%
Divisional 17% 31% 27% 41% 25% 30%
Secondary 2% 6% 13% 20% 26% 20%
Distressed 0% 1% 1% 2% 1% 1%
LBOs by target location:
(% of combined
enterprise value)
United States and Canada 87% 72% 60% 44% 47% 52%
United Kingdom 7% 13% 16% 17% 15% 15%
Western Europe (except 3% 13% 20% 32% 30% 26%
UK)
Asia and Australia 3% 1% 2% 4% 6% 4%
Rest of World 0% 2% 2% 3% 3% 3%

Note: The table reports transaction characteristics for 17,171 worldwide leveraged buyout transactions
that include every transaction with a financial sponsor in the CapitalIQ database announced between
1/1/1970 and 6/30/2007. Enterprise value is the sum of the sum of equity and net debt used to pay for
the transaction in millions of 2007 U.S. dollars. For the transactions where enterprise value was not
recorded, these have been imputed using the methodology in Strömberg (2008).

Public company buyouts increased, although buyouts of private companies still

accounted for over 80 percent of transaction value and more than 90 percent of
transactions. An increasing fraction of buyouts were so-called secondary buyouts—
private equity funds exiting their old investments and selling portfolio companies
to other private equity firms. By the early 2000 –2004 period, secondary buyouts
comprised over 20 percent of total transaction value. The largest sources of deals in
this period, however, were large corporations selling off divisions.
Buyouts also spread rapidly to Europe. From 2000 –2004, the western Euro-
pean private equity market (including the United Kingdom) had 48.9 percent of
worldwide leveraged buyout transaction value, compared with 43.7 percent in the
United States. The scope of the industry also continued to broaden, with compa-
nies in services and infrastructure becoming increasingly popular buyout targets.
The private equity boom from 2005 to mid-2007 magnified many of these
trends. Public-to-private and secondary buyouts grew rapidly in numbers and size,
together accounting for more than 60 percent of the $1.6 trillion leveraged buyout
transaction value over this time. Buyouts in nonmanufacturing industries contin-
ued to grow in relative importance, and private equity activity spread to new parts
of the world, particularly Asia (although levels were modest compared to western
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Leveraged Buyouts and Private Equity 9

Europe and North America). As large public-to-private transactions returned,

average (deflated) deal sizes almost tripled between 2001 and 2006.

Manner and Timing of Exit

Because most private equity funds have a limited contractual lifetime, invest-
T2 ment exits are an important aspect of the private equity process. Table 2 presents
statistics on private equity investment exits using the CapitalIQ buyout sample. The
top panel shows the frequency of various exits. Given that so many leveraged
buyouts occurred recently, it is not surprising that 54 percent of the 17,171 sample
transactions (going back to 1970) had not yet been exited by November 2007. This
raises two important issues. First, any conclusions about the long-run economic
impact of leveraged buyouts may be premature. Second, empirical analyses of the
performance of leveraged buyouts will likely suffer from selection bias to the extent
they only consider realized investments.
Conditional on having exited, the most common route is the sale of the
company to a strategic (nonfinancial) buyer; this occurs in 38 percent of exits. The
second most common exit is a sale to another private equity fund in a secondary
leveraged buyout (24 percent); this route has increased considerably over time.
Initial public offerings, where the company is listed on a public stock exchange
(and the private equity firm can subsequently sell its shares in the public market),
account for 14 percent of exits; this route has decreased significantly in relative
importance over time.
Given the high debt levels in these transactions, one might expect a nontrivial
fraction of leveraged buyouts to end in bankruptcy. For the total sample, 6 percent
of deals have ended in bankruptcy or reorganization. Excluding post-2002 lever-
aged buyouts, which may not have had enough time to enter financial distress, the
incidence increases to 7 percent. Assuming an average holding period of six years,
this works out to an annual default rate of 1.2 percent per year. Perhaps surpris-
ingly, this is lower than the average default rate of 1.6 percent that Moody’s reports
for all U.S. corporate bond issuers from 1980 –2002 (Hamilton et al., 2006). One
caveat is that not all cases of distress may be recorded in publicly available data
sources; some of these cases may be “hidden” in the relatively large fraction of
“unknown” exits (11 percent). Perhaps consistent with this, Andrade and Kaplan
(1998) find that 23 percent of the larger public-to-private transactions of the 1980s
defaulted at some point.
The bottom panel of Table 2 shows average holding periods for individual
leveraged buyout transactions. The analysis is done on a cohort basis, to avoid the
bias resulting from older deals being more likely to have been exited. Over the
whole sample, the median holding period is roughly six years, but this has varied
over time. Median holding periods were less than five years for deals from the early
1990s, presumably affected by the “hot” initial public offering markets of the late
1990s.
Recently, private equity funds have been accused of becoming more short-term
oriented, preferring to “flip” their investments rather than to maintain their
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10 Journal of Economic Perspectives

Table 2
Exit Characteristics of Leveraged Buyouts across Time

1970– 1985– 1990– 1995– 2000– 2003– 2006– Whole

Year of original LBO 1984 1989 1994 1999 2002 2005 2007 period

Type of exit:
Bankruptcy 7% 6% 5% 8% 6% 3% 3% 6%
IPO 28% 25% 23% 11% 9% 11% 1% 14%
Sold to strategic buyer 31% 35% 38% 40% 37% 40% 35% 38%
Sold to financial buyer 5% 13% 17% 23% 31% 31% 17% 24%
Sold to LBO-backed firm 2% 3% 3% 5% 6% 7% 19% 5%
Sold to management 1% 1% 1% 2% 2% 1% 1% 1%
Other/unknown 26% 18% 12% 11% 10% 7% 24% 11%
No exit by Nov. 2007 3% 5% 9% 27% 43% 74% 98% 54%
% of deals exited within
24 months (2 years) 14% 12% 14% 13% 9% 13% 12%
60 months (5 years) 47% 40% 53% 41% 40% 42%
72 months (6 years) 53% 48% 63% 49% 49% 51%
84 months (7 years) 61% 58% 70% 56% 55% 58%
120 months (10 years) 70% 75% 82% 73% 76%

Note: The table reports exit information for 17,171 worldwide leveraged buyout transactions that include
every transaction with a financial sponsor in the CapitalIQ database announced between 1/1/1970 and
6/30/2007. The numbers are expressed as a percentage of transactions, on an equally-weighted basis.
Exit status is determined using various databases, including CapitalIQ, SDC, Worldscope, Amadeus, Cao
and Lerner (2007), as well as company and LBO firm web sites. See Strömberg (2008) for a more
detailed description of the methodology.

ownership of companies for a sustained time. In our analysis, we see no evidence

that “quick flips,” defined as exits within 24 months of the private equity fund’s
investment, have become more common. Instead, holding periods of private equity
funds have increased since the 1990s. Overall, only 12 percent of deals are exited
within 24 months of the leveraged buyout acquisition date.
Finally, because of the high fraction of secondary buyouts in recent years, the
individual holding periods understate the total time in which leveraged buyout
firms are held by private equity funds. Accounting for secondary buyouts, Ström-
berg (2008) shows that the median leveraged buyout is still in private equity
ownership nine years after the original buyout transaction. In comparison, Kaplan
(1991), who also takes secondary buyouts into account, found the median lever-
aged-buyout target remained in private ownership for 6.82 years, which is consistent
with privately owned holding periods having increased since the 1980s.

Is Private Equity a Superior Organizational Form?

Proponents of leveraged buyouts, like Jensen (1989), argue that private equity
firms apply financial, governance, and operational engineering to their portfolio
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Steven N. Kaplan and Per Strömberg 11

companies, and, in so doing, improve firm operations and create economic value.
In contrast, some argue that private equity firms take advantage of tax breaks and
superior information, but do not create any operational value. Moreover, critics
sometimes argue that private equity activity is influenced by market timing (and
market mispricing) between debt and equity markets. In this section, we consider
the proponents’ views and the first set of criticisms about whether private equity
creates operational value. In the next section, we consider market timing issues in
more detail.

Financial, Governance and Operational Engineering

Private equity firms apply three sets of changes to the firms in which they
invest, which we categorize as financial, governance, and operational engineering.
Jensen (1989) and Kaplan (1989a, b) describe the financial and governance
engineering changes associated with private equity. First, private equity firms pay
careful attention to management incentives in their portfolio companies. They
typically give the management team a large equity upside through stock and
options—a practice that was unusual among public firms in the early 1980s (Jensen
and Murphy, 1990). Kaplan (1989b) finds that management ownership percent-
ages increase by a factor of four in going from public to private ownership. Private
equity firms also require management to make a meaningful investment in the
company, so that management not only has a significant upside, but a significant
downside as well. Moreover, because the companies are private, management’s
equity is illiquid—that is, management cannot sell its equity or exercise its options
until the value is proved by an exit transaction. This illiquidity reduces manage-
ment’s incentive to manipulate short-term performance.
It remains the case that management teams obtain significant equity stakes in
portfolio companies. We collected information on 43 leveraged buyouts in the
United States from 1996 to 2004 with a median transaction value of over $300
million. Of these, 23 were public-to-private transactions. The median chief execu-
tive officer receives 5.4 percent of the equity upside (stock and options) while the
management team as a whole gets 16 percent. Acharya and Kehoe (2008) find
similar results in the United Kingdom for 59 large buyouts (with a median trans-
action value of over $500 million) from 1997 to 2004. They report the median chief
executive officer gets 3 percent of the equity; the median management team as a
whole gets 15 percent. These magnitudes are similar to those in the 1980s public-
to-private transactions studied by Kaplan (1989b). Even though stock- and option-
based compensation have become more widely used in public firms since the 1980s,
management’s ownership percentages (and upside) remain greater in leveraged
buyouts than in public companies.
The second key ingredient is leverage—the borrowing that is done in connec-
tion with the transaction. Leverage creates pressure on managers not to waste
money, because they must make interest and principal payments. This pressure
reduces the “free cash flow” problems described in Jensen (1986), in which
management teams in mature industries with weak corporate governance could
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12 Journal of Economic Perspectives

Fn2 dissipate cash flows rather than returning them to investors.2 In the United States
and many other countries, leverage also potentially increases firm value through
the tax deductibility of interest. On the flip side, if leverage is too high, the
inflexibility of the required payments (as contrasted with the flexibility of payments
to equity) increases the chance of costly financial distress.
Third, governance engineering refers to the way that private equity investors
control the boards of their portfolio companies and are more actively involved in
governance than public company boards. Private equity portfolio company boards
are smaller than comparable public company boards and meet more frequently
(Gertner and Kaplan, 1996; Acharya and Kehoe, 2008; Cornelli and Karakas,
Fn3 2008).3 Acharya and Kehoe (2008) report that portfolio companies have twelve
formal meetings per year and many more informal contacts. In addition, private
equity investors do not hesitate to replace poorly performing management.
Acharya and Kehoe (2008) report that one-third of chief executive officers of these
firms are replaced in the first 100 days while two-thirds are replaced at some point
over a four-year period.
Financial and governance engineering were common by the late 1980s. Today,
most large private equity firms have added another type that we call “operational
engineering,” which refers to industry and operating expertise that they apply to
add value to their investments. Indeed, most top private equity firms are now
organized around industries. In addition to hiring dealmakers with financial engi-
neering skills, private equity firms now often hire professionals with operating
backgrounds and an industry focus. For example, Lou Gerstner, the former chief
executive officer of RJR and IBM is affiliated with Carlyle, while Jack Welch, the
former chief executive officer of GE, is affiliated with Clayton Dubilier. Most top
private equity firms also make use of internal or external consulting groups.
Private equity firms use their industry and operating knowledge to identify
attractive investments, to develop value creation plans for those investments, and to
implement the value creation plans. A plan might include elements of cost-cutting
opportunities and productivity improvements, strategic changes or repositioning,
acquisition opportunities, as well as management changes and upgrades (Acharya
and Kehoe, 2008; Gadiesh and MacArthur, 2008).

Operating Performance
The empirical evidence on the operating performance of companies after they
have been purchased through a leveraged buyout is largely positive. For U.S.
public-to-private deals in the 1980s, Kaplan (1989b) finds that the ratio of operating
income to sales increased by 10 to 20 percent (absolutely and relative to industry).

2
Axelson, Strömberg, and Weisbach (forthcoming) also argue that leverage provides discipline to the
acquiring leveraged buyout fund, which must persuade third-party investors—the debt providers—to
co-invest in each deal.
3
Empirical evidence on public firm boards (Yermack, 1996) suggests that smaller boards are more
efficient.
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Leveraged Buyouts and Private Equity 13

The ratio of cash flow (operating income less capital expenditures) to sales in-
creased by roughly 40 percent. The ratio of capital expenditures to sales declined.
These changes are coincident with large increases in firm value (again, absolutely
and relative to industry). Smith (1990) finds similar results. Lichtenberg and Siegel
(1990) find that leveraged buyouts experience significant increases in total factor
productivity after the buyout.
Most post-1980s empirical work on private equity and leverage buyouts has
focused on buyouts in Europe, largely because of data availability. Consistent with
the U.S. results from the 1980s, most of this work finds that leveraged buyouts are
associated with significant operating and productivity improvements. This work
includes Harris, Siegel, and Wright (2005) for the United Kingdom; Boucly, Sraer,
and Thesmar (2008) for France; and Bergström, Grubb, and Jonsson (2007) for
Sweden. Cumming, Siegel, and Wright (2007) summarize much of this literature
and conclude there “is a general consensus across different methodologies, mea-
sures, and time periods regarding a key stylized fact: LBOs [leveraged buyouts] and
especially MBOs [management buyouts] enhance performance and have a salient
effect on work practices.”
There has been one exception to the largely uniform positive operating
results—more recent public-to-private buyouts. Guo et al. (2007) study U.S. public-
to-private transactions completed from 1990 to 2006. The 94 leveraged buyouts
with available post-buyout data are concentrated in deals completed by 2000. The
authors find modest increases in operating and cash flow margins that are much
smaller than those found in the 1980s data for the United States and in the
European data. At the same time, they find high investor returns (adjusted for
industry or the overall stock market) at the portfolio company level. Acharya and
Kehoe (2008) and Weir, Jones, and Wright (2007) find similarly modest operating
improvements for public-to-private deals in the United Kingdom over roughly the
same period. Nevertheless, Acharya and Kehoe (2008) also find high investor
returns. These results suggest that post-1980s public-to-private transactions may
differ from those of the 1980s and from leveraged buyouts overall.
While the empirical evidence is consistent overall with significant operating
improvements for leverage buyouts, it should be interpreted with some caution.
First, some studies, particularly those in the United States, are potentially
subject to selection bias because performance data for private firms are not always
available. For example, most U.S. studies of financial performance study leveraged
buyouts that use public debt or subsequently go public, and leveraged buyouts of
public companies. These may not be representative of the population. Still, studies
undertaken in countries where accounting data is available on private firms, which
therefore do not suffer reporting biases—for example, Boucly, Sraer, and Thesmar
(2008) for France and Bergström, Grubb, and Jonsson (2007) for Sweden—find
significant operating improvements after leveraged buyouts.
Second, the decline in capital expenditures found in some studies raises the
possibility that leveraged buyouts may increase current cash flows, but hurt future
cash flows. One test of this concern is to look at the performance of leveraged
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14 Journal of Economic Perspectives

buyout companies after they have gone through an initial public offering. In a
recent paper, Cao and Lerner (2007) find positive industry-adjusted stock perfor-
mance after such initial public offerings. In another test of whether future pros-
pects are sacrificed to current cash flow, Lerner, Sorensen, and Strömberg (2008)
study post-buyout changes in innovation as measured by patenting. Although
relatively few private equity portfolio companies engage in patenting, those that
patent do not experience any meaningful decline in post-buyout innovation or
patenting. Furthermore, patents filed post-buyout appear more economically im-
portant (as measured by subsequent citations) than those filed pre-buyout, as firms
focus their innovation activities in a few core areas.
Overall, we interpret the empirical evidence as largely consistent with the
existence of operating and productivity improvements after leveraged buyouts.
Most of these results are based on leveraged buyouts completed before the latest
private equity wave. Accordingly, the performance of leveraged buyouts com-
pleted in the latest private equity wave is clearly a desirable topic for future
research.

Employment
Critics of leveraged buyouts often argue that these transactions benefit private
equity investors at the expense of employees who suffer job and wage cuts. While
such reductions would be consistent (and arguably expected) with productivity and
operating improvements, the political implications of economic gains achieved in
this manner would be more negative (for example, see comments from the Service
Employees International Union, 2007).
Kaplan (1989b) studies U.S. public-to-private buyouts in the 1980s and finds
that employment increases post-buyout, but by less than other firms in the industry.
Lichtenberg and Siegel (1990) obtain a similar result. Davis, Haltiwanger, Jarmin,
Lerner, and Miranda (2008) study a large sample of U.S. leveraged buyouts from
1980 to 2005 at the establishment level. They find that employment at leveraged
buyout firms increases by less than at other firms in the same industry after the
buyout, but also find that leveraged buyout firms had smaller employment growth
before the buyout transaction. The relative employment declines are concentrated
in retail businesses. They find no difference in employment in the manufacturing
sector. For a subset of their sample, Davis et al. (2008) are able to measure
employment at new establishments as well as at existing ones. For this subsample,
the leveraged buyout companies have higher job growth in new establishments
than similar non-buyout firms.
Outside the United States, Amess, and Wright (2007a) study buyouts in the
United Kingdom from 1999 to 2004 and find that firms that experience leveraged
buyouts have employment growth similar to other firms, but increase wages more
slowly. The one exception to the findings in the United States and United Kingdom
are those for France by Boucly, Sraer, and Thesmar (2008), who find that leveraged
buyout companies experience greater job and wage growth than other similar
companies.
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Steven N. Kaplan and Per Strömberg 15

Overall, then, the evidence suggests that employment grows at firms that
experience leveraged buyouts, but at a slower rate than at other similar firms. These
findings are not consistent with concerns over job destruction, but neither are they
consistent with the opposite position that firms owned by private industry experi-
ence especially strong employment growth (except, perhaps, in France). We view
the empirical evidence on employment as largely consistent with a view that private
equity portfolio companies create economic value by operating more efficiently.

Taxes
The additional debt in leveraged buyout transactions gives rise to interest tax
deductions that are valuable, but difficult to value accurately. Kaplan (1989a) finds
that, depending on the assumption, the reduced taxes from higher interest deduc-
tions can explain from 4 percent to 40 percent of a firm’s value. The lower
estimates assume that leveraged buyout debt is repaid in eight years and that
personal taxes offset the benefit of corporate tax deductions. The higher estimates
assume that leveraged buyout debt is permanent and that personal taxes provide no
offset. Assuming that the truth lies between these various assumptions, a reasonable
estimate of the value of lower taxes due to increased leverage for the 1980s might
be 10 to 20 percent of firm value. These estimates would be lower for leveraged
buyouts in the 1990s and 2000s, because both the corporate tax rate and the extent
of leverage used in these deals have declined. Thus, while greater leverage creates
some value for private equity investors by reducing taxes, it is difficult to say exactly
how much.

Asymmetric Information
The generally favorable results on operating improvements and value creation
are also potentially consistent with private equity investors having superior infor-
mation on future portfolio company performance. Critics of private equity often
claim that incumbent management is a source of this inside information. To some
extent, supporters of private equity implicitly agree that incumbent management
has information on how to make a firm perform better. After all, one of the
justifications for private equity deals is that with better incentives and closer
monitoring, managers will use their knowledge to deliver better results. A less
attractive claim, however, is that incumbent managers favor a private equity buyout
because they intend to keep their jobs and receive lucrative compensation under
the new owners. As a result, incumbent managers may be unwilling to fight for the
highest price for existing shareholders—thus giving private equity investors a better
deal.
Several observations suggest that it is unlikely that operating improvements are
simply a result of private equity firms taking advantage of private information. First,
Kaplan (1989b) studies the forecasts the private equity firms released publicly at the
time of the leveraged buyout. The asymmetric information story suggests that actual
performance should exceed the forecasts. In fact, actual performance after the
buyout lags the forecasts. Moreover, Ofek (1994) studies leveraged buyout attempts
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16 Journal of Economic Perspectives

that failed because the offer was rejected by the board or by stockholders (even
though management supported it) and finds no excess stock returns or operating
improvements for these firms. It would be useful to replicate these studies with
more recent transactions.
Second, private equity firms frequently bring in new management. As men-
tioned earlier, Acharya and Kehoe (2008) report that one-third of the chief
executive officers in their sample are replaced in the first 100 days and two-thirds
are replaced over a four-year period. Thus, incumbent management cannot be sure
that it will be in a position to receive high-powered incentives from the new private
equity owners.
Third, it seems likely that at times in the boom-and-bust cycle, private equity
firms have overpaid in their leveraged buyouts and experienced losses. For exam-
ple, the late 1980s was one such time, and it seems likely that the tail end of the
private equity boom in 2006 and into early 2007 will generate lower returns than
investors expected as well. If incumbent management provided inside information,
it clearly wasn’t enough to avoid periods of poor returns for private equity funds.
While these findings are inconsistent with operating improvements being the
result of asymmetric information, there is some evidence that private equity funds
are able to acquire firms more cheaply than other bidders. Guo et al. (2007) and
Acharya and Kehoe (2008) find that post-1980s public-to-private transactions ex-
perience only modest increases in firm operating performance, but still generate
large financial returns to private equity funds. This finding suggests that private
equity firms are able to buy low and sell high. Similarly, Bargeron, Schlingemann,
Stulz, and Zutter (2007) find that private equity firms pay lower premiums than
public company buyers in cash acquisitions. These findings are consistent with
private equity firms identifying companies or industries that turn out to be under-
valued. Alternatively, this could indicate that private equity firms are particularly
good negotiators, and/or that target boards and management do not get the best
possible price in these acquisitions.
Overall, then, the evidence does not support an important role for superior
firm-specific information on the part of private equity investors and incumbent
management. The results are potentially consistent with private equity investors
bargaining well, target boards bargaining badly, or private equity investors taking
advantage of market timing (and market mispricing), which we discuss below.

Private Equity Fund Returns

The company-level empirical evidence suggests that leveraged buyouts by

private equity firms create value (adjusted for industry and market). This evidence
does not necessarily imply, however, that private equity funds earn superior returns
for their limited partner investors. First, because private equity firms often purchase
firms in competitive auctions or by paying a premium to public shareholders, sellers
likely capture a meaningful amount of value. For example, in KKR’s purchase of
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Leveraged Buyouts and Private Equity 17

RJR Nabisco, KKR paid a premium to public shareholders of roughly $10 billion.
After the buyout, KKR’s investors earned a low return, suggesting that KKR paid out
most, if not all of the value-added to RJR’s public shareholders. Second, the limited
partner investors in private equity funds pay meaningful fees. Metrick and Yasuda
(2007) estimate that fees equal $19 in present value per $100 of capital under
management for the median private equity fund. As a result, the return to outside
investors net of fees will be lower than the return on the private equity fund’s
underlying investments.
Kaplan and Schoar (2005) study the returns to private equity and venture
capital funds. They compare how much an investor (or limited partner) in a private
equity fund earned net of fees to what the investor would have earned in an
equivalent investment in the Standard and Poor’s 500 index. They find that private
equity fund investors earn slightly less than the Standard and Poor’s 500 index net
of fees, ending with an average ratio of 93 percent to 97 percent. On average,
therefore, they do not find the outperformance often given as a justification for
investing in private equity funds. At the same time, however, these results imply that
the private equity investors outperform the Standard and Poor’s 500 index gross of
fees (that is, when fees are added back). Those returns, therefore, are consistent
with private equity investors adding value (over and above the premium paid to
selling shareholders).
At least two caveats are in order. First, Kaplan and Schoar (2005) use data from
Venture Economics which samples only roughly half of private equity funds, leaving an
unknown and potentially important selection bias. Second, because of data avail-
ability issues, Kaplan and Schoar compare performance to the Standard and Poor’s
500 index without making any adjustments for risk.
Kaplan and Schoar (2005) also find strong evidence of persistence in perfor-
mance—that is, performance by a private equity firm in one fund predicts perfor-
mance by the firm in subsequent funds. In fact, their results likely understate
persistence because the worst-performing funds are less likely to raise a subsequent
fund. In contrast, mutual funds show little persistence and hedge funds show uncertain
persistence. This persistence result explains why limited partners often strive to invest
in private equity funds that have been among the top performers in the past (Swensen,
2000). Of course, only some limited partners can succeed in such a strategy.
Phalippou and Gottschalg (forthcoming) use a slightly updated version of the
Kaplan and Schoar (2005) data set. They obtain qualitatively identical results to
Kaplan and Schoar (2005) for the average returns and persistence of private
equity/buyout funds relevant here.

Boom and Bust Cycles in Private Equity

Portfolio Company Level

The pattern of private equity commitments and transactions over recent
decades suggests that credit market conditions may affect this activity. One hypoth-
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18 Journal of Economic Perspectives

esis is that private equity investors take advantage of systematic mispricings in the
debt and equity markets. That is, when the cost of debt is relatively low compared
to the cost of equity, private equity can arbitrage or benefit from the difference.
This argument relies on the existence of market frictions that enable debt and
equity markets to become segmented. Baker and Wurgler (2000) and Baker,
Greenwood, and Wurgler (2003) offer arguments that public companies take
advantage of market mispricing.
To see how debt mispricing might matter, assume that a public company is
unleveraged and being run optimally. If a private equity firm can borrow at a rate
that is too low given the risk, the private equity firm will create value by borrowing.
In the recent wave, interest rate spreads for private equity borrowing increased
from roughly 250 basis points over the benchmark LIBOR (London Interbank
Offered Rate) in 2006 to 500 basis points over LIBOR in 2008 (Standard and
Poor’s, 2008). Under the assumptions that debt funds 70 percent of the purchase
price and has a maturity of eight years, debt mispricing of 250 basis points would
justify roughly 10 percent of the purchase price or, equivalently, would allow a
private equity fund investor to pay an additional 10 percent (that is, the present
value of an eight-year loan for 70 discounted at the higher interest rate is 60, not
70).
The mispricing theory implies that relatively more deals will be undertaken
when debt markets are unusually favorable. Kaplan and Stein (1993) present
evidence consistent with a role for overly favorable terms from high-yield bond
investors in the 1980s buyout wave. The credit market turmoil in late 2007 and early
2008 suggests that overly favorable terms from debt investors may have helped fuel
the buyout wave from 2005 through mid-2007.
To study buyout market cyclicality, we make more detailed “apples-to-apples”
comparisons of buyout characteristics over time by combining the results in Kaplan
and Stein (1993) for the 1980s buyout wave with those in Guo et al. (2007) for the
last ten years. Both papers study public-to-private transactions in the United States.
First, we look at valuations or prices relative to cash flow. To measure the price
paid for these deals, we calculate enterprise value as the sum of the value of equity
and net debt at the time of the buyout. Firm cash flow is calculated using the
standard measure of firm-level performance, EBITDA, which stands for earnings
F3 before interest, taxes, depreciation, and amortization. Figure 3 reports the median
ratio of enterprise value to cash flow for leveraged buyouts by year. The figure
shows that prices paid for cash flow were generally higher at the end of the buyout
waves than at the beginning. (The first private equity wave began in 1982 or 1983
and ended in 1989; the second began in 2003 or 2004 and ended in 2007.) The
more recent period, in particular, exhibits a great deal of cyclicality, first dipping
substantially from 2000 through 2002, and then rising afterwards.
Figure 3 also shows that valuation multiples in the recent wave exceeded those
in the 1980s wave, although this conclusion is open to some interpretation. In
general, ratios of all corporate values to cash flow were higher in the last decade
than in the 1980s. When the ratios in Figure 3 are deflated by the median ratio for
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Steven N. Kaplan and Per Strömberg 19

Figure 3
Enterprise Value to EBITDA in Large U.S. Public-to-Private Buyouts, 1982 to 2006
(“EBITDA,” a measure of cash flow, stands for earnings before interest, taxes, depreciation,
and amortization)

12.00

10.00

8.00

6.00

4.00

2.00

0.00
19

19

19

19

19

20

20

20

20

20

20
19

19

19

19

19

19

20
83

86

87

97

00

02

04
98

01

03

05
82

84

85

88

89

99

06
Source: Kaplan and Sein (1993) and Guo, Hotchkiss, and Song (2007).
Note: The first private equity wave began in 1982 or 1983 and ended in 1989; the second began in
2003 or 2004 and ended in 2007.

nonfinancial companies in the Standard and Poor’s 500 index, the valuations of
leveraged buyout deals relative to the Standard and Poor’s 500 are slightly lower in
the recent wave relative to the previous wave. Even after such a calculation, the
cyclicality of the recent wave remains.
Next, we look at changes in leverage buyout firm capital structures. We
compare the ratio of equity used to finance leveraged buyouts in each time period
and find that the share of equity used to finance leveraged buyouts was relatively
constant in the first wave at 10 percent to 15 percent and relatively constant in the
second wave, but at roughly 30 percent. This striking increase in equity percentage
from one era to the other is both a prediction of and consistent with the arguments
in Kaplan and Stein (1993) that debt investors offered overly favorable terms,
particularly too much leverage, in the buyout wave of the 1980s.
Valuations relative to a standardized measure of profits—EBITDA (earnings
before interest, taxes, depreciation and amortization)—were higher in the recent
F4 wave, but debt levels were lower. Interest rates also changed. Figure 4 combines
these factors by measuring the ratio of EBITDA to forecast interest for the lever-
aged buyouts of the two eras. This interest coverage ratio is a measure of the
fragility of a buyout transaction. When this ratio is lower, it implies that the buyout
is more fragile, because the firm has less of a cushion from not being able to meet
interest payments. Figure 4 has two interesting implications. First, interest coverage
ratios are higher in the recent wave, suggesting the deals are less fragile. Second,
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20 Journal of Economic Perspectives

Figure 4
EBITDA to Interest in Large U.S. Public to Private Buyouts, 1982 to 2006
(“EBITDA,” a measure of cash flow, stands for earnings before interest, taxes, depreciation,
and amortization)

2.5

1.5

0.5

0
19

19

19

19
19

19

19

19

19

19

19

20

20

20

20
20

20

20
82

83

84

88
85

86

87

89

97

98

99

00

01

02

03

05

06
04
Source: Kaplan and Stein (1993) and Guo, Hotchkiss, and Song (2007).
Note: The first private equity wave began in 1982 or 1983 and ended in 1989. The second private
equity wave began in 2003 or 2004 and ended in 2007.

the cyclical pattern of the second wave remains. Coverage ratios are higher from
2001 to 2004 than in the periods before and after.
Leveraged buyouts of the most recent wave also have been associated with
more liberal repayment schedules and looser debt covenants. Consistent with this,
we find patterns similar to (if not stronger than) those in Figure 4 when we factor
in debt principal repayments. Demoriglu and James (2007) and Standard and
Poor’s (2008) also confirm that loan covenants became less restrictive at the end of
the recent wave.
F5 Figure 5 considers cyclicality in private equity in one additional way. It com-
pares the median ratio of EBITDA to enterprise value for the Standard & Poor’s
500, to the average interest rate on high-yield bonds—the Merrill Lynch High Yield
(cash pay bonds)— each year from 1985 to 2006. In particular Figure 5 looks at
operating earnings yield net of interest rate. This measures the relation between
the cash flow generated per dollar of market value by the median company in the
Standard & Poor’s 500 and the interest rate on a highly leveraged financing. One
can interpret this measure as the excess (or deficit) from financing the purchase of
an entire company with high-yield bonds.
The pattern is suggestive. A necessary (but not sufficient) condition for a
private equity boom to occur is for earnings yields to exceed interest rates on
high-yield bonds. This pattern held true in the late-1980s boom and in the boom
of 2005 and 2006. When operating earnings yields are less than interest rates from
high-yield bonds, private equity activity tends to be lower.
These patterns suggest that the debt used in a given leveraged buyout may be
driven more by credit market conditions than by the relative benefits of leverage for
the firm. Axelson, Jenkinson, Strömberg, and Weisbach (2008) find evidence
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Leveraged Buyouts and Private Equity 21

Figure 5
Standard & Poor’s EBITDA/Enterprise Value Less High-Yield Rates, 1985–2006
(“EBITDA,” a measure of cash flow, stands for earnings before interest, taxes, depreciation,
and amortization)

4.00%
3.00%
2.00%
1.00%
0.00%
1985 1988 1991 1994 1997 2000 2003 2006
-1.00%
-2.00%
-3.00%
-4.00%
Year
Note: Median EBITDA/Enterprise Value for S&P 500 companies less Merrill Lynch High-Yield Master
(Cash Pay Only) Yield. Enterprise Value is the sum of market value of equity, book value of long-
and short-term debt less cash and marketable securities.

consistent with this in a sample of large leveraged buyouts in the United States
and Europe completed between 1985–2007. They find that leverage is cross-
sectionally unrelated to leverage in similar-size, same industry, public firms and
is unrelated to firm-specific factors that explain leverage in public firms. In-
stead, leveraged buyout capital structures are most strongly related to prevailing
debt market conditions at the time of the buyout. Leverage in leveraged buyouts
decreases as interest rates rise. The amount of leverage available, in turn, seems
to affect the amount that the private equity fund pays to acquire the firm.
Similarly, Ljungqvist, Richardson, and Wofenzon (2007) find that private equity
funds accelerate their investment pace when interest rates are low. These results are
consistent with the notion that debt financing availability affects booms and busts
in the private equity market.
These patterns raise the question as to why the borrowing of public firms does
not follow the same credit market cycles. One potential explanation is that public
firms are unwilling to take advantage of debt mispricing by increasing leverage,
either because managers dislike debt or because public market investors worry
about high debt levels. A second explanation is that private equity funds have better
access to credit markets because they are repeat borrowers, which enables them to
build reputation with lenders. Recent papers by Ivashina and Kovner (2008) and
Demiroglu and James (2007) suggest that more prominent private equity funds are
able to obtain cheaper loans and looser debt covenants than other lenders. A third
explanation is that the compensation structures of private equity funds provide
incentives to take on more debt than is optimal for the individual firm (Axelson,
Jenkinson, Strömberg, and Weisbach, forthcoming).
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22 Journal of Economic Perspectives

Private Equity Fund Level

The time series of private equity fund commitments examined earlier appear
to exhibit a boom and bust pattern. In this section, we consider this more closely
by studying the relation between commitments and returns.
First, we consider the relation between private equity fundraising and subse-
T3 quent private equity fund returns. Table 3 presents illustrative regressions in which
the dependent variable is the capital-weighted return to all private equity funds
raised in a particular year. We refer to this as the “vintage year return.” We use the
vintage year returns for U.S. private equity funds from Venture Economics as of
September 2007 for vintage years 1984 to 2004. The return measures are noisy
because Venture Economics does not have returns for all private equity funds. In
addition, the funds that comprise the more recent vintage years are still active and
their returns may change over time. (This factor is probably unimportant because
we obtain similar results when we eliminate all vintages after 1999.) As independent
variables, we use capital committed to private equity funds in the vintage year and
the previous vintage year relative to the total value of the U.S. stock market.
Regressions 1 to 4 in Table 3 indicate a strong negative relation between fundrais-
ing and subsequent vintage year returns. Including a time trend does not affect the
results. While this simple regression finding can only be considered illustrative of
broader patterns, it suggests that inflows of capital into private equity funds in a
given year can explain realized fund returns during the subsequent ten- to twelve-
year period when these funds are active. It strongly suggests that an influx of capital
into private equity is associated with lower subsequent returns.
Next we consider the extent to which past returns affect capital commitments.
In these regressions, the dependent variable is the annual capital committed to U.S.
private equity funds as a fraction of the U.S. stock market from 1987 to 2006. The
independent variables are the two previous year’s returns to private equity, again,
as reported by Venture Economics. Note that the annual return to private equity is
different from the vintage year return (which was the dependent variable in the
previous regressions). The vintage year return measures the annual return to all
funds raised in a particular year over the life of the fund—that is, the vintage year
return is a geometric average of many years of returns. In contrast, the annual
return to private equity is the return to all private equity funds of different vintages
in a given calendar year.
Again, these regressions are meant only to be suggestive. In these two regres-
sions in panel B, capital commitments are positively and significantly related to
lagged private equity returns—in other words, investors seem to follow good
returns. The positive trend is consistent with significant secular growth in private
equity fund commitments over time above any cyclical factors.
To summarize the regressions, private equity fund returns tend to decline
when more capital is committed to this asset class. Capital commitments to private
equity tend to decline when realized returns decline. These patterns are consistent
with a boom and bust cycle in private equity.
tapraid4/z30-jep/z30-jep/z3000408/z302125d08a moyerr S516 9/22/08 18:31 Art: z30-2125 Input-mek

Steven N. Kaplan and Per Strömberg 23

Table 3
Relation of Private Equity Returns and Fundraising in United States

Panel A

Dependent variable: Vintage year average internal rate of return to

private equity (capital weighted) from 1984 to 2004

(1) (2) (3) (4)

Constant 0.31 0.31 0.35 0.35

(6.2) (7.0) (7.5) (7.2)
Private equity commitments to 232.60** 220.79*
stock market, t (22.4) (21.6)
Private equity commitments to 236.87*** 228.66**
stock market, t-1 (23.0) (22.2)
Private equity commitments to 224.78***
stock market, t 1 t-1 (23.5)
Trend 20.004 20.003 20.002 20.002
(21.2) (21.0) (20.8) (20.8)
Adj. R2 0.28 0.36 0.44 0.41

Panel B

Dependent variable: Private equity commitments to Stock Market, t from

1984 to 2007 (as a fraction of the total value of the U.S. stock market)

(1) (2)

Constant 20.091 20.292

(20.7) (21.8)
Annual private equity return, t-1 0.007** 0.008***
(2.1) (2.6)
Annual private equity return, t-2 0.007**
(2.4)
Trend 0.031*** 0.031***
(4.1) (4.6)
Adj. R2 0.40 0.50

Note: Private equity vintage year internal rate of return is the average internal rate of return to U.S.
private equity funds raised in a given year, according to Venture Economics. Mean vintage year internal rate
of return is 16.5 percent. Private equity commitments are capital committed to U.S. private equity funds
from Private Equity Analyst as a fraction of the total value of the U.S. stock market. Mean private equity
commitments are 0.43 percent. Private equity annual return is the annual return to all U.S. private
equity funds according to Venture Economics. Mean annual return is 18.6 percent. Standard errors are in
parentheses.
*, **, and *** indicate statistical significance at the 10, 5, and 1 percent levels, respectively.

Some Speculations

The empirical evidence is strong that private equity activity creates economic
value on average. We suspect that the increased investment by private equity firms
in operational engineering will ensure that this result continues to hold in the
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24 Journal of Economic Perspectives

future. Because private equity creates economic value, we believe that private equity
activity has a substantial permanent component.
However, the evidence also is strong that private equity activity is subject to
boom and bust cycles, which are driven by recent returns as well as by the level of
interest rates relative to earnings and stock market values. This pattern seems
particularly true for larger public-to-private transactions.
From the summer of 2007 into mid-2008, interest rates on buyout-related debt
increased substantially—when buyout debt is even available at all. At the same time,
corporate earnings have softened. In this setting, private equity activity is likely to
be relatively low, particularly large public-to-private buyouts. Institutional investors
are likely to continue to make commitments to private equity for a time, at least,
because reported private returns have not declined, but are still robust. As of
September 2007, Venture Economics reports private equity returns over the previous
three years of 15.3 percent versus Standard and Poor’s 500 stock market returns of
12.7 percent.
The likelihood that investors’ commitments to private equity funds remain
robust while debt markets remain unfavorable will create pressure for private firms
to invest the capital committed. Given the fee structure of private equity funds, we
do not expect that many private equity firms will return the money. However, these
patterns suggest that the structure of private equity deals will evolve.
First, we suspect that private equity firms will make investments with less
leverage, at least initially. While this change may reduce the magnitude of expected
returns (and compensation), as long as the private equity firms add value, it will not
change risk-adjusted returns.
Second, we suspect that private equity firms will be more likely to take minority
equity positions in public or private companies rather than buying the entire
company. Private equity firms have experience with minority equity investments,
both in venture capital investments and in overseas investments, particularly in
Asia. The relatively new operational engineering capabilities of private equity firms
may put them in a better position to supply minority investments than in the past,
because private equity firms can provide additional value without having full
control. Moreover, top executives and boards of public companies may have an
increased demand for minority equity investments. Shareholder and hedge fund
activism and hostility have increased substantially in recent years (Brav, Jiang,
Partnoy, and Thomas et al., forthcoming). In the face of that hostility, private equity
firms are likely to be perceived as partners or “white knights” by some chief
executive officers and boards.
Finally, what will happen to funds and transactions completed in the recent
private equity boom of 2005 to mid-2007? It seems plausible that the ultimate
returns to private equity funds raised during these years will prove disappointing
because firms are unlikely to be able to exit the deals from this period at valuations
as high as the private equity firms paid to buy the firms. It is also plausible that some
of the transactions undertaken during the boom were less driven by the potential
of operating and governance improvements, and more driven by the availability of
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Leveraged Buyouts and Private Equity 25

debt financing, which also implies that the returns on these deals will be disap-
pointing.
If and when private equity returns decline, private equity commitments also
will decline. Lower returns to recent private equity funds are likely to coincide with
some failed transactions, including debt defaults and bankruptcies. The relative
magnitude of defaults and failed deals, however is likely to be lower than after the
previous boom in the early 1990s. While private equity returns for this period may
disappoint, the transactions of the recent wave had higher coverage ratios and
looser debt covenants on their debt than those of the 1980s, which reduces the
likelihood that those companies will subsequently default.

y This research has been supported by the Kauffman Foundation, the Lynde and Harry
Bradley Foundation, and the Olin Foundation through grants to the Stigler Center for the
Study of the Economy and the State, and by the Center for Research in Security Prices. We
thank Jim Hines, Antoinette Schoar, Andrei Shleifer, Jeremy Stein, Timothy Taylor, and Mike
Wright for very helpful comments.

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 Note on Leveraged Buyouts

Introduction
A leveraged buyout, or LBO, is an acquisition of a company or division of another company
financed with a substantial portion of borrowed funds. In the 1980s, LBO firms and their
professionals were the focus of considerable attention, not all of it favorable. LBO activity
accelerated throughout the 1980s, starting from a basis of four deals with an aggregate value of
$1.7 billion in 1980 and reaching its peak in 1988, when 410 buyouts were completed with an
aggregate value of $188 billion1.

In the years since 1988, downturns in the business cycle, the near-collapse of the junk bond
market, and diminished structural advantages all contributed to dramatic changes in the LBO
market. In addition, LBO fund raising has accelerated dramatically. From 1980 to 1988 LBO
funds raised approximately $46 billion; from 1988 to 2000, LBO funds raised over $385 billion2.
As increasing amounts of capital competed for the same number of deals, it became increasingly
difficult for LBO firms to acquire businesses at attractive prices. In addition, senior lenders have
become increasingly wary of highly levered transactions, forcing LBO firms to contribute higher
levels of equity. In 1988 the average equity contribution to leveraged buyouts was 9.7%. In
2000 the average equity contribution to leveraged buyouts was almost 38%, and for the first
three quarters of 2001 average equity contributions were above 40%3.

These developments have made generating target returns (usually 25 to 30%) much more
difficult for LBO firms. Where once they could rely on leverage to generate returns, LBO firms
today are seeking to build value in acquired companies by improving profitability, pursuing
growth including roll-up strategies (in which an acquired company serves as a “platform” for
additional acquisitions of related businesses to achieve critical mass and generate economies of
scale), and improving corporate governance to better align management incentives with those of
shareholders.

History of the LBO

While it is unclear when the first leveraged buyout was carried out, it is generally agreed that the
first early leveraged buyouts were carried out in the years following World War II. Prior to the
1980s, the leveraged buyout (previously known as a “bootstrap” acquisition) was for years little
more than an obscure financing technique.

This note was written by Jonathan Olsen (T'03) under the supervision of Professor Colin Blaydon and Professor Fred Wainwright.
Copyright 2002 Tuck School of Business at Dartmouth College.
In the years following the end of World War II the Great Depression was still relatively fresh in
the minds of America’s corporate leaders, who considered it wise to keep corporate debt ratios
low. As a result, for the first three decades following World War II, very few American
companies relied on debt as a significant source of funding. At the same time, American
business became caught up in a wave of conglomerate building that began in the early 1960s.
Executives filled boards of directors with subordinates and friendly “outsiders”4 and engaged in
rampant empire building. The ranks of middle management swelled and corporate profitability
began to slide. It was in this environment that the modern LBO was born.

In the late 1970s and early 1980s, newly formed firms such as Kohlberg Kravis Roberts and
Thomas H. Lee Company saw an opportunity to profit from inefficient and undervalued
corporate assets. Many public companies were trading at a discount to net asset value, and many
early leveraged buyouts were motivated by profits available from buying entire companies,
breaking them up and selling off the pieces. This “bust-up” approach was largely responsible for
the eventual media backlash against the greed of so-called “corporate raiders”, illustrated by
books such as The Rain on Macy’s Parade and films such as Wall Street and Barbarians at the
Gate, based on the book by the same name.

As a new generation of managers began to take over American companies in the late 1970s,
many were willing to consider debt financing as a viable alternative for financing operations.
Soon LBO firms’ constant pitching began to convince some of the merits of debt-financed
buyouts of their businesses. From a manager’s perspective, leveraged buyouts had a number of
appealing characteristics:
• Tax advantages associated with debt financing,
• Freedom from the scrutiny of being a public company or a captive division of a larger
parent,
• The ability for founders to take advantage of a liquidity event without ceding operational
influence or sacrificing continued day-to-day involvement, and
• The opportunity for managers to become owners of a significant percentage of a firm’s
equity.

The Theory of the Leveraged Buyout

While every leveraged buyout is unique with respect to its specific capital structure, the one
common element of a leveraged buyout is the use of financial leverage to complete the
acquisition of a target company. In an LBO, the private equity firm acquiring the target
company will finance the acquisition with a combination of debt and equity, much like an
individual buying a house with a mortgage. Just as a mortgage is secured by the value of the
house being purchased, some portion of the debt incurred in an LBO is secured by the assets of
the acquired business. Unlike a house, however, the bought-out business generates cash flows
which are used to service the debt incurred in its buyout – in essence, the acquired company
helps pay for itself (hence the term “bootstrap” acquisition).

2
The use of significant amounts of debt to finance the acquisition of a company has a number of
advantages, as well as risks. The most obvious risk associated with a leveraged buyout is that of
financial distress. Unforeseen events such as recession, litigation, or changes in the regulatory
environment can lead to difficulties meeting scheduled interest payments, technical default (the
violation of the terms of a debt covenant) or outright liquidation. Weak management at the
target company or misalignment of incentives between management and shareholders can also
pose threats to the ultimate success of an LBO.

There are a number of advantages to the use of leverage in acquisitions. Large interest and
principal payments can force management to improve performance and operating efficiency.
This “discipline of debt” can force management to focus on certain initiatives such as divesting
non-core businesses, downsizing, cost cutting or investing in technological upgrades that might
otherwise be postponed or rejected outright. In this manner, the use of debt serves not just as a
financing technique, but also as a tool to force changes in managerial behavior.

Another advantage of the leverage in LBO financing is that, as the debt ratio increases, the equity
portion of the acquisition financing shrinks to a level at which a private equity firm can acquire a
company by putting up anywhere from 20-40% of the total purchase price. Private equity firms
typically invest alongside management, encouraging (if not requiring) top executives to commit
a significant portion of their personal net worth to the deal. By requiring the target’s
management team to invest in the acquisition, the private equity firm guarantees that
management’s incentives will be aligned with their own.

Mechanics
To illustrate the mechanics of a leveraged buyout we will look at an LBO of Target Company.
Exhibit 1 lays out operating and transaction assumptions for a leveraged buyout of Target
Company, as well as a rudimentary set of financial projections and a summary of Target’s post-
LBO capitalization. Exhibit 1 should be largely self-explanatory, with the possible exception of
a few line items:

Transaction Fee Amortization: This line item reflects the capitalization and amortization of
financing, legal, and accounting fees associated with the transaction. Transaction fee
amortization, like depreciation, is a tax-deductible non-cash expense. In most cases the
allowable amortization period for such fees is five to seven years (although in some cases LBO
firms may choose to expense all such fees in year one so as to present the “cleanest” set of
numbers possible going forward).

Interest Expense: For simplicity, interest expense for each tranche of debt financing is calculated
based upon the yearly beginning balance of each tranche. In reality, interest payments are often
made quarterly, so interest expense in the case of the Target LBO may be slightly overstated.

Capitalization: Most leveraged buyouts make use of multiple tranches of debt to finance the
transaction. Looking at the sources and uses of funds of funds in exhibit 1 it can be seen that the
LBO of Target is financed with only two tranches of debt, senior and junior. In reality, a large
leveraged buyout will likely be financed with multiple tranches of debt that could include (in
decreasing order of seniority) some or all of the following:

3
 • A revolving credit facility (“revolver”) is a source of funds that the bought-out firm can
draw upon as its working capital needs dictate. A revolving credit facility is designed to
offer the bought-out firm some flexibility with respect to its capital needs – it serves as a
line of credit that allows the firm to make certain capital investments, deal with
unforeseen costs, or cover increases in working capital without having to seek additional
debt or equity financing.
• Bank debt, which is often secured by the assets of the bought-out firm, is the most senior
claim against the cash flows of the business. As such, bank debt is repaid first, with its
interest and principal payments taking precedence over other, junior sources of debt
financing.
• Mezzanine debt, so named because it exists in the middle of the capital structure, is
junior to the bank debt incurred in financing the leveraged buyout. As a result,
mezzanine debt (like each succeeding level of junior debt) is compensated for its lower
priority with a higher interest rate.
• Subordinated or High-Yield Notes are what are commonly referred to as junk bonds.
Usually sold to the public, these notes are the most junior source of debt financing and as
such command the highest interest rates to compensate holders for their increased risk
exposure.
Each tranche of debt financing will likely have different maturities and repayment terms. For
example, some sources of financing require mandatory amortization of principal in addition to
scheduled interest payments. Some lenders may receive warrants, which allow lenders to
participate in the equity upside in the event the deal is highly successful. There are a number of
ways private equity firms can adjust the target’s capital structure. The ability to be creative in
structuring and financing a leveraged buyout allows private equity firms to adjust to changing
market conditions.

In addition to the debt financing component of an LBO, there is also an equity component.
• Private equity firms typically invest alongside management to ensure the alignment of
management and shareholder interests. In large LBOs, private equity firms will
sometimes team up to create a consortium of buyers, thereby reducing the amount of
capital exposed to any one investment. As a general rule, private equity firms will own
70-90% of the common equity of the bought-out firm, with the remainder held by
management and former shareholders.
• Another potential source of financing for leveraged buyouts is preferred equity.
Preferred equity is often attractive because its dividend interest payments represent a
minimum return on investment while its equity ownership component allows holders to
participate in any equity upside. Preferred interest is often structured as pay-in-kind, or
PIK, dividends, which means any interest is paid in the form of additional shares of
preferred stock. LBO firms will often structure their equity investment in the form of
preferred stock, with management and employees receiving common stock.

Cash Sweep: A cash sweep is simply a provision of certain debt covenants that stipulates that
any excess cash (namely free cash flow available after mandatory amortization payments have
been made) generated by the bought-out business will be used to pay down principal. For those
tranches of debt with provisions for a cash sweep, excess cash is used to pay down debt in the

4
order of seniority. For example, in the case of Target the cash sweep does not begin to pay down
Junior Debt until Year 4.

Exit Scenario: As a general rule, leveraged buyout firms seek to exit their investments in 5 to 7
years. An exit usually involves either a sale of the portfolio company, an IPO or a
recapitalization (effectively an acquisition and relevering of the company by another LBO firm).
Exhibit 2 describes returns to an LBO investor in a sale of a portfolio company at various
EBITDA multiples (companies are often valued based upon a multiple of Earnings Before
Interest, Taxes, Depreciation and Amortization, or EBITDA).

Buyout Firm Structure and Organization

The equity that LBO firms invest in an acquisition comes from a fund of committed capital that
has been raised from a pool of “qualified” investors (defined by the SEC as (i) an individual with
net worth, or joint net worth with spouse, over $1 million, or (ii) an individual with income over
$200,000 in each of the two most recent years or joint income with spouse exceeding $300,000
for those years and a reasonable expectation of the same income level in the current year). These
funds are structured as limited partnerships, with the firm’s principals acting as general partner
and investors in the fund (usually investment funds, insurance companies, pension funds and
wealthy individuals) acting as limited partners. The general partner is responsible for making all
investment decisions relating to the fund, with the limited partners responsible for transferring
committed capital to the fund upon notice of the general partner.

As a general rule, funds raised by private equity firms have a number of fairly standard
provisions:

Minimum Commitment: Prospective limited partners are required to commit a minimum amount
of equity. Limited partners make a capital commitment, which is then drawn down (a
“takedown” or “capital call”) by the general partner in order to make investments with the fund’s
equity.

Investment or Commitment Period: During the term of the commitment period, limited partners
are obligated to meet capital calls upon notice by the general partner by transferring capital to the
fund within an agreed-upon period of time (often 10 days). The term of the commitment period
usually lasts for either five or six years after the closing of the fund or until 75 to 100% of the
fund’s capital has been invested, whichever comes first.

Term: The term of the partnership formed during the fund-raising process is usually ten to
twelve years, the first half of which represents the commitment period (defined above), the
second half of which is reserved for managing and exiting investments made during the
commitment period.

Diversification: Most funds’ partnership agreements stipulate that the partnership may not invest
more than 25% of the fund’s equity in any single investment.

The LBO firm generates revenue in three ways:

5
Carried Interest: Carried interest is a share of any profits generated by acquisitions made by the
fund. Once all the partners have received an amount equal to their contributed capital any
remaining profits are split between the general partner and the limited partners. Typically, the
general partner’s carried interest is 20% of any profits remaining once all the partners’ capital
has been returned, although some funds guarantee the limited partners a priority return of 8% on
their committed capital before the general partner’s carried interest begins to accrue.

Management Fees: LBO firms charge a management fee to cover overhead and expenses
associated with identifying, evaluating and executing acquisitions by the fund. The management
fee is intended to cover legal, accounting, and consulting fees associated with conducting due
diligence on potential targets, as well as general overhead. Other fees, such as lenders’ fees and
investment banking fees are generally charged to the acquired company after the closing of a
transaction. Management fees range from 0.75% to 3% of committed capital, although 2% is
common. Management fees are often reduced after the end of the commitment period to reflect
the lower costs of monitoring and harvesting investments.

Co-Investment: Executives and employees of the leveraged buyout firm may co-invest along
with the partnership on any acquisition made by the fund, provided the terms of the investment
are equal to those afforded to the partnership.

6
Exhibit 1 – LBO Structure
Assumptions Year 1 Year 2 Year 3 Year 4 Year 5
Sales Growth 5.0% 5.0% 5.0% 5.0% 5.0%
COGS as % of Sales 60.0% 60.0% 60.0% 60.0% 60.0%
S,G&A as % of Sales 15.0% 15.0% 15.0% 15.0% 15.0%
Depreciation as % of Sales 5.5% 5.5% 5.5% 5.5% 5.5%
Transaction Fee Amortization (5 years) $ 1.0 $ 1.0 $ 1.0 $ 1.0 $ 1.0
Tax Rate 35.0% 35.0% 35.0% 35.0% 35.0%
Cap. Ex. as % of Sales 5.5% 5.5% 5.5% 5.5% 5.5%
Inc. in WC as % of Inc. in Sales 7.0% 7.0% 7.0% 7.0% 7.0%
Uses of Funds Sources of Funds
Purchase Price $ 200.0 Senior Debt (@ 9.0%) 45.0
Transaction Costs 5.0 Junior Debt (@ 13.0%) 100.0
Equity 60.0

Total $ 205.0 $ 205.0

Target Projections Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Net Sales 170.0 178.5 187.4 196.8 206.6 217.0
COGS 102.0 107.1 112.5 118.1 124.0 130.2
S,G&A 25.5 26.8 28.1 29.5 31.0 32.5
Depreciation 9.4 9.8 10.3 10.8 11.4 11.9
Operating Income 33.1 34.8 36.5 38.4 40.3 42.3
Transaction Fee Amortization - 1.0 1.0 1.0 1.0 1.0
EBIT 33.1 33.8 35.5 37.4 39.3 41.3
Interest Expense
Senior Debt 9.0% 4.1 3.0 1.9 0.5 -
Junior Debt 13.0% 13.0 13.0 13.0 13.0 11.5
Total Interest Expense 17.1 16.0 14.9 13.5 11.5
Pre-tax Income 16.8 19.5 22.5 25.8 29.8
Income Taxes 5.9 6.8 7.9 9.0 10.4
Net Income 10.9 12.7 14.6 16.8 19.4
Free Cash Flow Calculation
Net Income 10.9 12.7 14.6 16.8 19.4
Plus: Depreciation 9.8 10.3 10.8 11.4 11.9
Plus: Transaction Fee Amortization 1.0 1.0 1.0 1.0 1.0
Less: Capital Expenditures (9.8) (10.3) (10.8) (11.4) (11.9)
Less: Increase in Working Capital (0.6) (0.6) (0.7) (0.7) (0.7)
Free Cash Flow 11.3 13.1 15.0 17.1 19.6
Capitalization Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Senior Debt - Beginning Balance 45.0 33.7 20.6 5.7 -
Mandatory Amortization $1.0 1.0 1.0 1.0 1.0 -
Cash Sweep 10.3 12.1 14.0 4.7 -
Senior Debt - Ending Balance 45.0 33.7 20.6 5.7 - -
Junior Debt - Beginning Balance 100.0 100.0 100.0 100.0 88.6
Mandatory Amortization $0.0 - - - - -
Cash Sweep - - - 11.4 19.6
Junior Debt - Ending Balance 100.0 100.0 100.0 100.0 88.6 68.9
Senior Debt 45.0 33.7 20.6 5.7 - -
Junior Debt 100.0 100.0 100.0 100.0 88.6 68.9
Equity 60.0 70.9 83.6 98.2 115.0 134.3
Total Capitalization 205.0 204.6 204.2 203.9 203.6 203.3
Senior Debt 22.0% 16.5% 10.1% 2.8% 0.0% 0.0%
Junior Debt 48.8% 48.9% 49.0% 49.0% 43.5% 33.9%
Equity 29.3% 34.7% 40.9% 48.2% 56.5% 66.1%

7
Exhibit 2 – LBO Return Calculations
Cash Flows to Common Equity Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
EBITDA 42.5 43.6 45.9 48.2 50.7 53.2
Total Debt 145.0 133.7 120.6 105.7 88.6 68.9

Exit Multiple Outflow Inflows

5.5 x (60.0) 106.2 131.6 159.4 190.0 223.9
6.5 x (60.0) 149.9 177.4 207.6 240.7 277.1
7.5 x (60.0) 193.5 223.3 255.8 291.4 330.4

Exit In: IRR

Year 1 5.5 x 77.1% (60.0) 106.2
6.5 x 149.8% (60.0) 149.9
7.5 x 222.5% (60.0) 193.5

Year 2 5.5 x 48.1% (60.0) - 131.6

6.5 x 72.0% (60.0) - 177.4
7.5 x 92.9% (60.0) - 223.3

Year 3 5.5 x 38.5% (60.0) - - 159.4

6.5 x 51.3% (60.0) - - 207.6
7.5 x 62.2% (60.0) - - 255.8

Year 4 5.5 x 33.4% (60.0) - - - 190.0

6.5 x 41.5% (60.0) - - - 240.7
7.5 x 48.4% (60.0) - - - 291.4

Year 5 5.5 x 30.1% (60.0) - - - - 223.9

6.5 x 35.8% (60.0) - - - - 277.1
7.5 x 40.7% (60.0) - - - - 330.4

8
 Sources:
1
Securities Data Corporation
2
Venture Economics
3
S&P/Portfolio Management Data
4
George P. Baker and George David Smith, The New Financial Capitalists: Kohlberg Kravis
Roberts and the Creation of Corporate Value, (Cambridge: Cambridge University Press, 1998).

9
Note on Leveraged Buyouts Case #5-0004

Updated September 30, 2003

Note on Leveraged Buyouts

A leveraged buyout, or LBO, is the acquisition of a company or division of a

company with a substantial portion of borrowed funds. In the 1980s, LBO firms
and their professionals were the focus of considerable attention, not all of it
favorable. LBO activity accelerated throughout the 1980s, starting from a basis of
four deals with an aggregate value of $1.7 billion in 1980 and reaching its peak in
1988, when 410 buyouts were completed with an aggregate value of $188 billion1.

In the years since 1988, downturns in the business cycle, the near-collapse of the
junk bond market, and diminished structural advantages all contributed to dramatic
changes in the LBO market. In addition, LBO fund raising has accelerated
dramatically. From 1980 to 1988 LBO funds raised approximately $46 billion;
from 1988 to 2000, LBO funds raised over $385 billion2. As increasing amounts of
capital competed for the same number of deals, it became increasingly difficult for
LBO firms to acquire businesses at attractive prices. In addition, senior lenders
have become increasingly wary of highly levered transactions, forcing LBO firms
to contribute higher levels of equity. In 1988 the average equity contribution to
leveraged buyouts was 9.7%. In 2000 the average equity contribution to leveraged
buyouts was almost 38%, and for the first three quarters of 2001 average equity

1
Securities Data Corporation
2
Venture Economics

This case was prepared by John Olsen T’03 and updated by Salvatore Gagliano T’04 under the
supervision of Adjunct Assistant Professor Fred Wainwright and Professor Colin Blaydon of the
Tuck School of Business at Dartmouth College. It was written as a basis for class discussion and not
to illustrate effective or ineffective management practices.

Copyright © 2003 Trustees of Dartmouth College. All rights reserved. To order additional copies,
please call (603) 646-0522. No part of this document may be reproduced, stored in any retrieval
system, or transmitted in any form or by any means without the express written consent of the Tuck
School of Business at Dartmouth College.
Note on Leveraged Buyouts Case #5-0004

contributions were above 40%3. Contributing to this trend was the near halt in
enterprise lending, in stark comparison to the 1990s, when banks were lending at up
to 5.0x EBITDA. Because of lenders’ over-exposure to enterprise lending, senior
lenders over the past two years are lending strictly against company asset bases,
increasing the amount of equity financial sponsors must invest to complete a
transaction.4

These developments have made generating target returns (typically 25 to 30%)

much more difficult for LBO firms. Where once they could rely on leverage to
generate returns, LBO firms today are seeking to build value in acquired companies
by improving profitability, pursuing growth including roll-up strategies (in which
an acquired company serves as a “platform” for additional acquisitions of related
businesses to achieve critical mass and generate economies of scale), and improving
corporate governance to better align management incentives with those of
shareholders.

History of the LBO

While it is unclear when the first leveraged buyout was carried out, it is generally
agreed that the first early leveraged buyouts were carried out in the years following
World War II. Prior to the 1980s, the leveraged buyout (previously known as a
“bootstrap” acquisition) was for years little more than an obscure financing
technique.

In the years following the end of World War II the Great Depression was still
relatively fresh in the minds of America’s corporate leaders, who considered it wise
to keep corporate debt ratios low. As a result, for the first three decades following
World War II, very few American companies relied on debt as a significant source
of funding. At the same time, American business became caught up in a wave of
conglomerate building that began in the early 1960s. In some cases, corporate
governance guidelines were inconsistently implemented.5 The ranks of middle
management swelled and corporate profitability began to slide. It was in this
environment that the modern LBO was born.

In the late 1970s and early 1980s, newly formed firms such as Kohlberg Kravis
Roberts and Thomas H. Lee Company saw an opportunity to profit from inefficient

3
S&P / Portfolio Management Data
4
Private Placement Newsletter, January 6, 2003.
5
George P. Baker and George David Smith, The New Financial Capitalists: Kohlberg Kravis
Roberts and the Creation of Corporate Value, (Cambridge: Cambridge University Press, 1998).

Center for Private Equity and Entrepreneurship 2

Note on Leveraged Buyouts Case #5-0004

and undervalued corporate assets. Many public companies were trading at a

discount to net asset value, and many early leveraged buyouts were motivated by
profits available from buying entire companies, breaking them up and selling off the
pieces. This “bust-up” approach was largely responsible for the eventual media
backlash against the greed of so-called “corporate raiders”, illustrated by books
such as The Rain on Macy’s Parade and films such as Wall Street and Barbarians
at the Gate, based on the book by the same name.

As a new generation of managers began to take over American companies in the

late 1970s, many were willing to consider debt financing as a viable alternative for
financing operations. Soon LBO firms’ constant pitching began to convince some
of the merits of debt-financed buyouts of their businesses. From a manager’s
perspective, leveraged buyouts had a number of appealing characteristics:

Tax advantages associated with debt financing,

Freedom from the scrutiny of being a public company or a captive division
of a larger parent,
The ability for founders to take advantage of a liquidity event without
ceding operational influence or sacrificing continued day-to-day
involvement, and
The opportunity for managers to become owners of a significant percentage
of a firm’s equity.

The Theory of the Leveraged Buyout

While every leveraged buyout is unique with respect to its specific capital structure,
the one common element of a leveraged buyout is the use of financial leverage to
complete the acquisition of a target company. In an LBO, the private equity firm
acquiring the target company will finance the acquisition with a combination of
debt and equity, much like an individual buying a rental house with a mortgage (See
Exhibit 1). Just as a mortgage is secured by the value of the house being purchased,
some portion of the debt incurred in an LBO is secured by the assets of the acquired
business. The bought-out business generates cash flows that are used to service the
debt incurred in its buyout, just as the rental income from the house is used to pay
down the mortgage. In essence, an asset acquired using leverage helps pay for itself
(hence the term “bootstrap” acquisition).

In a successful LBO, equity holders often receive very high returns because the debt
holders are predominantly locked into a fixed return, while the equity holders
receive all the benefits from any capital gains. Thus, financial buyers invest in
highly leveraged companies seeking to generate large equity returns. An LBO fund

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Note on Leveraged Buyouts Case #5-0004

will typically try to realize a return on an LBO within three to five years. Typical
exit strategies include an outright sale of the company, a public offering or a
recapitalization. Table 1 further describes these three exit scenarios.

Table 1. Potential investment exit strategies for an LBO fund.

Exit Strategy Comments

Sale Often the equity holders will seek an outright sale to a strategic
buyer, or even another financial buyer
Initial Public Offering While an IPO is not likely to result in the sale of the entire entity,
it does allow the buyer to realize a gain on its investment
Recapitalization The equity holders may recapitalize by re-leveraging the entity,
replacing equity with more debt, in order to extract cash from the
company

LBO Candidate Criteria

Given the proportion of debt used in financing a transaction, a financial buyer’s

interest in an LBO candidate depends on the existence of, or the opportunity to
improve upon, a number of factors. Specific criteria for a good LBO candidate
include:

Steady and predictable cash flow Divestible assets

Clean balance sheet with little debt Strong management team
Strong, defensible market position Viable exit strategy
Limited working capital requirements Synergy opportunities
Minimal future capital requirements Potential for expense reduction
Heavy asset base for loan collateral

Transaction Structure

An LBO will often have more than one type of debt in order to procure all the
required financing for the transaction. The capital structure of a typical LBO is
summarized in Table 2.

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Note on Leveraged Buyouts Case #5-0004

Table 2. Typical LBO transaction structure.

Percent of Cost of
Offering Transaction Capital Lending Parameters Likely Sources
Senior Debt 50 – 60% 7 – 10% 5 – 7 Years Payback Commercial
2.0x – 3.0x EBITDA banks
2.0x interest coverage Credit companies
Insurance
companies

Mezzanine 20 – 30% 10 – 20% 7 – 10 Years Payback Public Market

Financing 1.0 – 2.0x EBITDA Insurance
companies
LBO/Mezzanine
Funds

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Note on Leveraged Buyouts Case #5-0004

Another advantage of the leverage in LBO financing is that, as the debt ratio
increases, the equity portion of the acquisition financing shrinks to a level at which
a private equity firm can acquire a company by putting up anywhere from 20-40%
of the total purchase price.

Interest payments on debt are tax deductible, while dividend payments on equity are
not. Thus, tax shields are created and they have significant value. A firm can
increase its value by increasing leverage up to the point where financial risk makes
the cost of equity relatively high compared to most companies.

Private equity firms typically invest alongside management, encouraging (if not
requiring) top executives to commit a significant portion of their personal net worth
to the deal. By requiring the target’s management team to invest in the acquisition,
the private equity firm guarantees that management’s incentives will be aligned
with their own.

The most obvious risk associated with a leveraged buyout is that of financial
distress. Unforeseen events such as recession, litigation, or changes in the
regulatory environment can lead to difficulties meeting scheduled interest
payments, technical default (the violation of the terms of a debt covenant) or
outright liquidation, usually resulting in equity holders losing their entire
investment on a bad deal.

The value that a financial buyer hopes to extract from an LBO is closely tied to
sales growth rates, margins and discount rates, as well as proper management of
investments in working capital and capital expenditures. Weak management at the
target company or misalignment of incentives between management and
shareholders can also pose threats to the ultimate success of an LBO. In addition,
an increase in fixed costs from higher interest payments can reduce a leveraged
firm’s ability to weather downturns in the business cycle. Finally, in troubled
situations, management teams of highly levered firms can be distracted by dealing
with lenders concerned about the company’s ability to service debt.

Buyout Firm Structure and Organization

The equity that LBO firms invest in an acquisition comes from a fund of committed
capital that has been raised from institutional investors, such as corporate pension
plans, insurance companies and college endowments, as well as individual
“qualified” investors. A qualified investor is defined by the SEC as (i) an individual
with net worth, or joint net worth with spouse, over $1 million, or (ii) an individual
with income over $200,000 in each of the two most recent years or joint income

Center for Private Equity and Entrepreneurship 6

Note on Leveraged Buyouts Case #5-0004

with spouse exceeding $300,000 for those years and a reasonable expectation of the
same income level in the current year. Buyout funds are structured as limited
partnerships, with the firm’s principals acting as general partner and investors in the
fund being limited partners. The general partner is responsible for making all
investment decisions relating to the fund, with the limited partners responsible for
transferring committed capital to the fund upon notice of the general partner.

As a general rule, funds raised by private equity firms have a number of fairly
standard provisions:

Minimum Commitment: Prospective limited partners are required to commit a

minimum amount of equity. Limited partners make a capital commitment, which is
then drawn down (a “takedown” or “capital call”) by the general partner in order to
make investments with the fund’s equity.

Investment or Commitment Period: During the term of the commitment period,

limited partners are obligated to meet capital calls upon notice by the general
partner by transferring capital to the fund within an agreed-upon period of time
(often 10 days). The term of the commitment period usually lasts for either five or
six years after the closing of the fund or until 75 to 100% of the fund’s capital has
been invested, whichever comes first.

Term: The term of the partnership formed during the fund-raising process is
usually ten to twelve years, the first half of which represents the commitment period
(defined above), the second half of which is reserved for managing and exiting
investments made during the commitment period.

Diversification: Most funds’ partnership agreements stipulate that the partnership

may not invest more than 25% of the fund’s equity in any single investment.

The LBO firm generates revenue in three ways:

Carried Interest: Carried interest is a share of any profits generated by acquisitions

made by the fund. Once all the partners have received an amount equal to their
contributed capital any remaining profits are split between the general partner and
the limited partners. Typically, the general partner’s carried interest is 20% of any
profits remaining once all the partners’ capital has been returned, although some
funds guarantee the limited partners a priority return of 8% on their committed
capital before the general partner’s carried interest begins to accrue.

Management Fees: LBO firms charge their limited partners a management fee to
cover overhead and expenses associated with identifying, evaluating and executing

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Note on Leveraged Buyouts Case #5-0004

acquisitions by the fund. The management fee is intended to cover legal,

accounting, and consulting fees associated with conducting due diligence on
potential targets, as well as general overhead. Other fees, such as lenders’ fees and
investment banking fees are generally charged to any acquired company after the
closing of a transaction. Management fees range from 0.75% to 3% of committed
capital, although 2% is common. Management fees are often reduced after the end
of the commitment period to reflect the lower costs of monitoring and harvesting
investments.

Co-Investment: Executives and employees of the leveraged buyout firm may co-
invest along with the partnership on any acquisition made by the fund, provided the
terms of the investment are equal to those afforded to the partnership.

See exhibits 1 and 2 below for detailed examples and analyses of leveraged
transactions.

Valuation

The valuation of established companies that are the usual acquisition targets of
LBO funds can be done using two primary methods:
Market comparisons. These are metrics such as multiples of revenue, net
earnings and EBITDA that can be compared among public and private
companies. Usually a discount of 10% to 40% is applied to private
companies due to the lack of liquidity of their shares.
Discounted cash flow (DCF) analysis. This is based on the concept that the
value of a company is based on the cash flows it can produce in the future.
An appropriate discount rate is used to calculate a net present value of
projected cash flows.6

6
Since interest is tax deductible, a more refined DCF analysis can calculate the value of interest tax
shields and the value of cash flows assuming the firm had no debt. The sum of the two values results
in the value of the enterprise. This is a methodology known as Adjusted Present Value, or APV, and
it shows explicitly the value contributed by debt. For further details see Corporate Finance, Ross,
Westerfield and Jaffe, 5th Edition, p. 455-459.

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Note on Leveraged Buyouts Case #5-0004

Exhibit 1. Leveraged Buyout: A Simple Example

The following example is intended to demonstrate the effect of leverage when

making an acquisition. Suppose you bought an apartment house on December 31,
2003 as an investment for $750,000 with a down payment of 10%, or $75,000. The
remaining $675,000 of the purchase price was financed through a bank loan with an
interest rate of 7.5%. Your annual rental income from the house is $250,000 and
your annual expenses are $50,000 in maintenance charges and $10,000 in property
taxes. For simplicity, assume there are no income taxes, all cash flows occur at the
end of each year, and the value of the rental property remains fixed.

Your income for the next five years can be summarized as follows:

Income Statement
Year Ending December 31, 2003 2004 2005 2006 2007 2008

Rental Income $250,000 $250,000 $250,000 $250,000 $250,000

Maintenace Charges 50,000 50,000 50,000 50,000 50,000

Property Taxes 10,000 10,000 10,000 10,000 10,000
Rental Income 190,000 190,000 190,000 190,000 190,000

Interest Payments 50,625 40,172 28,935 16,855 3,869

Free Cash Flow Used to Repay Debt 139,375 149,828 161,065 173,145 186,131

Assuming that all free cash flow each year is used to repay debt and the value of the
property remains fixed, your equity ownership in the house should steadily increase
over the period as you pay down your mortgage:

Year Ending December 31, 2003 2004 2005 2006 2007 2008

Mortgage
Beginning Balance $675,000 $675,000 $535,625 $385,797 $224,732 $51,587
(Payments) / Borrowings 0 (139,375) (149,828) (161,065) (173,145) (51,587)
Ending Balance 675,000 535,625 385,797 224,732 51,587 0
Interest Expense at 50,625 40,172 28,935 16,855 3,869

Capitalization
Debt $675,000 $535,625 $385,797 $224,732 $51,587 $0
Equity 75,000 214,375 364,203 525,268 698,413 750,000
Total Capitalization 750,000 750,000 750,000 750,000 750,000 750,000

Ownership
Debt 90.0% 71.4% 51.4% 30.0% 6.9% 0.0%
Equity 10.0% 28.6% 48.6% 70.0% 93.1% 100.0%
Total Capitalization 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

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Note on Leveraged Buyouts Case #5-0004

At the end of five years, your equity ownership as a percentage of total

capitalization increases from 10% to 100%.

Return on Investment
Equity Value $884,544
Compund Annual Return on Equity 63.81%

Taking into account the value of the apartment house at the end of 2008, your initial
$75,000 investment is worth nearly $900,000, representing a compounded annual
return of 64%. Because you were able to take advantage of leverage in financing
the purchase, you now own an asset of relatively significant equity value relative to
the amount of your initial equity investment.

Financing the purchase of the apartment house with significant amounts of debt will
dramatically influence your return on the investment. To further illustrate this,
consider the effect of varying combinations of debt and equity to make the original
purchase. Furthermore, assume that the real estate market takes a turn for the worse
and that you can only rent the house for $125,000 a year while still having to pay
the same expenses in maintenance and property taxes.

Assuming that you are stuck with this investment for the next five years, your
income stream can be summarized as:

Income Statement
Year Ending December 31, 2003 2004 2005 2006 2007 2008

Rental Income $125,000 $125,000 $125,000 $125,000 $125,000

Maintenace Charges 50,000 50,000 50,000 50,000 50,000

Property Taxes 10,000 10,000 10,000 10,000 10,000
Rental Income 65,000 65,000 65,000 65,000 65,000

Interest Payments 50,065 48,901 47,647 46,295 44,837

Free Cash Flow Used to Repay Debt 14,935 16,099 17,353 18,705 20,163

If you eventually sell the house in 2008 for $500,000, $750,000 or $1 million, your
compounded annual return on investment in each financing scenario can be
summarized as:

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Note on Leveraged Buyouts Case #5-0004

Five- Year Internal Rates of Return Based on Varying Financing Combinations and Exit Prices

100% Equity 50% Debt / 50% Equity 75% Debt / 25% Equity
Proceeds to Return to Proceeds to Return to Proceeds to Return to
Equity Equity Equity Equity Equity Equity
Sale Price Holders Holders Holders Holders Holders Holders
162,256 100.00% 100.00% 50.00% 50.00% 25.00% 25.00%
$500,000 $825,000 1.92% $348,830 (1.44%) $75,971 (16.53%)
750,000 1,075,000 7.47% 598,830 9.81% 325,971 11.70%
1,000,000 1,325,000 12.05% 848,830 17.75% 575,971 25.16%

The proceeds to you at exit include the repayment of the outstanding mortgage
balance and the proceeds from your exiting sale price. Note how increasing
financing leverage magnifies your IRR, either positively or negatively.

While this example is rather simple, we see that levering up to make an investment
in any asset increases financial risk and significantly influences one’s gain or loss
on the investment.

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Note on Leveraged Buyouts Case #5-0004

Exhibit 2. LBO Mechanics

To illustrate the mechanics of a leveraged buyout we will look at an LBO of ABC

Company. The Leveraged Buyout Model shown in the following pages lays out
transaction assumptions, analyses and pro forma financial statements for the
Company. An explanation of each section of the model follows.

Transaction Assumptions
This section includes basic transaction assumptions, including the expected closing
date, the accounting method, amortization for transaction fees and relevant market
interest rates. Within the model, the closing date drives the calculation of internal
rates of returns to the equity investors. The accounting method for the transaction is
either purchase or recapitalization accounting. In an acquisition, the Purchase
Method treats the acquirer as having purchased the assets and assumed the
liabilities of the target, which are then written up or down to their respective fair
market values. The difference between the purchase price and the net assets
acquired is attributed to goodwill. In a recapitalization, the target’s capitalization is
restructured without stepping up the basis of the target’s assets for accounting
purposes, and there is no transaction goodwill. For recapitalization accounting to
be used in a transaction, the Securities and Exchange Commission requires that the
target company be an existing entity that is not formed or altered, such as through
reincorporation, to facilitate the transaction.

Transaction fees, such as lenders’ fees, the equity sponsor’s transaction costs and
investment banking fees are generally charged to the acquired company after the
closing of a transaction, capitalized on the company’s balance sheet (since benefits
from the transaction accrue to the company over multiple years) and typically
amortized over a period of seven years. Market interest rates, primarily Treasury
note rates and the London InterBank Offered rate (LIBOR), are used by lenders to
price the debt lent in the transaction. Finally, the Transaction Summary shows the
equity purchase price of the transaction, calculates the transaction value, and
summarizes the relevant transaction multiples.

Sources and Uses of Funds

This section is used to input the transaction structuring assumptions for debt and
equity sources. The funds raised are then allocated accordingly, including the
purchase of the Company’s common equity, the refinancing of current debt and
payment of transaction fees.

Capitalization: Most leveraged buyouts make use of multiple tranches of debt to

finance the transaction. Looking at the sources and uses of funds of funds in
Exhibit 2 it can be seen that the LBO of Target is financed with only two tranches

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Note on Leveraged Buyouts Case #5-0004

of debt, senior and junior. In reality, a large leveraged buyout will likely be
financed with multiple tranches of debt that could include (in decreasing order of
seniority) some or all of the following:

Bank Debt is usually provided by one of more commercial banks lending to

the transaction. It is usually comprised of two components: a revolving
credit facility and term debt, which sit pari passu to each other. Bank lenders
have the most senior claim against the cash flows of the business. As such,
bank debt has the senior claim on the assets of the Company, with bank debt
principal and interest payments taking precedence over other, junior sources
of debt financing.
- A revolving credit facility (“bank revolver”) is a source of funds
that the bought-out firm can draw upon as its working capital needs
dictate. A revolving credit facility is designed to offer the bought-
out firm some flexibility with respect to its capital needs. It serves as
a line of credit that allows the firm to make certain capital
investments, deal with unforeseen costs, or cover increases in
working capital without having to seek additional debt or equity
financing. Credit facilities usually have maximum borrowing limits
and conservative repayment terms. The model below assumes that
the company uses excess cash flow to repay outstanding borrowings
against its credit facility.
- Term debt, which is often secured by the assets of the bought-out
firm, is also provided by banks and insurance companies in the form
of private placement investments. Term debt is usually priced with a
spread above treasury notes and has maturities of five to ten years.
The amortization of term debt is negotiable and can be a straight-line
amortization or interest-only payments during the first several years
with full amortization payments thereafter.

Mezzanine Financing is so named because it exists in the middle of the

capital structure and generally fills the gap between bank debt and the equity
in a transaction. Mezzanine financing is junior to the bank debt incurred in
financing the leveraged buyout and can take the form of subordinated notes
from the private placement market or high-yield bonds from the public
markets, depending on the size and attractiveness of the deal. Mezzanine
financing is compensated for its lower priority and higher level of risk with
higher interest rates, either cash, paid-in-kind (PIK) or both, and, at times,
warrants to purchase typically 2% to 5% of the pro forma company’s
common equity.

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Note on Leveraged Buyouts Case #5-0004

Each tranche of debt financing will likely have different maturities and repayment
terms. For example, some sources of financing require mandatory amortization of
principal in addition to scheduled interest payments. There are a number of ways
private equity firms can adjust the target’s capital structure. The ability to be
creative in structuring and financing a leveraged buyout allows private equity firms
to adjust to changing market conditions.

In addition to the debt component of an LBO, there is also an equity component in

financing the transaction.

Private equity firms typically invest alongside management to ensure the

alignment of management and shareholder interests. In large LBOs, private
equity firms will sometimes team up to create a consortium of buyers,
thereby reducing the amount of capital exposed to any one investment. As a
general rule, private equity firms will own 70-90% of the common equity of
the bought-out firm, with the remainder held by management and former
shareholders.

Another potential source of financing for leveraged buyouts is preferred

equity. Preferred equity is often attractive because its dividend interest
payments represent a minimum return on investment while its equity
ownership component allows holders to participate in any equity upside.
Preferred interest is often structured as PIK dividends, which means any
interest is paid in the form of additional shares of preferred stock. LBO
firms will often structure their equity investment in the form of preferred
stock, with management, employees and warrant holders receiving common
stock.

Capitalization Information and Summary Coverage & Leverage Statistics

Buyout funds pay close attention to the Company’s ability to service the principal
and interest payments following the transaction. This section estimates the
Company’s pro forma ability to service its debt and amount of leverage it takes on
in the transaction.

Balance Sheet Transaction Adjustments

This section depicts the changes in the Company’s balance sheet as a result of the
LBO. The “Actual” column shows the Company’s most recent balance sheet before
the transaction. The “Adjustments” columns adjust the balance sheet to take into
account the capital raised, repayment of current Company debt, and purchase of the
Company’s common equity. This section also depicts the capitalization of

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Note on Leveraged Buyouts Case #5-0004

transaction goodwill and transaction costs. Finally, the “LBO Pro Forma” column
shows the balance sheet after the transaction.

Pro Forma Financial Statements

The model also describes the Company’s revised financial projections post-LBO.
Certain line items to take note of on the income statement and balance sheet
include:

Transaction Fee Amortization: This line item reflects the amortization of

capitalized financing, legal, and accounting fees associated with the transaction.
Transaction fee amortization, like depreciation, is a tax-deductible non-cash
expense. In most cases the allowable amortization period for such fees is five to
seven years (although in some cases LBO firms may choose to expense all such
fees in year one so as to present the “cleanest” set of numbers possible going
forward).

Management Fees: In addition to transaction fees, LBO shops will often charge a
transaction closing fee to the company, usually around 3% of the equity provided.
Also, in many deals the LBO shop will charge an ongoing management fee of
approximately $1 to $4 million annually, depending on the size of the company and
the magnitude of the role of the LBO shop.

Interest Expense: Interest expense for each tranche of debt financing is calculated
based upon the average yearly balance of each tranche. This method of calculating
interest expense attempts to resemble the quarterly interest payments that are often
made in reality.

Transaction Goodwill: When the purchase method of accounting is used,

transaction goodwill, or the amount in excess of tangible book value the acquirer
paid for the Company, is capitalized at closing and adjusted each year for any
impairment.

Cash Sweep Assumption: For the purpose of simplicity, the model assumes a cash
sweep, or Excess Cash Flow Recapture, on the bank revolver and senior term debt.
A cash sweep is a provision of certain debt covenants that stipulates that a portion
of excess cash (namely free cash flow available after mandatory amortization
payments have been made) generated by the bought-out business will be used to
pay down principal by tranche in the order of seniority. In reality, a cash sweep
usually applies to the bank facility and senior term debt but not to mezzanine and
high-yield financing. Note that term debt is not a credit line. Once paid down, term
debt cannot be “reborrowed” by the company. Usually, subordinated debt holders
charge a significant prepayment penalty, or “make-whole premium,” for any

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Note on Leveraged Buyouts Case #5-0004

prepayments. Note that if a cash sweep was not mandated by banks and the
Company was able to reinvest its available cash flow in projects whose internal rate
of return was higher than the cost of debt, the overall return to the LBO investors
would be higher.

Equity Sponsor IRR Calculation

This section summarizes the returns the buyout fund should expect three to five
years after closing the transaction assuming the company is acquired at a multiple
of EBITDA. As a general rule, leveraged buyout firms seek to exit their
investments in 5 to 7 years. Financial projections that rely solely on “multiple
arbitrage” to build enterprise value are suspect, since the expansion or contraction
of valuation multiples is dictated partly by the financial markets and partly by the
sector focus and competitive strengths of the individual company. An exit usually
involves either a sale of the portfolio company, an IPO, a recapitalization, or a sale
to another LBO firm.

[See next page]

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Note on Leveraged Buyouts Case #5-0004

Leveraged Buyout Analysis

Transaction Assumptions Sources and Uses of Funds

Transaction Date 12/31/03 Sources of Funds Interest Rates Uses of Funds
Leveraged Recap? (Yes = 1, No = 0) 1 Debt & Preferred Stock Amount Percent Cash PIK Amount Percent
Transaction Accounting Method Recap Bank Revolver $5.0 0.1% 6.5% Purchase Common Equity $3,631.0 82.3%
Transaction Fee Rate 3.00% Acquisition Senior Debt 2,205.8 50.0% 6.5%
Transaction Fee Amortization Years 7 Acquisition Mezzanine Financing 661.8 15.0% 15.0% 1.0% Refinance Short-term Debt 5.0 0.1%
Treasury Notes 4.47% Acquisition PIK Preferred 0.0 0.0% 0.0% 0.0%
Total Debt & Preferred Stock 2,872.6 65.1% Refinance Senior Debt 689.5 15.6%
Transaction Summary @ Deal Equity Amount Percent % Equity
Equity Purchase Price per Share $32.00 Management $10.0 0.2% 0.6% Refinance Mezzanine Debt 0.0 0.0%
Common Shares Outstanding 113.5 Rollover Equity 0.0 0.0% 0.0%
Equity Value $3,631.0 Equity Sponsor 1,529.0 34.7% 99.4% Transaction Fees 86.2 2.0%
Plus: Total Debt 694.5 Total Equity 1,539.0 34.9% 100.0%
Less: Cash (148.6) Total Sources of Funds 4,411.7 100.0% Total Uses of Funds $4,411.7 100.0%
Transaction Value $4,176.9
Capitalization Information Summary Coverage & Leverage Statistics
Transaction Multiples Analysis @ Deal Current @ Deal LTM PF 2003 PF 2004 PF
LTM EBITDA 7.7x Total Debt $694.5 $2,872.6 EBITDA / Interest Expense 2.3x 2.6x 3.3x
LTM EBIT 10.7x Total Stockholders Equity 1,579.5 (512.5) (EBITDA - Capex) / Interest Expense 0.6x 0.9x 1.4x
FYE 2003 E EBITDA 6.8x Total Capitalization $2,274.0 $2,360.2 EBITDA / Fixed Charges (1) 2.3x 2.6x 3.3x
FYE 2003 E EBIT 14.2x Total Debt / Equity 44.0% (560.5%) (EBITDA - Capex) / Fixed Charges 0.6x 0.9x 1.4x
FYE 2004 E EBITDA 5.4x Total Debt / Total Cap. 30.5% 121.7% Total Debt / EBITDA 5.3x 4.7x 3.6x
FYE 2004 E EBIT 11.2x Total Net Debt / Total Cap. 24.0% 115.4% Total Debt / (EBITDA - Capex) 19.1x 13.2x 8.4x

(1) Fixed charges defined as cash interest plus PIK preferred dividends.

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Balance Sheet Transaction Adjustments

Actual Adjustments LBO

06/29/03 Sources Uses Pro Forma
Assets
Cash and Cash Equivalents $148.6 $4,411.7 ($4,411.7) $148.6
Accounts Receivable 96.5 0.0 0.0 96.5
Inventory 49.8 0.0 0.0 49.8
Other Current Assets 21.8 0.0 0.0 21.8
Total Current Assets 316.6 4,411.7 (4,411.7) 316.6

Net Property, Plant & Equipment 1,948.3 0.0 0.0 1,948.3

Transaction Goodwill 0.0 0.0 0.0 0.0
Transaction Costs 0.0 0.0 86.2 86.2
Goodwill 279.5 0.0 0.0 279.5
Intangibles 47.1 0.0 0.0 47.1
Other Assets 193.3 0.0 0.0 193.3
Total Assets $2,784.8 $4,411.7 ($4,325.5) $2,871.0

Liabilities and Shareholders' Equity

Bank Revolver $5.0 $5.0 ($5.0) $5.0
Accounts Payable 91.0 0.0 0.0 91.0
Other Current Liabilities 218.8 0.0 0.0 218.8
Total Current Liabilities 314.8 5.0 (5.0) 314.8

Other Liabilities 201.0 0.0 0.0 201.0

Senior Debt 689.5 2,205.8 (689.5) 2,205.8
Subordinated Debt 0.0 661.8 0.0 661.8
Total Liabilities 1,205.3 2,872.6 (694.5) 3,383.5

Existing Preferred Stock 0.0 0.0 0.0 0.0

Acquisition PIK Preferred 0.0 0.0 0.0 0.0
Common Equity 1,579.5 1,539.0 (3,631.0) (512.5)
Total Liabilities and Equity $2,784.8 $4,411.7 ($4,325.5) $2,871.0

Balance Sheet Check 0.0000 0.0000 0.0000 0.0000

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Note on Leveraged Buyouts Case #5-0004

Pro Forma Income Statement

Estimated Projected
Fiscal Year End 12/31 2003 PF 2004 2005 2006 2007 2008

Sales $3,139.8 $3,532.3 $3,973.8 $4,410.9 $4,852.0 $5,288.7

Cost of Goods Sold 1,591.2 1,766.1 1,947.2 2,117.2 2,304.7 2,512.1
Gross Profit 1,548.6 1,766.1 2,026.6 2,293.7 2,547.3 2,776.6

SG&A 273.4 282.6 317.9 352.9 388.2 423.1

Other Operating Expenses 664.5 706.5 755.0 838.1 921.9 1,004.9
EBITDA 610.7 777.1 953.7 1,102.7 1,237.3 1,348.6

Depreciation 309.9 398.2 497.6 607.8 729.1 782.9

Amortization 5.9 5.9 5.9 5.9 5.9 5.9
EBIT 294.9 373.0 450.2 489.0 502.2 559.8

Amortization of Transaction Fees 12.3 12.3 12.3 12.3 12.3 12.3

Management Fees 1.0 1.0 1.0 1.0 1.0 1.0
Interest Expense (net) 236.0 236.0 229.2 216.4 198.1 175.3
Other (Income) / Expense 6.9 6.9 6.9 6.9 6.9 6.9
Pre-Tax Income 38.7 116.8 200.8 252.3 283.9 364.4

Provision for Taxes 14.2 42.9 73.8 92.7 104.3 133.9

Net Income 24.5 73.8 127.0 159.6 179.6 230.5

Preferred Dividends 0.0 0.0 0.0 0.0 0.0 0.0

Net Income to Common $24.5 $73.8 $127.0 $159.6 $179.6 $230.5

Margin & Growth Rate Analysis

Revenue Growth -- 12.5% 12.5% 11.0% 10.0% 9.0%
COGS as a % of Sales 50.7% 50.0% 49.0% 48.0% 47.5% 47.5%
Gross Margin 49.3% 50.0% 51.0% 52.0% 52.5% 52.5%
SG&A as a % of Sales 8.7% 8.0% 8.0% 8.0% 8.0% 8.0%
Other Op. Exp. as a % of Sales 21.2% 20.0% 19.0% 19.0% 19.0% 19.0%
EBITDA Margin 19.5% 22.0% 24.0% 25.0% 25.5% 25.5%
EBIT Margin 9.4% 10.6% 11.3% 11.1% 10.4% 10.6%
Effective Tax Rate 36.8% 36.8% 36.8% 36.8% 36.8% 36.8%
Net Margin 0.8% 2.1% 3.2% 3.6% 3.7% 4.4%
Net Income Growth -- 202.0% 72.0% 25.6% 12.5% 28.3%

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Pro Forma Balance Sheet

Estimated Projected
2003 2004 2005 2006 2007 2008
Assets
Cash and Cash Equivalents $148.6 $155.3 $162.0 $168.8 $175.6 $182.5
Accounts Receivable 96.5 96.8 108.9 120.8 132.9 144.9
Inventory 49.8 58.9 64.9 70.6 76.8 83.7
Other Current Assets 21.8 24.5 27.6 30.6 33.6 36.7
Total Current Assets 316.6 335.4 363.3 390.8 419.0 447.8

Net Property, Plant & Equipment 1,948.3 1,991.7 1,990.8 1,934.4 1,811.7 1,690.0
Transaction Goodwill 0.0 0.0 0.0 0.0 0.0 0.0
Transaction Costs 86.2 73.9 61.6 49.2 36.9 24.6
Goodwill 279.5 279.5 279.5 279.5 279.5 279.5
Intangibles 47.1 41.1 35.2 29.3 23.4 17.4
Other Assets 193.3 193.3 193.3 193.3 193.3 193.3
Total Assets $2,871.0 $2,914.8 $2,923.7 $2,876.4 $2,763.8 $2,652.6

Liabilities and Shareholders' Equity

Bank Revolver $5.0 $0.0 $0.0 $0.0 $0.0 $0.0
Accounts Payable 91.0 96.8 106.7 116.0 126.3 137.7
Other Current Liabilities 218.8 246.1 276.9 307.4 338.1 368.5
Total Current Liabilities 314.8 342.9 383.6 423.4 464.4 506.2

Other Liabilities 201.0 201.0 201.0 201.0 201.0 201.0

Senior Debt 2,205.8 2,141.1 1,975.5 1,722.1 1,382.1 991.7
Subordinated Debt 661.8 668.4 675.1 681.9 688.8 695.7
Total Liabilities 3,383.5 3,353.5 3,235.3 3,028.4 2,736.2 2,394.6

Existing Preferred Stock 0.0 0.0 0.0 0.0 0.0 0.0

Acquisition PIK Preferred 0.0 0.0 0.0 0.0 0.0 0.0
Common Equity (512.5) (438.6) (311.6) (152.0) 27.6 258.0
Total Liabilities and Equity $2,871.0 $2,914.8 $2,923.7 $2,876.4 $2,763.8 $2,652.6

Balance Sheet Check 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

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Pro Forma Cash Flow Statement

Projected
2004 2005 2006 2007 2008
Cash Flow from Operations
Net Income $73.8 $127.0 $159.6 $179.6 $230.5
Depreciation 398.2 497.6 607.8 729.1 782.9
Amortization 5.9 5.9 5.9 5.9 5.9
Amortization of Deferred Financing Fees 12.3 12.3 12.3 12.3 12.3
Change in Working Capital 21.0 19.5 19.1 19.6 19.9
Change in Other Assets 0.0 0.0 0.0 0.0 0.0
Change in Other Liabilities 0.0 0.0 0.0 0.0 0.0
Cash Provided / (Used) by Operating Activities $511.3 $662.3 $804.8 $946.6 $1,051.4

Cash Flow From Investing Activities

Capital Expenditures ($441.5) ($496.7) ($551.4) ($606.5) ($661.1)
Cash Provided / (Used) by Investing Activities ($441.5) ($496.7) ($551.4) ($606.5) ($661.1)

Cash Flow From Financing Activities

Change in Revolver (5.0) 0.0 0.0 0.0 0.0
Change in Senior Debt (64.7) (165.6) (253.4) (340.1) (390.4)
Change in Subordinated Debt 6.7 6.7 6.8 6.9 6.9
Existing Preferred Stock 0.0 0.0 0.0 0.0 0.0
Plus: Non-cash Dividend 0.0 0.0 0.0 0.0 0.0
Less: Common Dividend Paid 0.0 0.0 0.0 0.0 0.0
Cash Provided / (Used) by Investing Activities ($63.1) ($158.9) ($246.6) ($333.2) ($383.4)

Beginning Cash Balance $148.6 $155.3 $162.0 $168.8 $175.6

Change in Cash 6.7 6.7 6.8 6.9 6.9
Ending Cash Balance $155.3 $162.0 $168.8 $175.6 $182.5

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Pro Forma Debt Schedule

Estimated Projected
2003 2004 2005 2006 2007 2008

Cash Available to pay down Bank Revolver $69.8 $165.6 $253.4 $340.1 $390.4

Bank Revolver
Beginning Balance $5.0 $0.0 $0.0 $0.0 $0.0
Borrowings / (Payments) (5.0) 0.0 0.0 0.0 0.0
Ending Balance $0.0 $0.0 $0.0 $0.0 $0.0
Interest Expense @ 6.47% $0.2 $0.0 $0.0 $0.0 $0.0

Cash Available to pay down Existing Senior Debt $64.7 $165.6 $253.4 $340.1 $390.4

Senior Debt
Beginning Balance $2,205.8 $2,141.1 $1,975.5 $1,722.1 $1,382.1
Borrowings / (Payments) (64.7) (165.6) (253.4) (340.1) (390.4)
Ending Balance $2,141.1 $1,975.5 $1,722.1 $1,382.1 $991.7
Interest Expense @ 6.47% $140.6 $133.2 $119.6 $100.4 $76.8

Subordinated Debt
Beginning Balance $661.8 $668.4 $675.1 $681.9 $688.8
Borrowings / (Payments) 0.0 0.0 0.0 0.0 0.0
Plus: PIK Accruals 6.7 6.7 6.8 6.9 6.9
Ending Balance $668.4 $675.1 $681.9 $688.8 $695.7
Interest Expense @ 15.00% $99.8 $100.8 $101.8 $102.8 $103.8
PIK Accruals @ 1.00% $6.7 $6.7 $6.8 $6.9 $6.9

Cash and Cash Equivalents

Beginning Balance $148.6 $155.3 $162.0 $168.8 $175.6
Borrowings / (Payments) 6.7 6.7 6.8 6.9 6.9
Ending Balance $155.3 $162.0 $168.8 $175.6 $182.5
Interest Income @ 3.00% $4.6 $4.8 $5.0 $5.2 $5.4

Net Interest Expense

Bank Revolver $0.2 $0.0 $0.0 $0.0 $0.0
Senior Debt 140.6 133.2 119.6 100.4 76.8
Subordinated Debt 99.8 100.8 101.8 102.8 103.8
Cash and Cash Equivalents (4.6) (4.8) (5.0) (5.2) (5.4)
Total $236.0 $229.2 $216.4 $198.1 $175.3

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Returns Analysis

Exit Year 12/30/2006 12/30/2007 12/29/2008

Exit multiple: 5.0x 5.5x 6.0x 5.0x 5.5x 6.0x 5.0x 5.5x 6.0x
Exit Year EBITDA $1,102.7 $1,102.7 $1,102.7 $1,237.3 $1,237.3 $1,237.3 $1,348.6 $1,348.6 $1,348.6

Exit Year Enterprise Value: $5,513.7 $6,065.0 $6,616.4 $6,186.3 $6,805.0 $7,423.6 $6,743.1 $7,417.4 $8,091.7
Less: Net Debt (2,235.3) (2,235.3) (2,235.3) (1,895.2) (1,895.2) (1,895.2) (1,504.9) (1,504.9) (1,504.9)
Common Equity Value: $3,278.4 $3,829.7 $4,381.1 $4,291.1 $4,909.7 $5,528.4 $5,238.2 $5,912.5 $6,586.9

% Initial
Equity Source / Holder Ownership Investment Equity Value of Holding and Implied IRR

Management 0.6% $10.0 $21.3 $24.9 $28.5 $27.9 $31.9 $35.9 $34.0 $38.4 $42.8

IRR 28.7% 35.5% 41.7% 29.2% 33.6% 37.7% 27.8% 30.9% 33.7%

Rollover Equity 0.0% 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

IRR NM NM NM NM NM NM NM NM NM

Equity Sponsor 98.4% 1,529.0 3,224.5 3,766.8 4,309.1 4,220.6 4,829.1 5,437.5 5,152.2 5,815.4 6,478.6

IRR 28.2% 35.1% 41.3% 28.9% 33.3% 37.3% 27.5% 30.6% 33.5%

Warrant Holders
PIK Preferred 0.0% 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Book Value of PIK 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

IRR NM NM NM NM NM NM NM NM NM

Center for Private Equity and Entrepreneurship 23

Leveraged Buyouts and Private Equity

Steven N. Kaplan and Per Strömberg

Steven N. Kaplan is Neubauer Family Professor of Entrepreneurship and Finance, University of Chicago
Graduate School of Business, Chicago, Illinois. Per Strömberg is Professor of Finance at the Stockholm
School of Economics and Director of the Swedish Institute of Financial Research (SIFR), both in
Stockholm, Sweden. Both authors are also Research Associates, National Bureau of Economic Research,
Cambridge, Massachusetts. Their e-mail addresses are <[email protected]> and
<[email protected]>.

This Draft: June 2008

Abstract

We describe and present time series evidence on the leveraged buyout / private equity industry, both firms
and transactions. We discuss the existing empirical evidence on the economics of the firms and
transactions. We consider similarities and differences between the recent private equity wave and the
wave of the 1980s. Finally, we speculate on what the evidence implies for the future of private equity.

Electronic copy available at: http://ssrn.com/abstract=1194962

 In a leveraged buyout, a company is acquired by a specialized investment firm using a relatively

small portion of equity and a relatively large portion of outside debt financing. The leveraged buyout

investment firms today refer to themselves (and are generally referred to) as private equity firms.1 In a

typical leveraged buyout transaction, the private equity firm buys majority control of an existing or

mature firm. This is distinct from venture capital (VC) firms that typically invest in young or emerging

companies, and typically do not obtain majority control. In this paper, we focus specifically on private

equity firms and the leveraged buyouts in which they invest.

Leveraged buyouts first emerged as an important phenomenon in the 1980s. As leveraged buyout

activity increased in that decade, Jensen (1989) predicted that the leveraged buyout organizations would

eventually become the dominant corporate organizational form. His argument was that the private equity

firm itself combined concentrated ownership stakes in its portfolio companies, high-powered incentives

for the private equity firm professionals, and a lean, efficient organization with minimal overhead costs.

The private equity firm then applied performance-based managerial compensation, highly leveraged

capital structures, and active governance to the companies in which it invested. According to Jensen,

these structures were superior to those of the typical public corporation with dispersed shareholders, low

leverage, and weak corporate governance.

A few years later, this prediction seemed to have been premature. The junk bond market crashed

following the demise of the investment bank, Drexel Burnham Lambert; a large number of high-profile

leveraged buyouts resulted in default and bankruptcy; and leveraged buyouts of public companies (so

called public-to-private transactions) virtually disappeared by the early 1990’s.

But the leveraged buyout market had not died – it was only in hiding. While leveraged buyouts

of public companies were relatively scarce during the 1990s and early 2000s, leveraged buyout firms

continued to purchase private companies and divisions. In the mid-2000’s, public-to-private transactions

1
We will use the terms private equity and leveraged buyout interchangeably.

Electronic copy available at: http://ssrn.com/abstract=1194962

reappeared. Fewer than twenty years after the previous crash, the U.S. economy (and the rest of the

world) experienced a second leveraged buyout boom.

In 2006 and 2007, a record amount of capital was committed to private equity, both in nominal

terms and as a fraction of the overall stock market. The extent of private equity commitments and activity

rivaled, if not overtook the activity of the first wave in the late 1980s that reached its peak with the buyout

of RJR Nabisco. Hence, Michael Jensen’s prediction seemed more relevant than ever. However, in 2008,

with the turmoil in the debt markets, private equity appears to have declined again.

We start the paper by describing how the private equity industry works. We describe private

equity organizations such as Blackstone, Carlyle, and KKR, and the components of a typical leveraged

buyout transaction, such as the buyout of RJR Nabisco or SunGard Data Systems. We present evidence

on how private equity fundraising, activity and transaction characteristics have varied over time.

The article then considers the effects of private equity. We look at evidence concerning how

private equity affects capital structure, management incentives, and corporate governance. This evidence

suggests that private equity activity creates economic value on average. At the same time, there is also

evidence consistent with private equity investors taking advantage of market timing (and market

mispricing) between debt and equity markets particularly in the public-to-private transactions of the last

fifteen years.

We also review the empirical evidence on the economics and returns to private equity at the fund

level. Private equity activity appears to experience recurring boom and bust cycles that are related to past

returns and to the level of interest rates relative to earnings. Given that the unprecedented boom of 2005

to 2007 has just ended, it seems likely that there will be a decline in private equity investment and

fundraising in the next several years. While the recent market boom may eventually lead to some defaults

and investor losses, the magnitude is likely to be less severe than after the 1980s boom because capital

structures are less fragile and private equity firms are more sophisticated. Accordingly, we expect that a

significant part of the growth in private equity activity and institutions is permanent.

3
Private Equity Firms, Funds, and Transactions

Private Equity Firms

The typical private equity firm is organized as a partnership or limited liability corporation.

Blackstone, Carlyle, and KKR are three of the most prominent private equity firms. In the late 1980s,

Jensen (1989) described these organizations as lean, decentralized organizations with relatively few

investment professionals and employees. In his survey of seven large leveraged buyout partnerships,

Jensen found an average of 13 investment professionals, who tended to come from an investment banking

background. Today, the large private equity firms are substantially larger, although they are still small

relative to the firms in which they invest. KKR’s S-1 (a form filed with the Securities and Exchange

Commission in preparation for KKR’s initial public offering) reports 139 investment professionals in

2007. At least four other large private firms appear to have more than 100 investment professionals as

well. In addition, private equity firms now appear to employ professionals with a wider variety of skills

and experience than was true 20 years ago.

Private Equity Funds

The private equity firm raises equity capital through a private equity fund. Most private equity

funds are “closed-end” vehicles in which investors commit to provide a certain amount of money to pay

for investments in companies as well as management fees to the private equity firm.2 From a legal

standpoint, the private equity funds are organized as limited partnerships in which the general partners

manage the fund and the limited partners provide most of the capital. The limited partners typically

include institutional investors, such as corporate and public pension funds, endowments, and insurance

companies, as well as wealthy individuals. The private equity firm serves as the fund’s general partner.

It is customary for the general partner to provide 1 percent of the total capital, although some invest more.

2
In a “closed-end” investment fund, investors cannot withdraw their funds until the fund is terminated. This is in
contrast to mutual funds, for example, where investors can withdraw their funds whenever they like. See Stein
(2005) for an economic analysis of closed vs. open-end funds.

4
 The fund typically has a fixed life, usually ten years, but can be extended for up to three

additional years. The private equity firm typically has up to five years to invest the capital committed to

the fund into companies, and then has an additional five to eight years to return the capital to its investors.

After committing their capital, the limited partners have little say in how the general partner deploys the

investment funds, as long as the basic covenants of the fund agreement are followed. Common covenants

include restrictions on how much fund capital can be invested in a single company, the types of securities

a fund can invest in, and restrictions on debt at the fund level (as opposed to borrowing at the portfolio

company level, which is unrestricted). Sahlman (1990), Gompers and Lerner (1996), and Axelson,

Strömberg, and Weisbach (forthcoming) discuss the economic rationale for these fund structures.

The private equity firm or general partner is compensated in three ways. First, the general partner

earns an annual management fee, which is a percentage of capital committed, and, then, as investments

are realized, a percentage of capital employed. Second, the general partner earns a share of the profits of

the fund, referred to as “carried interest,” that almost always equals 20 percent. Finally, some general

partners charge deal fees and monitoring fees to the companies in which they invest. Metrick and Yasuda

(2007) describe the structure of fees in great detail and provide empirical evidence on those fees.

For example, assume that a private equity firm, ABC partners, raises a private equity fund, ABC

I, with $2 billion of capital commitments from limited partners. At a 2 percent management fee, ABC

partners would receive $40 million per year for the five-year investment period. This amount would

decline over the following five years as ABC exited or sold some of its investments. The management

fees typically end after ten years, although the fund can be extended thereafter. ABC would invest the

difference between the $2 billion and the cumulative management fees into companies.

If the investments of ABC’s fund turned out to be successful and ABC was able to realize $6

billion from its investments – a profit of $4 billion – ABC would be entitled to a carried interest or profit

share of $800 million (or 20 percent of the $4 billion profit). Added to management fees of $300 to $400

million, ABC partners would have received a total of almost $1.2 billion over the life of the fund.

5
 In addition, general partners sometimes charge deal and monitoring fees that are paid by the

portfolio companies. The extent to which these fees are shared with the limited partners is a somewhat

contentious issue in private equity fundraising negotiations. A common arrangement is that these fees

end up being split 50-50 between general and limited partners.

The Private Equity Analyst (2008) lists 33 global private equity firms (22 U.S.-based) with more

than $10 billion of assets under management at the end of 2007. The same publication lists the top 25

investors in private equity. Those investors are dominated by public pension funds with CalPERS

(California Public Employees' Retirement System), CasSTERS (California State Teachers' Retirement

System), PSERS (Public School Employees' Retirement System), and the Washington State Investment

Board occupying the top four slots.

Private Equity Transactions

In a typical private equity transaction, the private equity firm agrees to buy a company. If

company is public, the private equity firm typically pays a premium of 15 to 50 percent over the current

stock price.3 (See Kaplan (1989a) and Bargeron et al. (2007).) The buyout is typically financed with

anywhere from 60 to 90 percent debt – hence the term, leveraged buyout. The debt almost always

includes a loan portion that is senior and secured, and is arranged by a bank or an investment bank. In the

1980s and 1990s, banks were also the primary investors in these loans. In the last several years, however,

institutional investors purchased a large fraction of the senior and secured loans. Those investors include

hedge fund investors and “collateralized loan obligation” managers, who combine a number of term loans

into a pool and then carve the pool into different pieces (with different seniority) to sell to institutional

investors. The debt in leveraged buyouts also often includes a junior, unsecured portion that is financed

3
It is well documented that bidders have to pay a substantial takeover premia to target shareholders when acquiring
public firms. The original explanation for this is Grossman and Hart (1980), who argue that target shareholders will
not sell unless they share in the future takeover gains that will result from the acquisition.

6
by either high yield bonds or “mezzanine debt” (that is, debt which is subordinated to the senior debt).

See Demiroglu and James (2007) and Standard and Poor’s (2008) for more detailed descriptions.

The private equity firm invests funds from its investors as equity to cover the remaining 10 to 40

percent of the purchase price. The new management team of the purchased company (which may or may

not be identical to the pre-buyout management team) typically also contributes to the new equity, but this

amount is usually a small fraction of the equity dollars contributed.

Kaplan (2005) describes a large leveraged buyout – the 2005 buyout of SunGard Data Systems –

in detail. The SunGard buyout was an $11.9 billion transaction financed with $8 billion of debt ($5

billion of senior secured debt and $3 billion of subordinated debt), $0.3 billion of existing cash, and $3.6

billion of equity. Seven private equity firms contributed $3.5 billion while management contributed $0.1

billion of the equity. Axelson et al. (2008) provide a detailed description of capital structures in these

kinds of leveraged buyouts.

Commitments to Private Equity Funds

Private equity funds first emerged in the early 1980s. Nominal dollars committed each year to

U.S. private equity funds have increased exponentially since then, from $0.2 billion in 1980 to over $200

billion in 2007. Given the large increase in equity and firm market values over this period, it is more

appropriate to measure committed capital as a percentage of the total value of the U.S. stock market. This

provides a measure of the real buying power of private equity funds. The deflated series, presented in

Figure 1, suggests that private equity commitments are cyclical. They increase in the 1980s, peak in

1988, decline in the early 1990s, increase through the late 1990s, peak in 1998, decline again in the early

2000s, and then begin climbing in 2003. By 2006 and 2007, private equity commitments appear

extremely high by historical standards, exceeding one percent of the value of the U.S. stock market. One

caveat to this observation is that many of the large U.S. private equity firms have only recently become

global in scope, and a meaningful fraction of the recent commitments will be invested outside the U.S.

7
Such foreign investments by U.S. private equity firms were much smaller 20 years ago, so the

comparisons are not exactly apples to apples.

Although we do not have comparable information on capital commitments to non-U.S. funds, it is

clear that they have also grown substantially. The Private Equity Analyst lists three non-U.S. private

equity firms in 2007 among the top twelve largest in the world in assets under management.

Private Equity Transactions

Figure 2 shows the number and combined transaction value of worldwide leveraged buyout

transactions backed by a private equity fund sponsor based on data from CapitalIQ. In total, 17,171

private equity-sponsored buyout transactions occurred from January 1, 1970, to June 30, 2007.

(Transactions that had been announced but not completed by November 1, 2007, are excluded.) The value

of transactions is measured as the combined enterprise value (i.e. market value of equity plus book value

of debt minus cash) of the acquired firms, converted into 2007 U.S. dollars. When transaction values are

not recorded (generally smaller, private-to-private deals), we impute values as a function of various deal

and sponsor characteristics. Figure 1 also uses the CapitalIQ data to report the combined transaction value

of U.S. leveraged buyouts backed by a private equity fund sponsor as a fraction of the total U.S. stock

market value. See Strömberg (2008) for a description of the sampling methodology and a discussion on

potential biases. The most important qualification is that it is likely that CapitalIQ underreports private

equity transactions before the mid-1990s, particularly smaller transactions.

The patterns documented in private equity fundraising are mirrored in overall buyout transaction

activity. There is a similar cyclicality in fundraising and transactions. The value of transactions peaked in

1988; dropped during the early 1990s, rose and peaked in the later 1990s, dropped in the early 2000s; and

increased dramatically from 2004 to 2006. A huge fraction of historic buyout activity has taken place

within the last few years. From 2005 through June 2007, CapitalIQ recorded a total of 5,188 buyout

transactions at a combined estimated enterprise value of over $1.6 trillion (in 2007 dollars), with those 2

8
years accounting for 30 percent of the transactions from 1984 to 2007 and 43 percent of the total real

value of these transactions, respectively.

Although Figure 2 only includes deals announced through December 2006 (and closed by

November 2007), the number of announced leveraged buyouts continued to increase until June 2007

when a record number of 322 deals were announced. Since then, deal activity has decreased substantially

in the wake of the turmoil in credit markets. In January 2008, only 133 new buyouts were announced.

As the private equity market has grown, the characteristics of the transactions undertaken have

evolved, as summarized in Table 1 (see Strömberg (2008) for a more detailed analysis). The first buyout

wave during the late 1980s was primarily a U.S., Canadian, and to a smaller extent a U.K., phenomenon.

From 1985-89, these three countries accounted for 89 percent of the worldwide leveraged buyout

transactions and 93 percent of the worldwide value of these transactions. At this time, the leveraged

buyout business was dominated by acquisitions of relatively large companies, in mature industries (such

as manufacturing and retail), and public-to-private deals accounted for almost half of the value of private

equity transactions. As the early private equity research studied the deals of the first buyout wave, these

transactions helped form the perception of private equity for years to come: leverage buyouts equal going

private transactions of large firms in mature industries.

Following the fall of the junk bond market in the late 1980s, public-to-private activity declined

significantly dropping to less than 10 percent of transaction value while the average enterprise value of

the companies acquired dropped from $401 million to $132 million (both in 2007 dollars). Instead,

“middle-market” buyouts of non-publicly traded firms – either independent companies or divisions of

larger corporations – grew significantly and accounted for the bulk of private equity activity at this time.

Manufacturing and retail firms became less dominant as buyout targets, as buyout activity spread to new

industries such as information technology/ media/telecommunications, financial services, and health care.

Although the aggregate value of transactions fell, there were twice as many deals undertaken in 1990-94

compared to the 1985-1989 period.

9
 As private equity activity experienced steady growth over the following period from 1995-2004

(with the exception of the dip in 2000-2001), the market continued to evolve. Buyouts of public

companies increased, although buyouts of private companies still accounted for more than 80 percent of

the value and more than 90 percent of the transactions during this time. An increasing share of buyout

deal-flow came from other private equity funds exiting their old investments. By the early 2000-2004

period, these so-called secondary buyouts made up over 20 percent of total transaction value. The largest

source of deals in this period, however, was large corporations selling off divisions.

The buyout phenomenon also spread rapidly to continental Europe. In the 2000-2004 period, the

western European private equity market (including the United Kingdom) had 48.9 percent of the total

value of worldwide leveraged buyout transactions, compared with 43.7 percent in the United States. The

scope of the industry also continued to broaden during this time, with the companies in the services and

infrastructure becoming increasingly popular buyout targets.

The private equity boom from the start of 2005 to mid-2007 magnified many of these trends.

Public-to-private deals and secondary buyouts grew rapidly both in numbers and size, together accounting

for more than 60 percent of the $1.6 trillion in total leveraged buyout transaction value over this time.

Buyouts in non-manufacturing industries continued to grow in relative importance, and private equity

activity spread to new parts of the world, particularly Asia (although levels were still modest compared to

Western Europe and North America). As large public-to-private transactions returned, average (deflated)

deal sizes almost tripled between 2001 and 2006.

Manner and Timing of Exit

Since most private equity funds have a limited contractual lifetime, exiting the investments is an

important aspect of the private equity process. Table 2 presents statistics on the exit behavior of private

equity funds using the sample of buyouts from CapitalIQ. The top panel of the table shows the frequency

of various exit types. Given that so many leveraged buyout deals occurred in recent years, it is not

surprising that 54 percent of the 17,171 transactions in the total sample (going back to 1970) had not yet

10
been exited by November 2007. This observation raises two important issues. First, any conclusions

about the long-run economic impact of leveraged buyouts are bound to be premature. Second, empirical

analyses of the performance of leveraged buyouts will very likely suffer from selection bias to the extent

they only look at realized investments.

Conditional on having exited, the most common route is the sale of the company to a strategic

(i.e. non-financial) buyer; this occurs in 38% of all exits. The second most common exit route is a sale to

another private equity fund in a so-called “secondary leveraged buyout” (24%); this exit route has

increased considerably over time. Initial public offerings, where the company is listed on a public stock

exchange (and the private equity firm can subsequently sell its shares in the public market), account for

14% of exits; this exit route has decreased significantly in relative importance over time.

The low fraction of IPOs does not imply that the growth of private equity has been at the expense

of public stock markets, however. Strömberg (2008) shows that for private equity transactions from

1970-2002 period, the fraction of firms eventually going public was 11%, while only 6% of these firms

were public before the buyout, implying a positive net flow from private to public equity markets.

Given the high debt levels involved in these transactions, one might expect a non-trivial fraction

of LBOs to end up in bankruptcy. For the total sample, 6% of deals have ended in bankruptcy or

reorganization. Excluding LBOs occurring after 2002, which may not have had enough time to enter

financial distress, the incidence increases to 7%. Assuming an average holding period of six years, this

works out to an annual default rate of 1.2% per year. Perhaps surprisingly, this is lower than the average

default rate of 1.6% that Moody’s reports for all U.S. corporate bond issuers from 1980-2002 (Hamilton

et al 2006). One caveat is that not all cases of distress may be recorded in publicly available data sources;

some of these cases may be “hidden” in the relatively large fraction of “unknown” exits (11%). Perhaps

consistent with this, Andrade and Kaplan (1998) find that 23% of the larger public-to-private transactions

of the 1980s default at some point.

The bottom panel of Table 2 shows the average holding periods for individual LBO transactions.

The analysis is done on a cohort basis, to avoid the bias resulting from older deals being more likely to

11
have been exited. Over the whole sample, the median holding period is around six years, but it seems to

have varied over time. In particular, median holding periods were less than five years for deals

undertaken in the early 1990’s, presumably affected by the “hot” IPO markets of the late 1990’s.

Recently, private equity funds have been accused of becoming more short-term oriented,

preferring to quickly “flip” their investments rather than keeping their ownership of companies to fully

realize their value potential. In our analysis, we see no evidence of “quick flips” (i.e. exits within 24

months of investment by private equity fund) becoming more common. On the contrary, holding periods

of private equity funds over the 12-, 24-, and 60-month horizons have increased since the 1990s. Overall,

only 12% of deals are exited within 24 months of the LBO acquisition date.

Finally, because of the high fraction of secondary buyouts in recent years, the individual holding

periods underestimate the total time period in which LBO firms are held by private equity funds.

Accounting for secondary buyouts, Strömberg (2008) shows that the median LBO is still in private equity

ownership nine years after the original buyout transaction. In comparison, Kaplan (1991) found the

median leveraged-buyout target remained in private ownership for 6.82 years, which is consistent with

privately-owned holding periods having increased since the 1980s.

Is Private Equity a Superior Organizational Form?

Proponents and critics of private equity have differing views concerning what private equity

investors actually do. Proponents, like Jensen (1989), argue that private equity firms apply financial,

governance, and operational engineering to their portfolio companies, and, in so doing, improve firm

operations and create economic value.

Criticisms and skepticism come in two different forms. First, some argue that private equity

firms take advantage of tax breaks and superior information, but do not create any operational value.

Second, some argue that private equity activity is influenced by market timing (and market mispricing)

between debt and equity markets. In this section, we consider the proponents’ views and the first set of

12
criticisms as well as the empirical evidence for them. In the next section, we consider market timing

issues in more detail.

Financial, Governance and Operational Engineering

Private equity firms apply three sets of changes to the firms in which they invest, which we

categorize as financial engineering, governance engineering, and operational engineering.

Jensen (1989) and Kaplan (1989a; b) describe the financial and governance engineering changes

associated with private equity. First, private equity firms pay careful attention to management incentives

in their portfolio companies. They typically give the management team a large equity upside through

stock and options—a provision that was quite unusual among public firms in the early 1980s (Jensen and

Murphy, 1990). Kaplan (1989a) finds that management ownership percentages increase by a factor of

four in going from public to private ownership. Private equity firms also require management to make a

meaningful investment in the company, so that management has not only a significant upside, but a

significant downside as well. Moreover, because the companies are private, management’s equity is

illiquid—that is, management cannot sell its equity or exercise its options until the value is proved by an

exit transaction. This illiquidity reduces management’s incentive to manipulate short-term performance.

It is still the case today that management teams obtain significant equity stakes in the portfolio

companies. We collected information on 43 leveraged buyouts in the U.S. from 1996 to 2004 with a

median transaction value of over $300 million. Of these, 23 were public-to-private transactions. We find

that the CEO gets 5.4% of the equity upside (stock and options) while the management team as a whole

gets 16%. Acharya and Kehoe (2008) find similar results in the United Kingdom for 59 large buyouts

(with a median value of over $500 million) from 1997 to 2004. In their sample, the median CEO gets 3%

of the equity; the median management team as a whole gets 15%. These are similar magnitudes to those

in the 1980s public-to-private transactions studied by Kaplan (1989a). Even though stock- and option-

based compensation have become more widely used in public firms since the 1980’s, management’s

ownership percentages (and upside) are still greater in leveraged buyouts than in public companies.

13
 The second key ingredient is leverage, i.e. the borrowing that is done in connection with the

transaction. Leverage creates pressure on managers not to waste money, because they must make interest

and principal payments. This pressure reduces the “free cash flow” problems described in Jensen (1986),

in which management teams in mature industries with weak corporate governance had many ways in

which they could dissipate these funds rather than returning them to investors.4 On the flip side, if

leverage is too high, the inflexibility of the required payments (as contrasted with the flexibility of

payments to equity) raises the chances of costly financial distress. In the U.S. and many other countries,

leverage also potentially increases firm value through the tax deductibility of interest. The value of this

tax shield, however, is difficult to calculate because it requires assumptions of the tax advantage of debt

(net of personal taxes), the expected permanence of the debt, and the riskiness of the tax shield.

Third, governance engineering refers to the way that private equity investors control the boards of

their portfolio companies and are more actively involved in governance than boards of public companies.

Boards of private equity portfolio companies are smaller than comparable public companies and meet

more frequently (Gertner and Kaplan, 1996; Acharya and Kehoe, 2008; Cornelli, 2008).5 Acharya and

Kehoe (2008) report that portfolio companies have twelve formal meetings per year and many more

informal contacts. In addition, private equity investors do not hesitate to replace poorly performing

management. Acharya and Kehoe (2008) report that one-third of chief executive officers of these firms

are replaced in the first 100 days and two-thirds are replaced at some point over a four-year period.

These methods of financial and governance engineering were common in the 1980s. Today, most

large private equity firms have added another piece that we call “operational engineering,” which refers to

industry and operating expertise that they can use to add value to their investments. Indeed, most top

private equity firms are now organized around industries. In addition to hiring dealmakers with financial

engineering skills, private equity firms now often hire professionals with operating backgrounds and an

industry focus. For example, Lou Gerstner, the former chief executive officer of RJR and IBM is

4
Axelson et al. (2007) also argue that leverage provides discipline to the acquiring leveraged buyout fund, who has
to be able to persuade third-party investors--the debt providers--to co-invest in the deal.
5
Empirical evidence on public firm boards (e.g. Yermack (1996)) suggests that smaller boards are more efficient.

14
affiliated with Carlyle, while Jack Welch, the former chief executive officer of GE, is affiliated with

Clayton Dubilier. Most top private equity firms also make use of internal or external consulting groups.

Private equity firms use their industry and operating knowledge to identify attractive investments, to

develop a value creation plan at the time of investment, and to implement the value creation plan. This

plan might include elements of cost-cutting opportunities and productivity improvements, strategic

changes or repositioning, acquisition opportunities, as well as management changes and upgrades

(Acharya and Kehoe, 2008; Gadiesh and MacArthur, 2008).

As mentioned above, critics question whether the different types of engineering have the claimed

effects. One alternative explanation is that private equity firms take advantage of asymmetric or

privileged information, usually with the help of incumbent management. Critics often ask why

companies, particularly public companies, need to be bought by a private equity firm and why they cannot

implement the same changes on their own.

Operating performance

The empirical evidence on the operating performance of companies after they have been

purchased through a leveraged buyout is largely positive. For U.S. public-to-private deals in the 1980s,

Kaplan (1989a) finds that the ratio of operating income to sales increased by 10 to 20 percent (absolutely

and relative to industry). The ratio of cash flow (operating income less capital expenditures) to sales

increase by roughly 40 percent. The ratio of capital expenditures to sales declined. These changes are

coincident with large increases in firm value (again, absolutely and relative to industry). Smith (1990)

finds similar results. Lichtenberger and Siegel (1990) find that leveraged buyouts experience significant

increases in total factor productivity after the buyout.

Most empirical work on private equity and leverage buyouts post-1980s has focused on buyouts

in Europe, largely because of data availability. Consistent with the U.S. results in the 1980s, most of this

work finds that leveraged buyouts are associated with significant operating and productivity

improvements. This work includes Harris et al. (2005) for the U.K., Boucly et al. (2008) for France, and

15
Bergström et al (2007) for Sweden. Cumming, Siegel, and Wright (2007) summarize much of this

literature and conclude there “is a general consensus across different methodologies, measures, and time

periods regarding a key stylized fact: LBOs [leveraged buyouts] and especially MBOs [management

buyouts] enhance performance and have a salient effect on work practices.”

There has been one general exception to the largely uniform positive operating results – more

recent public-to-private buyouts. Guo et al. (2008) study U.S. public-to-private transactions completed

from 1990 to 2006. The 94 leveraged buyouts with available post-buyout data are concentrated in deals

completed by 2000. The authors find modest increases in operating and cash flow margins that are much

smaller than those found in U.S. data in the 1980s and for Europe in the 1990s. At the same time, they

find high investor returns (adjusted for industry or the overall stock market) at the portfolio company

level. Acharya and Kehoe (2008) and Weir et al. (2007) find similarly modest operating improvements

for public-to-private deals in the U.K. over roughly the same period. Nevertheless, Acharya and Kehoe

(2008) also find high investor returns. These results suggest that post-1980s public-to-private

transactions may differ from those of the 1980s and from leveraged buyouts overall.

While the empirical evidence is consistent overall with significant operating improvements for

leverage buyouts, it has to be interpreted with some caution.

First, some studies, particularly those in the U.S., are potentially subject to a selection bias

because performance data for private firms are not always available. For example, most U.S. studies of

financial performance have studied leveraged buyouts that use public debt or subsequently go public, and

leveraged buyouts of public companies. These may not be representative of the population. Still, studies

undertaken in countries where accounting data is available on private firms, and therefore do not suffer

reporting biases (e.g., Boucly et al. (2008) for France and Bergström et al. (2007) for Sweden) find

significant operating improvements after leveraged buyouts.

Second, the decline in capital expenditures found in some studies raises the possibility that

leveraged buyouts may increase current cash flows, but hurt future cash flows. This could occur if

private equity funds forced their portfolio companies to boost short-term cash flows in order to service the

16
buyout debt at the expense of long-term performance. One test of this concern is to look at the

performance of leveraged buyout companies after they have gone through a initial public offering. In the

most recent and comprehensive of these papers, Cao and Lerner (2007) find positive industry-adjusted

stock performance after such initial public offerings. In another test of whether future prospects are

sacrificed to current cash flow, Lerner et al. (2008) study post-buyout changes in innovation as measured

by patenting. Although relatively few private equity portfolio companies engage in patenting, those that

do patent do not experience any meaningful decline in post-buyout innovation or patenting. In addition,

patents filed post-buyout appear more economically important (as measured by subsequent citations) than

those filed pre-buyout, as firms focus their innovation activities in a few core areas.

Overall, we interpret the empirical evidence as largely consistent with the existence of operating

and productivity improvements after leveraged buyouts, and as largely inconsistent with value destruction

or short-termism. Most of these results are largely based on leveraged buyouts completed before the

latest private equity wave. The performance of leveraged buyouts completed in the latest private equity

wave is clearly a desirable topic for future research, particularly given the increased incidence of large

public-to-private transactions.

Employment

Critics of leveraged buyouts by private equity firms often argue that these transactions benefit

investors in private equity at the expense of employees who suffer job and wage cuts. While such

reductions would be consistent (and arguably expected) with productivity and operating improvements,

the political implications of economic gains achieved in this manner would be more negative (for

example, see comments from the Service Employees International Union, 2007).

Kaplan (1989a) studies U.S. public-to-private buyouts in the 1980s and finds that employment

increases post-buyout but by less than other firms in the industry. Lichtenberg and Siegel (1990) obtain a

similar result. Davis et al. (2008) study a large sample of U.S. leveraged buyouts from 1980 to 2005 at

the establishment level. They find that employment at leveraged buyout firms increases by less than at

17
other firms in the same industry after the buyout. This continues a pre-buyout trend, i.e., leveraged

buyout firms had smaller employment growth before the buyout transaction. The relative employment

declines are concentrated in retail businesses. They find no difference in employment in the

manufacturing sector. For a subset of their sample, Davis et al. (2008) are able to measure employment at

new establishments as well as at existing ones. For this subsample the leveraged buyouts companies

higher job growth in new establishments than similar non-buyout firms. Davis et al. (2008) are unable to

determine the net effect of leveraged buyouts of the lower growth in existing establishments, but higher

growth in new ones.

Outside the U.S., Amess and Wright (2006) study buyouts in the United Kingdom from 1999 to

2004 and find that firms which experienced leveraged buyouts have employment growth similar to other

firms, but increase wages more slowly. The one exception to the findings in the U.S. and U.K. are those

for France by Boucly et al. (2008). They find that leveraged buyouts companies experience greater job

and wage growth than other similar companies.

Overall, then, the evidence suggests that employment grows at firms that experience leveraged

buyouts, but at a slower rate than at other similar firms (except in France). These findings are not

consistent with concerns over job destruction, but neither are they consistent with the diametrically

opposite position that firms owned by private industry experience especially strong employment growth

(except, perhaps, in France). We view the empirical evidence on employment as largely consistent with a

view that private equity portfolio companies create economic value by operating more efficiently.

Taxes

The additional debt taken on in leveraged buyout transactions gives rise to interest tax deductions

that are valuable, but difficult to value accurately. Kaplan (1989b) uses a range of assumptions and finds

that, depending on the assumption, the reduced taxes from the higher interest deduction can explain from

4 percent to 40 percent of a firm’s value. The lower estimates assume that the leveraged buyout debt is

repaid in eight years and that personal taxes offset the benefit of corporate tax deductions. The higher

18
estimates assume that the leveraged buyout debt is permanent and that personal taxes provide no offset.

Assuming that the truth lies between these various extreme assumptions, a reasonable estimate of the

value of lower taxes due to increased leverage for the 1980s might be 10 percent to 20 percent of firm

value. These estimates would be lower for leveraged buyouts in the 1990s and 2000s, because both the

corporate tax rate and the extent of leverage used in these deals have declined. It is safe to say, therefore,

that greater leverage does create some value for private equity investors by reducing the taxes owed by

the firm, but difficult to say exactly how much.

Asymmetric Information

The generally favorable results on operating improvements and value creation are also potentially

consistent with private equity investors having superior information on future portfolio company

performance. Critics of private equity often claim that incumbent management is a plausible source of

this inside information. To some extent, supporters of private equity deals agree that incumbent

management has information on how to make a firm perform better. After all, one of the economic

justifications for private equity deals is that when managers experience better incentives and closer

monitoring, they will use their insider knowledge of the firm to deliver better results. However, a less-

attractive claim is that incumbent managers root in favor of a private equity buyout, because they intend

to keep their jobs under the new owners and receive a lucrative compensation deal. As a result,

incumbent managers may not be willing to fight for the highest price for existing shareholders—and thus

the private equity buyer gets a better deal.

Several observations suggest that it is unlikely that operating improvements are simply a result of

private equity firms taking advantage of private information. First, Kaplan (1989a) considers this

possibility by looking at the forecasts the private equity firms released publicly at the time of the

leveraged buyout. The asymmetric information story suggests that actual performance should exceed the

forecasts. In fact, actual performance after the buyout lags the forecasts. Moreover, Ofek (1994) studies

leveraged buyout attempts that failed because the offer was rejected by the board or by stockholders (even

19
though management supported it) and finds no excess stock returns or operating improvements for these

firms. It would be useful to replicate these studies with more recent transactions.

Second, private equity firms frequently bring in new management. As mentioned earlier,

Acharya and Kehoe (2008) report that one-third of chief executive officers of their sample firms are

replaced in the first 100 days and two-thirds are replaced at some point over a four-year period. Thus,

incumbent management cannot be sure that it will be in a position to receive high-powered incentives

from the new private equity owners.

Third, it seems likely that at certain times in the boom-and-bust cycle, private equity firms have

overpaid in their leveraged buyouts and experienced losses. For example, the late 1980s were one such

time, and it seems likely that the tail end of the private equity boom in 2006 and into early 2007 will have

lower returns than investors had expected as well. If incumbent management provided inside information,

it clearly wasn’t enough to avoid periods of poor returns for private equity funds.

While these findings are inconsistent with operating improvements simply being the result of

asymmetric information, there is some evidence that private equity funds are able to acquire firms more

cheaply than other bidders. Guo et al. (2008) and Acharya and Kehoe (2008) find that post-1980s public-

to-private transactions experience only modest increases in firm operating performance, but still generate

large financial returns to private equity funds. This suggests that private equity firms are able to buy low

and sell high. Similarly, Bargeron et al. (2007) find that private equity firms pay lower premiums than

public company buyers in cash acquisitions. These findings are consistent with private equity firms

successfully identifying companies or industries that turn out to be undervalued ex post. Alternatively,

this could indicate that private equity firms are particularly good negotiators, and / or that target boards

and management do not get the best possible price in these acquisitions.

Overall, then, the evidence is not supportive of an important role for superior firm specific

information on the part of private equity investors and incumbent management. The results are potentially

consistent with private equity investors bargaining well, target boards bargaining badly, or private equity

investors taking advantage of market timing (and market mispricing) which we discuss below.

20
Private Equity Fund Returns

The empirical evidence at the company level suggests that leveraged buyouts by private equity

firms create value (adjusted for industry and market). This finding does not necessarily imply, however,

that private equity funds earn superior returns for their limited partner investors. First, because private

equity firms often purchase firms in competitive auctions or by paying a premium to public shareholders,

sellers likely capture a meaningful amount of value. For example, in KKR’s purchase of RJR Nabisco,

KKR paid a premium to public shareholders on the order of $10 billion. After the buyout, KKR’s

investors earned a low return, which means that in that deal, KKR paid out most, if not all of the value-

added to RJR’s public shareholders. Second, the limited partner investors in private equity funds pay

meaningful fees. Metrick and Yasuda (2008) estimate that fees equal $19 in present value per $100 of

capital under management for the median private equity fund. This implies that the return to outside

investors net of fees will be lower than the return on the private equity fund’s underlying investments.

Kaplan and Schoar (2005) study the returns to private equity and venture capital funds. They

compare how much an investor (or limited partner) in a private equity fund actually earned net of fees to

what the investor would have earned in an equivalent investment in the Standard and Poor’s 500 index.

On average, they find that private equity fund investors earn slightly less than the Standard and Poor’s

500 index net of fees, ending with an average ratio of 93 percent to 97 percent. On average, therefore,

they do not find the outperformance often given as a justification for investing in private equity funds. At

the same time, however, these results imply that the private equity investors outperform the Standard and

Poor’s 500 index gross of fees (i.e., when fees are added back). Those returns, therefore, are consistent

with private equity investors adding value (over and above the premium paid to selling shareholders).

At least two caveats are in order. First, Kaplan and Schoar (2005) use data from Venture

Economics which samples only roughly half of private equity funds, leaving an unknown and potentially

important selection bias. Second, because of data availability issues. Kaplan and Schoar compare

performance to the Standard and Poor’s 500 index without making any adjustments for risk.

21
 Kaplan and Schoar (2005) also find strong evidence of persistence in performance — that is,

performance by a private equity firm in one fund predicts performance by the firm in subsequent funds.

The persistence result is unlikely to be affected by selection bias. In fact, their results likely understate

persistence because the worst-performing funds are less likely to raise a subsequent fund. In contrast,

mutual funds show little persistence and hedge funds show uncertain persistence. This persistence result

explains why limited partners often strive to invest in private equity funds that have been in the top

quartile of performers in the past (Swensen, 2000). Of course, only some limited partners can succeed in

such a strategy. For example, Lerner, Schoar, and Wang (2007) find that endowments (particularly those

of Ivy League Universities) have consistently earned higher returns on their private equity investments

than other types of limited partners, such as pension funds, fund-of-funds, and other institutional

investors.

Phalippou and Gottschalg (2007) use a slightly updated version of the Kaplan and Schoar (2005)

data set. They obtain qualitatively identical results to Kaplan and Schoar (2005) for the average returns

and persistence of private equity / buyout funds relevant to this article.

Boom and Bust Cycles in Private Equity

Portfolio Company Level

The pattern of private equity commitments and transactions over recent decades suggests that

credit market conditions may affect this activity.

One hypothesis is that private equity investors take advantage of systematic mispricings in the

debt and equity markets. That is, when the cost of debt is relatively low compared to the cost of equity,

private equity can arbitrage or benefit from the difference. This argument relies on the existence of

market frictions that enable debt and equity markets to become segmented. (See Baker and Wurgler

(2000) and Baker et al (2003) for arguments that public companies take advantage of market mispricing.)

To see how debt mispricing might matter, assume that a public company is unleveraged and being

run optimally. If a private equity firm can borrow at a rate that is too low given the risk, the private

22
equity firm will create value by borrowing. In the recent wave, interest rate spreads increased from

roughly 250 basis points over LIBOR in 2006 to 500 basis points over LIBOR in 2008. (See Standard

and Poor’s (2008)). Under the assumptions that debt funds 70% of the purchase price and has a maturity

of eight years, debt mispricing of 250 basis points would justify roughly 10 percent of the purchase price

or, equivalently, would allow a private equity fund investor to pay an additional 10 percent. (I.e., the

present value of an eight year loan discounted at the higher interest rate is 60 rather than 70.)

This also raises the possibility that the private equity firm will find it worthwhile to encourage its

portfolio companies to make operating changes that increase current cash flow, but reduce future cash

flows, in order to borrow more of the mispriced debt. This would give a different interpretation of the

evidence on operating improvements after leveraged buyouts. Still, the fact that Cao and Lerner (2007)

and Lerner et al (2008) find no negative effect of buyouts on long-run performance and long-run

investment suggests that this may not be a major concern.

Axelson et al (2007) propose a different (not mutually exclusive) hypothesis. They argue that

private equity firms are constrained in the amount of fund capital they can invest in a given deal, and

therefore have to use leverage to fund their investments. The theory builds on the premise that general

partners in a private equity fund can have an incentive to undertake risky but unprofitable investments,

because such investments generate fees if the investment is successful, while the downside risk is borne

by the limited partner investors in the fund. To mitigate this problem, it is optimal to force general

partners to use external leverage to finance the fund’s investments, because it will be harder to get bank

loans for unprofitable deals that the general partner may otherwise have an incentive to undertake. As a

result, more leveraged buyouts will be undertaken during times when external lenders perceive

investment opportunities to be particularly favorable. Still, because deals are easier to undertake in a

favorable credit market environment, there will be some overinvestment in unprofitable deals during these

times as well. This implies that the level of buyout activity will correlate positively with the credit market

environment, and that the average deal undertaken in “hot” credit markets will underperform the average

deal undertaken in “cold” credit markets.

23
 Both of the mispricing and agency-based theories imply that relatively more deals will be

undertaken when debt markets are unusually favorable. Kaplan and Stein (1993) present evidence that is

consistent with a role for overly favorable terms from high yield bond investors in the 1980s buyout

wave. The credit market turmoil in late 2007 and early 2008 suggests that overly favorable terms from

debt investors may have helped fuel the buyout wave from 2005 through mid-2007.

To study the cyclicality of the buyout market, we make more detailed “apples-to-apples”

comparisons of buyout characteristics over time by combining the results in Kaplan and Stein (1993) for

the 1980s buyout wave with the results in Guo et al. (2008) for the last ten years. Both papers study

public-to-private transactions in the United States.

First, we look at valuations or prices relative to cash flow. To measure the price paid for these

deals, we calculate enterprise value as the sum of the value of debt and equity at the time of the buyout.

Firm cash flow is calculated using the standard measure of firm-level performance, EBITDA which

stands for earnings before interest, taxes, depreciation, and amortization. Figure 3 reports the median ratio

of enterprise value to cash flow for leveraged buyouts by year. The figure shows that prices paid for cash

flow were generally higher at the end of the buyout waves than at the beginning. The more recent period,

in particular, exhibits a great deal of cyclicality, first dipping substantially in the 2001 to 2003 period and

then rising afterwards.

Figure 3 also shows that valuation multiples in the recent wave exceeded those in the 1980s

wave, but this conclusion is open to some interpretation. In general, ratios of all corporate values to cash

flow were higher in the last decade than in the 1980s. When the ratios in Figure 3 are deflated by the

median ratio for non-financial companies in the Standard and Poor’s 500 index, the valuations of

leveraged buyout deals relative to the Standard and Poor’s 500 are actually slightly lower in the recent

wave. However, even after the calculation, the cyclicality of the recent wave remains.

Next, we look at changes in various aspects of leverage buyout firm capital structures. We

compare the ratio of equity used to finance leveraged buyouts in each time period, and find that the share

of equity used to finance leveraged buyouts was relatively constant in the first wave at 10 percent to 15

24
percent, and relatively constant in the second wave, but at roughly 30 percent. This striking increase in

equity percentage from one era to the other is both a prediction of and consistent with the arguments in

Kaplan and Stein (1993) that debt investors offered overly favorable terms, particularly too much

leverage, in the buyout wave of the 1980s.

Valuations relative to EBITDA were higher in the recent wave, but debt levels were lower.

Interest rates also changed. Figure 4 combines these factors by measuring the ratio of EBITDA to

forecast interest for the leveraged buyouts of the two eras. This interest coverage ratio is a measure of the

fragility of a buyout transaction. When this ratio is lower, it implies that the buyout is more fragile,

because the firm has less of a cushion from not being able to meet interest payments. Figure 4 has two

interesting implications. First, interest coverage ratios are higher in the recent wave, suggesting the deals

are less fragile. Second, the cyclical pattern of the second wave remains. Coverage ratios are higher in

the 2001 to 2004 period than in the periods before and after.

Leveraged buyouts of the most recent wave also have been associated with more liberal

repayment schedules and looser covenants. Consistent with this, we find patterns similar to (if not

stronger than) those in Figure 4 when we factor in debt principal repayments. Demoriglu and James

(2008) and Standard and Poor’s (2008) also confirm that loan covenants became less restrictive at the end

of the recent wave.

Figure 5 considers this cyclicality in one additional way. It compares the median ratio of

EBITDA to enterprise value for the S&P 500 to the average interest rate on high yield bonds – the Merrill

Lynch High Yield (cash pay bonds) – each year from 1984 to 2006. This measures the relation between

the cash flow generated per dollar of market value by the median company in the S&P 500 to the interest

rate on a highly leveraged financing. One can interpret this operating earnings yield net of interest rate as

the excess (or deficit) from financing the purchase of an entire company with high yield bonds.

The pattern is suggestive. A necessary (but not sufficient) condition for a private equity boom to

occur is for earnings yields to exceed high yield interest rates. This was true in the late 1980s boom and

25
in the boom of 2005 and 2006. When operating earnings yields are less than high yield interest rates, PE

activity tends to be lower.

These patterns suggest that the debt used in a given leverage buyout may be more driven by credit

market conditions than the relative benefits of leverage for the particular firm. Axelson et al. (2008) find

evident consistent with this using a sample of large leveraged buyouts in U.S. and Europe completed

between 1985 – 2007. They find that leverage is cross-sectionally unrelated to leverage in similar-size

public firms in the same industry and is unrelated to firm-specific factors that explain leverage in public

firms. Instead, leveraged buyout capital structures are most strongly related to prevailing debt market

conditions at the time of the buyout. The extent of leverage in leveraged buyouts is decreasing as interest

rates rise. The amount of debt financing available, in turn, seems to affect the amount that the leveraged

buyout fund can pay to acquire the firm. Similarly, Ljungqvist et al. (2007) find that private equity funds

accelerate their investment pace when interest rates are low. These results are consistent with the

availability of debt financing impacting booms and busts in the private equity market.

These patterns raise the question as to why the public firms’ borrowings do not follow the same

credit market cycles. One potential explanation is that public firms may not be willing to take on

additional leverage to take advantage of debt mispricng, either because managers dislike debt or because

public market investors worry about high debt levels.

A second explanation is that private equity funds have better access to credit markets because

they are repeated borrowers in the market, which enables them to build reputation with lenders. Recent

papers by Ivashina and Kovner (2008) and Demiroglu and James (2007) find that more prominent private

equity funds seem to be able to obtain cheaper loans and looser covenants than other lenders.

A third explanation is that the compensation structures of private equity funds provide incentives

to take on more debt than is optimal for the individual firm, as suggested by Axelson et al (2007).

Private Equity Fund Level

26
 The time series of commitments to private equity funds examined earlier appear to exhibit a

boom and bust pattern. In this section, we look at this more closely by considering the relation between

commitments and returns.

First, we consider the relation between fundraising and subsequent private equity fund returns.

Table 3 presents illustrative regressions in which the dependent variable is the capital-weighted return to

all private equity funds raised in a particular year. This is referred to as the “vintage year return.” We use

the vintage year returns for U.S. private equity funds from Venture Economics as of September 2007 for

vintage years 1984 to 2004. The return measures are noisy. As mentioned earlier, Venture Economics

does not have returns for all private equity funds. In addition, the funds that comprise the more recent

vintage years are still active and will certainly change over time. This is probably not important, though,

because we obtain similar results when we eliminate all vintages after 1999. As independent variables,

we use capital committed to private equity funds in the vintage year and the previous vintage year relative

to the total value of the U.S. stock market. Regressions 1 to 4 in table 3 indicate a strong negative relation

between fundraising and subsequent vintage year returns. The inclusion of a time trend does not affect

the results. While this simple regression finding can only be considered illustrative of broader patterns, it

suggests that the inflow of capital into private equity funds in a given year can explain realized fund

returns during the subsequent ten- to twelve year period when these funds are active. In particular, it

strongly suggests that an influx of capital into private equity is associated with lower subsequent returns.

Next we consider the extent to which past returns affect capital commitments. In these

regressions, the dependent variable is the annual capital commitment to U.S. private equity funds as a

fraction of the U.S. stock market from 1987 to 2006. The independent variables are the each of the three

previous year’s returns to private equity, again, as reported by Venture Economics. Note that the annual

return to private equityis different from the vintage year return, which was the dependent variable in the

previous regression. The vintage year return measures the annual return to all funds raised in a particular

year over the life of the fund. So, the vintage year return is a geometric average of many years of returns.

In contrast, the annual return to private equity is the return to all private equity funds of different vintages

27
in a given calendar year. Again, these regressions are meant to be suggestive. In regressions 5 and 6, we

find that capital commitments are positively and significantly related to lagged private equity returns.

I.e., investors seem to follow good returns. Second, the positive trend is consistent with significant

secular growth in private equity fund commitments over time above any cyclical factors.

To summarize the regressions, private equity fund returns tend to decline when more capital is

committed to this asset class. Capital commitments to private equity tend to decline when realized returns

decline. In other words, the patterns are consistent with a boom and bust cycle in private equity.

Some Speculations

The empirical evidence is strong that private equity activity creates economic value on average.

We suspect that the increased investment by private equity firms in operational engineering will ensure

that this result continues to hold in the future. Because private equity creates economic value, we believe

that private equity activity has a substantial permanent component.

However, the evidence also is strong that private equity activity is subject to boom and bust

cycles, which are driven by recent returns as well as by the level of interest rates relative to earnings and

stock market values. This seems particularly true for larger public-to-private transactions.

From the summer of 2007 into mid-2008, interest rates on buyout-related debt have increased

substantially – if buyout debt can be raised at all. At the same time, corporate earnings may have

softened. In this setting, private equity activity, particularly large public-to-private buyout deals, is likely

to be relatively low. Institutional investors are likely to continue to make commitments to private equity

for a time, at least, because reported private returns have not declined, but are still robust. As of

September 2007, Venture Economics reports private equity returns over the previous three years of 15.3

percent versus Standard and Poor’s 500 stock market returns of 12.7 percent.

The likelihood that commitments by investors to private equity funds remain robust at the same

time that debt markets remain unfavorable will create pressure for private firms to invest the capital

committed. Given the fee structure of private equity funds, we do not expect that many private equity

28
firms will return the money. However, these patterns suggest that the structure of private equity deals

will evolve.

First, we suspect that private equity firms will make investments with less leverage, at least

initially. While this change may reduce the magnitude of expected returns (and compensation), as long as

the private equity firms add value, it will not change risk-adjusted returns.

Second, we suspect that private equity firms will be more likely to take minority equity positions

in public or private companies rather than buying the entire company. Private equity firms have

experience with minority equity investments, both in venture capital investments and in overseas

investments, particularly in Asia. The relatively new operational engineering capabilities of private

equity firms may put them in a better position to supply minority investments than in the past, because

private equity firms can provide additional value without having full control. Moreover, top executives

and boards of public companies may have an increased demand for minority equity investments as well.

Shareholder and hedge fund activism and hostility have increased substantially in recent years (Brav et

al., forthcoming). In the face of that hostility, private equity firms are likely to be perceived as partners or

“white knights” by some chief executive officers and boards.

Finally, what will happen to funds and transactions completed in the recent private equity boom

of 2005 to mid-2007? It seems plausible that the ultimate returns to private equity funds raised during

these years will prove disappointing because firms are unlikely to be able to exit the deals from this time

period at valuations as high as the private equity firms paid to buy the firms. It is also plausible that some

of the transactions undertaken during the boom were less driven by the potential of operating and

governance improvements, and more driven by the availability of debt financing, which also implies that

the returns on these deals will be disappointing.

If and when private equity returns decline, commitments to private equity also will decline.

Lower returns to recent private equity funds are likely to coincide with some failed transactions, including

debt defaults and bankruptcies. The relative magnitude of defaults and failed transactions, however is

likely to be lower than after the previous boom in the early 1990s. While private equity returns for this

29
time period may disappoint, the transactions of the recent wave had higher coverage ratios and looser

covenants on their debt than those of the 1980s, which reduces the chances of default. Also, there are

reasons to believe that the overall economic costs of the defaults that do occur may not be all that large.

Andrade and Kaplan (1998) study the transactions from the 1980s leveraged buyout wave that became

financially distressed. They estimate costs of distress not larger than 20 percent of firm value. They also

estimate that even the financially distressed buyouts were no less, or even more valuable after the

resolution of financial distress than they were before the leveraged buyout. This implies that the net value

impact of the leveraged buyout and distress for those distressed transactions is roughly zero, or even

marginally positive. There is no reason to believe that the results for defaulting transactions in the current

wave will be any worse.

30
Acknowledgements

This research has been supported by the Kauffman Foundation, by the Lynde and Harry Bradley
Foundation and the Olin Foundation through grants to the Stigler Center for the Study of the Economy
and the State, and by the Center for Research in Security Prices. We thank Jim Hines, Antoinette Schoar,
Andrei Shleifer, Jeremy Stein, Tim Taylor, and Mike Wright for very helpful comments.

31
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34
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35
 Table 1: Global Leveraged Buyout Transaction Characteristics Across Time.
The table reports transaction characteristics for 17,171 worldwide leveraged buyout transactions that include
every transaction with a financial sponsor in the CapitalIQ database announced between 1/1/1970 and
6/30/2007. Enterprise value is the sum of the sum of equity and net debt used to pay for the transaction in 2007
U.S. dollars. For the transactions where enterprise value was not recorded, these have been imputed using the
methodology in Strömberg (2008).

Period 1985- 1990- 1995- 2000- 2005- 1970-

1989 1994 1999 2004 6/30/2007 6/30/ 2007
Sum
Combined Enterprise Value $257,214 $148,614 $553,852 $1,055,070 $1,563,250 $3,616,787
Number of transactions 642 1,123 4,348 5,673 5,188 17,171

LBOs by type:: % of Combined Enterprise Value

Public to private 49% 9% 15% 18% 34% 27%
Independent private 31% 54% 44% 19% 14% 23%
Divisional 17% 31% 27% 41% 25% 30%
Secondary 2% 6% 13% 20% 26% 20%
Distressed 0% 1% 1% 2% 1% 1%

LBOs by target location:

United States and Canada 87% 72% 60% 44% 47% 52%
United Kingdom 7% 13% 16% 17% 15% 15%
Western Europe (except UK) 3% 13% 20% 32% 30% 26%
Asia and Australia 3% 1% 2% 4% 6% 4%
Rest of World 0% 2% 2% 3% 3% 3%

Table 2: Exit Characteristics of Leveraged Buyouts Across Time.

The table reports exit information for for 17,171 worldwide leveraged buyout transactions that include every
transaction with a financial sponsor in the CapitalIQ database r announced between 1/1/1970 and 6/30/2007.
The numbers are expressed as percentage of transactions, on an equally-weighted basis. Exit status is
determined using various databases, including CapitalIQ, SDC, Worldscope, Amadeus, Cao and Lerner (2007),
as well as company and LBO firm web sites. See Strömberg (2008) for a more detailed description of the
methodology.

Year of original LBO 1970- 1985- 1990- 1995- 2000- 2003- 2006- Whole
1984 1989 1994 1999 2002 2005 2007 period
Type of exit:
Bankruptcy 7% 6% 5% 8% 6% 3% 3% 6%
IPO 28% 25% 23% 11% 9% 11% 1% 14%
Sold to strategic buyer 31% 35% 38% 40% 37% 40% 35% 38%
Sold to financial buyer 5% 13% 17% 23% 31% 31% 17% 24%
Sold to LBO-backed firm 2% 3% 3% 5% 6% 7% 19% 5%
Sold to management 1% 1% 1% 2% 2% 1% 1% 1%
Other / unknown 26% 18% 12% 11% 10% 7% 24% 11%
No exit by Nov. 2007 3% 5% 9% 27% 43% 74% 98% 54%

% of deals exited within

24 months 14% 12% 14% 13% 9% 13% 12%
60 months 47% 40% 53% 41% 40% 42%
72 months 53% 48% 63% 49% 49% 51%
84 months 61% 58% 70% 56% 55% 58%
120 months 70% 75% 82% 73% 76%
Table 3: Relation of PE Returns and PE Fundraising in U.S.

Relation of PE Returns and PE Fundraising in U.S.. PE Vintage Year IRR is the average IRR to U.S. PE funds
raised in a given year, according to Venture Economics. Mean Vintage Year IRR is 16.5%. PE Commitments
are capital committed to U.S. PE funds from Private Equity Analyst as a fraction of the total value of the U.S.
stock market. Mean PE Commitments are 0.43%. PE Annual Return is the annual return to all U.S. PE funds
according to Venture Economics. Mean Annual Return is 18.6%. Standard errors are in brackets.

Dependent Variable:
Panel A: Vintage Year IRR (capital weighted) from 1984 to 2004

(1) (2) (3) (4)

Constant 0.31 0.31 0.35 0.35

[6.2] [7.0] [7.5] [7.2]

PE Commitments to Stock Market, t -32.60** -20.79*

[-2.4] [-1.6]

PE Commitments to Stock Market, t-1 -36.87*** -28.66**

[-3.0] [-2.2]

PE Commitments to Stock Market, t + t-1 -24.78***

[-3.5]

Trend -0.004 -0.003 -0.002 -0.002

[-1.2] [-1.0] [-0.8] [-0.8]

Adj. R2 0.28 0.36 0.44 0.41

Dependent Variable:
Panel B: PE Commitments to Stock Market, t from 1984 to 2007

(1) (2)

Constant -0.091 -0.292

[-0.7] [-1.8]

Annual PE Return, t-1 0.007** 0.008***

[2.1] [2.6]

Annual PE Return, t-2 0.007**

[2.4]

Trend 0.031*** 0.031***

[4.1] [4.6]

Adj. R2 0.40 0.50

Significant at * 10%, ** 5%, and *** 1% levels.

Figure 1

Sources: Private Equity Analyst, CapitalIQ, Strömberg (2008), authors’ calculations.

Figure 2

Sources: CapitalIQ, Strömberg (2008), authors’ calculations.

Figure 3

Figure 4
Figure 5
Median EBITDA / Enterprise Value for S&P 500 companies less Merrill Lynch High-Yield Master (Cash Pay Only)
Yield. Enterprise Value is the sum of market value of equity, book value of long- and short-term debt less cash and
marketable securities.
 Updated 9/9/02

Private Equity Glossary

“A” round – a financing event whereby venture capitalists become involved in a fast
growth company that was previously financed by founders and/or angels.

Accredited investor – a person or legal entity, such as a company or trust fund, that
meets certain net worth and income qualifications and is considered to be sufficiently
sophisticated to make investment decisions in complex situations. Regulation D of the
Securities Act of 1933 exempts accredited investors from protection under the Securities
Act. Typical qualifications for a person are: $1 million net worth and annual income
exceeding $200,000 individually or $300,000 with a spouse. Directors and executive
officers are considered to be accredited investors.

Alternative asset class – a class of investments that includes private equity, real estate,
and oil and gas, but excludes publicly traded securities. Pension plans, college
endowments and other relatively large institutional investors typically allocate a certain
percentage of their investments to alternative assets with an objective to diversify their
portfolios.

Angel – a wealthy individual that invests in companies in relatively early stages of

development. Usually angels invest less than $1 million per startup. The typical angel-
financed startup is in concept or product development phase.

Anti-dilution – a contract clause that protects an investor from a substantial reduction in

percentage ownership in a company due to the issuance by the company of additional
shares to other entities. The mechanism for making adjustments is called a Ratchet.

“B” round – a financing event whereby professional investors such as venture capitalists
are sufficiently interested in a company to provide additional funds after the “A” round of
financing. Subsequent rounds are called “C”, “D” and so on.

This document was developed by Professor Colin Blaydon and Professor Fred Wainwright as a basis for class discussion rather than
to illustrate either effective or ineffective management. The authors gratefully acknowledge the support of the Center For Private
Equity and Entrepreneurship.

 Copyright Colin C. Blaydon, 2001, 2002. All rights reserved.

Best efforts offering – a commitment by a syndicate of investment banks to use best
efforts to ensure the sale to investors of a company’s offering of securities. In a best
efforts offering, the syndicate avoids any firm commitment for a specific number of
shares or bonds.

Beta Product – a product that is being tested by potential customers prior to being
formally launched into the marketplace.

Blow-out round – see Cram-down round.

Board of directors – a group of individuals, typically composed of managers, investors

and experts, which have a fiduciary responsibility for the well being and proper guidance
of a corporation. The board is elected by the shareholders.

Boat anchor – a person, project or activity that hinders the growth of a company.

Book – see Private placement memorandum.

Bootstrapping – the actions of a startup to minimize expenses and build cash flow,
thereby reducing or eliminating the need for outside investors.

Bridge financing – temporary funding that will eventually be replaced by permanent

capital from equity investors or debt lenders. In venture capital, a bridge is usually a
short term note (6 to 12 months) that converts to preferred stock. Typically, the bridge
lender has the right to convert the note to preferred stock at a price that is a 20% discount
from the price of the preferred stock in the next financing round. See Wipeout bridge
and Hamburger Helper bridge.

Broad-based weighted average ratchet - a type of anti-dilution mechanism. A weighted

average ratchet adjusts downward the price per share of the preferred stock of investor A
due to the issuance of new preferred shares to new investor B at a price lower than the
price investor A originally received. Investor A’s preferred stock is repriced to a
weighted average of investor A’s price and investor B’s price. A broad-based ratchet uses
all common stock outstanding on a fully diluted basis (including all convertible
securities, warrants and options) in the denominator of the formula for determining the
new weighed average price. See Narrow-based weighted average ratchet.

Burn rate – the rate at which a startup with little or no revenue uses available cash to
cover expenses. Usually expressed on a monthly or weekly basis.

Business plan – a document that describes a new concept for a business opportunity. A
business plan typically includes the following sections: executive summary, market need,
solution, technology, competition, marketing, management, operations and financials.

2
Buyout – a sector of the private equity industry. Also, the purchase of a controlling
interest of a company by an outside investor (in a leveraged buyout) or a management
team (in a management buyout).

Buy-sell agreement – a contract that sets forth the conditions under which a shareholder
must first offer his or her shares for sale to the other shareholders before being allowed to
sell to entities outside the company.

C corporation – an ownership structure that allows any number of individuals or

companies to own shares. A C corporation is a stand-alone legal entity so it offers some
protection to its owners, managers and investors from liability resulting from its actions.

Capital call – when a private equity fund manager (usually a “general partner” in a
partnership) requests that an investor in the fund (a “limited partner”) provide additional
capital. Usually a limited partner will agree to a maximum investment amount and the
general partner will make a series of capital calls over time to the limited partner as
opportunities arise to finance startups and buyouts.

Capitalization table – a table showing the owners of a company’s shares and their
ownership percentages. It also lists the forms of ownership, such as common stock,
preferred stock, warrants and options.

Capital gains – a tax classification of investment earnings resulting from the purchase
and sale of assets. Typically, an investor prefers that investment earnings be classified as
long term capital gains (held for a year or longer), which are taxed at a lower rate than
ordinary income.

Capital stock – a description of stock that applies when there is only one class of shares.
This class is known as “common stock”.

Capped participating preferred stock – preferred stock whose participating feature is

limited so that an investor cannot receive more than a specified amount. See
Participating preferred stock.

Carried interest – a share in the profits of a private equity fund. Typically, a fund must
return the capital given to it by limited partners plus any preferential rate of return before
the general partner can share in the profits of the fund. The general partner will then
receive a 20% carried interest, although some successful firms receive 25%-30%. Also
known as “carry” or “promote.”

Catch-up – a clause in the agreement between the general partner and the limited
partners of a private equity fund. Once the limited partners have received a certain
portion of their expected return, the general partner can then receive a majority of profits
until the previously agreed upon profit split is reached.

3
Change of control bonus – a bonus of cash or stock given by private equity investors to
members of a management group if they successfully negotiate a sale of the company for
a price greater than a specified amount.

Clawback – a clause in the agreement between the general partner and the limited
partners of a private equity fund. The clawback gives limited partners the right to reclaim
a portion of disbursements to a general partner for profitable investments based on
significant losses from later investments in a portfolio.

Closing – the conclusion of a financing round whereby all necessary legal documents are
signed and capital has been transferred.

Collateral – hard assets of the borrower, such as real estate or equipment, for which a
lender has a legal interest until a loan obligation is fully paid off.

Commitment – an obligation, typically the maximum amount that a limited partner

agrees to invest in a fund.

Common stock – a type of security representing ownership rights in a company. Usually,

company founders, management and employees own common stock while investors own
preferred stock. In the event of a liquidation of the company, the claims of secured and
unsecured creditors, bondholders and preferred stockholders take precedence over
common stockholders. See Preferred stock.

Comparable – a publicly traded company with similar characteristics to a private

company that is being valued. For example, a telecommunications equipment
manufacturer whose market value is 2 times revenues can be used to estimate the value of
a similar and relatively new company with a new product in the same industry. See
Liquidity discount.

Control – the authority of an individual or entity that owns more than 50% of equity in a
company or owns the largest block of shares compared to other shareholders.

Consolidation – see Rollup.

Conversion – the right of an investor or lender to force a company to replace the

investor’s preferred shares or the lender’s debt with common shares at a preset
conversion ratio. A conversion feature was first used in railroad bonds in the 1800’s.

Convertible debt – a loan which allows the lender to exchange the debt for common
shares in a company at a preset conversion ratio

Convertible preferred stock – a type of stock that gives an owner the right to convert to
common shares of stock. Usually, preferred stock has certain rights that common stock
doesn’t have, such as decision-making management control, a promised return on
investment (dividend), or senior priority in receiving proceeds from a sale or liquidation

4
of the company. Typically, convertible preferred stock automatically converts to common
stock if the company makes an initial public offering (IPO). Convertible preferred is the
most common tool for private equity funds to invest in companies.

Convertible security – a security that gives its owner the right to exchange the security
for common shares in a company at a preset conversion ratio. The security is typically
preferred stock, warrants or debt.

Co-sale right- the right that gives the investor a contractual right to sell some of the
investor’s stock along with the founder’s stock if the founder elects to sell stock to a
third-party.

Cost of revenue – the expenses generated by the core operations of a company.

Covenant – a legal promise to do or not do a certain thing. For example, in a financing

arrangement, company management may agree to a negative covenant, whereby it
promises not to incur additional debt. The penalties for violation of a covenant may vary
from repairing the mistake to losing control of the company.

Cram down round – a financing event upon which new investors with substantial
capital are able to demand and receive contractual terms that effectively cause the
issuance of sufficient new shares by the startup company to significantly reduce
(“dilute”) the ownership percentage of previous investors..

Cumulative dividends – the owner of preferred stock with cumulative dividends has the
right to receive accrued (previously unpaid) dividends in full before dividends are paid to
any other classes of stock.

Current ratio – the ratio of current assets to current liabilities.

Deal flow – a measure of the number of potential investments that a fund reviews in any
given period.

Debt service – the ratio of a loan payment amount to available cash flow earned during a
specific period. Typically lenders insist that a company maintain a certain debt service
ratio or else risk penalties such as having to pay off the loan immediately.

Default – a company’s failure to comply with the terms and conditions of a financing
arrangement.

Defined benefit plan – a company retirement plan in which both the employee and the
employer contribute to the plan. Typically the plan is based on the employee’s salary and
number of years worked. Fixed benefits are outlined when the employee retires. The
employer bears the investment risk and is committed to providing the benefits to the
employee. Defined benefit plan managers can invest in private equity funds.

5
Defined contribution plan – a company retirement plan in which the employee elects to
contribute some portion of his or her salary into a retirement plan, such as a 401(k) or
403(b). With this type of plan, the employee bears the investment risk. The benefits
depend solely on the amount of money made from investing the employee’s
contributions. Defined contribution plan capital cannot be invested in private equity
funds.

Demand rights – a type of registration right. Demand rights give an investor the right to
force a startup to register its shares with the SEC and prepare for a public sale of stock
(IPO).

Dilution – the reduction in the ownership percentage of current investors, founders and
employees caused by the issuance of new shares to new investors.

Dilution protection – see Anti-dilution and Ratchet.

Direct costs – see Cost of revenue.

Disbursement – an investment by a fund in a company.

Discount rate – the interest rate used to determine the present value of a series of future
cash flows.

Discounted cash flow (DCF) – a valuation methodology whereby the present value of all
future cash flows expected from a company is calculated.

Distribution – the transfer of cash or securities to a limited partner resulting from the
sale, liquidation or IPO of one or more portfolio companies in which a general partner
chose to invest.

Dividends – regular payments made by a company to the owners of certain securities.

Typically, dividends are paid quarterly, by approval of the board of directors, to owners
of preferred stock.

Down round – a round of financing whereby the valuation of the company is lower than
the value determined by investors in an earlier round.

Drag-along rights – the contractual right of an investor in a company to force all other
investors to agree to a specific action, such as the sale of the company.

Drive-by VC – a venture capitalist that only appears during board meetings of a portfolio
company and rarely offers advice to management.

Due diligence – the investigatory process performed by investors to assess the viability
of a potential investment and the accuracy of the information provided by the target
company.

6
Early stage – the state of a company after the seed (formation) stage but before middle
stage (generating revenues). Typically, a company in early stage will have a core
management team and a proven concept or product, but no positive cash flow.

Earnings before interest and taxes (EBIT) – a measurement of the operating profit of a
company. One possible valuation methodology is based on a comparison of private and
public companies’ value as a multiple of EBIT.

Earnings before interest, taxes, depreciation and amortization (EBITDA) – a

measurement of the cash flow of a company. One possible valuation methodology is
based on a comparison of private and public companies’ value as a multiple of EBITDA.

Earn out- an arrangement in which sellers of a business receive additional future

payments, usually based on financial performance metrics such as revenue or net income.

Elevator pitch – a concise presentation, lasting only a few minutes (an elevator ride), by
an entrepreneur to a potential investor about an investment opportunity.

Employee Stock Ownership Program (ESOP) – a plan established by a company to

reserve shares for long-term incentive compensation for employees.

Equity – the ownership structure of a company represented by common shares, preferred

shares or unit interests. Equity = Assets – Liabilities.

ESOP – see Employee Stock Ownership Program.

Evergreen fund – a fund that reinvests its profits in order to ensure the availability of
capital for future investments.

Exit strategy – the plan for generating profits for owners and investors of a company.
Typically, the options are to merge, be acquired or make an initial public offering (IPO).

Expansion stage – the stage of a company characterized by a complete management

team and a substantial increase in revenues.

Fairness opinion – a letter issued by an investment bank that charges a fee to assess the
fairness of a negotiated price for a merger or acquisition.

Firm commitment - a commitment by a syndicate of investment banks to purchase all

the shares available for sale in a public offering of a company. The shares will then be
resold to investors by the syndicate.

Flipping – the act of selling shares immediately after an initial public offering.
Investment banks that underwrite new stock issues attempt to allocate shares to new
investors that indicate they will retain the shares for several months. Often management

7
and venture investors are prohibited from selling IPO shares until a “lock-up period”
(usually 6 to 12 months) has expired.

Founder – a person who participates in the creation of a company. Typically, founders

manage the company until it has enough capital to hire professional managers.

Founders stock – nominally priced common stock issued to founders, officers,

employees, directors, and consultants.

Friends and family financing – capital provided by the friends and family of founders
of an early stage company. Founders should be careful not to create an ownership
structure that may hinder the participation of professional investors once the company
begins to achieve success.

Full ratchet – an anti-dilution protection mechanism whereby the price per share of the
preferred stock of investor A is adjusted downward due to the issuance of new preferred
shares to new investor B at a price lower than the price investor A originally received.
Investor A’s preferred stock is repriced to match the price of investor B’s preferred stock.
Usually as a result of the implementation of a ratchet, company management and
employees who own a fixed amount of common shares suffer significant dilution. See
Narrow-based weighted average ratchet and Broad-based weighted average ratchet.

Fully diluted basis – a methodology for calculating any per share ratios whereby the
denominator is the total number of shares issued by the company on the assumption that
all warrants and options are exercised and preferred stock.

Fund-of-funds – a fund created to invest in private equity funds. Typically, individual

investors and relatively small institutional investors participate in a fund-of-funds to
minimize their portfolio management efforts.

Gatekeepers- intermediaries which endowments, pension funds and other institutional

investors use as advisors regarding private equity investments.

General partner (GP) – a class of partner in a partnership. The general partner retains
liability for the actions of the partnership. In the private equity world, the GP is the fund
manager while the limited partners (LPs) are the institutional and high net worth
investors in the partnership. The GP earns a management fee and a percentage of profits
(see Carried interest).

GP – see General partner.

Grossing up – an adjustment of an option pool for management and employees of a

company which increases the number of shares available over time. This usually occurs
after a financing round whereby one or more investors receive a relatively large
percentage of the company. Without a grossing up, managers and employees would

8
suffer the financial and emotional consequences of dilution, thereby potentially affecting
the overall performance of the company.

Growth stage – the state of a company when it has received one or more rounds of
financing and is generating revenue from its product or service. Also known as “middle
stage.”

Hamburger helper – a colorful label for a traditional bridge loan that includes the right
of the bridge lender to convert the note to preferred stock at a price that is a 20% discount
from the price of the preferred stock in the next financing round.

Hart-Scott-Rodino Act – a law requiring entities that acquire certain amounts of stock
or assets of a company to inform the Federal Trade Commission and the Department of
Justice and to observe a waiting period before completing the transaction.

Harvest – to generate cash or stock from the sale or IPO of companies in a private equity
portfolio of investments.

Hockey stick – the general shape and form of a chart showing revenue, customers, cash
or some other financial or operational measure that increases dramatically at some point
in the future. Entrepreneurs often develop business plans with hockey stick charts to
impress potential investors.

Hot issue – stock in an initial public offering that is in high demand.

Hurdle rate – a minimum rate of return required before an investor will make an
investment.

Incorporation – the process by which a business receives a state charter, allowing it to

become a corporation. Many corporations choose Delaware because its laws are business-
friendly and up to date.

Incubator – a company or facility designed to host startup companies. Incubators help

startups grow while controlling costs by offering networks of contacts and shared
backoffice resources.

Initial public offering (IPO) – the first offering of stock by a company to the public.
New public offerings must be registered with the Securities and Exchange Commission.
An IPO is one of the methods that a startup that has achieved significant success can use
to raise additional capital for further growth. See Qualified IPO.

Inside round – a round of financing in which the investors are the same investors as the
previous round. An inside round raises liability issues since the valuation of the company
has no third party verification in the form of an outside investor. In addition, the terms of
the inside round may be considered self-dealing if they are onerous to any set of
shareholders or if the investors give themselves additional preferential rights.

9
Institutional investor – professional entities that invest capital on behalf of companies or
individuals. Examples are: pension plans, insurance companies and university
endowments.

Internal rate of return (IRR) – the interest rate at which a certain amount of capital
today would have to be invested in order to grow to a specific value at a specific time in
the future.

Investment thesis / Investment philosophy – the fundamental ideas which determine

the types of investments that an investment fund will choose in order to achieve its
financial goals.

IPO – see Initial public offering.

IRR – see Internal rate of return.

Issuer – the company that chooses to distribute a portion of its stock to the public.

Junior debt – a loan that has a lower priority than a senior loan in case of a liquidation of
the asset or borrowing company. Also known as “subordinated debt”.

Later stage – the state of a company that has proven its concept, achieved significant
revenues compared to its competition, and is approaching cash flow break even or
positive net income. Typically, a later stage company is about 6 to 12 months away from
a liquidity event such as an IPO or buyout. The rate of return for venture capitalists that
invest in later stage, less risky ventures is lower than in earlier stage ventures.

LBO – see Leveraged buyout.

Lead investor – the venture capital investor that makes the largest investment in a
financing round and manages the documentation and closing of that round. The lead
investor sets the price per share of the financing round, thereby determining the valuation
of the company.

Letter of intent – a document confirming the intent of an investor to participate in a

round of financing for a company. By signing this document, the subject company agrees
to begin the legal and due diligence process prior to the closing of the transaction. Also
known as a “Term Sheet”.

Leverage – the use of debt to acquire assets, build operations and increase revenues. By
using debt, a company is attempting to achieve results faster than if it only used its cash
available from pre-leverage operations. The risk is that the increase in assets and
revenues does not generate sufficient net income and cash flow to pay the interest costs
of the debt.

10
Leveraged buyout (LBO) – the purchase of a company or a business unit of a company
by an outside investor using mostly borrowed capital.

Limited liability company (LLC) – an ownership structure designed to limit the

founders’ losses to the amount of their investment. An LLC does not pay taxes, rather its
owners pay taxes on their proportion of the LLC profits at their individual tax rates.

Limited partnership – a legal entity composed of a general partner and various limited
partners. The general partner manages the investments and is liable for the actions of the
partnership while the limited partners are generally protected from legal actions and any
losses beyond their original investment. The general partner receives a management fee
and a percentage of profits (see Carried interest), while the limited partners receive
income, capital gains and tax benefits.

Limited partner (LP) – an investor in a limited partnership. The general partner is liable
for the actions of the partnership while the limited partners are generally protected from
legal actions and any losses beyond their original investment. The limited partner
receives income, capital gains and tax benefits.

Liquidation – the selling off of all assets of a company prior to the complete cessation of
operations. Corporations that choose to liquidate declare Chapter 7 bankruptcy. In a
liquidation, the claims of secured and unsecured creditors, bondholders and preferred
stockholders take precedence over common stockholders.

Liquidation preference – the contractual right of an investor to priority in receiving the

proceeds from the liquidation of a company. For example, a venture capital investor with
a “2x liquidation preference” has the right to receive two times its original investment
upon liquidation.

Liquidity discount – a decrease in the value of a private company compared to the value
of a similar but publicly traded company. Since an investor in a private company cannot
readily sell his or her investment, the shares in the private company must be valued less
than a comparable public company.

Liquidity event – a transaction whereby owners of a significant portion of the shares of a

private company sell their shares in exchange for cash or shares in another, usually larger
company. For example, an IPO is a liquidity event.

Lock-up agreement – investors, management and employees often agree not to sell their
shares for a specific time period after an IPO, usually 6 to 12 months. By avoiding large
sales of its stock, the company has time to build interest among potential buyers of its
shares.

LP – see Limited partner.

11
Management buyout (MBO) – a leveraged buyout controlled by the members of the
management team of a company or a division.

Management fee – a fee charged to the limited partners in a fund by the general partner.
Management fees in a private equity fund typically range from 0.75% to 3% of capital
under management, depending on the type and size of fund.

Management rights – the rights often required by a venture capitalist as part of the
agreement to invest in a company. The venture capitalist has the right to consult with
management on key operational issues, attend board meetings and review information
about the company’s financial situation.

Market capitalization – the value of a publicly traded company as determined by

multiplying the number of shares outstanding by the current price per share.

MBO – see Management buyout.

Mezzanine – a layer of financing that has intermediate priority (seniority) in the capital
structure of a company. For example, mezzanine debt has lower priority than senior debt
but usually has a higher interest rate and often includes warrants. In venture capital, a
mezzanine round is generally the round of financing that is designed to help a company
have enough resources to reach an IPO.

Middle stage – the state of a company when it has received one or more rounds of
financing and is generating revenue from its product or service. Also known as “growth
stage.”

Multiples – a valuation methodology that compares public and private companies in

terms of a ratio of value to an operations figure such as revenue or net income. For
example, if several publicly traded computer hardware companies are valued at
approximately 2 times revenues, then it is reasonable to assume that a startup computer
hardware company that is growing fast has the potential to achieve a valuation of 2 times
its revenues. Before the startup issues its IPO, it will likely be valued at less than 2 times
revenue because of the lack of liquidity of its shares. See Liquidity discount.

Narrow-based weighted average ratchet – a type of anti-dilution mechanism. A

weighted average ratchet adjusts downward the price per share of the preferred stock of
investor A due to the issuance of new preferred shares to new investor B at a price lower
than the price investor A originally received. Investor A’s preferred stock is repriced to a
weighed average of investor A’s price and investor B’s price. A narrow-based ratchet
uses only common stock outstanding in the denominator of the formula for determining
the new weighed average price.

NDA – see Non-disclosure agreement.

12
Non-compete – an agreement often signed by employees and management whereby they
agree not to work for competitor companies or form a new competitor company within a
certain time period after termination of employment.

Non-cumulative dividends – dividends that are payable to owners of preferred stock at a

specific point in time only if there is sufficient cash flow available after all company
expenses have been paid. If cash flow is insufficient, the owners of the preferred stock
will not receive the dividends owed for that time period and will have to wait until the
board of directors declares another set of dividends.

Non-interference – an agreement often signed by employees and management whereby

they agree not to interfere with the company’s relationships with employees, clients,
suppliers and sub-contractors within a certain time period after termination of
employment.

Non-solicitation – an agreement often signed by employees and management whereby

they agree not to solicit other employees of the company regarding job opportunities.

Non-disclosure agreement (NDA) – an agreement issued by entrepreneurs to protect the

privacy of their ideas when disclosing those ideas to third parties.

Offering memorandum – a legal document that provides details of an investment to

potential investors. See Private placement memorandum.

OID – see Original issue discount.

Optics – the way a concept is presented. Sometimes entrepreneurs’ presentations are

strong on optics but weak in content.

Options – see Stock options.

Option pool – a group of options set aside for long term, phased compensation to
management and employees.

Original issue discount (OID) – a discount from par value of a bond or debt-like
instrument. In structuring a private equity transaction, the use of a preferred stock with
liquidation preference or other clauses that guarantee a fixed payment in the future can
potentially create adverse tax consequences. The IRS views this cash flow stream as, in
essence, a zero coupon bond upon which tax payments are due yearly based on “phantom
income” imputed from the difference between the original investment and “guaranteed”
eventual payout. Although complex, the solution is to include enough clauses in the
investment agreements to create the possibility of a material change in the cash flows of
owners of the preferred stock under different scenarios of events such as a buyout,
dissolution or IPO.

Orphan – a startup company that does not have a venture capitalist as an investor.

13
Outstanding shares – the total amount of common shares of a company, not including
treasury stock, convertible preferred stock, warrants and options.

Oversubscription – when demand exceeds supply for shares of an IPO or a private

placement.

Pay or play – a clause in a financing agreement whereby any investor that does not
participate in a future round agrees to suffer significant dilution compared to other
investors. The most onerous version of “pay to play” is automatic conversion to common
shares, which in essence ends any preferential rights of an investor, such as the right to
influence key management decisions.

Pari passu – a legal term referring to the equal treatment of two or more parties in an
agreement. For example, a venture capitalists may agree to have registration rights that
are pari passu with the other investors in a financing round.

Participating dividends – the right of holders of certain preferred stock to receive

dividends and participate in additional distributions of cash, stock or other assets.

Participating preferred stock – a unit of ownership composed of preferred stock and

common stock. The preferred stock entitles the owner to receive a predetermined sum of
cash (usually the original investment plus accrued dividends) if the company is sold or
has an IPO. The common stock represents additional continued ownership in the
company. Participating preferred stock has been characterized as “having your cake and
eating it too.”

PE ratio – see Price earnings ratio.

Piggyback rights – rights of an investor to have his or her shares included in a

registration of a startup’s shares in preparation for an IPO.

PIPEs – see Private investment in public equities.

Placement agent – a company that specializes in finding institutional investors that are
willing and able to invest in a private equity fund. Sometimes a private equity fund will
hire a placement agent so the fund partners can focus on making and managing
investments in companies rather than on raising capital.

Portfolio company – a company that has received an investment from a private equity
fund.

Post-money valuation – the valuation of a company including the capital provided by

the current round of financing. For example, a venture capitalist may invest $5 million in
a company valued at $2 million “pre-money” (before the investment was made). As a
result, the startup will have a post-money valuation of $7 million.

14
PPM – see Private placement memorandum.

Preference – seniority, usually with respect to dividends and proceeds from a sale or
dissolution of a company.

Preferred stock – a type of stock that has certain rights that common stock does not
have. These special rights may include dividends, participation, liquidity preference, anti-
dilution protection and veto provisions, among others. Private equity investors usually
purchase preferred stock when they make investments in companies.

Pre-money valuation – the valuation of a company prior to the current round of

financing. For example, a venture capitalist may invest $5 million in a company valued at
$2 million pre-money. As a result, the startup will have a “post-money” valuation of $7
million.

Price earnings ratio (PE ratio) – the ratio of a public company’s price per share and its
net income after taxes on a per share basis.

Primary shares – shares sold by a corporation (not by individual shareholders).

Private equity – equity investments in non-public companies.

Private investment in public equities (PIPES) – investments by a private equity fund in

a publicly traded company, usually at a discount.

Private placement – the sale of a security directly to a limited number of institutional

and qualified individual investors. If structured correctly, a private placement avoids
registration with the Securities and Exchange Commission.

Private placement memorandum (PPM) – a document explaining the details of an

investment to potential investors. For example, a private equity fund will issue a PPM
when it is raising capital from institutional investors. Also, a startup may issue a PPM
when it needs growth capital. Also known as “Offering Memorandum.”

Private securities – securities that are not registered with the Securities and Exchange
Commission and do not trade on any exchanges. The price per share is negotiated
between the buyer and the seller (the “issuer”).

Promote – see Carried interest.

Prospectus – a formal document that gives sufficient detail about a business opportunity
for a prospective investor to make a decision. A prospectus must disclose any material
risks and be filed with the Securities and Exchange Commission.

15
Prudent man rule – a fundamental principle for professional money management which
serves as a basis for the Prudent Investor Act. The principle is based on a statement by
Judge Samuel Putnum in 1830: “Those with the responsibility to invest money for others
should act with prudence, discretion, intelligence and regard for the safety of capital as
well as income.”

Qualified IPO – a public offering of securities valued at or above a total amount

specified in a financing agreement. This amount is usually specified to be sufficiently
large to guarantee that the IPO shares will trade in a major exchange (NASDAQ or New
York Stock Exchange).

Quartile – one fourth of the data points in a data set. Often, private equity investors are
measured by the results of their investments during a particular period of time.
Institutional investors often prefer to invest in private equity funds that demonstrate
consistent results over time, placing in the upper quartile of the investment results for all
funds.

Ratchet – a mechanism to prevent dilution. An anti-dilution clause is a contract clause

that protects an investor from a reduction in percentage ownership in a company due to
the future issuance by the company of additional shares to other entities.

Realization ratio – the ratio of cumulative distributions to paid-in capital. The

realization ratio is used as a measure of the distributions from investment results of a
private equity partnership compared to the capital under management.

Recapitalization – the reorganization of a company’s capital structure.

Red herring – a preliminary prospectus filed with the Securities and Exchange
Commission and containing the details of an IPO offering. The name refers to the
disclosure warning printed in red letters on the cover of each preliminary prospectus
advising potential investors of the risks involved.

Redeemable preferred – preferred stock that can be redeemed by the owner (usually a
venture capital investor) in exchange for a specific sum of money.

Redemption rights – the right of an investor to force the startup company to buy back
the shares issued as a result of the investment. In effect, the investor has the right to take
back his/her investment and may even negotiate a right to receive an additional sum in
excess of the original investment.

Registration – the process whereby shares of a company are registered with the
Securities and Exchange Commission under the Securities Act of 1933 in preparation for
a sale of the shares to the public.

Registration rights – the rights of an investor in a startup regarding the registration of a

portion of the startup’s shares for sale to the public. Piggyback rights give the

16
shareholders the right to have their shares included in a registration. Demand rights give
the shareholders the option to force management to register the company’s shares for a
public offering. Often times registration rights are hotly negotiated among venture
capitalists in multiple rounds of financing.

Regulation D – an SEC regulation that governs private placements. Private placements

are investment offerings for institutional and accredited individual investors but not for
the general public. There is an exception that 35 non-accredited investors can participate.

Restricted shares – shares that cannot be traded in the public markets.

Return on investment (ROI) – the proceeds from an investment, during a specific time
period, calculated as a percentage of the original investment. Also, net profit after taxes
divided by average total assets.

Rights offering – an offering of stock to current shareholders that entitles them to

purchase the new issue, usually at a discount.

Rights of co-sale with founders – a clause in venture capital investment agreements that
allows the VC fund to sell shares at the same time that the founders of a startup chose to
sell.

Right of first refusal – a contractual right to participate in a transaction. For example, a

venture capitalist may participate in a first round of investment in a startup and request a
right of first refusal in any following rounds of investment.

Road show – presentations made in several cities to potential investors and other
interested parties. For example, a company will often make a road show to generate
interest among institutional investors prior to its IPO.

ROI – see Return on investment.

Rollup – the purchase of relatively smaller companies in a sector by a rapidly growing

company in the same sector. The strategy is to create economies of scale. For example,
the movie theater industry underwent significant consolidation in the 1960’s and 1970’s.
Round – a financing event usually involving several private equity investors.

Rule 144 – a rule of the Securities and Exchange Commission that specifies the
conditions under which the holder of shares acquired in a private transaction may sell
those shares in the public markets.

S corporation – an ownership structure that limits its number of owners to 100. An S

corporation does not pay taxes, rather its owners pay taxes on their proportion of the
corporation’s profits at their individual tax rates.

17
Small Business Investment Company (SBIC) – a company licensed by the Small
Business Administration to receive government loans in order to raise capital to use in
venture investing.

Scalability – a characteristic of a new business concept that entails the growth of sales
and revenues with a much slower growth of organizational complexity and expenses.
Venture capitalists look for scalability in the startups they select to finance.

Scale-down –a schedule for phased decreases in management fees for general partners in
a limited partnership as the fund reduces its investment activities toward the end of its
term.

Scale-up – the process of a company growing quickly while maintaining operational and
financial controls in place. Also, a schedule for phased increases in management fees for
general partners in a limited partnership as the fund increases its investment activities
over time.

SEC – see Securities and Exchange Commission.

Secondary market – a market for the sale of partnership interests in private equity funds.
Sometimes limited partners chose to sell their interest in a partnership, typically to raise
cash or because they cannot meet their obligation to invest more capital according to the
takedown schedule. Certain investment companies specialize in buying these partnership
interests at a discount.

Secondary shares – shares sold by a shareholder (not by the corporation).

Security – a document that represents an interest in a company. Shares of stock, notes

and bonds are examples of securities.

Securities and Exchange Commission (SEC) – the regulatory body that enforces
federal securities laws such as the Securities Act of 1933 and the Securities Exchange Act
of 1934.

Seed capital – investment provided by angels, friends and family to the founders of a
startup in seed stage.

Seed stage – the state of a company when it has just been incorporated and its founders
are developing their product or service.

Senior debt – a loan that has a higher priority in case of a liquidation of the asset or
company.

Seniority – higher priority.

18
Series A preferred stock – preferred stock issued by a fast growth company in exchange
for capital from investors in the “A” round of financing. This preferred stock is usually
convertible to common shares upon the IPO or sale of the company.

Spin out – a division of an established company that becomes an independent entity.

Stock – a share of ownership in a corporation.

Stock option – a right to purchase or sell a share of stock at a specific price within a
specific period of time. Stock purchase options are commonly used as long term incentive
compensation for employees and management of fast growth companies.

Strategic investor – a relatively large corporation that agrees to invest in a young

company in order to have access to a proprietary technology, product or service. By
having this access, the corporation can potentially achieve its strategic goals.

Subordinated debt – a loan that has a lower priority than a senior loan in case of a
liquidation of the asset or company. Also known as “junior debt”.

Sweat equity – ownership of shares in a company resulting from work rather than
investment of capital.

Syndicate – a group of investors that agree to participate in a round of funding for a

company. Alternatively, a syndicate can refer to a group of investment banks that agree to
participate in the sale of stock to the public as part of an IPO.

Syndication – the process of arranging a syndicate.

Tag-along rights – the right of an investor to receive the same

Takedown – a schedule of the transfer of capital in phases in order to complete a

commitment of funds. Typically, a takedown is used by a general partner of a private
equity fund to plan the transfer of capital from the limited partners.

Takeover – the transfer of control of a company.

Ten bagger – an investment that returns 10 times the initial capital.

Term sheet – a document confirming the intent of an investor to participate in a round of

financing for a company. By signing this document, the subject company agrees to begin
the legal and due diligence process prior to the closing of the transaction. Also known as
“Letter of Intent”.

Trade secret – something that is not generally known, is kept in secrecy and gives its
owners a competitive business advantage.

19
Turnaround – a process resulting in a substantial increase in a company’s revenues,
profits and reputation.

Two x – an expression referring to 2 times the original amount. For example, a preferred
stock may have a “two x” liquidation preference, so in case of liquidation of the
company, the preferred stock investor would receive twice his or her original investment.

Under water option – an option is said to be under water if the current fair market value
of a stock is less than the option exercise price.

Underwriter – an investment bank that chooses to be responsible for the process of

selling new securities to the public. An underwriter usually chooses to work with a
syndicate of investment banks in order to maximize the distribution of the securities.

Venture capital – a segment of the private equity industry which focuses on investing in
new companies with high growth rates.

Venture capital method – a valuation method whereby an estimate of the future value of
a company is discounted by a certain interest rate and adjusted for future anticipated
dilution in order to determine the current value. Usually, discount rates for the venture
capital method are considerably higher than public stock return rates, representing the
fact that venture capitalists must achieve significant returns on investment in order to
compensate for the risks they take in funding unproven companies.

Vintage – the year that a private equity fund stops accepting new investors and begins to
make investments on behalf of those investors.

Voting rights – the rights of holders of preferred and common stock in a company to
vote on certain acts affecting the company. These matters may include payment of
dividends, issuance of a new class of stock, merger or liquidation.

Warrant – a security which gives the holder the right to purchase shares in a company at
a pre-determined price. A warrant is a long term option, usually valid for several years or
indefinitely. Typically, warrants are issued concurrently with preferred stocks or bonds in
order to increase the appeal of the stocks or bonds to potential investors.

Washout round – a financing round whereby previous investors, the founders and
management suffer significant dilution. Usually as a result of a washout round, the new
investor gains majority ownership and control of the company.

Weighted average ratchet – an anti-dilution protection mechanism whereby the

conversion rate of preferred stock is adjusted in order to reduce an investor’s loss due to
an increase in the number of shares in a company. Without a ratchet, an investor would
suffer from a dilution of his or her percentage ownership. Usually as a result of the
implementation of a weighted average ratchet, company management and employees

20
who own a fixed amount of common shares suffer significant dilution, but not as badly as
in the case of a full ratchet.

Wipeout round – see Washout round.

Wipeout bridge – a short term financing that has onerous features whereby if the
company does not secure additional long term financing within a certain time frame, the
bridge investor gains ownership control of the company. See Bridge financing.

Write-down – a decrease in the reported value of an asset or a company.

Write-off – a decrease in the reported value of an asset or a company to zero.

Write-up – an increase in the reported value of an asset or a company.

Zombie – a company that has received capital from investors but has only generated
sufficient revenues and cash flow to maintain its operations without significant growth.
Typically, a venture capitalist has to make a difficult decision as to whether to kill off a
zombie or continue to invest funds in the hopes that the zombie will become a winner.

21
 Tuck School of Business
Dartmouth College
Updated 10/2/02

DEAL STRUCTURE NOTE

INTRODUCTION

Term Sheets are brief preliminary documents designed to facilitate and provide a
framework for negotiations between investors and entrepreneurs. A term sheet generally
focuses on a given enterprise’s valuation and the conditions under which investors agree
to provide financing. The term sheet eventually segues into a formal agreement known
as the “Stock Purchase Agreement” which is a legal document that details who is buying
what from whom, at what price, and when.

The process of arranging venture financing is challenging. Negotiating deals with terms
that are satisfactory to both sides and ensuring that stakeholders’ interests are properly
aligned is crucial. This process begins with a term sheet.

The paragraphs below describe the key financial items in most term sheets, and numerical
examples are included to illustrate the most important concepts. Typically, term sheets
also contain additional control provisions.

VALUATION

Traditionally, companies in the industry assign value to enterprises after a financing

event. This approach is based on a per-share value and the valuation is on a fully diluted
basis.

Pre-money value is the valuation of a company immediately before an injection of

capital occurs. The pre-money value may be calculated as follows:

Pre Money Value = Total Number of Old Shares * Share Price

Pre Money Value = Post Money Value – New Investment

Post-money value is the valuation of a company including the capital provided by the
current round of financing:

This note was prepared by George M. Bene (T’02) under the supervision of Professor Colin C. Blaydon
and Adjunct Associate Professor Fred E. Wainwright of the Tuck School of Business at Dartmouth
College. Copyright © 2002.
 Deal Structures Note

Post Money Value = Pre Money Value + Investment

Post Money Value = Investment / Percent Ownership Acquired
Post Money Value = Total Shares (includes old and new) * Share Price
Share Price = Investment / Number of new shares issued

Step-ups describe the increase in share price from one financing round to the next. They
also describe the increase in the value of the company since the last round of financing.
Step-ups help motivate all the shareholders (both management and investors) to remain
engaged in the enterprise’s effort to build value. Note that if options have been issued
between financings, each of the two methods of calculating the step up will give different
results. The method using share price is the one generally cited.

Step-up = New round share price / Previous round share price

Step-up = New round pre-money valuation / Previous round post-money
valuation

EXAMPLE

Startup Company is a private company that is wholly owned by its founders, as shown
below:

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000

The founders need additional capital to expand the business and arrange venture capital
financing:

Owners/Investors Security Shares Investment

Series A Convertible preferred 4,000,000 $2,000,000

What are the pre and post-money valuations of Round A?

Post-money = $2,000,000 (investment) / 40% (ownership acquired) = $5,000,000

Post-money = 10,000,000 (new total shares) * $0.50 (price per share) = $5,000,000

Pre-money = 6,000,000 (previous total shares) * $0.50 (share price) = $3,000,000

Pre-money = $5,000,000 (post-money valuation) - $2,000,000 (investment) = $3,000,000

Step-up = $0.50 (new round share price) / $0.0083 (previous share price) = 60
Step-up = $3,000,000 (new round pre-money) / $50,000 (last round post-money) = 60

2
 Deal Structures Note

SECURITIES

Different investments have varying risk/reward characteristics which call for different
types of securities to accommodate investors’ goals. The most common types used in
venture capital transactions are described below.

Common stock is a type of security representing ownership rights in a company.

Common stock is generally not convertible into any other type of security. It entitles the
owner to one vote per share as well as any future dividend payments that may be issued
at the discretion of the Board of Directors. Furthermore, no special rights (e.g. anti-
dilution provisions, liquidation preferences, etc.) are generally associated with common
stock. Usually, company founders, management and employees own common stock
while investors own preferred stock. Claims of secured and unsecured creditors,
bondholders and preferred stockholders take precedence over those of the common
stockholders.

EXAMPLE

Startup Company is a private company that is wholly owned by its founders, as shown
below:

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000

The company arranges an A round of financing with a VC firm that agrees to provide $2
million in exchange for a 40% ownership stake:

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000
A Common 4,000,000 $2,000,000

Post-money valuation: $5,000,000

What are the implications to the VCs if they agree to accept common stock?

In the absence of restrictive covenants associated with the investment or a vesting period
for the founders, the founders maintain a controlling stake and are free to sell the
company under terms of their choosing. For example, if the founders sell for $4,000,000,
they would receive $2,400,000 (a substantial return on their $50,000 investment) while
the Series A investor would get only $1,600,000 for a $400,000 loss.

3
 Deal Structures Note

Convertible preferred stock provides its owner with the right to convert to common
shares of stock. Usually, preferred stock has certain rights that common stock does not
have, such as a specified dividend that normally accrues and senior priority in receiving
proceeds from a sale or liquidation of the company. Therefore, it provides downside
protection due to its negotiated rights and allows investors to profit from share
appreciation through conversion. The face value of preferred stock is generally equal to
the amount that the VC invested. For accounting purposes, convertible stock is usually
regarded as a common stock equivalent and is treated as such in valuing a company.

Typically, convertible preferred stock automatically converts to common stock if the

company makes an initial public offering (IPO). When an investment banking
underwriter is preparing a company to go public, it is critical that all preferred investors
agree to convert so the underwriter can show public investors that the company has a
clean balance sheet. Convertible preferred is the most common tool for private equity
funds to invest in companies.

EXAMPLE

In the example above, suppose that the Series A investor receives convertible preferred
stock with senior priority in receiving all proceeds from sale or liquidation, up to the
original investment amount ($2 million).

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000
A Convertible preferred 4,000,000 $2,000,000

Now, if the company were sold for $4 million, the Series A investor would choose not to
convert his shares to common and would receive:

Proceeds to Series A = $2,000,000 (original investment)

Proceeds to founders = $4,000,000 (sale price) - $2,000,000 (to Series A) = $2,000,000

When would a holder of convertible preferred stock choose not to convert?

If the company were sold for $5 million, then the Series A investor would be indifferent
to converting. He would receive $2,000,000 (40% of $5 million) through conversion to
common or as shown above. At a sale price above $5 million, the VC would choose to
convert.

Participating preferred stock is a unit of ownership that is essentially composed of two

elements -- preferred stock and common stock. The preferred stock element entitles an

4
 Deal Structures Note

owner to receive a predetermined sum of cash (usually the original investment plus
accrued dividends) if the company is sold or liquidated. The common stock element
represents additional continued ownership in the company (i.e. a share in any remaining
proceeds available to the common shareholder class). Like convertible preferred stock,
participating preferred stock usually converts to common stock (without triggering the
participating feature) if the company makes an initial public offering (IPO).
Participation can be pari passu or based on seniority of rounds. For example, if a C round
has seniority, then rather than A, B and C rounds sharing in the equity in accordance with
their percentage ownership of common, the C round will be paid first, then the B round,
and if there is any cash left, the A round.

EXAMPLE

Now suppose that amid a weak IPO market, the Series A investor in Startup Company
negotiates participating preferred shares with seniority over common up to the original
investment amount:

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000
A Participating preferred 4,000,000 $2,000,000

In this case, if the company were sold for $4 million, the funds would be distributed as
follows:

Proceeds to Series A = $2,000,000 (original investment) + $800,000 (40% * $2,000,000

remaining from sale) = $2,800,000

Proceeds to founders = $4,000,000 (sale price) - $2,800,000 (to Series A) = $1,200,000

Multiple Liquidation Preference is a provision that gives preferred stock holders of a

specific round of financing the right to receive a multiple (2x, 3x, or even 6x) of their
original investment if the company is sold or liquidated. A multiple liquidation
preference still allows the investor to convert to common stock if the company does well,
and it provides a guaranteed return (assuming the selling price is sufficient to cover the
multiple) if an IPO is unlikely.

EXAMPLE

Startup Company negotiates an A round of funding with the investor receiving 4,000,000
shares of participating preferred stock with a 3x liquidation preference for $2,000,000:

Owners/Investors Security Shares Investment

5
 Deal Structures Note

Founders Common 6,000,000 $50,000

A Participating preferred 4,000,000 $2,000,000

If the company were sold for $4 million, then the Series A investor would receive all of
the proceeds from the sale because the 3x liquidation preference entitles him to the first
$6 million (3 * $2,000,000 investment) generated by any sale or liquidation. The
founders would get nothing.

If the company were sold for $10 million, the Series A investor would once again choose
the multiple over conversion, since he would receive $6 million as opposed to $4 million
for his 40% share of the common stock. The founders would receive the remaining $4
million.

Series A would be indifferent between the two options at a sale price of $15 million,
above which he would choose to convert and receive his 40% share.

Redeemable preferred stock can be redeemed for face value at the choice of the
investor. Sometimes called straight preferred, it cannot be converted into common stock.
Usually, the terms of the issue specify when the stock must be redeemed, such as after an
IPO or a specific time period. Redeemable preferred gives the investor an exit vehicle
should an IPO or sale of the company not materialize.

Convertible debt is a loan vehicle that allows the lender to exchange the debt for
common shares in a company at a preset conversion ratio.

Mezzanine debt is a layer of financing that has lower priority than senior debt but
usually has a higher interest rate and often includes warrants.

Senior debt is a loan that enjoys higher priority than other loans or equity stock in case
of a liquidation of the asset or company.

Subordinated debt is a loan that has a lower priority than a senior loan in case of a
liquidation of the asset or company.

Warrants are derivative securities that give the holder the right to purchase shares in a
company at a pre-determined price. Typically, warrants are issued concurrently with
preferred stock or bonds in order to increase the appeal of the stock or bonds to potential
investors. They may also be used to compensate early investors for increased risk.

Options are rights to purchase or sell shares of stock at a specific price within a specific
period of time. Stock purchase options are commonly used as long-term incentive
compensation for employees and management.

ANTI-DILUTION

6
 Deal Structures Note

Dilution occurs when an investor’s proportionate ownership is reduced by the issue of

new shares. Investors are primarily concerned with “down rounds,” or financing rounds
that value the company’s stock at a lower price per share than previous rounds. Down
rounds may occur due to a number of factors like economic conditions or company
performance. Since investors cannot determine with certainty whether a company will
undergo a down round, they negotiate certain rights, or anti-dilution provisions referred
to as “ratchets,” that may protect their investment. The two most common mechanisms
are full ratchets and weighted average ratchets.

Full Ratchets protect investors against future down rounds. A full ratchet provision
states that if a company issues stock to a lower price per share than existing preferred
stock, then the conversion price of the existing preferred stock is adjusted (or “ratcheted”)
downward to the new, lower price. This has the effect of protecting the ratchet holder’s
investment by automatically increasing his number of shares. Of course, this occurs at
the expense of any stockholders who do not also enjoy full ratchet protection.

EXAMPLE

Assume that Startup Company has the ownership structure described in previous
examples, and that the Series A investor’s convertible preferred shares carry a full
ratchet:

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000
A Convertible preferred 4,000,000 $2,000,000

The company is not yet profitable and needs additional capital, but an IPO is not feasible
and the Series A investor is unable or unwilling to provide more funding. Consequently,
the company seeks funding from an outside investor, who is willing to invest $1 million
at $0.10 per share:

Owners/Investors Security Shares Investment

B Convertible preferred 10,000,000 $1,000,000

The Series A ratchet reprices the Series A convertible preferred stock at $0.10 per share,
giving Series A 20 million total shares:

Series A total shares = $2,000,000 (original investment) / $0.10 (new share price)
= 20,000,000

Startup Company’s ownership now looks like this:

Owners/Investors Security Shares Investment

7
 Deal Structures Note

Founders Common 6,000,000 $50,000

A Convertible preferred 20,000,000 $2,000,000
B Convertible preferred 10,000,000 $1,000,000

Note that the Series A investor now owns 56% of the company, Series B owns 28%, and
the founders have been “crammed down” to only 17%.

Finally, the valuations of Startup Company after the second round of financing are
calculated as follows:

Post-money = $1,000,000 (investment) / 28% (ownership acquired) = $3,600,000

Post-money = 36,000,000 (new total shares) * $0.10 (price per share) = $3,600,000

Pre-money = 26,000,000 (previous total shares, includes ratchet shares) * $0.10 (share
price) = $2,600,000
Pre-money = $3,600,000 (post-money valuation) - $1,000,000 (investment) = $2,600,000

EXAMPLE

Now suppose that instead of bringing in an outsider, the Series A investor decides to
provide the additional $1 million at $0.10 per share. If the investor decides to implement
the ratchet, the pre- and post-money valuations are calculated differently because there is
no new outside money:

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000
A Convertible preferred 20,000,000 $2,000,000
Same
investor B Convertible preferred 10,000,000 $1,000,000

Effective share price = $1,000,000 (investment) / 26,000,000 (new and ratchet shares) =
$0.038 per share

Post-money = 36,000,000 (new total shares) * $0.038 (effective price per share) =
$1,384,615

Pre-money = $1,384,615 (post-money valuation) - $1,000,000 (investment) = $384,615

In this case, the calculation is different because the same investor is acquiring both new
and ratchet shares through the B round investment. Note that the conventional approach
would value the company’s shares at $0.10 instead of $0.038 per share. Understandably,
this can be a sensitive issue.

8
 Deal Structures Note

Weighted average provisions are generally viewed as being less harsh than full ratchets.
In general, the weighted average method adjusts the investor’s conversion price
downward based on the number of shares in the new (dilutive) issue. If relatively few
new shares are issued, then the conversion price will not drop too much and common
stockholders will not be crammed down as severely as with a full ratchet. If there are
many new shares and the new issue is highly dilutive to earlier investors, however, then
the conversion price will drop more. The actual mathematical equation used may vary
from deal to deal, but a common form is as follows:

New conversion price = (A+C) / (A+D) * old conversion price, where

A = number of shares outstanding before the dilutive issue

C = number of shares that would have been issued at the old conversion price for the
investment in the dilutive round
D = number of shares actually issued in the dilutive round

The weighted average protection may be broad-based, taking into account all shares
outstanding before the new dilutive issue (A is calculated on a fully-diluted basis), or
narrow based, where A may take into account only preferred stock or omit options
outstanding.

EXAMPLE

Taking Startup Company as in the first ratchet example, now assume the Series A
investor’s convertible preferred shares have broad-based weighted average anti-dilution
protection:

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000
A Convertible preferred 4,000,000 $2,000,000

A new, outside investor agrees to fund a B round of financing as before:

Owners/Investors Security Shares Investment

B Convertible preferred 10,000,000 $1,000,000

Applying the weighted average formula,

A = 10,000,000 (number of shares before the B round)

C = $1,000,000 (new investment) / $0.50 (old conversion price) = 2,000,000 (number of
shares that would have been issued at the old conversion price)
D = 10,000,000 (new shares actually issued)

New conversion price = (12,000,000 / 20,000,000) * $0.50 per share = $0.30 per share

9
 Deal Structures Note

Therefore, the Series A investor receives $2,000,000 / $0.30 – 4,000,000 = 2,666,667

new shares:

Owners/Investors Security Shares Investment

Founders Common 6,000,000 $50,000
A Convertible preferred 6,666,667 $2,000,000
B Convertible preferred 10,000,000 $1,000,000

In this case, the Series A investor now owns 29%, Series B owns 44%, and the founders
retain 26%

Pay-to-play (aka Play or Pay) Provisions are usually used with price-based anti-
dilution measures, these provisions require an investor to participate (proportionally to
their ownership share) in down rounds in order to receive the benefits of their anti-
dilution provision. Failure to participate results in forced conversion from preferred to
common or loss or the anti-dilution protection. This encourages VCs to support
struggling portfolio companies through multiple rounds and increases the companies’
chances of survival.

OTHER ISSUES

In addition to the key financial provisions described above, term sheets usually include a
number of other important items related to control, and a mix of financial and non-
financial terms is common. Many of the provisions described in this paper, both financial
and non-financial, tend to be used more often during difficult economic times. It should
be noted that overly burdensome, shortsighted terms may misalign interests and invite the
competition to provide a better deal. Some non-financial terms are discussed below:

Voting Rights. Term sheets often address issues of control in order to allow investors in
a company to add value and also to exercise control if things go wrong. While investors
may not want majority board control if things are going well, they may negotiate
provisions that give them control if certain events occur. The golden rule often applies:
he who has the gold makes the rules.

Board Representation. Venture capitalists may negotiate control of part of the Board of
Directors, generally to influence decision-making and to protect their investments rather
than to run the company. Often, classes of stockholders are allowed to elect a percentage
of the board members separately. If venture capitalists invest as a syndicate and board
representation is not possible for all of the participating firms, then board observer rights
are an option. These rights allow investors to monitor their portfolio companies and to
influence decisions by being present at board meetings, but they are not allowed to vote.

10
 Deal Structures Note

Covenants. Most preferred stock issues and debt issues have associated covenants, or
things that the portfolio company promises to do (positive covenants), and not to do
(negative covenants). They are negotiated on a case-by-case basis and often depend on
other aspects of the deal. Failure to comply with covenants can have serious
consequences such as loss of board control.

Vesting. This provision states that a manager or entrepreneur earns ownership of

common stock or options only after a predetermined period of time or after the company
achieves certain milestones. The most important effect of vesting is that it motivates
employees to stay with the company and may prevent them from leaving prematurely to
pursue other opportunities.

Bridge Loans. Bridge financing can be used to prepare a company for sale or as a pre-
round financing. A bridge is, in essence, short term financing designed to be either repaid
or converted into ownership securities. In the sale case, a bridge is useful when a
company needs a relatively small amount of capital to achieve its final targets and
achieve maximum value in the eyes of potential buyers. A bridge is also useful to pump
cash into a company quickly while investors are found to complete a formal round of
financing. Bridge investors often insist on warrants or equity kickers to compensate them
for the higher risk of lending money to high growth ventures. If the bridge becomes a
pier, that is, no additional sources of funding step up to the challenge, then the bridge
lenders have senior rights to any equity holders for the remaining assets of the company.

Phased financing. A venture capital firm may agree to phased financing, or incremental
financing in tranches. In this case, the entrepreneur and his or her team must reach certain
milestones in order for the venture capitalist to agree to invest more capital in the startup.
This has the additional benefit of allowing the startup and the venture firms to trumpet
the larger commitment amount, generating positive PR, while limiting the actual cash
disbursements until the startup has proven itself.

Staged financing may also cause misalignment of goals, however, since management
may be motivated to cut corners to achieve milestones rather than focusing on the long
term health of the company, its customer relationships, and the value of its products and
services.

11
 Deal Structures Note

REFERENCES AND SELECTED READING

Structuring Venture Capital, Private Equity and Entrepreneurial Transactions, Jack

Levin, Aspen Publishers, 2001

Venture Capital Due Diligence, Justin J. Camp, John Wiley & Sons, 2002

Dictionary of Finance and Investment Terms, John Downes and Elliot Goodman,
Barron’s, 1998

VC Library, www.vcexperts.com

Note on Securities and Deal Structure, Colin Blaydon and Fred Wainwright, Tuck
School, 2001

12
 Case # 5-0019

Updated August 14, 2003

Note on Limited Partnership Agreements

Private equity investment funds have a fixed term that is typically ten years with
possible one to two year extensions. Investment fund managers and their sources of
capital must develop sophisticated agreements that can stand the test of time. These
agreements should ensure that appropriate long-term frameworks, boundaries and
alignment of interests are in place.

By far the most common legal structure for private equity funds is the limited
partnership. The name refers to the limited liability of the providers of capital,
called the “limited partners” or “LPs.” The investment manager is the “general
partner” or “GP.” The partnership is governed by a limited partnership agreement
(“LPA”) negotiated and signed by the parties involved.

In U.S. private equity funds, each LP must be an “accredited investor,” which is a

person or legal entity, such as a company or trust fund, that meets certain net worth
and income qualifications and is considered to be sufficiently sophisticated to make
investment decisions about complex securities and businesses. Regulation D of the
Securities Act of 1933 permits accredited investors to invest in a private partnership
without the protections of a registered public offering under the Securities Act.
Qualifications for a person are: $1 million net worth or annual income exceeding
$200,000 individually or $300,000 with a spouse.

The GP manages the day-to-day activities of the partnership and has unlimited
liability for the actions of the partnership. To mitigate this risk, a GP may be formed
as another partnership or a limited liability company (“LLC”). An LLC is like a
corporation, but with the tax benefit of flow-through of income and losses to

This case was prepared by Adjunct Assistant Professor Fred Wainwright under the supervision of
Professor Colin Blaydon of the Tuck School of Business at Dartmouth College. It was written as a
basis for class discussion and not to illustrate effective or ineffective management practices.

Copyright © 2003 Trustees of Dartmouth College. All rights reserved. To order additional copies,
please call (603) 646-0522. No part of this document may be reproduced, stored in any retrieval
system, or transmitted in any form or by any means without the express written consent of the Tuck
School of Business at Dartmouth College.
Note on Limited Partnership Agreements Case # 5-0019

individual owners. In addition, the GP may establish a separate management

company (typically a corporation) to provide management services to the fund or a
family of funds.

In analyzing private equity limited partnership agreements, several key concepts

should be understood.

Management fee

This is a fee charged by the GP to the LPs. Management fees in a private equity
fund typically range from 1.5% to 2.5% of committed capital, depending on the
type and size of fund. This fee structure differs from that of mutual fund managers,
which invest in public markets and on average earn less than 1% of assets under
management.

The GP management fee may vary over the life of the fund, generally decreasing
over time, as the LPs’ original committed capital is paid back from investment
returns. The argument for decreasing the fee is that the bulk of the GP’s effort is
during the first 5 to 6 years of the fund as compared to the monitoring and
distribution phase of the fund. Furthermore, GPs are willing to give up management
fees in the later years of a fund in anticipation of raising subsequent funds that
generate additional streams of management fees.

An alternative to the percentage fee system is a budget-based fee. An annual budget

is developed by the GP and LPs with the help of the advisory board to operate the
GP on a break-even basis. This preserves the incentive for the GP to seek its
primary compensation through its “carried interest” (see below) in the fund’s
profits, rather than through the management fee.

Before the 1990’s, most private equity funds were flat organizations with minimal
staffing. An institutionalization trend has developed since the early 1990’s that has
led to geographical networks of affiliate funds, families of venture capital and
buyout funds, joint ventures with mutual funds and other relatively complex
structures.

Typically, buyout funds derive significant consulting and advisory fees from
portfolio companies, in addition to the management fees from the funds. In some
cases, LPs try to limit or share in those portfolio company fees in order to
incentivize the GP to generate capital appreciation.

Center for Private Equity and Entrepreneurship 2

Note on Limited Partnership Agreements Case # 5-0019

Carried interest

Carried interest is the GP’s share in the profits of a private equity fund. Typically, a
fund must return the capital given to it by the LPs before the GP can share in the
profits of the fund. The GP will then receive a 20% of the net profits as “carried
interest,” although some successful firms receive 25%-30%. This fee is also known
as “carry” or “promote.” Many funds must also require repayment of management
fees from investment proceeds before the GP can receive any carry.

Some LPAs include a minimum rate of return on the capital invested before the GP
can earn any carry. This minimum rate is often called “hurdle rate” or “preferred
return.” Hurdle rates typically range from 5% to 10%. Other LPAs require that the
GP generate sufficient investment profits to repay original capital, management
fees, and the preferred return on all capital invested before the GP can earn any
carry. Some LPAs allow the GP to earn a carry on a deal-by-deal basis, that is, the
GP receives the carried interest on the profits on each deal as it is liquidated without
being required to first return all contributed capital.

Commitment

Commitment refers to the maximum amount of capital that an individual LP agrees

to invest in a fund. The commitment generally includes management fees charged
by the GP, as well as other fund expenses.

LPs often insist that GP members individually invest in the partnership. Historically
a 1% capital commitment from the GP was required for tax reasons. Although the
tax laws have eliminated this requirement, it remains an industry standard and many
successful GPs contribute even more. Some GPs may make their capital
contribution in the form of promissory notes, although LPs are less tolerant of this
practice lately.

Takedown

This term is used in two ways. First, in reference to a schedule of transfer of capital
in phases in order to complete a commitment of funds. Second, and more
commonly, in reference to a single payment by an LP of a portion of a total
commitment of capital. In this sense, takedown is synonymous with “drawdown”
and “capital call.” Relatively large, early payments from LPs are inefficient because
cash waiting to be invested earns minimal interest, which depresses the fund’s
overall returns. Consequently, just-in-time drawdowns of capital as needed have

Center for Private Equity and Entrepreneurship 3

Note on Limited Partnership Agreements Case # 5-0019

become the norm. The partnership agreement generally places a limit on the time
period over which funds are invested (the “investment period”), which typically
does not exceed 6 years.

Distribution and “Clawback”

As investments are monetized via private sales and mergers or public stock
offerings, the LPA specifies how profits are allocated. The timing and form of
distribution (cash vs. securities) will also be defined. This includes clawback
provisions, which give LPs the right to reclaim a portion of carried interest
disbursements to a GP for early profitable investments if there are significant losses
from later investments in a portfolio. The goal is for disbursements to match the
targeted carried interest (for example, an 80/20 split of the cumulative net profit
between LPs and the GP). These issues can become very complex in negotiation of
the partnership agreement.

Termination and No-fault “Divorce”

LPs can generally terminate their participation in a fund under extreme

circumstances, such as the death or withdrawal of key members of the GP group
efforts of the partnership. Such “key person” provisions protect them against the
departure of key GP members. Usually a clause exists that allows the LPs, acting
with a majority or super-majority vote, to terminate the fund if they have lost
confidence in the GP. It is likely that any such move will lead to litigation.

Occasionally, an LP will lack sufficient cash to fulfill its commitment or wish to

exit a fund for other reasons. GPs will typically help the LP sell its interest in a
secondary market (usually at a discount to net asset value). If this cannot be
arranged, the GP may impose severe default penalties that may wipe out an LP’s
entire investment. However, several multibillion dollar funds have been raised in
the past few years specifically to purchase LP interests. Despite continued
information asymmetry among participants in private equity, there is some liquidity
in LP interests.

Many institutional investors require excuse clauses that are triggered if regulatory
changes prevent them from continued participation in private equity funds.

Center for Private Equity and Entrepreneurship 4

Note on Limited Partnership Agreements Case # 5-0019

Investments

According to a typical LPA, a fund has to make most of its investments during the
first four to six years of its existence. Although LPs cannot control the actions of
the GP (thus risking the loss of liability protection provided by the limited
partnership), LPs may require that the GP commit to invest only in specific industry
sectors of expertise. Generally, there is wide latitude for GP discretion in
investment thesis, since markets shift and new opportunities may develop over time.
However, there is always a restriction on the size of any one investment the GP can
make in a specific company. This encourages diversification and can prevent
“spending good money after bad,” whereby a GP uses cash to attempt to salvage a
persistently unprofitable investment.

Private equity funds are typically unleveraged. GPs are restricted in the amount of
debt the fund can incur. This does not prevent a fund’s portfolio companies from
borrowing. Another important restriction, usually more common in the venture
capital industry than in buyouts, applies to cross-fund investing. Each fund is a
separate entity. A GP usually cannot use capital from one fund to make investments
in companies already funded through an earlier fund managed by the same GP.
Individual GPs are often prevented from investing personal capital in startups
funded by the partnership. If they convince the LPs to waive this, then the LPs
require that the GP individual invest only in the same financing round with the
same terms as the fund. Sometimes LPs are allowed to invest additional capital in a
portfolio company with the same terms as the fund. In such cases the LPs are
considered co-investors in the round.

Private placement memorandum (PPM)

A PPM is a formal document explaining the details of a proposed private equity

partnership to potential investors. Typical sections of a PPM include:

• Executive summary
• Investment performance / track record
• Investment thesis
• Investment strategy
• Competitive advantage
• Management biographies
• Board of advisors
• Summary of terms of partnership

Center for Private Equity and Entrepreneurship 5

Note on Limited Partnership Agreements Case # 5-0019

• Potential risks
• Applicable regulatory, tax and securities laws
• Accounting and reporting practices

The PPM is often the starting point for meetings, discussions and negotiations
among a potential LP and GP, which if successful, ultimately lead to a final LPA.

Center for Private Equity and Entrepreneurship 6

Note on Limited Partnership Agreements Case # 5-0019

References and Selected Reading

• Structuring Venture Capital, Private Equity and Entrepreneurial Transactions,

Jack S. Levin, Panel Publishers, 2001
• Private Equity Partnership Terms and Conditions, David Toll et al., Asset
Alternatives, 1999
• Equity Finance, Joseph Bartlett, Wiley Law Publications – John Wiley & Sons,
1995
• The Economics of the Private Equity Market, George Fenn et al., Federal
Reserve, 1995
• Venture Capital & Public Offering Negotiation, Michael J. Halloran et al,
Aspen Law & Business, 1994

Center for Private Equity and Entrepreneurship 7

LBO in practice: structuring and modeling
Readings
• Vernimmen Letter articles on LBOs
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• NEWS: Creating and sharing values in LBOs
•THIS MONTH'S TABLE: Debt as a % of GDP
• RESEARCH PAPER: Competitive IPO
• Q&A: Contingent convertible capital
***
N° 51 NEWS: Creating and sharing value in LBOs

June 2010 It may seem a bit odd to be talking about creating value through LBOs at a time
when, firstly, the number of LBOs has hit a low point (in the UK, 2009 saw the
same number of LBOs as in 1995!) and secondly, it is estimated that around
80% of LBOs have breached covenants (even though official statistics on the
basis of statements are a lot more modest), thus demonstrating that they have
not got off to a good start in terms of value creation.
We have always thought and written (1) that LBOs will take off again as they
present, in a certain number of cases, a form of governance that is better than
that of the family-run company or of a listed company. We are now seeing the
beginnings of the return, for several reasons:
• the return of IPOs (Amadeus, which belonged to BC Partners and Cinven was
listed in Madrid on April), giving the LBO investors the cash they needed for a
kick-start;
• the dazzling reopening of the high yield bond market (2) (Novasep raised
€370m in December, Virgin Media hoped to raise £500m in January, and faced
with demand, was able to raise £1,500m) which could become a major, and no
longer marginal, means of financing LBOs. This dynamic behaviour recalls that
of the investment grade bond market during the worst moment of the crisis, at a
time when it was difficult to borrow from banks;
• a slight relaxing of restrictions at lending banks which are again keen to
finance LBOs, although obviously only if conditions are attractive and leverage
reasonable.
Ultimately, in response to the rather traumatising situation for many over the
last two years, two new implements, which could clearly boost the market’s
Next month : rebound, have been added to the Private Equity “tool box”.
- NEWS: Financial But on the strength of this, can we really refer to a sustainable rebound? Over
analysis of Brazilian the last months of 2009, more or less everywhere in the world, volumes of new
groups operations rose from one month to the next, the sort of growth that had not
been seen for a long time. We were, however, starting out from a very very low
point. Let’s wait a few months to see whether the trend is confirmed.
- GRAPH: Working
capital of the Finally, readers who know us will know that even in this section, entitled “News”,
Eurostoxx 50 we try and see further than the end of our noses!
(1) For example in the introduction of the 2009 edition of the Vernimmen.
(2) For more information on high yield bonds, see chapter 25 of the Vernimmen.
- RESEARCH PAPER:
Equity or cash

- Q&A: Steps of an
M&A process
THE VERNIMMEN.COM NEWSLETTER: AND TO THE WEB SITE
COMPLEMENTARY TO THE BOOK WWW.VERNIMMEN.COM
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Several recently published studies(3):

• the first study analyses 241 LBOs carried out between 1999 and 2006, with
85% in Europe and equity capital investments between €1m and €4.3bn,
making this one of the widest ever samples for a study;
• the second study analyses 66 LBOs in the UK between 1996 and 2004, most of
which were exited between 2000 and 2007;
• the BCG and IESE study is based on the study or the performances of 218
private equity funds from 1979 to 2002;
N° 51 arrive at converging results.
On average, an investment in the equity capital of a private equity fund is
June 2010
multiplied by 2.72 over an LBO period of 3.5 years, or an IRR on equity capital
of 48%. This result is explained by the huge success of certain investements,
with IRRs of over 300% (sic). The median IRR "is only” 33%. On entry, the
debt / EBITDA ratio is 4.2 and on exit it is 2.7.
The authors break down this multiplying factor of the initial stake of 2.72 as
follows:
• the leverage effect of the debt which increased IRRs and multiplying ratios,
accounts for 0.89 points out of the 2.72, which is only one-third;
• the effect on the period studied of the increased multiples (value of capital
employed / EBITDA, EV / EBITDA), accounts for another 0.47 points, or 17%;
• the rest, or half, comes from operational improvements: growth of EBITDA
accounts for 29% and the effect of cash flow generation allows for deleveraging
of 15%. For its part, growth in EBITDA is explained mainly (77%) by the
increase in sales and 23% by the increase in the EBITDA margin/Sales ratio.
When the analysis is taken deeper, we see that over the recent period (2001-
2006), leverage effects have increased compared with the previous period
(1989-2000), resulting in higher rates of return, with a cost of risk that is
naturally higher, although the share of EBTIDA growth is a lot smaller, showing
that less value has been created.
The best IRRs are obtained on investments made during poor economic periods
(1991-1993 and 2001-2003) while most of the operational improvement comes
from the growth of sales. Warren Buffet couldn’t put it better!
The authors also look, over the same period, at the capital employed (i.e. by
neutralising the leverage effect resulting from the debt) of an investment in the
shares of listed companies in the same sectors of activity in Europe, and with
the same EBITDA margins / sales at the time the LBO was put in place. They
show a superperformance of companies under LBO corresponding to six
additional IRR points, excluding the leverage effect, and accordingly for a
comparable capital structure. The IRR of LBOs is 31% compared with 25% for
comparable listed companies.
Which amounts to saying that over an average LBO period of 3.5 years, an
investment of 100 becomes 100 x 1.31 ^ 35 = 257. Which makes a capital gain
of 157. Managers of LBO funds take around 20% of the capital gain as carried
interest, or 31, and 2% per year of the funds managed, or 7.

(3)Value Creation in Private Equity by A.K. Achleitner (Centre for Entrepreneurial and Financial
Studies – Capital Dynamics ; Corporate governance and value creation : Evidence from Private
Equity by V. Acharya, M. Hahn and C. Kehoe ; The advantage of persistence by H. Meerkatt, J. Rose,
M. Brigl (BCG) and H. Liechtenstein, M. Julia Prats and A. Herrera (IESE).

2
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So, in total, the net capital gain for the investor is 157 - 31 - 7 = 119, or an IRR
over 3.5 years of 25%. In other words, as much as an investment in the shares
of a listed company, which means two things:
• the managers of LBO funds do create value for their shareholders, the
investors in the fund;
• but, they claw, on average, all of it back and sometimes more since the
calculation does not factor in the cost of the illiquidity of the investment in these
LBO funds compared with the liquidity of a stock market investment.
N° 51
The BCG study comes to the same conclusions.
June 2010 However, investors have cottoned on to this because, except for private equity
funds with a well-established track record of regular superperformances, the
20%/2% remuneration rule is a thing of the past.
It remains to be understood how the managers of LBO funds are able to improve
the operational performances of companies that they have bought through
LBOs.
There are reasons, linked to the corporate governance put in place, why the
interests of the managers of the company under LBO are strongly aligned with
those of the fund. The dual effect of the managers of the operational company
getting a share in the financial performance of the LBO on its investment, and
the restriction of the debt which pushes them to be more efficient in the
generation of free cash flows(4) (5).
Additionally, the last two studies show that over and above the implementation
and the functioning of another form of corporate governance, managers of the
LBO funds are capable of outperforming when:
• the partners are specialised in a number of economic sectors that they know
like the backs of their hands, which makes them more industrial than financial
specialists;
• the partners are focussed because, the quicker the experience curve can be
reduced, the bigger the competitive advantage that can be built;
• the partners have the ability to get involved upstream in order to detect future
operations (the famous investment fund angle), enabling them to win over the
managers of the target more easily and to speed up the purchasing process;
• the partners have real skills in improving the operational efficiency of firms,
sometimes going as far as to get personally involved in the management of the
company under LBO.
The multiplication of the number of LBO funds over the last 10 years has
certainly diluted to some degree, the average skills, and finding an angle is
becoming increasingly complex.
That said, given that a number of LBO funds are going out of business as a
result of their poor performances, and these include the most recent arrivals on
the market, the average level should improve in the near future.

(4) We have always told our students that more Olympic records would be broken if we put crocodiles
behind the swimmers!
(5) For more on agency theory, see chapter 31 of the Vernimmen.

3
 The Vernimmen.com
The Vernimmen.comnewsletter
newsletter

Annual amounts raised by private equity funds at a worldwide level

1400 700

1200 600

1000 500

800 400

N° 51 600 300

400 200

June 2010
200 100

0 0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

N u m b e r o f fu n d s c r e a te d F u n d s r a is e d ( M d $ )

Source: Preqin.

***

THIS MONTH’S TABLE: Debt as a % of GDP

Although the debt issued by Japanese governmental bodies is the highest in the
sample, at 197% of GDP, 93% of it is held locally (this figure is 44% for
France), which makes it easier to bear.

Borrower USA United Kingdom Japan Germany France Italy Spain Switzerland China India Russia Brazil

Government 67% 59% 197% 73% 80% 109% 56% 37% 32% 66% 5% 66%

Non financial
79% 110% 95% 69% 114% 83% 141% 75% 96% 42% 40% 30%
corporation

Households 97% 103% 69% 64% 44% 41% 87% 118% 12% 10% 10% 13%

Financial
53% 194% 110% 80% 84% 82% 82% 84% 18% 11% 16% 33%
institutions

Total 296% 466% 471% 285% 323% 315% 366% 313% 159% 129% 71% 142%

Date Q2 2009 Q2 2009 Q2 2009 Q2 2009 Q2 2009 Q2 2009 Q2 2009 2007 2008 2008 2008 2008

Source : Debt and deleveraging: The global credit bubble and its economic consequences McKinsey Global Institute, Janvier 2010.
Highest debt Lowest
ratios debt

In the developed world, the size of companies' debt in relation to GDP is largely
due to the degree of their internationalisation and accordingly to their size
(since the largest corporations are the most international): United Kingdom,
France, Switzerland. Alternatively, it reflects a high level of debt compared with
the cash flow generated: China, Japan, Spain.

4
LBO in practice: structuring and modeling
Readings
• McK Kinsey articles on PE
McKinsey on Finance

Perspectives on The crisis: Timing strategic moves 1

Corporate Finance Timing is key as companies weigh whether to make strategic investments now or
and Strategy wait for clear signs of recovery. Scenario analysis can expose the risks of moving too
quickly or slowly.
Number 31, Just-in-time budgeting for a volatile economy 6
Spring 2009 A volatile economy makes traditional budgets obsolete before they’re even completed.
Here’s how companies can adapt more quickly.

The future of private equity 11

These funds face a credit-constrained world; they must adapt to thrive.

The voice of experience: Public versus private equity 16

Few directors have served on the boards of both private and public companies.
Those who have give their views here about which model works best.

The economic impact of increased US savings 22

US consumers are spending less and saving more. The economic impact of that
combination will depend upon how fast incomes grow.

Opening up to investors 26
Executives need to embrace transparency if they want to help investors make
investment decisions. But what should be disclosed?
 11

The future of private equity

These funds face a credit-constrained world; they must adapt to thrive.

Conor Kehoe and Is there life after leverage for private equity? The global financial system is struggling to
Robert N. Palter work its way out of disaster: banks are flat on their backs, equity markets have plummeted,
and a business culture built on leveraged portfolios has come unhinged. The future of
private equity is one of the more intriguing questions for corporate finance and corporate
governance alike.

It may seem hard to be sanguine about Yet the prognosis isn’t entirely bleak. In
the sector’s long-term prospects. With returns our experience, the sector’s strengths have
under pressure, private-equity firms come not from its use of leverage but
will struggle to perform.1 The megabuyouts from its ability to marshal resources, both
(deals valued at more than €5 billion) human and financial; its strong incentives
that absorbed so much of the sector’s capital to adapt quickly; and its active ownership.
since 2004 are nowhere to be found. Some Opportunities do exist: megadeals may
limited partners—in particular, sovereign- have vanished, but not medium-sized or all-
wealth funds—have shown a willingness to equity deals. Moreover, private-equity firms
bypass private-equity firms and strike out are well poised to stand in as a new class of
on their own. With an estimated $470 billion shareholder in the overturned public-
in committed but unused funds, the sector equity market, in developing economies, and
faces an enormous challenge just finding in financial institutions. Despite the current
ways to invest. Finally, its portfolio companies, difficulties, it bears remembering that the best
with their high debt levels, may become private-equity firms have persistently
1
Even the venerable 2 percent management financially distressed and default in the event outperformed both their private-equity
fee and 20 percent carry structure may be of only small downturns in sales and counterparts and the public-equity markets,
vulnerable as limited partners respond to the
current crisis and the weakening perfor- EBITDA.2 Recent bankruptcies of several in good times and bad, over the past two
mance of buyout funds.
2 private equity–backed companies hint decades. The winners will be firms with the
Earnings before interest, taxes, depreciation,
and amortization. at how dark the future may be. wits to adapt to a much harsher environment.
 12 McKinsey on Finance Spring 2009

Managing the downturn through external support networks—than

Right now, the first priority for the vast they had in previous downturns. In the
majority of private-equity firms is mitigating short term, all the committed but unused
the recession’s impact on portfolio capital could be turned to advantage
companies and, to some extent, on cash- if it were deployed in overstretched portfolio
strapped limited partners. companies. And the lessons of the 1990
downturn, when the debt levels of private
equity–owned companies were much
Contrary to common perceptions, the challenges higher, suggest that even if such companies
portfolio companies face do not result from levered risky go into bankruptcy, they are more
valuable than they would have been without
investments
private-equity ownership,4 despite the
costly process of managing the reorganiza-
Yet contrary to common perceptions, the tion. That’s good news for employees
challenges portfolio companies face do not and customers, if not equity investors.
result from levered risky investments.
The average private equity–owned company, There will of course be failures, even in
despite its higher initial leverage, is only the short term, and each private-equity firm
slightly riskier than an average public-market should move aggressively to reduce the
company. Indeed, although the typical threats in its portfolio’s cash, cost, and risk
leveraged buyout starts with more than twice position and to mitigate their effects.
the leverage of its public-market counter- What’s more, since exits are now very difficult,
part, its leverage is often lower on exit.3 In it will be necessary to learn how to manage
addition, research shows that private- portfolio companies beyond the normal
equity firms tend to buy steady companies three- to four-year cycle, without letting
whose volatility, before the extra leverage, returns slip. Some private-equity firms
is about two-thirds that of companies listed are already addressing this problem by
on public markets. Portfolios tend to be simulating an internal sale when the initial
concentrated in companies and sectors less value creation plan runs its three-year
susceptible to the effects of booms and course—in other words, forcing themselves
busts—a critical condition for supporting the to take an outsider’s perspective to identify
higher initial leverage the private-equity missed opportunities. These firms review such
model has typically deployed. Not surprising, companies and their industries and
private-equity portfolios, though spread appoint new internal teams, if necessary,
across most industries, are underrepresented to develop another value creation plan,
in the battered construction, automobile, to change management, or to conduct a due-
and financial-services sectors. We expect the diligence process as if the firm were buying
3
See Alexander Groh and Oliver Gottschlag, revenues and before-interest earnings the business anew.
“The risk-adjusted performance of US buyouts,”
Groupe HEC , Les Cahiers de Recherche, of private equity–owned companies will fall
Number 834, January 2006; and Viral V. Acharya, less than those of companies listed in Finally, many private-equity firms that
Moritz Hahn, and Conor Kehoe, “Corporate
governance and value creation: Evidence from public markets. expanded their staffs and opened new offices
private equity,” working paper, January 2009. during the recent investment surge must
4
See Gregor Andrade and Steven N, Kaplan,
“How costly is financial (not economic) distress? Moreover, private-equity firms also enter now make do with less. Even the top
Evidence from highly leveraged transactions
this downturn with much stronger performers can expect smaller funds and
that became distressed,” Journal of Finance,
1998, Volume 53, Number 5, pp. 1443–93. operational capabilities—either in house or lower fee income in the next few years.
 The future of private equity 13

Managing investors entirely if they wish by investing their cash

Private-equity firms will need to manage directly. Their recent direct investments
their relationships with investors carefully. already include the stakes that the govern-
Limited partners are not protected from the ment of Singapore and the Kuwaiti
general downturn. Some are having difficulty Investment Authority took in Western banks
meeting their commitments to provide last year, as well as the holdings of direct-
funds—in particular, because reduction in the investment arms such as Mubadala Develop-
value of quoted equities has mechanically ment (Abu Dhabi) and Temasek Holdings
increased the percentage of assets allocated to (Singapore). It can be tricky for sovereign-
private equity.5 Further, the difficulty of wealth funds to be assertive and active
exiting from portfolio companies means that owners, though, especially in Western com-
money from private-equity funds is flowing panies. Investing through private-equity firms
back much more slowly than might have raises fewer political hackles, but the firms
been expected. Some supposedly liquid assets, will need to sharpen their value proposition.
which limited partners could otherwise
have sold to finance private-equity cash calls, By and large, the sector is well prepared
aren’t nearly as liquid as had been assumed. for these challenges. Active ownership is its
biggest competitive advantage over
Except in extreme circumstances, limited companies in the quoted market: the best
partners probably won’t default—they’d risk private-equity firms are more effective
losing the cash they have already subscribed because of their stronger strategic leadership
and access to top funds—but they may and performance oversight, as well as their
pressure private-equity firms to reduce fees, ability to manage key stakeholders.6 Firms
commitments, or both if investment must continue to hone these skills and
opportunities don’t open up soon. In the to ensure that they are applied consistently.
near future, limited partners may also Even the better firms have a great deal of
demand improved terms before subscribing opportunity for improvement—particularly
to new funds and invest lower amounts in in attracting partners with the right operating
them. Private-equity firms should act strate- skills, getting a better balance between
gically in these situations by giving some financiers and active owners, adding people
limited partners more flexible terms if they who have experience in downturns, and
experience short-term difficulties. This reviewing the current portfolio with the rigor
approach could play an important role in traditionally devoted to new investments.
maintaining relationships with attractive
long-term funding sources. Finding new ways to invest
In the long term, the math of deploying the
A relatively new class of private-equity industry’s $470 billion in committed but
investor—sovereign-wealth funds—needs uninvested capital looks challenging. Forty
particularly careful nurturing. These long- percent (about $240 billion) of the equity
term investors constitute a very large group capital that private-equity firms invested
5 Private equity–owned companies aren’t always in the aggregate, with $3 trillion in total from 2004 to 2007 financed 55 megadeals
marked to market, yet the investors’ public assets in 2007 and a projected $8 trillion in (2 percent of all private-equity deals).
securities are—so the value of the latter appears
to have declined much more. the next decade. By the end of 2007, It could take a long time for megadeals to
6
See Viral Acharya, Conor Kehoe, and Michael
Reyner, “The voice of experience: Public versus
they had committed about $300 billion to the reemerge if recently completed ones
private equity,” in this issue. private-equity sector, but they can bypass it perform less well than quoted companies
 14 McKinsey on Finance Spring 2009

do.7 And even if the core midmarket leveraged Developing markets

buyout comes back quickly, it probably Companies in developing markets enjoy
won’t absorb all the available capital, so the favorable demographics and are opening
sector must look for new investment up to the global economy. Nonetheless,
opportunities. Given its current market immature regulatory and legal systems, along
share—the value of the capital that private with a lack of transparency, can bedevil
equity controls equals only some 2 to 3 per- outside investors who lack connections to
cent of the total value of all the equity the companies in which they invest.
quoted on public markets—more opportu- Although those companies may have local
nities for active owners exist, though sources of new money, they often lack
few are proven. the value-adding capital that experienced
private-equity firms can offer. In particular,
Private investment in public equity family-controlled companies that aim to excel
One way for private-equity firms to use their internationally see them as a way to
ownership expertise would be to channel gain expertise previously available only from
some of the capital under their control into multinationals. Private-equity firms can
public companies through private investment deploy their managerial and sectoral know-
in public equity (PIPE)8 and to assert how to help such companies, family
themselves, even without complete control, owned or otherwise, and to provide close
on the boards of those companies. The local supervision on behalf of the firms’
benefit to a public company’s executives— international investors. These companies are
besides quick access to capital—would a very important long-term outlet for
be the commitment of a shareholder that will private-equity firms, though from 2003 to
be stable in the medium term and perhaps 2007 their investments outside Europe
provide them with private equity–style and North America accounted for only
incentives to ensure that the company acts in around 5 percent of their $630 billion of
the interest of shareholders. Private-equity invested equity.
firms will need to learn how to operate in
7
After the late-1980s collapse of the junk- public companies, however. Private-equity Financial institutions
bond market, the $25 billion (enterprise value)
RJR Nabisco deal of 1998, at more than
board members can help a public company In the past, private-equity firms seldom
8
90 percent leverage, wasn’t topped until 2006. focus on shareholder value, as well as offer invested in financial institutions, like banks
The purchase of stock, at a discount to the
current market value per share, by a private- their own time and the resources of their and insurance companies, which are
investment firm, mutual fund, or other firms and networks. But they have much to already leveraged to very high levels set by
qualified investor for the purpose of raising
capital for the issuing company. The learn from their public-market colleagues regulators, as the current banking crisis
discount is needed when companies seek to about communicating with a dispersed body has clearly demonstrated. Yet today such
raise significant capital or when there
is an illiquidity provision in the agreement. of stakeholders and compliance with institutions provide a fascinating oppor-
public-market regulation. tunity: they may be cheap, their productivity
varies widely, and recent events show that
they clearly need more intense governance
and will face demands that they obtain it.
The board of an average bank, for example,
could add considerable value by resolving
to use a private equity–like approach
to improve the bank’s operational and risk-
management practices. Measuring the
value of so-called toxic assets presents real
 The future of private equity 15

difficulties to a private-equity transaction, that private equity has persistent outperfor-

however, and these risks may be too mers and underperformers has been
great unless the authorities hive off such analytically substantiated and taken root.
assets to a “bad” bank. Private-equity We therefore expect that the more dis-
firms might then be tempted to infuse the criminating limited partners will concen-
“good” institutions with much-needed trate European and US investments in
private capital—and $470 billion of it gives fewer private-equity firms and that many
the authorities a strong incentive to firms will disappear when they can’t
explore this route. raise their next round of funds.9

The alternative
If the private-equity sector can’t identify
new channels for investment, it may have to Private equity’s core value proposition—
contract. In any event, it will probably superior representation to maximize returns
concentrate. The top ten firms controlled for the long-term investor—remains sound.
9
Allocations to newcomers in emerging
30 percent of the sector’s capital in 2008, But private-equity firms that hope to survive
markets may offset this concentration in the
developed world. just as they did in 1998. Since then, the idea must adapt to a new world. MoF

Conor Kehoe ([email protected]) is a partner in McKinsey’s London office, and Robert Palter
([email protected]) is a partner in the Toronto office. Copyright © 2009 McKinsey & Company.
All rights reserved.
 C O R P O R A T E F I N A N A C E

DECEMBER 2008

The voice of experience: Public

versus private equity
Few directors have served on the boards of both private and public
companies. Those who have give their views here about which model works
best.

Viral Acharya, Conor Kehoe, and Michael Reyner

Advocates of the private-equity model have long argued that the better PE firms
perform better than public companies do. This advantage, these advocates say,
stems not only from financial engineering but also from stronger operational
performance.

Directors who have served on the boards of both public and private companies
agree—and add that the behavior of the board is one key element in driving
superior operational performance. Among the 20 chairmen or CEOs we
recently interviewed as part of a study in the United Kingdom,1 most said that
PE boards were significantly more effective than were those of their public
counterparts. The results are not comprehensive, nor do they fully reflect the
wide diversity of public- and private-company boards. Nevertheless, our
findings raise some important issues for public boards and their chairmen.

When asked to compare the overall effectiveness of PE and public boards, 15 of

the 20 respondents said that PE boards clearly added more value; none said
that their public counterparts were better. This sentiment was reflected in the
scores the respondents gave each type of board, on a five-point scale (where 1
was poor and 5 was world class): PE boards averaged 4.6, public boards 3.5.

Clearly, public boards cannot (and should not) seek to replicate all elements of
the PE model: the public-company one offers superior access to capital and
liquidity but in return requires a more extensive and transparent approach to
governance and a more explicit balancing of stakeholder interests.
Nevertheless, our survey raises many questions about the two ownership
models and how best to enhance a board’s effectiveness. How, for example, can
public boards be structured so that their members can put more time into
managing strategy and performance? Moreover, can—and should—the
interests of public-board members be better aligned with those of executives?

How both models add value

Respondents observed that the differences in the way public and PE boards
operate—and are expected to operate—arise from differences in ownership
structure and governance expectations. Because public companies need to
protect the interests of arm’s-length shareholders and ensure the flow of
accurate and equal information to the capital markets, governance issues such
as audit, compliance, remuneration, and risk management inevitably (and
appropriately) loom much larger in the minds of public-board members. Our
research did indeed suggest that public-company boards scored higher on
governance and on management development. However, respondents saw PE
boards as more effective overall because of their stronger strategic

1
leadership and more effective performance oversight, as well as their
management of key stakeholders (Exhibit 1).

EX HI B IT 1
Private boards excel

Strategic leadership
In almost all cases, our respondents described PE boards as leading the
formulation of strategy, with all directors working together to shape it and
define the resulting priorities. Key elements of the strategic plan are likely to
have been laid out during the due-diligence process. Private-equity boards are
often the source of strategic initiatives and ideas (for example, on M&A) and
assume the role of stimulating the executive team to think more broadly and
creatively about opportunities. The role of the executive-management team is
to implement this plan and report back on the progress.

By contrast, though most public companies state that the board’s responsibility
includes overseeing strategy, the reality is that the executive team typically
takes the lead in proposing and developing it, and the board’s role is to
challenge and shape management’s proposals. None of our interviewees said
that their public boards led strategy: 70 percent described the board as
“accompanying” management in defining it, while 30 percent said that the
board played only a following role. Few respondents saw these boards as
actively and effectively shaping strategy.

2
Performance management
Interviewees also believed that PE boards were far more active in managing
performance than were their public counterparts: indeed the nature and
intensity of the performance-management culture is perhaps the most striking
difference between the two environments. Private-equity boards have what one
respondent described as a “relentless focus on value creation levers,” and this
focus leads them to identify critical initiatives and to decide which key
performance indicators (KPIs) to monitor. These KPIs not only are defined
more explicitly than they are in public companies but also focus much more
strongly on cash metrics and speed of delivery. Having set these KPIs, PE
boards monitor them much more intensively—reviewing progress in great
detail, focusing intently on one or two areas at each meeting, and intervening in
cases of underperformance. “This performance-management focus is the
board’s real raison d’être,” one respondent commented.

In contrast, public boards were described as much less engaged in detail: their
scrutiny was seen at best as being on a higher level (“more macro than micro,”
one interviewee said) and at worst as superficial. Moreover, public boards
focus much less on fundamental value creation levers and much more on
meeting quarterly profit targets and market expectations. Given the
importance of ensuring that shareholders get an accurate picture of a
business’s short-term performance prospects, this emphasis is perhaps
understandable. But what it produces is a board focused more on budgetary
control, the delivery of short-term accounting profits, and avoiding surprises
for investors.

Management development and succession

Private-equity boards scored less well on their development of human
capital—both absolutely and relative to public boards. PE boards do focus
intensely on the quality of the top-executive team, in particular the CEO and the
CFO, and are quick to replace underperformers. But such boards invest little or
no time exploring broader and longer-term issues, such as the strength of the
management team, succession plans, and developing management. “Their
interest in management development is frustratingly narrow,” one interviewee
said.

Public boards, by comparison, were seen as more committed to and effective

for people issues. Such boards insist on thorough management-review
processes, discuss not only the top team but also its potential successors,
debate the key capabilities needed for long-term success, are more likely to
challenge and influence management-development processes, and play a more
active role in defining remuneration policies and plans. There are weaknesses,
however: public boards can be slower to react when change is needed, and their

3
voice on everything but the CEO succession tends to be more advisory than
directive. Remuneration discussions are thorough, but public boards can seem
more concerned about the reaction of external stakeholders to potential plans
than about their impact on performance. Overall, however, public boards are
more focused on people, tackle a broader range of issues, and work in a more
sophisticated way.

Stakeholder management
Our respondents felt that PE boards were much more effective at managing
stakeholders, largely as a result of structural differences between the two
models. Public boards operate in a more complex environment, managing a
broader range of stakeholders and dealing with a disparate group of investors,
including large institutions and small shareholders, value and growth investors,
and long-term stockholders and short-term hedge funds. These groups have
different priorities and demands (and, in the case of short-selling hedge funds,
fundamentally misaligned interests). The chairmen and CEOs of public
companies therefore have to put a lot of effort into communicating with
diverse groups.

The challenge for PE boards is more straightforward. Their effective

shareholders (the investors in PE funds) are locked in for the duration of the
fund. The shareholders’ representatives (the PE house) are in effect a single
bloc (or a very small number of blocs in a club deal) and so act in alignment.
Furthermore, these representatives are more engaged than board members in
the public world are—they are literally “in the room” with executives and are
much better informed about business realities than are investors in public
companies. Unsurprisingly, therefore, the burden of investor management is
much less onerous for PE boards and the quality of the dialogue much better.

Yet PE boards are much less experienced in engaging with broader

stakeholders, such as the media, unions, and other pressure groups. This
inexperience was evident in the initial response of these boards to the greater
scrutiny they attracted in 2007. The Walker Report2 and the changes PE
houses subsequently made to increase the frequency and transparency of their
communications do go some way in addressing the shortcomings, but public
boards typically are still more sophisticated and effective in this area.

Governance and risk management

Public boards earned their best scores in governance and risk management, a
result that reflected the drive to improve governance standards and controls in
the wake of the various scandals that led to the Sarbanes–Oxley legislation and
the initiatives suggested in the Higgs Report.3 The typical board subcommittees
(audit, nomination, remuneration, and corporate social responsibility) are seen

4
as conducting a thorough, professional scrutiny of the agreed-upon areas of
focus, while the overall board supervises effectively and can draw on a broad
range of insights and experiences to identify potential risks. Compliance with
the United Kingdom’s Combined Code on Corporate Governance is high—an
important factor in building investor confidence.

Yet there are important underlying concerns. Unsurprisingly, many

respondents held that some elements of governance are overengineered and, as
a result, consume much time while generating little value. Of greater concern,
perhaps, many respondents felt that, in emphasizing governance, public boards
had become too conservative. “Boards seek to follow precedent and avoid
conflict with investors rather than exploring what could maximize value,”
commented one respondent. “The focus is on box-ticking and covering the right
inputs, not delivering the right outputs,” said another.

Private-equity boards scored lower on governance, reflecting their lower level

of emphasis on it and their typically less sophisticated processes for managing
it. In every case, governance efforts focused on a narrower set of activities,
though almost all PE boards embraced the need for a formal audit committee.
Interestingly, though, PE boards in general were seen as having a deeper
understanding of operational business risks and financial risks. They were also
perceived to be more focused on, and skilled in, risk management as opposed
to risk avoidance.

Sources of difference?
Since our respondents felt that PE boards were typically more effective than
public ones were in adding value, we sought to learn why. The comments of the
respondents suggest two key differences. First, nonexecutive directors of public
companies are more focused on risk avoidance than on value creation (Exhibit
2). This attitude isn’t necessarily illogical: such directors are not financially
rewarded by a company’s success, and they may lose their hard-earned
reputations if investors are disappointed.

5
EX HI B IT 2
Risk vs value creation

Second, our respondents noted a greater level of engagement by nonexecutive

directors at PE-backed companies. The survey suggested that PE directors
spend, on average, nearly three times as many days on their roles as do those
at public companies (54 versus 19). Even in the bigger FTSE 100 companies,
the average commitment is only 25 days a year. Respondents also observed
differences in the way nonexecutive directors invest their time. In both models
of ownership, they spend around 15 to 20 days a year on formal sessions, such
as board and committee meetings. However, PE nonexecutives devote an
additional 35 to 40 days to hands-on, informal interactions (such as field visits,
ad hoc meetings with executives, phone calls, and e-mails), compared with only
3 to 5 days a year for nonexecutive directors at public companies.

About the Authors

Viral Acharya is a professor of finance and the academic director of the London Business School’s Private Equity
Institute; Conor Kehoe is a director in McKinsey’s London office, and Michael Reyner, a McKinsey alumnus, is a
partner at MWM Consulting. This article is an excerpt from a longer report published by London Business School and
MWM Consulting.

The authors are grateful to Ann Iveson, the executive director of the London Business School’s Private Equity
Institute, for her invaluable support in conducting the interviews and synthesizing their findings, and to David Wood, a
consultant at McKinsey, who led the data analysis.

6
Notes

1
We interviewed directors who had, over the past five years, served on the boards both of FTSE 100 or FTSE 250
businesses and PE-owned companies with a typical value of more than £500 million. While the number of
interviewees may seem small, it is probably a large proportion of the limited population of such directors.
2
See David Walker, Guidelines for Disclosure and Transparency in Private Equity, Walker Working Group, 2007.
3
See Derek Higgs, Review on the Role and Effectiveness of Non-Executive Directors, UK Department of Trade and
Industry, 2003.

Related Articles on mckinseyquarterly.com

“Private equity’s ongoing allure”

“What public companies can learn from private equity”

“Running with risk”

“Why some private equity firms do better than others”

Copyright © 2008 McKinsey & Company. All rights reserved.

7
McKinsey Quarterly: The Online Journal of McKinsey & Company Page 1 of 7

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Public companies will need to raise their governance game if they are to
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January 2007 • Andreas Beroutsos, Andrew Freeman, and Conor F. Kehoe

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McKinsey Quarterly: The Online Journal of McKinsey & Company Page 3 of 7

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McKinsey Quarterly: The Online Journal of McKinsey & Company Page 4 of 7

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McKinsey Quarterly: The Online Journal of McKinsey & Company Page 5 of 7

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McKinsey Quarterly: The Online Journal of McKinsey & Company Page 6 of 7

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https://www.mckinseyquarterly.com/article_print.aspx?L2=5&L3=2&ar=1910 10/3/2011
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About the Authors

Andreas Beroutsos is a partner in McKinsey’s New York office. Andrew Freeman is an adviser based in the
London office, where Conor Kehoe is a partner.
The authors would like to thank Braam Verster for his contributions to this article.
This article was first published in the Winter 2007 issue of McKinsey on Finance. Visit McKinsey's corporate finance
site to view the full issue.
McKinsey Quarterly: The Online Journal of McKinsey & Company Page 1 of 8

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A panel of executives explores why private equity has been giving
public ownership such a run for its money.
October 2006

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McKinsey Quarterly: The Online Journal of McKinsey & Company Page 7 of 8

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HYHQLQODUJHEXVLQHVVHV

Panelist Profiles

Kurt W. Bock is CFO at the German-based chemical

company BASF. BASF itself is publicly held, but a
number of its businesses have been sold to private
equity firms, and many of its major competitors are now
private equity owned.

Johannes P. Huth is managing director and head of European operations at Kohlberg

Kravis Roberts. KKR is one of the original US buyout firms and now operates in Europe
as well. The firm has taken the view that the private equity model is a way of creating
more value than a quoted company does.

David Pitt-Watson serves as chief executive of Hermes Focus Funds, Europe's largest
shareholder activist fund manager and the world's only one sponsored by a major
investment institution. Hermes invests in companies that are grappling with issues
concerning strategy, management, governance, or capital structure. It works with the
board to ensure that change is implemented.

https://www.mckinseyquarterly.com/article_print.aspx?L2=5&L3=2&ar=1856 10/3/2011
McKinsey Quarterly: The Online Journal of McKinsey & Company Page 8 of 8

Lennart Sundén is
president and CEO of
Sanitec, a leading
European provider of
bathroom products, which
is currently owned by the
private equity group EQT.
From 1977 until 1998, he
worked in various
positions at publicly held
companies, including 21
years at Electrolux and 5
years as president and
CEO of Swedish Match.

Return to reference

About the Author

Richard Dobbs is a partner in McKinsey's London office.
This article was first published in the Autumn 2006 issue of McKinsey on Finance.

Back to top

Notes
1
John R. Graham, Campbell R. Harvey, and Shivaram Rajgopal, "The economic implications of corporate financial
reporting," NBER working paper number 10550, January 11, 2005.

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McKinsey Quarterly: The Online Journal of McKinsey & Company Page 1 of 3

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Investments don’t govern themselves; active ownership is the answer.
February 2005 • Joachim Heel and Conor Kehoe

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McKinsey Quarterly: The Online Journal of McKinsey & Company Page 2 of 3

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McKinsey Quarterly: The Online Journal of McKinsey & Company Page 3 of 3

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About the Authors

Joe Heel is a principal in McKinsey's Miami office, and Conor Kehoe is a director in the London office.

Back to top

Notes
1
In 3 of the 60 deals, value was created primarily through arbitrage. Since these deals are relatively rare, and
interviews indicated that they are difficult to find, we excluded them from our analysis.
2
Calculated by dividing the cash realized from a deal by the cash invested.

© Copyright 1992-2011 McKinsey & Company

https://www.mckinseyquarterly.com/article_print.aspx?L2=5&L3=5&ar=1572 10/3/2011
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 Private equity’s new challenge | 1

which private equity firms have thrived.

Private equity’s More and more, they are encountering
heavier competition for opportunities to
new challenge invest, often against new competitors. The
rise of the auction sales process is eroding
the buyout players’ ability to gain
privileged access to investments from their
once-legendary networks of relationships.
The creative financial-engineering skills
once guarded by a few top practitioners
have become commodities, and a tougher
stock market has worked against players
A changed competitive landscape calls for a looking to purchase, restructure, and then
different business model. quickly sell a company. Taken together,
these changes threaten to lower median
returns over the next five to ten years,
Neil W. C. Harper and For more than two decades, buyout compared with the public equity markets,
Antoon Schneider
funds—or nonventure private equity and could make standout performance
funds—have been an important force in considerably more difficult.
global corporate finance and restructuring.
Top-quartile funds, in particular, have Of course, as long as there are attractive
turned in consistently strong performances, buyout opportunities—and there will be,
generating attractive returns for their particularly in the European industries that
investors (Exhibit 1). In the 1980s the are restructuring and in less financially
sector led a revolution in value creation and developed markets—the top buyout fund
corporate restructuring that continues to managers will continue to generate attractive
reenergize economies in the developed and, returns for investors. But the most successful
increasingly, the developing world. Viewed
exhibit 1
from corporate suites, buyout players have
alternately been willing acquirers of Private performance
underperforming businesses, formidable Comparison of private equity funds with public equity market: average
annual net returns to investors, 1986–2003, %
competitors, and, under the right
circumstances, valued partners. Storied Europe United States
firms such as Clayton, Dubilier & Rice, Private equity
Kohlberg Kravis Roberts, and The Overall average1 19.0 12.4

Blackstone Group may be emblematic of the

Minimum return
sector, but its ranks also include many other for top quartile1 23.0 17.5

private limited partnerships, investment

Public equity2 12.3 17.1
banks, and public-investment vehicles that
follow a similar business model.
1 Through 2003, for investments initiated from 1986 to 1998; excludes
returns for investments initiated in more recent years, as substantial
That model, however, may soon look quite portion of returns are still unrealized.
2 5-year forward rolling average of returns for investments initiated

different. A convergence of market forces from 1986 to 1998.

Source: Thomson Financial; McKinsey analysis
has altered the competitive landscape in
2 | McKinsey on Finance | Summer 2004

exhibit 2
awaiting deployment (Exhibit 2). The result
Money to burn is more competition for each new
Estimated total amount of private equity capital awaiting deployment1 investment opportunity, more marginal or
Europe, € billion2 United States, $ billion high-priced deals, and greater pressure from
institutional investors to return some
122
previously invested capital.
90

62
Privileged access is less important.
39
30 Discussions with fund managers and
10
investors indicate that the privileged deal is
1997 2000 2003 1997 2000 2003 a thing of the past. Historically, the
relatively limited number of fund managers
1 6-yearcumulative total of capital committed to private equity funds
minus amount deployed; for buyout funds only.
(primarily experienced investment bankers)
2 Averageexchange rate: €1 = $1.13 in 1997, $0.92 in 2000,
$1.14 in 2003.
had unique networks of relationships that
Source: Thomson Financial; European Private Equity & Venture provided access to investment opportunities
Capital Association (EVCA)
that other, less well-connected buyers
couldn’t match. Indeed, fund managers
fund managers will be those willing to could sometimes consummate buyouts
change significantly their historical without a competitive bid process.
investment and value-creation models. For
the rest, recent trends will likely lead to This situation has changed gradually over
something of a shakeout as well as the years; today there are many more well-
increasingly differentiated performance networked participants with much better
between top buyout funds and the median. information. Almost all significant deals
today are subject to a visible and public
Diminished advantages auction process as sellers seek the maximum
Our research and work with clients highlight price. In many large deals, the number of
a series of changes in the landscape where bidders, both alone and in consortia, can
private equity firms have thrived. reach double digits. The recent auction of a
US newspaper publishing business, for
An excess supply of capital. Throughout example, attracted almost all of the large
the 1980s and most of the 1990s, well- active US buyout funds.
positioned players could rapidly deploy their
capital because the demand for private Commodity financial-engineering skills. For
equity financing generally exceeded the years, the ability to create value through
available capital. That situation has reversed financial engineering was important. At its
dramatically, however. In the late 1990s, simplest level, a buyout fund would
buyout funds collectively raised as much as restructure and increase the debt of
$50 billion to $60 billion per year. Yet by companies with too much equity. In this way,
the early 2000s, annual deployment had the fund reduced the companies’ exposure to
fallen to the $30 billion to $40 billion corporate-income tax, used heavy interest
range,1 and today a significant pool of payments to manage cash flows, and
capital—some $90 billion in the United encouraged management performance with
States and €39 billion in Europe—is levered equity-based incentives.
 Private equity’s new challenge | 3

Such skills remain important, but today firms now raise funds for each individual
they are broadly available. Vendors are transaction from investors who can choose
beginning to use so-called stapled finance, to participate on a case-by-case basis, for
where assets and businesses are auctioned example. A few have used this model for
with aggressive buyout leverage already in years, but others are attempting to copy it.
place or preapproved by the financing Such funds may be more flexible in
banks, for instance. Even the sales of responding to market conditions than those
businesses with lower leverage tend to that engage in significant fund-raising
attract multiple bidders, each with its own activities only every few years and may feel
access to similar sources of debt through less pressure to rapidly put money to work.
the financial sponsors’ groups of large Another example involves the accelerated
investment and commercial banks. IPO, whereby businesses being auctioned
Acquisition prices therefore tend to reflect are offered a rapid route to IPO,
most of the upside from leverage. circumventing the typical intermediate step
of buyout-fund ownership for a three- to
Cyclical difficulties in ensuring attractive seven-year period. Undoubtedly, we will see
exit. Particularly during the 1990s, strong additional categories of competitors,
equity markets frequently permitted buyout further increasing the competition for
firms to use initial public offerings (IPOs) to available transactions.
divest their interests. Beginning in 2000 that
became more difficult, as markets Fewer pull-through opportunities for
plummeted, and even today this approach is banks. Buyout funds within financial
a harder sell. As a result, buyout firms institutions can create value both by earning
increasingly are changing their divestment a basic investment return and by creating
strategies. Some are selling via secondary opportunities to pull through fee-based
buyouts, while others are holding onto their business such as M&A advisory and
investments longer. Indeed, Initiative Europe underwriting fees. Indeed, much buyout
has reported that average holding periods activity has been carried out within broader
increased from 37 months in 2002 to corporate-form financial institutions
52 months in 2003.2 (predominantly investment banks) using
both their own capital and that of third-
While some will argue that the current party investors. A number of such bank
situation merely reflects the cyclical nature funds historically have been very strong
of the IPO market, it may well signal a performers, although investors, unlike those
fundamental change in the way that in partnership-form peers, have suffered
investors, markets, and regulators think from double taxation of fund returns.
about the characteristics of an IPO as well
as the track record necessary for a Recent market conditions, however, have
successful listing. severely limited pull-through business: few
significant IPOs have been completed, and
Emergence of new types of competitors. the fees per deal related to debt financing
Several categories of new competitors have have continued to fall. Hence, while some
emerged, further complicating the buyout banks will likely continue to create value
world. An increasing number of buyout from buyout activity, it may be worthwhile
4 | McKinsey on Finance | Summer 2004

for all banks to reconsider carefully how and procurement and supply chain
much of their own capital they must invest management.
to optimize total returns—including the
pull-through of fee-based business. To develop these sources of competitive
advantage, fund managers must add to their
Changing the model for success teams more professionals with deep
Some forward-thinking fund managers have strategic and industry insight, operational-
already begun to respond to this improvement expertise, and other functional
dramatically changed environment, but so skills. Several firms have begun to build
far few have embarked on a broader effort groups of strategists, former operating
to redesign their historical investment and executives, and turnaround specialists, while
value-creation model. others have entered into alliances with third
parties to provide such services. Success
In a new environment for private equity will require extending this effort further;
firms, a logical first step would be to begin to attract the highest-quality operating and
investing more aggressively in due diligence. strategic talent, leveraged-buyout firms will
Funds traditionally have been reluctant to have to cast aside past practices and
invest heavily up front to really understand increasingly offer up a share of the carry
what is needed to realize the upside to such professionals.
potential in a proposed buyout. This
pattern may be partially due to the incentive Some firms will want to focus on a limited
structure of most funds, where up-front number of industry segments. Truly superior
investment in incomplete deals effectively strategic and operational insights and the
reduces the cash available for the development of potentially privileged
compensation of fund managers and other networks for sourcing require deeper
professionals. The likely result, however, is industry knowledge in today’s environment.
too many deals being taken too far through Firms that quickly develop their knowledge
the process. Early, detailed, and rigorous of a few narrowly defined industry segments
transaction screening can yield significant and geographies will be better positioned to
dividends in the appropriate deployment of translate this expertise into a perspective on
fund professionals’ time and the ultimate value-creation potential, transaction price,
success of each deal. and potential returns.

Another likely source of competitive Last, another competitive edge will likely
advantage in this new landscape is the come from the better sizing of funds to
development of a more hands-on approach targeted investment opportunities.
to ownership and management. Several Successful fund managers have tended to
buyout firms now recognize that they can raise funds as large as the market will allow.
create value (in conjunction with While there is nothing inherently wrong
management teams) by participating more with large funds—some of the top
in managing the companies in their performers have been large, and there are
investment portfolio and by developing some deals that are so large that only a few
cross-industry functional skills—including funds can compete—size has several
marketing, pricing, lean manufacturing, unfortunate and unintended consequences.
 Private equity’s new challenge | 5

First, in the United States and Europe, assets and strikingly different proposals for
competition for big deals is often fierce, with alternative forms of partnership.
multiple funds and consortia chasing most
deals. Second, very large funds force buyout Many buyout firms also have increased
firms to “institutionalize” as organizations their interest in private investment in public
grow, and many fund managers feel a threat equity (PIPE). These investments are
to their entrepreneurial culture—a key to typically minority equity or convertible
success. Finally, as the size of deals increases stakes in public entities that can in some
with fund size, so does the difficulty of cases be linked to financing for specific
ensuring that fund managers have the acquisitions. PIPE investments can also be
appropriate skills to effect multidimensional part of an attempt to broaden the available
change in organizations with substantial set of opportunities beyond private deals,
portfolios. Although large funds should not to get ahead of the competition for
necessarily be avoided, fund managers privileged access to divestitures of
should think carefully about their firm’s nonstrategic assets, or even to involve
focus and the nature and scale of its likely leveraged buyouts of complete public
opportunities and then adjust their fund- entities. Corporations will increasingly see
raising accordingly. buyout firms positioning themselves as
potential minority shareholders and
Corporate connections strategic partners, but CEOs and CFOs
The trends altering the private equity should consider carefully the true cost of
landscape can offer opportunities to CFOs such capital infusions from these players
and other corporate strategists. Because of compared with the alternatives.
the surplus of capital in the current market,
corporations looking at acquisitions are Finally, corporate executives should be
seeing more and more competition from a prepared to encounter more competition
broader set of financial buyers in addition from buyout firms for top managerial talent.
to the anticipated strategic buyers. Not only will buyout fund managers seek to
However, buyout firms are increasingly add operational and strategic expertise to
willing to partner with corporations that their ever-broadening teams that evaluate,
bring complementary industry knowledge execute, and monitor investments but also to
and managerial and operating skills. These offer more compelling financial incentives
partnerships create new strategic for such talent to accept positions in the
opportunities for public companies—and turnaround and ongoing management of
might even reassure some shareholders that portfolio companies. MoF
they are investing alongside smart money.
Neil Harper ([email protected]) is a

What’s more, corporate buyers often bring principal in McKinsey’s New York office, and Antoon

assets that can be combined attractively Schneider ([email protected]) is a

with the target business. While preparing a consultant in the London office.

bid for a technology company during a

recent auction, one corporation was 1
In equity value.
2
Founded in 1988, Initiative Europe is a leading independent
approached by four buyout funds, for provider of specialist and in-depth information focused purely
example, each with varying complementary on European private equity and venture capital markets.
 1

M AY 2 0 10

McKinsey conversations with

global leaders: David Rubenstein of
The Carlyle Group

A founding managing director of The Carlyle Group reflects on the

future of the private-equity industry, China’s role in a rebalancing
global economy, and the leadership gap between the public and
private sectors.
2

David Rubenstein, a founding managing director of The Carlyle Group, one of

the world’s premiere private-equity firms, has built a career on assessing companies across
industries and around the globe. In this video, the latest in our interview series McKinsey
conversations with global leaders, Rubenstein shares his insights on how to manage a
diverse and decentralized organization, how to identify the markets of greatest potential in a
changing world economy, and how to attract leaders who are both intelligent and “have their
ego in check.” He also discusses the new ecosystem he sees developing for the private-
equity industry as pressures build for some of its largest players go public. Richard Elder, a
director in McKinsey’s Washington, DC, office, conducted the interview.

The big picture: Global rebalancing

The Quarterly: !"#$!%&"'$(%)*+%&!,-!%*.%*%/!(0$120%-!3"4!-+5%6"'%.-*4!$%.7!%&"-$(8%

+"'%7*4!%124!)."-)%*-"'2(%.7!%&"-$(5%9!,(%$"4!%."%7*4!%+"'-%#!-)#!3.14!)%"2%7"&%+"'%)!!%
.7!%-!3"4!-+%#$*+120%"'.5%

David Rubenstein: Very few people predicted how serious the recession would be or
exactly the timing of its length. And therefore any prediction about how great the recovery
will be or how it will occur probably should be taken with a grain of salt. Nobody really
knows, is the point.

My perception, though, is that the recovery is underway in different ways around the world.
The United States is recovering nicely but not as great as we would like. We’ll probably
grow at 2 to 3 percent this year. I believe that we will have very serious problems, though,
with our debt. We still have $14 trillion of debt coming out of this recession. We have an
!!" #$%&'()*$+,$-./0$*1)##)+!/$2&$3 4&$"!&56#+75&!*$*3 *$)8$8* *&%$*+$9&$:/;$6&1(&!*$9"*$
*3 *$)8$ (*" ##7$ 9+"*$.0/<$6&1(&!*=$),$7+"$(+"!*$6&+6#&$>3+$ 1&$#++?)!@$,+1$,"##A*)5&$B+98$
*3 *$3 4&$6 1*A*)5&$B+98/$C!%$>&$3 4&$ $8&1)+"8$61+9#&5$>)*3$+"1$("11&!(7/

In Europe, I think growth is probably going to be even less than in the United States. The
northern European countries by and large, with the exception of England and Ireland,
perhaps, are growing quite nicely. I’m not sure there’s going to be any real growth in the
southern European countries; and as a result, the growth overall on year will probably be
2 to 3 percent at best case. Maybe 1 to 2 percent overall.

Asia and the other emerging markets that have become very important of late are probably
@+)!@$*+$@1+>$ !7>3&1&$,1+5$<$*+$.D$6&1(&!*$ $7& 1/$C!%$ 8$ $1&8"#*=$*3 *E8$>3&1&$5 !7$
of the investors around the world really want to put a lot of their money. So China, India,
Brazil, Turkey, Saudi Arabia, Korea, Taiwan are all great emerging markets, and I think
they’re all likely to go pretty well.
3

2&$'!%$*3&$@1& *&8*$8)!@#&$&5&1@)!@$5 1?&*$)!$*3&$>+1#%$)!$F3)! /$G3&1&E8$!+*3)!@$(#+8&$

to it because of its size and entrepreneurial spirit, the encouragement of private equity, the
@1& *$@1+>*3$+66+1*"!)*)&8$>&$8&&$ ##$*31+"@3+"*$*3&$&(+!+57$)!$F3)! /$2&$3 4&$H<$,"##A
time Chinese natives working for us now in China doing deals through various funds that
>&$3 4&/$2&$3 4&$*31&&$1&@"# 1$,"!%8=$ $9"7+"*$,"!%=$ $@1+>*3$,"!%=$ $1& #A&8* *&$,"!%=$
and now two renminbi funds—so I don’t think you can deploy too much money in China.

I don’t really want my competitors to come there and realize that, but right now it is a little
9)*$5+1&$(+56&*)*)4&$*3 !$)*$3 8$9&&!$)!$*3&$6 8*/$C!%$*3&$(+56&*)*)+!$)8$!+*$B"8*$,1+5$
@#+9 #$61)4 *&A&I")*7$'158$+1$C5&1)( !$61)4 *&A&I")*7$'158$)!4&8*)!@$*3&1&/$J!%)@&!+"8$
F3)!&8&$'158$ 1&$61+9 9#7$!+>$+"1$9)@@&8*$(+56&*)*+1$)!$F3)! /

The Quarterly: :14!2%*$$%.7!%37*20!)%.7*.%7*4!%7*##!2!(%*)%+"'%.712;%*<"'.%.7!%

#"-.="$1"%.7*.%+"'%*$$%7*4!>%!)#!31*$$+%"'.)1(!%.7!%?21.!(%@.*.!)>%*2(%&7*.%-!0'$*.1"2%
A107.%"-%A107.%2".%3"A!>%7"&%7*)%B*-$+$!%.7!2%-!.7"'07.%7"&%1.%*))!))!)%-1);C

David Rubenstein: Political risk is something that’s on your mind all the time when
you’re investing overseas. To be honest, the greatest political risk that I see is the United
States. In other countries around the world, sometimes you have a better sense of what
they’re going to do and they’re more consistent than the United States. But sure, you do
have political risks in all countries. You never know what a government might do at a
change of power in a country.

We have people around the world who help us assess risk, and we actually have a lot of
people who are specializing in government and understanding government and who help
our investment teams assess whether or not the investment makes sense.

The Quarterly: D"&%("%+"'%.7!2%.712;%*<"'.%)"A!%"=%.7!%(!4!$"#120%A*-;!.)%"'.%.7!-!C%

David Rubenstein: 2&##=$)!$*3&$7& 1$KD.H$*3&$&5&1@)!@$5 1?&*8$>)##$8"16 88$*3&$

developed markets in GDP. And therefore, it’s not really fair to call some of these markets
!A!-0120% !7$#+!@&1/$J,$F3)! =$97$*3&$7& 1$KDL<=$)8$*3&$9)@@&8*$&(+!+57$)!$*3&$>+1#%=$3+>$
much longer can you call it an emerging market?

India will probably be the second biggest economy in the world at that time. How much
#+!@&1$( !$>&$( ##$*3 *$ !$&5&1@)!@$5 1?&*M$G3&$&5&1@)!@A5 1?&*$(+!(&6*$)8$ $#)**#&$% *&%=$
!%$J$*3)!?$>&$1& ##7$3 4&$*+$9),"1( *&$&5&1@)!@A5 1?&*$(+"!*1)&8$*3 *$3 4&$&5&1@&%N#)?&$
China, India, Brazil, Turkey, Korea, Taiwan—and those that are much smaller and are not
likely to emerge as great economic powers for some time.

Right now, we think that the greatest emerging markets are China, India, Brazil, Turkey,
Taiwan, Korea, Saudi Arabia. Countries in Africa have great appeal to people like us. I
4

%+!E*$*3)!?$7+"$( !$%&6#+7$*3 *$5"(3$( 6)* #$*3&1&$)!$8"9AO 3 1 !$C,1)( $+1$)!$O+"*3$

Africa, but we do think that the opportunities will be considerable as those countries begin
to develop further their natural resources.

The Quarterly: E2!%3"'2.-+%+"'%7*4!2,.%A!2.1"2!(%1)%F'))1*5%D"&%("%+"'%.712;%

*<"'.%F'))1*C

David Rubenstein: We opened in Russia twice and we closed in Russia twice. I don’t
*3)!?$*3 *$*3&$+66+1*"!)*)&8$ 1&$ 8$@1& *$*3&1&$,+1$2&8*&1!$61)4 *&A&I")*7$( 6)* #$ 8$,+1$
other countries. And one of the reasons is, there is a fair amount of excess capital in Russia,
certainly held by the oligarchs, and they don’t really need our capital to develop deals.

I would say that in countries like China, they don’t really need our capital either. At this
point I think what China really wants is expertise, contacts, management skills. What they
>+"#%$#)?&$*+$%+$)8$*+$3 4&$*3&$61)4 *&A&I")*7$8?)##8$ !%$*&(3!)I"&8$ !%$(+!* (*8$+,$2&8*&1!$
'158$(+5&$*+$F3)! =$*& (3$*3&$F3)!&8&$3+>$*3&8&$*3)!@8$ 1&$%+!&$)!$*3&$2&8*=$ !%$*3&!$
when those skills are imparted, probably the Chinese will be able to do some of the same
things we’ve done in the West. So they don’t really need our capital so much, but they
tolerate our capital in order to get the other things that I think they would like.

In the industry: Private equity

The Quarterly: G)%.7!%#-14*.!H!I'1.+%12(').-+%3"2.12'!)%."%!4"$4!>%*-!%+"'%)!!120%.7*.%

.7!-!,)%0"120%."%<!%*%=!&!-%2'A<!-%"=%$*-0!-%J-A)%$1;!%B*-$+$!>%K$*3;)."2!>%LLF>%!.%3!.!-*>%
*2(%.7!%A1(($!%.1!-%A107.%0!.%)I'!!M!(%"'.C%E-%*-!%+"'%)!!120%*%#-"$1=!-*.1"2%"=%='2()N
*2(%.7!-!="-!%3"A#*21!)%"'.%.7!-!N0"120%="-&*-(C

David Rubenstein: J$*3)!?$)*E8$4&17$%),'("#*$*+$@&*$ $!&>$,"!%$+1$'15$+,,$*3&$@1+"!%$

*+% 7/$P!$*3&$+*3&1$3 !%=$J$%+!E*$*3)!?$ $#+*$+,$*3&$,"!%8$+1$'158$*3 *$>&!*$)!*+$9"8)!&88$
years ago are going to implode or go out of business. Some may. Some may have track
records that are so damaged as a result of the recession they can’t raise a new fund.

J$*3)!?$>3 *$7+"$>)##$9&@)!$*+$8&&$)8$8+5&$+,$*3&8&$85 ##&1$'158$)!$(&1* )!$!)(3&$ 1& 8$9&$

(I")1&%$97$# 1@&1$'158=$ !%$J$%+$*3)!?$*3 *$8+5&$'158$>)##$61+9 9#7$!+*$9&$ 8$%+5)! !*$
in their area as they once were because their track record isn’t as good or they can’t raise as
much money as they once did.

P!$*3&$+*3&1$3 !%=$J$%+$*3)!?$*3 *$*3&$# 1@&$61)4 *&A&I")*7$'158=$*3&$# 1@&8*$+!&8NQQR=$

Blackstone, Carlyle, TPG, Apollo, Bain—will aggregate even a larger percentage of capital
that’s available, because their brand names, I think, give investors some comfort. These
'158$ ##$8"14)4&%$*3&$1&(&88)+!$)!$1& 8+! 9#7$@++%$83 6&/$C!%$J$*3)!?$ ##$*3&8&$'158$ 1&$
@+)!@$*+$9&(+5&$>3 *$JE##$( ##$S #*&1! *)4&$)!4&8*5&!*A,"!%$5 ! @&18/T$G3&7$>+!E*$B"8*$
<

9&$61)4 *&A&I")*7$'158/$G3&7E1&$!+>$@+)!@$*+$&U6 !%$*3&)1$+,,&1)!@8$8+$*3&7$3 4&$!+*$B"8*$

61)4 *&$&I")*7$9"*$*3&7$5)@3*$3 4&$1& #A&8* *&$,"!%8=$)!,1 8*1"(*"1&$,"!%8=$%)8*1&88&%$
%&9*$,"!%8=$ !%$(1&%)*$,"!%8=$ !%$B"8*$ ##$?)!%8$+,$%),,&1&!*$,"!%8/$V&%@&$,"!%8/$V&%@&$
,"!%$+,$,"!%8/$W1)4 *&A&I")*7$,"!%$+,$,"!%8/$O+$*3&7$( !$"8&$*3&)1$91 !%$! 5&$ !%$3&#6$
sell those funds around the world, but also acquire very talented people who could manage
*3&8&$,"!%8/$J$*3)!?$4)1*" ##7$ ##$+,$*3&8&$,"!%8$ !%$'158$>)##$61+9 9#7$9&$6"9#)($&!*)*)&8$
>)*3)!$'4&$7& 18$+1$8+/

The Quarterly: 97!2%+"'%)*+%*%#'<$13%!2.1.+>%7"&%A'37%"=%1.%("%+"'%.712;%&1$$%<!%

#'<$13C%O)%.7!-!%*%3!-.*12%*A"'2.%.7*.%+"'%&"'$(%)*+%1)%#-"<*<$+%*$&*+)%0"120%."%<!%
-!.*12!(%&1.712%*%)A*$$%0-"'#%"=%="'2(!-)C

David Rubenstein:$2&##=$J$*3)!?$*3 *$*3&$# 1@&=$@#+9 #$61)4 *&A&I")*7$'158N5+8*=$

again, of which are American—will go public in part because having currency to make
(I")8)*)+!8$+,$*3&$?)!%$+,$'158$J$*3)!?$*3&7$( !$ (I")1&$*+$&U6 !%$*3&)1$+,,&1)!@$9 8&$>)##$
be possible with the currency of a public stock.

Secondly, the currency will enable you to retain and recruit employees and, particularly
if your competitors have those currencies to offer, you need to do that. And third, the
monetization of the founders is an important factor that shouldn’t be ignored. Most of the
,+"!%&18$+,$*3&8&$@#+9 #$61)4 *&A&I")*7$'158$ 1&$61+9 9#7$9&*>&&!$<<$ !%$0</$C!%$ *$8+5&$
point, they want to monetize what they have built, and I think the IPO helps monetize it. It
also helps to reduce the share the founders have and probably spreads the wealth within
*3&$'15=$ !%$5 79&$*3 *E8$ $3& #*37$*3)!@/$O+$J$*3)!?$,+1$ ##$*3&8&$1& 8+!8=$>&E##$61+9 9#7$
8&&$*3&8&$'158$@+$6"9#)($)!$*3&$!+*$*++$%)8* !*$,"*"1&/

The Quarterly: P"%+"'%J2(%.7*.%&7!2%+"'%.*$;%."%*%$".%"=%".7!-%#-14*.!H!I'1.+%J-A)>%

*2(%3!-.*12$+%.7!%<*2;120%12(').-+>%.7*.%G)1*%1)%.7!%2!Q.%<10%-'2%*2(%.7*.%#!"#$!%
*-!%0"120%."%$!*4!%*$"2!%)"A!%"=%.7!)!%".7!-)%*)%.7!+,-!%&*1.120%="-%.7120)%."%)"-.%
.7!A)!$4!)%"'.C

David Rubenstein:$C##$+,$*3&$# 1@&=$@#+9 #$61)4 *&A&I")*7$'158$ 1&$5+1&$+1$#&88$

American. I don’t know if that can continue forever, because at some point other parts of
*3&$>+1#%$>)##$8 7=$S2&$83+"#%$3 4&$@#+9 #$%+5)! !*$61)4 *&A&I")*7$'158$3&1&/T

The United States, right after World War II, was 48 percent of the world’s GDP. We’re now
9+"*$KK$6&1(&!*/$O+$*3&$>+1#%$5 7$8 7=$S237$)8$)*=$>)*3$B"8*$KK$6&1(&!*$+,$*3&$>+1#%E8$XYW=$
*3 *$ ##$*3&$@#+9 #$61)4 *&A&I")*7$'158$ 1&$9 8&%$)!$*3&$Z!)*&%$O* *&8MT$G3 *$61+9 9#7$>)##$
(3 !@&/$C*$F 1#7#&=$>3)(3$)8$ !$C5&1)( !$'15=$>&$8* 1*&%$+"*$B"8*$)!4&8*)!@$)!$*3&$Z!)*&%$
States. Now we invest more money out of the United States than in the United States; we
have more people outside the United States than we have inside the United States investing.
0

Management lessons: The art of the deal

The Quarterly: E4!-%.1A!>%B*-$+$!%7*)%0"..!2%<100!-%*2(%<100!-%*2(%.7!-!="-!%A"-!%

0!"0-*#713>%&1.7%A"-!%#!"#$!>%A"-!%)+).!A)>%!.%3!.!-*5%D"&%("%+"'%A*2*0!%.7*.%
=-"A%&7!-!%+"'%).*-.!(N&7137%&*)%R').%*%=!&%"=%+"'N."%*%4!-+>%4!-+%(14!-)!>%4!-+%
(!3!2.-*$1M!(%J-A%*-"'2(%.7!%&"-$(C

David Rubenstein: All of us that are doing this are kind of making it up a bit on the
[7/$P94)+"8#7$>&E1&$#++?)!@$ *$+*3&1$@#+9 #$'158$ !%$>3 *$*3&7E4&$%+!&/$J!$+"1$( 8&=$>3 *$
we tend to do is control all the investment decisions centrally, so we have centralized
investment committees—not one committee, but several different committees, that
approve the deal.

So to make sure we have quality control, all the deals have to be approved centrally and by
experienced people who are serving on those committees. Secondly, we do have training
programs, extensive training programs, to give people a sense of what we are about, how
we regard ethics as an important part of our business, and make sure there’s a common
("#*"1&$)!$*3&$'15/

2&$( ##$)*$P!&$F 1#7#&/$\4&179+%7$)8$6 1*$+,$+!&$'15/$]+$5 **&1$>3 *$6 1*$+,$*3&$'15$

you’re at, you’re part of Carlyle. It’s one Carlyle. We also try to make sure that the people in
*3&$'15$@&*$*+@&*3&1$+!$ $1&@"# 1$9 8)8$ *$(+!,&1&!(&8$+1$ *$*1 )!)!@$8&88)+!8$ !%$1&*1& *8$
to make sure they understand who they’re working with. And we also incent people. Those
6&+6#&$>3+$(++6&1 *&$>)*3$+*3&1$6&+6#&$)!$*3&$'15=$!+$5 **&1$>3 *$6 1*$+,$*3&$'15$*3&7E1&$
with, we take note of it and we reward people in bonuses and other types of compensation.
So, through many different ways, we try to inculcate a common culture. In many different
ways we try to manage it. We do manage things centrally a bit by the investment approval
process, and the hiring process is largely central as well.

The Quarterly: B*-$+$!%7*)%*$&*+)%7*(%.7!%=*A"')%SPKPTN.7!%.7-!!%"=%+"'%UP*41(%

F'<!2).!12>%K1$$%B"2&*+>%P*2%P*21!$$*V%0!.%."0!.7!-5%6"',4!%<!!2%4!-+%4"3*$%.7*.%
+"'%("2,.%2!3!))*-1$+%)"31*$1M!%"'.)1(!%<'.%.7*.%+"'%*3.'*$$+%&"-;%!Q.-!A!$+%&!$$%
."0!.7!-%12)1(!5%

David Rubenstein: There are three people who really have been running Carlyle for
most of its history, and we do get along quite well, in part because we have different
areas of responsibility. Bill Conway tends to oversee most of the investment activity. Dan
Y !)&## $+4&18&&8$ $#+*$+,$*3&$+6&1 *)+! #$ (*)4)*)&8=$ 8$>&##$ 8$+"1$1& #A&8* *&$&!&1@7$
businesses. And I tend to oversee fundraising and probably recruiting a bit and somewhat
*3&$8*1 *&@)($4)8)+!$+,$*3&$'15/$J$3 4&$9&&!$5+1&$+1$#&88$*3&$, (&$+,$*3&$'15$9&( "8&$JE4&$
been willing to do interviews and make speeches. But all of us are equal partners and all of
us consult regularly on all matters, even though one person may be taking the lead.
;

J,$7+"E1&$ $6"9#)($(+56 !7=$)*E8$%),'("#*$*+$8 7$7+"$3 4&$*31&&$F\P8/$C!%$8+$>&$1&(+@!)^&$

that. Without conceding that we’re going to go public or even saying that we will, if we
were to go public I suspect we might have to change our model a bit and have either a CEO
+1$%&8)@! *&$+!&$+,$"8$*+$9&$*3&$F\PN+1$'!%$8+5&+!&$&#8&$>)*3)!$*3&$'15$*+$%+$)*/

G3&1&E8$!+$%+"9*$*3 *=$ 8$#+!@$ 8$*3&$*31&&$,+"!%&18$ 1&$*3&1&=$)*E%$9&$%),'("#*$,+1$8+5&9+%7$

else to completely be the CEO, but we recognize that we might have to step back a bit if
8+5&9+%7$&#8&$>&1&$*3&$F\P/$2&$B"8*$3 4&!E*$%&()%&%$*3 *$7&*=$)!$6 1*$9&( "8&$>&$3 4&!E*$
yet decided if we’re going to go public.

The Quarterly: 97*.%7*4!%+"'%-!*$$+%$!*-2!(N*2(%7"&%7*)%.7*.%37*20!(%"4!-%.1A!N

=-"A%.7!%(1==!-!2.%A*2*0!A!2.%).+$!)%*2(%.7!%(1==!-!2.%.+#!)%"=%3"A#*21!)%+"'%*$$%7*4!%
"&2!(C

David Rubenstein: One, you don’t really know how good a company is going to be when
7+"$9"7$)*/$])!&*7A'4&$6&1(&!*$+1$5+1&$+,$*3&$61+B&(*)+!8$+,$>3 *$7+"E1&$@+)!@$*+$& 1!$ 1&$
>1+!@/$2&E1&$B"8*$!+*$1)@3*$+!$3+>$@++%$(+56 !)&8$ 1&$@+)!@$*+$9&$+1$3+>$9 %$*3&7$5)@3*$
be. Secondly, when you don’t have a good manager at the outset, you need to get one. And
),$8+5&9+%7$)8$!+*$ $4&17$@++%$5 ! @&1$)!$*3&$'18*$7& 1$+1$8+=$3&E8$61+9 9#7$!+*N+1$83&E8$
not—going to get much better, so you probably should make a change.

You should be very careful about the assumptions, in terms of the economy, that you get in
7+"1$61+B&(*)+!8/$O+5&$6&+6#&$+,*&!$ 88"5&$*3&$&(+!+5)&8$ 1&$@+)!@$*+$@+$4&17$>&##$ ##$*3&$
time, and that’s probably a mistake. Buying companies that really have a good culture is
&U*1&5&#7$)56+1* !*/$_ ?)!@$(&1* )!$*3 *$*3&$6&+6#&$)!$7+"1$'15$?!+>$3+>$*+$ %%$4 #"&N
that’s also very important. Making certain that the numbers you see when you do the
due diligence are accurate, and making sure the accounting that you look at when you’re
buying a company works. I’d say generally there are many different mistakes we’ve made,
and I think we’ve probably made every mistake you can make, but actually we’ve generally
done pretty well.

2&E4&$ 4&1 @&%$ 9+"*$LD$6&1(&!*$@1+88$)!*&1! #$1 *&$+,$1&*"1!$+!$ ##$*3&$5+!&7$>&E4&$

)!4&8*&%N #5+8*$-0D$9)##)+!$+,$&I")*7$+4&1$*3&$KL$7& 18$+1$8+$+,$*3&$'15/$O+$>&E4&$9&&!$
right more than we’ve been wrong. And I like to focus a bit more on our mistakes, because
I like to look at what we did wrong—and the deals we should have done that we didn’t
do, or the deals we shouldn’t have done that we did do. And I tend to focus on that. But
obviously the deals we’ve done that have worked out have been much greater than deals
that we’ve had that didn’t work out.

The Quarterly: D"&%("%+"'%*3.'*$$+%0!.%.7*.%$!4!$%"=%12)107.%12."%&7*.%-!*$$+%A*;!)%*%

3"A#*2+%.13;%<!="-!%+"'%3"AA1.%.7!%3*#1.*$C
8

David Rubenstein: The gestation period from the beginning of looking at a deal to
the closing of a deal is probably about six months. Now if you had a year or two to look
at a company, you’d probably even know more, but six months is probably an average
gestation period. So during that period of time, we are retaining consultants. It might be
!$ ((+"!*)!@$'15=$)*$5)@3*$9&$ $# >$'15N86&() #)^&%$)!8"1 !(&$ ! #78*8=$ !%$ ##$?)!%8$+,$
%),,&1&!*$&U6&1*8$>3+$( !$@)4&$"8$8+5&$8&!8&$+,$>3 *$*3&$'15$)8$#)?&/

Obviously we spend a lot of time with management as well. We talk to competitors. We talk
to customers. There’s no foolproof way, and obviously some people do make mistakes. But
5+1&$+,*&!$*3 !$!+*=$9"7+"*$%& #8=$61)4 *&A&I")*7$%& #8=$>)##$>+1?$+"*`$ !%$*3 *E8$)!$6 1*$
because of the extensive amount of due diligence.

P!&$+,$*3&$1& 8+!8$61)4 *&A&I")*7$%& #8$*&!%$*+$>+1?$+"*$*+$ $3)@3&1$&U*&!*$*3 !$4&!*"1&A

capital deals is you have a long amount of time to do the due diligence. You’re looking at
61&%)(* 9#&$( 83$[+>8=$&U)8*)!@$5 ! @&5&!*$8*1"(*"1&8/$a&!*"1&$( 6)* #N*76)( ##7=$)*E8$
much less developed in terms of the management structure, and the idea may not actually
>+1?$+"*=$ !%$*3&$( 83$[+>$5 7$!+*$1& ##7$9&$*3&1&/

So that’s why venture capital deals tend not to do as well, in terms of numbers. Eight out of
every ten may not work in venture capital. Two may work. Whereas in buyouts, I suspect
nine out of every ten probably work.

The Quarterly: E2!%"=%.7!%7".%."#13)%-107.%2"&%="-%A").%<')12!))!)%1)%"-0*213%0-"&.75%

D"&%("%+"'%*$$%#-"*3.14!$+%.712;%*<"'.%.7!%122"4*.1"2%.7*.%1)%-!I'1-!(%&1.712%.7!)!%
3"A#*21!)%."%3-!*.!%.7*.%"-0*213%0-"&.7C

David Rubenstein: Well, when you’re looking at an emerging company—a growth

company or an emerging growth company or something like that—you are looking
at whether they are going to be innovative enough to actually grow a business from a
relatively modest business to a real earnings business.

And at those kinds of companies, you are looking at innovation—whether they have one or
two ideas that are really going to take this to the next level. In more mature buyouts, you
*&!%$!+*$*+$9&$#++?)!@$ 8$5"(3$,+1$)!!+4 *)+!$ 8$,+1$5+1&$&,'()&!(7/$b+"$> !*$*+$5 ?&$
the company operate more effectively. Maybe they could reduce their costs in some ways.
_ 79&$*3&7$( !$%+$ $9+#*A+!$ (I")8)*)+!/$b+"$*&!%$!+*$*+$,+("8$ 8$5"(3$+!$)!!+4 *)+!$)!$
some of the larger companies, and maybe to some extent we’re doing that now.

But I think you see the innovation much more in these emerging companies where you
3 4&$-.D$5)##)+!$*+$-HD$5)##)+!$+,$1&4&!"&=$5 79&$4&17$5+%&8*$ 5+"!*8$+,$& 1!)!@8N9"*$
*3&7$ 1&$*+$*3&$6+)!*$>3&1&$*3&7$1& ##7$( !$@1+>$*+$ $5 B+1$(+56 !7$),=$)!$, (*=$*3&7$3 4&$
one or two innovations that will take effect. And what we tend to do is spend a lot of time
:

in the due diligence process assessing whether these innovations they have on the drawing
boards are likely to happen.

The Quarterly: 97!2%+"'%.712;%*<"'.%*$$%.7!%(1==!-!2.%3"A#*21!)%+"'%"&2>%!)#!31*$$+%

*-"'2(%.7!%&"-$(N"<41"')$+%*%$".%"=%(1==!-!2.%$"3*$%3'$.'-!)>%*%$".%"=%(1==!-!2.%#-*3.13!)>%
!.%3!.!-*N7"&%("%+"'%<*$*23!%<!.&!!2%.7!%$"3*$%*'."2"A+%="-%.7!%(!*$%.!*A%.7!-!>%!4!2%
.7"'07%.7!%'$.1A*.!%*##-"4*$%1)%("2!%3!2.-*$$+%7!-!>%*2(%*$$%.7")!%(1==!-!2.%2'*23!)%*2(%
!4!-+.7120%!$)!%.7*.%-!I'1-!%+"'%."%A*;!%.7!%-107.%(!31)1"2C

David Rubenstein: The deal teams tend to generate their own ideas. You can’t
completely control everything centrally, because the more and more you control centrally
and squeeze your local people, they will not be happy. If you have a very, very dedicated,
talented team of people and they’re very good at negotiating deals, they are people who
want some freedom.

C!%$),$7+"$@&*$6&+6#&$>3+$B"8*$%+!E*$> !*$ !7$,1&&%+5$ !%$>3+$>)##$%+$>3 *&4&1$7+"$

tell them centrally, they’re not the kind of people you want representing you, because,
presumably, in negotiating deals with the people they’re trying to buy things from they’ll
be as weak as they might be in dealing with you.

So you want strong people. You want people who are willing to argue with you and debate
with you, because if they’re not willing to debate with people on the centralized investment
committees, they presumably won’t debate with their own CEOs, and that’s not a good
thing.

Business in society: Redefining public service

The Quarterly: G)%+"'%.712;%*<"'.%.7!%#-14*.!H!I'1.+%12(').-+>%7"&%("%+"'%.712;%*<"'.%

.7!%)"31!.*$%"-%!241-"2A!2.*$%1A#$13*.1"2)%"=%.7!%124!).A!2.)%.7*.%+"'%7*##!2%."%<!%
A*;120C

David Rubenstein: 2&##=$*3&1&E8$!+$%+"9*$*3 *$5 !7$61)4 *&A&I")*7$)!4&8*+18$,+("8&%$

,+1$5 !7$7& 18$+!$@&**)!@$@++%$1 *&8$+,$1&*"1!$ !%$B"8*$*&##)!@$*3&)1$)!4&8*+18$ 9+"*$*3+8&$
good rates of return, and then getting more money from those same investors. I think
increasingly, we’ve recognized that if you only focus on internal rates of return, you’re
probably going to do a disservice to yourself. Because in the end, other people who are
stakeholders in what you do are not going to be happy.

We need to make a better case that we are paying taxes, we are sensitive to environmental
concerns, we are sensitive to socially responsible investment principles. I think the
61)4 *&A&I")*7$)!%"8*17$5 7$9&$ $#)**#&$# *&$*+$*3 *$@ 5&=$9"*$)*E8$!+>$( *(3)!@$"6=$ !%$J$
*3)!?$>&E1&$%+)!@$ $5"(3$9&**&1$B+9/$J!$+"1$+>!$( 8&$ *$F 1#7#&=$>&E4&$9&&!$4&17$( 1&,"#$*+$
.D

invest in certain areas and not invest in other areas. We have, for example, not invested
in tobacco. We haven’t invested in alcohol. We haven’t invested in gambling. We haven’t
invested in handguns, things like that. We’ve been careful about investing in certain areas
*3 *$>&$B"8*$ 1&$!+*$3 667$ 9+"*$ !%$%+!E*$> !*$*+$9&$ 88+() *&%$>)*3/

Generally, we try to invest in companies we think are going to add some productivity to
*3&$&(+!+57$*3 *E8$1&#&4 !*=$ !%$ %%$B+98/$2&E1&$!+*$)!*&1&8*&%$)!$9"7)!@$(+56 !)&8$>3&1&$
>&E1&$+!#7$@+)!@$*+$5 ?&$+"1$5+!&7$97$%&8*1+7)!@$B+98=$+1$* ?)!@$*3&5$+,,83+1&/

The Quarterly: B*2%+"'%(!)3-1<!%*%$1..$!%*<"'.%&7*.%)"31*$%-!)#"2)1<1$1.+%A!*2)%."%+"'>%

#!-)"2*$$+C

David Rubenstein: 23&!$J$*"1!&%$<H=$J$1& %$*3 *$ $6&18+!$57$ @&$61+9 9#7$>+"#%$#)4&=$

+!$ 4&1 @&=$ !+*3&1$K;$7& 18=$ !%$*3&1&,+1&$J$1& #)^&%$J$3 %$#)4&%$*>+A*3)1%8$+,$57$#),&=$ !%$
J$%)%!E*$> !*$*+$B"8*$86&!%$*3&$+*3&1$*3)1%$+,$57$#),&$B"8*$ (I")1)!@$5+1&$5+!&7$ !%$> )*)!@$
for my heirs to give it away.

So, I concluded I would try to give away as much as I could while I was alive. And therefore,
I decided to get deeply involved in a lot of philanthropic areas, particularly ones that were
helpful to me: schools that were helpful to me, causes that were helpful to me, things that
were important to my community.

I’m deeply involved in education, deeply involved in performing arts, deeply involved
in medical research, and deeply involved in a number of other areas that I think are
important to our country. I think at a younger age, people still are very interested in going
into public service. And I have underwritten a program at Harvard Business School where
6&+6#&$>3+$@&*$ $B+)!*$_cC$ !%$_WC$%&@1&&$,1+5$*3&$Q&!!&%7$O(3++#$@&*$8(3+# 183)68/$
And that program is designed to encourage people to go into business at some point in
their career and to go into public service. And it’s designed to show that you can mix these
two types of careers.

I do encourage people to go into public service. I think it’s easier to do it early in life—when
you can have more responsibility, probably, in the government than you would in the
private sector—and then come out and make money, if you can, and then perhaps later in
life you can do things in public service.

But the important thing from the time that I went into government to now is this: when I
>&!*$)!*+$@+4&1!5&!*$)!$*3&$.:;D8=$),$7+"$> !*&%$*+$8&14&$7+"1$(+"!*17=$*76)( ##7$7+"$%)%$
)*$)!$@+4&1!5&!*/$b+"$5)@3*$9&$)!$*3&$5)#)* 17=$*3&$W& (&$F+168=$+1$)!$,&%&1 #A@+4&1!5&!*$
service. Now there are many NGOs—nongovernmental organizations—that are providing
extensive public services to our country, that you can serve in these NGOs and do a very
@++%$B+9=$+1$(1& *&$7+"1$+>!$]XP/$C!%$8+=$J$*3)!?$5 !7$6&+6#&$>3+$> !*$*+$@+$)!*+$6"9#)($
11

service today don’t feel they have to go into government. And I encourage them to not,
necessarily, go into government if they want to do something in public service.

Everybody has a social responsibility to make the earth a little bit better than when you
came into it. And so, when I die, I hope people will say that I did something to make the
world a little bit better in one or two areas. And I hope my children will take the same kind
of responsibility in whatever wealth they may get and use it in the same kind of useful
ways.

On leadership: Mending the public–private divide

The Quarterly: D"&%("%+"'%.712;%*<"'.%$!*(!-)%*2(%$!*(!-)71#>%12%.!-A)%"=%."(*+,)%

<')12!))%3"2.!Q.C

David Rubenstein: Well, clearly there are fewer individuals around the country to look
up to as leaders in the business community, for example, than may have been the case
7& 18$ @+/$2&$%)%=$)!$*3&$.:;D8$ !%$EdD8=$9&@)!$*+$5 ?&$1+(?$8* 18$+,$+"1$F\P8/$c"*$J$%+!E*$
*3)!?$*3 *$*+% 7$*3&1&$ 1&$ 8$5 !7$#& %&18$)!$*3&$'! !() #A8&14)(&8$(+55"!)*7$ 8$J$>)83$
there were, because so many of them had problems in the recession.

I do feel, unfortunately, that we’ve demonized business leaders to some extent. I think the
government of the United States, to some extent, has in effect implied that if you make
too much money, if you’re too highly compensated by the government’s standards, you
must have done something wrong. And as a result of that, very few business leaders are as
willing to be engaged with government as they were in the past.

One of the strengths of the US government system has been that people who have
61)4 *&A8&(*+1$&U6&1)&!(&$( !$@+$,1&&#7$)!$ !%$( !$@+$,1&&#7$+"*/$J$*3)!?$+"1$@+4&1!5&!*$
3 8$9&!&'*&%$97$3 4)!@$6&+6#&$>)*3$&U*&!8)4&$61)4 *&A8&(*+1$&U6&1)&!(&/$C!%$J$*3)!?$
+"1$61)4 *&$8&(*+1$3 8$9&!&'*&%$,1+5$6&+6#&$>)*3$@+4&1!5&!*$&U6&1)&!(&$@+)!@$)!*+$*3&$
private sector. Now, at the senior levels of government, people who are willing to go in from
the private sector are fewer and fewer. The most talented people in the business world that
I know today wouldn’t consider going into government. It’s unfortunate.

The Quarterly: D"&%&!-!%+"'%)7*#!(%<+%+"'-%.1A!%12%#'<$13%)!-413!C

David Rubenstein: Well, I was very fortunate. I was a young man. I became, at the
@&$+,$K;=$%&6"*7$%+5&8*)($6+#)(7$ %4)8+1$*+$*3&$61&8)%&!*$+,$*3&$Z!)*&%$O* *&8N $B+9$*3 *$
J$61+9 9#7$> 8!E*$I" #)'&%$,+1/$c"*$)*$@ 4&$5&$ $@1& *$*31)##$>+1?)!@$)!$*3&$23)*&$V+"8&=$
advising the president of the United States. And I did learn much more about public policy
and about the world than I would have if I’d been practicing law at that time, which was
probably the alternative.
12

C8$J$#++?$ *$578&#,$!+>$ 8$ $5 !$+,$0D$7& 18$+#%=$J$*3)!?$*3 *$&U6&1)&!(&$> 8$4&17$@++%$

in shaping my perspectives and making me understand how government works, how our
country relates to other countries. And I wouldn’t have traded those four years in the
23)*&$V+"8&$,+1$ !7*3)!@$&#8&=$!+$5 **&1$>3 *$&#8&$J$5)@3*$3 4&$3 %$)!$*&158$+,$'! !() #$
opportunities at the time. I’m very glad that I did it. On the other hand, I don’t lust to go
back into government.

The Quarterly: 97!2%+"'%0"%.7-"'07%.7!%.*$!2.%#-"3!))%*2(%71-120%#-"3!))>%("%+"'%$"";%

="-%#!"#$!%&7"%7*4!%*3.'*$$+%7*(%)"A!%;12(%"=%#'<$13H)!-413!%<*3;0-"'2(C%

David Rubenstein: W1)4 *&A&I")*7$'158$3 4&$@+**&!$ $#)**#&$9)*$)!*+$ $1"*$+,$3)1)!@$

6&+6#&$>3+$3 4&$@+!&$*+$4&17$@++%$(+##&@&8=$86&!*$*>+$7& 18$)!$ !$)!4&8*5&!*A9 !?)!@$
'15=$*3&!$@+**&!$ !$_cC=$ !%$*3&!$&)*3&1$86&!*$ $7& 1$+1$*>+$)!$61)4 *&$&I")*7=$ !%$*3&!$
come to them.

And I think we are now increasingly looking for people that have operational skills, as well
8$'! !(&$8?)##8/$C!%$9&( "8&$@+4&1!5&!*$)8$)!(1& 8)!@#7$ !$)56+1* !*$6 1*$+,$+"1$#)4&8=$
we’re probably going to have people with more government skills. Right now, I spend more
*)5&$%& #)!@$>)*3$@+4&1!5&!*8$ 1+"!%$*3&$>+1#%$*3 !$J$%)%$.D$+1$.<$7& 18$ @+=$9&( "8&$
governments are increasingly looking at what private equity’s doing; increasingly looking
*$>3 *$)!4&8*5&!*$'158$ 1&$%+)!@/

C!%$J$*3)!?$"!%&18* !%)!@$>3 *$@+4&1!5&!*8$ 1&$*3)!?)!@$ !%$3+>$*3&7$1&# *&$*+$61)4 *&A

&I")*7$'158$)8$)56+1* !*/$O+$J$%+$#++?$ *$*3+8&$?)!%8$+,$8?)##8$ 8$>&##/$c"*$@&!&1 ##7=$JE5$
looking for people that have good overall qualities. And if you are a talented person and
you’re willing to work hard, whether you were in the government or not in the government
doesn’t make that much difference to me—particularly when I’m hiring somebody under
*3&$ @&$+,$LD/$]+>=$),$JE5$3)1)!@$8+5&9+%7$>3+E8$HD$7& 18$+#%=$H<=$<D$7& 18$+#%=$*3&7E1&$
more fully formed, in terms of their career. Then I’m going to assess whether their
government connections and their government responsibilities and their government
?!+>#&%@&$)8$1& ##7$@+)!@$*+$9&$3&#6,"#$*+$+"1$'15=$+1$>3&*3&1$)*$1& ##7$>+"#%!E*$9&$ 8$
3&#6,"#$ 8$3 4)!@$8+5&9+%7$*3&$8 5&$ @&$*3 *$3 %$61)4 *&A8&(*+1$&U6&1)&!(&/

I tend to look for people that have certain skills that transcend what part of the
government they serve in. I’m looking for people who are intelligent, but not geniuses.
X&!)"8&8$ 1&$%),'("#*$*+$%& #$>)*3/$e++?)!@$,+1$)!*&##)@&!*$6&+6#&=$6&+6#&$>3+$ 1&$
hardworking, people that know how to get along with other people, people that have their
ego in check, people that want to create wealth—people that want to create wealth but not
necessarily spend a lot of money, but create wealth for other purposes—people who want
*+$9&$6 1*$+,$ $9)@@&1$878*&5$*3 !$B"8*$*3&)1$+>!$&!*)*7/$JE5$#++?)!@$,+1$6&+6#&$*3 *$1& ##7$
 13

Related thinking have their egos in check but also want to make something with their lives and really make
themselves productive citizens in our country by creating some wealth but also giving that
“The future of private equity”
money away, ultimately, to good social causes.

“Rebuilding the American

dream: An interview with
The Quarterly: W*).%I'!).1"2%="-%+"'5%97*.,)%)"A!%"=%.7!%<!).%*(413!%.7*.%+"'%7*4!%!4!-%
Pete Peterson” <!!2%014!2%12%+"'-%3*-!!-C

“Growth and stability David Rubenstein: I would say the advice that I’ve pretty much tried to stick to is: Try to
in China: An interview 5 ?&$7+"18&#,$)!%)86&!8)9#&$)!$*3&$+1@ !)^ *)+!/$_ 8*&1$+!&$8"9B&(*=$5 ?&$8"1&$7+"$?!+>$
with UBS’s chief Asia it better than anybody else. Keep your ego in check. Make sure you get along with other
economist”
people. Try to share the credit. Make sure that you are not focused on the wrong things—
you don’t want to make money for the wrong reasons.
“The future of capitalism:
Credit, lending, and
leverage” C!%$5 ?&$8"1&$*3 *$>3&!$7+"$%+$3 4&$8+5&$'! !() #$8"((&88=$7+"$@)4&$9 (?$*+$*3&$
community. Make sure that you are making the community a better place because of the
wealth that you have. I’ve tried to do some of those things, perhaps imperfectly, but I’m
*17)!@$*+$%+$ $9&**&1$B+9$ 8$J$@+$ #+!@/

Copyright © 2010 McKinsey & Company. All rights reserved.

 © Kentoh/iStock/Getty Images

Erik Hirsch on private equity

The chief investment officer of a big fund of funds explains why top-quartile performance is
no longer enough.

Aly Jeddy and Bryce Klempner

Erik Hirsch is the chief investment officer of an industry that was simply vanilla or chocolate
Hamilton Lane, a US-based provider of investment- to one that now is Baskin-Robbins, with 31 flavors.
management services to investors in private It wasn’t long ago that LPs could choose either
markets. The firm manages more than $33 billion venture capital or buyout, the chocolate or vanilla
and advises on an additional $191 billion. He options. Sure, there were fringe strategies—
spoke with McKinsey’s Aly Jeddy and Bryce growth equity, mezzanine—but the world was largely
Klempner in April 2015. made up of only two flavors. Today, there are many
more, and they continue to evolve.
McKinsey on Investing: Given Hamilton Lane’s
size and breadth, you see as much or more of One obvious implication for LPs is that it’s much
what’s happening in private equity than perhaps easier to pick funds when you only have two
any other limited partner (LP). Let’s start with your flavors. This year, I would estimate that Hamilton
view on the most significant changes taking place Lane will review 650 to 700 institutionally sized
in private equity. funds. To source and review that volume, institu-
tional investors need substantial resources.
Erik Hirsch: To me, the most interesting evolution Participating in this asset class successfully with
is in the expansion of private-market strategies. small teams and single offices is very challenging.
In the past ten years, we have rapidly evolved from

Erik Hirsch on private equity 1

 Another implication is much greater flexibility in McKinsey on Investing: At Hamilton Lane, you see
portfolio construction. General partners [GPs] and a lot of that data.
LPs can now have a real discussion about how
to use the private markets to achieve objectives for Erik Hirsch: Yes. But data is still a great challenge
returns, risk, duration, exposure, and getting for the industry. If you consider that the returns
the balance right in a way that they couldn’t ten of private versus public markets are well documented
years ago. and that private markets have outperformed
public ones through multiple cycles, you would expect
McKinsey on Investing: So the LPs’ selection that allocations would be rising rapidly. They
risk has increased. Does this mean that the GPs’ are not—they’re rising only slightly. So you have to
track records have become less relevant? ask, why does the average LP allocate less than
10 percent of its portfolio to private equity [PE]? One
Erik Hirsch: It does and it doesn’t. Comparing track reason is that PE has been very data constrained.
records is easier when you’re evaluating vanilla That makes ranking, benchmarking, and decision
and chocolate. The comparison is much clearer. But making difficult for investors.
as the world has evolved and become more com-
plicated, not every GP fits in a neat bucket. And let’s McKinsey on Investing: Do you see that changing?
be honest—GPs often don’t want to fit in a neat
bucket; they want comparisons to be hard to make. Erik Hirsch: Yes, but not quickly. One reason is
And so calculating track records and truly that in some cases, we’ve created the problem.
understanding peer groups is harder today. The Many people like the fact that data is private. Lots
good news is that we have more data on this of people don’t want to live in a perfectly efficient
asset class, and it is increasingly accessible, though world, because lots of people make a living from
we have a long way to go. inefficiencies. Some GPs have reveled in the lack of

Erik Hirsch
Vital statistics Fast facts
Born September, 1972, in Regular lecturer at University of
Charlottesville, VA Pennsylvania’s Wharton School

Married to Margaret McAllister Frequent guest on CNBC, Fox Business,

and Bloomberg TV
Education
Engaged in a variety of charitable
Holds a bachelor’s degree from
endeavors, including Main Line Animal
University of Virginia
Rescue and the City of Philadelphia
Mural Arts Program
Career highlights
Hamilton Lane
(1999–present)
Chief investment officer and board
member
Previously an investment banker
with Brown Brothers Harriman

2 McKinsey on Investing Number 2, Summer 2015

transparency, and some LPs have too. Someone’s or erratic. It is significant and it is consistent over
managing those fourth-quartile funds, and long time frames.
someone’s investing in them. Not everyone wants
to see all of that brought into the light of day. McKinsey on Investing: So is there ultimately
a trade-off between the scale and the returns of this
There are also some practical challenges in evalu- asset class?
ation methods and knowing how to compare
strategies. Other asset classes have managed to Erik Hirsch: The issue is really more the supply of
figure that out in far less time than PE, however, transactions. Deal volume is shrinking. Deals come
so I think the change is inevitable. from just a few channels—the classic private owner
selling to a private-equity firm, PE firms selling to
McKinsey on Investing: What other challenges other PE firms, public companies or divisions
are holding back LPs? going private. “Take privates” have historically been
a meaningful part of deal volume but today represent
Erik Hirsch: One has to do with duration. PE is virtually none. Private-equity practitioners view
known to be a fairly long-term asset class, but the the public markets as very fully priced. Even in this
data suggests that it’s even longer than people leverage environment, and even with the tool kit to
think. The life of most funds is not 10 years, as we improve businesses, practitioners are still not doing
expected; on average, today it’s 12 to 14 years. these deals. So while purchase prices in private
That’s a meaningful difference and certainly gives markets are going up, most GPs would tell you they
some LPs pause about locking up capital for that still think that private-market multiples look more
period of time. attractive than public-market multiples.

Another issue is liquidity. The secondary market So to me, the question around scale is really
continues to grow, and LPs are using it for liquidity more about supply, not whether more capital makes
and, increasingly, for portfolio management. But the industry efficient and thereby automatically
this is an inefficient system that by nature produces lowers performance. When you look at the classic
a discount in net asset value. Add the friction costs channels—US and European buyout funds—we
associated with completing a transaction, and these are at a supply–demand imbalance today, so more
are real stall points for a lot of LPs. capital makes that worse, not better. When you
look at why the industry has been growing so much,
McKinsey on Investing: You noted that private it has not been buyouts. Back to our ice-cream
markets have outperformed public markets analogy, it’s really been the arrival of all the new
over the long haul. Do you see that performance flavors of asset classes, plus new geographies. That’s
continuing or changing? where you’re seeing a lot of the growth. You’re not
seeing it in just another US midmarket buyout firm.
Erik Hirsch: I see it continuing. The asset class That market is relatively flat, and some firms
has some real advantages over the public markets— are disappearing.
control, tight alignment of interests between GP
and management, operational toolboxes that can be McKinsey on Investing: If developed markets are
brought to bear. The outperformance isn’t random flat, what is your prognosis for emerging markets?

Erik Hirsch on private equity 3

 Most LPs we speak to think that while these look place. It’s more cost efficient, and GPs are becoming
exciting and dynamic, historically the returns have more adept at using it. That will help take out some
not justified the risk. How do you see that evolving? of the currency risk.

Erik Hirsch: No question, that’s what this has All of those are good factors. You’re also starting
been historically. You can certainly find numerous to see fund-raising decrease in a lot of those markets.
exceptions, but as an asset class, emerging-market Ironically, one of the things that help returns go
PE returns have been disappointing. You have not up in our asset class is when fund-raising drops. Over
been rewarded for the risk, and in some cases you the past ten years, performance in emerging markets
have not been rewarded, period. Emerging-market has been relatively disappointing, so fund-raising
funds have underperformed relative to funds in has decreased, which I think is going to prove, over
the US or in Europe, and when you factor in currency the next cycle, to be a very good thing.
volatility, geopolitical risk, et cetera, it’s even worse.
McKinsey on Investing: You have mentioned the
Will that change? A lot of LPs flock to emerging GP tool kit a couple of times. Do you believe that
markets believing that as public markets go, so go active ownership can produce real, differential
the private markets. The data suggests that’s not value for LPs? And if you see financial engineering
true. The factors that create good public markets are and operational improvements as the first sets
often very macro, and that’s not at all true in private of tools, what do you think is next?
markets. Good GDP growth, rising employment
rates, a maturing demographic, or the expansion of Erik Hirsch: I do think active ownership is real
the middle class may cause positive public-market when it’s done well. As an industry, though, it would
reactions, but they may not alter the fundamental be grossly unfair to say that everyone does it
behavior or nature of an individual business. well and that everyone has the resources; they don’t.
There is a huge gap in the level of resources that
For that performance to turn around, you need a each firm has and how firms actually utilize them.
few things to happen. One, you need to grow the talent People have prognosticated that the dispersion
base as managers continue to mature and expand. of returns would shrink as our asset classes grew, to
That’s a very positive thing and will certainly help which we at Hamilton Lane loudly say: That’s not
returns. Second, culturally, you’re beginning to see going to happen. Too much of the value creation is
more openness to control buyouts in emerging about what you do with the business after you
markets. Deal volume has largely been a growth- buy it, not what you paid for it or how you sourced it.
equity story to date, and as an asset class, that’s The data suggests that is still the case.
never been our strong suit. Private equity often does
best when playing a much more hands-on, active So then the question arises of what comes next.
role in managing businesses, using all of the tools in I think the tool that’s beginning to come on—and it’s
its toolbox. But a lot of emerging markets have ironic that it’s coming on now and didn’t sooner—
not been as receptive to that for cultural, structural, is portfolio-construction techniques. A lot of GPs
and tax reasons, among others. That is beginning were investors first and portfolio constructors
to change, which will also help. The third piece second, if at all. It was “find good deal, do good deal;
is that currency hedging as a tool is more common- find good deal, do good deal.”

4 McKinsey on Investing Number 2, Summer 2015

“Elite firms are thinking about being portfolio managers,
not just investors. Portfolio construction is becoming
another tool for general partners to further enhance and
differentiate performance.”

Today, among the elite firms, I’m seeing a lot But as an industry, frankly, I think we’ve done a
more time and attention spent on managing the pretty lackluster job at either rewarding or punish-
internal rate of return (IRR). They’re thinking ing risk and risk management. There has just
more about the timing of cash flows, how assets get been a fairly exclusive focus on returns and not
assembled, using tools like lines of credit as fund- enough focus on the broader picture.
ing mechanisms—thinking about being a portfolio
manager, not just an investor. That’s becoming McKinsey on Investing: Continuing with that
another tool for GPs to further enhance and differ- line of thought, what are some of the greatest
entiate performance. misconceptions LPs have about private equity, and
what do you see as GPs’ greatest misconceptions
McKinsey on Investing: Not all IRRs are created about LPs?
equal—some GPs take on more risk to achieve the
same result. To what extent are LPs differentiating Erik Hirsch: It’s probably easier to start with the
among returns by level or type of risk? latter. Most GPs are not particularly good students of
their own asset class. For their portfolio companies,
Erik Hirsch: It varies by LP. A surprising number they know chapter and verse about the competitive
don’t have the tools or the resources to think through environment, but they tend to know very little
that, because the data required to do so effectively about other GPs. This is somewhat understandable
is pretty significant, and not every GP is racing to as data is hard to come by, and good data even
provide it. But the theory is absolutely right. It’s one harder. But very few GPs seem to think about the
of the reasons a firm like ours can add real value: world that way. They have grown up believing that if
we have the tools, the data, and the resources to go they do a good job and generate a top-quartile return,
and figure all that out. So for us, that is a key they should and will be funded by LPs.
criterion, and we spend a lot of time tracing every
dollar of gain to understand where it came from. It GPs forget that we’re in a world of a few thousand
could come from multiple expansion, from earnings fund managers, so even the top quartile is still
growth, from leverage, or from some combination. a really big pool. A typical Hamilton Lane client
Tracing that gain is a key part of our due diligence. invests in six to ten funds a year. Last year alone,
Then you can begin tracing the gain in portfolio screening out all the noise, we saw 630 fund
decisions—how much came from timing, from sector managers that could work for an institution, raising
weighting, from IRR-enhancement tools. You begin funds of at least $100 million. So if you allocate
to draw the full picture by tracing back each of those to six to ten funds, you’re investing in 1 to 2 percent
underlying pieces.

Erik Hirsch on private equity 5

 of the total asset class. If a GP’s sole pitch is that it’s is adding that next GP doing for us? Is it providing
in the top quartile, that isn’t exactly compelling. diversification that we have lacked? A different
type of cash-flow stream? A different type of risk
McKinsey on Investing: So does that mean the or return profile?” If the answer is none of
top decile is the new top quartile? Or that being in the above, the LP is just adding costs to its portfolio
the top quartile is now just table stakes? management and getting little in return.

Erik Hirsch: I think it means some of both. It also This is one reason you’re seeing relationships
means that LPs are becoming more sophisticated between some GPs and LPs expand. It’s better for
about portfolio construction. The LPs’ portfolio- the LPs to have fewer partners that can do more
construction approach used to be “find GPs I like, for them. And some of the GPs are taking advantage
back them, keep backing them, keep finding new of that—through bigger strategic partnerships
GPs that I like, and back them too.” Those LPs then and separate accounts.
woke up after several years and realized they had
200 funds, many with duplicative strategies, similar McKinsey on Investing: What services do LPs
returns, and similar risk profiles. So now they’ve value most today?
diversified for the sake of diversity.
Erik Hirsch: Mainly, it’s having one GP that invests
The other reality is that the asset class is becoming across multiple strategies. With such a partner,
more expensive to manage. LPs’ legal bills are LPs are diversifying strategy and returns, but doing
all going up because they’re dealing with more so with less friction cost because there’s only one
amendments, more fund extensions, and so on. We partner to manage.
all want more data, but getting, tracking, and
storing more data is also expensive. The more funds McKinsey on Investing: To what extent do you
you do due diligence on, the more it costs. see LPs beginning to insource capabilities?
Is there a tension in expanding GP relationships
So LPs are thinking about how to limit the number while bringing capabilities in-house?
of GPs. They are doing new things, like secondaries.
Ten years ago, an LP selling a big part of its private- Erik Hirsch: Bringing capabilities in-house is more
equity portfolio meant that something bad was spoken about than actually done. Very few LPs
happening in its organization. Today, secondaries are truly equipped to execute as a GP would using
are becoming much more of a portfolio-construction in-house resources. For most, cost remains a
tool. Some LPs today will do a secondary sale if real challenge; it is tough for them to attract and
the returns look right, then turn around and retain the right talent. Add all the other resources
redeploy that money elsewhere. Portfolio manage- required—multiple offices, operating partners—
ment is changing. and this is a difficult model to replicate well. Some
will, that’s inevitable, but this will be the exception,
Most LPs today are not making the decision to not the rule. The resource gap is growing wider.
invest simply because of the returns number or GPs are adding more resources every day. So the
the benchmark. Top quartile is a start, but the LP challenges of replicating that model are increasing.
is then going to have to move quickly to questions
like what this is going to do for the portfolio and the If there’s a tension, it’s closer to “What have you
bigger and better questions: “Do I need this? What done for me lately?” The LPs’ expectations of the

6 McKinsey on Investing Number 2, Summer 2015

biggest bang for the buck continue to rise. There are make money is by slashing jobs and slashing costs.
more demands being put on LPs by constituents That too is simply not true.
and boards, and they in turn relay those pressures
back to the GP. Transparency is chief among those New pockets of capital are also arriving from
pressures. Ask GPs which costs have risen fastest in different geographies. The question of how to package
the past few years, and they’ll tell you that it’s back- this asset class effectively for the high-net-worth or
office and investor-relations personnel. retail channel has not yet been solved but inevitably
will be. That will be good for new capital flowing
McKinsey on Investing: This falls under the in, but it does make us ask whether the asset class can
broader rubric of GPs becoming institutionalized. absorb all the capital. Institutional investors need
Where do you see them making progress and to think about whether they will be seen by GPs as an
where are they struggling? attractive source of capital in the future if GPs have
unfettered access to the retail market.
Erik Hirsch: The dispersion in the level of profes-
sionalization and institutionalization is vast and will McKinsey on Investing: As that plays out, how
stay vast for a long time. GPs have to make a real do you see the power dynamic shifting between GPs
choice whether to professionalize or not—not all GPs and LPs?
believe they need to do this. Overall, the trend is
a good one because while people chafe at increased Erik Hirsch: You can imagine a world in which the
regulation, it does bring increased professionali- retail code is cracked and funds are packaged and
zation, and LPs benefit from transparency, disclosure, sold freely so GPs have essentially unlimited access
and better access to information. to capital. Retail investors have historically been
less demanding because they’re fragmented, with
The flip side, though, is that this adds a lot of costs no lead voice demanding transparency or meetings.
for LPs, who need to build out their infrastructure. That market has been very cost insensitive relative
You can’t track your private-markets portfolio today to the institutional channel. As a GP, this world
in all of its detailed glory using Excel and some probably looks much more attractive to you than the
notebooks. You need to invest in real technology and institutional world.
in the personnel for managing it or to outsource it
to a provider. Either way, that’s a real cost. I think the But this retail world is also prone to class-action law-
outcome is going to be better, but it’s not free. suits. It opens you up to public scrutiny that perhaps
you don’t have today, and distributing and managing
McKinsey on Investing: What new kinds of LPs the capital base is expensive. What emerges is likely
are entering the private-equity asset class? not going to be either extreme, but today it’s not clear
what that reality will look like. The institutional
Erik Hirsch: We see new LPs every day. A surprising investors need to understand that although to date
number just hadn’t gotten around to investing public pension funds and sovereigns have been
in the private markets earlier. Sometimes, they were the loudest and most important voices in the room,
not investing because of misperceptions, and they things may not stay that way forever.
entered as those misperceptions were cleared up.
Some in the media still say you could replicate the McKinsey on Investing: Let’s talk about the
return stream by simply levering the public markets— ecosystem surrounding GPs and LPs. What is the
which is completely false. Others say the only way to outlook for funds of funds and investment
consultants over the next five to ten years?

Erik Hirsch on private equity 7

 Erik Hirsch: It’s very fluid. There’s a real difference Then there are all the other supporting pieces. You
between a service provider like ourselves and a want to be active in the secondary markets
VLPSOHIXQGRIIXQGV7RPHWKHIXQGRIIXQGVíRQO\ because they are a good portfolio-management tool;
world is challenged because institutions want high you need resources to do that. You want to do
levels of customization. Funds of funds, by their very coinvestments; you need resources. You want to
nature, are more one size fits all. If the retail track and analyze the massive amount of data
market thrives, that will probably be good for funds that we’re demanding and expecting; you need
of funds. For the small-market investor or for the resources. We have those resources, but the clients’
retail investor, this may be the only option. expectations go up every day. We try to stay one
step ahead.
The environment for broader service providers like
us is different. Adding another layer of cost is never Aly Jeddy ([email protected]) is a director in
seen as a good thing, so we have to prove our value. McKinsey‘s New York office, where Bryce Klempner
Again, back to our ice-cream analogy, it is more ([email protected]) is a principal.
complicated than ever before to navigate through
all the flavors and to choose wisely and to assemble Copyright © 2015 McKinsey & Company.
All rights reserved.
them in the proper way. And the resources needed
to do so are higher than ever before.

8 McKinsey on Investing Number 2, Summer 2015

LBO in practice: structuring and modeling
Readings
• LBO in question
Get Ready for the Private-Equity
Shakeout
Will This Be the Next Shock to the Global Economy?

Heino Meerkatt (BCG) and Heinrich Liechtenstein (IESE)

with contributions from M. Julia Prats, Alejandro Herrera, and Ronny Grunwald of IESE;
and Michael Brigl, Anja-Maria Lehnen, Patrick Bauer, and Markus Brummer of BCG

December 2008
Contents

1. Introduction 1

2. Private Equity Is in the Middle of the Perfect Storm 1

A. The Debt Bubble Has Burst 2
B. Company Earnings Have Dropped 2
C. Multiples Have Collapsed 2
D. Institutional Investors Are Reducing Their Private-Equity Asset Allocation 3

3. Most Private-Equity Firms’ Portfolio Companies Are Expected to Default 3

4. How Will the Defaults Affect the Global Economy? 4

A. Another Shock to the Banking System? 4
B. A Hidden Time Bomb? 5
C. Massive Breakups and Layoffs? 5

5. A Shakeout of Private-Equity Firms Is Inevitable 6

6. What Can Private-Equity Firms Do Now? 8

T B C G D 

Get Ready for the Private-Equity
Shakeout
Will This Be the Next Shock to the Global Economy?

1. Introduction
Private-equity firms have enjoyed extraordinary growth and returns over the last five years, but the col-
lapse of the world’s debt markets and the deepening economic crisis have brought this boom to an abrupt
end, with potentially severe consequences for private-equity firms, the companies they own (so-called
portfolio companies), and the real economy.

In fact, new research from The Boston Consulting Group and the IESE Business School indicates that at
least 20 percent of the 100 largest leveraged-buyout (LBO) private-equity firms—and possibly as many as
40 percent—could go out of business within two to three years.1 More disturbingly, most private-equity
firms’ portfolio companies are expected to default on their debts, which are estimated at about $1 trillion.2

This paper addresses four questions:

◊ What is the root of the problem?

◊ How will the shakeout affect different players within the private-equity industry?

◊ What impact will the collapse of private-equity portfolio companies have on the wider economy?

◊ What can private-equity firms do now to deal with the threat of a shakeout or to capitalize on any op-
portunities?

Our research is based on publicly available data for private-equity firms, portfolio companies, banks, and
credit default swap (CDS) rates, as well as our own analysis of loan trading levels, spreads, and default
probabilities. 3

2. Private Equity Is in the Middle of the Perfect Storm

For decades, the world’s top private-equity firms have sustained above-average returns in the long run
by focusing on fundamental value creation and, in particular, operational improvements, as we demon-
strated in our February 2008 report.4 However, from 2003 through 2007, nearly all private-equity firms
were able to grow exponentially thanks to an unusually favorable financial and economic climate and,
in particular, four major drivers of growth: massive amounts of cheap debt, rising profitability across all
industries, escalating asset prices, and the allocation of significant assets from institutional investors to
private-equity funds. The recent financial and economic crisis has sent all these drivers racing rapidly in
the opposite direction.

1. Throughout this paper, the phrase “private-equity firm(s)” refers exclusively to LBO private-equity firm(s).
2. Based on U.S. and European direct LBO loan-issuance data from Dealogic and based only on LBO debt raised from 2006
through 2007.
3. The publicly available sources of data are Dealogic, the Federal Reserve, mergermarket, Preqin, Standard & Poor’s, Standard &
Poor’s Leveraged Commentary & Data (LCD), and Thomson Reuters.
4. See The Advantage of Persistence: How the Best Private-Equity Firms “Beat the Fade,” BCG and IESE report, February 2008.

T B C G D 

 Get Ready for the Private-Equity Shakeout 2

Exhibit 1. Global LBO Debt Markets Have Contracted Sharply

U.S. LBO loans European LBO loans

$billions $billions
400 400
379

300 300 290

232

200 200
164
146

100 96 100
74 72
62 54 60
41 38
25 33
12 16 16 17 14 20
6 6 4 8 9 9 3 2 3 6 5 11 3
0 0
’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 Q1- Oct. ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 Q1- Oct.
Q3 and Q3 and
’08 Nov. ’08 Nov.
’08 ’08
Source: Dealogic, December 9, 2008.
Note: LBO = leveraged buyout.

A. The Debt Bubble Has Burst

From 2003 through 2007, annual LBO debt issuance rocketed from $71 billion to $669 billion. 5 Today the
world’s debt markets have virtually ground to a halt. Debt volumes in the third quarter of 2008, for ex-
ample, were roughly 75 percent lower than they were in the third quarter of 2007.6 In October and Novem-
ber 2008, only $6 billion was raised in LBO transactions in the United States and Europe.7 (See Exhibit 1.)
Given that the financial sector is under pressure to deleverage, this situation is unlikely to improve in the
near term.

B. Company Earnings Have Dropped

Until the third quarter of 2007, most industries enjoyed strong earnings growth. For example, from 2003
through 2006, EBITDA for the S&P 500 rose 16 percent per annum on average—and many companies’
business plans for the next five years were built on expectations of further earnings growth. Yet today,
most industries have negative EBITDA growth. And the situation is likely to get worse. BCG concluded in
its first Collateral Damage White Paper that in a worst-case scenario, sales volumes could drop by up to
20 percent and sales prices could fall by up to 10 percent in 2009.8 This scenario would produce negative
earnings for many companies unless they introduced drastic measures.

C. Multiples Have Collapsed

From 2003 through 2007, EBITDA multiples grew by 41 percent in the United States and 43 percent in
Europe. 9 Private-equity firms were able to earn a good return from this appreciation without having to
improve their portfolio companies’ performance. In 2008, the 45 percent drop in stock prices has changed
this situation dramatically, pushing multiples below the level of the previous three to four years.10 Any
potential sale of a portfolio company with reduced earnings expectations and lower multiples will lead to
a loss.

5. Dealogic.
6. Dealogic.
7. Dealogic.
8. See Collateral Damage, Part 1: What the Crisis in the Credit Markets Means for Everyone Else, BCG White Paper, October 7, 2008.
9. EBITDA multiples are defined as enterprise value divided by EBITDA. Source: Standard & Poor’s LCD.
10. MSCI Global Standard Indices.

T B C G D 

 Get Ready for the Private-Equity Shakeout 3

D. Institutional Investors Are Reducing Their Private-Equity Asset Allocation

The high returns generated by private-equity firms from 2003 through 2007 attracted an increasing num-
ber of institutional investors—such as pension funds, endowments, and hedge funds—and encouraged
existing investors to increase the proportion of assets they allocated to private-equity funds, providing the
industry with additional fuel for growth. The California State Teachers’ Retirement System (CalSTRS), for
example, more than tripled its private-equity asset allocation from 2.3 percent to 7.4 percent from 1998
through 2007. Through the recent depreciation of other assets, such as bonds, equities, and real estate,
many institutional investors now have higher private-equity commitments than they targeted or even
approved internally. As a result, some investors are trying to get out of their commitments, sometimes at
heavy discounts or by threatening defaults. These stakes have been trading at up to a 55 percent discount
in the secondary market.11 Other investors are trying to delay additional investments. The largest U.S.
pension fund, California Public Employees’ Retirement System (CalPERS), for example, has asked private-
equity firms to reduce requests for additional capital that it had previously committed.12

Exhibit 2. Roughly 60 Percent of Loans Are Trading at Distressed Levels

Debt-trading 100
level (%) ~ 60% trade at distressed levels
90

80
Private-equity
70 portfolio
companies
60

50

40

30

20

10

0
0 1,000 2,000 3,000 4,000
Spread in basis points

Source: BCG-IESE data. Debt-trading level per company

Note: Trading levels and spreads for 328 portfolio companies.

3. Most Private-Equity Firms’ Portfolio Companies Are Expected to Default

Any debt with a credit spread in excess of 1,000 basis points is considered “distressed,” with a high expec-
tation that the company will default within the next three years.13 Reuters Loan Pricing Corporation re-
vealed that in 2006 less than 1 percent of LBO debt was distressed. When we analyzed the credit spreads
of 328 private-equity portfolio companies in November 2008, we found that roughly 60 percent of their
debt was trading at distressed levels. (See Exhibit 2.) At current trading levels, this suggests that almost 50
percent of these companies could default during the next three years.14 (See Exhibit 3.) And with profits
further deteriorating, that number could grow.

11. Financial Times, November 23, 2008.

12. Wall Street Journal Europe, November 5, 2008.
13. According to Standard & Poor’s, a company with “distressed debt” is likely to default or, more specifically, breach its cov-
enants (agreements to meet repayment and milestone performance criteria). However, a default does not necessarily lead to bank-
ruptcy—a legal arrangement that protects debtors from their creditors. This will depend on how creditors react to the default.
14. Current trading levels of distressed debt are potentially distorted by technical effects such as low liquidity and disposal
pressure.

T B C G D 

 Get Ready for the Private-Equity Shakeout 4

Exhibit 3. Almost 50 Percent of Portfolio Companies Will Probably Default

Three-year 100
cumulative default Default
probability1 (%) 90 very likely

80

70

60

50 Ø 49%

40

30

20

10

0
Private-equity portfolio companies (328)
Source: BCG-IESE data.
Note: Cumulative default probability for 328 portfolio companies.
1
Defined as 1 – the product of the survival rates of the next three years, wherein the survival rate equals (1 – default probability) for the corresponding
year. Default probability for each year is calculated as credit spread / (1 – recovery rate) / 10,000; the assumed recovery rate is 40 percent.

Obviously, companies that are achieving their planned earnings growth or were not financed during the
debt bubble will not default and will fulfill all their covenants, which are built into deals to secure the
lenders’ money. Surprisingly, there are also some companies that were financed at the peak of the bubble
that will not default in the next few years because their deals involve so-called covenant-lite contracts.
These types of covenants have few or no performance and default conditions built into them. According
to Standard & Poor’s, 17.9 percent of the loan market in the United States in 2007 was covenant-lite—up
from 5.7 percent at the end of 2006 and 1 percent at the end of 2005. In Europe, only 7 percent of deals
were covenant-lite in 2007. Although covenant-lite deals can give businesses welcome breathing space in
difficult times, they can present substantial long-term risks.

But what about the large number of portfolio companies that will default? What will be the impact of the
massive debt write-offs? And what will happen to the portfolio companies that default? Will there be a
tidal wave of breakups, triggering another shock wave in the real economy?

4. How Will the Defaults Affect the Global Economy?

We calculate that the potential book loss from the defaults is about $300 billion—on the basis of an esti-
mated LBO debt of around $1 trillion for the entire market and assuming a current value of this debt for
a sample of 328 private-equity portfolio companies.15 In comparison, the losses that sparked the crisis in
the U.S. housing market are now up to $700 billion at banks alone. But who will take the hit from the LBO
debt write-offs?

A. Another Shock to the Banking System?

The overhang of LBO debt on banks’ balance sheets might be as small as $50 billion to $80 billion because
banks have already offloaded or written off most of their LBO debts.16 These numbers are also less worri-
some than they might appear, because the discounted value of the debt is transparent for any bank and
there is a market for this type of debt. Indeed, the market for distressed debt is growing strongly. A large

15. Based on U.S. and European direct LBO loan-issuance data from Dealogic and based only on LBO debt raised in 2006 and
2007.
16. The S&P estimate is $50 billion, and BCG-IESE’s estimate, based on banks’ Q10 reports, is $80 billion.

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 Get Ready for the Private-Equity Shakeout 5

buyer of distressed debt, for example, recently closed a substantial distressed-debt fund significantly above
the fund’s original target value. As a result, banks can further offload their debt—although with a strong
discount—and improve their liquidity. So we don’t believe that the defaults will send shock waves into the
banking sector.

B. A Hidden Time Bomb?

The more disturbing question is, Who holds the remaining debt that is not sitting in the balance sheets
of banks and buyers of distressed debt? It’s very difficult to answer this question because this debt is not
transparent. During the debt bubble, the banks that initially signed this debt syndicated the largest part of
it to collateralized debt obligation (CDO) managers, hedge funds, and other institutional investors. Al-
though the linkages of CDO managers and hedge funds themselves to the real economy are debatable, the
pure size of the write-offs and the lack of transparency of the investors behind those institutions could be
a source of a shock wave.

C. Massive Breakups and Layoffs?

As mentioned earlier, one in two portfolio companies are expected to default on their debt obligations
(covenants) within the next three years. What will the owners of the equity and debt do when there are
defaults? Again, the answer is not obvious, because there are no precedents for the current situation, given
the potential number of defaults, the structure of the debt, and the difficulties faced by today’s equity
owners.

As we learned from the subprime crisis, the transparency of the assets, market values, and ownership
structures plays an important role in determining probable outcomes. On the plus side, the equity owner-
ship of portfolio companies is transparent. In most cases, there is only one private-equity firm investing in
each company. Only 21 percent of European LBO deals in 2007 involved two or more private-equity funds.
This figure rose to 30 percent in the first three quarters of 2008.

The debt structure, however, is more complicated. From 2005 through 2007, the banks’ share of European
private-equity debt fell to less than 50 percent as hedge funds, CDO managers, and security firms entered
the market. (See Exhibit 4.) Also, the banks have syndicated most of their debt to other institutions, as
mentioned earlier. As a result, it is not clear, in most cases, who owns the debt.

Exhibit 4. More Institutional Investors Have Entered the European LBO Debt
Market, Adding Complexity

Institutional investors split up by CDO managers, Transparency?

hedge funds, and others
% 100
Other
Hedge funds
CDO managers
80
Institutional investors
Securities firms
Non-European banks
60
European banks

40

20

0
1999 2000 2001 2002 2003 2004 2005 2006 2007 Q1-Q3
2008
Sources: Standard & Poor’s data on European leverage loan market; BCG-IESE analysis.
Note: CDO = collateralized debt obligation.

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 Get Ready for the Private-Equity Shakeout 6

Why is this complexity relevant? Because different stakeholders in multiparty arrangements might not
be able to agree on how to deal with a healthy yet overleveraged company when it defaults, leading to
the breakup of the business. Although this wouldn’t benefit the equity and debt holders, it could be in the
short-term interests of some parties.

In most other cases, there will be two broad scenarios. First, the equity holder—the private-equity firm or,
more accurately, the fund that the private-equity firm is advising—will continue to run the portfolio com-
pany, either by injecting additional equity or by being mandated to act as the owner by the debt holders’
committee. Alternatively, the owner of the debt will take over and run the company. Whether the equity
holder or the debt holder operates the business, neither party has any interest in breaking up the com-
pany, unless the business has a higher liquidation value than a going-concern value. Significant restructur-
ing is already evident at most portfolio companies. We believe this is a necessary reaction to the economic
crisis but one that will lead to massive cost cutting and many difficult layoffs.

In short, we do not think that the large number of defaults at portfolio companies will trigger a real-econ-
omy shock wave. Moreover, we are confident that these companies—even though they are defaulting—
have the same chances of survival as companies not owned by private-equity firms.

5. A Shakeout of Private-Equity Firms Is Inevitable

The biggest impact of the perfect storm will be on the private-equity firms themselves. We estimate that
around 20 to 40 percent of these firms will disappear; on the other hand, at least 30 percent will survive.
The fate of the remaining firms will hang in the balance.17

The timing of the next fundraising round and the private-equity firms’ historical performance will drive
this shakeout. On the basis of an analysis of 87 private-equity firms, including 79 percent of all private-
equity LBO funds raised over the last ten years,18 we found that the shakeout will affect individual firms in
very different ways, depending on the interplay of four main factors: the timing of the firm’s fundraising
needs, its long-term performance, the timing of its recent divestitures and acquisitions, and its exposure to
default-prone industries.

◊ Timing of Fundraising Needs. Any firm requiring additional funding in the near term is likely to face
difficulties. As Exhibit 5 illustrates, the industry as a whole appears to have sufficient surplus funds, or
dry powder. The median of dry powder as a proportion of total funds raised over the last five years is
56 percent. With significantly reduced investment levels, this dry powder could last for more than five
years on average. However, there are big differences in the proportion of dry powder that individual
private-equity firms have, ranging from 100 percent to 0 percent. Firms at the bottom end of the spec-
trum will need to raise funds in the next two to three years, but they will get additional funding only if
they have a very strong historical performance (see below) and investors that are liquid and loyal.

◊ Long-Term Performance. Investors are likely to favor firms that have produced top-quartile, long-term
performance. As previous research has suggested, top-quartile private-equity firms not only gener-
ate twice the returns of mutual funds and publicly listed companies, they also sustain above-average
returns in the long run.19 More remarkably, their returns barely fade at all, unlike other asset classes.
Third- and fourth-quartile performers produce much weaker results. In the recent past, when nearly all
funds did well, investors were willing to give lower-quartile players a chance, but they are unlikely to do
so in the future.

17. Some private-equity firms are diversified, with infrastructure funds, real estate funds, distressed-debt funds, and financial ad-
visory services. These firms will be less exposed to the shakeout.
18. Based on data from Preqin.
19. See The Advantage of Persistence: How the Best Private-Equity Firms “Beat the Fade,” BCG and IESE report, February 2008.

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 Get Ready for the Private-Equity Shakeout 7

Exhibit 5. Fundraising Needs Vary Strongly Among Private-Equity Players

Dry powder1/5-year funds raised (le axis)

% Dry powder1 (right axis) $billions
100 30

25
80

20
60
56% median

15

40
10

20
5

0 0
Private-equity firms2
Sources: Preqin; BCG-IESE analysis.
1
Dry powder is the capital committed by investors into a private-equity fund minus the capital invested by the firm managing the fund.
2
Sample of 87 private-equity firms.

◊ Timing of Recent Divestitures and Acquisitions. The run-up to the financial and economic crisis,
when multiples were high, was a good time to sell and a poor time to buy, given the subsequent collapse
in multiples. Firms that cashed in before the crisis, selling more than they bought, will deliver positive
returns, which is rare in any asset class today. Again, the differences among all private-equity firms are
very big. Some of the firms we analyzed divested five times more than they invested during the debt
bubble. Others invested two to three times more than they divested. Regardless of the portfolio compa-
nies’ performance, the impact from the change in multiples—positive as well as negative—will domi-
nate the effect on the overall return of the private-equity firm.

◊ Exposure to Default-Prone Industries. Private-equity firms’ performance will be heavily influenced

by whether their portfolio companies are in relatively recession-proof industries such as the European
utilities sector, which has one of the lowest default insurance premiums (measured by industry credit
default swaps), or in recession-hit sectors such as the U.S. automotive industry. We found a difference
by a factor of 7 when we applied industry CDS values to all the respective portfolio companies of the
private-equity firms analyzed.

Approximately 20 percent of private-equity firms score low on all four dimensions, and this proportion
could rise as high as 40 percent if institutional investors significantly reduce their private-equity asset allo-
cations. These private-equity firms will sell their remaining portfolio companies and dissolve their teams.
We do not expect this to have any effect on the larger economy.

At the opposite end of the shakeout spectrum, 30 percent of private-equity firms score high on all four di-
mensions. These “winners” do not need funds in the next few years, they divested more than they bought
before the crisis, they have historically produced first- or second-quartile returns, and their portfolios are
relatively unexposed to cyclical industries. We forecast that these firms will be the first to receive addi-
tional equity from institutional investors. They will also be in a strong position to capitalize on today’s low
asset prices.

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 Get Ready for the Private-Equity Shakeout 8

Exhibit 6. The Best Deals Are Done in Downturns

Net IRR in Year-over-year U.S.

vintage years1 (%) Downturns GDP growth (%)
70 5

60 4

IRR of private-
50
equity funds
Top 3
quartile
40
Median
Lower 2
30 quartile

20 1

10 0

0
–1
–10
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Sources: Preqin; the Economist Intelligence Unit.
Note: IRR = internal rate of return.
1
Buyout funds with a focus on the U.S. market.

6. What Can Private-Equity Firms Do Now?

There are three main steps that private-equity firms should take:

First, they should prepare all their portfolio companies for a long and deep recession, focusing on opera-
tional improvements. As the top-performing private-equity firms have shown, operational value creation
holds the key to success. This will be the most critical differentiator in today’s recession, especially for the
50 percent of private-equity firms that are hovering between survival and extinction.

Second, private-equity firms should look for opportunities to take stakes in the troubled portfolio compa-
nies of other private-equity firms as they come onto the market at a significant discount. Since the debt
holders will be in the driver’s seat, this could be done either by buying the debt or by teaming up with
distressed-debt funds and offering the capabilities to run the company.

Finally, the clear winners in the shakeout—the players with substantial dry powder—should consider
offering equity in the wider corporate arena. With $450 billion of dry powder in total, the private-equity
industry is one of the few groups with the resources to help here, along with governments and sovereign
wealth funds.20

The private-equity model is here to stay, but the shakeout will significantly change the shape of the in-
dustry. Pure debt and multiple players, for example, will disappear. It is also likely that the winners will
consolidate the market, lay the foundations for superior long-term returns by investing in cheap assets
during the downturn, and emerge with an even greater focus on operational value creation. Although
there will be defaults, they will not lead to a massive wave of portfolio company breakups or send another
shock wave through the banking sector. The losses from the LBO debt at other institutions, however, are a
cause for concern.

More immediately, the winners of the shakeout should focus on seizing opportunities. The private-equity
industry might be in the middle of a perfect storm, but, as Exhibit 6 illustrates, downturns are perfect mo-
ments to do deals.

20. Preqin.

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 Get Ready for the Private-Equity Shakeout 9

About the Authors

Heino Meerkatt is a senior partner and managing director in BCG’s Munich office. You may contact him
at [email protected].

Heinrich Liechtenstein is an assistant professor of financial management at the IESE Business School.
You may contact him at [email protected].

The Boston Consulting Group (BCG) is a global management consulting firm and the world’s leading advi-
sor on business strategy. We partner with clients in all sectors and regions to identify their highest-value
opportunities, address their most critical challenges, and transform their businesses. Our customized ap-
proach combines deep insight into the dynamics of companies and markets with close collaboration at all
levels of the client organization. This ensures that our clients achieve sustainable competitive advantage,
build more capable organizations, and secure lasting results. Founded in 1963, BCG is a private company
with 66 offices in 38 countries. For more information, please visit www.bcg.com.

The IESE Business School of the University of Navarra is one of the world’s top ten business schools and
has pioneered executive education in Europe since its founding in 1958 in Barcelona. In 1964 IESE intro-
duced Europe’s first full-time MBA program and, subsequently, the world’s first bilingual program in two
of the most important languages of business, English and Spanish. IESE distinguishes itself in its general-
management approach, extensive use of the case method, international outreach, and emphasis on plac-
ing people at the heart of managerial decision making. With a truly global outlook, IESE currently runs
executive-education programs on four continents. For more information, please visit www.iese.edu.

© The Boston Consulting Group, Inc., and the IESE Business School of the University of Navarra, 2008. All rights reserved.

12/08

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