Advanced Introduction to Private Equity

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Advanced Introduction to

Private Equity
PAUL A. GOMPERS
Eugene Holman Professor of Business
Administration, Harvard Business School, USA

STEVEN N. KAPLAN
Neubauer Family Distinguished Service Professor
of Entrepreneurship and Finance, Booth School of
Business, University of Chicago, USA

Elgar Advanced Introductions

© Paul A. Gompers and Steven N. Kaplan 2022

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EEP BoX
Contents

About the authors vi

Preface viii
Acknowledgments by Paul A. Gompers x
Acknowledgments by Steven N. Kaplan xii

1 Introduction to private equity 1

2 Private equity: performance at the portfolio company 29

3 Private equity performance at the fund level 46

4 Investment decision making 69

5 Financial engineering 97

6 Governance engineering 131

7 Operationalizing operational engineering 148

8 Private equity exits 163

9 Raising a private equity fund 194

10 Managing the private equity firm 211

Index 240

v
About the authors

Paul A. Gompers is the Eugene Holman Professor of Business

Administration at the Harvard Business School and specializes in research
on startup, high growth and newly public companies as well as venture cap-
ital and private equity investors. He has published six books, dozens of ref-
ereed journal articles and more than 100 business case studies. He received
his A.B. summa cum laude in biology from Harvard College in 1987. He
attended Oxford University on a Marshall Fellowship where he received
an M.Sc. in economics. He completed his Ph.D. in Business Economics
at Harvard University in 1993. Professor Gompers is co-founder and
non-executive director of Spur Capital Partner, a venture capital fund-of-
funds. He is also a board member of the Boston Symphony Orchestra, the
Beth-Israel Deaconess Hospital and USA Triathlon Foundation.

vi
 About the authors vii

Steven N. Kaplan is the Neubauer Family Distinguished Service Professor

of Entrepreneurship and Finance at the University of Chicago Booth
School of Business. He is a Research Associate at the National Bureau
of Economic Research. A Fortune magazine article referred to Professor
Kaplan as “probably the foremost private equity scholar in the galaxy.” He
co-created the Kaplan-Schoar Public Market Equivalent (PME) private
equity benchmarking approach. He also co-created the Lincoln Middle
Market Index. BusinessWeek named him one of the top 12 business school
teachers and one of the top four entrepreneurship teachers. He is an inves-
tor in several private equity funds.
Preface

This book represents the integration of several streams of professional

activities that we have been involved in over the past several decades.
Both of us have been active in researching, teaching, advising and
investing in the private equity industry for more than 30 years.

We’ve often been asked by private equity professionals, MBA students and
investors to recommend a book that explains both what private equity
does and how to do it. We usually make a couple of recommendations, but
reply that there is no one book that integrates the insights from academic
research with practical recommendations and examples. The best thing
they can do is to take one of our courses. Until now. We decided that it
was time to take the material from our courses and turn the material into
this book.

Over the three-plus decades of our careers, the private equity industry
has grown dramatically in assets under management, diversity of
investment strategies and breadth of geographies. The number of private
equity professionals has similarly exploded. The huge demand for courses
addressing these issues from our MBA students is another indication of
these changes. The high level of compensation of private equity investors
has received a great deal of attention as well, much of it highly politicized.

The demand from students, practitioners and academics for actionable

insights has grown commensurately. Most top business schools have
scholars researching and teaching private equity. Those academics have
contributed to a significant body of academic research that describes and
evaluates a number of important facets of the private equity industry.
That work has explored how PE funds and investments perform, how
various stakeholders are affected, the levers that PE firms employ to effect
those changes and how PE firms are organized and compensated.

viii
 Preface ix

We have organized this book around these major research streams,

integrated that research with a large number of detailed examples and
attempted to provide useful frameworks and actionable insights. Many
of these examples are derived from detailed case studies that are among
the many case studies we have written on private equity firms and
investments. Other examples come from our relationships with private
equity professionals and our own investing experience in private equity.

At the end of the day, the business of investing depends on decision mak-
ing under uncertainty. No decision can be made with perfect foresight.
But investment decisions made that are based upon insights from data,
buttressed by well-reasoned examples and logically articulated, have a
much better chance to generate attractive returns. We hope that this
book can serve as a source of these insights and that everyone who has an
interest in private equity – academics, students, young professionals and
industry veterans – finds this book to be a useful reference.
Acknowledgments
Paul A. Gompers

This book would not have been possible without so many people who
have been a part of my professional career. I have had the privilege to
have amazing mentors from the very beginning of my academic career.
Andrei Shleifer, Richard Ruback and Bill Sahlman have continued to pro-
vide tremendous opportunities to grow as a scholar and have given me
critical advice over the years. Andrei has always focused on the impor-
tance and rigor of the research and ideas. Rick provided early encourage-
ment to dive into the private equity space and continues to be a sounding
board in many areas. And Bill always made sure that my research had a
lens towards ideas that mattered in practice. My co-author in this book,
Steven Kaplan, deserves a special shout-out. Thirty-five years ago as I
toiled doing a biochemistry D.Phil., Steve helped guide me to pursue my
Ph.D. in business economics and started me on the path to this career.
His friendship and counsel for nearly 40 years have been pivotal, making
the writing of this book that much more meaningful.

I have also benefited from having tremendous co-authors over the years.
Andrew Metrick, Josh Lerner, David Scharfstein, Alon Brav, Yuhai
Xuan, Vladimir Muhkarlyamov and Sophie Calder-Wang, in particular,
have contributed to my intellectual growth in numerous ways. Each
has helped me see finance and research in new ways and deepened my
understanding of private equity.

My research and insights for this book have been deepened by my

teaching at Harvard Business School. Over my 27 years at the school, I
have written more than a hundred case studies. Each of those companies
and protagonists was willing to share their stories and provided faces and
texture to insights from the academic research. Many of the frameworks

x
 Acknowledgments xi

for this book have come out of knitting the case insights together. I am
also indebted to the thousands of students who have helped shape the
discussion around those cases.

My colleagues at Spur Capital Partners also deserve special note. While

it was never my intention to found an investment management company,
when circumstances presented themselves to put insights from my work
into practice, I eagerly joined Paul Fetsch, Joan Heidorn and Brad Kelly
to start on a 21-year adventure in the private equity space. We have been
joined on this journey by Teri Hightower, Matt Horten and Kevin Moore.
Having to meet with investors and vote on investments has forced me
to think practically about the research and teaching that are at the core
of my career. Senior professionals at the underlying funds in which we
invest have also given me a greater appreciation for how great investors
operate.

Finally, my family has been a source of support and inspiration. Jody,

Sivan, Annika and Zoe have always been willing to challenge conventional
wisdom. Through their own efforts to achieve in their own domains, I
have continued to find motivation to plow new fields.
Acknowledgments
Steven N. Kaplan

I began studying leveraged buyouts and private equity almost 40 years

ago. At that time, the asset class was new, relatively small and not well
understood. I have been lucky to be able to research and teach in an area
that has grown spectacularly. I have many people to thank for their help
and interest.

I first started thinking about leveraged buyouts and private equity

sometime in the mid-1980s with the encouragement of Bob Glauber at
Harvard Business School. Mike Jensen continued that encouragement
as the chair of my dissertation committee. He is a Nobel Prize–caliber
economist and an amazing mentor.

I also have had a wonderful set of co-authors on private equity research

from whom I have learned and continue to learn. They include Greg
Brown, Paul Gompers, Will Gornall, Oleg Gredil, Bob Harris, Wendy Hu,
Tim Jenkinson, Josh Lerner, Vladimir Mukharlyamov, David Robinson,
Antoinette Schoar, Berk Sensoy, Morten Sorensen, Ilya Strebulaev, Per
Stromberg and Rudi Stucke.

Bob Hamada suggested I teach entrepreneurial finance and private equity

when Paul Gompers left the University of Chicago to return to Harvard
Business School. Since 1996, I have learned about private equity and how
to teach it from thousands of students. A number of those students have
gone on to be successful private equity investors as well as friends. One of

xii
 Acknowledgments xiii

the few good things about getting older is that you get to see your former
students become more and more successful.

I also want to thank Paul Gompers. He has been a terrific co-author and
friend. He suggested we write this book and was the driving force behind
getting it done.

Finally, and most importantly, my wife – Carol Rubin – and my sons –

Sam and Alec – have provided support, motivation and encouragement
for everything I have done.
1 Introduction to private
equity

Why this book?

This book explores and provides a guide to private equity. This guide
has four components. The first provides a brief history of private equity.
The second describes the effects of private equity at both the portfolio
company level and the fund level, particularly whether and how private
equity creates economic value. The third provides a set of frameworks
and considerations for making successful private equity investments.
The fourth provides frameworks and considerations for setting up and
running a successful private equity firm.

We have written this book because we think it will be useful for a book
to put all four components succinctly in one place. The book should be
useful to a number of different types of people: anyone who is interested
in working for a private equity firm; anyone who is interested in selling
their business to a private equity firm; and anyone who is interested in
investing in a private equity fund.

In this introduction, we do four things. First, we describe the private

equity industry, focusing on different sub-sectors and geographies.
Second, we offer a brief history of the development of the private equity
industry. Third, we present a framework for understanding the creation
of value by private equity investors. Fourth, as we discuss the first three,
we describe the contents of the rest of the book.

What is private equity?

The term private equity investment in the most general sense means
investments in equity (stock) of companies that are not traded on stock

1
2 Advanced Introduction to Private Equity

exchanges and, therefore, are not available for investment by the general
public. Private equity firms are financial intermediaries that help investors
(usually large institutional investors and often referred to as limited
partners or “LPs”) make private equity investments by contributing
capital to “funds” established by the private equity firms. Successful
private equity investing relies on careful evaluation of investments,
structuring the investments or deals, financial engineering, governance
engineering and operational engineering. Each of those activities creates
value for private equity investors and their operating companies.

In this book, we draw a distinction between venture capital and private

equity. Private equity grew out of the venture capital industry, but the
typical definition of private equity generally refers to investments in lev-
eraged buyouts (LBOs, discussed below), growth capital (large, but usu-
ally minority investments in stock of growing or scaling companies),
distressed investments (investing in company securities in bankruptcy or
close to it) and, sometimes, mezzanine capital (preferred equity invest-
ments senior to common stock, typically raised by smaller companies).

The private equity industry became established during the leveraged

buyout boom of the 1980s, but was preceded by the first venture capi-
tal funds which were formed in the 1940s. Although they emerged later,
buyout funds share a common structure, compensation and investor
base with venture capital funds. The industry practices in buyout funds,
in many respects, stem from the venture capital industry’s practices that
developed during the early stages of its evolution.

As discussed above, private equity investors often have various strategies

that target companies at different stages of their life cycle or different
states of financial health. The earliest private equity investments were
leveraged buyouts, which emerged and became important in the first half
of the 1980s. In a typical leveraged buyout transaction, a private equity
firm buys majority control of an existing company – whether, public,
private or the division of another company – hence, the “buyout.” Target
companies are generally sought for identifiable opportunities for private
equity investors to create value. Many of the early targets of LBO firms
were underperforming or undermanaged public companies in which the
incentives of management were misaligned with outside shareholders.
Some of those targets were firms that engaged in conglomerate mergers
in the 1960s and 1970s. Private equity investors would take private these
 Introduction to private equity 3

companies by raising a significant amount of debt and delisting their

stock from the public market.

The rise in leveraged buyouts in the 1980s was fueled by the rapid
development of the “junk bond” market that allowed firms with less than
an investment-grade rating to raise significant amounts of debt capital.
With a source of debt, LBO investors could target underperforming
firms and put in place financial, governance and, later, operational levers
that improved performance.

Michael Jensen in a variety of seminal papers argued that LBOs were

a superior organizational form for many companies. Managers, who
typically owned little in the way of company stock, had a much larger
ownership of the firm after the LBO, providing incentives to increase
cash flows and value. The large, fixed interest and principal repayment
schedules on debt enforced discipline on these managers as well.

LBOs are typically financed by equity capital from the private equity
firm and debt capital provided by banks, private investors and the public
markets. The fraction of deal value provided by equity capital has varied
markedly over time from a low of roughly 10% in the late 1980s to roughly
50% today. In Chapter 5, we discuss financial engineering and explore the
firm- and market-specific factors that influence the amount of debt that is
raised when a transaction is completed. We highlight the important inter-
mediaries and contractual terms that are typically used in these deals.
Private equity investors usually look to firms with strong stable cash flows
to pay the fixed interest and principal payments. Similarly, firms that are
underleveraged, having relatively modest amounts of debt, create the
opportunity to enhance value through increased interest tax shields.

LBO transactions occur across the size spectrum. Many of the transac-
tions that receive public attention are the large, take private transactions in
which large public companies are taken private. These transactions can be
in the tens of billions of dollars. On the other end of the spectrum, lower
middle-market private equity investors target smaller companies, most of
which are already private. In these transactions, convincing the owners
to sell their stake is often the critical element of the deal process. Some
of these lower middle-market private equity firms specialize in buy-and-
build transactions, often purchasing multiple players in an industry in the
hopes of building a larger company that can be sold at a higher price.
4 Advanced Introduction to Private Equity

A second important sub-sector of private equity is growth capital or growth

equity. Growth equity investors look for companies that have established
business models but require large amounts of capital to scale. Some of
these companies may have started as venture capital-backed startups but
have grown to the point at which growth equity is required. In these cases,
growth equity often partially cashes out the venture capitalists and found-
ers. Many other growth equity investments have been bootstrapped or
grown as private companies and are looking to transition to the next stage
of their development. An example would be a company with a restaurant
concept that is established with five or ten sites in a region, but needs capi-
tal to expand nationally. Many growth equity investors specialize by indus-
try and bring strategic/operational knowledge to the deal.

Distressed investing represents a third sub-sector within private equity.

Distressed investors often look to acquire their ownership through the
purchase of debt instruments. Typically, the debt of a distressed com-
pany trades at a discount, i.e., below par value, in anticipation of a poten-
tial default and bankruptcy restructuring. Distressed investors typically
have a strategy that either entails having the debt repaid at par value or
exchanging their debt holdings for equity in some type of debt for equity
swap. Given the complex contractual and legal aspects of these invest-
ments, private equity firms that focus on distress typically have significant
knowledge and capabilities around the reorganization and bankruptcy
process. Deal execution often entails coordination of multiple parties as
the restructuring progresses.

Finally, some private equity investors opportunistically target private

investments in public equity (PIPEs). In a PIPE transaction, the private
equity firm invests a substantial amount of equity in a public company,
but does not take the company private. The company may need liquidity
or may want access to the private equity investors’ expertise. Terms of the
PIPE typically provide the private equity investors with favorable terms
and conditions in return for providing needed capital. PIPE investments
tend to be somewhat counter-cyclical to debt markets, i.e., when it is
more difficult to raise debt capital for LBOs, private equity investors often
look to invest in PIPE transactions. Two examples would be Silver Lake
Partners investing in Airbnb and Expedia in the midst of the COVID-19
pandemic in the spring of 2020.

One other class of funds, secondary private equity funds, is worth men-
tioning. In the last twenty years, these funds have emerged to provide
 Introduction to private equity 5

liquidity for investors (in all types of private equity funds) who need to
sell their fund positions for liquidity, regulatory or strategic reasons.

Whatever the sector, a critical element of the private equity investment

process is identifying potential targets, evaluating them and negotiating
transactions. In Chapter 4, we explore the deal sourcing, selection and
structuring of private equity investments. Importantly, we present both
qualitative and quantitative frameworks for evaluating investments.

As the private equity industry has grown, deals have become more com-
petitive and driven up purchase multiples. Some private equity firms,
particularly those that target smaller deals, claim that they have propri-
etary deal flow and are able to purchase companies at attractive prices.
As the market for private equity deals has become more competitive,
however, this has become increasingly difficult to do. Most private equity
firms, if not all, need to focus on generating value through other means.

Accordingly, most private equity firms seek to identify companies that

need operational improvements. Improving operating performance is
critical to consistently generating attractive returns. Private equity inves-
tors do this by picking targets in attractive industry segments and then
improving governance and operations. In fact, investors often specialize
in a sector and/or have sector-focused operating partners within their
firms. In Chapter 6, we discuss governance engineering in more detail,
and in Chapter 7, we discuss operational engineering in more detail.

Before purchasing a company, private equity firms conduct extensive due

diligence; i.e., research and analysis of the company’s strategy, business
plans, financial information, products, relationships with customers,
suppliers and employees, positioning in the industry, etc. Effective due
diligence does at least two things. First, it reduces the general uncertainty
about the transaction. This allows the private equity investor to better
forecast cash flows and outcomes. That, in turn, allows the investors
to better decide whether a transaction is desirable, at what price and
whether it can support leverage.

Second, due diligence reduces the asymmetry of information between

the private equity investor and the seller of the portfolio company. This
is important because the seller will typically know more about what it is
selling than the buyer does. When the buyer is at such an information
disadvantage, the buyer is afraid of getting a “lemon” and will tend to
6 Advanced Introduction to Private Equity

offer a lower price. When a buyer gets access to better and more detailed
information, information asymmetry is reduced. If the information is
favorable, the buyer will be willing to bid higher. Acquirers who are
strongly aligned with the target’s management generally have access
to better information and also are able to interpret that information
through the eyes of key senior management.

In addition to being skilled themselves in analyzing targets and

managing their portfolio companies, private equity firms, particularly
the larger ones, often retain leading consulting firms that have specific
expertise in a particular industry or area of operations – both during
the due diligence period and after the purchase. Typical operating
improvements that private equity firms introduce include retaining
experienced professional management, finding new areas of growth,
reducing costs, spinning off non-core activities and achieving synergies
with other portfolio companies of the same funds of private equity firms.

Private equity investors do not intend to own and operate portfolio

companies indefinitely. Because the funds from which investments are
made have predetermined lives, usually between 10 and 13 years, private
equity investors target an exit within that time frame. Most deals are
modeled with a five-year time horizon. Typical realized holding periods
are between three and eight years.

Private equity investors look to exit by taking the company public

through an initial public offering (“IPO”), selling the company to a
strategic acquirer or another private equity investor, performing a
leveraged recapitalization in which debt is raised to buyback the private
equity firm’s equity and, most recently, by selling to a special purpose
acquisition corporation or SPAC. By forcing private equity firms to seek
an exit, limited partners ensure that private equity managers do not
retain investors’ cash and are forced to raise new funds if they desire
to continue making new investments. In Chapter 8, we discuss exit in
greater detail.

Private equity organizations

Private equity firms typically raise dedicated funds in the form of lim-
ited partnerships. Investors in these limited partnerships (referred to as
 Introduction to private equity 7

LPs) are large institutional investors like pension funds, endowments,

sovereign wealth funds and family offices or high net worth individuals.
Private equity, as an asset class, has grown substantially over the past
20 years. This growth has been accelerated by the increased allocation
to the asset class by large institutions. This desire to increase allocation
has been driven, in part, by the substantial outperformance of large uni-
versity endowments like Yale University (and its longtime chief invest-
ment officer, David Swensen) which were early investors in these types
of funds.

Some private equity firms raise multiple funds with distinct investment
strategies (growth, buyout, distress) or distinct geographies (e.g., US,
Europe, Asia). Other private equity firms with more narrow strategies
may raise only one fund at a time. All of these funds typically have 10- to
13-year lives with an investment period that is usually on the order of
five years. Private equity firms typically raise a new fund every two to
five years depending upon how quickly they invest the capital from their
current existing fund.

Limited partnership agreements govern the relationship between GPs

(the private equity investors) and LPs. The limited partnership agree-
ment explicitly specifies the terms that govern the private equity firm’s
compensation during the fund’s lifetime. It is rare for terms to be rene-
gotiated. In addition, the specified compensation has a simple form that
governs the relationship over the entire 10- to 13-year life of the fund.
The private equity investor typically receives an annual fixed fee based
on committed capital or net asset value (1–2%) plus variable compensa-
tion, or carried interest, that is a specified fraction of the fund’s profits
(usually about 20%).

Among other terms, these contracts contain a variety of restrictions on

the GPs in terms of their investment activities. There are often limits on
portfolio concentration or on which types of investments can be made.
From a governance perspective, LPs typically do not become involved
in oversight of the GPs and rely on the limited partnership contract to
define the relationship between investors and the fund managers.

Private equity firms’ fundraising comes in the form of commitments

from LPs rather than actual cash. The private equity firm calls the
funds from investors when an investment has been located and closed
8 Advanced Introduction to Private Equity

or when management fees need to be paid. The LPs then contribute a

proportional share of their commitments. This “just in time” funding
of investments and fees ensures that cash is put to use as needed while
generally maximizing the rate of return on investment. In Chapter 9, we
discuss fundraising and how funds are structured in greater detail.

The history of private equity

The evolution of the modern private equity firm begins with the history
of venture capital in the US. Venture capital first developed in the late
nineteenth and early twentieth centuries. Wealthy families began to look
for ways to invest in potentially high-return, high-tech undertakings.
The market for venture capital remained largely unorganized and frag-
mented throughout the late nineteenth and early twentieth centuries.
The first impetus to organize investing came from wealthy Americans. In
the 1930s and 1940s, members of the Rockefeller, Bessemer and Whitney
families hired professional managers to seek out investments in promis-
ing young companies.

The first modern venture capital firm was formed in 1946, when MIT
president Karl Compton, Massachusetts Investors Trust chairman
Merrill Griswold, Federal Reserve Bank of Boston president Ralph
Flanders and Harvard Business School Professor General Georges F.
Doriot started American Research and Development (ARD). The goal of
the company was to finance commercial applications of technologies that
were developed during World War II.

These earliest venture capital firms were organized in the Northeast,

centered both in Boston and New York. It was not until 1957 that
West Coast venture capital came into existence. Arthur Rock, then
an investment banker at Hayden, Stone & Co. in New York City, was
sent to investigate a potential project in California. Rock called various
individual and institutional investors to secure financing for Eugene
Kleiner and a group of Shockley Laboratory employees.

A key event in the history of venture capital, and hence private equity
funds, was the rise of the limited partnership. The early venture capital
firms were structured as publicly traded closed-end funds. This struc-
ture created a number of problems, particularly the difficulty of raising
 Introduction to private equity 9

additional capital when the fund’s share price was depressed. The intro-
duction of the limited partnership, by Draper, Gaither and Anderson in
1959, heralded a critical innovation for the industry that would serve as
the nearly universal organizational form for private equity funds.

Private equity, as distinct from venture capital, begins in the late 1970s
when the private equity firm Kohlberg Kravis & Roberts (KKR) began
financing and, likely, invented the first meaningful LBOs. LBOs increased
in size and frequency in the 1980s, a decade when hostile takeovers and
other often highly leveraged transactions also became common. The
growth in the junk bond market, created by Michael Milken and Drexel
Burnham Lambert, fueled both the LBO and hostile takeover wave. Many
of these transactions purchased companies with ever higher levels of debt
to total capital and came under public scrutiny. Perhaps no deal better
captures this time period than KKR’s purchase in 1988 of RJR-Nabisco,
a large public company. KKR, which has gone on to become one of the
largest global managers of private equity, paid a large premium – roughly
100% – to take control of RJR-Nabisco. The deal became the stuff of legend
when Barbarians at the Gate, a best-selling account of the deal, was pub-
lished. The deal also inspired movies like Wall Street, which demonized
LBO investors. The rise of the LBO led to scrutiny among regulators and
lawmakers as the transactions gained a reputation for drastically reduc-
ing costs, including employment. In 1989, the US Senate and House con-
ducted hearings on “LBOs and Corporate Debt.”

Private equity today

The private equity industry has grown substantially over the decades.
Table 1.1 shows the amount of money committed to private equity funds
globally each year from 2006 through 2019. Fundraising from 2006 to
2008 was strong, at roughly $300 billion annually. It declined markedly
with the global financial crisis in 2009 and 2010, bottoming out at $130
billion raised globally in 2010. Since then, robust global economic growth
likely has fueled rapid growth of the industry. Fundraising has increased
steadily and reached a record of $733 billion in 2021.1

One of the more dramatic changes in the private equity industry over
the past 30 years has been its expansion outside of the US as shown in
Table 1.2 which tabulates global fundraising by region. Not surprisingly,
10 Advanced Introduction to Private Equity

Table 1.1 Private Equity Fundraising Activity

Capital Raised (USD bn) Number of Funds
2006 $280.17 540
2007 $387.41 614
2008 $301.72 551
2009 $170.16 362
2010 $129.95 408
2011 $176.78 481
2012 $183.88 493
2013 $276.51 564
2014 $322.74 682
2015 $259.07 632
2016 $350.59 656
2017 $397.02 702
2018 $476.38 610
2019 $505.40 529
Source: Pitchbook

North America has been the top region in every year, accounting for
$162.6 billion in capital in 2006 and $322.3 billion in 2019. Europe
has generally been the second most active region, raising $90.2 billion
in 2006 and increasing to $108.3 billion in 2019. The most significant
growth in recent years has occurred in Asia. At the beginning of the
period, Asian private equity firms raised only $16.7 billion. In 2018,
Asian funds raised $169.4 billion. Oceania, the Middle East and Africa
have generally been substantially smaller private equity markets, usually
only several billion dollars per year.

To get a sense of magnitudes, PE funds raised almost $1.2 trillion in North

America from 2015 to 2019. PE funds generally hold their investments
for five years, so this would be a good estimate of the stock of invested
capital. Those investments tend to be leveraged at least 1 to 1, meaning
the portfolio company values would exceed $2.4 trillion. This represents
almost 10% of the value of the US stock market during that period.

Table 1.3 illustrates the diversity of fund types and variation in fundrais-
ing by tabulating total amount of capital committed to various sub-sec-
tors of private equity from 2006 to 2019. Buyout fundraising decreased
Table 1.2 Private Equity Funds Raised by Geography
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Rest of $1.02 $3.45 $3.57 $0.91 $3.97 $9.99 $1.54 $1.87 $3.29 $1.62 $1.87 $1.75 $0.96 $2.01
world
Africa $1.15 $4.19 $2.76 $1.74 $1.81 $1.52 $0.95 $3.48 $0.89 $4.16 $2.66 $0.67 $1.34 $0.61
Middle $5.00 $4.39 $9.54 $1.21 $1.68 $0.99 $5.05 $1.74 $1.50 $1.42 $2.09 $1.66 $0.21 $0.49
East
Oceania $3.65 $1.42 $4.93 $0.55 $2.75 $1.67 $3.61 $0.81 $1.48 $2.03 $2.68 $2.82 $2.96 $0.00
Asia $16.65 $28.15 $35.89 $14.51 $28.32 $29.81 $38.16 $24.87 $69.59 $37.37 $35.70 $28.76 $169.42 $71.66
Europe $90.16 $108.40 $78.04 $51.59 $27.61 $54.34 $33.15 $79.81 $61.01 $57.55 $72.62 $98.15 $89.64 $108.33
North $162.55 $237.40 $166.98 $99.64 $63.80 $78.46 $101.41 $163.92 $184.99 $154.92 $232.97 $263.21 $211.85 $322.30
America

Source: Pitchbook
Introduction to private equity
11
12 Advanced Introduction to Private Equity

Table 1.3 Capital Raised by Fund Type

Buyout Diversified Mezzanine PE Growth/ Restructuring/
Private Equity Expansion Turnaround
2006 $226.01 $0.16 $30.91 $20.97 $2.12
2007 $333.01 $0.55 $27.18 $22.07 $4.60
2008 $245.85 $0.12 $22.52 $29.78 $3.45
2009 $139.95 $0.04 $8.82 $20.54 $0.82
2010 $91.90 $1.25 $9.09 $26.02 $1.71
2011 $128.32 $0.23 $11.78 $35.45 $1.00
2012 $144.04 $0.00 $17.78 $22.06 $0.00
2013 $231.85 $0.19 $15.36 $24.36 $4.75
2014 $257.62 $2.17 $11.16 $49.75 $2.04
2015 $204.51 $0.00 $16.06 $38.50 $0.00
2016 $264.76 $3.10 $37.75 $40.02 $4.95
2017 $336.01 $0.05 $18.97 $41.80 $0.20
2018 $302.90 $0.39 $27.06 $140.00 $6.04
2019 $398.89 $0.33 $6.76 $90.12 $9.29
Source: Pitchbook

substantially after the financial crisis, declining to $91.9 billion in 2010,

but then growing to $398.9 billion in 2019. As befits its name, the larg-
est percentage growth has been in growth-stage private equity, which
increased by almost seven times from only $21 billion in 2006 to $140
billion in 2018. Mezzanine and turnaround investing, in contrast, have
been relatively smaller sub-sectors.

Over the past 30 years, the growth in global private equity fundraising
has led to the emergence of global players managing many billions of dol-
lars in capital. Table 1.4 lists the top 20 private equity firms based on capi-
tal under management and highlights their investment focus, namely the
asset class and strategies in which they invest, as well as their geographies.
Most of the global private equity firms invest across multiple geographies
and multiple asset classes. Nine of the top 10 global private equity firms
are headquartered in the US. Carlyle, KKR and Blackstone are the three
largest, with each managing more than $100 billion. CVC is the largest
non-US headquartered fund with $108 billion under management and
headquartered in the UK. There are a few exceptions. Sino-IC Capital
Table 1.4 Largest Private Equity Firms in 2020
Firm Name Total Funds Funds in Estimated Asset Strategy Geographic Focus Headquarters
Raised Market Dry Powder Class
(USD mn) (USD mn)
Carlyle Group $129 743 19 $31 609 PE, VC Buyout, growth Asia, North America, Europe, US
US, Japan, Brazil, China,
Germany, Middle East, Peru,
South America, Tanzania, UK,
West Europe
KKR $116 579 10 $19 894 PE, VC Buyout, growth US, North America, Europe, US
Asia, Greater China
Blackstone $116 564 13 $12 289 PE, VC Buyout, growth US, North America, Mexico, US
Group Asia, China
TPG $109 073 4 $18 880 PE, VC Buyout, US, Asia, China, North US
growth, America, South America
turnaround
CVC $108 762 0 $34 482 PE, VC Buyout, growth Asia, Europe, West Europe UK
Apollo $79 148 8 $19 073 PE Buyout North America, US, Asia US
Bain Capital $71 781 5 $12 115 PE Buyout US, North America, Europe, US
Asia, Japan
Advent $70 520 1 $16 135 PE Buyout Americas, North America, US
International Central and East Europe, West
Europe, Europe
Silver Lake $62 687 2 $21 178 PE, VC Buyout, growth North America, US US
Introduction to private equity

(Continued)
13
Table 1.4 (Continued)
14

Firm Name Total Funds Funds in Estimated Asset Strategy Geographic Focus Headquarters
Raised Market Dry Powder Class
(USD mn) (USD mn)
Hellman & $53 251 2 $12 494 PE Buyout North America, US US
Friedman
SINO-IC Capital $52 315 0 $23 400 PE, VC Growth China China
Permira $51 900 0 $11 037 PE, VC Buyout, growth Europe, France, UK, Germany UK
The Goldman $50 650 4 $4 569 PE, VC Buyout, growth North America, Asia, China US
Sachs
Apax Partners $46 439 1 $765 PE, VC Buyout, growth Europe, Israel, North America UK
Vista Equity $45 276 3 $13 167 PE Buyout North America US
Partners
EQT $44 762 2 $22 466 PE Buyout, Europe, Asia, US Sweden
turnaround
Clayton Dubilier $43 375 1 $14 654 PE Buyout North America, US US
& Rice
Advanced Introduction to Private Equity

Cinven $41 624 0 $9 490 PE Buyout Europe UK

Leonard Green $39 523 0 $12 030 PE Buyout North America, US US
Providence $36 937 1 $5 870 PE, VC Buyout, growth North America, Europe US
Equity Partners
Source: Preqin
 Introduction to private equity 15

invests solely in China, while Cinven focuses on Europe. Sino-IC focuses

on growth equity, while all of the other firms invest in buyouts. This is
consistent with the younger maturity of the Chinese market, where there
are fewer buyout opportunities.

The prior statistics looked at fundraising by private equity firms.

Because many of the deals include leverage, and because funds are
invested over a three- to five-year period, it is useful to also examine
the amount of actual investments made in a given year. Table 1.5 looks
at the geography and value of private equity transactions from 2017 to
2019. The US was the largest market for transactions, with more than
$300 billion in transaction value in each year, peaking at $372 billion

Table 1.5 Private Equity Value of Transactions by Country

2017 2018 2019
United States $349 943 $338 485 $372 056
China $97 344 $120 647 $84 071
United Kingdom $61 294 $44 321 $68 443
Germany $17 997 $25 649 $36 901
Spain $24 145 $30 254 $24 279
France $20 118 $47 322 $22 182
Canada $12 306 $41 053 $21 320
South Korea $11 029 $19 064 $21 139
India $18 958 $17 651 $19 421
Switzerland $4 134 $3 796 $19 165
Australia $16 800 $22 098 $16 733
Netherlands $9 386 $28 417 $14 402
Japan $32 109 $3 092 $14 150
Brazil $3 672 $5 885 $13 028
Hong Kong $2 923 $6 789 $11 266
Sweden $5 873 $7 857 $9 584
Chile $480 $113 $8 898
Italy $12 158 $21 623 $8 416
Israel $5 057 $4 226 $7 603
Bermuda $4 568 $8 036 $6 118
Source: Bureau van Dijk (BVP)
16 Advanced Introduction to Private Equity

Table 1.6 Global Private Equity Transactions 2014–19

Number of Deals Total Deal Value (USD mn)
2014 26 470 $845 561
2015 27 123 $905 995
2016 25 742 $811 298
2017 25 565 $609 791
2018 27 703 $767 991
2019 25 923 $564 627
Source: Bureau van Dijk (BVP)

in 2019. China represented the next largest market in terms of transac-

tion values, ranging from $84 billion in 2019 to $120 billion in 2018.
The UK, Germany, Spain and France were the four next largest mar-
kets. Several emerging economies also appear on the list, including
India, Brazil and Chile. Overall, the table clearly shows the global
impact of private equity.

Table 1.6 provides a summary of total private equity transaction value

from 2014 to 2019. While the data source differs from Table 1.5, Table 1.6
identifies more than 25 000 transactions in each year, with aggregate
transaction values between $564 and $905 billion. The largest single cat-
egory of investments is buyouts whose fundraising from 2000 to 2019 we
tabulate in Table 1.7. Aggregate capital raised increased substantially in
the early 2000s before declining after the financial crisis. Over the past
10 years, we have seen a consistent increase in both the aggregate capital
raised and average fund size. In 2019, a record $387 billion of buyout
capital was raised with an average fund size of $1.5 billion.

The investment activity of buyout funds from 2009 through

2019 is tabulated in Table 1.8. Over the period, buyout funds engaged
in 54 816 transactions with an aggregate deal value of $3.9 trillion. The
average deal size was $306 million. In 2009, the buyout industry engaged
in 2565 transactions for a total aggregate transaction value of $118.7 bil-
lion. Aggregate transaction value peaked in 2018 when 6673 buyouts
had a total transaction value of $435 billion. These data show that the
private equity industry has clearly been transformative in the overall
economy. Subsequent chapters will explore exactly how private equity
firms operate, how they add value and the role that they play in the over-
all economy.
 Introduction to private equity 17

Table 1.7 Leveraged Buyouts Funds Raised from 2000 to 2019

Number of Aggregate Capital Average Size
Funds Raised (USD bn) (USD mn)
2000 146 $89.90 $676.00
2001 118 $55.05 $496.00
2002 114 $62.97 $606.00
2003 107 $43.88 $418.00
2004 146 $67.41 $485.00
2005 215 $143.15 $698.00
2006 262 $225.61 $899.00
2007 278 $250.09 $947.00
2008 251 $233.78 $974.00
2009 151 $113.07 $825.00
2010 148 $79.21 $587.00
2011 153 $94.13 $672.00
2012 185 $103.11 $614.00
2013 226 $191.07 $932.00
2014 252 $187.51 $808.00
2015 291 $179.89 $689.00
2016 314 $243.90 $856.00
2017 358 $309.34 $937.00
2018 273 $238.57 $921.00
2019 286 $387.87 $1 498.00
Source: Prequin

Table 1.9 ranks global private equity firms by the number of transac-
tions in 2019. Some private equity firms are extremely active yet make
middle-market or smaller transactions. Audax, a middle-market private
equity firm, generated the most deals, closing 96 transactions in 2019.
KKR closed the second most with 92 deals. HarbourVest, a fund-of-
funds, closed on 91, primarily through co-investments with underlying
partnerships in which they had invested. The list shows a mix of types
of private equity firms from the largest, globally diversified firms, e.g.,
KKR, Carlyle and Blackstone, to more focused private equity managers
like Genstar and Insight Partners.
18 Advanced Introduction to Private Equity

Table 1.8 Leveraged Buyout Transactions 2009–19 (USD bn)

Year Number of Aggregate Deal Value Average Deal Size
Deals (USD bn) (USD mn)
2009 2 565 $118.7 $151.6
2010 3 755 $246.7 $212.5
2011 4 505 $292.3 $216.2
2012 4 602 $289.3 $218.3
2013 4 354 $328.8 $263.7
2014 5 205 $386.0 $299.0
2015 5 458 $477.2 $403.1
2016 5 780 $367.2 $314.4
2017 6 230 $448.8 $408.0
2018 6 673 $520.5 $439.6
2019 5 689 $435.3 $448.3
Overall 54 816 $3 910.8 $306.4
Source: Prequin

Table 1.9 Top Global PE Firms by Deal Count

Investor Number of Deals
Audax Group 96
Kohlberg Kravis Roberts 92
HarbourVest Partners 91
The Carlyle Group 82
Genstar Capital 72
Business Growth Fund 71
Bpifrance 71
TA Associates Management 67
The Blackstone Group 66
Ardian 62
Caisse de dépôt et placement du Québec 60
Government of Singapore Investment Corporation (GIC) 56
EQT 56
Hellman & Friedman 55
Insight Partners 53
Source: Pitchbook
 Introduction to private equity 19

Assessing value creation in private equity

Private equity investors seek to generate attractive returns for their inves-
tors by executing well-developed strategies. LPs hope to earn returns that
exceed the risk of those returns, so-called positive risk-adjusted returns
or returns with a positive alpha. Private equity investors can create risk-
adjusted value in three ways: by reducing the riskiness of those cash flows,
by buying low or by increasing future cash flows from the company.

Decreasing the riskiness of cash flows is hard to do in practice. Risk is

generally thought of in terms of “systematic risk,” i.e., how the riskiness
of a diversified portfolio is affected by adding the investment in question.
The simplest model of systematic risk and return, the capital asset pric-
ing model (CAPM), leaves little room for private equity investors to cre-
ate value. Other multi-factor models, including the Fama–French model,
look at size as a factor for systemic risk. In this framework, growing a
company (either organically or through acquisition) may increase value
because systematic risk is lower.2

Historically, PE firms have tried to buy assets at a below market price.

In an increasingly competitive deal environment, this is difficult to do.
Accordingly, much of what private equity investors do focuses on improv-
ing cash flows and increasing the growth rate of those cash flows. Below
we will highlight how improving cash flows relates to the way these firms
typically assess investments.

In this section, we discuss how private equity firms typically evalu-

ate their investments in terms of value creation and explicitly tie it to
an understanding of the sources of real value creation from academic
research. In practice, private equity investors examine three levers that
could, at least in theory, generate positive risk-adjusted returns for their
investors: operational or cash flow improvements, multiple expansion
and leverage. Accordingly, many private equity firms use what is often
referred to as a “value bridge” to measure the increase in value both pro-
spectively before an investment is made and, retrospectively, after a deal
exit is realized. While the concept of a value bridge is helpful, there are
some elements that can be misleading.

The price a private equity firm pays for a portfolio company is the total
enterprise value of the firm. This represents the value of the equity and
20 Advanced Introduction to Private Equity

debt that are used to finance the transaction. It helps to think of the
enterprise value of the portfolio company as the equivalent of the value
of a house. And, like a house, the enterprise value is split between equity
(the down payment) and debt (the mortgage). Enterprise values are usu-
ally referred to as multiples of the portfolio company’s earnings before
interest, taxes, depreciation and amortization (EBITDA). EBITDA pro-
vides a measure of the cash flow a company generates. The enterprise
value at the time of investment represents the total consideration paid by
the private equity firm to buy the company which determines an entry
EBITDA multiple, Multiplein, that can be determined by dividing the
total purchase price by current EBITDA, EBITDAin.

The private equity investor is interested in understanding the sources of

the increase in equity value over the life of an investment. Equity value at
the time the investment closes, Equityin, is determined by estimating the
enterprise value at the time of the investment minus the amount of debt
outstanding after the transaction closes. Equityin is the amount of equity
that is actually invested by the private equity investors into the transac-
tion. A similar exercise is done for the deal at the time of exit. Equityout
is what the private equity investor is trying to determine and represents
the equity proceeds that they receive at the sale of the company. The
enterprise value at exit represents the total consideration received by the
private equity firm at the time the portfolio company is sold. The exit
enterprise value then determines an exit EBITDA multiple, Multipleout,
that can be determined by dividing the total exit price by exit year
EBITDA, EBITDAout. In order for the private equity firm to estimate its
proceeds from the sale, it needs to subtract debt outstanding at the time
the deal is sold, Debtout, from the enterprise value. Equityout is the gross
amount of money that the private equity firm receives to pay returns to
investors and carried interest. As mentioned earlier, Equityout is projected
at the time of investment to estimate what the potential gross return on
the investment might be in order to make a decision about whether it
makes sense for the PE firm to undertake.

It is fairly easy to derive the math behind a value bridge. Multiplein

represents the EBITDA multiple paid when the firm is purchased, and
Multipleout is the EBITDA multiple at which the company is sold upon
exit. Total enterprise values (TEV) at purchase (in) and exit (out) are
given by:
 Introduction to private equity 21

(1) TEVpurchase = EBITDAin × Multiplein and

TEVout  = EBITDAout × Multipleout

The TEV, in turn, is split between debt and equity both at purchase (in)
and at exit (out):

(2) But, TEVin = Debtin + Equityin and TEVout = Debtout + Equityout

(3) Equityout – Equityin = (EBITDAout × Multipleout – Debtout)
– (EBITDAin × Multiplein – Debtin)

If we rearrange, (6) shows that the increase in equity value consists

of three components: (i) multiple expansion – the increase in multi-
ple between the purchase and sale multiplied by the exit EBITDA, (ii)
EBITDA growth – the increase in EBITDA between purchase and sale
multiplied by the exit multiple, and (iii) debt reduction.

(4) Equityout – Equityin = (EBITDAout × Multipleout

– EBITDAin × Multiplein) – Debtout + Debtin
(5) Equityout – Equityin = (EBITDAout × Multipleout – EBITDAout × Multiplein)
+ ( EBITDAout × Multiplein – EBITDAin × Multiplein)
+ (Debtin – Debtout)
(6) Equityout – Equityin = EBITDAout × (Multipleout – Multiplein)
[Multiple expansion]
+ (EBITDAout – EBITDAin) × Multiplein
[EBITDA growth]
+ (Debtin – Debtout) [Debt reduction]

Private equity firms typically calculate two measures of return to evalu-

ate deals, internal rate of return (IRR) and multiple on invested capital
(MOIC). MOIC is simply calculated by taking the ratio of Equityout over
Equityin. IRR is the rate of return over the holding period of the invest-
ment and is calculated by (Equityout/Equityin)1/n – 1 where n is the number
of years that the investment has been held.

At the time of investment, private equity investors typically use hurdle

rates for MOIC and IRR that determine whether the investment is attrac-
tive. A typical MOIC hurdle is 2.5 to 3.0 times (over five years) and a typi-
cal IRR hurdle rate is 20% to 25%. If the prospective investment has a
return above these thresholds, it is usually considered attractive.
22 Advanced Introduction to Private Equity

 
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Figure 1.1 Value Bridge from Dia Kanri Investment by Advantage Partners

An example of a real value bridge is helpful in understanding how

it is used in practice. Figure 1.1 shows a real value bridge created by
Advantage Partners, a Japanese private equity firm, when it evaluated
its performance after selling Dia Kanri, a roll-up in the condominium
management business.3

Dia Kanri was an investment completed in September 2008 that intended

to roll up condominium management companies in Japan. The total pur-
chase price (TEV) was 8.0 billion yen (net of cash). The performance of
the company improved substantially under Advantage Partners manage-
ment. Revenue grew from 16.5 billion yen in 2008 to 26.9 billion yen in
2013. EBITDA increased from 1.3 billion yen in 2008 to 3.5 billion yen
in 2013. Advantage Partners sold the company in an auction in August
2013 to Tokyu, a publicly traded condominium management company,
for 36 billion yen, i.e., the TEV at exit was 36 billion yen. After adjusting
for management stock options and deal expenses, Advantage Partners’
 Introduction to private equity 23

equity investment of 1.5 billion yen grew by 32.8 billion yen to an exit
value of 34.3 billion yen.

Figure 1.1 shows that the debt was completely paid off (labeled “Leverage
Effect”), i.e., Debtin – Debtout contributed 6.5 billion yen to the return. The
increase in EBITDA (EBITDAout –EBITDAin) accounted for a 13.5 billion
yen increase in equity value. Similarly, the increase in the EBITDA multi-
ple from the time of acquisition to the time of exit (Multipleout – Multiplein)
was responsible for 14.5 billion yen of equity value appreciation.

Advantage Partners also calculated its return on the investment using

both an IRR and MOIC. Dia Kanir was held within the portfolio for 4.9
years. The IRR on the equity investment was 90% and the MOIC was 23×.
These returns are extremely high, but illustrate how most private equity
firms seek to attribute value. As mentioned earlier, most private equity
firms do a value bridge both prospectively to understand how they may
be able to generate returns, as well as retrospectively, in order to under-
stand what actually created value after the fact.

While this general framework is helpful to understand mechanically how

value is created, a deeper understanding of the drivers of value is criti-
cal to both making better investment decisions, as well as evaluating the
contribution of private equity to the overall economy.

Multiple expansion is the process of buying a given dollar of cash flow at

a lower valuation than it is ultimately sold for in the future. There are at
least three reasons why the exit multiple might be higher than the entry
multiple. First, as mentioned earlier, the private equity firm might be able
to buy cheaply, i.e., at a cost below a market price, because of some pro-
prietary advantage.

Second, and related to this, some private equity investors believe there
are differences between public markets and private markets as to how
they value companies, that if they buy an asset in the private markets,
they will be able to sell it for a higher multiple in the public market. This
belief is often referred to as “public-private arbitrage.” This concept is
slightly misguided. Private acquisition multiples may be lower because of
a lack of competition for a deal. As the private equity industry has grown
and more firms target smaller, private companies, acquisition multi-
ples in private markets have increased. The sustainability of executing a
24 Advanced Introduction to Private Equity

private equity program based upon “public-private arbitrage,” however,

is increasingly questionable.

Third, exit multiples can expand if a strategic acquirer has synergies

with the portfolio company, particularly cost overlaps. In this case, the
EBITDA available to the acquirer is greater than the EBITDA of the
company alone. This does raise the question of why a strategic acquirer
did not buy the company in the first place. Some private equity firms
claim that one of the ways they add value is to improve a company’s
processes so that it becomes attractive to a strategic acquirer.

Finally, exit multiples will expand if the private equity investor improves
the future or long-term prospects of the portfolio company. Because
a multiple can be viewed as a one-step discounted cash flow, a firm’s
multiple will increase if long-run growth prospects are higher at exit
than at acquisition.

It is worth mentioning that multiples do not always expand. If the pur-

chase price is very high or growth does not materialize, the multiple can
decline and detract from the equity value created.

In the value bridge calculations, most private equity investors include

debt paydown, Debtin – Debtout, as value created. While the debt paydown,
all else being equal, does increase equity value, the debt paydown does
not create firm value. In fact, it is possible that debt paydown reduces
overall value. Paying off the debt just reduces the debt claim on the over-
all enterprise value. As long as the debt is “fairly priced,” this is compen-
sation for the debt providers in accordance with the risk they bear. If the
cash to pay off the debt had been retained, then the equity holders would
own a smaller percentage of a larger enterprise value. This is true because
the value of the enterprise is higher by the amount of the cash on the
balance sheet. Paying off the debt lowers the enterprise value by the cash
payout, so equity holders own a larger piece of a smaller enterprise value.
In the absence of taxes or governance effects, the value of the equity is
independent of whether you pay off the debt or not.

Financial economists have shown how debt can create value, but it is typ-
ically not in the way private equity investors calculate it. First, because
interest payments are typically deductible as an expense before taxes, the
interest tax shield creates value because it lowers overall taxes paid by the
 Introduction to private equity 25

firm. The higher the debt, ignoring any cost of potential financial dis-
tress, the higher the tax shield and the higher the enterprise value. In this
case, paying off debt actually lowers overall enterprise (and equity) value
because the interest tax shield is reduced in subsequent years.4

A second potential source of value from increasing debt relates to the

governance benefits discussed above. A significant amount of academic
research has focused on the disciplining effects of debt on management.
Because management has to make fixed payments or risk default, there
is an incentive to reduce wasteful spending and to improve operations.
Jensen (1986)5 was among the first to highlight this disciplining role.
Jensen (1989)6 argued that the disciplining role of debt increased the
alignment of management incentives and provided a significant advantage
to private equity investors. We will highlight the critical role that debt can
play in governance engineering in Chapter 5.

A second conception among many private equity investors is that taking

on more debt increases equity returns because more of the purchase is in
the form of debt and this leverage mechanically increases equity returns.
Leverage does increase the expected returns on equity, but does so by
increasing the underlying cash flow risk of the company. Leverage does
not increase the value of the company, i.e., leverage is not a free lunch.
Basic finance demonstrates that in the absence of taxes and governance
benefits, the increase in expected equity returns is simply a compensa-
tion for greater risk.

The ability to generate returns via leverage, however, is also subject

to external market conditions and the receptivity of debt providers to
leveraged transactions. The market for debt has been highly cyclical with
booms in credit over periods such as 2004 to 2007 and 2020 to 2021, as
well as severe retrenchment during other periods like the financial crisis
in 2008 and 2009. If markets for credit become “overheated” with debt
providers willing to provide capital at interest rates below what might
reasonably be the riskiness of the investment, then private equity firms
may be able to generate value for their investors. Ivashina and Kovner
(2008)7 have shown that relationships with banks often provide private
equity investors with access to debt capital at more favorable rates. Kaplan
and Stein (1993)8 examine how the growth in the “junk bond” market in
the late 1980s increased the valuation being paid in leveraged buyouts.
Other research has highlighted the potential role of investor sentiment in
26 Advanced Introduction to Private Equity

providing credit. If debt markets are subject to these underlying forces,

raising favorably priced debt could create value for investors. We will
deal with debt and equity financing issues in Chapter 5 on financial
engineering.

Finally, private equity investors often focus on improvements in the

cash flow generating ability of the firms they purchase, i.e., they can
make EBITDAout greater than EBITDAin. Private equity investors have
two levers to grow EBITDA. First, private equity investors can engage
in operational engineering. By actively helping firms grow sales and
become more efficient through consulting and advice, value is increased.
Second, private equity investors can improve oversight and incentives of
management through governance engineering. This provides incentives
for the management team to find ways to grow sales and become more
efficient. In terms of the ability to sustainably generate value, these two
levers are complementary.

Many private equity firms institute detailed operational plans based

on their own (or their outside consultants and affiliates’) expertise in
operations. These efforts typically target growth in EBITDA through
increased revenues and efficiencies. These efforts are seen as essential for
value creation. It is critical to examine how a particular private equity
firm can improve operations. The critical levers by which PE investors
can increase operating performance include operational and governance
engineering. We will explore the types of activities that PE investors
engage in during their ownership of portfolio companies in Chapter 7.

Governance engineering will be discussed in Chapter 6. In that chapter,

we look at the ways private equity investors better align the incentives of
managers with investors. A common feature of many private equity trans-
actions is a large increase in the equity ownership of management. This
equity compensation would better align incentives. In the average Fortune
1000 company, Jensen and Murphy (1990)9 showed that the typical public
company CEO in the 1980s held relatively little of the company’s equity,
with their total compensation changing by less than $3 for every $1000
change in shareholder value. By comparison, the average CEO of an LBO
portfolio company in the 1980s experienced a change of roughly $64 per
$1000 – and the entire operating management team, which owned about
20% of the equity, experienced a $200 change. Similarly, equity sponsors
of these LBOs typically owned more than 60% of the companies’ equity.
 Introduction to private equity 27

As a large outside shareholder, the LBO firms have a strong incentive to

monitor their portfolio companies and intervene.

Similarly, private equity firms often bring in knowledgeable board mem-

bers who take an active role in providing advice and guidance to senior
managers of the company. If the portfolio company gets into financial
trouble or has operating problems, the board can quickly intervene,
potentially appointing a new senior management team if needed. The
board members also typically help with the corporate finance function,
including negotiations with lenders and the investment banking com-
munity. All of these changes are intended to improve operations, i.e.,
increase EBITDA and growth.

One important caveat to keep in mind is who gets the value of these
improvements in the level of EBITDA? There are three possibilities:
selling shareholders, LPs and GPs. Arguments for selling shareholders
include the fact that with the growth in private equity, competitive
bidding has led to higher transaction prices. If private equity firms do not
have any comparative advantage in terms of improving operations and
no comparative advantage in financing, then selling shareholders may
actually get a large fraction of the gains from operating improvements.

Similarly, there are several arguments for why the GPs are the likely
beneficiary of the value improvements. If there are proprietary aspects of
what specific private equity investors do to improve companies, private
equity investors can generate positive risk-adjusted returns at the gross
investment level. In this case, better PE investors would charge fees that
provide them with the benefit of the value creation, leaving LPs with
returns which are just commensurate with the riskiness of the investment.

Finally, LPs may still be able to receive some of the value creation
benefits. GPs may need to offer some of the returns to “skill” to induce
their investors to allocate capital to their funds. As such, the possibility
exists that LPs may get some of this return. The next chapter will discuss
the empirical evidence on returns (gross and net) and whether there is
any academic evidence on the persistence of performance within private
equity investing.

The discussion in this section outlines the issues for assessing value crea-
tion in private equity, both prospectively and retrospectively. Much of
28 Advanced Introduction to Private Equity

the way private equity investors evaluate deals makes sense. Some of
their approaches, however, are less grounded in a clear relationship to
real sources of value. Investors and private equity managers care about
earning returns on their investments that are above the risk-adjusted cost
of capital.

In the rest of this book, we discuss the evidence for value creation
in private equity and provide frameworks for creating value going
forward. In Chapter 2, we summarize the evidence for value creation
at the portfolio company level. In Chapter 3, we consider the evidence
for value creation at the fund level. The next several chapters provide
frameworks that private equity investors use to create value.
Chapter 4 looks at investment decision making; Chapter 5, financial
engineering; Chapter 6, governance engineering; Chapter 7, operational
engineering; and Chapter 8, successfully exiting investments. In the
remaining two chapters, we consider how private equity firms structure
and raise their funds (Chapter 9) and how they manage their firms
(Chapter 10).

Notes
1 Carmela Mendoza, 2022, Fundraising Hit a New Full-Year Record in 2021,
Private Equity International, 18 January 2022.
2 Recent evidence, however, has cast doubt on whether size can be interpreted
as a risk factor.
3 Based on Paul A. Gompers and Akiko Kanna, 2013, Advantage Partners:
Dia Kanri (A), Harvard Business School Case Number 9-214-016.
4 See Kaplan (1989), who calculates the value of interest tax shields in a set
of leveraged buyouts in the 1980s and shows that it was important to those
transactions. Steven N. Kaplan, 1989, Management Buyouts: Evidence on
Taxes as a Source of Value, Journal of Finance 44, 611–32.
5 Michael Jensen, 1986, Agency Costs of Free Cash Flow, Corporate Finance,
and Takeovers, American Economic Review 76, 323–9.
6 Michael Jensen, 1989, Eclipse of the Public Corporation, Harvard Business
Review 67, 61–73.
7 Victoria Ivashina and Anna Kovner, 2011, The Private Equity Advantage:
Leveraged Buyout Firms and Relationship Banking, Review of Financial
Studies 24, 2462–98.
8 Steven N. Kaplan and Jeremy Stein, 1993, The Evolution of Buyout Pricing
and Financial Structure in the 1980s, Quarterly Journal of Economics 108,
313–58.
9 Michael Jensen and Kevin J. Murphy, 1990, Performance Pay and Top-
Management Incentives, Journal of Political Economy 98, 225–64.
2 Private equity:
performance at the
portfolio company

Since the first large buyouts in the 1980s, there has been a continued
interest in the effect of buyouts and private equity on portfolio companies
and, more broadly, on the economy. Private equity investors argue that
buyout transactions create value by improving the operations of their
portfolio companies in different ways. Critics counter that private equity
firms overleverage their companies, underinvest in them and create sys-
temic risk. According to the critics, PE investors generate returns by buy-
ing undervalued assets, selling overvalued assets and by firing workers
without creating real value. In the critics’ view, the large payoffs to and
wealth of private equity investors are not deserved. These issues received
a great deal of attention from a wide audience when Mitt Romney, one of
the founders of Bain Capital, became the Republican nominee for presi-
dent in 2012.

In the first part of this chapter, we summarize what is known from

the academic literature about the effects of private equity on portfolio
company financial performance and productivity, as well as on broader
non-financial measures. The results on operating performance and
productivity are overwhelmingly positive. A wide number of research
papers find that private equity portfolio companies have higher operat-
ing margins and/or higher productivity. The results are largely positive
on non-financial measures, although not uniformly so.

In the second part of this chapter, we consider the reasons for portfolio
company outperformance. We show how private equity firms make use
of financial engineering, governance engineering and operational engi-
neering. We explore each of these mechanisms for improving portfolio
company performance in Chapters 5 through 7.

29
30 Advanced Introduction to Private Equity

How have private equity-funded companies performed?

Operating margins and productivity
The first major study of the performance of LBO companies was con-
ducted by one of us. The public-to-private buyouts of the 1980s were
studied by Kaplan (1989),1 who found that buyouts are followed by sig-
nificant increases in operation margins and cash flows, both in absolute
terms, as well as relative to the public companies’ operation in the same.
Such increases were sustained at least over the three-year period covered
by the study. For the deals in Kaplan’s sample that could be tracked after
the buyouts, the operating gains resulted in increases of roughly 100%
in enterprise values. Those gains were divided fairly evenly between the
selling shareholders and the private equity investors. We explore how
the gains of company improvements are split and why it matters for the
investment returns in Chapter 3.

Since that early study, almost every large sample study of private equity
portfolio companies has found similar results – outperformance rela-
tive to firms in similar industries. In Europe, several papers by Michael
Wright, including Harris et al. (2005),2 find outperformance by buyouts
in the UK in the 1990s and 2000s. Boucly et al. (2011)3 find that buyouts in
France are more profitable and grow more quickly than other companies.
Acharya et al. (2013)4 study 395 private equity transactions in Western
Europe undertaken by large private equity firms from 1991 to 2007 and
find that the unleveraged deal returns outperform unleveraged public
company returns over the holding period of the investment. Despite
the public rhetoric that returns are driven by slashing employment and
expenses, the excess returns are related to greater sales growth as well as
greater improvement in operating margins. Biesinger et al. (2020)5 study
a large sample of small European buyouts and find that “company opera-
tions and profitability improve.”

In the US, using more recent data – corporate tax return data for the years
1995 to 2009 – Cohn, Hotchkiss and Towery (2020)6 find both significant
post-buyout improvements in operating performance and rapid growth.
And, in two prominent, recent studies, Davis et al. (2014 and 2019)7,8 look
at a large fraction of all US buyouts from the 1980s to 2011 and find the
net effect of a leveraged buyout is a significant increase in productivity.
Private equity portfolio companies tend to exit low productivity plants
while they enter or build high productivity plants. This only measures
 Private equity: performance at the portfolio company 31

what happens in US operations; private equity portfolios are unable to

measure what happens outside the US. If private equity portfolio com-
panies were quicker or more likely to move overseas, the productivity
increases would be larger.

There are two caveats to these results, one negative and one positive.
On the negative side, the results are less consistent for public-to-private
firms. Guo et al. (2011)9 find evidence of significant value creation in
public-to-private buyouts, yet only modest (and insignificant) operat-
ing gains. Cohn and Towery (2014)10 also find modest operating gains
for public-to-private transactions using tax data. And while Davis et al.
(2019)11 find that public-to-private firms increase productivity as much as
other buyouts, the increase is not statistically significant.

On the positive side, most of the large sample evidence uses deals com-
pleted before 2012. Operational engineering has increased in importance
and, likely, effectiveness since then. Early public-to-private transactions
focused largely on creating value through the use of improved incentives
and leverage (financial engineering). As the industry has grown and
become more competitive, successful buyout firms have had to increas-
ingly focus on other levers of value creation, including operational
improvements. If this is the case, the record of operating improvement
will also improve as more recent data become available.

The bottom line from all of these studies is clear. On average, private
equity ownership leads to value creation as companies become more pro-
ductive, earn higher margins and grow faster. Of course, this is not true
in every deal. Some private equity investments perform poorly. But, the
results from the large sample studies show that deals that perform well
outweigh the poor performers.

This was true of the US deals in the 1980s; it proved to be true of the sec-
ond great wave of buyouts in the UK and continental Europe; and it has
been true for US buyouts in the 1990s and 2000s. Because it takes from
five to seven years for private equity funds to realize their returns, it is still
too soon to know how the many deals transacted during the boom of the
mid-2010s will materialize. Yet the key finding from these more recent
studies is consistent with Kaplan’s main finding for US buyouts in the
1980s – namely, the significant and sustainable improvements in the pro-
ductivity and operating performance of private equity-funded companies.
32 Advanced Introduction to Private Equity

Employment and workers

Private equity-funded companies have been frequently and repeatedly
charged with making their money largely by firing employees, seen and
popularized in books such as Barbarians at the Gate, or movies such as
Wall Street. Although the patterns are more complicated, this does not
seem to be the general case. In their study of US private equity-owned
establishments that we mentioned earlier, Davis et al. (2019) distinguish
between employment at buyout firms’ existing plants and operations, and
employment in the new operations they start or acquire.12 In the existing
operations, employment declines by 4% relative to that of other compa-
nies in the same industry. Yet in these same portfolio companies, employ-
ment increases by 2.3% relative to competitors in the new operations. The
net effect on employment is a decline of 1.7%. The authors also find mod-
estly lower compensation per employee (1.7%) relative to competitors. The
results differ for private-to-private deals relative to public-to-privates. In
private-to-private deals, employment increases more in those compa-
nies than in other companies in the same industry; in public-to-private
deals, the opposite is true. And, again, the data do not include non-US
operations.

Amess and Wright (2007)13 study buyouts in the UK from 1999 to 2004 and
find that firms which experienced leveraged buyouts have employment
growth similar to other firms, but increase wages more slowly. Boucly
et al. (2011)14 find that leveraged buyout companies experience greater
job and wage growth than other similar companies. Antoni et al. (2019)15
find similar or consistent results in a study of post-buyout employment of
companies in the Netherlands. The buyout companies became more effi-
cient and profitable; healthier-than-average workers experienced gains
in wages and ascending career paths; less healthy workers were more
likely to be fired while experiencing reduced wages and further declines
in health.

Overall, then, the empirical evidence on employment is largely consistent

with the view that private equity portfolio companies create economic
value by operating more efficiently. Private equity firms grow less mature
companies (and companies in France) and consolidate more mature
companies. These findings do not support the concerns over substantial
job destruction, but neither do they support the diametrically opposite
position that all firms owned by private equity experience especially
strong employment growth.
 Private equity: performance at the portfolio company 33

Other non-financial measures

Apart from the questions of jobs and taxes, there are now many stud-
ies of the non-financial performance-related effects of private equity.
These studies help provide a more complete picture of how companies
are transformed by their private equity investors.

On the positive side, Bloom, Sadun and van Reenen (2015)16 find that
private equity-backed firms have better management practices than
almost all other ownership groups, based on thousands of firms across
34 countries. Fracassi, Previtero and Sheen (2017)17 find that private
equity firms have been more likely to achieve growth with new products
and in new geographic markets instead of raising prices for consumers.
Lerner et al. (2011)18 find that buyout-owned firms that patent become
more innovative. Cohn, Nestoriak and Wardlaw (2021)19 find that pri-
vate equity-operated companies have fewer workplace injuries relative
to their public competitors. Bernstein and Sheen (2016)20 find that pri-
vate equity-funded restaurants have fewer health violations. Agrawal
and Tambe (2016)21 find that private equity-backed companies increase
human capital by improving technical job skills that are more valued
by subsequent employers. And Bellon (2020)22 finds that private equity
ownership for firms in the oil and gas industry leads to a 70% reduction
in the use of toxic chemicals and a 50% reduction in CO2 emissions. This
reduction is identified by comparing projects from private equity-backed
firms to their close geographical neighbors using novel satellite imaging
and administrative datasets from the oil and gas industry. Collectively,
these studies demonstrate that along other dimensions, private equity
managers appear to improve the firms in which they invest.

On the negative side of the ledger, however, several papers find that pri-
vate equity companies profit by taking advantage of government regu-
lations in ways that turn out to have social costs. Eaton et al. (2018)23
find that buyouts in the for-profit college education industry are associ-
ated with worse outcomes for students, including higher tuition, higher
per-student debt, lower education inputs and lower graduation rates
and per-graduate earnings. One thing that these private equity-backed
for-profit educators were especially good at – securing funding through
a generous, and what now appears to have been a poorly designed, gov-
ernment-subsidized student loan program – has proved to be a mixed
blessing.
34 Advanced Introduction to Private Equity

Pradhan et al. (2014)24 find that private equity-owned nursing homes had
fewer and, on average, less-skilled Registered Nurses and worse health
outcomes than their non-private equity counterparts. Consistent with
this finding, Gupta et al. (2020)25 find a negative impact of private equity
buyouts on patient health and compliance with care standards, a find-
ing the authors attribute to fewer frontline nursing staff and higher bed
utilization. In these cases, the authors point to a kind of “arbitraging”
of nursing home regulations and Registered Nurse classifications that
effectively encourages excessive reliance on highest-skilled (Level I) and
minimally skilled (Level III) caregivers, with too little use of higher-paid,
mid-tier (Level II) caregivers. (Again, on the flip side, two recent papers
find that private equity-owned nursing homes had better COVID-19 out-
comes, so the jury is still out.)

In both positive and negative cases, the private equity-backed companies

appear to operate in a profit-maximizing way that, although compliant
with laws and regulation, is not always viewed as socially optimal. One
might interpret these results as consistent with a view of private equity
as “capitalism in high gear.” That is to say, private equity is a high-pow-
ered way to optimize operations, financing, governance and, ultimately,
returns. But this view also carries an important message for policymak-
ers: make sure policies do not create incentives for profit maximizers to
take advantage in ways that are not advantageous to society.

Why do private equity firms make their portfolio

companies more efficient?

The empirical evidence at the portfolio company level overwhelmingly

indicates that private equity investors make companies more efficient and
increase the value of their portfolio companies. And, as we will explain
below, we expect the evidence to improve over time. The private value
at the portfolio company level often comes with positive non-financial
externalities, but not always, particularly when government regulations
are poorly designed. This is important to remember any time you read
something that describes a failed private equity deal or disparages pri-
vate equity.

The critical question is where does that value come from? Kaplan and
Stromberg (2009)26 lay out an explanation and framework that we copy
 Private equity: performance at the portfolio company 35

and rely on throughout the book. 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 engi-
neering. Financial engineering provides more effective incentives and
capital structures. Governance engineering provides more effective
management and monitoring. Operational engineering provides various
capabilities that help portfolio companies operate more efficiently. We
describe each of these in more detail below.

In this section, we will also refer to the results of two surveys of pri-
vate equity investors that we conducted with Vladimir Mukharlyamov
in 2012 and 2020. In Gompers et al. (2016)27 or GKM (2016), we surveyed
79 private equity investors with roughly $750 billion of assets under
management (AUM), representing almost half of buyout capital at the
time. In Gompers et al. (2020)28 or GKM (2020), we surveyed more than
200 private equity investors with almost $2 trillion of AUM.

Financial engineering
Jensen (1989)29 and Kaplan (1989)30 describe the financial and governance
engineering changes associated with private equity. These changes were
pioneered by KKR in the early buyouts of the 1980s. First, private equity
firms pay careful attention to management incentives in their portfo-
lio companies, and 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. Kaplan (1989) finds that manage-
ment ownership percentages increase by a factor of four in going from
public-to-private ownership. Private equity firms also require manage-
ment to make a meaningful investment in the company, so that manage-
ment 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 that management teams obtain significant equity stakes
in the portfolio companies. Kaplan and Stromberg (2009)31 collected
information on 43 leveraged buyouts in the US from 1996 to 2004 with
a median transaction value of over $300 million. Of these, 23 were pub-
lic-to-private transactions. They find that the CEO acquires 5.4% of the
equity upside (stock and options) while the management team as a whole
36 Advanced Introduction to Private Equity

acquires 16%. Acharya et al. (2013)32 find similar results in the UK for
59 large buyouts (with a median value of over $500 million) from 1997 to
2004.

In GKM (2020), the private equity investors report that their portfolio
company CEOs receive a median of 5% (average of 10%) of the company
equity upside while the management team receives a median of 15% (and
average of 20%). These results are remarkably consistent over time, with
the percentages having increased somewhat since the mid-2000s.

Even though stock- and option-based compensation have become more

widely used in public firms since the 1980s, management’s ownership
percentages (and upside) are still greater in leveraged buyouts than in
public companies. Consistent with a very important role for incentives,
improved incentives are the second most frequently mentioned pre-deal
source of value by the private equity investors in the survey of GKM
(2016).

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 pay-
ments. This pressure reduces the “free cash flow” problems described in
Jensen (1986),33 in which management teams in mature industries with
weak corporate governance had many ways in which they could dis-
sipate these funds rather than returning them to investors. 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 US and many other countries, lever-
age 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 per-
sonal taxes), the expected permanence of the debt and the riskiness of
the tax shield.

Governance engineering
Governance engineering refers to the way that private equity investors
control the boards of their portfolio companies – they 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 (Acharya et al. (2013), Cornelli and
 Private equity: performance at the portfolio company 37

Karakaş (2008)34 and GKM (2016, 2020)). In GKM (2016, 2020), private
equity investors report that the typical board of their portfolio compa-
nies has seven or fewer directors.

In GKM (2020), at the height of the pandemic, 81% of the private equity
investors reported that they met with the typical company in their port-
folio at least once per week. Fifty-eight percent met multiple times per
week. This is undoubtedly much more frequent than the typical public
company director.

At the same time, the private equity investors reported that invest-
ment professionals spent roughly 40% of their time, 20 plus hours per
week, assisting portfolio companies. While this may have been higher
than normal because of the COVID pandemic, it indicates an extraor-
dinary amount of time, particularly compared to the typical director
of a public company, who might spend on average three to five hours
per week.

Private equity investors also take an active role in replacing manage-

ment when appropriate. Acharya et al. (2013)35 report that one-third of
chief executive officers of their portfolio companies are replaced in the
first 100 days and two-thirds are replaced at some point over a four-year
period. In the GKM (2016) survey, the private equity investors reported
very similar activity. Thirty percent of private equity investors stated they
were actively involved in bringing in a new executive team before closing
the investment, while 50% said they were actively involved in bringing in
a new team after closing the investment. So, overall, 58% reported bring-
ing in their own senior management team.

Consistent with an important role for improved governance, the private

equity investors in GKM (2016) affirmed that improving corporate gov-
ernance, changing the CEO or CFO and changing other senior manage-
ment are important sources of value in, respectively, 47%, 31% and 33%
of private equity deals.

Operational engineering
From the early 1980s through the early 2000s, most private equity firms
relied on financial and governance engineering. Some firms, however,
innovated and developed an operational engineering capability. Bain
Capital was among the first to make systematic use of management
38 Advanced Introduction to Private Equity

consulting resources. Clayton & Dubilier (now CD&R) was among the
first to recruit senior operating executives.

In the 2000s, however, driven by growth in the private equity indus-

try and increased competition for deals, the need to add more value in
order to achieve high returns increased significantly. Most private equity
firms added their own form of “operational engineering.” For example,
KKR added Capstone, an “in-house consulting firm,” whose princi-
pals participate in transactions from their inception and due diligence
to the final sale of the firm – they are compensated based on deal suc-
cess. Additionally, Blackstone created a portfolio operations team that
is comprised of former senior operating executives. All of these efforts
were meant to provide internal resources that could engage with portfo-
lio companies and enhance operating performance.

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 an industry focus and
an operating background. The industry specialization allows the firm
to better understand operating levers that can enhance the company’s
performance. 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, develop a value creation plan at the
time of investment and implement the value creation plan. This plan
might include elements of cost-cutting opportunities and productivity
improvements, strategic changes or repositioning, acquisition opportu-
nities, as well as management changes and upgrades.

GKM (2016 and 2020) have a number of findings consistent with an

important role for operational engineering. First, Table 2.1 shows that
the majority of firms in 2012 were organized by industry or the equiva-
lent; only 37% of the sample firms were generalists. At the time, roughly
one out of six firm professionals were consultants or operating execu-
tives. Almost half of the firms had a CEO council, senior advisors or the
equivalent. And roughly one-third of the firms regularly hired strategy
consultants to help with operating plans. Organizing around industry
is consistent with private equity firms looking for ways to add value and
improve portfolio company performance.
Table 2.1 How Is the Firm Organized?
Mean Low High Low IRR High Old Young Local Global
AUM AUM IRR
Industry 54.4 54.1 54.8 65.5 55.2 64.7 46.7 54.5 54.3
Criteria 11.4 10.8 11.9 13.8 3.4 11.8 11.1 6.8 17.1
Product 16.5 5.4 26.2 17.2 17.2 29.4 6.7 2.3 34.3
Generalist 36.7 40.5 33.3 27.6 34.5 26.5 44.4 43.2 28.6
Other 6.3 2.7 9.5 10.3 6.9 8.8 4.4 2.3 11.4
Number of 79 37 42 29 29 34 45 44 35
responses
Source: Gompers, Kaplan and Muhkarlyamov (2016)
Private equity: performance at the portfolio company
39
40 Advanced Introduction to Private Equity

Table 2.2 Deal Selection – Ranking of Factors Considered by Private

Equity Investors in Choosing Investments (with Higher
Numbers More Important)
Mean Median Low High Low High Old Young Local Global
AUM AUM IRR IRR
Ability to add 3.6 3.0 3.6 3.6 3.9 3.5 3.5 3.7 3.5 3.8
value
Business 4.6 5.0 4.5 4.7 4.5 4.5 4.4 4.7 4.6 4.5
model/
competitive
position
Fit with fund 2.3 2.0 2.7 1.9 2.0 2.2 2.2 2.4 2.5 2.0
Industry/ 3.2 3.0 3.4 3.0 3.3 3.0 3.3 3.1 3.5 2.8
market
Management 3.8 4.0 3.7 4.0 3.9 4.0 4.1 3.6 3.8 3.8
team
Valuation 3.5 3.0 3.2 3.8 3.4 3.8 3.5 3.5 3.0 4.1
Number of 65 65 32 33 24 23 31 34 37 28
responses

Source: Gompers, Kaplan and Muhkarlyamov (2016)

Second, Table 2.2 reports the relative importance of various factors when
selecting deals to invest in. The ability to add value is ranked third in
importance by private equity investors. Only the firm’s business model
or competitive position and the management team are more important
considerations.

Third, Table 2.3 reports that the private equity firms rank growing rev-
enues and reducing costs as the two most important sources of value.
Growth in revenue is rated substantially higher than reducing costs.
Leverage and increases in multiples are substantially less important. The
importance of growing revenue was greater in the GKM (2020) survey
than it had been in the 2012 survey of GKM (2016), suggesting that the
private equity firms are increasingly focused on helping their companies
grow faster.

Table 2.4 from GKM (2016) reports more detailed results that examine
expected sources of value. Private equity investors reported that growing
revenues was by far the most important expected source of value (70% of
 Private equity: performance at the portfolio company 41

Table 2.3 Sources of Value Creation

Source of Value Mean Median AUM Age
Low High Young Old
Growth in revenue 8.1 8.0 7.9 8.3 8.0 8.1
of the underlying
business
Reducing costs 5.4 5.0 5.5 5.4 5.5 5.3
Industry-level 4.6 4.5 4.4 4.8 4.6 4.7
multiple arbitrage
Leverage 3.9 4.0 3.9 4.0 4.0 3.8
Refinancing 3.2 3.0 3.2 3.1 3.2 3.2
Other 1.7 1.0 1.5 1.9 1.9 1.6
Observations 145 145 73 72 77 68
Source: Gompers, Kaplan and Muhkarlyamov (2020)

the time). Reducing costs in general (36%), redefining the current busi-
ness model or strategy (34%), improving IT systems (26%) and introduc-
ing shared services (16%) were important.

Summary

To summarize this section, the empirical evidence is exceptionally strong

that private equity investors, on average, make their portfolio companies
more productive and more valuable. This conclusion mirrors the conclu-
sion more than 10 years ago in Kaplan and Stromberg (2009) that “the
empirical evidence is strong that private equity activity creates economic
value on average.” Furthermore, many of the non-financial results are
also positive, although not uniformly so, particularly in the presence of
ill-designed government incentives.

The increased value at the portfolio companies comes from three

sources or competencies: financial, governance and operational engi-
neering. Private equity firms continue to invest in and improve these
capabilities, particularly in governance and operational engineering.
Chapters 5 through 7 explore in greater detail how private equity firms
exploit each of these capabilities.
Table 2.4 Pre-Investment (Expected) Sources of Value Creation – The Percentage of Deals That Private Equity Investors
42

Identify Having the Following Pre-Deal Sources of Value

Mean Median Low High Low High Old Young Local Global
AUM AUM IRR IRR
Reduce costs in 35.6 27.5 35.8 35.5 37.1 37.3 39.9 32.0 31.0 41.8
general
Improve IT/ 26.1 20.0 30.8 21.6 22.0 23.3 23.9 28.0 26.7 25.3
information systems
Introduce shared 15.6 2.5 16.4 14.9 11.6 18.3 16.9 14.6 14.9 16.6
services
Increase revenue/ 70.3 80.0 77.5 63.5 75.0 63.5 67.0 73.2 70.6 70.0
improve demand
factors
Redefine the current 33.8 29.5 27.8 39.5 43.0 29.8 32.1 35.3 32.8 35.2
business model or
strategy
Change CEO or CFO 30.6 27.5 33.4 28.0 29.2 32.9 30.9 30.4 29.3 32.4
Change senior 33.4 30.0 37.3 29.7 32.5 33.1 27.9 38.1 35.4 30.8
Advanced Introduction to Private Equity

management team
other than CEO and
CFO
Improve corporate 47.0 37.0 52.4 41.9 40.1 45.5 39.4 53.5 47.3 46.6
governance
Improve incentives 61.1 73.5 60.7 61.5 58.3 67.0 65.5 57.4 59.0 63.9
Follow-on 51.1 50.0 53.9 48.4 52.0 46.9 51.0 51.2 53.2 48.3
acquisitions
Strategic investor 15.6 10.0 16.4 14.8 12.3 14.0 14.4 16.5 15.1 16.2
Facilitate a high- 50.0 43.5 61.0 39.6 45.6 42.0 40.4 58.1 53.5 45.4
value exit
Purchase at an 44.3 43.0 49.2 39.6 38.2 43.3 40.9 47.1 44.9 43.5
attractive price (buy
low)
Purchase at an 46.6 50.0 54.5 39.2 38.7 47.3 42.9 49.8 50.1 42.0
attractive price
relative to the
industry
Other 9.8 0.0 9.4 10.2 0.0 14.3 9.4 10.1 12.4 6.4
Number of responses 74 74 36 38 27 27 34 40 42 32
Source: Gompers, Kaplan and Muhkarlyamov (2016)
Private equity: performance at the portfolio company
43
44 Advanced Introduction to Private Equity

Notes
1 Steven N. Kaplan, 1989, Management Buyouts: Evidence on Taxes as a
Source of Value, Journal of Finance 44, 611–32.
2 Richard Harris, Donald Siegel and Mike Wright, 2005, Assessing the Impact
of Management Buyouts on Economic Efficiency: Plant-Level Evidence
from the United Kingdom, Review of Economics and Statistics 87, 148–53.
3 Quentin Boucly, David Sraer and David Thesmar, 2011, Growth LBOs,
Journal of Financial Economics 102, 432–53.
4 Viral Acharya, Oliver Gottschalg, Moritz Hahn and Conor Kehoe, 2013,
Corporate Governance and Value Creation: Evidence from Private Equity,
Review of Financial Studies 26, 368–402.
5 Markus Biesinger, Çağatay Bircan and Alexander Ljungqvist, 2020, Value
Creation in Private Equity, EBRD Working Paper No. 242, Swedish House
of Finance Research Paper No. 20-17.
6 Jonathan B. Cohn, Edith Hotchkiss and Erin Towery, 2020, The Motives for
Private Equity Buyouts of Private Firms: Evidence from U.S. Corporate Tax
Returns, Working Paper.
7 Steven J. Davis, John C. Haltiwanger, Kyle Handley, Ron S. Jarmin, Josh
Lerner and Javier Miranda, 2014, Private Equity, Jobs, and Productivity,
American Economic Review 104, 3956–90.
8 Steven J. Davis, John Haltiwanger, Kyle Handley, Ben Lipsius, Josh
Lerner and Javier Miranda, 2019, The Economic Effects of Private Equity
Buyouts (No. w26371). National Bureau of Economic Research.
9 Shourun Guo, Edith S. Hotchkiss and Weihong Song, 2011, Do Buyouts
(Still) Create Value? Journal of Finance 66, 479–517.
10 Jonathan B. Cohn, Lillian Mills and Erin M. Towery, 2014, The Evolution
of Capital Structure and Operating Performance after Leveraged Buyouts:
Evidence from US Corporate Tax Returns, Journal of Financial Economics
111, 469–94.
11 Steven J. Davis, John Haltiwanger, Kyle Handley, Ben Lipsius, Josh
Lerner and Javier Miranda, 2019, The Economic Effects of Private Equity
Buyouts (No. w26371). National Bureau of Economic Research.
12 Steven J. Davis, John Haltiwanger, Kyle Handley, Ben Lipsius, Josh
Lerner and Javier Miranda, 2019, The Economic Effects of Private Equity
Buyouts (No. w26371). National Bureau of Economic Research.
13 Kevin Amess and Mike Wright, 2007, Barbarians at the Gate? Leveraged
Buyouts, Private Equity and Jobs, Working Paper.
14 Quentin Boucly, David Sraer and David Thesmar, 2011, Growth LBOs,
Journal of Financial Economics 102, 432–53.
15 Manfred Antoni, Ernst Maug and Stefan Obernberger, 2019, Private Equity
and Human Capital Risk, Journal of Financial Economics 133, 634–57.
16 Nicolas Bloom, Raffaella Sadun and John van Reen, 2015, American
Economic Review 105, 442–6.
17 Cesare Fracassi, Alessandro Previtero and Albert Sheen, 2021, Barbarians
at the Store? Private Equity, Products, and Consumers, Journal of Finance
77, 1439–88.
 Private equity: performance at the portfolio company 45

18 Josh Lerner, Morten Sorensen and Per Stromberg, 2008, Private Equity and
Long Run Investment: The Case of Innovation, Working Paper, Harvard
Business School.
19 Jonathan Cohn, Nicole Nestoriak and Malcolm Wardlaw, 2021, Private
Equity Buyouts and Workplace Safety, Review of Financial Studies 34,
4876–925.
20 Shai Bernstein and Albert Sheen, 2016, The Operational Consequences of
Private Equity Buyouts: Evidence from the Restaurant Industry, Review of
Financial Studies 29, 2387–418.
21 Ashwini Agrawal and Prasanna Tambe, 2016, Private Equity and Workers’
Career Paths: The Role of Technological Change, Review of Financial
Studies 29, 2455–89.
22 A. Bellon, 2020, Does Private Equity Ownership Make Firms Cleaner? The
Role of Environmental Liability Risks. Available at SSRN 3604360.
23 C. Eaton, S. Howell and C. Yannelis, 2018, When Investor Incentives and
Consumer Interests Diverge: Private Equity in Higher Education (No.
w24976). National Bureau of Economic Research.
24 R. Pradhan, R. Weech-Maldonado, J. S. Harman and K. Hyer, 2014, Private
Equity Ownership of Nursing Homes: Implications for Quality, Journal of
Health Care Finance 42(2), 1–12.
25 A. Gupta, S. Howell C. Yannelis and A. Gupta, 2020, Does Private Equity
Investment in Healthcare Benefit Patients? Evidence from Nursing Homes.
NYU Stern School of Business. Available at SSRN 3537612.
26 Steven N. Kaplan and Per Stromberg, 2009, Leveraged Buyouts and Private
Equity, Journal of Economic Perspectives Winter, 121–46.
27 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov,
2016, What Do Private Equity Firms (Say They) Do? Journal of Financial
Economics 121, 449–76.
28 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov, 2020,
Private Equity and Covid-19, NBER Working Paper.
29 Michael Jensen, 1989, Eclipse of the Public Corporation, Harvard Business
Review 67, 61–73.
30 S. N. Kaplan, 1989, The Effects of Management Buyouts on Operating
Performance and Value, Journal of Financial Economics 24, 217–54.
31 Steven N. Kaplan and Per Stromberg, 2009, Leveraged Buyouts and Private
Equity, Journal of Economic Perspectives Winter, 121–46.
32 Viral Acharya, Oliver Gottschalg, Moritz Hahn and Conor Kehoe, 2013,
Corporate Governance and Value Creation: Evidence from Private Equity,
Review of Financial Studies 26, 368–402.
33 Michael Jensen, 1986, Agency Costs of Free Cash Flow, Corporate Finance,
and Takeovers, American Economic Review 76, 323–9.
34 Francesca Cornelli and Og ̃uzhan Karakaş, 2008, Private Equity and
Corporate Governance: Do LBOs Have More Effective Boards, Working
Paper.
35 Viral Acharya, Oliver Gottschalg, Moritz Hahn and Conor Kehoe, 2013,
Corporate Governance and Value Creation: Evidence from Private Equity,
Review of Financial Studies 26, 368–402.
3 Private equity performance
at the fund level*

We have seen in Chapter 2 that private equity investors create value at

the portfolio company level. The next question to ask is what happens at
the fund level. There are two primary frictions that affect whether perfor-
mance at the company level translates into performance at the fund level.
First, the private equity firm must buy the company. If the purchase takes
place in a competitive situation, some (or even all) of the gains can end
up going to the seller, leaving the buyer with less. Second, private equity
firms charge fees to their limited partner investors. It is possible that the
fees more than offset the private equity value creation. Phalippou (2020)1
claims that fees offset private equity value creation to leave private equity
returns equal to those of public markets.

The evidence we present in this chapter, however, makes clear that the
performance improvements at the portfolio company level have trans-
lated into outperformance relative to reasonable public benchmarks at
the fund level. In other words, private equity funds have consistently
outperformed the equivalent public equity markets over all relevant time
periods over the last 30 years. That is undoubtedly a large part of the
reason why investors in private equity funds (referred to throughout this
chapter as limited partners or LPs) have increased their investments in
private equity over that period.

In this chapter, we begin with an overview of the structure of private

equity funds. We then discuss the different ways performance is meas-
ured at the fund level. That leads us to the most important section that
describes the evidence on the average performance of private equity
funds. Next, we consider whether superior (or inferior) performance per-
sists from one fund of a private equity partnership to the next. Finally,
we will look at whether there is a cyclical component to private equity

46
 Private equity performance at the fund level 47

returns, i.e., what is the performance of private equity across business

cycles?

The organization of private equity funds

Private equity funds are financial intermediaries that pool their investors’
capital and make investments in portfolio companies. A defining char-
acteristic of the private equity industry is that these portfolio companies
are generally either private or become private as part of the private equity
transaction, so that there is no organized exchange for the company’s
equity. The goal of private equity investing is to exit the portfolio company
after increasing its equity value. Private equity funds are active investors
who attempt to increase value through financing and other contractual
structures, value-added monitoring, advice and management staffing.
These features distinguish private equity funds from mutual funds and
hedge funds, which are primarily passive investors. Successful exit mech-
anisms include acquisitions by operating companies, IPOs and, in buyout,
acquisitions by other buyout firms (known as secondary buyouts).

Although venture capital and private equity funds have a similar organi-
zational form and compensation structure, they are distinguished by the
types of investments they make and the way they finance them. Private
equity funds, and in particular leveraged buyout (LBO) funds, generally
acquire a majority ownership position in the target firm and use leverage.
Venture capitalists take minority positions in private businesses and do
not use debt financing. Growth equity funds are somewhere in between.

Legally, private equity funds are usually organized as limited liability

partnerships (LLPs). The fund is managed by a private equity “firm,” such
as Blackstone or KKR, which takes the role of the general partner (GP) of
the partnership. The fund investors are the limited partners (LPs). These
investors are typically large institutions such as endowments, pension
plans and banks. LPs retain limited liability for the actions of the part-
nership in exchange for delegating all management decisions to the GP.

The contracted life of the partnership is typically 10 years. The year the
fund makes its first investment, or its first call for LP capital, is known
as its “vintage year.” At the inception of the fund, LPs commit to a total
48 Advanced Introduction to Private Equity

investment amount (“committed capital”). These committed amounts

are not transferred to the GP immediately, but rather are kept by the
LPs until called by the GP to fund investments and management fees
(“capital calls” or “takedowns”). Investments are made during the first
few years of the fund’s life, with the subsequent years devoted to efforts
to add value and exit investments. New investments are typically sourced
and selected in the first three to five years of a fund. Generally, invest-
ments are held for three to eight years before exit. The fund’s life can
be and often is extended for an additional period if portfolio companies
have not achieved the desired improvements or if exit markets are rela-
tively weak. Usually the LP agreement allows for automatic extensions of
one to three years. If more time is needed, and it usually is, the GPs and
LPs must come to a mutual agreement. The median life of private equity
funds turns out to be roughly 15 years.

Unlike investors in mutual funds and hedge funds, investors in private

equity funds typically cannot redeem their stakes even after a redemp-
tion period, because the nature of the private equity investing cycle makes
unplanned liquidations of portfolio companies extremely costly. In recent
years, a more active secondary market has developed for LP stakes in pri-
vate equity funds for those investors who require liquidity prior to the
winding down of the particular private equity fund. Many of the second-
ary market players are themselves organized as private equity funds.

The GP is compensated with an annual management fee and a share of

the profits generated by the fund, known as the carried interest or carry.
The modal management fee is 2% of committed capital per year over the
investment period and, then, 2% of invested capital thereafter. There is
substantial variation in both the percentage fee and the basis on which
it is calculated. Carried interest is almost always 20%, with variation in
the value of carry driven primarily by differences in the basis and timing
rules for its calculation. A very few funds charge a premium carry of 25%
or 30%. Other funds charge a premium carry, but only after investors
have received an agreed-upon return using a 20% carry.

In addition, the GP itself invests its own capital in the fund, in order to
impose some downside risk on the GP. This is referred to as the GP com-
mitment. Historically, the GP commitment was initially 1% of total capital.
As some GPs have succeeded and accumulated wealth, LPs have strongly
encouraged the GPs to commit a meaningful amount of liquid wealth to
 Private equity performance at the fund level 49

their funds. Accordingly, today, the GP commitment is more commonly

2% or 3% of committed capital, but with a great deal of variance depend-
ing on the past successes of the GP and the size of the fund being raised.

Fund-level performance measures

Absolute performance measures – IRR and MOIC
The fact that most of the investments in the typical private equity fund
are in illiquid portfolio companies means that there is no completely
objective way to mark a private equity fund’s investments to market
except when an investment is made or exited. The GPs generally report
their performance every quarter to LPs. The assessments of the fund’s
net asset value (NAV) that GPs report – before the GP has exited all of its
investments – are necessarily subjective. And the fund NAVs do not nec-
essarily adjust for any transaction costs the fund would bear if it actually
tried to sell the underlying investments.

Consequently, industry practice, as well as most academic work, has

shied away from the very technical performance evaluation based on fac-
tor pricing models that is used for mutual funds and hedge funds. These
methods require more frequent and accurate performance reporting that
just does not exist in private equity. Any use of relatively frequent returns
would lean heavily on the self-reported NAVs. Instead, the practice has
been to measure performance using, to the extent possible, the objective
cash flows between GPs and LPs.2

An LP’s cash outflows consist of management fees and capital called for
investments. Inflows to the LP result from cash distributions as the GPs
exit investments (net of the applicable carried interest the GP withholds
from these distributions). Traditionally, industry practice expresses fund
performance in two ways: the internal rate of return (IRR) of this cash
flow stream; and the ratio of the cumulative returns to the LPs (distri-
butions) to cumulative capital contributions by the LPs (capital calls),
known as the multiple of invested capital (MOIC) or total value to paid
in capital (TVPI). In both cases, the return measure is net of all fees.

While useful, the IRR and MOIC both have several drawbacks. Most
importantly, both the IRR and MOIC are absolute, not relative, meas-
ures of performance. They do not control for movements in the overall
50 Advanced Introduction to Private Equity

market or any other source of risk. This makes it difficult to compare

funds. Table 3.1 provides a good example of this. Fund A has a high IRR,
but a low MOIC. Fund C is the opposite. Fund B is in between. It is hard
to know which fund has the better performance.

The IRR is particularly problematic because it is highly affected by tim-

ing. A way to see this is to compare fund A and A’. Fund A has two invest-
ments. The first is $12 million that returns $23 million in one year. The
second is $8 million that turns out to be worthless. Fund A has a 50% IRR
largely because the first investment was very good. Fund A’ has exactly
the same two investments, but fund A’ made the bad one first and the
good one second. Note that the IRR drops to 8%. But, in a real sense, A
and A’ have the exact same performance, which the identical MOICs of
1.17 do reflect.

There are two lessons here. First, from an LP perspective, you want to
understand if the GP is investing consistently well. Do not be fooled by
a very strong first investment. Second, and acknowledging that LPs are
not always completely rational, there is a huge incentive for a GP to make
sure the first investment or two in a fund perform very well. A strong first
investment or two will ensure a strong IRR for the fund.

Survey evidence of private equity firms in Table 3.2 demonstrates the

importance of IRR and MOIC. Gompers, Kaplan and Muhkarlamov
(2016) found that, on average, 25.4% of private equity firms said that Net
IRR was the most important benchmark for their LPs. An additional
27.0% said that Net IRR relative to the fund’s vintage year was most

Table 3.1 Calculating Fund Returns

Year Fund A Fund B Fund C Fund D
0 −12 −20 −20 −8
1 23 21 0 0
2 −8 0 0 −12
3 0 5 0 23
4 0 0 33 0
5 0 0 0 0
IRR 50% 22% 14% 8%
MOIC 1.17 1.30 1.67 1.17
Table 3.2 The Most Important Benchmark for the Limited Partners (LPs) Investing in the Private Equity Investors
Mean Low High Low High Old Young Local Global
AUM AUM IRR IRR
Net IRR 25.4 29.0 21.9 27.3 21.7 26.7 24.2 22.2 29.6
Net IRR vs S&P 7.9 6.5 9.4 9.1 4.3 10.0 6.1 8.3 7.4
Net IRR with respect to fund 27.0 19.4 34.4 27.3 43.5 40.0 15.2 33.3 18.5
vintage year
Net multiple/cash-on-cash 38.1 45.2 31.3 31.8 30.4 20.0 54.5 33.3 44.4
IRR of other GPs 1.6 0.0 3.1 4.5 0.0 3.3 0.0 2.8 0.0
Number of responses 63 31 32 22 23 30 33 36 27
Source: Gompers, Kaplan and Muhkarlyamov (2016)
Private equity performance at the fund level
51
52 Advanced Introduction to Private Equity

important to LPs. Finally, 38.1% said Net MOIC was the benchmark that
was most important.

Market-adjusted performance measures – LN-PME,

KS-PME, direct alpha
While IRR and MOIC are useful, they are absolute measures. They do not
tell an investor how the private equity fund performed relative to other
alternatives, particularly relative to public equities.

The first attempt to deal with this came from Long and Nickels (1996).3
They propose a method to market-adjust the IRR, in what has become
known as the Long-Nickels public market equivalent (LN-PME).
Essentially, the LN-PME calculates the IRR an investor would have
received from investing in the relevant public equity benchmark and
compares that IRR to the IRR from the private equity fund. The LN-PME
has the advantage that many investors think in terms of IRRs. At the
same time, the LN-PME has two disadvantages. First, it shares with the
IRR the unattractive attribute of being unusually sensitive to investment
sequencing, particularly the success of a fund’s early investments. Second,
the LN-PME “blows up” or cannot be calculated for some funds, particu-
larly those that are very successful and return capital quickly. Because of
these unattractive properties, the LN-PME is rarely used anymore.

Kaplan and Schoar (2005)4 proposed a new method to market-adjust

performance. Instead of market-adjusting the IRR, they market-adjusted
the MOIC. The Kaplan-Schoar (KS) PME is calculated as the ratio of the
sum of discounted distributions to the sum of discounted capital calls,
where the discount rate is the total return on the relevant public equity
benchmark from an arbitrary reference date to the date of the cash flow
in question. Following Kaplan and Schoar (2005), the S&P 500 is usu-
ally used as the public benchmark. A fund with a KS-PME (hereafter,
simply PME) greater than one outperformed the benchmark (net of all
fees); a fund with a PME less than one underperformed. For instance,
a PME of 1.20 (0.80) means that the investor ended up with 20% more
(fewer) dollars by investing in the private equity fund instead of the pub-
lic benchmark. The PME has the advantages that it can always be cal-
culated and has an intuitive interpretation. One practical disadvantage
for practitioners is that it provides a cumulative measure rather than an
annualized return measure.
 Private equity performance at the fund level 53

Gredil, Griffiths and Stucke (2014)5 propose an alternative method to

market-adjust the IRR. They calculate the differential alpha to the rel-
evant benchmark that discounts the private equity fund cash flows to a
net present value of zero. Accordingly, it is the analog to the KS-PME.
While it is an improvement over the LN-PME, it still has some of the
disadvantages of IRR and the LN-PME.

Table 3.3 shows the KS-PME and direct alphas for the investments in
Table 3.1 under the assumptions that the stock market return over the
fund life is 0% and that it is 10% per year. Under the assumption of 0%
returns to the stock market, the absolute and relative measures are the
same!

Alternatively, if the stock market increases by 10% per year, funds A, B

and C all have the same KS-PME of 1.14. This is because the early returns
to fund A can be reinvested in the stock market at a 10% return, while
fund C returns 14% annually versus the stock market at 10%. Over four
years, this works out to a cumulative 14% advantage. Fund A’ remains
a laggard despite the fact that it has the same investments as fund A
because the later successful investment is not reinvested in the growing
public market.

Table 3.3 Calculation of Fund Returns, PMEs, and Direct Alpha

Year Fund A Fund B Fund C Fund D
0 −12 −20 −20 −8
1 23 21 0 0
2 −8 0 0 −12
3 0 5 0 23
4 0 0 33 0
5 0 0 0 0
IRR 50% 22% 14% 8%
MOIC 1.17 1.30 1.67 1.17
PME (at 0%) 1.17 1.30 1.67 1.17
PME (at 10%) 1.14 1.14 1.14 0.96
Direct alpha (at 50% 22% 14% 8%
0%)
Direct alpha (at 36% 11% 3% -2%
10%)
54 Advanced Introduction to Private Equity

The bottom line here is that different performance measures can give dif-
ferent results. Fund A is desirable if you can reinvest in another fund A.
If, on the other hand, fund A could be A’, then funds B and C look more
desirable.

At the end of the day, LPs (and GPs) should look for private equity funds
that outperform the public markets (net of fees). If private equity does not
outperform public markets (net of fees), then it is harder, although not
impossible, to make the case for investing.

Other risk adjustments

Since Kaplan and Schoar (2005) introduced the PME, it has been the
standard performance measure in the academic literature measuring
private equity returns using fund-level cash flows. Practitioners also
increasingly use the KS-PME and direct alpha.

A natural question is to what extent the market-adjustment embedded

in the PME suffices to risk-adjust fund returns. Theoretical works by
Sorensen and Jagannathan (2013)6 and Korteweg and Nagel (2013)7 have
tried to link private equity performance measurement to asset pricing
theory. These papers establish that the PME suffices to adjust for risks
spanned by the benchmark return, regardless of the beta of private equity
with respect to the benchmark, under the assumption that investors have
log utility.8 On the other hand, as the authors acknowledge, investors
may not have log utility 9 and there are likely relevant risks not spanned
by a single benchmark return.

Average performance10
Who measures performance?
Currently, the four primary providers of private equity performance or
benchmarks are (in alphabetical order) Burgiss Private I, Cambridge
Associates, Pitchbook and Preqin.11

Burgiss has the advantage that it is sourced exclusively from LPs. LPs use
Burgiss’s software to manage their private equity investments – record
keeping and fund investment monitoring. Burgiss uses those data to
measure performance. LPs comprise a wide array of institutions. The
 Private equity performance at the fund level 55

data come from “institutional allocators including endowments, foun-

dations, OCIOs, pension funds, and family offices . . . representing over
$1.7 trillion in assets” and include data from “more than 1,000 firms in
32 countries, delivering data that represents nearly $9 trillion in private
assets.” Burgiss believes the private equity funds in the sample represent
greater than 70% of funds ever raised.

The advantage of the Burgiss database is that if the fund is in the LP port-
folio, the GPs have to report. So, there is no reporting bias. The only pos-
sible bias is if the Burgiss LPs do not invest in a representative sample of
private equity funds. Given the number of LPs and funds in the database,
this seems unlikely. As a result, we view the Burgiss database as likely to
be the most reliable for measuring private equity performance.

Cambridge Associates (CA) provides an array of investment manage-

ment services to LP clients. For many LP clients, this means providing
private investment performance reporting and recommending GPs. CA
receives roughly two-thirds of its fund-level data from GPs that are in
LP client portfolios. They also receive data from other GPs who are not
in client portfolios (but, presumably, would like to be). This may create a
slight positive selection bias.

The advantage of CA, and particularly Burgiss, is that their data are likely
to have relatively little selection and reporting bias. The disadvantage is
that they do not report the performance of individual funds or fund
names. This makes it difficult for GPs and LPs to perform more detailed
benchmarking comparisons.

Pitchbook and Preqin are primarily data providers. These data providers
obtain fund-level data by gathering information from (1) public sources,
which include using Freedom of Information Act (FOIA) requests (or their
parallel outside the US) requiring some LPs to reveal the performance of
the funds in which they invest; and (2) from requests to LPs and GPs to
voluntarily provide the information. Roughly half of Preqin’s data comes
from GPs. Some funds report only IRRs, some report cash flows as well.

Pitchbook and Preqin have the advantage of reporting the performance

of individual funds and reporting GP names. The disadvantage is that
they potentially have a selection bias and a reporting bias in the funds
they include.
56 Advanced Introduction to Private Equity

Harris et al. (2014)12 compare the performance reported for US buy-

out funds by the four data providers. They find that the reported per-
formance is reasonably similar for funds with post-2000 vintages. This
is not so true for VC funds. Burgiss and Cambridge Associates tended
to show higher performance for VC funds than Pitchbook and Preqin,
likely because a number of the best VC funds do not allow their numbers
to be publicly reported or used.

What is performance?
Table 3.4 shows the pooled average and median IRR, MOIC and KS-PME
for North American buyout and growth funds by vintage year from
Burgiss’s Private IQ database as of 30 September 2021. Figures 3.1 to​
3.4 show the data graphically for vintages from 1991 to 2017. The pooled
average puts all the fund cash flows of a vintage year together and is closer
to a value-weighted average. These vintages have a reasonable number of
data points and are old enough to have meaningful performance infor-
mation. More recent funds are still investing and performance is con-
tinuing to emerge.

Figure 3.1 shows that the average vintage year IRR has varied quite a bit,
with some vintages over 20% and some under 10%. Figure 3.2 shows that
the average vintage year MOICs are generally between 1.5 and 2 with
strong vintage years exceeding 2 and poor years less than 1.5. The inter-
esting result here is that every vintage since 1995 has returned at least 1.3
times the capital invested. For investors concerned with absolute returns
and capital preservation, this is a very attractive (and impressive) result.

As discussed earlier, it is difficult to know if this IRR and MOIC vin-

tage year performance is particularly good or bad without being able to
compare it to an alternative. The KS-PMEs (relative to the S&P 500) in
Figure 3.3 show the stunning result that the pooled average performance
of every vintage from 1994 to 2017 – 24 in a row – has outperformed the
S&P 500. This is net of fees for private equity funds, but assuming no
fees for investing in the S&P 500. The median fund has outperformed
the S&P 500 in 22 of 24 vintages, never going below a KS-PME of 0.92.
Figure 3.4 annualizes the KS-PMEs and presents direct alphas by vintage
year. As with the KS-PME, the direct alphas show that the pooled aver-
age of buyouts outperforms the S&P 500 in every vintage since 1994. For
post-financial crisis vintages (2009 to 2017), direct alphas are almost 5%
on average. The strong relative performance is one of the reasons that
Table 3.4 Historical Private Equity Fund Returns by Vintage Year
Vintage Capitalization (M) Number of IRR IRR MOIC MOIC KS-PME KS-PME
Funds Average Median Average Median Average Median
1980 2 28.25 23.20 9.34 7.67 2.24 1.91
1982 2 28.17 24.95 2.86 2.77 1.37 1.21
1983 3 20.52 8.51 3.04 1.81 1.21 0.71
1984 2 27.18 23.19 4.40 4.09 1.53 1.38
1985 4 131.67 35.87 7.11 2.43 5.03 1.30
1986 1 453 5 24.42 16.79 5.77 2.36 1.52 1.11
1987 8 371 8 10.81 12.85 2.24 2.19 0.87 0.97
1988 6 060 8 15.17 11.21 2.01 1.60 0.98 0.84
1989 3 129 11 26.74 25.67 2.93 3.05 1.48 1.45
1990 2 306 8 14.56 13.09 2.23 1.96 0.92 0.93
1991 4 26.25 29.02 2.77 2.86 1.22 1.35
1992 4 087 9 32.07 19.95 2.12 1.95 1.20 1.09
1993 4 574 9 18.76 17.43 1.90 1.72 0.97 0.90
1994 6 855 19 16.82 8.75 1.83 1.42 1.12 0.94
1995 16 991 27 11.67 10.49 1.60 1.56 1.12 1.03
1996 4 888 19 15.44 9.05 1.75 1.70 1.30 1.14
1997 26 240 30 8.26 3.81 1.51 1.23 1.24 1.04
Private equity performance at the fund level

1998 39 578 43 5.34 8.46 1.32 1.44 1.21 1.44

(Continued)
57
Table 3.4 (Continued)
58

Vintage Capitalization (M) Number of IRR IRR MOIC MOIC KS-PME KS-PME
Funds Average Median Average Median Average Median
1999 29 891 34 7.79 8.94 1.44 1.53 1.26 1.37
2000 54 914 51 15.12 12.93 1.84 1.66 1.39 1.32
2001 23 338 33 23.11 20.67 1.97 1.92 1.47 1.47
2002 20 639 22 16.89 15.13 1.92 1.74 1.41 1.29
2003 22 018 24 20.46 14.20 2.05 1.90 1.55 1.34
2004 35 760 46 13.40 11.93 1.79 1.67 1.35 1.26
2005 53 678 63 9.14 8.35 1.63 1.60 1.16 1.07
2006 142 122 71 7.76 10.16 1.56 1.61 1.01 1.07
2007 125 896 73 10.90 12.64 1.71 1.73 1.02 1.07
2008 95 164 75 13.97 11.61 1.71 1.66 1.01 0.92
2009 20 653 26 20.18 22.12 2.14 2.17 1.19 1.24
2010 21 470 34 14.10 15.11 1.87 1.82 1.01 1.03
Advanced Introduction to Private Equity

2011 65 082 55 18.40 18.46 2.18 2.06 1.16 1.16

2012 55 791 56 19.43 16.70 2.02 1.88 1.17 1.09
2013 72 623 53 18.99 18.68 1.99 1.91 1.15 1.13
2014 87 733 80 22.22 16.84 2.11 1.82 1.25 1.08
2015 73 299 60 22.02 18.61 1.94 1.65 1.18 1.07
2016 113 295 78 21.86 22.69 1.83 1.77 1.11 1.09
(Continued)
2017 91 169 61 30.60 30.26 1.89 1.72 1.26 1.21
2018 123 938 72 22.88 25.25 1.45 1.42 1.04 1.02
2019 224 975 98 32.13 23.98 1.36 1.26 1.09 1.01
2020 135 003 73 40.47 20.68 1.27 1.17 1.08 1.00
2021 120 793 53 23.99 -3.27 1.08 0.97 1.06 0.97
(All) 1 937 632 1 504 15.86 15.35 1.75 1.62 1.18 1.09
Source: Burgiss
Private equity performance at the fund level
59
60 Advanced Introduction to Private Equity

35.00

30.00

25.00

20.00

15.00

10.00

5.00 Average
Median

0.00
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: Burgiss

Figure 3.1 US Buyout IRRs by Vintage Year, 1991–2017 Pooled Ave. and
Median as of 2021 Q3

3.00

2.50

2.00

1.50

1.00

Average
0.50
Median

0.00
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: Burgiss

Figure 3.2 US Buyout MOICs by Vintage Year, 1991–2017 Pooled Ave.

and Median as of 2021 Q3
 Private equity performance at the fund level 61

1.60

1.50

1.40

1.30

1.20

1.10

1.00

Average
0.90
Median
0.80
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: Burgiss

Figure 3.3 US Buyout PMEs by Vintage Year, 1991–2017 Pooled Ave. and
Median as of 2021 Q3

20.00
Average
Median
15.00

10.00

5.00

0.00
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

–5.00
Source: Burgiss

Figure 3.4 US Buyout Direct Alphas by Vintage Year, 1991–2017 Pooled

Ave. and Median as of 2021 Q3
62 Advanced Introduction to Private Equity

institutional investors have increased their allocations/investments to

private equity over time. It is worth adding that the results are quali-
tatively similar for European private equity funds relative to the MSCI
World Index or the MSCI Europe Index.

Sensitivities
There are various questions one might have about the basic results.13
First, the S&P 500 may not be the best benchmark. Buyout funds tend to
invest in companies that would be considered mid-cap or small-cap. The
most frequently used and most liquid small-cap index is the Russell 2000.
Figure 3.5 presents KS-PMEs relative to the Russell 2000. Every vintage
from 1999 to 2016 has outperformed the Russell 2000. The KS-PMEs
relative to the Russell 2000 tend to be a bit lower than those relative to
the S&P 500 pre-financial crises, but much greater post-financial crisis.
In fact, for vintages from 2009 to 2017, the average KS-PME relative to
the Russell exceeds 1.25. This reflects the fact that the Russell 2000 has
greatly underperformed the S&P 500 since the financial crisis.

1.60

1.50

1.40

1.30

1.20

1.10

1.00
Average
0.90
Median

0.80
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: Burgiss

Figure 3.5 US Buyout PMEs by Vintage Year, 1991–2017 Pooled Ave. and
Median as Pooled Ave. as of 2021 Q3 Russell 2000
 Private equity performance at the fund level 63

Second, some have argued that buyout investing should be compared

to value investing in mid-cap or small-cap public stocks because of the
type of companies in which private equity funds invest. According to
this argument, buyout performance should be compared to returns to a
value index like the Russell 2000 value index. Brown and Kaplan (2019)14
make this comparison. They find that buyout funds consistently have
the Russell 2000 value index except for a few vintages in the late 1990s.
The outperformance has been particularly strong post-financial crisis as
small-cap value and mid-cap value have markedly underperformed the
overall small-cap and mid-cap markets as well as the S&P 500.

A third alternative is to try to adjust for leverage and the level of mar-
ket risk (i.e., the CAPM beta). Ilmanen et al. (2019)15 assume that the
market risk inherent in a portfolio of US buyout funds is equivalent to
having a beta of 1.2 and adjust accordingly. Because buyout funds are
illiquid, it is difficult to estimate betas directly. The academic literature
on this is inconclusive with betas typically ranging from 1.0 to 1.3. In
general, using a beta above 1.0 has the effect of lowering the PMEs and
direct alphas of buyout funds because the stock market, on average, has
gone up.

We note that, empirically, beta does not do a good job of explaining real-
ized returns, i.e., a portfolio of higher beta public stocks does not per-
form much differently from a portfolio of low beta stocks. Evidence for
this comes from Frazzini and Pedersen (2014).16 It is further not clear to
what extent risk measures based on volatility and covariance are particu-
larly meaningful for illiquid investments, where cash flows are somewhat
at the discretion of the fund manager. Nevertheless, Brown and Kaplan
(2019) compare the performance of buyout funds to a leveraged invest-
ment (with a beta of 1.2) in the S&P 500 and Russell 2000. Buyout funds
still outperform, albeit by less than when using a beta of 1.0.

The bottom line to take from this section is that buyout funds of vin-
tages from 1995 to 2017 have performed very well, both in an absolute
sense and relative to various public market benchmarks. This consist-
ent outperformance is an important reason why investors have mark-
edly increased their allocations to buyout and growth equity funds over
recent time periods. While impressive, it is important to note that there is
no guarantee that outperformance will continue in the future.
64 Advanced Introduction to Private Equity

Performance persistence

The next logical question is whether particular GPs can consistently out-
perform. Figure 3.6 shows quartile performance cutoffs by vintage year
for all buyout and growth equity funds in the Burgiss database as of the
third quarter of 2021. For most vintage years, top-quartile funds have
PMEs above 1.2 while bottom quartile funds have PMEs below 1.0. It
would be very valuable if one could know in advance to invest in funds
that were going to be in the top quartile while avoiding funds that were
going to be in the bottom quartile. For post-2000 buyout funds, Harris
et al. (2020) report that funds in the top quartile have an average PME of
1.70 while funds in the bottom quartile average only 0.71.

A common strategy employed by investors in private equity is to invest

in GPs whose previous funds have done well. This is a good strategy if
there is persistence in performance. Kaplan and Schoar (2005) were the
first to study performance persistence in private equity. They found that
the performance (PME or IRR) of a given fund was positively related
to the performance of the previous fund raised by the same private
equity firm. This was an unusual result given the fact that there is little

2.00

1.80

1.60

1.40

1.20

1.00

0.80
Median
0.60 Top 1/4
Bot 1/4
0.40
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: Burgiss

Figure 3.6 US LBO PMEs by Vintage Year, 1991–2017 Top 1/4, Median
and Bottom 1/4 as of 2021 Q3
 Private equity performance at the fund level 65

evidence of persistence in mutual fund performance (Carhart (1997),17

Fama and French (2010)18), and, at best, modest evidence of persistence
in hedge fund performance (Ammann et al. (2013)19 and Jagannathan
et al. (2010)20).

More recently, however, using the Burgiss database (through June 2019),
Harris et al. (2020)21 revisit the question of persistence, focusing on funds
raised since 2001 – after the period studied by Kaplan and Schoar. Using
ex post or most recent fund performance as of June 2019, they find there
is modest persistence from fund to fund for post-2000 funds – the final
performance of a GP’s fund predicts the latest performance of the next
fund. For example, if fund 2 of a particular GP is in the top quartile, there
is a 33% chance that its next fund, fund 3, will be in the top quartile. If it
were random, the likelihood would be 25%. Subsequent funds of funds
that were in the top quartile had PMEs of 1.27 while funds previously in
the second, third and bottom quartiles had PMEs of 1.18, 1.15 and 1.02.
This is modestly good news for GPs. Good risk-adjusted performance
persists somewhat.

The news for LPs is more complicated. When Harris et al. (2020) look at
the information an LP would actually have – previous fund performance
at the time of fundraising rather than final performance – they find little
or no evidence of persistence for buyouts, both overall and post-2000.
This occurs because GPs can choose when to raise their funds. They tend
to try to raise funds when performance of their current fund is strong.
GPs with poorly performing funds often decide to wait. If performance
improves, they raise another fund; if performance is sufficiently poor,
they are unable to raise another fund. This means LPs should be wary of
relying on the conventional wisdom to invest in top-performing private
equity funds.22 The results and advice are different for venture capital
funds where persistence appears to have persisted.

Blackstone Capital Partners (BCP) provides a nice example of a lack

of persistence. Table 3.5 shows the MOIC and IRR for BCP IV to VII
according to Pitchbook as of 30 September 2021. For each fund, the table
also reports the vintage year quartile both for MOIC and IRR where the
BCP fund sits based on the Burgiss Private IQ performance data. BCP IV
performed very well and is in the top quartile of funds raised in 2002 for
both MOIC and IRR. In fact, the performance is in the top 10%. Contrast
that with BCP V which is in the second quartile for MOIC for funds
66 Advanced Introduction to Private Equity

Table 3.5 Blackstone Capital Partners IV–VII Fund Returns

Vintage Fund MOIC Burgiss IRR Burgiss
Year Size (bn) Quartile Quartile
Blackstone Capital 2016 $18.90 1.52× 3 21.0% 2
Partners VII
Blackstone Capital 2011 $17.50 1.73× 3 13.0% 3
Partners VI
Blackstone Capital 2006 $21.70 1.64× 2 8.0% 3
Partners V
Blackstone Capital 2002 $6.77 2.46× 1 36.0% 1
Partners IV
Source: Pitchbook and Burgiss

raised in 2006. BCP VI and BCP VII are both in the third quartile for
MOIC for funds raised, respectively, in 2011 and 2016. The IRR quar-
tiles also move around. Thus for BCP, since 2002, there is essentially no
consistency.

The discussion in this chapter demonstrates that, as an asset class, pri-

vate equity has performed quite well and has outperformed public equity
benchmarks across any reasonable time horizon. Efforts to risk-adjust
private equity returns leave that outperformance intact. As such, the
dramatic growth in the private equity industry can be understood as
institutional investors understanding that performance and increasing
their allocation accordingly. We do want to end with the caution that
successful past performance is no guarantee that that performance will
continue.

Notes
* This chapter borrows from and updates Kaplan and Sensoy (2015).
1 Ludovic Phalippou, 2020, An Inconvenient Fact: Private Equity Returns &
The Billionaire Factory, https://papers​.ssrn​.com​/sol3​/papers​.cfm​?abstract​
_id​=3623820.
2 For active funds, it is usually assumed that the last observed NAV is a fair
measure of the true value of the fund, so the last observed NAV is treated as
a liquidating distribution for the purposes of calculating performance.
3 A. M. Long and C. J. Nickels, 1996, A Private Investment Benchmark,
AIMR Conference on Venture Capital Investing.
4 S. N. Kaplan and A. Schoar, 2005, Private Equity Returns: Persistence and
Capital Flows, Journal of Finance 60, 1791–823.
 Private equity performance at the fund level 67

5 O. Gredil, B. Griffiths and R. Stucke, 2014, Benchmarking Private Equity:

The Direct Alpha Method, University of North Carolina Working Paper.
6 Morten Sorensen and Ravi Jagannathan, 2015, The Public Market Equivalent
and Private Equity Performance, Financial Analysts Journal 71, 43–50.
7 Arthur Korteweg and Stefan Nagel, 2016, Risk-Adjusting the Returns to
Venture Capital, Journal of Finance 71, 1437–70.
8 Technically, it is the difference between the sum of discounted distributions
and the sum of discounted capital calls that provides the appropriate risk
adjustment, rather than their ratio.
9 Log utility implies that risk aversion and the intertemporal elasticity of sub-
stitution are both equal to one. The asset pricing literature has found these
implications hard to reconcile with the equity premium and risk-free rate in
the data.
10 This section relies on data and analysis in Robert S. Harris, Tim Jenkinson
and Steven N. Kaplan, 2014, Private Equity Performance: What Do
We Know? Journal of Finance October, 1851–82; Robert S. Harris, Tim
Jenkinson and S. N. Kaplan, 2016, How Do Private Equity Investments
Perform Compared to Public Equity? Journal of Investment Management
14, 1–24; Robert S. Harris, Tim Jenkinson, S. N. Kaplan and R. Stucke,
2018, Financial Intermediation in Private Equity: How Well Do Funds of
Funds Perform? Journal of Financial Economics 129, 287–305; Robert S.
Harris, Tim Jenkinson, S. N. Kaplan and R. Stucke, 2020, Has Persistence
Persisted in Private Equity? Evidence from Buyout and Venture Capital
Funds, https://papers​.ssrn​.com​/sol3​/papers​.cfm​?abstract​_id​=2304808;
and G. Brown and S. N. Kaplan, 2019, Have Private Equity Returns Really
Declined? Journal of Private Equity 22(4), 11–18.
11 Kaplan serves on the board of directors of Morningstar, the owner of
Pitchbook.
12 Robert S. Harris, Tim Jenkinson and Steven N. Kaplan, 2014, Private Equity
Performance: What Do We Know? Journal of Finance October, 1851–82.
13 See Ludovic Phalippou, 2020, An Inconvenient Fact: Private Equity Returns
& The Billionaire Factory, https://papers​.ssrn​.com​/sol3​/papers​.cfm​?abstract​_
id​=3623820, who raises several of these questions (albeit in a misleading way).
14 G. Brown and S. N. Kaplan, 2019, Have Private Equity Returns Really
Declined? Journal of Private Equity 22(4), 11–18.
15 Anti Ilmanen, Swati Chandra and Nicholas McQuinn, 2019, Demystifying
Illiquid Assets: Expected Returns for Private Equity, AQR Working Paper.
16 A. Frazzini and L. H. Pedersen, 2014, Betting Against Beta, Journal of
Financial Economics 111, 1–25.
17 M. Carhart, 1997, On Persistence of Mutual Fund Performance, Journal of
Finance 52, 57–82.
18 E. F. Fama and K. R. French, 2010, Luck versus Skill in the Cross-Section of
Mutual Fund Returns, Journal for Finance 65, 1915–47.
19 M. Ammann, O. Huber and M. Schmid, 2013, Hedge Fund Characteristics
and Performance Persistence, European Finance Management 19, 209–50.
20 R. Jagannathan, A. Malakhov and D. Novikov, 2010, Do Hot Hands Exist
among Hedge Fund Managers? An Empirical Evaluation, Journal of Finance
65, 217–55.
68 Advanced Introduction to Private Equity

21 Robert S. Harris, Tim Jenkinson, S. N. Kaplan and R. Stucke, 2020, Has

Persistence Persisted in Private Equity? Evidence from Buyout and Venture
Capital Funds, https://papers​.ssrn​.com​/sol3​/papers​.cfm​?abstract​_id​
=2304808.
22 Performance persistence has also been documented at finer levels of detail
than the private equity fund. R. Braun et al. (2019) study individual buy-
out managers. They find deal-level gross PME performance persistence;
the individual is around four times more important than the GP organi-
zation. R. Braun, N. Dorau, T. Jenkinson and D. Urban, 2019, Whom to
Follow: Individual Manager Performance and Persistence in Private Equity
Investments, University of Oxford Working Paper.
4 Investment decision
making

Access to attractive investment opportunities is a critical factor that

influences the ultimate returns generated by private equity investors.
Industry professionals typically refer to the deal “funnel” to describe
the process of sourcing potential investments and then winnowing them
down to those that justify an investment.

In this chapter, we explore how private equity investors bring investment

opportunities into the firm, evaluate the attractiveness of the deal and
decide which opportunities to invest in. We start by understanding deal
sourcing and deal selection. How do private equity managers gain access
to their deals, and what factors are most important for their selection?
We then move on to discuss the analytical tools private equity investors
use to evaluate deals. We review the theory and practice of the finance
tools taught in most business schools and then evaluate which tools are
utilized while exploring how they are employed by decision makers.
Finally, we present an investment framework that can assist in determin-
ing which deals are attractive.

Deal sourcing

Private equity investors emphasize the importance of deal sourcing in

the value creation process. There are numerous channels that private
equity managers utilize to gain access to attractive deals. The GKM
(2016)1 survey of a large group of PE investment managers examined this
issue. Many outsiders are under the illusion that private equity managers
just bring great companies in the door and quickly close a transaction.
Table 4.1 shows that this is not the case. For every 100 opportunities that
come in the door, the typical investor does deep due diligence on fewer
than 24, signs an agreement with fewer than 14 and ultimately invests

69
 70

Table 4.1 Private Equity Deal Funnel

AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
All considered 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
opportunities
Review with partner 61.8 50.0 56.9 66.6 65.8 61.3 63.0 60.8 56.5 69.2
group/investment
committee
Meet management 52.8 40.0 38.1 67.0 58.5 53.2 62.2 44.5 42.0 67.5
Limited due 49.1 40.0 35.2 62.6 56.7 46.5 59.1 40.4 42.5 58.1
diligence
Deep due diligence 23.7 20.0 16.3 30.9 29.0 21.2 29.5 18.7 19.1 30.0
Offer term sheet/ 22.5 19.0 14.4 30.3 25.7 22.9 27.1 18.5 16.2 31.1
negotiate detailed
Advanced Introduction to Private Equity

terms
Sign LOI 13.6 8.0 9.1 17.9 15.2 11.0 14.5 12.8 8.0 21.2
Close 6.1 4.0 4.0 8.1 7.0 5.4 7.3 5.0 4.1 8.8
Number of 71 71 35 36 26 26 33 38 41 30
responses
 Investment decision making 71

in only six. This indicates that private equity investors devote consider-
able resources to evaluating transactions, despite the fact that they will
ultimately invest in only a very few. The winnowing process is a critical
part of what private equity managers do. A key element of this process
is quickly deciding which deals make sense to examine intensively and
which merit a quick pass.

When we compare the deal funnel at different types of private equity

firms, larger private equity firms have an investment rate nearly twice
as high as smaller private equity firms (8.1 deals per 100 opportunities
considered versus 4.0 deals per 100 opportunities considered). There are
several potential explanations. First, larger private equity firms may have
higher quality initial deal sourcing and hence do not need to weed out as
many deals at all stages. Alternatively, the larger fund sizes may reduce
the investment hurdle rate relative to the investment hurdle rate of small
funds given their abundance of capital. In other words, larger funds may
be doing more marginal deals compared to smaller funds. Finally, there
may simply be fewer large deals to evaluate.

It is also important to understand exactly how quality deals are introduced

to the private equity firms. Table 4.2 looks at the source for closed deals
within each private equity firm, i.e., where do the deals they do come from.
Not surprisingly, a large fraction of deals that are done are considered “pro-
prietary,” 35.6%. Proprietary deals are potentially important to the ability
to achieve high returns. Academic research tells us the greater the com-
petition for the deal, the higher the acquisition price paid is likely to be.
Private equity firms would be willing to pay a price which reflects a portion
of the operating improvements that they can create in their portfolio com-
panies. In fact, auction theory states that the winning bidder in an auction
pays a price that is equal to the value that can be created by the second-best
bidder. As such, multiple bidders give more of the total value created to the
seller as opposed to the buyer. Proprietary deals are one way to keep from
paying a higher price (that translates directly into lower returns).

On a more granular level, private equity managers indicate that 7.4%

of deals come from solicitations by management and 8.6% come from
their executive network. These have the potential to be proprietary as
well. Another third come from investment banks that shop deals on
behalf of sellers, 8.6% are from deal brokers and 4.3% from other private
equity funds. These deals are unlikely to be proprietary. In total, private
 72

Table 4.2 Source of Private Equity Closed Deals

AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
Proactively 35.6 30.0 37.7 33.5 39.3 35.5 35.8 35.4 35.3 35.9
self-generated
Investment bank 33.3 25.0 30.5 36.0 33.0 37.0 38.2 29.1 33.0 33.7
generated
Inbound from 7.4 5.0 5.8 8.9 6.1 9.0 7.4 7.3 7.2 7.6
management
Other PE firm 4.3 0.0 5.4 3.3 4.1 2.2 4.1 4.5 5.0 3.5
Deal brokers 8.6 0.0 9.5 7.7 6.8 7.1 8.4 8.7 8.7 8.5
Executive network 8.6 5.0 8.3 9.0 8.8 8.5 4.6 12.1 9.1 8.0
LPs/investors 1.7 0.0 2.5 0.9 0.6 0.7 0.4 2.7 1.2 2.3
Advanced Introduction to Private Equity

Conferences 0.6 0.0 0.3 0.9 1.0 0.3 1.1 0.3 0.5 0.8
Other 0.0 0.0 0.1 0.0 0.1 0.0 0.0 0.1 0.1 0.0
% of deals considered 47.9 50.0 54.0 41.9 48.0 43.9 41.5 53.4 47.6 48.3
proprietary
Number of responses 71 71 35 36 26 26 33 38 41 30
 Investment decision making 73

equity managers viewed nearly half (48%) of their deals to be proprietary.

Clearly, a significant amount of time and effort are put into bringing in
deals that are not “over-shopped.”

There are many examples of deal sourcing employed in the PE indus-

try. A number of firms like Summit Partners and TA Associates pro-
actively “cold call” numerous private companies in order to assess the
owner’s willingness to potentially take private equity. Often referred to as
“smiling and dialing for deals,” this often occurs many years before any
contemplated transaction is made, and is meant to introduce the firm
and the concept of private equity to companies. Even in new markets,
this strategy could work well. In 2012, TA partners Michael Berk and
Ed Sippel led TA’s first investment out of its Hong Kong office by proac-
tively contacting P.J. Beylier, CEO of satellite communication company
SpeedCast. Beylier hoped to buy SpeedCast – a wholly owned subsidiary
of AsiaSat, a Hong Kong-based publicly traded company. The wrinkle
was that not only would TA have to convince Beylier that the deal made
sense, they would have to convince AsiaSat, the parent, to sell. Their per-
sistence led to the opportunity for the buyout and consolidation of sev-
eral other regional players in the industry in what was ultimately a highly
successful transaction.2

Other private equity firms attempt to gain proprietary access by meet-

ing with management of public companies and getting them to agree to
a “take private.” In order to avoid an auction, some private equity firms
attempt to convince senior management that a negotiated transaction
makes sense for both shareholders and management. These transac-
tions typically require an independent special committee of the board
of directors to negotiate with the private equity firms prior to agreeing
to the transaction. They also generally require the selling company to
“check the market” by considering other bids for some fixed amount of
time. This process is necessary to ensure that outside shareholders’ inter-
ests are taken into consideration.

Michael Chu of Catterton Private Equity had been courting Bill Allen, CEO
of Outback Steakhouse, for more than six months about the possibility of
taking the restaurant chain private. Chu convinced Allen that the deal
made sense only after he brought in Andrew Balson and Mark Nunnelly
of Bain Capital, a much larger private equity firm that could provide Allen
with assurances that the deal would get done. Through a multi-month
74 Advanced Introduction to Private Equity

period of negotiation, Bain and Catterton were able to take Outback private
in November 2006 without the company going to a formal auction.3

Another strategy to access deals is to use networks to identify a potential

investment. These networks can typically come from past employment or
business associates, but can also come through social networks. Brazos
Private Equity’s partner, Randall Fojtasek, used connections through his
Southern Methodist University alumni network to identify Cheddar’s (a
restaurant chain in the Southwest) as a potential investment opportunity.
Aubrey Good, the company’s founder, had deep ties in Dallas and was an
alum of Southern Methodist University. Even though the Cheddar’s deal
had been previously shopped by an investment bank, Fojtasek was able
to utilize his connections and shared alma mater connection to make
Cheddar’s a proprietary deal.4

A critical takeaway from this discussion is that the deal funnel matters
immensely for PE investors. Many strategies are employed to generate
deal flow, and that process is an integral part of the PE process. Because
there is not always the ability to bring unique value-add to a portfolio
company, avoiding competition for a transaction is often a necessary step
for generating attractive returns.

Deal selection

The winnowing process that private equity managers undertake is criti-

cal to picking the best opportunities for the capital they have to deploy.
We start by understanding the qualitative factors utilized by PE investors
then move to the quantitative tools employed by PE managers. Both are
critical drivers of the selection process.

A central debate among economists as well as practitioners has been

whether the business model (horse) or the management team (jockey) is
more important in deal selection for investors in private companies.5 Is it
more important to have a great set of senior executives in place to imple-
ment the plan for improvement or are the industry and business model
of the company more important? Clearly, having both is ideal, but when
forced to rank which is more important, how do PE managers respond?
Good business models likely have the ability to keep and attract custom-
ers, have important competitive advantages and have the ability to grow
 Investment decision making 75

and defend the company’s position. Still, the management team has to
run the business.

In order to better understand how PE investors select and differentiate

among investments, our GKM (2016) survey asked about the qualitative fac-
tors that PE investors considered when investing. PE managers ranked the
factors they considered when choosing their investments. Table 4.3 shows
that the highest ranked factor was the firm’s business model/competitive
position (i.e., the horse). We obtained the same relative ranking in our more
recent GKM (2020) survey. This would indicate that PE investors believe
that generating returns with a bad business is difficult to achieve. Most pri-
vate equity managers are, generally, not interested in turning around dra-
matically poorly performing companies. These rankings indicate that PE
investors are looking for companies that they can grow in a variety of ways.

Somewhat behind the business model were the management team and
the ability of the PE firm to add value to that particular investment.
Again, the focus on these choices aligns with the desire for growth. The
image of private equity firms slashing expenses and headcount seems at
odds with these rankings. This was confirmed when the survey asked
private equity investors to rate the source of returns. Table 4.4 shows that
the dominant source of returns was growth in the value of the underly-
ing business followed closely by operational improvements. Again, the
importance of growth is even stronger in our more recent survey.

These results stand in sharp contrast to much of the received wisdom about
private equity. The popular press often paints private equity managers as
“barbarians at the gate” who take a cleaver to jobs and massively reduce
expenses. The advice, services and incentives that private firms provide
through operational and governance engineering therefore are critically
important to the process of generating returns by growing the business.
We explore each of these in subsequent chapters and look at the granular
nature of the activities that PE managers employ to achieve that growth.

Interestingly, the results are somewhat different for venture capital inves-
tors. Similar survey evidence shows that the management team (i.e., the
jockey) is the most important qualitative selection criterion, particularly
for early-stage venture capitalists.6 The difference likely reflects the fact
that the business is nascent and, therefore, must rely more on the man-
agement team.
 76

Table 4.3 Factors for Selecting Private Equity Deals

AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
Ability to add value 3.6 3.0 3.6 3.6 3.9 3.5 3.5 3.7 3.5 3.8
Business model/competitive 4.6 5.0 4.5 4.7 4.5 4.5 4.4 4.7 4.6 4.5
position
Fit with fund 2.3 2.0 2.7 1.9 2.0 2.2 2.2 2.4 2.5 2.0
Industry/market 3.2 3.0 3.4 3.0 3.3 3.0 3.3 3.1 3.5 2.8
Management team 3.8 4.0 3.7 4.0 3.9 4.0 4.1 3.6 3.8 3.8
Valuation 3.5 3.0 3.2 3.8 3.4 3.8 3.5 3.5 3.0 4.1
Advanced Introduction to Private Equity

Number of responses 65 65 32 33 24 23 31 34 37 28
Table 4.4 Sources of Private Equity Deal Value before Investment
AUM IRR Age Offices
Mean Low High Low High Old Young Local Global
Growth in the value 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
of the underlying
business
Industry-level 64.8 74.3 55.6 50.0 65.4 66.7 63.2 61.0 70.0
multiple arbitrage
Leverage 76.1 74.3 83.3 65.4 88.5 81.8 71.1 73.2 80.0
Operational 97.2 74.3 100.0 100.0 96.2 100.0 94.7 95.1 100.0
improvements
Refinancing 97.2 28.6 44.4 34.6 42.3 45.5 28.9 29.3 46.7
Other 26.8 28.6 25.0 23.1 19.2 21.2 31.6 31.7 20.0
Number of 71 35 36 26 26 33 38 41 30
responses
Investment decision making
77
78 Advanced Introduction to Private Equity

Investment frameworks for private equity and

buyout transactions

In every deal they do, private equity investors create an investment mem-
orandum that describes the deal and the reasons they want to do the deal.
These investment memos can be over 100 pages. The investment memos
generally combine both qualitative and quantitative analyses. In this sec-
tion, we present an investment framework for the qualitative aspects of
deal evaluation. In the next section, we outline the quantitative tools that
private equity investors apply when evaluating deals.

Our qualitative framework can be summarized with the pneumonic

OUTSX-CUPID. OUTSX stands for Opportunity, Uncertainty, Team,
Structure and eXit. CUPID describes the different pieces for evaluat-
ing the opportunity and determining whether it is qualitatively attrac-
tive. The pieces of CUPID are Competition/industry, Undervalued,
Proprietary, Improvements and Debt capacity. It is worth noting in
advance that the components of OUTSX-CUPID interact.

The first questions to ask about the opportunity (O) are: how attractive
are the industry dynamics and how attractive is the company’s competi-
tive position within the industry? Industry dynamics include industry
growth prospects, technological change, customer concentration and
competitors, among other aspects. Competitive position considers
whether the company has existing or potential competitive advantages
that will allow the company to compete and do well given the industry
dynamics. The analysis of competition and industry (C) generally occu-
pies a large fraction of the typical investment memorandum. In these
analyses, investors will consider whether the industry is growing and
whether that growth will support the investment thesis.

The next question to ask is whether the deal is undervalued (U) or, equiva-
lently, whether the price is attractive. This reflects the possibility that one
can buy an average company at a below average price. Alternatively, one
can pay too much for a great company. This analysis generally includes
several quantitative analyses that we present in the next section.

Proprietary (P) asks whether there is anything proprietary about the

deal. P can also stand for why is the deal positive present value, i.e., a
good, valuable deal. Today, because almost every deal is competitive
 Investment decision making 79

in some way, this is arguably the most important question to answer.

At a University of Chicago private equity conference, Bill Conway, the
co-founder of Carlyle, paraphrased this thinking by pointing out that
PE investors need to ask on every deal what their unique edge is. If you
cannot come up with some unique advantage relative to others bidding
for the transaction, you are likely overpaying. This is particularly true in
deals that are auctioned.

In a recent conversation with one of us, a very senior partner of a meg-

afund reiterated this. His firm will not commit to a deal unless they have
conviction in a well-thought-out plan that will increase the value of the
company and that they have some advantage over other bidders.

Examples of having an edge or a proprietary advantage would include

knowing the particular industry or subsegment better than anyone else,
having an idea for a new initiative that no one else has, bringing in a
better management team or having a better relationship with the seller
or selling management team that no one else has. In some cases, particu-
larly with private company sellers, this can be as simple as having the
seller like you more than the other bidders.

Improvement (I) asks if there is room for improvement in the com-

pany. Is it possible to reduce costs? Is it possible to reduce taxes? Is it
possible to make value-increasing acquisitions? Are there new “bolt-
on” investments to make that will increase firm growth? Are there
strategic changes that will increase growth, reduce costs or both? The
greater opportunity that exists to improve operations, the more likely
the deal is undervalued and the more likely the private equity investor
has some proprietary angle. In Chapter 7, we discuss operational engi-
neering and the many ways in which private equity firms help their
portfolio companies improve.

A good example is Silver Lake Partners’ buyout of Instinet.7 Instinet was

an institutional broker with old and high-cost back-end systems. Silver
Lake realized that if Instinet could rip out those existing systems and
replace them with new ones, Instinet would reduce costs substantially
and make themselves more attractive to a strategic buyer. Instinet, with
Silver Lake’s support, hired top talent who implemented the changes in
little more than a year. Shortly thereafter, a strategic investor bought the
company for six times what Silver Lake had paid.
80 Advanced Introduction to Private Equity

The final piece of CUPID is to understand the debt capacity (D) of

the company being bought. A deal should use enough leverage to
take advantage of interest tax shields and potentially lower cost debt,
but should not use too much leverage that it constrains the company
from operating efficiently and risks putting the company into financial
distress.

In basic corporate finance terms, this means understanding the prob-

ability of financial distress/constraints and the costs of financial distress/
constraints. Other things equal, firms in industries with lower downside
risk, less volatile cash flows and less competitive pressure can take on
more debt. Similarly, firms that are less adversely affected by financial
distress can take on more debt. Distress and excess leverage are very
costly if capital and R&D expenditures are crucial and non-deferrable, or
if key employees and customers are likely to leave when the company hits
a rough spot. Alternatively, more leverage is feasible if employees will not
leave and those investment expenditures are deferrable.

Attractive investments will have favorable CUPID components. In our

view, understanding P, the investor’s edge or proprietary advantage, is
the most important. Deals with P will tend to have favorable industry
and competitive dynamics, tangible expected improvements, and, as a
result, are more likely to be acquired at a price that generates attractive
returns.

Even for investments with favorable CUPID components, there are

always aspects that are uncertain (U). This is the U in OUTSX. Or, in
other words, all deals have some risk. For some companies, the greatest
uncertainty may revolve around the technology or product. For others,
competitors and their response to entry may be most critical. For others,
the management team and their ability to navigate strategy is the most
important. Private equity investors keep close track of the aspects of the
deal that are uncertain or risky. To the extent possible, they focus due
diligence on resolving those uncertainties. If the uncertainties resolve
favorably, the deal becomes more attractive; unfavorably, less attractive.
Even after due diligence is done, some uncertainty invariably remains. It
is rare for a deal to be a sure thing. Accordingly, investors will continue
to keep close track of those uncertainties after the deal closes, to be ready
to respond as the uncertainty resolves.
 Investment decision making 81

As we mentioned earlier, the team (T) is also important to a successful

investment. Is the management team capable of executing the strategy
that is implicit in CUPID? If it is the same management team, why will
they be able to implement the expected improvements? Why didn’t they
do so before? If it is a new management team, why will they be better
than the existing management team? Will the management team work
well together in a more leveraged environment? Private equity investors
spend a great deal of due diligence effort evaluating the management
team and conducting reference checks. Increasingly, private equity firms
have relied on executive assessment firms, like ghSMART, or have hired
their own executive assessment and search professionals or both.8 As we
will see in Chapter 6, governance engineering is a critical lever that many
private equity firms pull.

The structure of the deal (S) also matters. There are three pieces to deal
structure. The first is the deal’s capital structure. Investors want to
make sure that the capital structure and leverage are consistent with
the firm’s debt capacity identified in CUPID. Second, investors want to
make sure incentives are well-structured. In particular, investors will
want the management team to have sufficient upside to motivate them
to perform. At the same time, investors will want the management team
to have sufficient downside or “skin in the game” to ensure that they
are really committed to the deal and will suffer along with the private
equity investors if the deal does not succeed. Third, investors should
ensure that the deal provides the appropriate board governance and
oversight. Chapter 6 looks more closely at incentive and governance
structures.

The final piece of OUTSX-CUPID is the exit (X). Successful private

equity investors think about a deal’s exit before they commit to the deal.
At some point, investors need to get their money out. Good deals have
clear paths to do so. A deal can be exited through (1) a sale to a strategic
acquirer, (2) a sale to another financial buyer(s) or (3) an initial public
offering (IPO) or, more recently, a merger with a publicly traded special
purpose acquisition corporation (SPAC). Chapter 8 explores where, when
and how private equity firms exit their investments.

It is useful to apply the OUTSX-CUPID framework to Bill Conway’s

“Ten Rules for Private Investing.” Conway is a co-founder of Carlyle
82 Advanced Introduction to Private Equity

Partners, one of the world’s largest private equity firms, who is con-
sidered among the best individual private equity investors. Conway’s
10 rules are: (1) Develop your own idea of what a business is worth.
Constantly assess the valuation [Opportunity–Undervalued]. (2) Avoid
auctions. “What is our edge?” [Opportunity–Proprietary]. (3) Pick your
spots [Opportunity–Proprietary]. (4) Approach each potential trans-
action with overwhelming force [Uncertainty]. (5) Follow the cash
[Opportunity–Debt capacity]. (6) Get help! [Uncertainty]. (7) Keep
your emotions in check [Opportunity–Proprietary and Undervalued].
(8) Develop trust with your managers and vice versa [Team and
Uncertainty]. (9) Make sure managers concentrate on the few vital
objectives [Team and Structure]. (10) When management is not work-
ing out, change them sooner rather than later [Team].

OUTSX-CUPID provides a framework that private equity investors can

use to help structure their analyses and avoid missing out on a critical
piece of the evaluation. All private equity firms cover these issues and
use some version of this framework. A huge amount of work and due
diligence go into each of the components of the framework. In the next
section, we outline the financial tools that private equity managers utilize
in their investment decisions. We also highlight the relative importance
of those tools in practice.

Financial tools utilized by private equity investors

to evaluate investments

Valuation is one of the central concepts in finance. Given the high lev-
erage and substantial sums of investor capital at risk in private equity,
getting the valuation right is absolutely critical, perhaps more so than in
many other settings. Private equity investors have developed a number of
financial tools and analyses that help them get to the right place.

We begin with a brief discussion of various financial tools that are taught
in most business schools and utilized by private equity investors. Private
equity managers employ many (if not all) of these financial tools during
the course of evaluating an investment opportunity. Our goal is not to
dive into any one of these methodologies in detail, but to help the reader
become familiar with the types of analysis that can be employed. The
interested reader can find other sources of information to dive more
deeply into each approach in the reference section of this book.
 Investment decision making 83

We first discuss discounted cash flow (DCF) analysis, the method that
most business schools teach. DCF not only provides one method for val-
uing an investment, but it also is helpful in understanding other valua-
tion approaches used by private equity investors. We then move on to the
methods that private equity professionals employ most in practice, the
LBO model and comparable companies’ approaches. In the LBO model,
the private equity investor models out cash flows and exit values. Based
on the amount of equity invested, the private equity investor calculates
an expected annualized internal rate of return (IRR) and a concomi-
tant multiple on invested capital (MOIC). The projected IRR or MOIC is
then compared to the firm’s “hurdle rate,” i.e., the rate of return or mul-
tiple necessary to justify the investment. In the comparable companies
approach, private equity investors use the values of similar companies
and transactions to value the investment they are considering.

Discounted cash flow methods

Both DCF methods and LBO investment models start by projecting

future financial performance for a potential investment opportunity.
Private equity firms will often take the projections prepared by the com-
pany as the starting point for their own projections.

From that starting point, private equity investors devote a great deal of
effort to drilling down on the forecasts. In many cases, this means going
to the granularity of individual customers (particularly in business-to-
business deals) and individual plants or operations. It seems natural to
assume that the initial management forecasts turn out to be optimistic.
In fact, this is usually what happens. In our survey of PE managers in
GKM (2016), we asked how they typically ended up adjusting manage-
ment’s forecasts. As a fraction of EBITDA – earnings before interest,
taxes, depreciation and amortization – a measure of pre-tax cash flow,
the private equity managers told us that, on average, they discounted
management’s projections by about 20%.

The key economically significant input that DCF and LBO models look to
is the operating cash flows of the company. Cash flows pay down the debt
and generate value for equity holders. Estimating cash flows requires a
detailed understanding of the firm, its industry and the prospects to grow
the business. Because of the vital importance of understanding future
performance, private equity managers increasingly specialize by industry.
84 Advanced Introduction to Private Equity

Once the investor has generated projected operating cash flows, usually
for a period of five years, the investor typically assumes that the invest-
ment will be exited at the end of that five-year period. As a result, the
investor will calculate a terminal exit value for both DCF and LBO meth-
ods. The terminal value captures the value of the company at the end of
the explicit projection period.

There are (at least) three possible ways to estimate the terminal value: (1)
using the (discounted) value of a growing perpetuity of the final year cash
flow in a CAPM-framework; (2) using the value of comparable or similar
public companies; and (3) using the value of acquisitions or transactions
involving comparable or similar companies.

In the DCF, once the terminal value is estimated, the stream of cash flows
and terminal value are valued as of today or the present using an appro-
priate “discount rate” in the DCF. Most DCF approaches use some form
of the capital asset pricing model (CAPM) to estimate a discount rate.
The discount rate in the CAPM depends on three elements: the current
risk-free rate (usually taken to be the current interest rate on the long-
term government bond), the equity market risk premium and the firm’s
beta. Beta captures how the company’s value moves up and down with
the overall market returns.

When you calculate a beta and discount rate for a firm, you should not
regard this as the discount rate. Considerable controversy exists about
the validity of the CAPM that underlies the calculation of costs of capital
in this way. Without going into the academic debate, we just warn that
betas can be very difficult to estimate, so they should be used with cau-
tion. However, it is not clear if there is a better alternative. Consistent
with this, in acquisition cases, the Delaware Courts look favorably on
this approach. A detailed discussion of these issues is beyond the scope
of this book, but basic finance textbooks deal with how to approach each
of these elements. The key point is that the discount rate for cash flows
depends upon the systematic risk of the company, i.e., how much its
returns correlate with the market, not the firm-specific riskiness.

DCF methods also factor in the value created by the deductibility of

interest payments. There are two ways to do this. The difference between
the two methods is where the tax advantages of debt come into the cal-
culation. The weighted average cost of capital (WACC) method includes
 Investment decision making 85

the value of the interest tax shield in the discount rate by lowering the
cost of capital. Alternatively, adjusted present value (APV) DCF method
uses a higher discount rate, but adds the value of the interest tax shield
as a separate (discounted) stream of cash flows. In both methods, the
net present value of the firm is calculated by discounting the appropriate
cash flows by the appropriate discount rate.

The advantage of the APV method is that it models a company’s actual

capital structure which varies over time. The disadvantage is that it
requires two sets of cash flows. The advantage of WACC is that it only
requires one set of cash flows. The disadvantage of WACC is that it
requires the incorrect assumption for most buyouts that the debt-to-
total-capital ratio is constant.

LBO investment models

Many, if not most, private equity investors eschew DCF models, and
instead utilize an LBO model for making decisions. The method starts
with a similar approach to a DCF analysis by projecting a company’s rev-
enues, income and cash flows over some period of time. In our survey, we
asked the PE investors to tell us the time horizon of the investment cash
flows they evaluate. The great majority of PE investors – almost 96% of
our sample – use a five-year forecast horizon. At the end of the five years,
they typically calculate a terminal or exit value. When asked why they
always use five years, they responded that it makes it easier to compare
investments against each other.

If the firm has taken on debt, the cash flow in each projection year –
after paying interest, and funding capital expenditures and net work-
ing capital – is assumed to “pay down” existing debt, so the amount of
outstanding debt each year changes. As noted above, the PE investors
then calculate an “exit value” in the final year of the projections. This exit
value captures what PE managers believe they can sell the company for
(or receive if they take it public) at that future time.

The exit value is usually determined by applying an exit multiple to the

portfolio company’s projected EBTIDA or revenues at the time of the
exit. Clearly, the exit multiple chosen has a large effect on the perceived
attractiveness of a deal. Accordingly, selecting the right exit multiple
requires judgment. If the investor selects an exit multiple that is too high,
the investor is more likely to win that deal, but also more likely to regret
86 Advanced Introduction to Private Equity

it later if the investor turned out to have overpaid. Alternatively, if the

investor chooses a multiple that is too low, the investor is more likely
to lose the deal – and regret it later if the winning bidder makes a lot of
money.

Many private equity investors begin by assuming that the exit multiple
will equal the multiple they plan to pay for the deal. This is known as
multiple in/multiple out (MI/MO). They then adjust around that depend-
ing on judgment. And that judgment will consider a number of factors.
For example, investors also will look at current industry multiples. While
those are informative, if the industry is growing more quickly today
(because it is a young industry or is in an expansion phase) than it will be
at exit, then exit multiples are likely to be lower in the future than they
are today. Alternatively, if values are currently depressed, perhaps at the
bottom of a recession, it is more likely that exit multiples will be greater
in the future.

Private equity investors also will look subjectively at the deal dynamics.
If the private equity firm believes that it “got a good deal” because the
deal was proprietary or they bought the firm cheaply, then they might
assume the exit multiple in year 5 will be higher than the multiple they
purchased the firm for today.

Given this uncertainty and judgment, while investors will have a mean/
point estimate of exit value, they also will typically use a range of multi-
ples and report a range of possible deal outcomes.

Based on the cash flows and the assumed exit value, the private equity
investor calculates the amount of exit value going to equity by subtract-
ing the debt projected to be outstanding at exit (akin to paying off a mort-
gage) and adding back any firm assets (including cash) whose value is not
reflected in the cash flows or exit value. The investor then uses the equity
at exit and the amount of equity invested up front to calculate an (annu-
alized) IRR and a (cumulative) MOIC.

The investor then compares the IRR or MOIC on their equity invest-
ment to their required IRR or MOIC. These are sometimes referred to
as investment hurdle rates. If the expected return is above the required
return or hurdle rate, the investment is attractive. Investments that have
 Investment decision making 87

a projected return below the hurdle rate would not likely receive a bid for
investment by the PE firm.

Where do these required returns or hurdle rates come from? Many are
derived from industry rules of thumb. If a firm is doing an LBO with
substantial leverage, it may look for a higher return. Similarly, deals
with riskier business models or in riskier industries may require higher
returns to compensate for the underlying risks of the investment.

It is important to understand how the IRR and MOIC in an LBO model

are driven. The discussion in Chapter 1 presented an overview of sources
of value. Because it is so important, we refresh that concept here. First,
the value created by the interim paydown of debt is captured by subtract-
ing a lower debt number at exit than the total debt outstanding when the
deal is consummated. As mentioned in Chapter 1, this is not value crea-
tion in the true sense because the paydown of debt only represents a fair
return on the capital provided by lenders. Value of the equity increases as
debt is paid off in intervening years, but this just represents a return on
equity. Value is created only in situations in which this return on equity is
above the firm’s cost of capital. Second, improvements in operating per-
formance, e.g., growth revenue and EBITDA, will also result in growth
in enterprise value. Finally, differences in the entry and exit multiples,
especially if a private equity firm can “buy right,” can lead to increases
in value creation for the private equity firm. This is often referred to as
“selling right.”

Multiples valuation methodology

As we mentioned, the common methods for valuation that are often
utilized by investment bankers, private equity investors and investment
analysts in addition to or rather than discounted cash flow are compa-
rable company valuation methods. These methods entail finding a com-
parable company or set of companies that are either trading publicly or
have been recently acquired. In this method, the value of a company or
set of companies is used to estimate the value of another company or pro-
ject. The comparable companies are chosen to be as similar as possible
to the company that is to be valued. Typical dimensions that are utilized
to gauge comparability include industry, past performance, size, growth
rates and business model.
88 Advanced Introduction to Private Equity

The comparable company valuation calculates “multiples” for the bench-

mark company, or companies, and then applies the average or median
multiple to the company that is to be valued. A multiple is generally the
ratio of company value (measured in different ways) to a performance
measure. The calculated multiple is adjusted (if appropriate) and then
multiplied by the utilized performance measure for the company of
interest in order to derive a valuation of that company. This performance
measure can be revenues, EBITDA, earnings, etc.

If a person valuing a particular firm only has one comparable company,

then it is imperative to adjust the multiple of the comparison company
for any differences in factors that may affect the multiple of the firm.
Close scrutiny of the growth rates, riskiness and cash flow generation of
the firms must be undertaken.

Implicit in every multiple is the relationship between the chosen metric

(EBITDA, net income, EPS, revenues, etc.) and cash flows. An EBITDA
or revenue multiple implicitly assumes that companies with the same
EBITDA or revenue generate similar cash flows. To the extent this is not
true, the multiple can be misleading.

For example, if two firms have the exact same revenues, but one firm has
twice the cash flow margin as the other, the firm with the higher cash
flow margin will have a higher value. If one uses the revenue multiple
from the firm that is more profitable to value the less profitable firm, the
revenue multiple would overvalue the less profitable firm. Similarly, if
two firms have the same EBITDA, but one has higher capital expendi-
tures and working capital needs, an EBITDA multiple will overvalue that
firm. A simple rule to follow when valuing a company using a multiples
method is to use a multiple that is derived from a performance measure
that is as close to cash flow as possible.

It is also important to benchmark the expected long-run growth and the

discount rates of the comparable firms to those of the firm that is being
valued. The higher the growth rate of the firm, the higher the value of the
multiple, all else being equal. Therefore, if the comparable firm that is
chosen to value a particular firm is actually expected to grow faster than
the firm to be valued, the comparable company method will overvalue
the firm of interest. In essence, the multiple implies a future growth rate
for the firm that is too high.
 Investment decision making 89

Similarly, the (systematic) riskiness of the comparable firms and the firm
to be valued need to be compared. As the systematic risk and discount
rate of a particular firm go up, the multiple that applies to that firm will
be lower.

What do private equity managers do in practice?

The description above provides a context for understanding what PE

investors do, in practice, when quantitatively evaluating investment
opportunities. Most MBA programs teach that DCF is the most appro-
priate way to evaluate such opportunities. One of the core principles of
finance is that the value of any asset is just the present value of expected
future cash flows. In terms of what actually happens in practice, however,
our PE survey provides a much different picture.

Table 4.5 shows that gross IRR and MOIC are almost universally utilized
by PE managers, with more than 90% of firms saying that they utilize
those methods when evaluating investment opportunities. PE investors
are far more likely to use comparable methods than discounted cash flow
methods as well. Nearly 72% of PE managers use comparable company
EBITDA multiples while only 9.3% use APV DCF methods and 10.9%
use WACC DCF methods. PE investors appear to be skeptical of CAPM-
based methods for valuing companies relative to the use of multiples-
based approaches and LBO investment models.

A similar approach is taken to terminal/exit value calculations. Most

finance courses and books teach that terminal values should be calcu-
lated using a growing perpetuity. Table 4.6 shows that only about 27% of
PE managers utilize that approach. Instead, 70% to 80% use a compara-
ble companies (public or transaction) approach to estimating terminal/
exit value with industry comparables being by far the most commonly
used metric. Firm riskiness ranks seventh among the different criteria.
Again, PE investors appear to be skeptical of using measures of risk that
have strong foundations in academic finance. In fact, more than 20%
simply use the entry or purchase multiple as the exit multiple.

Given the predominance of IRR and MOIC, two natural questions arise:
what do these hurdle rates look like in practice, and how do private
 90

Table 4.5 Quantitative Investment Metric Used to Select Investments

AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
Gross IRR 92.7 100.0 88.5 97.0 99.9 96.9 100.0 86.4 94.2 90.5
Multiple of invested 94.8 100.0 92.1 97.7 99.1 93.3 96.1 93.7 95.5 93.8
capital
APV DCF 9.3 0.0 7.1 11.5 9.3 7.3 3.9 13.9 10.5 7.6
WACC-based DCF 10.9 0.0 9.3 12.5 5.5 15.2 8.9 12.5 9.4 12.9
Comparable company 71.7 100.0 71.4 72.1 63.0 90.7 75.9 68.1 76.7 64.8
EBITDA multiples
Free cash flow return 43.8 33.0 29.7 58.3 45.2 43.7 44.4 43.2 40.7 48.1
Advanced Introduction to Private Equity

to equity
Other 13.8 0.0 10.3 17.4 7.0 21.7 12.1 15.3 8.3 21.4
Number of responses 67 67 34 33 25 23 31 36 39 28
Table 4.6 Method for Calculating Terminal Value
AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
Comparable 81.4 100.0 75.3 87.7 81.3 88.6 87.3 76.3 78.2 85.8
companies
Comparable 71.4 99.0 67.8 75.0 73.2 80.3 79.5 64.4 76.1 64.8
transactions
DCF-based growing 27.3 10.0 20.5 34.3 28.1 16.4 26.6 27.9 21.0 36.0
perpetuity
Other 25.6 0.0 33.5 17.4 20.7 31.1 22.8 27.9 28.7 21.3
Number of responses 67 67 34 33 25 23 31 36 39 28
Investment decision making
91
92 Advanced Introduction to Private Equity

equity firms adjust those hurdle rates? Hurdle rates vary from firm to
firm and also depend upon the size, stage and industry of the investment.
These hurdle rates are based upon gross return, i.e., before fees and car-
ried interest are taken out by the PE manager. Our survey, GKM (2016),
showed that the average (median) IRR hurdle rate was 27.0% (25.0%).
Table 4.7 shows that smaller private equity firms and those with global
investment operations tend to target higher IRRs. A rough calculation
suggests that this target exceeds a CAPM-based rate by a wide margin.
In 2012, long-term Treasury bond rates did not exceed 4%. One research
paper estimated an average portfolio company equity beta of 2.3,9 which
would imply a CAPM-based discount rate of less than 18%. This beta
estimate is higher than most beta estimates for private equity funds.

MOIC hurdle rates are 2.85× on average (2.50× at the median) in our
sample. At a five-year time horizon, this implies a gross IRR of approxi-
mately 20%. The mean MOIC of 2.85 times implies a gross IRR of 23%.
Once again, smaller and younger private equity firms have MOIC hurdle
rates that are about 0.6× higher than larger and older PE firms.

In our more recent survey from the summer of 2020, GKM (2021), both
IRR and MOIC hurdle rates had declined from our 2012 survey. IRR hurdle
rates in the summer of 2020 were 22.6% on average and MOIC hurdle rates
were 2.69× on average. This reduction in hurdle rates is likely driven by the
tremendous growth in PE which likely increased competition for deals and
lowered industry-wide hurdle rates. The declines, however, are modest.

It is relatively easy to understand the high target rates of return, espe-

cially relative to CAPM-based returns. PE investors take management
fees and receive their carry or share of the profits from gross returns. (We
describe this in greater detail in Chapter 9.) PE limited partners (LPs)
receive their returns net of those fees. Therefore, in order to generate a
rate of return that is above the public market return net of fees, target
hurdle rates must be above the CAPM or public market discount rates.
As we saw in Chapter 3, PE investors have been successful historically in
generating net returns in excess of the public market.

Finally, most PE firms do adjust their hurdle rates depending on a vari-

ety of factors. Table 4.7 tabulates factors that affect hurdle rates. These
risks can be divided into macroeconomic risks (unexpected inflation,
interest rate, term structure, business cycle and foreign exchange) and
Table 4.7 Private Equity Required Return Targets and Their Determinants
AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
Panel A: IRR
Gross IRR target 27.0 25.0 30.0 24.1 24.5 24.9 24.8 29.3 25.7 28.9
Number of responses 62 62 31 31 24 22 31 31 36 26
Panel B: IRR determinants
Firm’s riskiness 86.2 84.4 87.9 91.7 91.3 90.3 82.4 91.9 78.6
Leverage 47.7 40.6 54.5 58.3 52.2 51.6 44.1 54.1 39.3
Historical return 30.8 40.6 21.2 20.8 30.4 22.6 38.2 37.8 21.4
expectations of LPs
Other 9.2 6.3 12.1 8.3 17.4 16.1 2.9 10.8 7.1
Not applicable 4.6 6.3 3.0 0.0 0.0 0.0 8.8 2.7 7.1
Number of responses 65 32 33 24 23 31 34 37 28
Panel C: adjustments to
the cash flows or the IRR
Risk of unexpected 17.7 0.0 8.2 26.9 26.0 13.9 21.2 14.5 12.2 25.0
inflation
Interest rate risk 25.5 2.0 22.6 28.3 33.5 26.5 26.3 24.8 26.3 24.5
Term structure risk 18.5 0.0 16.6 20.3 14.9 26.9 22.9 14.4 13.5 25.0
(Continued)
Investment decision making
93
Table 4.7 (Continued)
94

AUM IRR Age Offices

Mean Median Low High Low High Old Young Local Global
GDP or business cycle risk 55.0 50.0 47.8 61.9 63.6 55.7 59.4 51.0 54.2 56.0
Commodity price risk 28.8 21.0 22.8 34.7 35.5 27.1 30.6 27.2 28.0 29.9
Foreign exchange risk 20.2 10.0 15.7 24.5 25.6 16.6 23.5 17.1 12.9 29.8
Distress risk 13.0 0.0 8.7 17.2 13.8 11.9 17.2 9.1 9.0 18.2
Size 28.6 10.0 31.8 25.5 25.1 25.5 22.9 33.8 31.1 25.3
Market-to-book ratio 7.5 0.0 5.3 9.6 9.3 5.6 7.4 7.6 6.6 8.6
Momentum 11.8 0.0 9.6 13.9 17.0 10.3 18.9 5.4 12.9 10.4
Illiquidity 20.3 0.0 22.2 18.5 19.8 6.8 15.2 25.0 15.8 26.3
Other 1.4 0.0 2.8 0.0 0.0 0.0 2.6 2.4 0.0
Number of responses 65 65 32 33 24 23 31 34 37 28
Advanced Introduction to Private Equity
 Investment decision making 95

firm-specific risks (distress, size, market-to-book, momentum and illi-

quidity). The results indicate that PE investors are somewhat sensitive
to macroeconomic risks, particularly GDP or business cycle risk, where
PE investors make some adjustment in roughly half of their deals. This
is consistent with PE investors taking market or equity risk into account.

Firm-specific adjustments appear less important, although there are a

variety of firm-specific factors that at least some of the PE firms use to
adjust their target hurdle rates. The most common firm-specific factor is
an adjustment for firm size. Larger deals create a less diversified portfolio
for the PE firm and, as such, would require a higher gross IRR to justify
the investment from the perspective of the PE firm. These adjustments
appear to suggest that PE managers use ad hoc factor models to assess the
attractiveness of prospective returns.

These results along with the terminal value results indicate that PE inves-
tors do not use (CAPM-based) DCF techniques very often. This contrasts
markedly with the results in Graham and Harvey (2001) for CFOs. In
that paper, they find that CFOs rely on net present value techniques
almost as frequently as IRR. This also is in sharp contrast to methods
taught in MBA finance courses at all top business schools as well as typi-
cal valuation analyses seen in investment banker fairness opinions for
mergers and acquisitions. CAPM-based discounted cash flow analyses
are the primary method taught and used in those settings.

Conclusion

In this chapter, we have seen that the sourcing and evaluating of deals
(both qualitatively and quantitatively) are critical elements of generating
attractive returns.

A critical strategic choice that PE firms make is their approach to deal

sourcing and deal selection. Focus both on proprietary deals and deals
that match a private equity firm’s ability to add value is important; sig-
nificant amounts of time and money are spent in this process. Getting
the “funnel” right is a necessary beginning to the PE process.

We also presented an investment framework, OUTSX-CUPID, that can

help private equity managers frame the decision-making process. The
96 Advanced Introduction to Private Equity

qualitative framework combined with the quantitative tools we outline

are critical elements of evaluating and selecting those opportunities that
have the greatest potential to provide strong returns. In the subsequent
chapters, we explore various levers of value that can increase returns,
namely financial, governance and operational engineering. Finally, we
sketched the LBO model that private equity investors use to evaluate
their deals quantitatively.

Notes
1 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov,
2016, What Do Private Equity Firms (Say They) Do? Journal of Financial
Economics 121, 449–76.
2 Paul Gompers and Monica Baraldi, 2015, TA Associates and Speedcast,
Harvard Business School Case Study.
3 Paul Gompers, Kristin Mugford and J. Daniel Kim, 2012, Bain Capital:
Outback Steakhouse. Harvard Business School Case Study.
4 G. Felda Hardymon, Josh Lerner and Ann Leamon, 2006, Brazos Partners
and Cheddar’s Inc., Harvard Business School Case Study.
5 Steven Kaplan, Berk Sensoy and Per Stromberg, 2009, Should You Bet on
the Jockey or the Horse? Evidence from the Evolution of Firms from Early
Business Plans to Public Companies, Journal of Finance 64(1), 75–115.
6 Paul Gompers, Will Gornall, Steven Kaplan and Ilya Strebulaev, 2020, How
Do Centure Capitalists Make Decisions? Journal of Financial Economics
135, 169–90.
7 Steven Kaplan and Rich Jones, 2005, Silver Lake, Nasdaq and Instinet.
8 Steven Kaplan and Morten Sorensen, 2021, Are CEOs Different?
Characteristics of Top Managers, Journal of Finance 76, 1773–1811; and
Steven Kaplan, Mark Klebanov and Morten Sorensen, 2012, Which CEO
Characteristics and Abilities Matter? Journal of Finance 67, 973–1007.
9 Ulf Axelson, Morten Sorensen and Per Stromberg, 2013, The Alpha and
Beta of Buyout Deals, Unpublished Working Paper.
5 Financial engineering

Most buyout investments are leveraged buyouts, or LBOs, i.e., they are
executed with a combination of debt and equity. For many of them, the
amount of debt is greater than the amount of equity raised. The factors
that affect the financial choices of private equity are critical to value crea-
tion. Financing or the financial engineering of the deal is often the differ-
ence between winning a deal and generating attractive rates of return or
not deploying capital. In this chapter, we explore the empirical patterns
of financing patterns in private equity. We begin by examining typical
capital structures in private equity transactions. We then explore the
ways in which financial engineering has been shown to enhance value.
The ability to structure a deal has increasingly become commoditized
and, hence, financial engineering as a competitive advantage among pri-
vate equity firms has declined in importance. At the same time, financial
engineering was one of the first sources of value identified by research
and continues to be important for private equity firms.

Types of debt

While many people consider debt and equity as monolithic financial

instruments, there is a broad spectrum of types of both debt and equity.
The structure of a “typical” private equity transaction varies with indus-
try, geography and deal size.

Table 5.1 provides an overview of deals from 2006 to 2019. Buyouts of

non-public companies represent the single largest category of debt deals
during the time period with 6385 deals raising over $1 trillion of debt.
Growth capital deals were the next most frequent transaction type with
3245 transactions, but they raised relatively little debt overall. From
2006 to 2019, there were 429 public-to-private transactions that raised
more than $950 billion of debt.
97
98 Advanced Introduction to Private Equity

Table 5.1 Private Debt Deals Breakdown (2006–19)

Number of Deals by Type Aggregate Deal Value (USD bn) by Type
Investment Type Number Investment Type Aggregate
of Deals Deal Value
(USD bn)
Buyout 6 385 Buyout 1 022.3
Growth capital 3 245 Growth capital 43.8
Recapitalization 1 972 Recapitalization 47.8
Add-on 1 912 Add-on 258
Public to private 429 Public to private 950.8
Merger 266 Merger 84.7
Restructuring 136 Restructuring 15.4
PIPE 56 PIPE 24.1
Turnaround 1 Turnaround -
Number of Transactions by Capital Aggregate Deal Value (USD bn) by
Structure Capital Structure
Capital Structure Number Capital Structure Aggregate
of Deals Deal Value
(USD bn)
Unknown 6 343 Unknown 1 832.9
Senior debt 4 584 Senior debt 434.7
Mezzanine 3 390 Mezzanine 256.7
Unitranche 976 Unitranche 116.7
Junior/subordinated 858 Junior/subordinated 64.4
Number of Deals by Region Aggregate Deal Value (USD bn) by
Region
Continent Number Continent Aggregate
of Deals Deal Value
(USD bn)
North America 9 463 North America 1 645.9
Europe 4 385 Europe 649.2
Asia 233 Asia 96.5
Africa 109 Africa 11.7
Australasia 106 Australasia 28
Latin America and the 64 Latin America and the 8.1
Caribbean Caribbean
Middle East 41 Middle East 7.5
Source: Preqin
 Financial engineering 99

These leveraged transactions require crafting a capital structure that at

the same time gets the deal done, imposes discipline on management,
provides value creating tax shields, but is also at a level at which the com-
pany can service the debt.

Financing sources vary by deal type and location. For example, smaller
private equity investments typically have simple capital structures and
are primarily financed by banks and, increasingly, direct lenders. Larger
deals often have both greater amounts of debt and different sources of
debt that fund different “layers.” While a complete exploration of these
underlying patterns is beyond the scope of this chapter, we describe broad
types of debt below to provide some general understanding of the choices.
This chapter largely focuses on the debt structure of private equity invest-
ments at deal closing. Every private equity investment, however, includes
common equity and other equity-like instruments such as preferred
equity. As a source of value, the equity structure of the deal is less impor-
tant. Academic research has focused on the disciplining nature of debt,
and most research points to the importance of debt as the critical lever.

Debt raised by private equity investors can typically be divided into two
broad layers: senior (secured) debt and junior (subordinated) debt. Senior
secured debt has a first lien, i.e., the right to seize the assets of the com-
pany in the case of default. Junior debt stands next in line. After junior
debt is paid, preferred equity (if it exists) gets paid before common equity,
which stands last in line. Tables 5.2 to ​5.4 provide data on the typical
capital structure of private equity investments.

As we explained in Chapter 4, transaction values and debt levels in most

deals are typically expressed as multiples of earnings before interest,
taxes, depreciation and amortization (EBITDA). EBITDA provides a
measure of the cash flow generated by the company that can be used to
pay interest and principal to the debt holders.

Table 5.2 looks at how LBOs were financed from 2004 through the first
half of 2020. Average purchase price multiples have risen substantially,
increasing from 7.3 times EBITDA to 11.5 times EBITDA in 2019. These
increased purchase multiples have been driven, in part, by low nomi-
nal and real interest rates as well as the growth in private equity fun-
draising and concomitant competition among PE firms. Equity’s share
of the transaction has grown as purchase price multiples have increased
100 Advanced Introduction to Private Equity

Table 5.2 Purchase Price Multiples for All LBOs

Senior Debt/ Sub Debt/EBITDA Equity/EBITDA Others Total
EBITDA
2004 3.37 1.27 2.58 0.1 7.32
2005 4.42 0.97 2.95 0.1 8.44
2006 4.48 0.77 3.05 0.08 8.38
2007 5.5 0.57 3.47 0.14 9.68
2008 4.12 0.84 4.03 0.13 9.11
2009 3.01 0.8 3.76 0.11 7.68
2010 4.04 0.55 3.8 0.1 8.49
2011 4.6 0.32 3.68 0.17 8.78
2012 4.85 0.27 3.49 0.07 8.68
2013 5.18 0.09 3.39 0.13 8.79
2014 5.7 0.03 3.89 0.05 9.67
2015 5.51 0.09 4.49 0.17 10.26
2016 5.31 0.1 4.49 0.12 10.02
2017 5.72 0.01 4.85 0.03 10.61
2018 5.78 0 4.77 0.04 10.6
2019 5.81 0.02 5.59 0.08 11.51

1H20 5.1 0 5.38 0.16 10.64

2Q20 4.93 0 4.32 0 9.24
Source: LCD, S&P Global Market Intelligence

commensurately with the increase in purchase multiples. Equity to

EBITDA ratios have increased from a low of 2.6× in 2004 to 5.6× in 2019.

For the typical deal, senior debt is the largest and most important source
of debt financing. Table 5.2 shows that senior debt-to-EBITDA levels
range from 3.4× to 5.8×. Senior debt to EBITDA has been substantially
higher over the past five years than during the prior decade. Junior debt
is relatively modest for deals on average, ranging between 0.0× and 1.3×
for middle- and large-market LBO investments. It is more important
for the largest deals. The availability of debt financing is often tied to
financial market cycles. At various times, interest rates are low and credit
is readily available. At other times, credit may become expensive and
harder to acquire.
 Financial engineering 101

Table 5.3 Average Debt Multiples of Large Corporate LBO Loans

FLD/EBITDA SLD/EBITDA Other Senior Sub Debt/ Total
Debt/EBITDA EBITDA
2004 2.90 0.10 0.30 1.60 4.80
2005 3.27 0.46 0.23 1.30 5.25
2006 3.73 0.67 0.30 0.73 5.43
2007 4.07 0.70 0.64 0.81 6.23
2008 3.37 0.17 0.55 0.82 4.90
2009 3.22 0.24 0.26 0.31 4.02
2010 3.51 0.10 0.76 0.35 4.71
2011 3.89 0.24 0.94 0.17 5.24
2012 3.75 0.69 0.70 0.13 5.26
2013 3.99 0.87 0.46 0.09 5.41
2014 4.25 1.18 0.39 0.00 5.83
2015 4.24 0.96 0.44 0.05 5.69
2016 4.29 0.90 0.29 0.03 5.50
2017 4.50 0.97 0.32 0.00 5.79
2018 4.72 0.93 0.21 0.00 5.86
2019 4.74 0.92 0.30 0.02 5.98
1H20 4.18 0.34 0.50 0.09 5.12
2Q20 3.94 0.00 0.71 0.28 4.93
Source: LCD, S&P Global Market Intelligence

Senior secured debt

Senior secured debt is typically provided by banks or bank syndicates.

The most senior debt instruments in a PE investment are asset-backed
loans (ABLs) and leveraged loans.

ABLs
ABLs and leveraged loans stand first in line in the case of default and are
secured by collateral. ABLs are secured by physical assets, either prop-
erty, plant and equipment or working capital. These loans are limited
by the liquidation value of the underlying asset. For example, a working
capital line of credit will typically look through to the value of the inven-
tory and accounts receivable. The “quality” of those assets will determine
102 Advanced Introduction to Private Equity

Average Debt Multiples of Middle-Market Corporate LBO

Table 5.4 
Loans
FLD/EBITDA SLD/EBITDA Other Senior Sub Debt/ Total
Debt/EBITDA EBITDA
2004 3.00 0.40 0.10 0.80 4.20
2005 3.39 0.71 0.17 0.43 4.69
2006 3.65 0.51 0.00 0.56 4.72
2007 4.01 1.13 0.08 0.38 5.61
2008 3.24 0.48 0.01 0.80 4.53
2009 2.52 0.00 0.00 0.73 3.25
2010 3.24 0.16 0.00 0.85 4.25
2011 3.64 0.14 0.00 0.52 4.30
2012 3.48 0.29 0.00 0.76 4.53
2013 3.95 0.68 0.00 0.19 4.82
2014 4.16 0.82 0.16 0.14 5.28
2015 4.25 0.82 0.02 0.24 5.33
2016 4.17 0.66 0.00 0.43 5.26
2017 4.60 0.81 0.00 0.04 5.46
2018 4.53 0.96 0.01 0.00 5.50
2019 4.74 0.48 0.00 0.16 5.37
Source: LCD, S&P Global Market Intelligence

the size of the loan relative to the value of those assets. Private equity
deals that involve considerable real estate, equipment or high levels of
quality inventory and receivables are able to raise a larger fraction of the
deal in the form of ABLs.

Because potential losses on an ABL are tied to the value of the underlying
assets, ABL lenders invest heavily in people and technology that can both
value and track assets that are pledged as collateral. When the collateral
backing the loan is working capital, lenders must assess the ability to sell
inventory and collect on receivables. Assessing credit worthiness of the
borrowers’ customers is also therefore a part of the loan process. Banks
are the primary provider of ABLs and the loans are typically structured
as private, floating-rate instruments. Given the focus on collateral value,
ABLs generally have fewer covenants than other types of corporate debt.
 Financial engineering 103

Leveraged loans
A second type of senior secured debt is a leveraged loan. Leveraged loans
are generally underwritten on the basis of cash flow that is available to
pay interest and principal payments. Leveraged loans typically have a
general first lien on the assets of the company. However, given that valu-
ing all of the collateral of the company is difficult and that the secondary
market for the underlying assets is illiquid, the principal amount of the
leveraged loan is not typically tied to the collateral value securing the
loan. Instead, it is tied to the company’s ability to generate cash flow.1

Leveraged loans are typically private, unlike many types of junior debt
that may be publicly traded. While leveraged loans can be bought and
sold, the market is typically relatively illiquid and settling trades typi-
cally takes considerable time. Leveraged loans are typically arranged by
a single bank and can be syndicated to a number of other lenders. The
close relationship between the lender and the lead bank is necessary
as the lead bank monitors compliance with the financing agreement.
Private relationships allow for the frequent exchange of confidential
information. Leveraged loans typically have a significant number of
covenants, and covenant violations are often used to renegotiate the
terms of the debt. In the absence of a renegotiation mechanism, a tight
covenant structure would lead to frequent defaults; whereas, a breach
of a covenant is just a technical default which rarely leads to an actual
default and a seizing of collateral. Covenants can be both positive and
negative, i.e., they can require certain actions or prohibit others. Typical
positive covenants focus on financial ratios that ensure the financial
health of the company and the company’s ability to pay interest and
principal.

Like ABLs, leveraged loans typically have floating interest rates that are
tied to a fixed spread over some base rate. The most frequently used base
rate in the US has been the London Interbank Offered Rate (LIBOR).
European transactions typically have leveraged loans that are spread
over euro-based EURIBOR. The historical time series for these rates is
shown in Table 5.5. More recently, the Secured Overnight Financing Rate
(SOFR) has replaced LIBOR. Additionally, borrowers usually have the
ability to pre-pay leveraged loans (i.e., they are callable) at any time with
no pre-payment penalty.
Table 5.5 Sources of Proceeds for LBO Transactions
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Bank debt 47.9% 44.1% 43.7% 37.3% 43.7% 49.4% 51.2% 53.3% 39.1% 33.1% 41.6%
Secured debt 0.5% 1.0% 0.0% 0.0% 1.0% 2.1% 3.2% 1.7% 2.4% 0.0% 1.3%
Senior unsec’d debt 0.5% 0.0% 0.0% 0.0% 2.5% 4.2% 3.1% 5.1% 6.1% 4.7% 5.8%
Public/144a high 1.8% 3.8% 6.3% 11.9% 9.9% 6.2% 3.3% 3.5% 1.8% 2.0% 0.7%
yield
Bridge loan 1.4% 2.7% 2.5% 0.3% 0.6% 1.3% 0.5% 0.3% 0.4% 4.7% 0.3%
Mezzanine 8.2% 5.8% 3.7% 5.0% 4.1% 3.2% 4.1% 1.8% 6.3% 7.1% 5.1%
HoldCo debt/seller 2.0% 4.4% 3.2% 1.6% 1.2% 0.8% 0.4% 0.3% 0.4% 0.0% 0.5%
note
Preferred equity 8.8% 6.8% 6.8% 4.9% 2.6% 0.9% 0.2% 0.1% 0.0% 0.0% 0.9%
Common equity 23.2% 23.8% 27.4% 28.3% 28.8% 28.1% 30.4% 30.4% 38.4% 45.5% 40.0%
Rollover equity 3.9% 5.5% 2.7% 4.7% 2.7% 2.3% 2.5% 2.0% 3.8% 5.1% 2.4%
Other 2.0% 2.2% 3.8% 6.1% 3.4% 1.4% 1.0% 1.3% 1.3% 2.2% 1.4%
104 Advanced Introduction to Private Equity

Total senior debt 48.9% 45.1% 43.7% 37.3% 47.2% 55.8% 57.5% 60.1% 47.6% 37.8% 48.7%
Total sub debt 11.4% 12.3% 12.6% 17.1% 14.7% 10.7% 8.0% 5.7% 8.5% 13.7% 6.1%
Total equity 37.8% 40.6% 40.0% 39.4% 35.3% 32.1% 33.6% 32.9% 42.6% 50.6% 43.8%
Average loan size $200M $195M $262M $300M $354M $418M $459M $540M $454M $251M $414M
Average sources $351M $389M $540M $716M $706M $972M $1309M $2095M $1732M $640M $1014M
Observations 116 51 40 66 133 134 178 207 69 23 78
 2011 2012 2013 2014 2015 2016 2017 2018 2019 1H20 2Q20
Bank debt 45.4% 48.8% 54.1% 55.8% 52.1% 51.2% 52.5% 55.6% 46.7% 41.0% 38.9%
Secured debt 0.3% 0.6% 2.0% 0.8% 0.3% 0.6% 0.2% 0.4% 2.1% 1.6% 1.8%
Senior unsec’d debt 7.0% 6.9% 4.3% 3.2% 2.9% 2.4% 2.7% 1.7% 2.5% 4.0% 5.5%
Public/144a high 0.9% 0.4% 0.6% 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0%
yield
Bridge loan 0.0% 0.0% 0.0% 0.0% 0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Mezzanine 2.7% 2.9% 0.4% 0.4% 0.6% 0.7% 0.2% 0.0% 0.0% 0.0% 0.0%
HoldCo debt/seller 0.5% 0.3% 0.0% 0.1% 0.0% 0.1% 0.2% 0.1% 0.0% 0.5% 0.0%
note
Preferred equity 0.3% 0.3% 0.6% 0.0% 0.2% 0.7% 0.1% 0.1% 0.1% 0.0% 0.0%
Common equity 37.5% 37.4% 35.1% 36.9% 40.3% 40.3% 41.8% 40.2% 45.4% 49.2% 53.0%
Rollover equity 3.6% 1.6% 1.4% 1.5% 1.9% 2.4% 1.6% 1.6% 1.9% 2.8% 0.8%
Other 1.8% 0.6% 1.5% 1.2% 1.3% 1.5% 0.5% 0.3% 1.0% 0.8% 0.0%
Total senior debt 52.8% 56.3% 60.5% 59.9% 55.4% 54.2% 55.4% 57.6% 51.3% 46.6% 46.3%
Total sub debt 3.6% 3.3% 1.0% 0.4% 0.9% 0.8% 0.2% 0.0% 0.0% 0.0% 0.0%
Total equity 41.8% 39.7% 37.1% 38.5% 42.4% 43.5% 43.7% 42.1% 47.5% 52.5% 53.7%
Average loan size $454M $537M $913M $676M $669M $878M $808M $1031M $1138M $1445M $1692M
Average sources $1139M $1010M $1484M $1099M $1178M $1776M $1365M $1749M $2301M $3260M $4386M
Observations 87 97 95 136 114 105 152 157 109 31 10
Source: LCD, S&P Global Market Intelligence
Financial engineering 105
106 Advanced Introduction to Private Equity

A leveraged loan package can contain several facilities. As with capital

structure more broadly, the structure of the loan package depends on
the deal size and market conditions. Small and medium-sized lever-
aged loans, like the ones backing middle-market transactions, tend to
be funded by one or a few banks. More recently, these have been funded
increasingly by direct lenders such as private debt funds and BDCs.
Senior secured loan packages financing a large LBO typically include
a revolving line of credit and an amortizing term loan (together these
are called the “pro-rata” tranche), as well as term facilities syndicated to
institutional investors (including collateralized loan obligations (CLOs),
hedge funds, mutual funds and insurance companies).

The “pro-rata” tranche is comprised of facilities syndicated primarily to

banks. This typically includes a revolving credit facility (revolver) and an
amortizing term loan (TLa). A term loan is an installment loan which is
typically fully funded at the outset and repaid over the life of the loan.
A revolver functions like a corporate credit card. As funds are needed,
the company draws down the revolver and can repay any or all of the
amounts due until the maturity date of the loan. Borrowers pay a com-
mitment fee for amounts not drawn down while they pay a rate which
is typically pegged to the rate on the term loan. Term loans are typi-
cally designed to finance the purchase of the company while revolvers are
generally meant to fund working capital needs or periodic investment in
capital expenditures.

For large LBOs, the largest portion of the leveraged loan financing is
the institutional tranche. A typical LBO has approximately 80% in the
institutional tranche, although that percentage does move over time.
(Figure 5.1 shows the composition of different portions of a leveraged
loan facility.) The institutional tranche is typically comprised of a term
loan (TLb) that has a first-lien and a second-lien facility. The second-lien
facility is a term loan that has a claim on the firm’s collateral that stands
behind the senior secured loans. Because the investors in the institu-
tional tranche are typically worried about reinvestment risk, the loans
have bullet repayment schedules as opposed to the amortization schedule
of the term loans in the pro-rata tranche.

Second-lien loans are part of the senior secured loans, however they have
a junior claim to the collateral (“lien”) backing the transaction. Being a
riskier position, second-lien loans are priced at a premium to first-lien
Source: LCD, S&P Global Market Intelligence

Figure 5.1 Loan Structures for US LBOs

Financial engineering 107
108 Advanced Introduction to Private Equity

loans. The spread differential ranges from 200 bps at a minimum to over
1000 bps in select cases. Second-lien loans tend to appear in buoyant
capital markets when there is higher tolerance for risk among investors
and then disappear again in a downturn. For example, in the period post-
2008, few second-lien loans have been issued.

The institutional tranche also includes at times a delay-draw special

purpose facility, such as acquisition lines. A special purpose facility is a
credit which can be drawn down over a certain period for a specific pur-
pose – for example to fund an acquisition. In contrast to RCFs, special
purpose facilities are not revolving and once drawn they are equivalent
to a traditional term loan.

Given that all first-lien tranches have the same seniority and claim over
the collateral, the pricing of the institutional tranche is similar to the
pricing of the pro-rata tranche. (See Figure 5.2.) Because the TLb tranche
have longer maturities and bullet repayment, their spreads tend to be
more volatile than the spread on the pro-rata tranches.

The next layer of the capital structure in most private equity transactions
is commonly referred to as junior debt. Junior debt has a claim on the
value of the capital that comes after senior secured debt, but its claim
is senior to equity. Junior debt is typically unsecured, i.e., their claim
is only paid off after the senior lenders have received their interest and
principal. There are a number of categories of junior debt, and any one
transaction may have multiple junior debt issuances. Unlike the senior
secured loans in which all tranches are governed by one credit agree-
ment, each category of junior debt is governed by separate loan contracts
and can have substantially different terms.

For most large private equity transactions in the US, junior debt takes
the form of high-yield bonds, regularly referred to as junk bonds. High-
yield bonds are typically publicly issued and require registration with the
Securities and Exchange Commission. Over the past decade, high-yield
bonds have been increasingly utilized in Europe as well.

Because high-yield bonds have an unsecured claim that comes after the
leveraged loans, they are relatively risky and are typically rated as non-
investment grade. These bonds can be issued either publicly or privately.
Underwritten public bond issuances are utilized by larger transactions
Source: LCD, S&P Global Market Intelligence

Figure 5.2 LBO Pro-Rata and Institutional Spreads by Size

Financial engineering 109
110 Advanced Introduction to Private Equity

and carry a higher fee structure. Additionally, bonds have a wider inves-
tor base which includes retail as well as institutional investors. All high-
yield bond issuances in the US are also regulated by the Securities Act of
1933, including updates to the Regulation like Regulation Fair Disclosure
(“Reg FD”). As such, the borrowing company cannot convey any private
information to investors. Because of the difficulty coordinating renego-
tiation of bond indentures given the dispersed nature of holders, these
indentures typically only contain incurrence covenants. Incurrence
covenants are only tested when the borrower takes a particular action.
Typical incurrence covenants take effect when firms engage in an acqui-
sition or divestiture, issuance of new debt senior to existing debt, etc.

High-yield bonds have maturities which extend beyond the senior

secured loans, typically eight to 10 years. While leveraged loans can be
repaid at any time, bonds are typically protected from pre-payment for
half of their maturity. Bonds also typically require a premium over par
value if they are pre-paid before they mature. Similarly, while leveraged
loans typically charge floating interest rates, high-yield bonds typically
charge fixed interest rates.

Figures 5.3 and 5.4 graph the volume of high-yield public bond issu-
ances in the US and Europe. There are important differences between
the US and Europe in terms of PE debt financing. US private equity
capital structures rely more on public markets (or quasi-public markets)
as sources of capital. European structures rely more on banks for their
financing needs, which has to do with the historical development of the
debt markets in each region. This explains several differences between
US and European capital structures, including the higher prevalence of
high-yield bonds in the US versus a higher share of bank term loans,
mezzanine and other private junior debt in Europe.

Differences in the development of the debt markets between the US and

Europe are largely due to the legal and regulatory environment as well
as the historic importance of regional commercial banks in Europe. In
particular, the US and Europe have different bankruptcy and financial
regulations. For example, Chapter 11 bankruptcy regulation in the US is
focused on restructuring companies through a public, in-court process,
whereas most bankruptcies in Europe are still focused on either liquida-
tion or an out-of-court private settlement. Because of these differences,
junior debtors typically have a weaker voice in European restructurings.
Source: Source: LCD, an offering of S&P Global Market Intelligence

Figure 5.3 High-Yield Public Bond Issuance in the US

Financial engineering 111
112 Advanced Introduction to Private Equity

Source: AFME Finance Europe, Q3 2020 European High Yield and Leveraged Loan
Report

Figure 5.4 High-Yield Public Bond Issuance in Europe

Restructuring deals there are either worked out privately between senior
lenders and the debtor, or companies are liquidated according to a strict
priority rule, giving the junior public lenders limited control over the
process.

The predominance of regional banks in Europe is tied to pre-European

Union currencies differences, different languages and national regula-
tions. These differences across countries have made it difficult for pan-
European institutional investors to accurately assess risks and directly
provide credit to companies across Europe. Instead, this situation has
provided regional banks with an advantage over institutional investors,
as regional banks focus on dealing with regional differences. While sev-
eral drivers, including the introduction of the common Euro-currency,
provided a boost to eliminating regional differences, many remain.
However, the differences between the US and Europe are not static. The
convergence between the two regions is facilitated by the globalization
of firms and financial sources. Large companies are increasingly able to
 Financial engineering 113

fund themselves abroad. The increasing presence of global banks is also a

reality which drives convergence of financing markets.

European private equity deals and smaller deals in North America

often use mezzanine financing in place of high-yield bonds. Mezzanine
financing is junior to the leveraged loans, but senior to equity. Mezzanine
financing is typically raised in private placements. Dedicated funds, often
managed by large private equity firms, often participate in mezzanine
finance. Terms can vary considerably given that the contracts are negoti-
ated for each deal and can be adapted to different situations as necessary.
While rates charged on the borrowing can vary, mezzanine has typically
charged floating interest rate. Some mezzanine facilities include provi-
sions which allow some of the interest to be “paid in kind” (PIK). PIK
interest accumulates over time and increases the principal amount of the
mezzanine. Regularly, the cash-interest component of mezzanine is sup-
plemented with a PIK component. Mezzanine debt also often includes
warrant payment.

Table 5.5 examines 20 years of LBO transaction financing structure data

at a granular level. Banks have been the dominant source of capital for
LBOs, never accounting for less than 33.1% of capital to more than 55.8%
for the average transaction in a given year. Common shares have been
the second most important element of financing LBOS, accounting for
between 23.2% and 53% of the transaction consideration, although most
years equity is approximately 35% of the capital provided. Other sources
of debt are, in aggregate, less important and vary from year to year.

What factors influence financial engineering in

private equity?

As discussed in Chapter 1, financial engineering increases value by

reducing taxes and providing discipline on managers not to waste free
cash flows. The tax advantage of debt results from the ability to deduct
interest payments from profits before taxes. The governance benefits arise
because debt is a fixed obligation that must be paid periodically making
it costly to engage in wasteful activities. In this section, we explore how
private equity managers think about financial engineering and how it is
executed in practice.
114 Advanced Introduction to Private Equity

Financial economics assesses various theories as to how firms set capi-

tal structure policy. In the trade-off theory popularized by Stew Myers,2
managers are assumed to set the level of debt at a point that balances the
value benefits of debt (taxes and disciplining benefits) with the costs of
debt (increasing risk of default). The assumption is that at some point,
the expected costs of default of additional debt outweigh any additional
value benefits. In the pecking order theory, firms issue the maximum
amount of safe debt (senior secured) before issuing riskier debt (subordi-
nated debt).3 Behavioral financial economists propose a different theory,
market timing, in which managers attempt to time when interest rates
are low and issue more debt in those periods.

Recent research by Axelson, Jenkinson, Stromberg and Weisbach4

(AJSW) argues that the trade-off theory implies that industry factors play
a primary role in leverage decisions because industries vary in cash flow
volatility over time. In periods in which the cash flows of an industry are
more volatile, the probability of default is higher. Similarly, factors that
affect investment decisions, e.g., investment opportunities and tangibil-
ity, also affect the costs of distress. The authors predict that firms that are
owned by private equity investors in the same industry would have simi-
lar levels of debt. On the contrary, the market timing theory would pre-
dict that leverage decisions would be influenced by the overall economy
and, hence, PE investments consummated at the same time would have
similar capital structures. For a large sample of PE investments, AJSW
do not find any support for the trade-off theories. Private equity capital
structures are not related to capital structures of similar public compa-
nies. Rather, debt levels for PE transactions are more similar depending
upon the time period in which the deal closed. This empirical fact is more
consistent with a market time view of capital structure.

Our two surveys, GKM (2016)5 and GKM (2020),6 asked numerous ques-
tions about how PE firms set capital structure at the time of investment.
The questions tested whether capital structure policy was set via a trade-
off view or a market timing view of the world. Table 5.6 compares the
target capital structure from both surveys to understand how capital
structure targets changed from 2012 to 2020. In our earlier survey, PE
investors said they targeted a median debt-to-total capital of 60% and
a median debt-to-EBITDA ratio of 4.0 times. Target maturity of senior
debt was 5.25 years and target maturity for junior debt was 6.89 years.
In the more recent survey during the COVID-19 pandemic, target
Table 5.6 Targeted Capital Structure
a. GKM (2016)
Capital structure AUM IRR Age Offices
measure
Mean Median Low High Low High Old Young Local Global
Debt-to-capital 55.7 60.0 54.3 57.2 56.6 56.9 55.0 56.4 55.0 56.8
(percent)
Number of responses 62 62 31 31 22 23 23 32 37 25
Debt-to-EBITDA ratio 3.9 4.0 3.6 4.2 4.1 4.2 4.2 3.6 3.8 4.1
Number of responses 60 60 31 29 22 21 29 31 36 24
b. GKM (2020)
AUM Age
Mean Median Low High Young Old
Maturity of bank/senior 4.2 4.0 3.9 4.6 4.0 4.5
debt (years)
Observations 145 145 73 72 79 66
Maturity of other long- 5.0 5.0 4.8 5.2 4.8 5.2
term debt (years)
Observations 133.0 133.0 67 66 71 62
Total debt-to-capital 44.6 50.0 41.8 47.4 43.8 45.5
ratio, D/(D + E) (%)
Observations 142 142 71 71 77 65
Debt-to-EBITDA 3.8 3.6 3.0 4.6 3.4 4.2
Observations 143 143 72 71 78 65
Financial engineering 115
116 Advanced Introduction to Private Equity

debt-to-capital ratios had fallen to 44.6% while debt-to-EBITDA ratios

had remained roughly similar at 3.8 times. Consistent with the reduction
in debt-to-total capital, target senior debt maturity in 2020 had fallen to
4.23 years and target junior debt maturity was 5.0 years. This reduction
supports a trade-off theory of capital structure in which a reduction in
cash flows and potentially greater uncertainty about cash flows lead to a
lower target level of debt in order to avoid costly default.

We illustrate the structure of private equity debt by examining two con-

trasting private equity deals. First, we look at one of the mega-private
equity deals from the mid-2000s, Harrah’s Entertainment. We then
explore how a smaller private equity investment, Hanson Manufacturing,
was structured. Both deals demonstrate the value that can be created by
careful financial engineering.

In December 2006, Harrah’s Entertainment announced that it had

entered into an agreement to be purchased by affiliates of Apollo
Global Management (“Apollo”) and TPG Capital (“TPG”).7 Apollo
and TPG had to be approved for gaming licenses in Harrah’s mar-
kets, which delayed the closing until January 2008. The total purchase
price, including fees and expenses, was $30.9 billion or approximately
10.7 × 2007 EBITDA, and included $25.2 billion of debt and $5.7 bil-
lion of equity. At the time of the acquisition, Harrah’s was the world’s
largest gaming operator, making the deal the fourth largest LBO of
all time. 8

Apollo and TPG purchased Harrah’s with the belief that they were acquir-
ing a leading gaming and lodging company with significant scale, diver-
sification and strong gaming brands (Caesars, Harrah’s, Horseshoe and
World Series of Poker). Gaming was often categorized as a “defensive”
rather than “cyclical” sector, evidenced by the growth in the industry
through the 1991 and 2001 recessions. The sheer scale of the transac-
tion drove the need for a tiered capital structure. Given its significant
real-estate holdings, Harrah’s was a logical candidate to raise commer-
cial mortgage-backed securities (“CMBS”), backed by a portion of its real
estate. In total, Harrah’s financed the transaction with $25.2 billion of
debt, including $4.6 billion of rolled over debt and $20.5 billion of new
financing.
 Financial engineering 117

Six properties – four in Las Vegas (Harrah’s Las Vegas, Paris, Flamingo
and Rio), Harrah’s Atlantic City and Harrah’s Laughlin – were placed
into a real-estate holding subsidiary and those properties were pledged
as collateral against $6.5 billion of CMBS. CMBS was a form of asset-
backed debt. Asset-backed debt was typically structured based upon loan
to hard asset value rather than multiples of cash flow. Lenders expected
to get their recovery through a liquidation of these hard assets rather
than a sale of the future cash flow streams. As such, the asset-backed
credit agreement tended to focus on protecting loan to value. Typically,
banks, insurance companies and structured vehicles (“CDOs”) would
own these types of asset-backed facilities.

The CMBS debt was tranched into $4.0 billion of senior mortgage debt
(first lien), $1.125 billion of senior mezzanine debt and $1.125 billion of
junior mezzanine debt.9

To finance the LBO, Harrah’s also formed an operating holding company

and raised a three-tiered capital structure comprised of $9.3 billion of
new senior secured credit facilities, $6.8 billion of new senior notes and
$4.6 billion of Existing Senior Notes that were rolled over into the new
structure. Leverage at close was approximately 9.1 × EBITDA.

The operating company had three tiers of financing. First came the $9.3
billion of senior secured credit facilities (also known as “bank loans”),
which was comprised of a $2.0 billion revolver undrawn at close, and a
$7.3 billion term loan. As of December 2008, the bank debt had a first
priority lien, or mortgage, on the assets of 22 domestic properties.10

Large institutional banks issued a $2.0 billion revolver, which was a line
of credit for the borrower to regularly draw from and pay back the lender.
This loan was typically used to fund operating expenses depending upon
the company’s cash flow needs. The $7.3 billion term loan was fully drawn
at close and had been broadly syndicated to a variety of investors, which
included institutional investors, mutual funds and structured vehicles
(“CLOs”). The term loan traded hands regularly and when it traded
below par, it attracted hedge funds and other distressed debt players.

Senior secured loans were typically callable at any time at par. They charged
a floating interest rate which in this case was LIBOR+300. The loans also
had covenants which the company needed to comply with. Some of these
118 Advanced Introduction to Private Equity

covenants were negative covenants that detailed things the borrower could
not do including the ability to: (1) incur additional debt, (2) create liens on
certain assets, (3) enter into sale and lease-back transactions, (4) make cer-
tain investments, (5) sell or acquire assets, (6) pay dividends or make other
restricted payments, (7) enter into certain transactions with its affiliates
and (8) make restricted subsidiaries unrestricted.11

Bank loans also typically had maintenance covenants – minimum per-

formance standards the company had to maintain to remain in compli-
ance. Harrah’s senior secured credit facilities had only one maintenance
test, a leverage test, that required the ratio of senior secured debt to last
12 months (“LTM”). Pro forma EBITDA needed to be below 4.75 to
1 when tested at the end of each quarter.

Next in line in the capital structure was $6.8 billion of new senior notes.
These were unsecured notes, which meant that they did not have a lien
on any assets. Like the bank loan, these notes were issued by the operat-
ing company. The new senior notes came in two forms – $5.275 billion
of bonds that matured in 2016 and $1.5 billion of bonds that matured in
2018. The 2018 notes also had a PIK Toggle feature, which meant that the
company could choose to pay the interest in cash or “pay-in-kind” (PIK)
by giving debt holders their interest payment in the form of new bonds
rather than cash.

High-yield bonds were typically non-callable for half their life (four years
on an eight-year maturity bond, five years on a 10-year bond, etc.). The
new senior notes also had covenants that were typical of high-yield bonds.
They had negative covenants, but not maintenance covenants. Similar to
the term loan, the negative covenants restricted asset sales and restricted
the ability to dividend cash from the borrower. The negative covenant that
restricted additional indebtedness and the ability to make future acquisi-
tions was a standard “incurrence test” that limited additional debt.12

Third in line in terms of priority stood Harrah’s pre-existing notes. Prior

to the LBO, Harrah’s had issued a series of unsecured senior notes with
covenants typical of investment grade bonds. Similar to a high-yield rated
bond, investment grade bonds had fixed coupons and were non-callable
for some time period. There were, however, major differences between
the two types of bonds. Investment grade bonds had very few covenants
compared to unsecured senior notes. Similar to the bank loans and the
 Financial engineering 119

new senior notes, the old senior notes were also issued by Harrah’s oper-
ating company. They were unsecured, which meant that they did not
have a lien on any assets or a pledge of any stock.

The rather lengthy description of Harrah’s capital structure illustrates that

financial engineering can be complex. The ability to access many differ-
ent forms of debt and to place it with many different types of investors
increases the availability of capital to execute transactions. The Harrah’s
deal also highlights important market timing elements within the private
equity sector. Figure 5.5 shows the average debt-to-EBITDA ratio for large
private equity transactions over time; 2006–2007 was clearly at a secular
peak in terms of debt availability. The extreme level of debt availability
influenced the manner in which private equity firms financed their trans-
actions. Similarly, the perceived counter-cyclical nature of gaming sup-
ports the trade-off theory in which strong, stable cash flows support higher
debt levels because of the ability to ensure interest and principal repayment.

Table 5.6 reports the typical capital structure that private equity inves-
tors reported they target at closing based in GKM (2016). Private equity
managers target a median debt-to-total capital of 60% and a median
debt-to-EBITDA ratio of 4.0 times. While these ratios may seem low (for
example, they are much lower than the ratios that were common in the
1980s), GKM (2016) surveyed private equity managers primarily in 2012,
soon after the financial crisis. The results also are somewhat lower than
the median ratios of 70% and 5.2 times, respectively, in AJSW.

Table 5.7 from our PE survey also supports a market timing motive. The
survey asks what factors the PE investors consider in determining capi-
tal structure. The trade-off theories suggest a role for firm industry, tax
benefits, default risk and the ability to generate operating improvements/
reduce agency costs. The results suggest that the trade-off theory and mar-
ket timing are equally important. Virtually all PE investors consider both
industry factors and current interest rates in determining capital struc-
ture. They also rank much higher than any of the other factors. In terms of
explicitly trading off tax benefits and risk of default, more than two-thirds
of PE managers explicitly consider that factor while 65% say they raise as
much debt as the market will bear. These factors rank third and fourth in
terms of importance. Finally, just under 40% consider the ability of debt to
force operational improvements.13 Overall, then, the survey indicates that
PE investors consider both trade-off theories and market timing.
 120 Advanced Introduction to Private Equity

Source: LCD, S&P Global Market Intelligence

Figure 5.5 Debt Levels for Large LBOs over Time

Table 5.7 Capital Structure Factors Considered Important and Ranked
AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
Panel A: IRR
Gross IRR target 27.0 25.0 30.0 24.1 24.5 24.9 24.8 29.3 25.7 28.9
Number of responses 62 62 31 31 24 22 31 31 36 26

Panel B: IRR
determinants
Firm’s riskiness 86.2 84.4 87.9 91.7 91.3 90.3 82.4 91.9 78.6
Leverage 47.7 40.6 54.5 58.3 52.2 51.6 44.1 54.1 39.3
Historical return 30.8 40.6 21.2 20.8 30.4 22.6 38.2 37.8 21.4
expectations of LPs
Other 9.2 6.3 12.1 8.3 17.4 16.1 2.9 10.8 7.1
Not applicable 4.6 6.3 3.0 0.0 0.0 0.0 8.8 2.7 7.1
Number of responses 65 32 33 24 23 31 34 37 28

Panel C: Adjustments
to the cash flows or the
IRR
Risk of unexpected 17.7 0.0 8.2 26.9 26.0 13.9 21.2 14.5 12.2 25.0
inflation
(Continued)
Financial engineering 121
Table 5.7 (Continued)
AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
Interest rate risk 25.5 2.0 22.6 28.3 33.5 26.5 26.3 24.8 26.3 24.5
Term structure risk 18.5 0.0 16.6 20.3 14.9 26.9 22.9 14.4 13.5 25.0
GDP or business cycle 55.0 50.0 47.8 61.9 63.6 55.7 59.4 51.0 54.2 56.0
risk
Commodity price risk 28.8 21.0 22.8 34.7 35.5 27.1 30.6 27.2 28.0 29.9
Foreign exchange risk 20.2 10.0 15.7 24.5 25.6 16.6 23.5 17.1 12.9 29.8
Distress risk 13.0 0.0 8.7 17.2 13.8 11.9 17.2 9.1 9.0 18.2
Size 28.6 10.0 31.8 25.5 25.1 25.5 22.9 33.8 31.1 25.3
Market-to-book ratio 7.5 0.0 5.3 9.6 9.3 5.6 7.4 7.6 6.6 8.6
Momentum 11.8 0.0 9.6 13.9 17.0 10.3 18.9 5.4 12.9 10.4
Illiquidity 20.3 0.0 22.2 18.5 19.8 6.8 15.2 25.0 15.8 26.3
Other 1.4 0.0 2.8 0.0 0.0 0.0 2.6 2.4 0.0
122 Advanced Introduction to Private Equity

Number of responses 65 65 32 33 24 23 31 34 37 28
Source: GKM (2016)
 Financial engineering 123

These results also fit with the description of the Apollo/TPG purchase
of Harrah’s. Given the low interest rates at the time and the tremendous
availability of debt, as well as the strong staple cash flows of Harrah’s,
the PE sponsors clearly had an incentive to raise a significant amount
of debt. The ultimate outcome of the Harrah’s transaction, however,
shows that raising debt at market peaks can be problematic. Ultimately,
Harrah’s ran into significant cash flow issues during the Great Recession
of 2008–2009 and needed to be restructured. Financial distress is not just
theoretical, it clearly happens in practice.

For a small private equity deal, Hanson Manufacturing’s purchase by

Rockwood Capital provides a clear illustration of how financial engi-
neering can make a deal possible and create value. It also represents a
private equity investment at the opposite end of the spectrum in terms of
size and sophistication.14 In July 2000 Rockwood, a small private equity
firm co-founded by Brett Keith and Owen Colligan, had won the bid
for the acquisition of Hanson Manufacturing Company at $13 million.
The company specialized in the manufacturing and sale of diesel engine
accessories, along with air filtration and heater products for military and
commercial markets. Keith and Colligan had sought to leverage the deal
as much as possible. By September, they had managed to raise $1 million
in equity capital, $2.5 million in seller financing and $7.5 million from
a local bank. The remaining $3 plus million of the purchase price was
paid using the company’s existing cash balance of $809 000 together with
marketable securities of nearly $2.5 million and the cash surrender value
on two life insurance policies held by the company of nearly $450 000.

The seller financing (as in many small deals) represented the junior debt
and was structured as a $2.25 million note and $250 000 in earn-out
payments. It held a junior claim to the equity investors. For the senior
secured debt, Keith and Colligan solicited financing from eight banks,
both regional and national, with offices in Cleveland, where Hanson was
located. They received $7.5 million in debt financing comprised of a $4
million revolving credit facility collateralized by inventory and accounts
receivable, along with a $3.5 million term note with a senior claim to all
other assets including the property, plant and equipment.

The bank they chose submitted the term sheet in Table 5.8. The term
sheet indicates that the interest rate charged on the loan would be a float-
ing rate with a spread relative to LIBOR. The spread would depend upon
Table 5.8 Model Bank Loan Term Sheet
Exhibit 5
Guaranty To the extent that a holding company is formed and remains in place in connection with the contemplated
transaction, then the Facilities will be guaranteed by the continuing, unlimited guaranty of such holding company
and secured by a pledge of the holding company’s ownership interests in the Borrower.
Repayment A. The Revolver will mature and be payable-in-full on 30 September 2002.
B. The Term Loan will amortize in 59 consecutive, monthly payments of $41 667 plus interest followed by a final
payment in the amount of $1 041 647 plus interest (seven-year amortization schedule/five-year maturity).
Mandatory A. Not Applicable.
Requirements B. In addition to the repayment schedule outlined above, the Term Loan will incorporate mandatory prepayments
in an amount equal to 50% of Excess Cash Flow on an annual basis. Such mandatory prepayments will be
applied in the inverse order of maturity and will be payable on 30 September 2002 (for the fiscal year ended
30 June 2002) and each 30 September thereafter.
Voluntary A. At the option of the Borrower, the commitment amount of the Revolver may permanently reduce in minimum
Requirements amounts of $500 000 and even increments of $100 000 upon prior written notice to the Bank.
B. At the option of the Borrower, the principal balance of the Term Loan may be prepaid in minimum amounts of
$250 000 and even increments of $50 000 without any type of premium (except for breakage fees associated
with any applicable LIBOR contracts) upon prior written notice to the Bank. Such voluntary prepayments will be
applied in the inverse order of maturity.
124 Advanced Introduction to Private Equity

Interest rate The Borrower will have the option of selecting interest rates based on the Bank’s Prime Rate or LIBOR (30, 60,
90 and 180 days). In addition, the Bank will provide a “daily” LIBOR option for the Revolver.
The applicable spreads over the Bank’s Prime Rate and LIBOR will be performance-driven, based on the
Borrower’s Leverage as follows:
(Continued)
 Leverage Revolver Term Loan
LIBOR Spread Prime Rate Spread LIBOR Spread Prime Rate Spread
x > 3.25 2.50% 0.25% 2.75% 0.50%
2.75 < x ≤ 3.25 2.25% 0.00% 2.50% 0.25%
2.25 < x ≤ 2.75 2.00% (0.25%) 2.25% 0.00%
x < 2.25 1.75% (0.50%) 2.00% (0.25%)
Pricing for the Facilities will be determined quarterly based on (1) audited financial statements for one quarter of
each fiscal year and (2) company-prepared financial statements for the remaining quarters and will be adjusted on
the first day of the month following each quarter-end.
Notwithstanding the foregoing, the initial interest spreads for the Facilities are highlighted in the above table.
These initial interest spreads will remain in effect from closing through 31 December 2000.
Interest on the Facilities will be payable as follows: (1) monthly for Prime Rate and “daily” LIBOR borrowings; (2)
at the end of the term for LIBOR contracts of 20, 60 and 90 days and (3) at the end of each three-month period for
LIBOR contracts of 180 days.
All LIBOR contracts (excluding “daily” LIBOR borrowings) will carry a prepayment fee and will be written in
minimum amounts of $500 000 and even increments of $100 000.
Fees Closing Fee in amount of 0.50% of the commitment amount of the Facilities.
Unused commitment fee in the amount of 0.25% of the unused portion of the Revolver, payable quarterly in
arrears.
The Borrower will be responsible for the payment of all of the Bank’s legal fees and out-of-pocket expenses in
connection with the Facilities.
(Continued)
Financial engineering 125
Table 5.8 (Continued)
Exhibit 5
Covenants The documentation for the Facilities will incorporate affirmative, negative and financial covenants customary for
this type of transaction including, but not limited to, the following:
1. Minimum Cash Flow Coverage Ratio of 1.10:1
2. Maximum Leverage as follows:
Closing through 9/29/01 3.50:1
9/30/01 through 6/29/02 3.25:1
6/30/02 through 6/29/03 3.00:1
6/30/03 and thereafter 2.50:1
3. Minimum Net Worth as follows:
6/30/01 through 6/29/02 $750 000
6/30/02 through 6/29/03 $1 500 000
6/30/03 and thereafter $1 500 000 plus 50% of Net Income on an annual basis.
4. Limitation on Annual Capital Expenditures of $250 000
5. Limitation on Annual Management Fees to Rockwood of $300 000
126 Advanced Introduction to Private Equity

Source: Paul Gompers, 2003, Hudson Manufacturing Company, Harvard Business School Case Number 9-203-064
 Financial engineering 127

what the debt-to-EBITDA ratio was at the time. At the time the transac-
tion closed, debt-to-EBITDA was 3.32 times. Additionally, the proposed
financing had a number of maintenance covenants, i.e., covenants that
would have to hold at all times. These covenants can either be positive
(i.e., the company must do something) or negative (i.e., the company
cannot do something). The covenants are generally meant as “trip wires”
so the lender can have the ability to intervene if the company’s perfor-
mance is lagging. Many of the covenants relate to the financial risk of the
firm including cash flow coverage, maximum leverage and minimum net
worth. There are also covenants that restrict actions like capital expendi-
ture and the ability to take cash outside the company. If the firm violates
a covenant, it typically begins the process of renegotiating the terms of
the loan typically called an “amend and extend.”

The financing package for Rockwood’s acquisition of Hanson demon-

strates the critical elements of how debt can create value for even small
private equity transactions. First, a conservative estimate of the present
value of the interest tax shields is $2 million, a substantial portion of the
purchase price. Second, Hanson had been historically highly inefficient,
and the high debt levels provided financial discipline for the company.
The contrast in size between Harrah’s and Hanson demonstrates that
while the size of the transaction may influence where a private equity
manager goes for debt financing, substantial amounts of value can be
created through careful deal structuring.

A final component of financial engineering that we discuss is how to split

the equity of the transaction. Management incentives are the second
important piece of financial engineering. The ability to leverage a trans-
action and provide meaningful equity ownership to a portfolio compa-
ny’s management can be a critical source of value. In fact, in our surveys,
the private equity investors pointed to improved incentives as one of the
two or three most important sources of value. Table 5.9 shows the typical
equity structure for PE investors in both GKM (2016) and GKM (2020).
As we discuss in Chapter 6, management incentives are also an impor-
tant component of governance engineering.

Equity ownership of senior management in public companies and, par-

ticularly, of managers running divisions of public companies can be
relatively low, both as a percentage of the firm and in absolute dollars.
Increasing equity ownership, particularly as a percentage of the equity
Table 5.9 Typical Equity Ownership
a. GKM (2016)
AUM IRR Age Offices
Mean Median Low High Low High Old Young Local Global
PE investors 79.6 85.0 74.9 84.3 82.7 83.6 82.9 76.6 81.2 77.3
CEO 8.0 5.0 10.0 6.0 7.1 6.1 7.8 8.2 6.9 9.5
Top ten management 7.2 7.0 8.1 6.3 7.1 6.9 7.0 7.3 7.6 6.6
(excluding CEO)
Other employees 1.8 0.0 1.1 2.4 3.0 0.9 1.7 1.8 1.3 2.5
Other 3.5 0.0 6.0 1.1 0.1 2.6 0.6 6.1 3.0 4.3
Number of responses 64 64 32 32 23 23 30 34 37 27
b. GKM (2020)
AUM Age
Mean Median Low High Old Young
PE investors 72.9 80.0 65.6 80.2 70.7 75.4
128 Advanced Introduction to Private Equity

CEO 10.9 5.0 14.8 7.0 12.1 9.5

Top ten management 8.9 7.0 11.0 6.8 9.5 8.2
(excluding CEO)
Top ten management 19.8 15.0 25.7 13.8 21.7 17.7
(including CEO)
Other employees 2.4 0.0 2.8 2.1 2.7 2.2
Other 4.7 0.0 5.9 3.4 5.0 4.3
Observations 138 138 69 69 73 65
 Financial engineering 129

upside, can dramatically enhance the incentives of management to drive

value improvements. Table 5.9 is consistent with this. It confirms previ-
ous academic work that demonstrates PE investors provide strong incen-
tives to portfolio company management.15

In our earlier survey, we found that PE investors allocate 17% of company

equity to management and employees. The CEO received an average of
8%. The growth of PE investing over the decade led to dramatic shifts in
our more recent survey. The share of the CEO increased to nearly 11% and
the share for all senior management was nearly 20%. When all employees
are included, the 2020 share increases to 22%. This is significantly higher
than equity ownership of senior management in public companies. A
comprehensive study of public companies finds that the average CEO of
a public company between 1993 and 2007 held 3.58% of the company’s
equity and the median CEO held only 1.57%.16

Conclusion

Private equity has grown, at least in part, because of the ability to craft
financing packages that align incentives of various parties as well as
increasing value directly through the tax advantage of debt. Market con-
ditions play an important role in how financing in private equity trans-
actions is structured. While the evidence on the value creation of deal
structuring is readily supported in both practice and academic research,
the tools of financial engineering are readily available to all investors.
Any private equity firm can use leverage and provide equity incentives
to management. As the private equity industry has grown, the increas-
ing competition for investments means that much of the value created
through financial engineering flows to the sellers. In the next two chap-
ters, we explore differential sources of value, governance and operational
engineering that allow private equity managers to both create value and
retain a portion of the value they create.

Notes
1 Chen Lian and Yueran Ma, 2021, Anatomy of Corporate Borrowing
Constraints (with Chen Lian), Quarterly Journal of Economics 136, 229–91.
2 S.C. Myers, 1984, The Capital Structure Puzzle. Journal of Finance 39,
575–92.
130 Advanced Introduction to Private Equity

3 S.C. Myers and N.S. Majluf, 1984, Corporate Financing and Investment
Decisions When Firms Have Information That Investors Do Not Have.
Journal of Financial Economics 13, 187–221.
4 U. Axelson, T. Jenkinson, P. Strömberg and M. Weisbach, 2013, Borrow
Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts.
Journal of Finance 68, 2223–67.
5 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov,
2016, What Do Private Equity Firms (Say They) Do? Journal of Financial
Economics 121, 449–76.
6 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov, 2020,
Private Equity and Covid-19, NBER Working Paper.
7 See Paul A. Gompers, Kristin Mugford and J. Daniel Kim, 2012, Harrah’s
Entertainment, Harvard Business School Case Number 9-213-054.
8 Dennis K. Berman, Christina Binkley and Peter Sanders, 2006, Harrah’s in
Talks to Be Acquired by Buyout Firms – Deal for Casino Operator Would
be Among Largest for Private Equity Investors, Wall Street Journal, via
Factiva, accessed 27 September 2012.
9 As was typical of asset-backed financing, the CMBS covenants restricted
the Propco’s ability to incur additional debt, buy or sell assets, engage in
new businesses or enter into transactions with affiliates. Source: Caesars
Entertainment Corporation, 31 December 2010 Form 10-K (filed 4 March
2010), supplemental discussion of financial results, via EDGAR, accessed
September 2012.
10 Caesars Entertainment Corporation, 31 December 2010 Form 10-K (filed
4 March 2010), p. 46, via EDGAR, accessed September 2012.
11 Harrah’s Entertainment, Inc., 31 December 2008 Form 10-K (filed 17 March
2009), p. 32, via EDGAR, accessed September 2012.
12 Harrah’s Entertainment, Inc., 31 December 2008 Form 10-K (filed 16 March
2009), p. 32, via EDGAR, accessed September 2012.
13 M. Jensen, 1989, Eclipse of the Public Corporation, Harvard Business
Review 67, 61–74.
14 See Paul Gompers, 2003, Hudson Manufacturing Company, Harvard
Business School Case Number 9-203-064.
15 S. Kaplan, 1989, The Effects of Management Buyouts on Operating and
Value, Journal of Financial Economics 24(2), 217–54; S.N. Kaplan and
P. Strömberg, 2009, Leveraged Buyouts and Private Equity, Journal of
Economic Perspectives Winter, 121–46; Viral V. Acharya, O. Gottschalg,
M. Hahn and C. Kehoe, 2013, Corporate Governance and Value Creation:
Evidence from Private Equity, Review of Financial Studies 26(2), 368–402.
16 B. Page, 2011, CEO Ownership and Firm Value: Evidence from a Structural
Estimation, University of Rochester Working Paper.
6 Governance engineering

Governance engineering is another key lever that private equity investors

use to create value in their portfolio companies. There are three impor-
tant governance drivers. First, PE firms focus on making sure the right
managers are in place at the firms they finance. Both before and after
their investment, PE managers actively replace top management and
recruit competent CEOs to run their companies. Second, PE managers
look to provide the right incentives for top managers by ensuring that
their compensation is largely determined by their equity ownership. As
we discussed in Chapter 5, by providing company management with a
meaningful stake in the portfolio company, PE investors ensure that they
are rewarded when performance improves. Finally, boards of directors at
PE-backed companies are very active in providing important oversight
and guidance. PE investors as well as outside directors with important
experience and insight are brought in to sit on boards and are actively
engaged in advising and monitoring company management. In this
chapter we examine the specific governance engineering levers that PE
managers utilize as well as what research has demonstrated about gov-
ernance effects on firms’ performance.

Does governance matter and what do PE investors do?

Management
Private equity investors are very focused on hiring the right top execu-
tives to run their portfolio companies. In GKM (2016)1 and GKM (2020),2
as noted earlier, we find that the management team is the second most
important criterion for making an investment after the business model/
competitive situation.

131
132 Advanced Introduction to Private Equity

Table 6.1, drawn from GKM (2016), also shows how active PE investors
are in recruiting senior management teams in their portfolio companies.
A meaningful fraction of PE investors, 31%, recruit their own senior
management teams before investing. These PE investors who bring in
their own team do not place a great deal of weight on the value of incum-
bency. In contrast, most (69%) PE managers do not recruit their own
senior management team before the investment. This is consistent with
the notion that many private equity firms want to be seen as wanting to
remain “friendly” when pursuing transactions. This suggests that differ-
ent PE investors have very different investment strategies.

After the investment, roughly 50% of the PE investors end up recruiting

their own senior management team. This is consistent with PE investors
becoming more actively involved in the governance of their companies
after the investment. When we combine the PE investors who recruit
their own teams before, after or both before and after investing, we find
that almost 58% of the PE investors recruit their own senior teams. This
indicates that the PE investors are actively involved in monitoring and
governing their portfolio companies.

This differs markedly from the typical experience in public companies.

Cziraki and Jenter (2020) find that for most of the largest US companies,
new CEOs come primarily from within the firm and those that come
from outside the firm typically have connections with the firm’s board
of directors. In work in progress, we are finding, in contrast, that private
equity firms primarily bring in new CEOs from outside the company.
This means that private equity firms rely much more heavily on an exter-
nal market for talent (Table 6.2).

Although it is not possible to ascribe any causality at this point, the cross-
sectional results suggest that the PE investors who recruit their own
teams have experienced better past investment performance.

Recruiting senior management is important for many different types of

PE investors. For example, Rockwood Equity, a small PE firm founded by
Brett Keith and Owen Colligan, purchased their first company, Hanson
Manufacturing, for $10.1 million on 27 October 2000.3 Hanson was a
manufacturer of military heaters and air filtration equipment. The
company had been undermanaged for many years and, consequently,
showed little growth. As part of the effort to improve operations, Keith
Table 6.1 Private Equity (PE) Recruitment of Management Teams
Senior Management Mean AUM IRR Age Offices
Recruitment
Low High Low High Old Young Local Global
Before investing
Yes 31.3 31.3 31.3 26.1 39.1 30.0 32.4 29.7 33.3
No 68.8 68.8 68.8 73.9 60.9 70.0 67.6 70.3 66.7
After investing
Yes 50.0 40.6 59.4 43.5 52.2 50.0 50.0 37.8 66.7**
No 50.0 59.4 40.6 56.5 47.8 50.0 50.0 62.2 33.3**
Before or after investing
Yes 57.8 53.1 62.5 47.8 63.4 56.7 58.1 48.6 70.4*
No 42.2 46.9 37.5 52.2 36.6 43.3 41.9 51.4 29.6*
Number of responses 64 32 32 23 23 30 34 37 27
Note: This table reports the percentage of the sample PE investors who recruit their own senior management teams before investing,
after investing and before or after investing. The sample is divided into subgroups based on the median of assets under management
(AUM), the internal rate of return (IRR) of most recent fund, the age of PE investor and whether PE investor has a global presence.
Statistical significance of the difference between subgroup means at the 1%, 5% and 10% levels are denoted by ***, ** and *, respectively.
Governance engineering 133
Table 6.2 PE Replacement of Chief Executive Officers (CEOs) after Investing
CEO Swapped Out Mean Median AUM IRR Age Offices
Low High Low High Old Young Local Global
Percent of deals 33.3 30.0 30.3 36.3 27.9 37.3 27.7 38.2 32.0 35.0
Number of 64 64 32 32 23 23 30 34 37 27
responses
Note: This table reports the percentage of deals in which the sample PE investors replace the CEO after the investment is made. The
sample is divided into subgroups based on the median of AUM, the IRR of most recent fund, the age of PE investor and whether PE
investor has a global presence.
134 Advanced Introduction to Private Equity
 Governance engineering 135

and Colligan replaced the entire management team, bringing on board

a new CEO, CFO, VP of Operations and a VP of Engineering. Each of
these hires was critical to both setting a new direction and growth. In
fiscal year 2000, Hanson generated $21 million in revenue. By 2003, the
company had increased revenue to $55 million and grown EBITDA from
$3.0 million to $8.0 million. While multiple factors contributed to this
improvement, bringing on board new senior management was a critical
component.

Key senior hires are important outside the US as well as illustrated by

AXA Private Equity’s purchase of Diana.4 At the time, Diana was a pro-
ducer of specialty chemicals in the food space. They had three main lines
of business: pet food ingredients; natural extracts for food, beverages and
cosmetics; and culinary ingredients for the food and beverage industry. In
2007, AXA approached Cognetas, the owner of Diana, about purchasing
the company. As part of the investment thesis, AXA began an immedi-
ate search for a new CEO and CFO for Diana. Ultimately, AXA identi-
fied Olivier Caix, the President of Rhodia Organics, a company that was
focused on chemicals in the consumer goods, automotive, energy and
manufacturing spaces. Caix experience made him perhaps overqualified
to be CEO, but AXA’s philosophy was to hire senior management for the
company they hoped to build, not the company that currently existed.
When AXA purchased Diana for €710 million, it was generating €254
million in revenue. Caix and his team were able to nearly double rev-
enue to €454 million when AXA sold the company in 2014 to Symrise, a
strategic German acquirer, for €1.3 billion. Caix’s background running a
large, chemical company was critical to this transformation. He brought
specific industry expertise as well as credibility with customers when he
assumed the CEO role.​

Blackstone and Lion Capital’s purchase of Orangina from Cadbury in

November 2005 provides another example in which key senior hires were
a critical lever of transforming a company.5 Blackstone and Lion paid
€1.85 billion to purchase the underperforming division from Cadbury.
The two private equity sponsors replaced the entire senior management
team. Importantly, Javier Ferran, who had been president and CEO of
Bacardi, became the Executive Chairman of Orangina. The new team
was able to restructure and streamline operations, push new product
innovation and dramatically grow the business. Blackstone and Lion
were ultimately able to exit in 2009 by selling to Suntory Holdings in
136 Advanced Introduction to Private Equity

November 2009 for €2.6 billion after paying off much of the debt. A criti-
cal element of the turnaround for the company was bringing in seasoned
executives to manage the turnaround.

Alignment of managerial incentives

The second key lever in governance engineering is increasing the amount

of senior managers’ compensation that comes from equity ownership.
Incentive compensation has been a particularly important area of gov-
ernance research for a long time. Jensen (1986) argued that managers
of publicly traded firms typically owned too little equity to make them
sensitive to maximizing shareholder value. Private equity managers who
are aware of this seek to align incentives through increases in managerial
equity ownership.

Kaplan (1989) examined management ownership changes in a sample of

leveraged buyouts from the 1980s and found that, on average, ownership
substantially increases. Given that equity ownership was the key driver
of incentive alignment, Kaplan concluded that one of the critical levers of
PE investing that improves performance is increasing managerial incen-
tive alignment. Peck (2004) looked at a more recent sample of 73 LBOs
and found that the management’s ownership increases to 20% after the
transaction. The average CEO owned 2.87% of the equity prior to the
LBO, but this percentage increased to 7.81% after the transaction with an
additional 3.42% of equity in the form of stock options. This represents
more than a tripling in pay sensitivity.

These results are in line with GKM (2016) who ask PE managers about
the typical equity ownership structures. Table 6.3 shows that, on aver-
age, (median) CEOs own 8.0% (5.0%) after the transaction. Smaller PE
firms and global PE players typically target great ownership for CEOs,
10.0% and 9.5%. Excluding the CEO, the top 10 managers own 7.2% of
the equity in the deal. Interestingly, below the top 10 managers, equity
ownership is relatively modest, 1.8% on average and a median of 0%.
Clearly, from the perspective of the PE managers, equity incentives are
most critical at the top of the firm. In fact, the CEO generally owns as
much equity as the rest of management.
Table 6.3 Typical Equity Ownership
Ownership Group Mean Median AUM IRR Age Offices
Low High Low High Old Young Local Global
PE investors 79.6 85.0 74.9 84.3** 82.7 83.6 82.9 76.6 81.2 77.3
CEO 8.0 5.0 10.0 6.0 7.1 6.1 7.8 8.2 6.9 9.5
Top 10 management 7.2 7.0 8.1 6.3** 7.1 6.9 7.0 7.3 7.6 6.6
(excluding CEO)
Other employees 1.8 0.0 1.1 2.4 3.0 0.9 1.7 1.8 1.3 2.5
Other 3.5 0.0 6.0 1.1** 0.1 2.6 0.6 6.1** 3.0 4.3
Number of responses 64 64 32 32 23 23 30 34 37 27
Note: This table reports the typical equity ownership of the sample PE investors, the CEO and top management. The sample is divided
into subgroups based on the median of AUM, the IRR of most recent fund, the age of PE investor and whether PE investor has a global
presence. Statistical significance of the difference between subgroup means at the 1%, 5% and 10% levels are denoted by ***, ** and *,
respectively.
Governance engineering 137
138 Advanced Introduction to Private Equity

The potential for improvement in incentives is perhaps greatest in buy-

outs of divisions of public companies, particularly larger conglomerates.
Substantial research has shown that many of the conglomerate merg-
ers of the 1960s and 1970s were value destroying. Managers of divisions
had little direct incentive to create value. TA Associates’ investment
in Speedcast represents just such an example.6 Speedcast was a wholly
owned subsidiary of AsiaSat that provided satellite communications
based in Hong Kong. Speedcast’s primary customers in the maritime, oil
and gas, and mining industries operated in geographies that were typi-
cally remote. Speedcast did not own their own satellites, but leased band-
width from companies that owned and operated those satellites.

Speedcast’s CEO, P.J. Beylier, saw an opportunity to grow by consolidat-

ing players in the VSAT satellite services sector in Asia and Africa. He
approached TA Associates about purchasing Speedcast from its parent,
AsiaSat. In the process of generating a growth strategy, Beylier identi-
fied several acquisition targets that could provide a greater footprint for
Speedcast’s services. The complex deal required that TA partners Michael
Berk and Ed Sippel negotiate with AsiaSat and the targets simultane-
ously. In March 2012, they reached an agreement to purchase Speedcast
from AsiaSat and one of the targets for $50 million. TA and Beylier nego-
tiated a management incentive plan that offered Beylier and his team a
pool of “performance shares” that, if targets were met, would total 20%
ownership on a fully diluted basis. The equity incentive plan envisioned a
base grant of performance shares in which the team would receive 10% of
the equity in an eventual sale if the proceeds were above TA’s cost. Four
additional tranches of 2.5% sharing rights would be granted at returns
of 1.5×, 2.0×, 2.5× and 3.0× compared to TA’s cost basis. By providing
management with an increasing share of the pie as returns improved, TA
provided high-powered incentives for Beylier and his team. This type of
an incentive plan would have been impossible as a subsidiary of AsiaSat.
The compensation program illustrates the importance of governance
engineering. After a number of years of exceptional growth, Beylier and
TA took Speedcast public on the Australian Stock Exchange in August
2014. The IPO placed a value of $254 million on Speedcast at the end of
the first day of trading.

“Take private” transactions can also provide opportunities to enhance

incentives of senior management. HgCapital’s purchase of Visma Software
illustrates the point.7 In March 2006, Nic Humphries and HgCapital bid
 Governance engineering 139

to take Visma ASA, a publicly listed Norwegian company, private in a

buyout valued in excess of £330 million (roughly $500 million). Visma
provided business software to small and medium-sized enterprises in
Scandinavia and had grown through the acquisition of smaller players.
While the firm was highly successful, senior management owned little
of the equity. For example, Oystein Moan, the CEO who had been with
Visma for more than eight and a half years, owned only 180 000 shares
(0.6% of the equity) and 300 000 options. Tore Bjerkan, the CFO who had
been with Visma for more than 10 years, owned 150 000 shares (0.5%)
and 100 000 options. Collectively, the top five executives owned only
1.8% of the firm’s equity. At a purchase price of NOK 135 per share, man-
agement’s equity and options were worth less than $10 million in aggre-
gate. In the course of the transaction, Moan’s stake alone increased to
6.6% of Visma’s equity, a ten-fold increase in his equity ownership. Moan
led the company for the next 14 years and grew Visma through multiple
acquisitions and additional HgCapital investments. In 2020, Visma had
an enterprise value of $12.2 billion.

Structuring effective boards of directors

Finally, even if top executives are motivated to maximize shareholder

value through appropriate incentive alignment, informational asym-
metries with providers of external capital can make external financing
more costly and drive a wedge between the actions of managers and inves-
tors. Myers and Majluf (1984)8 and Greenwald, Stiglitz and Weiss (1984)9
develop the intuition around how these asymmetries can be detrimental to
firm performance. More generally, contracts between managers and out-
side investors cannot anticipate every potential situation. When outcomes
cannot be readily observed, it is impossible to write contracts contingent
upon particular events. Models of ownership and potential problems that
can arise (Hart and Moore (1990)10 and Hart and Moore (1998)11) have
shown the limitations of contracts in alleviating these problems.

While most of these papers develop theory, the implications are real in
practice. Management typically knows significantly more than outsid-
ers about customer demand, future orders, product development, core
technology, and so on. These insights may not easily be communicated to
investors, especially if the company is public and worries about provid-
ing sensitive information to competitors.
140 Advanced Introduction to Private Equity

An active and incentivized board of directors provides a partial solution

to these types of information and incomplete contracting issues. Fama
and Jensen (1983)12 and Williamson (1983)13 hypothesize that the compo-
sition of the board should be shaped by the need for oversight, advice and
guidance. Having investors on the board is critical to monitoring man-
agement and exercising oversight. Private equity investors, as the owners
of the firms in which they invest, typically take board seats and serve this
monitoring function.

The simple monitoring function points toward an independent board,

composed largely of outsiders. Clearly, having senior management on the
board is critical to providing information to the directors whose role is
to monitor and advise management. The two most common measures of
board effectiveness that have been examined in the academic literature
are size (e.g., the number of directors) and composition (e.g., the fraction
of insiders, investors, independent outsiders, etc.).14 Large boards are typ-
ically found to be suboptimal. The optimal size of the board of directors
balances the costs and benefits of additional directors. Yermack (1996)15
and Eisenberg et al. (1998)16 find that performance, measured by mar-
ket valuation and operating ratios, decreases with the size of the board
of directors for public companies. The median public board size in the
Yermack sample is 12; firms with a board size less than seven have the
highest levels of performance measures.

A second common statistic is board composition. A variety of papers

have looked at the determinants of board composition. This work tends
to find that companies with a larger fraction of outsiders or independ-
ent directors perform better or make better decisions (Weisbach (1988),17
Hermalin and Weisbach (1998),18 Denis and Sarin (1999),19 Byrd and
Hickman (1992)20) and share price reactions to the enactment of poison
pills are higher (Brickley, Coles and Terry (1994)21). Outsider-dominated
boards are more likely to replace CEOs in response to poor performance
(Weisbach (1988),22 Borokhovich et al. (1996)23 and Perry (2000)24).

In addition to their monitoring role, boards of directors are often viewed

as an important governance tool to provide strategic advice and guid-
ance. Fama and Jensen (1983)25 discuss the role of boards and how boards
should function. Hermalin and Weisbach (1998)26 examine the determi-
nants of board structure and argue that boards should be structured
to minimize conflicts and maximize value. Coles, Daniels and Naveen
 Governance engineering 141

(2008)27 examine how board size is related to both firm characteristics

and then firm performance. In general, this literature also argues that
small boards dominated by outsiders perform better.

As we have seen, PE firms take large ownership positions in firms and

perform substantial analysis on ways that firms can be improved. PE
investors are typically not passive. By scrutinizing firms before pro-
viding capital and then monitoring them afterwards, PE investors can
both monitor how the firm is doing and provide key strategic advice to
managers.

Prior work on private equity has looked at small samples of PE-financed

companies as well as their board compositions. In a sample of UK take
private transactions, Cornelli and Karakaş (2012)28 show that boards typ-
ically become smaller and heavily dominated by the PE sponsors. They
find that average board size decreases after an LBO, falling from around
6.5 members to between 4 and 5 after the transaction. Interestingly,
Cornelli and Karakaş find that LBO sponsors do join the board, but they
typically replace independent outsiders on the board, not insiders.

GKM (2016) asked a number of questions related to board governance in

PE-financed firms. Table 6.4 confirms previous work in showing in Panel
A that PE investors prefer smaller boards of directors, with over 90%
including between 5 and 7 members. Larger private equity firms tend to
have portfolio companies with larger boards while younger and better
performing PE firms tend to have smaller boards. Panel B indicates that
PE investors target taking roughly three of the board seats while allocat-
ing one or two to management, and one or two to outsiders who are not
affiliated with the PE firms. Again, the results for board composition are
consistent with theory, with previous work and with conventional wis-
dom in which private equity managers seek to optimize the board both
for monitoring and strategic advice. Small boards with significant rep-
resentation by PE investors and outsiders are important for monitoring
and providing strategic advice.

Table 6.5 indicates that PE investors are actively involved in advising

their companies in the great majority of their deals. In fact, the median
PE investor claims to be actively involved in all of their deals. We also
find some differences across PE firm types. Global PE firms and PE firms
with higher IRRs are slightly more active in their deals, indicating an
Table 6.4 Board of Directors’ Size and Composition
Size and Mean Median AUM IRR Age Offices
Composition
Low High Low High Old Young Local Global
Panel A: Board of directors’ size
3 or less 3.1 3.1 3.1 8.7 0.0 3.3 2.9 0.0 7.4
4 1.6 3.1 0.0 0.0 4.3 0.0 2.9 2.7 0.0
5 32.8 40.6 25.0 21.7 30.4 23.3 41.2 37.8 25.9
6 10.9 12.5 9.4 21.7 8.7 20.0 2.9** 10.8 11.1
7 46.9 37.5 56.3 39.1 52.2 46.7 47.1 43.2 51.9
8 3.1 0.0 6.3 8.7 0.0 3.3 2.9 2.7 3.7
9 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
10 1.6 3.1 0.0 0.0 4.3 3.3 0.0 2.7 0.0
11 or more 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Number of 64 32 32 23 23 30 34 37 27
responses
142 Advanced Introduction to Private Equity
 Panel B: Board of directors’ composition
Inside directors 1.6 1.0 1.6 1.5 1.4 1.5 1.5 1.6 1.5 1.7
PE directors 2.8 3.0 2.7 2.9 2.8 2.9 2.8 2.7 2.7 2.8
Outside 1.7 2.0 1.6 1.9 1.9 1.7 1.9 1.6 1.8 1.6
directors
Other 0.1 0.0 0.1 0.1 0.0 0.2 0.1 0.1 0.1 0.1
Number of 64 64 32 32 23 23 30 34 37 27
responses
Note: Panel A presents the desired size of a board of directors reported by the sample PE investors. Panel B presents the desired
composition of the board of directors by the sample PE investors. The sample is divided into subgroups based on the median of AUM,
the IRR of most recent fund, the age of PE investor and whether PE investor has a global presence. Statistical significance of the differ-
ence between subgroup means at the 1%, 5% and 10% levels are denoted by ***, ** and *, respectively.
Governance engineering 143
Table 6.5 PE Involvement in Portfolio Companies
Active Involvement Mean Median AUM IRR Age Offices
Low High Low High Old Young Local Global
Percent of deals 87.5 100.0 84.8 90.1 81.3 90.2 85.2 89.5 83.0 93.6
Number of 64   64 32 32 23 23 30 34 37 27
responses
Note: This table reports the fraction of deals in which the sample PE investors become involved in the management of portfolio com-
panies, i.e., actively advising the company on strategic choices. The sample is divided into subgroups based on the median of AUM, the
IRR of most recent fund, the age of PE investor and whether PE investor has a global presence.
144 Advanced Introduction to Private Equity
 Governance engineering 145

active involvement in more than 90% of their transactions on average.

Much of this activity happens through the active role that PE managers
play on boards. As we discuss in Chapter 7, private equity managers are
also actively engaged in operational engineering through their involve-
ment in portfolio companies.

The Hanson Manufacturing buyout by Rockwood Equity discussed above

provides a clear example of structuring an effective board. Prior to the
transaction, there was no board of directors as the company was owned
exclusively by one person. The previous owner was 72 years old and had
been only modestly active in the firm’s operations. After the buyout, in
addition to Keith and Colligan’s presence on the board, they recruited
three important outside directors. First, because the Department of
Defense was the key customer, they recruited a retired Two-Star Army
general to the board. Second, they identified and recruited the former
CEO of a $100 million Cleveland-based defense contractor. Both of
these directors provided contacts and credibility with the DoD and were
instrumental in facilitating new contracts with the military. Finally,
the former president of Brush-Wellman, a Cleveland-based producer of
beryllium and beryllium compounds, was added to the board to provide
important supply chain and manufacturing insights. In the first three
years after the buyout, these additions to the board, as well as the recruit-
ing of an entire new senior management team, led to the largest contract
in company history (10 years and $106 million) as well as the introduc-
tion of a variety of new products. In 2004, Keith and Colligan were able
to sell Hanson to Behrman Capital for $93 million. With only $6 million
of debt outstanding, the equity value of Hanson increased from $1 mil-
lion in 2000 to more than $87 million in four years.

Conclusion

This chapter has explored how private equity managers use govern-
ance engineering to increase the value of their portfolio companies. The
evidence from academic research identifies three important govern-
ance levers that have the ability to improve performance: management
replacement, improved incentives and effective boards of directors. PE
managers use each of these levers.
146 Advanced Introduction to Private Equity

Notes
1 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov,
2016, What Do Private Equity Firms (Say They) Do? Journal of Financial
Economics 121, 449–76.
2 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov, 2020,
Private Equity and Covid-19, NBER Working Paper.
3 See Paul A. Gompers, 2002, Hudson Manufacturing, HBS Case 9-203-064.
4 See William Sahlman and Michael Roberts, 2011, AXA Private Equity: The
Diana Investment, HBS Case 9-812-042.
5 See G. Felda Hardymon, Josh Lerner and Ann Leamon, 2006, Lion and
Blackstone: The Orangina Deal, HBS Case 9-807-005.
6 See Paul Gompers and Monica Baraldi, 2015, TA Associates and SpeedCast,
HBS Case 9-216-010.
7 See Paul A. Gompers, Karol Misztal and Joris Van Goode, 2012, HgCapital
and the Visma Transaction (A), HBS Case 9-214-018.
8 Stewart C. Myers and Nicholas S. Majluf, 1984, Corporate Financing and
Investment Decisions When firms Have Information That Investors Do Not
Have, Journal of Financial Economics 13, 187–221.
9 Bruce Greenwald, Joseph Stiglitz and Andrew Weiss, 1984, Informational
Imperfections in the Capital Market and Macroeconomic Fluctuations,
American Economic Review 74, 194–9.
10 Oliver Hart and John Moore, 1990, Property Rights and the Nature of the
Firm, Journal of Political Economy 98, 1119–58.
11 Oliver Hart and John Moore, 1998, Default and Renegotiation: A Dynamic
Model of Debt, Quarterly Journal of Economics 113, 1–41.
12 Eugene F. Fama and Michael C. Jensen, 1983, Separation of Ownership and
Control, Journal of Law and Economics 26, 301–25.
13 Oliver E. Williamson, 1983, Organization Form, Residual Claimants, and
Corporate Control, Journal of Law and Economics 26, 351–66.
14 Benjamin Hermalin and Michael Weisbach, 2003, Boards of Directors as an
Endogenously Determined Institution, FRBNY Economic Policy Review,
7–26 provide a more complete survey of the empirical evidence.
15 David Yermack, 1996, Higher Market Valuation of Companies with a Small
Board of Directors, Journal of Financial Economics 40, 185–211.
16 Theodore Eisenberg, Stefan Sundgren and Martin T. Wells, 1998, Larger
Board Size and Decreasing Firm Value in Small Firms, Cornell Law Faculty
Publications 393.
17 Michael S. Weisbach, 1988, Outside Directors and CEO Turnover, Journal
of Financial Economics 20, 431–60.
18 Benjamin E. Hermalin and Michael S. Weisbach, 1998, Endogenously
Chosen Boards of Directors and Their Monitoring of the CEO, American
Economic Review 88, 96–118.
19 D.J. Denis and A. Sarin, 1999, Ownership and Board Structures in Publicly-
Traded Corporations, Journal of Financial Economics 52, 187–223.
20 John W. Byrd and Kent A. Hickman, 1992, Do Outside Directors Monitor
Managers: Evidence from Tender Offer Bids, Journal of Financial Economics
32, 195–221.
 Governance engineering 147

21 James A. Brickley, Jeffrey Coles and Rory L. Terry, 1994, Outside Directors
and the Adoption of Poison Pills, Journal of Financial Economics 35, 371–90.
22 Michael S. Weisbach, 1988, Outside Directors and CEO Turnover, Journal
of Financial Economics 20, 431–60.
23 Kenneth A. Borokhovich, Robert Parrino and Teresa Trapani, 1996,
Outside Directors and CEO Selection, Journal of Financial and Quantitative
Analysis 31, 337–55.
24 Tod Perry, 2000, Incentive Compensation for Outside Directors and CEO
Turnover, Indiana University Working Paper.
25 Eugene F. Fama and Michael C. Jensen, 1983, Separation of Ownership and
Control, Journal of Law & Economics 26, 301–25.
26 Benjamin E. Hermalin and Michael S. Weisbach, 1998, Endogenously
Chosen Boards of Directors and Their Monitoring of the CEO, American
Economic Review 88, 96–118.
27 Jeffrey L. Coles, Naveen D. Daniel and Lalitha Naveen, 2008, Boards: Does
One Size Fit All? Journal of Financial Economics 87, 329–56.
28 Francesca Cornelli and Oğuzhan Karakaş, 2012, Corporate Governance of
LBOs: The Role of Boards, London Business School Working Paper.
7 Operationalizing
operational engineering

As we discussed in Chapter 2, private equity (PE) firms have increas-

ingly focused on adding operational value to their portfolio companies.
This increase in focus has been driven by the rapid increase in capital
committed to the private equity industry and the competition for deals.
In order to earn a return, PE firms increasingly have to focus on grow-
ing revenues and profits of their portfolio companies. We refer to this
as “operational engineering.” In the 1980s, Clayton Dubilier and Rice
(CDR) pioneered the use of operating partners while Bain Capital (and
Mitt Romney) pioneered the use of consulting resources and analyses.
Today, many top private equity firms have operating partners and make
use of both internal and external consulting groups. In Chapter 10, we
will look at how various PE firms organize and recruit to focus on these
operational improvements. Most private equity firms today incorporate
some form of operational engineering in addition to financial and gov-
ernance engineering. In this chapter, we look in more detail at the differ-
ent approaches private equity firms take.

As we see in Table 7.1 taken from Gompers et al. (2020)1 survey of PE

firms, the two most important sources of value creation for private equity
firms are, first, growing revenues and, second, reducing costs in their
portfolio companies. Both of these operating levers go to increase the
profits of the portfolio company and thereby increase value. It is interest-
ing that despite the COVID-19 pandemic, PE firms have a primary focus
in increasing revenues.

In our 2012 survey, we asked about those sources in more detail. Table 7.2
provides the breakdown. Again, growing revenues was the most impor-
tant expected source of value (70% of the time). Other forms of opera-
tional engineering also were important – follow-on acquisitions (51%),
reducing costs in general (36%), redefining the current business model

148
 Operationalizing operational engineering 149

Table 7.1 Sources of Value Creation

Source of Value Mean Median AUM Age
Low High Young Old
Growth in revenue 8.1 8.0 7.9 8.3 8.0 8.1
of the underlying
business
Reducing costs 5.4 5.0 5.5 5.4 5.5 5.3
Industry-level 4.6 4.5 4.4 4.8 4.6 4.7
multiple arbitrage
Leverage 3.9 4.0 3.9 4.0 4.0 3.8
Refinancing 3.2 3.0 3.2 3.1 3.2 3.2
Other 1.7 1.0 1.5 1.9 1.9 1.6
Observations 145 145 73 72 77 68
Source: Gompers, Kaplan and Muhkarlyamov (2020)

or strategy (34%), improving IT systems (26%) and introducing shared

services (16%). When compared to other sources of potential return gen-
eration, improving operating performance is clearly the dominant lever.

Most top PE firms are organized around industries. As we will see in

Chapter 10, this industry focus is embodied by the people who execute
the investment and operating improvements. PE 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.

Operational value creation levers

The plan for operational engineering or value creation begins when the
PE firm decides to pursue a transaction. As we saw in Chapter 4, two of
the important drivers of the decision to invest in a deal are a proprietary
strategy and capability from the private equity firm to improve the com-
pany and the room for improvement in the target company’s operations.
Often, the proprietary strategy involves the development of the operat-
ing plan that has the potential to improve operating performance as well
as having people who can help implement that operating plan to achieve
those improvements. Chapter 2 also presented the academic evidence on
how PE investments affect the performance of the companies they control.
Table 7.2 Pre-Investment (Expected) Sources of Value Creation – The Percentage of Deals That Private Equity Investors
Identify Having the Following Pre-Deal Sources of Value
Mean Median Low High Low High Old Young Local Global
AUM AUM IRR IRR
Reduce costs in 35.6 27.5 35.8 35.5 37.1 37.3 39.9 32.0 31.0 41.8
general
Improve IT/ 26.1 20.0 30.8 21.6 22.0 23.3 23.9 28.0 26.7 25.3
information systems
Introduce shared 15.6 2.5 16.4 14.9 11.6 18.3 16.9 14.6 14.9 16.6
services
Increase revenue/ 70.3 80.0 77.5 63.5 75.0 63.5 67.0 73.2 70.6 70.0
improve demand
factors
Redefine the current 33.8 29.5 27.8 39.5 43.0 29.8 32.1 35.3 32.8 35.2
business model or
strategy
150 Advanced Introduction to Private Equity

Change CEO or CFO 30.6 27.5 33.4 28.0 29.2 32.9 30.9 30.4 29.3 32.4
Change senior 33.4 30.0 37.3 29.7 32.5 33.1 27.9 38.1 35.4 30.8
management team
other than CEO and
CFO
 Improve corporate 47.0 37.0 52.4 41.9 40.1 45.5 39.4 53.5 47.3 46.6
governance
Improve incentives 61.1 73.5 60.7 61.5 58.3 67.0 65.5 57.4 59.0 63.9
Follow-on 51.1 50.0 53.9 48.4 52.0 46.9 51.0 51.2 53.2 48.3
acquisitions
Strategic investor 15.6 10.0 16.4 14.8 12.3 14.0 14.4 16.5 15.1 16.2
Facilitate a high- 50.0 43.5 61.0 39.6 45.6 42.0 40.4 58.1 53.5 45.4
value exit
Purchase at an 44.3 43.0 49.2 39.6 38.2 43.3 40.9 47.1 44.9 43.5
attractive price (buy
low)
Purchase at an 46.6 50.0 54.5 39.2 38.7 47.3 42.9 49.8 50.1 42.0
attractive price
relative to the
industry
Other 9.8 0.0 9.4 10.2 0.0 14.3 9.4 10.1 12.4 6.4
Number of responses 74 74 36 38 27 27 34 40 42 32
Source: Gompers, Kaplan and Muhkarlyamov (2016)
Operationalizing operational engineering 151
152 Advanced Introduction to Private Equity

Overall, the evidence indicated that PE investors dramatically improve

company performance, increasing sales, profits, productivity and innova-
tion. Here, we explore a variety of examples and particular areas within
portfolio companies in which performance is enhanced.

The importance of operational improvements has not gone unnoticed in

the PE industry. The exemplary implementation of these types of strate-
gies is recognized annually in the Private Equity International’s (PEI’s)
annual Operational Excellence Awards. The awards recognize PE firms
that “have delivered operational value to their portfolio companies” in a
transaction that has been at least partially realized. One of us (Kaplan)
has served for a number of years as a judge for these awards. In 2021,
PE firms submitted a record number of entries for the Americas awards.
Those entries had a number of commonalities. Several of the exam-
ples below are taken from winners in the PEI’s Operational Excellence
Awards.

Team upgrade/new CEO

It is very common for PE firms to upgrade the existing management team.

This often involves bringing in new members of the C-suite including
new chief executive officers (CEOs), chief operating officers (COOs) and
chief financial officers (CFOs). To do this, PE firms make use of in-house
talent management teams that are focused on sourcing talent for port-
folio companies. Recent work by Cziraki and Jenter (2021)2 has demon-
strated that the market for CEO talent in public companies is primarily
limited to candidates from within the firm or candidates who are con-
nected to the board. The labor market for CEOs in PE-backed companies,
however, is very different. Gompers, Kaplan and Muhkarlyamov (2022)
show that the majority of PE-financed companies replace CEOs and the
replacements are most likely to be company outsiders.3 It is now common
for PE firms to have a head of talent management. This head of talent
management has extensive networks and the capability to identify senior
executive talent. PE firms also make use of executive assessment firms
like ghSMART that systematically assess the candidates. Kaplan and
Sorensen (2021)4 and Kaplan, Klebanov and Sorensen (2012)5 describe the
ghSMART assessments and the information about top executives that is
in those assessments. Both papers show that CEO candidates could be
characterized by general ability versus communication/interpersonal
 Operationalizing operational engineering 153

skills. General ability appears to be a better predictor of performance in

a sample of buyout and venture capital-financed companies.

An illustration of the importance of new senior management is illus-

trated by Ardian’s purchase of Diana, a European chemical additive com-
pany, in 2007.6 Ardian purchased in an LBO for an enterprise value of
€710 million and €415 million of debt. The advent of the financial crisis
severely strained Diana’s ability to meet its debt obligations. As Diana
was struggling, Ardian hired an outsider, Olivier Caix, to turn the com-
pany around. Caix had served as President of Rhodia Organics for nearly
four years and had over a decade of experience in the chemical additive
business. The ability to reach outside of Diana for management talent was
critical to the turnaround.

Clayton, Dubilier and Rice utilized management upgrades in its

2016 investment in agilon health.7 Ravi Sachdev, a partner at Clayton,
Dubilier, led the merger of two companies, Primary Provider Management
and Cyber-Pro Systems, and was joined on the board by operating part-
ner, Ron Williams, former chairman and CEO of Aetna. A year later,
Central Ohio Primary Care was merged into the company as well. The
goal was to create a healthcare company focused on senior patients. A
critical element of Clayton, Dubilier’s strategy was to hire a senior man-
agement team that could provide operational excellence. The entire
C-suite of the company was hired including Steve Sell as CEO (former
President and CEO of Health Net), Tim Bensley as CFO (former CFO of
Blue Apron) and Girish Venkatachaliah as CTO. Agilon health was able
to go public on the New York Stock Exchange in April 2021 and gener-
ated a 43 times gross multiple for Clayton, Dubilier on its investment.

New strategy

One of the ways for a PE firm to increase growth in portfolio companies

is by helping to implement a new strategy. This commonly includes intro-
ducing new products and services or expanding to new geographies. In
order to do this, PE firms often specialize in particular industries and
hire experienced operators. Almost half of the PEI award submissions
in 2021 reported implementing a new strategy while almost one-third
reported initiating a geographic expansion. Arbor Investments’ experi-
ence with Rise Bakers illustrates the point. Arbor is a PE firm focused
154 Advanced Introduction to Private Equity

on the food and beverage industry. The firm highlights its focus on
operational engineering by touting that 60% of professionals are in non-
finance roles.8 These professionals have deep industry domain expertise
and focus on issues that are critical for these types of companies. Ten of
Arbor’s prior investments had been in bakeries, and this deep domain
expertise has been particularly important in helping to drive value.9 In
2013, Arbor helped create Rise Bakeries through the consolidation of five
regional bakeries into one large North American company with a suite of
products for in-store retailers and food service operators. Arbor invested
in R&D so the company could create and offer new products with a
primary focus on frozen cookie dough.10 The company also focused
on the large in-store bakery market and quickly dominated the space.
Those changes helped Rise add new national customers like WalMart
and Costco that would have been hard to approach as a regional bakery.
When Arbor eventually exited their investment in Rise through a sale to
Olympus Partners, they ended up earning 7.2 times their money on the
investment.

Even in complex service industries, PE can bring substantial value by

helping portfolio companies implement new strategies. For example,
Apollo Global Management bought budget regional passenger airline,
Sun Country Airlines, in 2017 and turned it into a “hybrid low-cost air
carrier that dynamically deploys shared resources across our synergistic
scheduled service, charter and cargo businesses.”11 Apollo undertook the
upgrading of the aircraft fleet by purchasing used planes, a strategy that
increased during the COVID-19 pandemic. Similarly, Apollo helped Sun
Country negotiate a cargo agreement with Amazon in 2019 that lead to
dramatic increases in revenues.12 Apollo also helped Sun Country move
to offer charter flights for college sports teams and other leisure travelers.

IK Investment Partners’ buyout of Transnorm in 2014 further illustrates

how changing strategy and target market can dramatically improve
performance.13 Transnorm is an automation business that provides sys-
tems for the transportation and delivery of goods. Prior to the acqui-
sition, airline baggage systems were a heavy emphasis at the company.
Major freight carriers like UPS, DHL and FedEx were also customers as
were e-commerce companies like Amazon and Alibaba. A key element
of IK’s investment strategy was to reposition the firm to focus primar-
ily on e-commerce and parcel delivery. This change in strategy necessi-
tated an investment in new product development that helped drive those
 Operationalizing operational engineering 155

customers. Similarly, the primary market prior to IK’s investment was

the European Union. Over the next four years, Transnorm made major
expansions in both North America and the Asia/Pacific region. The
strategy grew Transnorm’s market share by 50% and led to the sale of the
company to Honeywell for €425 million. IK generated a gross multiple
on its investment of 6.0 times over four years.

Technology upgrade

Another strategy that PE firms employ is to help their portfolio com-

panies upgrade the companies’ technology or help with digital trans-
formation. Cloud-based software, AI and new B-2-B SaaS tools have
transformed many industries, and PE investors have specialized internal
teams that help companies implement these tools. PE firms invested in
such technology upgrades in more than 40% of the 2021 PEI award port-
folio company nominees. The importance of implementing technology
is illustrated by Rockwood Equity Partners’ September 2000 buyout of
Hanson Manufacturing, a small manufacturer of military heaters and
air filtration units based in Cleveland.14 When Rockwood co-founders,
Brett Keith and Owen Colligan, purchased Hanson, the company did not
have an inventory management system, instead having nearly a year’s
worth of work in progress and raw material inventory. Similarly, Hanson
had limited use of message and communication tracking, including basic
technology like voice mail. Implementing these changes dramatically
improved communication and cash flows. Inventory levels shrank by
75%, dramatically reducing the company’s working capital needs.

Similarly, New Mountain’s investment in Equian, a healthcare payment

integrity provider, demonstrates the ability to accelerate company and
industry changes. In 2019, New Mountain was awarded Buyouts overall
deal of the year for its investment in Equian. New Mountain purchased
the company in December 2015 and merged it with Trover Solutions.15
New Mountain helped Equian invest heavily in technology that ensures
that health insurers pay the right claims with the appropriate level of reim-
bursement, thereby avoiding overpaying for covered medical expenses.
The company processes more than $500 billion in healthcare claims a
year. New Mountain sold Equian to United Healthcare in 2019 for $3.2
billion, which provided New Mountain with a gross multiple on invested
capital of 8.3 times and an IRR of 79%.
156 Advanced Introduction to Private Equity

Sales reorganization/go to market

As we saw earlier, PE firms focus on increasing portfolio company rev-

enues, noting that top-line growth is the most important source of value
for PE-backed portfolio companies. One way to do this is to improve the
sales function at portfolio companies. This might involve reorganizing
the sales force or changing how the company goes to market. Similarly,
PE firms may help portfolio companies access new market segments or
innovate their products and services. Consistent with this, over 50% of
the 2021 PEI award entries mentioned sales reorganization or a change
in go to market strategy as an important source of value. For example,
in addition to the other changes mentioned earlier, Arbor helped Rise
change its sales team structure and sold to retailers resulting in major
new contracts with chains like Walmart and Costco.

Similarly, Riverside’s 2014 acquisition of Censis Technologies, a provider

of SaaS-based surgical instrument tracking and workflow solutions for
sterile processing departments (SPDs) of hospitals, demonstrates how
PE firms can accelerate the sales function within portfolio companies.16
Riverside implemented and aided an expansion of the sales and market-
ing function within Censis. The PE firm also led the add-on acquisition
of Applied Logic in 2018 which expanded Censis’s offerings.17 These
changes allowed the company to quadruple the number of hospitals it
served and led to a successful exit in November of 2019 when the com-
pany was sold to Fortive.

Valor Equity Partners worked with Tesla to design Tesla’s unusual and
innovative direct sales model and process for selling the Tesla Roadster.18
This included designing a sales system to maximize test drives, identify-
ing the right type of salesperson, designing a training program for those
salespersons and reducing the brick-and-mortar dealership footprint.

New products and services

Another way to increase revenues is to introduce new products. Roughly

one-half of the PEI award entries highlighted that the companies and
PE firms had introduced meaningful new products. For example, in
Riverwood’s investment in Hanson Manufacturing, Keith and Colligan
helped the company hire three Ph.D. engineers who helped the company
 Operationalizing operational engineering 157

develop and market new, more advanced units that successfully com-
peted for a variety of military programs.19

As mentioned earlier, Arbor and Rise invested heavily in new baking

products. Apollo and Sun Country added cargo operations in addition
to its passenger airline business. L Catterton and Peloton added “broader
content and equipment options for subscribers and commercial custom-
ers.” Riverside and Censis introduced new modules and new functional-
ity to its software.

Better marketing and branding

Better marketing can go hand in hand with improvements in sales. In

retail settings, this can be critical to a turnaround. Bain Capital’s invest-
ment in Outback Steakhouse shows the importance of this type of activ-
ity.20 Under operating partner Mark Verdi’s guidance, Bain’s retail team
examined how Outback was advertising and determined that there
was insufficient “call-to-action” in Outback’s promotions. Historically,
Outback had crafted an image as a restaurant for special occasions. The
Bain marketing team saw an opportunity to grow revenues by build-
ing the image of the restaurant as “an everyday” establishment. Along
with the pricing and portfolio changes discussed above, Bain was able
to drive greater foot traffic to the restaurants and dramatically improve
performance.

Operating improvements

Private equity firms also help create value by improving operations or cut-
ting costs. Such improvements/reductions can come from improving man-
ufacturing, supply chain and procurement. Almost 40% of the PEI award
entries cited such improvements as important sources of value. In the
example of Hanson Manufacturing discussed above, Keith and Colligan
implemented reorganized manufacturing around the Japanese kaizen
model of continuous improvement, and sales expanded dramatically. These
improvements led to a sale of Hanson to Behrman Capital in 2004 for $93
million, a return of nearly 40 times their invested capital. Over the four
years that Rockwood owned Hanson, revenues grew from $21 million to
$55 million, and EBITDA grew from $1.5 million to over $8 million.21
158 Advanced Introduction to Private Equity

TPG’s 2009 investment in Daphne International, one of the world’s larg-

est shoe manufacturers and retailers, also highlights PE firms’ ability to
transform operations.22 Jin-Goon Kim, a TPG partner who led TPG’s
operating group in China, was TPG’s representative on Daphne’s board.
TPG had made their investment in Daphne via a private investment in
public equity. Daphne’s share price had not performed well and, in 2011,
Jin-Goon and TPG successfully transformed Daphne into the world’s
first fast-fashion shoe retailer. Fast fashion had become a major theme
within retail during the 2000s, yet it had not been implemented in the
shoe space. The transformation of Daphne included substantial changes
to the entire supply chain and manufacturing infrastructure of Daphne.
Daphne reduced initial store orders by 69% and was able to identify the
best sellers within a few weeks. The transformed supply chain then was
able to restock the best sellers quickly. Over the next two years, the stock
price of Daphne International increased from around ¥6 per share to
more than ¥11 per share.

Valor Equity Partners used the manufacturing expertise of its operat-

ing group to help Tesla reduce the cost of the Roadster. 23 Valor was
instrumental in redesigning the supply chain, in particular, moving
Tesla’s battery facility to the US. Valor Partner and Head of Operations
Timothy Watkins and his team were instrumental in providing direc-
tion to Tesla as it sought to expand its battery supply chain. Initially,
the battery packs were manufactured in Asia using low-cost labor. The
packs were then shipped to Tesla’s manufacturing partner in Europe.
Cars were then manufactured in the UK and shipped to the US.
Watkins and his team realized that scaling this supply chain at vol-
ume would be complex and expensive. Hence, Valor advocated mov-
ing the entire supply chain, including manufacturing batteries, to the
US. These changes led to a substantial supply and cost advantage for
Tesla in the race to supply high quality, yet affordable electric vehicles.

Acquisitions
It is very common for private equity firms to invest in one portfolio com-
pany, sometimes called a platform, and then make add-on acquisitions,
i.e., investments in other companies in the same industry. Sometimes
the acquired companies provide additional capabilities to the platform
company. Sometimes, the acquired companies provide entries to new
geographies. And sometimes, the acquired companies have overlapping
operations or employees that the combined company can eliminate.
 Operationalizing operational engineering 159

Roughly 40% of the PEI award entries noted acquisitions as an important

source of value creation.

The acquisition of Hanson Manufacturing by Rockwood Capital, dis-

cussed above, also illustrates the value that can be created through
“bolt-on” acquisitions.24 Keith and Colligan identified several synergistic
acquisitions that could extend Hanson’s product line. In August 2001,
they acquired a specialized military heater manufacturer that added
$12.5 million to annual revenues. They added a second manufacturer of
military heaters in September 2002 that added an additional $4 million
in annual revenue. Finally, Keith and Colligan purchased a company that
had developed advanced technology for specialized nuclear, biological
and chemical (NBC) filtration and hired the company’s co-founder and
Chief Scientist to upgrade the Hanson team. These product line exten-
sions were critical for growing the underlying revenue and profits of the
firm and facilitating the exit to Behrman Capital in 2004.

A version of the acquisition strategy that a number of PE investors pur-

sue is a roll-up strategy. In this strategy, a platform company grows a
business by purchasing small players in a highly fragmented industry to
achieve economies of scale as well as potential increases in liquidity and
exit multiples. Housatonic Partners’ investment in Archive One illus-
trates the success of that strategy. Will Thorndike, founder and manag-
ing director at Housatonic Partners, identified Archive One, founded by
A. J. Wasserstein in 1998, as a potential investment in the records storage
space.25 The records management industry at the time was dominated by
two large industry players, but a large number of small players existed.
Wasserstein realized there was an opportunity to create a third player
by rolling up these smaller mom-and-pop shops. Housatonic invested in
1998, and Archive One proceeded on a path of rapid acquisition. Over
the next six years, the company purchased 16 small records storage com-
panies and substantially grew the revenues and profits of the company.
Revenues grew from just under $2 million in 1998 to nearly $21 million
in 2004. EBITDA grew from $200 000 to $4.8 million. In 2004, ABRY
Partners provided follow-on capital that accelerated the growth. In 2007,
Archive One was sold to Iron Mountain.

Optimized pricing
Private equity firms increasingly include or enlist the help of pricing
experts to determine whether their portfolio companies are pricing
160 Advanced Introduction to Private Equity

their offerings optimally. Eleven percent of the PEI award entries men-
tioned change in pricing strategy as an important value creation lever.
This often means raising prices, but not always. The purchase of Outback
Steakhouse by Bain Capital and Catterton in November 2006 illustrates
the dramatic improvements that this can engender.26 Mark Verdi led
Bain’s operations team to implement a variety of pricing and promo-
tion changes that dramatically improved profitability. First, Outback had
historically been unwilling to offer promotional prices, fearing it would
reduce profitability. Bain’s team determined that promotions on vari-
ous days of the week could drive increased traffic into the restaurants.
Second, by analyzing plates that were cleared from tables after customers
left, Bain’s team determined that a significant number of customers were
leaving food, i.e., Outback’s portions were generally too large. Outback
reduced portion sizes and increased profitability.

Apollo’s acquisition of Sun Country also illustrates the interplay of oper-

ating improvements and improved pricing strategy.27 With Apollo’s assis-
tance in raising additional financing, Sun Country switched from leasing
aircraft to ownership, reducing overall costs of assets and improving prof-
itability. Unit costs declined by 20% which allowed Sun Country to lower
fares by an average of 43% and increase overall revenue by 25% through
increased load capacity. Investments in new information technology also
allowed Sun Country to initiate a variety of new pricing models includ-
ing checked baggage charges and upgrade fees. These changes resulted in
an increase in ancillary revenue per passenger of 60%.28

Conclusion

In this chapter, we have seen that most private equity firms incorporate
operational engineering in addition to financial and governance engi-
neering. The PE firms employ a host of different operational engineer-
ing strategies to increase value in their portfolio companies. This active
involvement in the companies in which they invest facilitates improve-
ments in operating performance. Over time, PE firms have become
increasingly focused on implementing operational improvements. We
have provided examples of the different ways PE firms can improve the
performance of their portfolio companies. Given the dramatic growth
in assets under management in the private equity industry, this trend
almost certainly will continue.
 Operationalizing operational engineering 161

Notes
1 P.A. Gompers, S. N. Kaplan and V. Muhkarlyamov, 2020, Private Equity
and Covid-19, Harvard Business School Working Paper.
2 P. Cziraki and D. Jenter, 2021, The Market for CEOs, London School of
Economics Working Paper.
3 P.A. Gompers, S.N. Kaplan and V. Muhkarlyamov, 2022, The Market For
CEOs: Evidence From Private Equity, University of Chicago Working
Paper.
4 S. Kaplan and M. Sorensen, 2021, Are CEOs Different? Characteristics of
Top Managers, Journal of Finance 1773–811.
5 S. Kaplan, M. Klebanov and M. Sorensen, 2012, Which CEO Characteristics
and Abilities Matter, Journal of Finance 973–1007.
6 P.A. Gompers and M. Roberts, 2014, Ardian – The Sale of Diana, Harvard
Business School Case Number 9-215-033.
7 www​.pri​vate​equi​t yin​tern​ational​.com​/opex​-awards​-21​-americas​-lower​-mid​
-market​-winner​-clayton​-dubilier​-rice/ accessed on 8 February 2022.
8 www​.arborpic​.com​/our​-approach/ accessed on 3 February 2022.
9 www​.arborpic​.com​/news​/arbor​-investments​-gobbles​-bakery​-cos/ accessed
on 4 February 2022.
10 www​.arborpic​.com​/news​/rise​-baking​-co​-and​-cookie​-kings/ accessed on
4 February 2022.
11 IPO Prospectus, 16 March 2021.
12 K. Broughton, 2021, Sun Country Looks to Buy Used Planes at Pandemic
Discount, Wall Street Journal.
13 PEI Operational Excellence Awards 2019, www​.peievents​.com​/en​/wp​-con-
tent​/uploads​/2019​/06​/PEI179​_OpExOCT19​.pdf accessed on 2 February
2022.
14 P.A. Gompers and V. Broussard, 2009, Hudson Manufacturing, Harvard
Business School Case Number 9-203-064.
15 www​ . buyoutsinsider​ . com​ /deal​ - of​ - the​ -year​ - new ​ - mountain ​ - capital/
accessed on 4 February 2022.
16 www​.riversidecompany​.com ​/select​-growth​-stories​/censis​-technologies/
accessed on 8 February 2022.
17 www​.pri​vate​equi​t yin​tern​ational​.com​/opex​-awards​-winner​-americas​-riv-
erside​-company​-censis​-technologies/ accessed on 8 February 2022.
18 See Kaplan et al. (2017).
19 P.A. Gompers and V. Broussard, 2009, Hudson Manufacturing, Harvard
Business School Case Number 9-203-064.
20 P.A. Gompers, K. Mugford and J.D. Kim, 2012, Bain Capital and Outback
Steakhouse, Harvard Business School Case Number 9-212-087.
21 P.A. Gompers and V. Broussard, 2009, Hudson Manufacturing, Harvard
Business School Case Number 9-203-064.
22 V. Ivashina, 2012, TPG China: Daphne International, Harvard Business
School Case Number 9-213-055.
23 https://turnaround​.org​/chicagomidwest​/tesla​-investor​-valor​-equity​-part-
ners​-addresses​-ctpctas​-luncheon accessed on 2 February 2022.
162 Advanced Introduction to Private Equity

24 P.A. Gompers and V. Broussard, 2009, Hudson Manufacturing, Harvard

Business School Case Number 9-203-064.
25 M.J. Roberts and N.N. El-Hage, 2006. Housatonic Partners and ArchiveOne,
Inc., HBS Case number 9-806-193.
26 P.A. Gompers, K. Mugford and J.D. Kim, 2012, Bain Capital and Outback
Steakhouse, Harvard Business School Case Number 9-212-087.
27 www​.pri​v ate​e qui​t yin​t ern​ational​.com​/opex​-awards​-21​-americas​-upper​
-mid​-market​-winner​-apollo​-global​-management/ accessed on 8 February
2022.
28 www​.pri​v ate​e qui​t yin​t ern​ational​.com​/opex​-awards​-21​-americas​-upper​
-mid​-market​-winner​-apollo​-global​-management/ accessed on 8 February
2022.
8 Private equity exits

Private equity (PE) investments are typically executed through closed-

end funds in which the PE manager serves as the general partner (GP)
and investors in their funds, such as pension funds and endowments,
serve as limited partners (LPs). As we will discuss in Chapter 9, funds
are typically 10 years in length although extensions are typically per-
missible and common.1 The funds’ limited life means that PE managers
need to assess, plan and execute exits for portfolio companies. The most
common exits include going public through a traditional underwritten
initial public offering (IPO), being acquired by a strategic buyer, being
acquired by a financial buyer and, more recently, merging with a special
purpose acquisition company (SPAC). This chapter discusses the process
and considerations that affect the timing and manner in which private
equity firms exit their investments. We also explore trends and factors
that affect the types of exits PE managers choose and how it affects the
returns that PE funds can generate.

Exit alternatives
Traditional IPOs
One exit path for a PE manager to pursue is an initial public offering
(IPO), the process of selling shares to the public for the first time. By
going public, companies are able to gain better access to capital, which
growth-stage companies need for expansion, and liquidity, which PE
managers need to provide returns to their respective LPs.

To be a credible candidate for a traditional underwritten IPO, it is con-

ventional wisdom that a PE portfolio company needs somewhat pre-
dictable revenue, historically positive profits, expectations for growth

163
164 Advanced Introduction to Private Equity

in revenues and profits, a public company-ready management team and

robust financial and compliance controls.

The attractiveness of an IPO relative to other forms of exit depends on

several considerations. The first is valuation. There are times when IPOs
have higher valuations than either strategic or financial sales. The sec-
ond is the need for liquidity. IPOs are usually a first step to liquidity, but
do not generate immediate liquidity. They are typically time consuming,
often taking up to a year to complete. Then, PE firms sell only a small por-
tion of their stake in the IPO. They continue to hold the majority of their
equity holdings for an extended period of time. As a result, IPOs leave PE
firms exposed to the risk of a significant decline in firm value as well as
decreasing the ability of PE firms to time exits to coincide with peaks in
valuation. Of course, the PE firm will benefit if the value increases. Third
is the burden of disclosure requirements. Some firms and management
teams are more willing to weather the disclosure requirements of becom-
ing a public company and the other costs associated with being a public
company.

When a portfolio company decides to go public, the process begins with

selecting an investment bank to serve as a lead underwriter for the offer-
ing as well as choosing additional underwriters. The lead underwriter
manages the deal. In addition to providing advice and helping with all
the necessary filing requirements, the lead underwriter is ultimately
responsible for setting the valuation of the company at issuance, making
the market for the firm’s shares after the offering and ensuring that the
company can sell its listed shares, at the offer price.

To do its job, the underwriter uses a “book building” process. First, it

works with the company to prepare projections and valuation analyses
that help determine an initial price range for the offering. The under-
writer relies on both discounted cash flow analyses and comparable com-
panies’ analyses to determine the preliminary filing range.

Next, the company’s senior officers go on a roadshow with the under-

writer to promote the company to institutional investors. At the end
of the roadshow, the underwriter receives indications of interest from
investors and adjusts the offer price based on investors’ stated demand
for the offering.
 Private equity exits 165

The lead and other underwriters then purchase shares from the listing
company and sell them to investors on the day of the stock’s debut. To
protect themselves against a loss and ensure market liquidity, underwrit-
ers at times exercise a “greenshoe provision,” which allows them to sell
up to 15% additional shares at the offer price. Underwriters usually sell
more shares in the offering than the company has allotted in the offer-
ing, i.e., they are naked short. If the price of the IPO goes up in the initial
aftermarket and stays above the offering price, the underwriter covers
their short position by exercising the greenshoe option. The lead under-
writer typically has 30 days in which to exercise the greenshoe option.
If the IPO trades down in price, the underwriter covers its naked short
position by purchasing shares in the open market. These open market
purchases have the effect of stabilizing the IPO share price. In return for
their work in bringing companies public, underwriters are paid a fee,
called an “underwriters’ spread,” typically 5% to 7% of the offering size.2

The risk of subsequent price movements is exacerbated by the fact that PE

firms are generally not permitted to divest any of their equity holdings
in the first 180 days following the IPO. This period of time is referred
to as the IPO lockup. When the issuing firm and the investment bank
enter into an agreement to offer securities in an IPO, they sign an under-
writer agreement. As Bartlett (1995)3 explains, these agreements typi-
cally include a covenant such as:

The Selling Securityholders agree that, without your (the investment bank’s)
prior written consent, the Selling Securityholders will not, directly or indi-
rectly, sell, offer, contract to sell, make any short sale, pledge or otherwise
dispose of any shares of Common Stock or any securities convertible into
or exercisable for or any rights to purchase or acquire Common Stock for a
period of 180 days following the commencement of the public offering of the
Stock by the Underwriters.

The lockup is meant to give confidence to IPO investors that pre-public

insiders are not going to take advantage of inside information and sell at
an inflated price. The lockup also allows the investment bank underwrit-
ing the offering to control the public float. The agreement to not sell or
sell-short their equity holdings is written into the underwriting agree-
ment and is imposed by the investment bank, not the SEC or state secu-
rities laws that regulate insider trading.4 Typically, when a firm’s equity
comes off of lockup, the stock price experiences a significant stock price
166 Advanced Introduction to Private Equity

decline, even though the date is fully known and the expiration is fully
anticipated.5

In addition, insider trading is likely to be regulated by the firm itself,

most of which impose trading windows for insiders. A large proportion
of IPO companies have a policy in place restricting insider trading by
employees as well as pre-specified blackout periods in which the com-
pany prohibits trading by insiders. Insiders who are governed by these
self-imposed company restrictions are sometimes granted permission to
trade during the blackout periods for liquidity or diversification reasons.

Even after the lockup expires, PE managers will often continue to hold
the shares in the company for months or even years. Once they decide to
liquidate their positions, there are two alternatives. First, the PE manag-
ers can sell the shares they hold on the open market or in a secondary
stock offering and distribute cash to limited partners. Alternatively, the
PE managers distribute shares to each limited partner and (frequently)
themselves. There are several factors that influence this decision.6

First, SEC rules restrict sales by corporate insiders. The sale of restricted
securities, that is, stock purchased in a private placement directly from
an issuer before the company is public, is governed by SEC Rule 144.
Rule 144 allows for the sale of restricted securities in limited quantities
in the aftermarket. Specifically, a person who has beneficially owned
shares of common stock for at least six months (one year if the firm is not
subject to reporting requirements) is entitled to sell, within any three-
month period, a number of shares that does not exceed the greater of 1%
of the number of shares of common stock then outstanding or the aver-
age weekly trading volume during the four calendar weeks preceding the
filing of a notice on Form 144 with respect to the sale.

Because the private equity fund may hold a large fraction of the com-
pany’s equity, selling the entire stake may take a long period of time. By
distributing shares to limited partners who are usually not considered
insiders, the private equity fund can dispose of a large block of shares
more quickly.

Second, tax motivations may also provide an incentive for the private
equity managers to distribute shares. If they sell shares and distribute
cash, taxable limited partners (e.g., individuals and corporations) and
 Private equity exits 167

the private equity managers themselves are subject to immediate capi-

tal gains taxes. These investors might prefer to postpone these taxes by
receiving distributions in kind and selling the shares at a later date. These
considerations will be unimportant to tax-exempt limited partners (e.g.,
pension funds and endowments). By distributing stock, private equity
funds provide limited partners with the flexibility to make their own
decisions about selling the stock.

Third, if selling the shares has a negative effect on prices, private equity
funds may want to distribute shares. The method of computing returns
employed by private equity funds typically uses the closing price of the
distributed stock on the day the distribution is declared. The actual
price received when the limited partners sell their shares may be lower.7
Private equity managers care about stated returns on their funds because
they use this information when they raise new funds. Thus, the potential
price pressure from selling the shares on the open market will typically
lower the value that they can quote compared to the value they can claim
if they distribute the shares directly.8

Finally, the private equity managers’ compensation can be affected by dis-

tribution policy. Carried interest payments – usually equal to 20% of the
profits of the fund – will be higher the higher the stated return to the fund.

Few SEC regulations cover distributions by private equity investors. Rule

16(a) states that individuals who are affiliates of a firm, such as direc-
tors, officers and holders of 10% of the company’s shares, must disclose
any transactions in the firm’s stock on a monthly basis. Provision 16(a)-7,
however, explicitly exempts distributions of securities that (1) were origi-
nally obtained from issuers and (2) are being distributed “in good faith,
in the ordinary course of business.” An interpretation widely accepted
within the industry is that private equity managers distribute invest-
ments in the normal course of business, and that they do not convey any
information unless the private equity manager makes an explicit recom-
mendation to hold or sell the shares at the time. Private equity lawyers
have applied the same principles when considering the applicability of
Rule 10(b)-5, the most general prohibition against fraudulent activity in
the purchase or sale of any security.

When one examines the price reaction around the distribution date,
i.e., the date that the private equity manager distributes shares to their
168 Advanced Introduction to Private Equity

limited partners, the evidence is consistent with the market reacting to

the inside information of the private equity fund: there is a systematic 2%
to 3% drop around the distribution that is akin to the reaction to public
announcements of secondary stock sales even though private equity dis-
tributions are not publicly disclosed.9

Regulatory and compliance costs associated with traditional IPOs mean-

ingfully increased as a result of the Sarbanes-Oxley Act of 2002. These
costs, typically estimated to be several million dollars annually, have
increased the minimum threshold in terms of market capitalization.
Similarly, the increase in the share of the market owned by institutional
investors has also increased the minimum size of IPOs. These changes
likely have reduced the number of IPOs compared to the 1990s.

Finally, insiders often objected to the large share price increase on the
first day of trading. Studies with data back to 1980 showed that, on aver-
age, IPO shares increased by 20% on their first day of trading.10 This led
many commentators to suggest that underwriters underpriced listing
shares intentionally and left value on the table for the companies they
represented, i.e., firms felt as if they could have raised more capital by
selling the same number of shares at a higher price. Taking the first day
underpricing into account can markedly increase the total cost of tradi-
tional IPOs.

One proposed path of reform is direct listings, which Spotify and Slack
undertook in 2018 and 2019, respectively. Direct listings differ from
traditional IPOs in that no new stock is issued in an offering. By con-
trast, existing shareholder stock is auctioned on a public exchange. As a
result, there is also no 180-day lockup period for existing investors and
underwriters were not needed to engage in the book building process.
Instead, companies hired capital advisors to communicate with institu-
tional investors, offer forward-looking guidance in advance of trading
and declare a reference price together with the hosting stock exchange.
Proponents for direct listings argued they were cheaper, faster, more
transparent and captured more value for the listing company.

The IPO of Globant demonstrates the value that PE firms can realize by
taking firms public. Globant was founded in 2003 by Martin Migoya,
Guibert Englebienne, Néstor Nocetti and Martin Umaran in Argentina
to focus on outsourced software development.11 In 2007, Francisco
 Private equity exits 169

Alvarez-Demalde, a co-founder of Riverwood Capital, led an investment

in Globant. Riverwood was a growth-stage PE firm that targeted tech-
nology investments in North and South America. Riverwood followed
on with two additional investments in Globant in 2007 and 2011, rais-
ing their ownership stake to 39%, and investing a total of $20.8 million
across all three rounds. Over the next six years, revenue grew from $22.8
million in 2007 to nearly $129 million in 2012. While significant growth
potential existed, Riverwood’s investment in Globant had been made in
its first fund which, by 2013, was fully invested. Taking Globant public
would provide the opportunity for Riverwood to demonstrate its invest-
ment prowess while retaining the public shares of Globant, which it
believed could continue to appreciate. Starting in 2013, Alvarez-Demalde
and the Globant founders prepared to take the company public and, on
18 July 2014, Globant raised $59 million at $10 per share, in an IPO. The
shares increased 10.2% on the first day of trading and the company had
a market capitalization of roughly $400 million at the market close.
Riverwood held onto its shares after the IPO and could revalue those
shares at the public market value, booking nearly an eight times return
on its investment. Based upon the success of Globant as well as another
Riverwood investment (GoPro), the PE firm was able to successfully raise
its second fund at $378 million.

SPACs

In recent years, special purpose acquisition companies, or SPACs for

short, rose in popularity as potential mechanisms for private firms to go
public.12 SPACs, which have been around for decades and historically have
had bad reputations, are blank check companies formed for the purposes
of finding and merging with a private business, thereby bringing it public.
Between 2018 and 2020, SPACs exploded as a means of taking private
companies public. While in 2018 there were 34 SPACs raising $6.4 bil-
lion, in 2020 there were 219 raising $72 billion, outpacing even traditional
IPOs by more than $6 billion. SPACs had gained so much traction so
quickly in the tech industry that commentators had begun labeling their
growth a bubble. (See Table 8.1 for SPAC funding over time.) Consistent
with that, their popularity has declined precipitously since 2022.

SPACs have five core steps. In the first, a SPAC is formed by issuing stock
(to the public) and raising capital at $10 per share in an IPO. The median
170 Advanced Introduction to Private Equity

Table 8.1 Number of SPAC and Operating Company IPOs

Year Number of IPOs Total Proceeds ($m) Average Proceeds ($m)
SPAC Operating SPAC Operating SPAC Operating
2010 2 91 104 29 822 52 328
2011 6 81 451 26 967 75 333
2012 9 93 475 31 112 53 335
2013 10 158 1 325 41 565 132 263
2014 11 206 1 555 42 200 141 205
2015 20 118 3 620 22 000 181 186
2016 13 75 3 224 12 518 248 167
2017 34 106 8 996 22 979 265 217
2018 46 134 9 935 33 467 216 250
2019 59 112 12 115 39 182 205 350
2020 248 165 75 300 61 900 304 375
Total 458 1 339 117 099 363 711 256 272
Source: Minmo Gahng, Jay Ritter and Donghang Zhang, 2021, SPACs, University
of Florida Working Paper

IPO proceeds for the 2019–20 SPAC cohort were $220 million. Second,
the SPAC then has up to two years to search for and negotiate with an
acquisition target. In the third step, a merger target is identified, a trans-
action is agreed to and IPO shareholders decide whether to exercise their
redemption rights (i.e., forcing the SPAC to repurchase their shares at $10)
or not. At the same time, in a fourth step, the SPAC lines up additional
capital in the form of a “private investment in public equity” (PIPE) to
replace the cash that will be used to pay back shareholders who exercise
their redemption rights. Finally, a SPAC merges with the target company,
bringing it public. (See Figure 8.1 for the SPAC process and timeline.)

A SPAC is created by a sponsor. The majority of sponsors are private

equity funds or senior officers of the world’s largest publicly listed com-
panies. Sponsors work with underwriters to bring SPACs public. Prior to
the IPO, sponsors purchase SPAC shares or warrants as part of a commit.
This commit serves primarily to cover the underwriting fees of the IPO
and all operating costs that are incurred during its search for an acquisi-
tion target. In addition, sponsors are allocated a sponsor’s promote, or
Source: PWC Accounting Advisory, Typical SPAC Timeline, https://www​.pwc​.com​/us​/en​/services​/audit​-assurance​/accounting​-advisory​/
spac​-merger​.html, accessed March 2021

Figure 8.1 Typical SPAC Timeline

Private equity exits 171
172 Advanced Introduction to Private Equity

10% to 20% of post-IPO equity. Sponsors, therefore, end up with 10% to

20% of the SPAC for relatively little money.

Over the next two years, sponsors have to find an appropriate acquisi-
tion target, convince existing shareholders to stay on through the merger,
bring in required new PIPE investors and close the merger successfully.
The promote serves as compensation for their efforts throughout this
process. After a successful merger, agreements usually lock up a spon-
sor’s holdings for one year. A recent study examined the performance
of SPACs and the return to various stakeholders.13 In the same research,
sponsors experienced a mean return on their investment in the SPAC of
393% and a median return of 202% when performance was measured
after three months post-merger.

One apparent benefit of a SPAC for the private company target is that
companies seeking to go public view the SPAC process as being less
costly than a traditional IPO. To bring a SPAC public, underwriters are
paid 2% of proceeds on average from the sponsor’s commit. Only upon a
successful merger are underwriters paid an additional 3.5%. For under-
writers, SPACs have an advantage over IPOs that seems to justify the
reduced fee structure. Underwriters are common targets for shareholder
lawsuits in traditional IPOs. But because there is little to disclose at the
IPO of a SPAC, they are generally protected from Section 11 liability. In
fact, there has not been a single lawsuit filed against SPAC underwriters
in the past decade. However, while underwriting fees seem more ame-
nable, most SPAC IPO investors exercise their redemption rights when
the sponsor proposes a merger candidate. Gahng et al. (2021) evaluate
this SPAC mechanism and conclude that the actual median underwrit-
ing fee was 16.3% for SPACs, based on the amount of capital that actually
remained with the company post-merger. Underwriters can also be paid
additional fees to help secure PIPE investors needed to move ahead with
a successful merger.

SPACs are sometimes referred to as “poor man’s private equity,” in which

average investors can participate actively in wealth creation. However, by
2020, 70% of SPAC IPO funding came from a group of hedge funds known
as the SPAC Mafia – those hedge funds that held at least 100 000 shares
in 10 different SPACs that went public between 2010 and 2020. SPAC IPO
proceeds are placed in a trust and invested in Treasury notes for two
years. As compensation for the illiquidity and as an incentive to make the
 Private equity exits 173

IPO investment, SPAC shareholders are given redemption rights. These

redemption rights allow SPAC shareholders to redeem their shares at the
IPO price ($10 per share) plus accumulated interest when a merger is pro-
posed. As an added incentive to put their money into a SPAC, SPAC IPO
shareholders are given warrants and rights. Warrants are call options
created by a SPAC company for new stock. The warrants and rights do
not expire even after SPAC IPO shareholders exercise their redemption
rights, i.e., even if they redeem their IPO shares for $10 plus accrued
interest, they continue to hold onto their warrants.

While sponsors offer private deals and discounts to keep existing SPAC
IPO shareholders invested through the merger, the majority take advan-
tage of their redemption rights. Klausner and Ohlrogge (2020)14 find that
the median redemption rate, or rate at which SPAC IPO investors opted
to exercise their redemption rights, was 73% for the 2019–20 merger
cohort. Of those who redeemed, the divestment rate, or the percentage
of a position an entity divested, was 98%. Combining the redemptions
and the warrants, the mean annualized return for redeeming SPAC IPO
shareholders was 11.6% for what was essentially a risk-free investment
(Gahng et al. (2021)).

PIPEs are another key piece of the typical SPAC as well as a potential
advantage of the SPAC over a traditional IPO. To replenish the cash lost
when shareholders redeem before the merger, SPACs often need to raise
new capital through the PIPEs. Prospective investors in PIPEs sign non-
disclosure agreements and are provided confidential information that
allows them to do more thorough due diligence, potentially resulting
in more accurate price discovery than what is possible in a traditional
IPO roadshow. Because high-quality PIPE investors also provide a strong
positive signal to prospective public investors, about one-third of PIPE
investors receive discounts of 10% or more relative to the IPO share price.
Gahng et al. (2021) find that PIPE investors provided a median of 24.6%
of total cash delivered to a target at the time of merger. (See Table 8.2 for
SPAC characteristics.)

Private companies merge with SPACs to go public for a variety of rea-

sons. Underwriters typically have criteria in terms of revenues, market
capitalization, profitability and so on, for which companies they take
public in a traditional IPO. Many companies that do not meet those cri-
teria have no other way to become public other than through a SPAC.
174 Advanced Introduction to Private Equity

Table 8.2 Overview of SPAC Characteristics

Median 25th Percentile 75th Percentile
IPO proceeds (USD mn) 220 141 328
Redemptions (% IPO 73 18 95
proceeds)
Total cash delivered to target 151.6 26 353
in merger (USD mn)
Cash to target (% IPO 71.5 16 121
proceeds)
Public SPAC investors (% 64.2 28 99
total cash delivered)
Third party PIPE (% total 24.6 0 43
cash delivered)
Sponsor PIPE (% total cash 0 0 11
delivered)
Target post-merger market 501.6 321 955
cap (USD mn)
Post-merger shares (%) held 34.5 24 50
by all SPAC shareholders
(including sponsor)
Post-merger shares (%) held 11.7 6 15
by sponsor
Source: Michael D. Klausner and Michael Ohlrogge, A Sober Look at SPACs,
SSRN Electronic Journal

In addition, going public via a SPAC only requires negotiations with a

single entity, unlike in a traditional IPO where road shows and pricing
meetings typically involve a large number of new institutional investors.
SPACs also have the potential to enable companies to go public faster
than by more traditional methods.

Finally, a point of friction for companies during a book-building process

of a typical IPO is that valuation and share prices are often locked in.
What is not locked in is the amount of capital that will be raised.

SPACs are not without substantial challenges and costs to some of their
stakeholders. While it is suggested that their personal commitments align
sponsors to the performance of a company more closely than underwrit-
ers have been in a traditional IPO, sponsors risk losing everything if
no merger ends up going through. Their chief incentive is therefore a
 Private equity exits 175

commitment to finding any deal, even if mediocre. Because of the pro-

mote, even a losing deal could generate substantial upside for a spon-
sor. Klausner and Ohlrogge (2020)15 find that the dilution experienced
by most SPACs – 50.4% of its IPO proceeds – is staggering and is borne
almost entirely by non-redeeming IPO shareholders and PIPE investors.
The post-merger public market performance of SPACs has also been dis-
appointing in the time periods that followed. Gahng et al. (2021)16 find
that in the three months after a merger, the median SPAC return was
–14.5%, or a performance of –32.5% against returns anticipated for a
company three months after an IPO. Twelve months after SPAC mergers
had gone through successfully, their median return to shareholders join-
ing at the merger was –65.3%. (See Table 8.3 for SPAC returns.)

The merger of Luminar demonstrates how SPACs can facilitate going

public.17 Austin Russell founded Luminar Technologies, an autonomous
vehicle sensor and software company, at the age of 17. Russell spent his
teenage years researching optics and photonics at Beckman Laser Institute
at the University of California Irvine, where he became fascinated with
building laser LiDAR systems used in self-driving cars. In 2012, he incor-
porated the company, graduated high school and later matriculated at
Stanford University to study physics. However, he dropped out after six
months to work on his business full-time after he was awarded the pres-
tigious Thiel Fellowship, a $100 000 grant from Peter Thiel given to stu-
dents to drop out of college.

Luminar Technologies spent its first five years researching and build-
ing out its intellectual property. In May 2013, Russell recruited Jason
Eichenholz, an experienced serial entrepreneur of various photonics
technologies. To finance their ambitious operation, however, Russell soon
turned to professional capital. He first raised funds from the 1517 Fund, a
venture capital firm backed by Peter Thiel. Over time, hedge funds, auto-
motive corporate venture capital funds and other venture funds joined
in. In September 2020, Luminar raised $184 million in a round led by
Alec Gores. While still private, Luminar Technologies raised over $434
million in capital. By the time of the SPAC merger on 3 December 2020,
Luminar Technologies had over 350 employees, 88 issued patents and
80 pending patents in the US or abroad.

Gores Metropoulos, Inc., the SPAC with which Luminar ultimately

merged, went public via an IPO in February 2019, raising $400 million in
Table 8.3 Post-Merger SPAC Returns (2019–20 Merger Cohort)
Three-Month Six-Month Twelve-Month
All HQ Non-HQ All HQ Non-HQ All HQ Non-HQ
Mean return –2.9% 31.5% –38.8% –12.3% 15.8% –37.6% –34.9% –6.0% –57.3%
Median return –14.5% –4.6% –46.9% –23.8% –15.9% –43.0% –65.3% –34.6% –66.3%
Mean return –13.1% 25.1% –53.0% –33.0% 0.4% –63.1% –47.1% –11.8% –74.6%
(excess over IPO
index)
Median return –32.8% 7.1% –52.1% –43.2% –31.0% –56.3% –56.5% –54.8% –89.9%
(excess over IPO
index)
Mean return –1.3% 37.5% –41.9% –10.9% 22.5% –41.0% –21.5% 9.7% –45.7%
(excess over
Russell 2000)
176 Advanced Introduction to Private Equity

Median return –16.1% 16.9% –47.2% –17.5% –2.4% –57.0% –44.9% –36.3% –55.0%
(excess over
Russell 2000)
N SPACs 47 24 23 38 18 20 16 7 9
Source: Michael D. Klausner and Michael Ohlrogge, A Sober Look at SPACs, SSRN Electronic Journal
 Private equity exits 177

proceeds. The SPAC’s sponsors were teams led by Alec Gores and Dean
Metropoulos. Gores was a private equity investor who built his career
making prominent leveraged buyouts of non-core businesses from
Fortune 500 companies. Metropoulos, too, was a private equity investor
who focused on buy-build transactions in the consumer brands sector.
The two had collaborated before in 2016 when Gores had led the merger
of his SPAC with Hostess Brands which had been privately owned by
Metropoulos. Media reports attributed the subsequent explosion of inter-
est in and growth of SPACs to the success that came from that merger.

In late 2020, Gores Metropoulos, Inc. announced that they had found an
appropriate target. The merger included $400 million in cash in a reverse
merger with Luminar Technologies at a market capitalization of $3.4 bil-
lion. This valuation included a contemporaneous financing round of $170
million which was also led by Gores and existing Luminar Technologies
investors. Shortly after that merger, the company was valued at more
than $10 billion with a share price over $40 per share. As of the beginning
of 2022, however, the stock price has declined to roughly $15.

Strategic sales
There are several advantages to a strategic sale relative to other common
PE exits. First, a strategic buyer will often realize synergies from the deal.
These synergies could be elimination of overhead, synergies in selling,
economies of scale and so on. As a result, a strategic acquirer can often
offer a higher price than a public offering or a financial acquirer.

Second, a strategic sale usually offers a complete exit from the investment
at a known price or value. As we have seen, this is not the case with a tra-
ditional IPO or SPAC. Usually strategic sales are all-cash deals. In some
cases, however, the acquirer will offer some or all of the consideration in
the acquirer’s shares. In this case, the PE manager ends up with shares
in a larger, typically public company. Those shares can usually be sold
relatively easily and quickly compared to shares in an IPO or SPAC, but
they do subject the PE seller to some price risk.

Offsetting these advantages are a few disadvantages. In many strategic

sales, the acquirer replaces the top management team and creates syner-
gies by firing employees. For some management teams, who are often sig-
nificant (albeit typically minority) shareholders, this will be unattractive.
178 Advanced Introduction to Private Equity

As a result, those management teams may be less than enthusiastic in the

sales process.

Another downside to strategic sales is that they carry a degree of competi-

tive risk. Potential acquirers need access to the firm’s accounting informa-
tion and other confidential records in order to formulate a bid. While some
firms may show genuine interest, others may simply feign interest in order
to understand any competitive advantages the firm has. Nondisclosure
agreements can mitigate this concern, but cannot eliminate it entirely.

A final disadvantage is that strategic sales can be slow and/or risky to

consummate. When one competitor seeks to acquire another, there can
be antitrust concerns. In the case where these concerns are important,
review of the proposed acquisition by the federal government can slow
the closing of the deal or kill it entirely.

The sale of CelTel, a large sub-Saharan mobile telecommunications pro-

vider to MTC, the Kuwaiti mobile operator, demonstrates the value that can
be achieved through strategic sales by private equity investors. CelTel was
founded in March 1998 by Mo Ibrahim, a former British Telecomm engi-
neer. Over the course of six years, Ibrahim raised over $413 million in pri-
vate equity to build his company. Lead investors included Bessemer Venture
Partners, Zephyr Asset Management and CVC International. In 2004,
CelTel operated in 13 companies and was considering going public when
they were approached by both MTN, a spinout of South Africa’s phone com-
pany, and MTC. In the bidding process, CelTel ultimately accepted MTC’s
offer for $3.4 billion in cash. The sale of CelTel illustrates that synergy value
can be an important driver of achieving high returns. Similarly, the ability to
have multiple bidders was critical to the ultimate sale price for CelTel.

Financial sale
Like a strategic sale, a financial sale has the benefit of providing a com-
plete exit of the investment. Unlike a strategic sale, however, antitrust
concerns are not an issue; so, assuming the new PE firm has lined up the
financing, financial sales can be relatively quick. This can be particu-
larly important for PE firms that need to exit their investments relatively
soon and in the form of cash, particularly deals in funds nearing the end
of their life. Financial sales also eliminate the issue of competitive risk
while often permitting the firm’s current managers to retain their jobs.
The importance of financial sales as an exit has grown considerably over
 Private equity exits 179

the past decades as the private equity industry has continued to grow.
Many portfolio companies are “traded up” from smaller PE managers to
larger PE managers over the course of several buyouts.

The main possible downside of a financial sale is the price. Because a

financial acquirer is unlikely to realize synergies, it may be unable to offer
as high a price as a strategic buyer, holding all else equal. Additionally,
because financial buyers typically rely on significant levels of debt, there
is a possibility that their financing will fall through and scuttle the deal.
In recent years, however, the amount of capital in the PE industry has
grown substantially. It has become increasingly common for smaller pri-
vate equity firms to sell their portfolio companies to larger PE managers.

Rockwood’s purchase of Hanson Manufacturing which we discussed in

Chapter 5 provides a useful illustration. Brett Keith and Owen Colligan
purchased Hanson Manufacturing for $10.5 million in October 2000.
Keith and Colligan were able to implement a large number of operational
changes, performed several bolt-on acquisitions which were financed by
debt and grew sales from $21 million in 2000 to more than $55 million
in 2003. In 2004, Behrman Capital, a middle-market PE firm, bid for and
purchased Hanson for $93 million. Rockwood had paid down the exist-
ing debt to $6 million at the time of the transaction. The deal grew equity
value from $1 million at the time of the purchase in 2000 to $87 million
at the time of sale to Behrman.

More recently, private equity funds have begun exiting investments via
a different kind of sale called a continuation fund/vehicle. Continuation
vehicles are private equity funds set up to invest in a portfolio company
that the PE firm and LPs would like to exit, but the PE firms still believes
is attractive to own. The challenge with continuation funds is managing
the conflict of interest that PE firms face when they are both the seller
and the buyer.

Leveraged dividend recapitalizations

A common and misunderstood form of partial exit is the leveraged divi-

dend recapitalization. In a leveraged dividend recap, the portfolio com-
pany issues new debt to raise cash that is then paid out in the form of a
special dividend to existing shareholders.18 As with other exit strategies,
leveraged dividend recaps have advantages and disadvantages.
180 Advanced Introduction to Private Equity

One benefit is that recaps can provide a significant return to private equity
investors; PE firms can often receive close to their full equity check back.
While this reduces the downside risk of the investment, recaps allow PE
firms to retain the upside as their share of the equity remains unaffected.
Moreover, unlike other forms of exit, the PE firms retain control of the
firm in the case of a recap. Recaps also can be done quickly. They are pri-
vate transactions that require only the permission of the existing lenders
and a willing lender of the new debt. It is worth noting that the lender of
the new debt must believe the loan will be a profitable one.

However, a potential disadvantage is that, by increasing the debt level,

recaps increase the risk of the remaining equity in the firm. Because
recaps are not a full exit and PE firms continue to hold a substantial frac-
tion of the equity, their stake, while smaller following the recap, is riskier.
While this is a consideration, it is important to recognize that companies
typically consider recaps only when they have paid down a meaningful
portion of the debt in the original buyout or when the company’s operat-
ing performance has improved meaningfully. Accordingly, after the debt
in the recap is issued, the company will typically have less debt than it
had in the original buyout and, rarely, will have more.

For example, in 2010, Oaktree Capital took out EUR 195 million from
Nodenia International AG, a German packaging company, through a
dividend funded by cash on hand and a bond issue. This represented more
than Oaktree’s entire original investment. Similarly, in September 2010, SK
Capital took out $922 million from Ascend Performance Materials. It should
be noted that SK Capital put only $50 million into Ascend in June 2009.

Another example of the ability to provide returns through leveraged

dividend recapitalizations is Providence Private Equity Partners (PEP)
portfolio company, World Triathlon Corporation (WTC), that PEP pur-
chased in 2008 for $85 million. WTC owned the Ironman brand and
aggressively grew races over the next several years. In June 2014, WTC
borrowed $240 million ($220 million through a five-year term loan and
$20 million via a revolving line of credit). WTC used $220 million of the
financing to pay a dividend to PEP, which gave PEP more than a two times
return on their initial investment. By taking money off the table, PEP
was able to continue to build WTC and in August 2015, PEP announced
it was selling WTC to Wanda, a Chinese sports conglomerate, for $650
Table 8.4 Fraction of PE Portfolio Targeted at Various Types of Exits
Mean Median Low High Low High Old Young Local Global
AUM AUM IRR IRR
IPO 18.8 11.7 10.9 26.4 23.7 18.9 20.6 17.2 12.1 27.7
Strategic sale 51.0 50.0 57.3 44.8 46.3 51.4 44.2 56.7 57.5 42.3
Financial sale 29.5 30.0 31.8 27.3 29.6 28.1 33.6 26.0 30.4 28.3
Other 0.7 0.0 0.0 1.5 0.5 1.6 1.6 0.0 0.0 1.7
Number of 63 63 31 32 22 23 29 34 36 27
responses
Source: Gompers, Kaplan and Muhkarlyamov (2016)
Private equity exits 181
182 Advanced Introduction to Private Equity

million including the assumption of debt. The deal represented a more

than four times return for PEP over a seven-year holding period.

Factors influencing private equity exits

GKM (2016) provides some insights into what PE managers target and
consider when setting an exit strategy. Table 8.4 indicates that PE inves-
tors expect to exit roughly one-half of their deals through a sale to a stra-
tegic buyer, i.e., to an operating company in a similar or related industry.
In almost 30% of deals, they expect to sell to a financial buyer, i.e., to
another private equity investor. In fewer than 20% of deals do PE inves-
tors expect to exit through an IPO. These percentages are consistent
with, in fact almost identical to, the exit results reported in Kaplan and
Stromberg (2009)19 who report that 53% of deals with known exits are to
strategic buyers, 30% are to financial buyers and 17% are through IPOs.

Not surprisingly, there is a significant difference between larger and

smaller PE investors. Larger PE investors expect to exit through an IPO
more than 26% of the time, while smaller PE investors expect to do so less
than 11% of the time. For the largest deals, it is less likely that there is a
strategic buyer large enough to sell to.

Table 8.5 presents the ranking of factors that PE investors consider in

deciding when to exit. Achieving the expected operational plan and capi-
tal market conditions are the most important and are ranked roughly
equally. They are important for more than 90% of the PE investors.
As with capital structure decisions, this suggests that PE investors put
roughly equal weight on fundamentals and on market timing.

Management’s opinion, competitive considerations and hitting a return

target are the next most important considerations and are ranked
roughly equally. They are considered by more than 75% of the PE inves-
tors. Considering management’s opinion is consistent with a coopera-
tive/advisory relationship between PE investors and management. The
requirement to hit a return target is potentially suggestive of an agency
problem between the PE investors and their limited partners. (See
Tables 8.6​to​​​8.11 and Figure 8.2.)
Table 8.5 Ranking of Factors That Affect Exit Timing
Mean Median Low High Low High Old Young Local Global
AUM AUM IRR IRR
Achieve operational 5.5 6.0 5.4 5.5 5.8 5.3 5.3 5.6 5.5 5.4
plan set out to achieve
Capital market 5.3 5.5 5.4 5.2 5.3 5.3 5.4 5.2 5.0 5.7
conditions
Competitive 3.5 4.0 3.5 3.5 3.2 3.1 3.4 3.5 3.9 2.9
considerations
Hit IRR or ROI target 4.0 4.0 3.9 4.2 4.2 4.6 3.8 4.3 3.9 4.3
LPs pressure to return 1.8 1.5 1.5 2.0 1.9 1.8 1.4 2.1 1.6 1.9
capital
Management’s 3.7 4.0 3.4 4.1 3.8 3.7 4.3 3.2 3.8 3.7
opinion
Other 0.7 0.0 0.7 0.7 0.7 0.7 0.6 0.7 0.5 0.9
Number of responses 64 64 32 32 23 23 30 34 37 27
Source: Gompers, Kaplan and Muhkarlyamov (2016)
Private equity exits 183
184 Advanced Introduction to Private Equity

Table 8.6 PE Buyout Capital-Backed Exits

No. of Exits Exit Value Average Exit Size
(USD bn) (USD mn)
2009 683 113.4 446.4
2010 1 317 265.1 425.6
2011 1 633 365.6 523
2012 1 759 307.5 438
2013 1 928 313.2 401
2014 2 202 512 551.8
2015 2 371 452.2 480.6
2016 2 351 406.2 494.1
2017 2 487 417.1 489.6
2018 2 586 407.7 462.2
2019 2 104 447 703.9
Overall 21 421 4 007 187.1
Source: Preqin

Table 8.7 Private Equity IPOs

Year No. of Exits Exit Value (USD bn) Average Exit Size
(USD mn)
2009 114 31.6 400.1
2010 213 58.4 345.6
2011 227 99.6 553.6
2012 233 64.5 379.3
2013 327 94.2 395.7
2014 361 120.2 424.7
2015 367 118.4 438.6
2016 293 78.1 371.7
2017 377 136.5 464.2
2018 253 76.8 374.6
2019 198 139.4 805.8
Overall 2 963 1 017.6 343.4
Source: Preqin
 Private equity exits 185

Table 8.8 Strategic Sales

Year No. of Exits Exit Value (USD Average Exit Size
bn) (USD mn)
2009 68 18.7 813.3
2010 103 3.3 300.2
2011 146 22.5 1 021.5
2012 177 16.4 746.8
2013 181 15.5 535.5
2014 243 21.5 551.7
2015 236 43.1 1 268.8
2016 304 23 589.3
2017 327 28.6 818.3
2018 430 23.1 642.7
2019 316 79.2 2 083.5
Overall 2 531 295 116.6
Source: Preqin

Table 8.9 Financial Sales

Year No. of Exits Exit Value (USD bn) Average Exit Size
(USD mn)
2009 155 16.1 341.6
2010 377 92.7 597.8
2011 513 101.6 518.2
2012 570 105.5 546.8
2013 559 101.6 493.2
2014 704 125.3 519.8
2015 785 111.2 439.5
2016 802 120.1 517.6
2017 810 124.3 594.9
2018 868 149.5 622.8
Overall 6 898 1 176.7 170.6
Source: Preqin
186 Advanced Introduction to Private Equity

Table 8.10 Management Purchases

Year No. of Exits Exit Value Average Exit Size (USD mn)
(USD bn)
2009 34 0.1 88.1
2010 37 0.4 73.6
2011 54 1.7 113.4
2012 71 3.1 195.4
2013 74 2.2 114.2
2014 72 5.8 278.5
2015 73 1.7 90.5
2016 70 2.3 188.7
2017 53 1.4 232.5
2018 66 4 232.8
2019 57 5.6 376.3
Overall 661 28.4 42.9
Source: Preqin

Table 8.11 Trade Sales

Year No. of Exits Exit Value Average Exit Size
(USD bn) (USD mn)
2009 363 67.6 493.7
2010 685 140.7 406.8
2011 859 245 628.2
2012 927 173.9 436.9
2013 1 011 172.6 426.3
2014 1 122 345.5 672.2
2015 1 190 292.4 572.3
2016 1 136 265.7 593
2017 1 135 229 562.6
2018 1 201 243.9 502.9
2019 976 281.6 818.5
Overall 10 605 2458 231.8
Source: Preqin
 Private equity exits 187

7.00

6.00

5.00

4.00
Years

3.00

2.00

1.00

0.00
2010 2011 2012 2013 2014 2015 2016

Strategic Acquisition IPO Financial Acquisition

Source: Preqin

Figure 8.2 Median Hold-Times by Exit Type

Statistics on private equity exits

Tables 8.12 and 8.13 present pre-GFC data while Tables 8.16 and 8.17 pre-
sent more recent data on private equity exits. Contrary to criticism of the
private equity industry of flipping, i.e., exiting soon after the LBO occurs,
the upper panel of Table 8.12 shows that PE firms held their investments
for extended periods of time. For leveraged buyouts between 1970 and
2007 with an exit observed by the end of 2007, the PE firm holds its invest-
ment for an average of 49 months. Moreover, only 2.7% of LBOs are exited
within 12 months of the LBO and less than 40% are exited within five years.

The lower panel of Table 8.12 shows that exits of private equity invest-
ments take the form of IPOs, strategic sales and financial sales. Among
investments that had an exit by the end of 2007, 13% took the form of
an IPO, 39% were strategic sales and 24% were sales to financial buyers.
Interestingly, although LBOs result in significant increases in debt levels,
confirmed bankruptcies represent only 6% of exits.

Just as exits vary over time, they also vary somewhat by geographies.
Table 8.13 shows that relative to the US and Canada, exits in the UK and
Europe are less likely to occur via IPO and more likely to occur via a
Table 8.12 Statistics on Private Equity Exits by Year of Buyout
Total 1970–84 1985–89 1990–94 1995–99 2000–2 2003–5 2006–7
Time to Exit
Mean (months) 49 87 80 61 54 43 24 9
Median (months) 42 63 72 52 50 43 24 10
Exit with 2.7% 1.6% 2.0% 3.9% 3.1% 2.5% 2.7% 2.0%
12 months
Exit with 10.7% 13.5% 11.3% 13.8% 12.4% 7.5% 11.0%
24 months
Exit with 38.7% 46.0% 39.2% 52.1% 39.2% 33.3%
60 months
Type of Exit
IPO 13% 28% 25% 22% 11% 8% 10% 1%
Strategic sale 39% 32% 34% 38% 39% 39% 41% 38%
188 Advanced Introduction to Private Equity

Financial sale 24% 6% 13% 17% 24% 30% 30% 22%

Sale to LBO- 5% 2% 3% 3% 5% 5% 6% 14%
backed firm
Bankruptcy 6% 7% 6% 5% 8% 6% 4% 3%
Other/unknown 13% 25% 19% 15% 13% 12% 9% 22%
Source: Per Stromberg, 2008, The New Demography of Private Equity, Globalization of Alternative Investment Working Papers
Volume 1, The Global Economic Impact of Private Equity Report 2008, World Economic Forum, Geneva
 Private equity exits 189

Table 8.13 Statistics on Private Equity Exits by Geography (1970–2002)

US and UK Europe Rest of the
Canada World
IPO 15% 11% 10% 19%
Strategic sale 38% 42% 36% 42%
Financial sale 20% 22% 34% 17%
Sale to LBO-backed firm 6% 3% 3% 2%
Bankruptcy 9% 8% 3% 2%
Other/unknown 12% 14% 14% 18%
Source: Per Stromberg, 2008, The New Demography of Private Equity,
Globalization of Alternative Investment Working Papers Volume 1, The Global
Economic Impact of Private Equity Report 2008, World Economic Forum, Geneva

Table 8.14 Median PE-Backed Exit Multiples by Type

Strategic Sale IPO Financial Sale
2010 7.36 7.35 8.62
2011 8.08 6.61 8.04
2012 7.89 5.82 8.37
2013 6.50 6.96 9.79
2014 8.53 7.25 8.09
2015 8.67 7.83 8.19
2016 9.17 7.74 9.43
Source: Pitchbook

Table 8.15 PE-Backed IPOs Hitting Range

Above Range Within Range Below Range
2010 6.15% 64.62% 29.23%
2011 22.73% 54.55% 22.73%
2012 4.55% 65.91% 29.55%
2013 17.86% 63.10% 19.05%
2014 3.51% 72.81% 23.68%
2015 9.23% 72.31% 18.46%
2016 3.85% 76.92% 19.23%
Source: Pitchbook
Table 8.16 US Private Equity Exits
Number of Transactions Total Exit Value of Transactions
Strategic Sale IPO Financial Sale Total Strategic Sale IPO Financial Sale Total
2006 389 71 309 769 81.51 40.49 67.92 189.92
2007 505 60 376 941 115.10 40.53 97.44 253.07
2008 388 16 229 633 78.28 5.79 34.71 118.78
2009 273 30 138 441 48.93 31.28 14.64 94.85
2010 470 48 328 846 107.16 30.09 68.34 205.60
2011 517 41 362 920 110.10 77.07 61.34 248.51
2012 594 43 492 1129 148.78 28.95 109.93 287.66
2013 548 68 444 1060 125.75 105.23 96.93 327.91
2014 681 69 575 1325 173.73 85.94 157.52 417.19
2015 702 45 616 1363 240.68 44.83 130.82 416.32
190 Advanced Introduction to Private Equity

2016 669 39 565 1273 190.55 35.05 142.55 368.15

2017 636 48 623 1307 195.87 39.05 173.63 408.54
2018 571 46 623 1240 215.78 47.26 179.00 442.04
2019 358 23 523 904 111.33 33.16 146.62 291.11
51% 4% 44% 48% 16% 36%
Source: Pitchbook
 Private equity exits 191

Table 8.17 Europe: PE Exit Activity

Total Value of Transactions by Type
Exit Value No. of Exits Strategic IPO Financial
(€bn) Closed Sale Sale
2008 €116.11 710 €49.32 €8.83 €57.96
2009 43.84 513 €28.72 €0.37 €14.75
2010 139.46 737 €42.24 €51.46 €45.76
2011 205.15 971 €93.47 €48.42 €63.26
2012 136.27 863 €71.95 €10.84 €53.48
2013 191.10 1064 €72.52 €43.72 €74.86
2014 250.25 1172 €110.05 €44.65 €95.55
2015 299.00 1385 €133.31 €42.76 €122.93
2016 261.42 1262 €137.71 €25.10 €98.61
2017 309.42 1327 €136.06 €34.17 €139.18
2018 259.79 1182 €109.56 €23.17 €127.06
2019 €170.67 798 €73.57 €20.35 €76.74
44% 15% 41%
Source: Pitchbook

1.02

1.00

0.98
Return

0.96

0.94

0.92

0.90
–20 –15 –10 –5 0 5 10 15 20
Date Relative to Distribution

Low Rep Firms Med Rep Firms High Rep Firms

Source: T. Dore, P.A. Gompers and A. Metrick, 2012, Reputation and Contractual
Flexibility: Evidence from Venture Capital Distribution Pricing Policies, Harvard
Business School Working Paper

Figure 8.3 Return around Distribution Date, by PE Firm Reputation

192 Advanced Introduction to Private Equity

strategic or financial sale. Interestingly, LBOs in the rest of the world are
more likely to have exits via IPO. (See also Tables 8.14 and 8.15.)

Tables 8.16 and 8.17 look at the three primary forms of exit from 2006 to
2019 for US and European deals. In the US, the number of exits is domi-
nated by strategic sales and sales to financial buyers, at 52% and 44% of
deals. Strategic sales represent 48% of total value while sales to financial
buyers represent 36%. Only 5% of the deals exited by IPO, but those deals
accounted for 16% of exit value. In Europe, the percentages for value are
very similar with 44% by strategic sale, 41% by financial buyers and 15%
by IPO. (See Figure 8.3.)

Notes
1 General partners generally have the option to extend the fund for an addi-
tional three years with the consent of the limited partners. In practice, the
median fund life is 15 years.
2 See Jay R. Ritter, IPO Statistics, https://site​.warrington​.ufl​.edu​/ritter​/files​/
IPO​-Statistics​.pdf.
3 Joseph Bartlett, 1995, Equity Finance: Venture Capital, Buyout,
Restructurings, and Reorganizations (John Wiley: New York).
4 It is important to note that the underwriter can release any of the securities
subject to the lockup agreements at any time without notice. Alon Brav and
Paul A. Gompers, 2003, The Role of Lockups in Initial Public Offerings,
Review of Financial Studies 16, 1–29 find that early release was used in
approximately 16% of the IPOs in their sample.
5 Alon Brav and Paul A. Gompers, 2003, The Role of Lockups in Initial Public
Offerings, Review of Financial Studies 16, 1–29; Laura Casares Field and
Gordon Hanka, 2001, The Expiration of IPO Share Lockups, Journal of
Finance 56, 471–500.
6 Paul A. Gompers and Josh Lerner, 2002, Venture Capital Distributions:
Short-Run and Long-Run Reactions, Journal of Finance 53, 2161–83.
7 Distributions are typically declared after the market closes. The record-
ing distribution price is typically the closing price on the distribution day.
Actual receipt of certificates and the ability to sell the shares may take sev-
eral days.
8 The price quoted in cases where the PE firm transfers the shares is dictated
by the agreement between the general partners and limited partners of the
fund. It is often the closing price on the day that the shares are transferred,
although an average closing price of the previous one or two weeks is also
common. See Timothy E. Dore, Paul Gompers and Andrew Metrick, 2011,
Reputation and Contractual Flexibility: Evidence from Venture Capital
Distribution Pricing Policies, Harvard Business School Working Paper.
 Private equity exits 193

9 Paul A. Gompers and Josh Lerner, 2002, Venture Capital Distributions:

Short-Run and Long-Run Reactions, Journal of Finance 53, 2161–83.
10 Jay Ritter, 1988, Initial Public Offerings, Journal of Applied Corporate
Finance 1, 37–45.
11 See Paul Gompers and Natee Amornsiripanitch, 2015, Globant: Going
Public, Harvard Business School Case 9-215-021.
12 Minmo Gahng, Jay R. Ritter and Donghang Zhang, July 2021 SPACs,
University of Florida Working Paper.
13 Michael D Klausner and Michael Ohlrogge, 2020, A Sober Look at SPACs,
SSRN Electronic Journal.
14 Michael D Klausner and Michael Ohlrogge, 2020, A Sober Look at SPACs,
SSRN Electronic Journal.
15 Michael D Klausner and Michael Ohlrogge, 2020, A Sober Look at SPACs,
SSRN Electronic Journal.
16 Minmo Gahng, Jay Ritter and Donghang Zhang, 2021, SPACs, University of
Florida Working Paper.
17 This discussion is based largely on Paul Gompers, Shai Bernstein, Matt
Wozny and Alex Gachanja, 2021, Luminar and the Rise of SPACs, Harvard
Business School Case Number 221-099.
18 Unleveraged dividend recaps are also possible, where the firm issues a spe-
cial dividend using cash on hand. However, due to the fact that only cash
on hand is paid out, unleveraged dividend recaps are much smaller than
leveraged dividend recaps.
19 Steven N. Kaplan and Per Stromberg, 2009, Leveraged Buyouts and Private
Equity, Journal of Economic Perspectives 23, 121–46.
9 Raising a private equity
fund

In this chapter, we examine the process by which private equity firms

raise funds for investing. The vast majority of PE funds are organized
as limited partnerships. The specific compensation and restrictions gov-
erned by these agreements are critical for the alignment of incentives
between PE managers and their investors. This chapter starts by looking
at the organization history within private equity, then examines issues
related to fund governance.

A brief history of private equity investing1

The ancestors of modern private equity firms in the US developed in

the late nineteenth and early twentieth centuries. Wealthy families
which had made their fortunes during the early days of the Industrial
Revolution began to look for ways to invest in private, potentially high-
return undertakings. The earliest investors in growth-oriented private
firms were wealthy family offices. This includes famous New York fami-
lies like the Vanderbilts, Whitneys, Morgans and Rockefellers who pro-
vided private capital to grow companies in the railroad, steel, oil and
banking industries. The market for private equity remained largely unor-
ganized and fragmented throughout the late nineteenth and early twen-
tieth centuries. The first impetus to organize investing into professional
organizations came from these same wealthy Americans. In the 1930s
and 1940s, members of the Rockefeller, Bessemer and Whitney families
hired professional managers to seek out investment in promising private
growth companies.

The earliest private equity firms were organized in the Northeast, primar-
ily in Boston and New York. The earliest firms to invest capital into pri-
vate firms were focused on early-stage, venture capital investments. The

194
 Raising a private equity fund 195

first modern venture capital firm was formed in 1946, when MIT presi-
dent Karl Compton, Massachusetts Investors Trust chairman Merrill
Griswold, Federal Reserve Bank of Boston president Ralph Flanders and
Harvard Business School professor General Georges F. Doriot started
American Research and Development (ARD). ARD and other early ven-
ture capital funds were typically structured as closed-end funds. Closed-
end funds raised capital by selling shares to public investors, then used
that capital to finance private companies. The closed-end structure
proved problematic because raising additional capital for investments
was always beholden to the fund’s stock price. Once a closed-end fund
had invested all the capital it had raised, it needed to issue new shares in
a secondary offering in order to continue to have capital to invest. If the
fund’s share price was severely depressed, raising additional capital was
very expensive or impossible. For much of its public existence, ARD’s
stock price was severely depressed and raising follow-on capital proved
difficult.

In the late 1950s, a new fund structure arose which facilitated both the
alignment of incentives and the ability to raise fund-specific dedicated
capital, the limited partnership. The first venture capital limited part-
nership, Draper, Gaither and Anderson, was formed in 1958. Unlike
closed-end funds, partnerships were exempt from securities regula-
tions, including the exacting disclosure requirements of the Investment
Company Act of 1940. The set of the investors from which the funds
could raise capital, however, was much more restricted. The interests in a
given partnership could only be held by a limited number of institutions
and high net-worth individual investors.

The Draper partnership and its imitators followed the template of other
limited partnerships common at the time: for example, those that had
been formed to develop real-estate projects and explore oil fields. In such
cases, the partnerships had a predetermined, finite life (usually 10 years,
though extensions were often allowed). Thus, unlike closed-end funds,
which often had indefinite lives, the partnerships were required to return
the capital to investors within a set period. From the days of the first
limited partnerships, the general partners of the fund could choose to
return capital to their limited partners either by liquidating their owner-
ship stake and returning cash or by distributing pro-rata shares of port-
folio companies to investors.
196 Advanced Introduction to Private Equity

The increase in institutional money had a dramatic impact on the pro-

cess of private equity investing which facilitated the rise of the limited
partnership as the dominant organizational form. A seminal event in the
emergence of the private equity industry was the formation of Kohlberg
Kravis and Roberts and Co. (KKR) in 1976 by three former Bear Stearns
investment bankers. Most of KKR’s early investments were financed
by deal-specific limited partnerships including their first investment, a
$25.6 million buyout of A.J. Industries, Inc.2 Many of the early private
equity firms focused on leveraged buyouts of both public and private
companies. These leveraged buyout funds were often structured on a
deal-by-deal basis.

Over time, limited partnerships moved to a co-mingled fund structure in

which multiple investments would be pooled within a single limited part-
nership. Since 1980, most of the capital committed to private equity has
been raised through limited partnerships. Most PE organizations raise
partnerships (funds) every two to five years. The typical PE fund makes
between 10 and 20 investments over its lifespan. In a private equity lim-
ited partnership, the PE managers are general partners and control the
fund’s activities. The investors, typically pension funds, insurance com-
panies, endowments, family offices and sovereign wealth funds, serve as
limited partners. Investors can monitor the fund’s progress, but cannot
become involved in the fund’s day-to-day management if they are to
retain limited liability. Compensation is, therefore, the most important
contractual mechanism for aligning the incentives of the PE managers
and their investors. We explore the nature of that compensation below.

The limited partnership agreement explicitly specifies the terms that gov-
ern the PE managers’ compensation over the entire 10- to 13-year life
of the fund. A model limited partnership term sheet published by the
Institutional Limited Partners’ Association (ILPA) can be found here:
https://ilpa ​.org ​/wp​- content ​/uploads​/2020​/07​/ ILPA​-Model​-LPA​-Term​
-Sheet​-WOF​-Version​.pdf. It is rare that these terms are renegotiated. The
specified compensation has a simple form: the PE managers typically
receive an annual fixed fee, usually between 1% and 2%, based on com-
mitted capital during the investment period and invested capital there-
after, plus variable compensation that is a specified fraction of the fund’s
profits (usually 20%). The simplicity and specificity of the contracts pro-
vide a readily assessable benchmark for the alignment of incentives.
 Raising a private equity fund 197

Limited partnerships terms and conditions

In addition to the compensation structure described below, additional

controls are often enumerated in the limited partnership. Because the
investors are generally restricted from active decision making in day-to-
day activities of the fund, these covenants serve to protect investors by
restricting various activities or requiring others. The model term sheet
from the ILPA provides a template, but many variants of each covenant
are found in the partnership agreements. Generally speaking, the more
worried limited partners are about potential conflicts, the more restric-
tive the agreement is. Prior research has shown that more restrictions are
typically placed on newer PE firms and PE firms that tend to make more
opaque investments.3 LPs are concerned that relatively new GPs might
seek to exploit the lack of active oversight. Many of these restrictions can
be grouped into broad buckets.

The first set of restrictions in the ILPA’s term sheet focuses on the fund’s
investment policy. The fund’s broad investment strategy is laid out in
the section on Investment Policy. More specific fund investment restric-
tions are then enumerated under the section Investment Restrictions. A
common theme among the investment restrictions is to limit increas-
ing volatility in the portfolio. To control for this potential, one common
restriction is restricting the amount of investment in any one portfolio
company. These provisions are intended to ensure a reasonably diversified
portfolio. The general partners typically do not receive a share of profits
until the limited partners have received the return of their investment.
The PE managers’ share of profits can be thought of as a call option: the
general partners may gain disproportionately from increasing volatility
of the portfolio at the expense of diversification. Putting all the invest-
ments in a small number of companies (or just one) would increase the
overall riskiness of the portfolio and would serve to primarily benefit
the general partner. This is one reason that private equity funds moved
away from the single investment limited partnership model of early LBO
funds towards a diversified fund approach. These limitations are fre-
quently expressed as a maximum percentage of capital invested in the
fund (committed capital) that can be invested in any one firm.

Other restrictions focus on other elements that lower the concentration

of risk in the portfolio. As the model term sheet shows, this includes
limitations on the amount invested in any one industry or in any one
198 Advanced Introduction to Private Equity

region. Similarly, these investment restrictions will also include classes

of investments that the LP wants to avoid, including hostile tender offers
or investments in other PE funds that charge a carried interest as well.

Finally, an increasing emphasis among LPs is to enforce certain ESG

investment standards. A recent analysis of 8810 PE firms found that
703 are signatories to the PRI ESG investment policies. These 703 represent
roughly $2.15 trillion in assets.4 While it is too soon to know what the
impact of the move towards ESG investing is, it is clear that many LPs
look for transparency on the issue.

Generally speaking, as outlined in the ILPA term sheet, exceptions

to these restrictions are possible with the approval of the Advisory
Committee. Advisory Committees are common for PE funds and are
generally made up of the largest investors in the fund. Exceptions to
investment limits, extensions to the fund life, etc., typically require a for-
mal approval of the committee.

A second covenant class limits the use of debt at the fund level (not the
company level). As option holders, general partners may be tempted to
increase the variance of their portfolio’s returns by leveraging the fund.
As discussed above, increasing the riskiness of the portfolio would
increase the value of their call option at investors’ expense. Partnership
agreements often limit the ability of PE managers to borrow funds them-
selves or to guarantee the debt of their portfolio companies (which might
be seen as equivalent to direct borrowing). Partnership agreements may
limit debt to a set percentage of committed capital or assets, and, as the
model term sheet illustrates, also restrict the maturity of the debt to
ensure that all borrowing is short-term.5

An additional class of covenants relates to reinvestment of profits. For

several reasons, PE managers may reinvest capital gains rather than dis-
tributing the profits to the limited partners. First, many partnerships
receive fees on the basis of either the value of assets under management or
adjusted committed capital (capital less any distributions). Distributing
profits will reduce these fees. Second, reinvested capital gains may yield
further profits for the general (as well as the limited) partners.6 The rein-
vestment of profits may require approval of the advisory board or the lim-
ited partners. Alternatively, such reinvestment may be prohibited after a
certain date, or after a certain percent of the committed capital is invested.
 Raising a private equity fund 199

A number of classes of restrictions curb the activities of the general part-

ners that may conflict with fund activity or seek to suspend the fund if key
members of the GP depart. The first of these limits the ability of the gen-
eral partners to invest personal funds in firms that fall within the scope
of the fund’s investment mandate. These restrictions are generally under
the Exclusivity section of the LP agreement. If general partners invest in
selected firms, they may devote excessive time to these firms and may not
terminate funding if the firms encounter difficulties. Similarly, they may
choose to invest their own funds in the most promising opportunities. In
addition, the PE managers may be required to seek permission from the
advisory board or limited partners. An alternative approach employed
in some agreements is to require the PE managers to invest a set dollar
amount or percentage in every investment made by the fund.

A second restriction addresses the reverse problem: the sale of partner-

ship interests by general partners. Rather than seeking to increase their
personal exposure to selected investments, general partners may sell
their share of the fund’s profits to other investors. While the general
partnership interests are not totally comparable with the limited part-
ners’ stakes (for instance, the general partners will typically only receive
distributions after the return of the limited partners’ capital), these may
still be attractive investments. Limited partners may worry that such a
sale will reduce the general partners’ incentives to monitor their invest-
ments. Partnership agreements may prohibit the sale of general partner-
ship interests outright, or else require that these sales be approved by a
majority (or super-majority) of the limited partners.

A third area for restrictions on the general partners is fundraising. The

raising of an additional fund will raise the management fees that general
partners receive and may reduce the attention that PE managers pay to
existing funds. Partnership agreements may prohibit fundraising by gen-
eral partners until a set percentage of the portfolio has been invested or
until a given date. Alternatively, fundraising may be restricted to a fund
of certain size or focus. For instance, the private equity organization may
be allowed to raise a buyout fund, which would presumably be managed
by other general partners.

Some partnership agreements restrict general partners’ outside activi-

ties. Because outside activities are likely to reduce the attention paid to
investments, PE managers may be required to spend “substantially all”
200 Advanced Introduction to Private Equity

(or some other fraction) of their time managing the investments of the
partnership. Alternatively, the general partners’ involvement in busi-
nesses, not in the private equity fund’s portfolio, may be restricted. These
limitations are often confined to the first years of the partnership, or until
a set percent of the fund’s capital is invested, when the need for attention
by the general partners is presumed to be the largest.

An additional area of concern relates to concerns that LPs have about who
manages the investments within the PE fund. Generally, the investment
team’s track record is marketed to investors and certain key individuals
are considered to be particularly important. These important individuals
are generally governed by a Key Person clause which can throw a fund
into suspension if a certain number of these Key People leave the firm.
Similarly, LPs may be concerned about the addition of new members to
the GP. By hiring less experienced general partners, PE managers may
reduce the burden on themselves. The quality of the oversight provided,
however, is likely to be lower. As a result, many funds require that the
addition of new general partners be approved by either the advisory
board or a set percentage of the limited partners.

While many issues involving the behavior of the general partners are
addressed through partnership agreements, several others typically are
not. One area that is almost never discussed in the sample is the vesting
schedule of general partnership interests. If general partners leave a pri-
vate equity organization early in the life of the fund, they may forfeit all
or some of their share of the profits. If PE managers do not receive their
entire partnership interest immediately, they are less likely to leave soon
after the fund is formed. A second issue is the division of profits among
the general partners. In some funds, most profits accrue to the senior gen-
eral partners, even if the younger partners provide the bulk of the day-to-
day management, deal sourcing and analysis and oversight. While these
issues are addressed in agreements between the general partners, they are
rarely discussed in the contract between the general and limited partners.

Compensation in private equity funds

Management fees
Compensation in private equity provides a way to align the incentives.
Considerable research and common sense have argued that value is
 Raising a private equity fund 201

reduced or destroyed when corporate decision makers have little eco-

nomic stake in the outcome of the companies they manage. Private
equity has been seen as an organizational form that entails high-powered
incentives for PE managers to maximize returns. While the advent of
mega-funds in the PE industry has renewed debate about whether PE
managers truly care about maximizing returns, it is still the case that
total compensation is highly dependent upon investment performance.

PE limited partnerships typically explicitly define compensation in two

specific components. The first component is a fixed management fee
which is outlined in the model term sheet under the section entitled
“Management Fee.” The fee is typically a percentage of capital commit-
ments made by the limited partners. While LBO funds in the 1980s often
had fees based upon NAV, today nearly 97% of funds have fees that are
based upon total commitments.7 Thus, even though GPs draw capital
down over a number of years (typically called “paid in capital”), LPs pay
on a fixed fee based upon the total amount that they will pay in over
the life of the fund. Early PE funds looked to the precedent set by ven-
ture capital limited partnerships which typically charged 2.5% on com-
mitted capital.8 While fixed fees in PE funds tend to be slightly lower, a
paper looking at fees in the 2000s found that 11 of 144 funds charged
greater than 2%, 59 charged exactly 2% and 74 of 144 charged less than
2%.9 More recently, Figure 9.1 shows that management fees in buyout
funds tend to be lower than fees in growth funds; 47.5% of funds have
fees between 1.76% and 2%. Another 45.8% have fees between 1.26% and
1.5%. Over half of growth equity PE funds have fees between 1.51% and
1.75% with 23.6% having fees higher than 1.76%.

These fees typically decrease as the fund passes its investment period.
As discussed earlier, PE funds typically have a 10-year life. Investments
are made in the first two to five years. There are a variety of ways that
fees decline over the remaining life of the fund. Sometimes, there are
explicit step downs at various fund anniversaries. The ILPA model term
sheet defines fee reductions in terms of two benchmarks. First, once the
fund fully invests its capital in underlying companies, the fee is reduced
to a given percentage of the capital that has been committed by LPs less
the cost basis of the investments in the funds that have been liquidated.
Similarly, if the PE firm raises a new fund, the fee is also reduced accord-
ingly. These provisions are meant to prevent PE investors from layering
fees from multiple funds in such a way that the GP is certain to make
Source: MJ Hudson Private Equity Fund Terms 2019/2020

Figure 9.1 Distribution of Management Fees for Private Equity Funds in 2019

202 Advanced Introduction to Private Equity
 Raising a private equity fund 203

meaningful income without having to generate attractive returns for

investors.

Because there are many ways in which management fees are structured,
it is interesting to understand how large they are in practice. To do this,
research often computes the net present value (at the time of the part-
nership’s closing) of the fixed fees that are specified in the contractual
agreement.10 To gauge how important these management fees are, they
are typically expressed as a percent of the committed capital. Because the
management fees are relatively certain, it is typical to use a relatively low
discount rate (on the order of 5–10%) to calculate the fee NPV.

The research on PE compensation has shown that the NPV of the base
compensation (as a percentage of committed capital) is generally lower
for older and larger PE firms when expressed as a percentage of com-
mitted capital. Although this ratio depends upon how fees change over
the life of the fund, the ratio of the NPV of management fees per $100 of
committed capital generally falls between $10 and $11 over the life of the
fund.11 Because there are economies of scale in PE investing (i.e., funds
are able to grow the amount of capital per partner by doing larger invest-
ments), the range of management fees per partner per $100 of committed
capital ranges averages $18.47, but ranges from a lower quartile of $6.85
to an upper quartile of $24.33. With an average of six partners and an
average fund size of $1238 million, a typical fund generates between $13
million and $48 million in management fee per partner.12

Transaction and monitoring fees can also be a source of considerable

value to PE investors. Metrick and Yasuda (2010) estimated these fees
to be roughly $4 per $100 of committed capital over the life of a fund.
More recently, Phalippou et al. (2018) estimate that these fees have
been roughly 6% of the total equity invested by PE funds and represent
nearly 3.6% of the EBITDA of the underlying portfolio companies.13
While up to 70% of the fees are offset by reductions in management
fees, these portfolio company fees are still an important form of com-
pensation to GPs.

Carried interest
A second source of compensation for PE investors is the carried interest,
i.e., the percentage of profits that they are paid. How much and when
the profits are paid is defined under the section entitled “Distributions/
204 Advanced Introduction to Private Equity

Waterfall.” Distributions are paid to investors upon the realization of

exits. These distributions can be in cash (if the investments are sold or
public stock is liquidated) or they can be publicly traded shares. Research
on PE compensation demonstrates that virtually all PE funds pay a car-
ried interest of 20%.14

There are two different methods to determine the timing of the payout
of the carried interest. They are known as return of capital (or European
waterfall) and deal-by-deal (or American waterfall). In the European
waterfall, PE investors do not receive carry until the LPs have received
distributions exceeding the fund’s total invested capital. In the American
waterfall, PE investors receive carry on any distribution as long as the
value of the fund’s realized portfolio is sufficiently greater than the
capital invested in realized deals. As their names suggest and Figure 9.2
shows, approximately 90% of European PE funds utilized a European
waterfall while 60% and 80% of North American-based PE funds utilize
an American waterfall.15

Most private equity funds also have a hurdle rate or preferred return that
further affects the payment of carry. (See “Preferred Return” section of
the ILPA model term sheet.) As Figure 9.3 shows, the most common hur-
dle rate is 8%, although some debt-focused PE funds have a hurdle rate of
6% and some funds, 22.6% in 2019, do not have a hurdle rate.

In a European waterfall, the carry is paid as long as the net return or IRR
to the LPs on the entire fund exceeds the hurdle rate. The carry is not
20% of the profits above the hurdle rate. For example, if after paying the
carry equal to 20% of the profits, the LPs have a net IRR greater than 8%,
then the PE investors receive the entire carry of 20% of the profits. In an
American waterfall, the PE investors receive 20% of the profits on each
exited deal as long as the IRR to the LPs for all deals exited to that point
exceeds 8% after the carry is paid.

From a GP’s perspective, an American waterfall is preferred because the

GP receives the carry sooner. Hence, from a time value of money per-
spective, it is more valuable. The American waterfall, however, can lead
to circumstances in which GPs receive a greater portion of the fund’s
profits than they are ultimately entitled to receive. This occurs when early
realizations are very successful, but later realizations perform poorly. The
General Partner Clawback section of the model term sheet outlines the
 Raising a private equity fund 205

Source: MJ Hudson Private Equity Fund Terms 2019/2020

Figure 9.2 Waterfall Structure for 2019 PE Funds. (a) US-Managed

Funds, (b) European-Managed Funds

manner in which total distributions are evaluated at the end of the fund
in circumstances in which GPs have received a greater portion of the
payout.

Figure 9.4 presents the distribution of the percentage of profits allocated

to the general partners after any provision for the return of invested capi-
tal or of invested capital plus a preferred return. The carry ranges from
0.7% to 45%, but between 84.7% and 87.5% of the funds have a 20% share
of the profits. The consistency of the percentage of profits is similar to
compensation in a number of other professions (like real estate or vari-
ous types of litigation) in which fees cluster on a particular percentage.
 206 Advanced Introduction to Private Equity

Source: MJ Hudson Private Equity Fund Terms 2019/2020

Figure 9.3 Hurdle Rate on Private Equity Funds 2017–19

Source: MJ Hudson Private Equity Fund Terms 2019/2020

Figure 9.4 Carried Interest Percentage in Private Equity Funds Raised 2017–19

Raising a private equity fund 207
208 Advanced Introduction to Private Equity

What we know about PE compensation

Research on compensation has often looked at the alignment of incen-

tives between managers and investors. Many scholars and pundits have
lamented the relatively weak incentives that corporate managers have
to perform. Most of the research on PE fund compensation has gener-
ally highlighted the close alignment of incentives between LPs and GPs.
Relative to the work that has been done on covenants and restrictions in
PE limited partnerships, a significant amount of research has examined
the role of compensation in PE limited partnerships as well as its evo-
lution. Early work on PE compensation showed that young, smaller PE
firms generally had higher management fees relative to older and larger
firms.16 Carried interest percentage was also highly concentrated at 20%
with more than 80% of the partnerships allocating 20% of the profits to
the GPs.

As discussed in Chapter 3, gross of fees as well as net of fees, PE firms

have generated positive risk-adjusted returns. One question that natu-
rally arises is whether higher performing managers increase their fees
and, if they do, do they take greater compensation by increasing man-
agement fees, carried interest or some other aspect of compensation. In
general, the time series pattern of PE compensation shows that total GP
compensation rises when the fundraising environment is robust. When
LP interest in investing in PE funds is high, some (or perhaps all) of the
surplus is extracted by GPs by raising fees.17 This result raises the ques-
tion of what are net returns to LPs and how do those net returns vary
with GP compensation. In the aggregate, funds that charge higher fees
earn high gross investment returns such that, on a net return basis, there
is no relationship between GP compensation and net returns.18

Another question is whether this result implies that there is little incentive
to generate positive net returns for investors. If all of the value created by
PE investors in portfolio companies is taken up by higher compensation,
then perhaps the incentive alignment is not as high as one would hope.
Another way to examine this issue is to assess other incentives that GPs
have. Given that PE firms raise funds every three to five years, there is a
powerful incentive to deliver attractive net returns to LPs. LPs care about
what they receive and, hence, evaluate managers based upon what they
are returned on a net of fee basis. The implicit incentive effects of gen-
erating positive net returns to LPs have been shown to be as significant
 Raising a private equity fund 209

as the carried interest percentage.19 The limited lifetime of PE limited

partnerships imposes powerful discipline on GPs to continually prove
themselves.

Conclusion

This chapter has examined how PE managers raise capital. The PE lim-
ited partnership has evolved as the primary vehicle by which PE inves-
tors raise, invest and return money. The governance and compensation
within private equity limited partnerships are critical for aligning incen-
tives in an opaque investment class. Understanding the control levers
that investors can utilize to prevent perverse behavior as well as the role
that compensation plays are central to the themes discussed. The value-
add activities that we discussed in earlier chapters (namely operational,
governance and financial engineering) are directly related to the rise of
the limited partnership as the dominant fund structure.

Notes
1 This section is largely based on Paul A. Gompers, 1994, A History of Venture
Capital, Journal of Business History 23, 1–24.
2 Peter Lattman, 2009, KKR – a Q&A with Pioneers in M&A, Wall Street
Journal.
3 Paul Gompers and Josh Lerner, 1996, The Use of Covenants: An Empirical
Analysis of Venture Partnership Agreements, Journal of Law and Economics
39, 463–98.
4 Ken Pucker and Sakis Kotsantonis, 2020, Private Equity Makes ESG
Promises. But Their Impact Is Often Superficial, Institutional Investor.
5 A related provision – found in virtually all partnership agreements – is that
the limited partners will avoid unrelated business taxable income. Tax-
exempt institutions must pay taxes on UBTI, which is defined as the gross
income from any unrelated business that the institution regularly carries
out.
6 Another reason why PE managers may wish to reinvest profits is that such
investments are unlikely to be mature at the end of the fund’s stated life. The
presence of investments that are too immature to liquidate is a frequently
invoked reason for extending the partnership’s life beyond the typical con-
tractual limit of 10 years. In these cases, the PE managers will continue to
generate fees from the limited partners (though often on a reduced basis).
7 MJ Hudson Private Equity Fund Terms 2019/2020.
210 Advanced Introduction to Private Equity

8 Paul Gompers and Josh Lerner, 1998, An Analysis of Compensation in

Venture Capital Limited Partnerships, Journal of Financial Economics 51,
3–44.
9 Andrew Metrick and Ayako Yasuda, 2010, The Economics of Private Equity
Funds, Review of Financial Studies 23, 2303–42.
10 Gompers and Lerner (1998) were the first authors to take an NPV approach
to compare fixed fees. Subsequent research has generally tended to follow
their methodology to compare management fees.
11 See Metrick and Yasuda (2010).
12 See Metrick and Yasuda (2010). Clearly, there is significant overhead and
additional staff in PE firms. Hence, this level of management fee does not
flow directly to partners.
13 Ludovic Phalippou, Christian Rauch and March Umber, 2018, Private
Equity Portfolio Company Fees, Journal of Financial Economics 129,
559–85.
14 See Gompers and Lerner (1998), Metrick and Yasuda (2010) and D.T.
Robinson and B.A. Sensoy, 2013, Do Private Equity Fund Managers Earn
Their Fees? Compensation, Ownership, and Cash Flow Performance,
Review of Financial Studies 26, 2760–97.
15 MJ Hudson Private Equity Fund Terms 2019/2020.
16 Gompers and Lerner (1998).
17 David T. Robinson and Berk A. Sensoy, 2013, Do Private Equity Fund
Managers Earn Their Fees? Compensation, Ownership, and Cash Flow
Performance, Review of Financial Studies 26, 2760–97.
18 David T. Robinson and Berk A. Sensoy, 2013, Do Private Equity Fund
Managers Earn Their Fees? Compensation, Ownership, and Cash Flow
Performance, Review of Financial Studies 26, 2760–97.
19 Ji-Woong Chung, Berk A. Sensoy, Léa Stern and Michael S. Weisbach, 2012,
Pay for Performance from Future Fund Flows: The Case of Private Equity,
Review of Financial Studies 25, 3259–330.
10 Managing the private
equity firm

Private equity (PE) firms have a wide range of organizational structures

and strategies. As discussed in prior chapters, PE firms have increasingly
focused on how to improve the underlying performance of their portfolio
companies through financial, governance and operational engineering.
This emphasis is reflected in the staffing and compensation structures
that PE firms employ. What does the team structure look like? What
are their past experiences and skills? How are employees compensated?
All of these factors are critically important for executing an investment
strategy and aligning incentives.

In this chapter, we dive into how PE firms manage their business. We

start by understanding staffing structures in PE firms. What are the vari-
ous tiers of employees? What are their roles in the deal process? We then
examine the background of PE professionals. We look at the resumes of
PE professionals to understand who gets hired and promoted in PE firms.
We also look at various models for recruiting talent in PE. These different
models reflect the particular skill sets that are required to execute one or
more of the levers of value creation. Finally, we provide a description of
compensation structures and levels for PE professionals. The nature and
level of compensation is an important tool for aligning the incentives of
PE managers to create value for their investors.

Given the increasing size and competitiveness of the industry, private

equity firms also have evolved their structures to account for the impor-
tance of specialization. PE firms often organize their staff around invest-
ment strategies. The most common approach is to organize around
industry sectors, geographies and transaction types. These specializa-
tions are an important tool PE firms utilize to increase value and gener-
ate attractive returns.

211
212 Advanced Introduction to Private Equity

Throughout this section, we will focus on seven private equity firms to

illustrate how firms are organized and staffed. These seven PE firms rep-
resent a range of strategies and geographies. The strategies encompass all
aspects of the private equity spectrum. From a size level, the firms range
from large, mega-fund PE managers to middle-market and small PE
firms. The firms also have distinct industry sectors in which they focus.
The industry focus is related to how the firms staff and make decisions.
Finally, the firms also have different strategies for how they intend to
generate returns: proprietary deal sourcing/selection versus governance,
operational or financial engineering. By examining these seven PE firms,
one can get a better understanding of the relationship between a firm’s
capabilities, its staff and the execution of its strategy.

We examine two mega-fund PE firms, Bain Capital and KKR. While the
exact definition can vary, typically, mega-funds are considered to be pri-
vate equity vehicles which raise at least $5 billion. The firms generally
manage over $20 billion in aggregate investment capital. Nearly a third
of all capital raised and invested over the past decade has been managed
by a small number of mega-fund PE managers.

We then profile three middle-market PE firms, Berkshire Partners, BC

Partners and Vistria Capital. Firms that raise funds from several hun-
dred million dollars up to $5 billion are typically considered to be middle
market. Additionally, middle-market PE firms generally target transac-
tions with enterprise values between $25 million and $1 billion. These
firms can invest in buyouts of these middle-market companies or invest
in growth equity situations.

Finally, we profile two small PE firms, Housatonic Partners and Alpine

Investors. Smaller PE firms generally invest in small, owner-led compa-
nies. Deal sourcing and partnering with owner-managers are critical for
these types of investors.

Private equity firm profiles

Bain Capital, founded in 1984, is a leading global private equity firm based
in Boston. As of 2021, it had roughly $150 billion under management.1
The primary focus of Bain Capital’s private equity investment activity is
sponsoring leveraged acquisitions and recapitalizations, including both
 Managing the private equity firm 213

growth capital and traditional buyouts across a variety of industries. In

April 2021, Bain Capital raised $11.8 billion in commitments for their
most recent private equity fund.

The founding of the firm can be traced to Bill Bain’s, the then head of
the consulting firm Bain & Company, offer to Mitt Romney to start a
new company to invest in private equity. Romney, along with two other
partners at Bain & Company, launched Bain Capital with no formal
connection to the consulting firm in 1984. The founders leveraged their
management consulting expertise and preserved the company’s opera-
tional approach to managing. Through its consulting-based strategy,
Bain Capital emphasizes people-intensive, data-driven diligence that
focuses primarily on operational engineering. As we will see below, this
is reflected in the large number of investment and operational staff who
have prior consulting industry experience.

Bain Capital is organized around five industry verticals: consumer, finan-

cial and business services, healthcare, industrials and technology. The
operations and investment professionals are typically associated with
one of these industry segments based on their prior career experience.

KKR, the first or one of the first PE firms, was founded in 1976 by Jerome
Kohlberg, Henry Kravis and George Roberts, former investment bankers
at Bear Stearns. In 1984, KKR raised the first $1 billion PE fund.2 KKR
became a household name after its high-profile buyout of RJR-Nabisco in
1988 for an enterprise value of almost $30 billion, the largest PE deal up
to that point in time. It would remain the large PE transaction in abso-
lute value for more than 15 years and, even today, is by far the largest PE
deal as a fraction of the value of the stock market. Today, it would be the
equivalent of a $200+ billion deal.

KKR was also one of the first PE firms to expand geographically. In

1998, KKR opened its London Office, and in 2007 it opened offices
in Hong Kong and Tokyo.3 In an attempt to provide more services to
its portfolio companies, KKR formed Capstone Consulting in 2000.
Capstone is a wholly owned consulting firm that provides analysis and
operational recommendations to portfolio companies. The Capstone
team is engaged in the due diligence process and throughout the life
of KKR’s involvement in the portfolio company. Unlike Bain Capital,
which integrates the consulting/operational team in the structure of
214 Advanced Introduction to Private Equity

the investment team, KKR employs their consulting team members

through a separate firm.

Berkshire Partners, a Boston-based firm, is representative of a middle-

market PE manager. The firm was founded in 1984 by Brad Bloom, Chris
Clifford, Russ Epker, Carl Ferenbach and Richard Lubin when they
raised $59 million for their first fund. The founders had worked together
at Thomas H. Lee Partners, an early PE firm also formed in Boston, in
1974.

Berkshire Partners’ stated investment strategy is to “partner with man-

agement teams who are building industry-leading companies with sus-
tainable differentiation and have a track record of innovating.”4 This
strategy is one focused on operational engineering as opposed to govern-
ance engineering and replacing management. The focus of Berkshire is
typically growth equity investments as opposed to leveraged buyouts.5
Berkshire has five industry verticals structured around business services
and technology, communications, consumer, healthcare and industri-
als. The investment team is organized around these industry verticals.
Fund II was raised in 1986 and had committed capital of $125 million.
In the 1990s, Berkshire raised a series of funds from $168 million in
1992 for Fund III to $985 million in 1998 in Fund V. Fund size grew
in the 2000s with their first billion-dollar fund, Fund VI at $1.7 billion
in 2002. The largest fund that Berkshire Partners has raised to date was
their 2016 Fund IX which had committed capital of $5.5 billion.

BC Partners is another upper middle-market firm, but one with its

founding roots in Europe as opposed to North America. BC Partners
was formed as a spinout of Barings Bank in 1996 as part of the restruc-
turing which followed the bankruptcy of Barings. In 1996, BC Partners
raised its first independent fund, a €450 million fund which they named
BC Partners V. During the 2000s, fund size increased rapidly, with BC
Partners VII being raised at €4.3 billion and BC Partners X at €10.4 bil-
lion. Their most recent fund, BC Partners XI, raised less, coming in at
€4.9 billion.

BC Partners focuses on buyouts with a primary geographic concentra-

tion in Europe. The firm emphasizes deal sourcing and deal selection
as important elements of its value creation strategy.6 Among the value
 Managing the private equity firm 215

creation levers, BC Partners highlights governance engineering through

“aligning with strong, incentivized management teams.”7

Vistria Capital was founded with the formation of Fund I with $400 mil-
lion in 2014 by Kip Kirkpatrick and Marty Nesbitt in Chicago with the
intention of aligning the firm’s investment strategy along two pillars:
generating returns for investors as well as achieving a social return.8
Increasingly, limited partners have become interested in measuring how
their investment dollars are impacting society. Many limited partners
have begun evaluating PE firms on the basis of their commitment to the
environment, social and governance (ESG). Several organizations have
begun the process of certifying investors as “ESG Compliant.” This type
of strategy is often labeled impact investing or double bottom line invest-
ing. Vistria is a relatively new PE firm that has tapped into this trend.

The firm lists its industry sectors as healthcare, education and financial
services. In particular, it emphasizes how these sectors are likely to have
“significant financial returns combined with positive social change for
communities across America.”9 Vistria’s two most recent funds have had
more than $1 billion in committed capital. In January 2020, the firm
closed Fund III with $1.1 billion and in June 2021 it raised Fund IV at
$2.68 billion.

Alpine Investors is a middle-market private equity firm based in San

Francisco with just over $7 billion of assets under management. The
firm was founded in 2001 by Graham Weaver a year after graduating
from Stanford Business School. Alpine targets companies with EBITDA
between $1 and $50 million and enterprise values up to $500 million.10

The firm lists its areas of focus as software and services. The investment
thesis of Alpine is to focus on management team quality with a heavy
focus on recruiting and retaining top CEO talent. Hence, the focus of
Alpine’s value creation relies more on governance engineering than direct
involvement in operational engineering. Like many PE firms in the lat-
est cycle, their fund size has grown substantially recently. Alpine raised
Fund I in 2001 with committed capital of $54 million. Fund II, raised
in 2003, had $68 million in commitments. Three years later, Alpine III
had committed capital of $125 million. In 2011, the firm raised $262 mil-
lion in Fund IV. As recently as 2017, Alpine VI had only $532 million in
216 Advanced Introduction to Private Equity

commitments. Most recently, in September 2021 Alpine raised its eighth

fund at $2.25 billion.

The final PE firm that we examine is Housatonic Partners. Housatonic

was founded in 1994 by Will Thorndike, Michael Jackson and Eliot
Wadsworth. The firm targets equity check sizes of between $10 and $50
million across a range of PE transaction types in the business services,
technology and healthcare sectors.11 While taking board seats in most of
their companies, Housatonic generally does not become involved in the
operations of their portfolio companies.12 The firm manages $1.3 billion
in committed capital and has invested in more than 100 companies since
its founding.

Private equity firm staffing

As PE firms increase in AUM and scale, they tend to have many employ-
ees and specific roles for them. In this section, we outline the various
roles in private equity firms, and then explore the staffing structures of
the seven private equity firms that we consider in this chapter. While the
discussion covers the typical structure, there are many different varia-
tions across firms on titles and roles that are beyond the scope of this
book.

PE firms typically employ both investment and operating profession-

als although it is common for staff to wear both hats in smaller firms.
Virtually all firms, from the smallest PE shops to the mega-funds, employ
a tiered structure in which junior staff members support senior profes-
sionals. Generally, there are more junior professionals at each level than
there are senior professionals. The most senior professionals in the firm
are typically managing directors, or MDs. Some firms use the term part-
ner or senior partner to refer to those most senior professionals. MDs and
partners typically make the investment decisions as well as determining
firm hiring, promotion and compensation. As we will see when we dis-
cuss compensation, they also typically are owners of the management
company and receive a share of the residual profits of the firm.

Staffing under MDs and partners in PE resembles the structure used

by investment banks. Typically, the entry level investment profession-
als are analysts. Analysts are part of the deal team and responsible for
 Managing the private equity firm 217

pulling together data, creating spreadsheets and presentations and gen-

erally providing low-level support to the deal team. Most analysts are
recent college graduates who also have had two to three years of invest-
ment banking experience. Increasingly, PE firms also are hiring analysts
directly out of college.

Most private equity firms have associates/senior associates who are pri-
marily recent MBA graduates. Some PE firms also choose to promote
their best analysts without requiring them to go to business school.
Some of those firms provide in-house training in lieu of an MBA pro-
gram. Associates are usually responsible for overseeing due diligence and
financial modeling. If a firm has analysts, the associates typically manage
their work product.

Next come the vice president positions, the most junior of senior staff
members. Vice presidents often manage the day-to-day work on deals,
supervising associates and analysts as they develop models and invest-
ment presentations/recommendation memoranda. Responsibility for the
investment thesis and value creation is usually part of the vice president’s
role.

Above vice presidents are principals and directors. A major role for prin-
cipals and directors is to generate deal flow. This can be by maintaining
contact with deal brokers and investment bankers. It can also be through
direct outreach to business owners, particularly for middle-market and
smaller private equity firms. Finally, the most senior staff members are
the partners, managing partners and managing directors. The exact use
of particular titles may vary by firm, but these senior professionals are
usually the face of the firm to investors. They maintain close relation-
ships with the most important limited partners. They are also typically
responsible for deal approval as well as staff promotions. And the larg-
est portion of economics typically is allocated to this group of senior
professionals.

Figure 10.1 looks at the typical years of PE experience by position.13

On average, analysts have one year of PE experience. Associates/sen-
ior associates range in PE experience of up to five years with an aver-
age of two. Many associates/senior associates have prior experience in
related finance positions like investment banking. Vice presidents have
six years’ PE experience on average while principals have worked in PE
 218 Advanced Introduction to Private Equity

Source: Heidrick & Struggles’ North America private equity compensation survey, 2021, n = 1 008 investment professionals

Figure 10.1 Years of Private Equity Experience by Level of Seniority

 Managing the private equity firm 219

for an average of nine years. Finally, the most senior roles in PE, partner/
managing director and managing partner, have typically much longer
experience at 14 and 20 years on average, respectively. The minimum
amount of PE industry experience for these senior positions is two and
three years. This indicates that some senior industry professionals have
careers in other sectors before transitioning to investing.

Staffing and backgrounds in PE firms

In this section, we examine the staff structures in the seven private equity
firms profiled above. In addition, we tabulate the prior career history of
these employees, highlighting the education and employment history
of those who work at each of the firms. There are important differences
among private equity firms, and these differences appear to be embedded
in the human capital of the PE managers.

We start with the two mega-fund PE firms, Bain Capital and KKR. Given
their size, it is not surprising that they employ hundreds of people. In
Table 10.1, we look only at the investment and operational professionals.
There are many other employees critical to the success of the firm. This
includes administrative, human resource, information technology and
other areas. We focus on investment and operational employees because
they are most directly linked to the investment strategies of the PE firms.

Given their size, mega-funds often appoint a senior professional to

manage the firm’s affairs. In the case of Bain Capital, that role is held
by the chairman, of which the firm has two. KKR has a single president
who serves a similar role. The most senior title at both Bain and KKR
is managing director. Bain has 63 managing directors while KKR has
22 as part of the private equity team and nine in KKR Capstone. KKR
has two additional senior professional levels: partner and director. On
the PE investment side, KKR has 32 partners and 27 directors while KKR
Capstone has two partners and 16 directors. Mid-level senior staff at Bain
includes principals (32) as well as several different vice presidents (11 sen-
ior VPs, 14 executive VPs and 63 vice presidents). Principal is the largest
category listed at KKR with the company having 44 principals on the
investment team and 25 in KKR Capstone.
Table 10.1 Staffing Structures at Representative Private Equity Firms
Panel A: Mega-Fund Private Equity Firms
Mega-Funds
Bain Capital KKR
Chairman 2 President 1
Managing director 63 Managing director 22
Principal 32 Director 27
Executive vice president 14 Partner 32
Senior vice president 11 Principal 44
Vice president 63
Operating partner 17 Partner 2
Senior advisor 6 Managing director 8
Senior executive 3 Director 16
Principal 25
Total 211 Total 178
220 Advanced Introduction to Private Equity

Panel B: Middle-Market Private Equity Firms

Middle-Market
Berkshire Partners BC Partners Vistria Capital
Managing director 21 Managing director 10 Senior partner 4
Director principal 3 Director 5 Partner 7
Principal 11 Partner 17 Principal 2
Operating executive 2 Industrial partner 1 Vice president 6
Operating director 6 Principal 13 Senior associate 1
Vice president 4 Associate 19 Associate 4
Operating vice president 2 Analyst 1
Senior advisor 4
Advisory director 12
Associate 19
Total 84 Total 65 Total 25
Panel C: Small Private Equity Firms
Small
Housatonic Partners Alpine Investment Partners
Managing 3 Partner 4
director
Partner 2 Director 1
VP 2 Principal 3
Director 1 Vice president 3
Associate 4 Senior associate 2
Associate 4
Analyst 5
Investment professional 9
Total 12 Total 31
Managing the private equity firm 221

Source: Company Websites
222 Advanced Introduction to Private Equity

There are several other positions at Bain Capital including 17 operating

partners. Operating partners in private equity are typically former sen-
ior executives with a track record of successfully operating companies
in industries targeted by the PE firm. Operating partners typically help
with the due diligence for deals, serve on the board of directors of port-
folio companies after they are purchased and sometimes serve as interim
or permanent senior management of the portfolio companies.

Both Bain and KKR have senior advisors (Bain Capital having six and
KKR having one). Senior advisors are generally not employees of the PE
firm, but provide contacts for deals or advice during the due diligence
process. Most are compensated with a retainer plus performance incen-
tives. It should be noted that both Bain Capital and KKR employ analysts
and associates, but these employees are typically not profiled on com-
pany websites or documents because most do not stay with the firm long
term. This is true of most mega-fund PE firms, but as we will see below,
middle-market and smaller PE firms do highlight more junior staff.

As shown in Panel B of Table 10.1, Berkshire Partners is typical of mid-

dle-market PE firms with a range of staff members. The most senior are
the 21 managing directors. Below the MDs are principals (11) and direc-
tors (three). Below the senior staff are vice presidents (four on the invest-
ment team and two operating VPs). Like many middle-market PE firms,
Berkshire makes use of a large number of associates to leverage the senior
partners, having 19 as of late 2021.

Berkshire Partners, given its focus on operational engineering, also has a

large number of professionals dedicated to assisting portfolio companies.
Among those positions are advisory directors and operating executives.
Berkshire defines advisory directors and operating executives as

business executives or industry experts well known to Berkshire who partici-

pate in specific activities that arise in their areas of expertise, including deal
origination, due diligence investigation, investment deliberation, and portfo-
lio company advisory services. Advisory Directors are independent advisors
that provide consulting services to Berkshire or its portfolio companies at
varying levels of engagement.14

Berkshire has 12 advisory directors and two operating executives. The sig-
nificant number of operating staff leads to a large number of profession-
als being associated with Berkshire relative to the other middle-market
 Managing the private equity firm 223

PE firms which we profile. In total, we identified 80 investment staff

members.

The heritage of BC Partners emerging from Baring’s Bank can be seen

in the heavy focus on investment professionals as opposed to pure oper-
ating staff members. The only partner directly allocated to operating
activities is their industrial partner which aligns with a greater focus
on governance and financial engineering in particular. BC Partners has
10 managing directors, five directors and 17 partners. Among junior staff
members, they have 13 principals and 19 associates. The total staff size on
the investment team that we could collect was 65 professionals.

Vistria, a relatively new PE firm, has a smaller staffing structure than

either Berkshire or BC Partners. The most senior professionals in Vistria
are senior partners and partners. There are four senior partners includ-
ing the co-founders and seven partners. Vistria has a similar number
of lower-tier senior professionals, two principals and six vice presidents.
There are fewer junior staff as well, with one senior associate, four asso-
ciates and one analyst employed at Vistria. This staffing structure com-
ports with Vistria’s strategy of adding value through high-level advice
and contacts, focusing on helping to provide guidance with staffing and
strategic relationships, as well as streamlining operations.15

Finally, we turn to staffing at small private equity firms. Housatonic illus-

trates a small PE firm focused on entrepreneur-led companies. Its invest-
ment philosophy is to back “exceptional entrepreneurs to build lasting
companies that re-define their categories.”16 At the senior level there are
three managing directors, one director and two partners. They are sup-
ported by two vice presidents and four associates.

Alpine Investors, a small PE firm in San Francisco that has recently

grown, demonstrates a PE firm in transition from being a smaller man-
ager to more of a middle-market one. There are only a few senior profes-
sionals (four partners and one director). The middle tier of staff members
is substantially larger than Housatonic Partners. Alpine has one princi-
pal, three vice presidents and two senior associates. The firm also has a
large number of junior team members, four associates and five analysts.
Given the team nature of PE, most firms do not scale by adding substan-
tially at the senior level. Like Alpine, they add middle and junior tier staff
that can grow with the firm.
224 Advanced Introduction to Private Equity

Educational and work backgrounds

of private equity professionals

In this section, we examine the education and work histories of employ-

ees in the firms we have profiled in this section. These summaries provide
insights into how firms match investment strategy with human capital.
Little research has explored these differences and how these differences
affect the types of investments a PE firm makes, the sources of value crea-
tion they pursue and the ultimate returns that the PE firms generate.

Our summary of backgrounds is taken from data we obtained from

EMSI/Burning Glass (EMSI). EMSI gathers data from online resume
sites and standardizes the information. Names of employers, titles, edu-
cational institution names and degrees are standardized to allow easier
data gathering and analysis. We collected resumes for individuals who
worked for any of our seven PE firms summarized in Table 10.1. Our
analysis looks at junior staff (associates, senior associates and vice presi-
dents) and senior staff (principals, partners, directors, managing direc-
tors and managing partners). In our analysis of junior staff members,
we include everyone who was ever a junior staff member, even if they
ultimately get promoted to a senior position in the firm, if they leave the
firm or if they are still at the firm in a junior position.

In Panel A of Table 10.2, we look at Bain Capital employees. As is true

of all our PE firms, they are heavily male dominated; 85.5% of senior
employees and 66.4% of junior employees are male. In terms of profes-
sional background, 26.9% of junior employees had a consulting back-
ground prior to coming to Bain while 37.6% of senior employees had
consulting experience. This is a high percentage relative to other large PE
firms. Another large fraction of senior employees were CEOs/founders
prior to joining Bain Capital (9.2%) while 15.0% had investment banking
experience.

Educational background at Bain is also different from other mega firms.

Senior employees are likely to have an MBA (66.9%) and that MBA is
likely to be from an elite MBA program (classified as Harvard, Stanford,
Wharton, University of Chicago and Northwestern). Elite or top-tier MBA
adds Dartmouth, MIT and Columbia. Similarly, a high proportion of the
senior (53.2%) and junior staff (40.7%) went to an elite undergraduate
 Managing the private equity firm 225

Educational and Employment Background of PE Firm

Table 10.2 
Employees
Panel A: Bain Capital
Characteristic Junior Employees (All) Senior
Employees
Mean Mean
Prior consulting experience 26.9% 37.6%
Prior CEO/founder experience 5.1% 9.2%
Prior IB/big bank experience 17.5% 15.0%
Prior finance experience (broad) 49.9% 43.4%
Male 66.4% 85.5%
Has MBA 28.0% 66.9%
Has elite MBA 21.4% 50.7%
Has elite or top-tier MBA 23.3% 54.9%
Elite undergraduate degree 40.7% 53.2%
Non-US undergraduate degree 5.5% 4.9%
Total 475 173
Panel B: KKR
Characteristic Junior Employees (All) Senior
Employees
Mean Mean
Prior consulting experience 13.5% 16.0%
Prior CEO/founder experience 3.2% 1.9%
Prior IB/big bank experience 32.1% 38.8%
Prior finance experience (broad) 63.9% 66.0%
Male 65.8% 70.4%
Has MBA 15.7% 29.8%
Has elite MBA 10.8% 18.2%
Has elite or top-tier MBA 11.5% 21.6%
Elite undergraduate degree 33.6% 33.3%
Non-US undergraduate degree 10.6% 8.4%
Total 504 430
(Continued)
226 Advanced Introduction to Private Equity

Table 10.2 (Continued)

Panel C: Berkshire Partners
Characteristic Junior Employees (All) Senior
Employees
Mean Mean
Prior consulting experience 35.0% 37.8%
Prior CEO/founder experience 5.0% 2.2%
Prior IB/big bank experience 31.7% 17.8%
Prior finance experience (broad) 50.0% 57.8%
Male 79.7% 81.4%
Has MBA 44.9% 91.4%
Has elite MBA 42.9% 91.4%
Has elite or top-tier MBA 42.9% 91.4%
Elite undergraduate degree 51.2% 59.3%
Non-US undergraduate degree 6.1% 0.0%
Total 60 45
Panel D: BC Partners (US-Based Employees Only)
Characteristic Junior Employees Senior
Employees
Mean Mean
Prior consulting experience 0.0% 16.7%
Prior CEO/founder experience 0.0% 5.6%
Prior IB/big bank experience 100.0% 77.8%
Prior finance experience (broad) 100.0% 88.9%
Male 87.5% 94.4%
Has MBA 0.0% 44.4%
Has elite MBA 0.0% 38.9%
Has elite or top-tier MBA 0.0% 38.9%
Elite undergraduate degree 87.5% 38.9%
Non-US undergraduate degree 0.0% 27.8%
Total 8 18
(Continued)
 Managing the private equity firm 227

Table 10.2 (Continued)

Panel E: Vistria Capital
Characteristic Junior Employees Senior
Employees
Mean Mean
Prior consulting experience 21.4% 17.6%
Prior CEO/founder experience 0.0% 11.8%
Prior IB/big bank experience 78.6% 47.1%
Prior finance experience (broad) 85.7% 94.1%
Male 71.4% 82.4%
Has MBA 35.7% 64.7%
Has elite MBA 35.7% 58.8%
Has elite or top-tier MBA 35.7% 58.8%
Elite undergraduate degree 35.7% 35.3%
Non-US undergraduate degree 7.1% 0.0%
Total 14 17
Panel F: Housatonic Partners
Characteristic Junior Employees Senior
Employees
Mean Mean
Prior consulting experience 20.0% 42.9%
Prior CEO/founder experience 0.0% 14.3%
Prior IB/big bank experience 60.0% 28.6%
Prior finance experience (broad) 100.0% 100.0%
Male 100.0% 85.7%
Has MBA 20.0% 71.4%
Has elite MBA 20.0% 71.4%
Has elite or top-tier MBA 20.0% 71.4%
Elite undergraduate degree 40.0% 71.4%
Non-US undergraduate degree 0.0% 14.3%
Total 5 7
(Continued)
228 Advanced Introduction to Private Equity

Table 10.2 (Continued)

Panel G: Alpine Investment Partners
Characteristic Junior Employees Senior
Employees
Mean Mean
Prior consulting experience 0.0% 0.0%
Prior CEO/founder experience 3.7% 22.2%
Prior IB/big bank experience 7.4% 0.0%
Prior finance experience (broad) 37.0% 44.4%
Male 63.0% 100.0%
Has MBA 0.0% 33.3%
Has elite MBA 0.0% 22.2%
Has elite or top-tier MBA 0.0% 33.3%
Elite undergraduate degree 92.6% 44.4%
Non-US undergraduate degree 0.0% 0.0%
Total 27 9
Source: Authors compiled from EMSI

program (defined as Ivy League, MIT, Stanford, University of Chicago,

UC Berkeley, Duke and Northwestern).

Panel B of Table 10.2 shows a contrast between Bain Capital and KKR.
KKR is slightly less male dominated with 70.4% of senior employees and
65.8% of junior employees being male. In terms of prior experience, KKR
is more focused on finance with 38.8% of senior employees having an
investment banking background and 66.0% having some form of finance
experience prior to KKR. Junior staff finance backgrounds look very sim-
ilar. On the other hand, relatively few senior or junior staff have consult-
ing (16.0% and 13.5%) or prior CEO/founder experience (1.9% and 3.2%).
This is consistent with the perception that KKR has a heavier focus on
financial engineering than does Bain Capital. It also is consistent with
KKR having an affiliated consulting firm in Capstone.

KKR is less reliant on MBAs. Only 29.8% of senior employees have an

MBA and only 15.7% of junior employees have an MBA. Many of the
mega-fund PE firms, like many investment banks, have invested in their
 Managing the private equity firm 229

internal training programs and, as such, a larger fraction of the junior

staff do not go back to business school.

We also see a range of backgrounds for middle-market PE firms.

Berkshire Partners has a higher percentage of junior and senior employ-
ees who are male than either KKR or Bain Capital with 81.4% of sen-
ior employees and 79.7% of junior employees. This is consistent with the
work of Calder-Wang and Gompers (2021) who look at how more than
90% of senior investment professionals at small venture capital firms are
male.17 Given that middle-market PE firms are smaller than the mega-
fund firms, it is more likely that homophily will lead to less diversity.

Berkshire Partners similarly has a high fraction of employees with con-

sulting backgrounds, 37.8% and 35.0% for senior and junior staff respec-
tively. A high percentage (57.8% for senior staff and 50% for junior staff)
also have prior finance experience. What is perhaps more striking, how-
ever, is the heavy reliance on MBAs and especially elite MBAs. Of sen-
ior staff, 91.4% have an MBA from an elite school while 42.9% of junior
employees have an elite MBA.

In Panel E, we tabulate the backgrounds of the US-based employees of

BC Partners. Our data are limited to resumes of individuals in the US.
At least for its US-based employees, BC Partners is heavily male, with
94.4% of senior employees and 87.5% of junior employees being male.
The data show the clear link of BC Partners to its banking roots; 77.8%
of senior employees have investment banking experience and 88.9% have
prior broad finance employment. For junior employees it is 100%. The
staffing matches the firm’s strategy of focusing on financial engineering
in its transactions. The firm also tends to rely less on MBAs; 38.9% of
senior employees have an elite MBA and none of the junior employees.

Our final middle-market PE firm, Vistria Capital, has a more mixed

staffing model. There is still a heavy reliance on finance experience; 47.1%
of senior employees and 78.6% of junior employees have an investment
banking background. When we look at a broader definition of finance
experience, that number increases to 94.1% for senior employees and
85.7% for junior employees. Roughly a fifth of both senior and junior
employees have some consulting experience. This brings both operational
and financial skills to the deals that Vistria executes. Finally, Vistria has a
230 Advanced Introduction to Private Equity

moderate reliance on elite MBAs with 58.8% of senior employees holding

an MBA from an elite program and 35.7% of junior employees.

Housatonic Partners and Alpine Investment Partners, as representative

of small PE firms, offer contrasting approaches to staffing. One simi-
larity is that both firms are heavily male, with 100% of all employees
at Housatonic and 100% of senior professionals at Alpine being male.
Housatonic is heavily dependent upon senior professionals with consult-
ing backgrounds and elite MBAs; 42.9% of senior staff have consulting
experience and 71.4% have an elite MBA. Interestingly, both senior and
junior professionals at Housatonic have prior finance experience as well.
This would seem to indicate that Housatonic wants professionals who
can combine both operating and investing experience. This is consist-
ent with Housatonic’s stated investment strategy of taking board seats to
advise management, but not becoming deeply involved in operations. At
Alpine, none of the senior or junior staff have consulting backgrounds;
22.2% of senior employees have prior CEO or founder experience. Only
33.3% of Alpine’s senior professionals have an MBA from a top program.
Given that Alpine’s focus is on finding quality management teams, it is
likely the operational and deep finance experience may be less important.

Compensation structure and levels

In recent years, the interest among young professionals and MBA stu-
dents in careers in PE has grown tremendously. One motivating factor is
the perceived attractive compensation of PE professionals. Compensation
in PE is complex and contains a number of pieces. There are a number
of organizations that do compensation surveys. Each has slightly differ-
ent methodologies and samples. For those interested in comparing sur-
veys, the reference section lists several other PE compensation overviews.
Here, we use data from Heidrick and Struggles 2021 North American
Private Equity Compensation Survey. The survey received compensation
data from 1011 PE investment professionals across a variety of fund sizes.

Like most professional positions, private equity cash compensation

typically has two components: base salary and bonus. Second, incentive
compensation also typically takes the form of a share of the carried inter-
est. Carried interest compensation is expressed as a number of points of
carry. One point of carry is 1% of the total carried interest that the firm
 Managing the private equity firm 231

is paid on a particular fund. For example, if a PE firm is paid 20% car-

ried interest on a particular fund and an employee is allocated 10 points
of carry, that represents 10% of the 20% or 2% of the profits on invested
capital.

Carry is typically allocated primarily to senior-level staff in private equity

firms. Ivashina and Lerner (2019) look at how various PE funds allocate
carried interest in individual funds.18 PE funds can have relatively “flat”
carry allocation in which most senior professionals (directors and part-
ners) receive similar allocations. Other firms have unequal distributions.
In these funds, Ivashina and Lerner find that typically founders of the PE
firm received substantially larger allocations of carry than other senior
professionals. This unequal allocation comes with costs. The greater the
unequal nature of carry, the higher the likelihood that senior profession-
als leave the PE firm. The departure of senior professionals is then associ-
ated with more difficulty fundraising afterwards.

The compensation survey from Heidrick and Struggles that we explore

looks at all three elements of compensation in 2020 across various lev-
els of seniority. In the compensation survey, carried interest is report as
“carried dollars at work.” It is simply the share of the carried interest (in
percent, p) times the size of the fund (S), and the percent carry charged by
the private equity manager. As an example, if a manager has 10 points of
carry (out of 100) on a $1 billion fund that charges a 20% carry, she would
have $20 million of carry dollars at work (10% × 20% × $1 000 000 000).
This would also be her expected payout if the fund returns twice the
invested capital. The survey expresses carry for all funds collectively for
which the employee has a share.

Figure 10.2 tabulates compensation in 2020 for PE managing partners

by firm AUM. For the smallest PE firms, those with AUM less than $500
million, average base cash compensation is just over $1 million and aver-
age cash bonus was $823 000. For the largest PE firms, managing part-
ners had the lowest base compensation ($300 000), but the largest cash
bonus ($3 million). This is likely due to these individuals owning a large
share of the PE firm’s management company. Management fees for a PE
fund are paid to the management company which is owned typically by
the PE firm’s founders or most senior employees. The management com-
pany then pays all the expenses of the firm, e.g., salaries, rent, travel.
Management fees in excess of these expenses are then paid out on an
 232 Advanced Introduction to Private Equity

Source: Heidrick & Struggles’ North America private equity compensation survey, 2021, n = 51 investment professionals

Figure 10.2 Managing Partner Compensation in 2020 in Private Equity

 Managing the private equity firm 233

annual basis to the owners of the management company. Hence, many

of the most senior partners who own a large stake in the management
company take relatively low salaries and receive a large share of the man-
agement company profits.

For most managing partners carried interest is by far the largest source of
compensation. For the smallest PE firms, the managing partners’ carry
averaged $10.29 million. As discussed above, this is what they would
expect to earn if all their funds earn a two times return on invested capi-
tal. Managing partners at large PE firms (those with more than $2 billion
under management) have carry across all funds that is very large, rang-
ing from $77.7 million for firms with $2.0 to $3.99 billion AUM to $102
million for PE firms with $4.0 to $5.99 billion.

The difference in compensation between a managing partner and part-

ner/managing director is relatively small for small PE firms, but quite
large for large PE firms as seen in Figure 10.3. Partners/managing direc-
tors for firms with less than $1 billion in capital have base cash salaries
between $332 000 and $435 000. Cash bonus in 2020 averaged between
$325 000 and $513 000 for this group. Carry across all funds was roughly
$11 million. For large PE firms, those in excess of $4 billion in AUM,
partner/managing director compensation was substantially below that
of the managing partners. Base cash salary ranged from $435 000 to
$885 000 and cash bonus averaged between $801 000 and $1.0 million.
These levels, especially the bonus, are substantially below those of man-
aging partners. As mentioned above, the difference is largely due to own-
ership of the management company. Carry, while larger for partners/
managing directors at larger PE firms, was also substantially smaller
than the carry of managing partners. For partners/managing directors
of PE firms with $4.0 to $5.99 billion under management, carry averaged
$27.2 million across all funds. For firms with greater than $10.0 billion
under management, carry for partners/managing directors was between
$36.9 and $40.2 million across all funds.

In Figure 10.4, the most junior senior professionals, principals, have sub-
stantially lower base cash salary and bonus than their senior colleagues.
Base cash salary, depending upon the size of the PE firm, ranges between
$250 000 and $350 000. Cash bonus at smaller PE firms is around
$200 000 and at larger PE firms can be around $600 000. Principals begin
to share in carry in a more meaningful way relative to their more junior
 234 Advanced Introduction to Private Equity

Source: Heidrick & Struggles’ North America private equity compensation survey, 2021, n = 216 investment professionals

Figure 10.3 Partner/Managing Director Compensation in 2020 in Private Equity

Source: Heidrick & Struggles’ North America private equity compensation survey, 2021, n = 190 investment professionals

Figure 10.4 Principal Compensation in 2020 in Private Equity

Managing the private equity firm 235
236 Advanced Introduction to Private Equity

colleagues. At small PE firms, carry at work is roughly $4 million while

at larger firms it can be as high as $20 million on average. These carry
figures are several-fold higher than the carry for vice presidents. As deal
authority increases for principals, allocation of a share of profits and the
alignment of incentives become more important.

For more junior professionals, the economics are generally substantially

lower. Figure 10.5 looks at the 2020 compensation for vice presidents and
Figure 10.6 shows associate/senior associate statistics. Base cash compen-
sation for vice presidents is around $200 000 for all size PE firms while
base cash salary for associates/senior associates is between $110 000 and
$150 000. Cash bonus is usually close to or a little below the base salary
numbers. As mentioned above, junior professionals get allocated rela-
tively little carried interest. Given that junior professionals are primarily
working at the direction of senior employees and have little deal author-
ity, this makes sense.

The survey clearly shows that PE professionals are well compensated.

The other important pattern is that compensation scales rapidly at more
senior levels. This compensation increases in both cash compensation
as well as incentive compensation as represented by carry allocation.
Finally, managing partners, who are usually founders of the PE firms,
receive a disproportionate share of the economics relative to other very
senior professionals.

Conclusion

In this chapter we have explored how PE firms are staffed, recruited and
compensated. Earlier chapters have been able to rely on extensive aca-
demic research to explore broader fund and investment issues including
how firms add value to portfolio companies. Much less work has been
done on the human capital that PE firms contain and how that human
capital facilitates different strategies for value creation. We hope that
this final chapter provides some insights into the tremendous heteroge-
neity that exists in the PE industry and how that can affect investment
performance.
Source: Heidrick & Struggles’ North America private equity compensation survey, 2021, n = 243 investment professionals

Figure 10.5 Vice President Compensation in 2020 in Private Equity

Managing the private equity firm 237
 238 Advanced Introduction to Private Equity

Source: Heidrick & Struggles’ North America private equity compensation survey, 2021, n = 279 investment professionals

Figure 10.6 Associate/Senior Associate Compensation in 2020 in Private Equity

 Managing the private equity firm 239

Notes
1 This discussion is based largely on Paul A. Gompers and Kristin Mugford,
Bain Capital and Outback Steakhouse, Harvard Business School Case
Number 212-087.
2 KKR website: www​.kkr​.com​/ businesses​/private​-equity accessed on
4 January 2022.
3 KKR website: www​.kkr​.com​/ businesses​/private​-equity accessed on
4 January 2022.
4 Berkshire Partners website: https://berkshirepartners​.com​/private​-equity​/
sector​-focus/ accessed on 7 January 2022.
5 Berkshire Partners website: https://berkshirepartners​.com​/private​-equity​/
sector​-focus/ accessed on 7 January 2022.
6 BC Partners website: www​.bcpartners​.com​/private​-equity​-strategy,
accessed on 6 January 2022.
7 BC Partners website: www​.bcpartners​.com​/private​-equity​-strategy,
accessed on 6 January 2022.
8 Vistria website: www​.vistria​.com​/philosophy/ accessed on 6 January 2022.
9 Vistria website: www​.vistria​.com​/philosophy/ accessed on 6 January 2022.
10 Alpine website: www​.alpineinvestors​.com/ accessed on 6 January 2022.
11 Housatonic website: https://housatonicpartners​.com​/companies/ accessed
on 7 January 2022.
12 Housatonic website: https://housatonicpartners​.com​/companies/ accessed
on 7 January 2022.
13 Heidrick and Struggles’ North American Private Equity Compensation
Survey, 2021.
14 Berkshire Partners website: https://berkshirepartners​.com​/team​/michael​
-grebe/​?rl​=advisory​-directors accessed on 9 January 2022.
15 Vistria website: www​.vistria​.com​/platform/ accessed on 10 January 2022.
16 Housatonic Partners website: https://housatonicpartners​.com/ accessed on
10 January 2022.
17 Sophie Calder-Wang and Paul A. Gompers, 2021, And the Children Shall
Lead: Gender Diversity and Performance in Venture Capital, Journal of
Financial Economics 142, 1–22.
18 Victoria Ivashina and Josh Lerner, 2019, Pay Now or Pay Later? The
Economics within the Private Equity Partnership, Journal of Financial
Economics 131, 61–87.
Index

absolute performance measures 49–52 of middle-market corporate LBO

Acharya, Viral V. 30, 36, 37 loans 99, 102
adjusted present value (APV) DCF average performance, fund level 46
method 85, 89 Burgiss database 54, 55
Advantage Partners 22, 23 Cambridge Associates (CA) 55
Agilon health 153 IRR, North American buyout
Agrawal, Ashwini 33 and growth funds 56–9
A.J. Industries, Inc. 196 KS-PME, North American
Allen, Bill 73 buyout and growth funds
Alpine Investors 223 56–9
employees’ educational and MOIC, North American buyout
employment background and growth funds 56–9
228, 230 Pitchbook 55
profiles 215–16 Preqin 55
roles in 216–19 Russell 2000 62–3
staffing structures 221, 223 US buyout Direct Alphas
Alvarez-Demalde, Francisco 168–9 (1991–2017) 56, 61
amend and extend loan 127 US buyout IRRs (1991–2017) 56,
American Research and Development 60
(ARD) 8, 195 US buyout MOICs (1991–2017)
Amess, Kevin 32 56, 60
amortizing term loan (TLa) 106 US buyout PMEs (1991–2017)
Antoni, Manfred 32 56, 61
Apollo 157 AXA Private Equity’s purchase of
Apollo Global Management 116, 154 Diana 135
“arbitraging” of nursing home Axelson, U. 114
regulations 34
Arbor’s prior investments 154 Bain Capital 29, 37
Archive One 159 employees’ educational and
asset-backed credit agreement 117 employment background
asset-backed financing 130n9 224, 225, 228
asset-backed loans (ABLs) 101–3 profiles 212–13
auction theory 71 roles in 216–19
Audax 17 staffing structures 219–20
average debt multiples Balson, Andrew 73
of large corporate LBO loans 99, bank loans 117, 118
101 Bartlett, Joseph 165

240
 Index 241

BC Partners 212 Byrd, John W. 140

employees’ educational and
employment background Caix, Olivier 135, 153
226, 229 Calder-Wang, Sophie 239n17
profiles 214–15 Cambridge Associates (CA) 54–6
roles in 216–19 capital asset pricing model (CAPM)
staffing structures 220–21, 223 19, 84, 89, 92, 95
Behrman Capital 159, 179 Capstone 38, 213, 219, 228
Biesinger, Markus 30 carried interest/carry 48, 49, 167,
Bellon, A. 33 203–7, 230–31, 233
Bensley, Tim 153 CelTel 178
Berk, Michael 73, 138 chief executive officers (CEOs)
Berkshire Partners 212 replacement 132, 133
employees’ educational and Chu, Michael 73
employment background Clayton Dubilier and Rice (CDR) 148
226, 229 Cleveland-based defense contractor
profiles 214 145
roles in 216–19 Clifford, Chris 214
staffing structures 220–21, 222–3 closed-end fund 8, 195
Bernstein, Shai 33 Cohn, Jonathan B. 30, 31, 33
Bessemer Venture Partners 178 Coles, Jeffrey L. 140
Beylier, P.J. 73, 138 Colligan, Owen 123, 132, 135, 145,
Bill Conway’s “Ten Rules for Private 155–7, 159, 179
Investing” 81–2 commercial mortgage-backed
Bjerkan, Tore 139 securities (“CMBS”) 116, 117
Blackstone 12, 17, 38, 47, 135 committed capital 7, 48, 49, 196–8,
Blackstone Capital Partners (BCP) 201, 203, 214–16
65 common stock 2, 165, 166
Bloom, Brad 33, 214 comparable company valuation 83,
boards of directors, governance 87–9, 164
engineering compensation 2, 7, 24–6, 32, 47, 131,
monitoring function 140 136, 138, 167, 172, 194, 196, 197
outsider-dominated boards 140 associate/senior associate
PE involvement in portfolio compensation (2020) 236,
companies 141, 144 238
senior management 140 base cash salary 233
size and composition 140–43 carried interest 203–7, 230–31
Two-Star Army general cash bonus 233
recruitment 145 management fees 200–203
“bolt-on” acquisitions 159, 179 managing partner compensation
“book building” process 164, 168, (2020) 231–3
174 partner/managing director
Boucly, Quentin 30, 32 compensation (2020) 233
Brav, Alon 192nn4–5 positive net returns for investors
Brown, G. 63 208–9
Brush-Wellman 145 principal compensation (2020)
Burgiss database 54, 55, 64, 65 233, 235, 236
buy-and-build transactions 3 raising fees 208
242 ADVANCED INTRODUCTION TO PRIVATE EQUITY

vice president compensation Dore, Timothy E. 192n8

(2020) 236, 237 Doriot, Georges F. 8, 195
Compton, Karl 8, 195 Draper partnership 195
Conway, Bill 79 due diligence 5, 6, 69, 80–82, 173, 213,
Cornelli, Francesca 37, 141 217, 222
CVC International 12, 178
Cyber-Pro Systems 153 earnings before interest, taxes,
Cziraki, P. 132, 152 depreciation and amortization
(EBITDA) 20–24, 26, 27, 83, 85,
Daniel, Naveen D. 140 87, 88, 99, 100, 116, 118, 135,
Daphne International 158 157, 159, 203, 215
Davis, Steven J. 30–32 Eaton, C. 33
DCF models see discounted cash flow Eichenholz, Jason 175
(DCF) models Eisenberg, Theodore 140
deal selection 69, 74–7, 214 EMSI/Burning Glass (EMSI) 224
deal sourcing 5, 200, 212, 214 Englebienne, Guibert 168
auction theory 71 environment, social and governance
for closed deals 71, 72 (ESG) 215
due diligence 69 Epker, Russ 214
investment banks 71 equity ownership 26, 31, 33, 127–9,
investment rate 71 131, 136, 137, 139
negotiated transaction 73
proprietary deals 71 Fama, Eugene F. 140
smiling and dialing for deals 73 Fama–French model 19
social networks 74 Ferenbach, Carl 214
winnowing process 71 Ferran, Javier 135
Delaware Courts 84 financial engineering 31, 35–6, 38,
Denis, D.J. 140 223, 228, 229
Dia Kanri 22, 23 average debt multiples, of large
discounted cash flow (DCF) models corporate LBO loans 99,
adjusted present value (APV) 101
method 85, 89 average debt multiples, of
beta and discount rate middle-market corporate
calculation 84 LBO loans 99, 102
capital asset pricing model average debt-to-EBITDA ratio
(CAPM) 84, 95 119, 120
cash flows estimation 83 bank loans 117, 118
EBITDA 83 capital structure factors 119,
gross IRR and MOIC 89, 90 121–2
LBO investment models 85–7 commercial mortgage-backed
multiples valuation methodology securities (“CMBS”) 116,
87–9 117
tax advantages 84 earnings before interest,
terminal/exit value calculation taxes, depreciation and
84, 89–91 amortization (EBITDA)
weighted average cost of capital 99, 100
(WACC) method 84–5, 89 equity ownership 127–9
distressed investments 2, 4 financing sources 99
 Index 243

high-yield bonds 118 multiple of invested capital

incurrence test 118 (MOIC) 49–52
investment grade bonds 118 organization of 47–9
junior subordinated debt 99, 100 performance persistence 64–6
management incentives 127 risk-adjust fund returns 54
market timing theory 114 fundraising 99, 231
model bank loan term sheet from (2006 through 2019) 9, 10
123–6 alignment of incentives 195, 196
pecking order theory 114 compensation 200–209
private debt deals breakdown diversity of fund types and
(2006–19) 97, 98 variation 10, 12
purchase of Hanson growth-oriented private firms
Manufacturing Company 194
116–29 limited partnership 197–200
purchase of Harrah’s by region 9–11
Entertainment 116–29
purchase price multiples for Gachanja, Alex 193n17
LBOs 99, 100 Gahng, Minmo 172, 173, 175
senior secured debt see senior general partner (GP) 195, 196
secured debt carried interest or carry 48
targeted capital structure 114, cash distributions 49
115 commitment 48
tax advantage 113 compensation 201
trade-off theory 114, 116, 119 distribution of the percentage of
Flanders, Ralph 195 profits 205, 207
Fojtasek, Randall 74 fund activity 199
Fracassi, Cesare 33 fundraising 199
Frazzini, A. 63 management decisions 47
free cash flow problems 36 “paid in capital” 201
Freedom of Information Act (FOIA) partnership agreements 198, 200
55 returns to “skill” 27
fund level sale of partnership interests 199
average performance see average share of profits 197
performance, fund level ghSMART assessments 152
differential alpha 52–4 global impact of private equity 16
growth equity funds 47 global private equity transactions
internal rate of return (IRR) from (2014–19) 16
49–52 by country 15
investments and management Globant 168–9
fees 48 Gompers, P.A. 35, 50, 148, 152
Kaplan-Schoar public market Good, Aubrey 74
equivalent (KS-PME) Gores, Alec 177
52–4 Gores Metropoulos, Inc. 175, 177
limited liability partnerships governance engineering 25, 26, 28, 29,
(LLPs) 47 35–7, 75, 81
Long-Nickels public market alignment of managerial
equivalent (LN-PME) incentives 136–9
52–4 boards of directors 139–45
244 ADVANCED INTRODUCTION TO PRIVATE EQUITY

chief executive officers (CEOs) roles in 216–19

replacement 132, 133 staffing structures 221, 223
governance drivers 131 Humphries, Nic 138
incentive compensation 136, 138 hurdle rates 21, 71, 83, 86, 87, 89,
key senior hires 135 92–5, 204
management team 131–6
performance shares 138 Ibrahim, Mo 178
senior management recruitment IK’s investment strategy 154, 155
132 Ilmanen, Anti 63
“take private” transactions 138 incentive compensation 136, 230, 236
typical equity ownership 136, 137 incurrence covenants 110
government-subsidized student loan information asymmetry 6
program 33 initial public offering (IPO) 6, 81, 163,
Graham, John 95 182, 184
Gredil, O. 53 “book building” process 164
“greenshoe provision” 165 direct listings 168
Greenwald, Bruce 139 disclosure requirements 164
Griffiths, B. 53 distribution policy 167–8
Griswold, Merrill 8, 195 first day underpricing 168
growth capital 2, 4, 97, 213 Globant 168–9
growth equity 4, 12, 47, 63, 64, 201, insider trading 166
212, 214 lead underwriter 164, 165
Guo, Shourun 31 lockup 165–6
Gupta, A. 34 market liquidity 164, 165
negative effect on prices 167
Hanson Manufacturing 116, 123, 132, price movements 165
145, 155–7, 159, 179 purchasing shares 165
HarbourVest 17 regulatory and compliance costs
Harrah’s Entertainment 116–19, 123 168
Harris, Robert S. 30, 56, 64, 65 roadshow 164
Hart, Oliver 139 SEC Rule 144 166
Harvey, Campbell 95 tax motivations 166–7
Hayden, Stone & Co. 8 valuation 164
Heidrick and Struggles 2021 North Instinet 79
American Private Equity Institutional Limited Partners’
Compensation Survey 230, 231, Association (ILPA) 196–8, 201,
239n13 204
Hermalin, Benjamin E. 140 internal rate of return (IRR) 21, 23,
Hickman, Kent A. 140 49–53, 65, 66, 83, 86, 87, 89, 90,
high-yield bonds 108, 110, 113, 118 92, 95, 204
history of private equity 8–9 US buyout IRRs (1991–2017)
holding periods 6, 21, 30, 182 56, 60
Hotchkiss, Edith 30 Investment Company Act of (1940)
Housatonic Partners 159, 212, 230 195
employees’ educational and investment decision making 216
employment background APV DCF methods 89
227, 230 deal selection 74–7
profiles 216 deal sourcing 69–74
 Index 245

discounted cash flow (DCF) profiles 213–14

models see discounted roles in 216–19
cash flow (DCF) models staffing structures 219–20, 222
financial tools 82–3 Korteweg, Arthur 54
firm-specific adjustments 95 Kotsantonis, Sakis 209n4
firm-specific risks 95 Kovner, A. 25
hurdle rates 89, 92–4 Kravis, Henry 213
investment memorandum 78
macroeconomic risks 92, 95 Lambert, Drexel Burnham 9
OUTSX-CUPID framework largest private equity firms (2020)
78–82 12–14
WACC DCF methods 89 Lattman, Peter 209n2
investment grade bonds 118 Lerner, Josh 33, 231
investment memorandum 78 leveraged buyouts (LBOs) 9, 47, 182,
IPO see initial public offering (IPO) 187, 196, 201
IRR see internal rate of return (IRR) average debt multiples, of large
Ivashina, V. 25, 231 corporate LBO loans 99,
101
Jackson, Michael 216 average debt multiples, of
Jagannathan, Ravi 54 middle-market corporate
Japanese kaizen model 157 LBO loans 99, 102
Jenkinson, T. 114 early targets of 2
Jensen, Michael C. 3, 25, 26, 35, 36, equity sponsors 26
136, 140 financed by 3
Jenter, D. 132, 152 fraction of deal value 3
junior subordinated debt 99, 100, 108, fundraising (2000 to 2019) 16
110, 123 Harrah’s 117, 118
investment activity (2009–19)
junk bonds 3, 9, 25, 108 16, 18
investment models 85–7
Kaplan, S.N. 25, 30, 34, 35, 52, 54, 63, “junk bond” market 3
65, 136, 152, 182, 193n19 Large Corporate LBO Loans 101
Kaplan-Schoar public market loan structures, US LBOs 106,
equivalent (KS-PME) 52–4, 107
56, 62 Middle-Market Corporate LBO
Karakaş, Oğuzhan 37, 141 102
Keith, Brett 123, 132, 145, 155–7, 159, pro-rata tranche 108, 109
179 purchase price multiples 99, 100
Kim, Jin-Goon 158 transactions 3
Kirkpatrick, Kip 215 leveraged dividend recapitalization
Klausner, Michael D. 173–5 179–80
Klebanov, M. 152 leveraged loans, senior secured debt
Kohlberg, Jerome 213 104–5
Kohlberg Kravis and Roberts and Co. amortizing term loan (TLa) 106
(KKR) 9, 17, 35, 38, 47, 196, 212 collateral value 103
employees’ educational and covenants 103
employment background euro-based EURIBOR 103
225, 228–9 floating interest rates 103
246 ADVANCED INTRODUCTION TO PRIVATE EQUITY

high-yield bonds in Europe 110, Moan, Oystein 139

112 model bank loan term sheet 123–6
high-yield bonds in US 110, 111 Moore, John 139
incurrence covenants 110 MSCI Europe Index 62
institutional tranche 106, 108 MSCI World Index 62
loan structures 106, 107 Mugford, Kristin 239n1
London Interbank Offered Rate Mukharlyamov, V. 35, 50, 152
(LIBOR) 103 multiple expansion 23
mezzanine financing 113 multiple in/multiple out (MI/MO) 86
“paid in kind” (PIK) 113 multiple on invested capital (MOIC)
pre-pay leveraged loans 103 21, 49–52, 83, 86, 87, 89, 90
“pro-rata” tranche 106, 108, 109 US buyout MOICs (1991–2017)
renegotiation mechanism 103 56, 60
second-lien loans 106, 108 multiples valuation methodology
small and medium-sized 87–9
leveraged loans 106 Murphy, Kevin J. 26
TLb tranche 108 Myers, S.C. 114, 139
underwritten public bond
issuances 108, 110 Nagel, Stefan 54
limited liability partnerships (LLPs) Nesbitt, Marty 215
47 Nestoriak, Nicole 33
limited partnerships (LPs) 6–9, 19, net asset value (NAV) 7, 49
27, 47–52, 54, 55, 65, 92, 163, New Mountain investment 155
195–201, 204, 208, 217 Nickels, C.J. 52
Lion Capital 135 Nocetti, Néstor 168
log utility 54, 67n9 non-financial measures, portfolio
London Interbank Offered Rate companies 29
(LIBOR) 103, 123 NPV 203
Long, A.M. 52 Nunnelly, Mark 73
Long-Nickels public market
equivalent (LN-PME) 52–4 Oaktree Capital 180
LPs see limited partnerships (LPs) Ohlrogge, Michael 173–5
Lubin, Richard 214 Olympus Partners 154
Luminar Technologies 175, 177 operational engineering 26, 31, 35
acquisitions 158–9
Majluf, N.S. 139 Apollo Global Management 154
management fees 8, 48, 49, 92, Arbor’s prior investments 154
199–203, 208, 231, 233 better marketing 157
managerial incentives, alignment of deal selection 40
136–9 firms organized by industry 38,
market-adjusted performance 39
measures 52–4 IK’s investment strategy 154, 155
market timing theory 114, 119, 182 improvements/reductions 157
Metrick, Andrew 203 new products and services 153,
Metropoulos, Dean 177 156–7
Mezzanine capital 2 operational value creation levers
Mezzanine financing 113 149, 152
Migoya, Martin 168 optimized pricing 159–60
 Index 247

pre-investment sources 40, 42, 43 primary provider management 153

pre-investment (expected) private equity exit strategy 180–82
sources of value creation buyout capital backed exits 182,
148, 150–51 184
proprietary strategy 149 in Europe 187, 191
Rise Bakers 153, 154 financial sales 182, 185
roll-up strategy 159 firm reputation 187, 191
sales reorganization 156 by geography (1970–2002) 187, 189
senior management 153 initial public offering (IPO)
sources of value creation 148, 149 163–9, 182, 184
team upgrade/new CEO 152–3 leveraged dividend
upgrading technology 155 recapitalization 179–80
value creation plan 38 management purchases 182, 186
value creation sources 40, 41 median hold-times by exit type
Outback Steakhouse 73, 157, 160 182, 187
OUTSX-CUPID framework median PE-backed exit multiples
Bill Conway’s “Ten Rules for by type 187, 189
Private Investing” 81–2 PE-backed IPOs hitting range
competition and industry (C) 187, 189
analysis 78 private equity exits by year of
debt capacity (D) 80 buyout 182, 187, 188
distress and excess leverage 80 ranking of factors 182, 183
edge/proprietary advantage 79 special purpose acquisition
exit (X) 81 companies (SPACs)
financial distress/constraints 80 169–79
good deals 81 strategic sales 182, 185
improvement (I) 79 trade sales 182, 186
opportunity (O) 78 in US 187, 190
proprietary (P) 78–9 private equity investment, definition
structure of deal (S) 81 1
team (T) 81 private equity organizations, origin 2
uncertain (U) 80 private equity (PE) recruitment of
undervalued (U) 78 management teams 132, 133
private investments in public equity
“paid in capital” 49, 201 (PIPEs) 4, 170, 172, 173
“paid in kind” (PIK) 113 proprietary deals 5, 71, 74, 149
Peck, Sarah 136 “pro-rata” tranche 106, 108, 109
pecking order theory 114 Providence Private Equity Partners
Pedersen, L.H. 63 (PEP) 180
performance persistence 64–6, 67n22 public-private arbitrage 23, 24
Phalippou, Ludovic 46, 203 public-to-private buyouts 30
PIK Toggle feature 118 Pucker, Ken 209n4
Pitchbook 54–6, 65
positive risk-adjusted returns 19 Rauch, Christian 210n13
Pradhan, R. 34 redemption rights 170, 172, 173
preferred equity 2, 99 Registered Nurse classifications 34
Preqin 55 Regulation Fair Disclosure (“Reg
Previtero, Alessandro 33 FD”) 110
248 ADVANCED INTRODUCTION TO PRIVATE EQUITY

Rise Bakers 153, 154 sponsors 170, 172, 174–5

Riverwood Capital 169 strategic sales 177–8
Roberts, George 213 target company 170
Rock, Arthur 8 timeline 170, 171
Rockwood Capital 123, 159, 179 underwriters 172, 173
Rockwood Equity 132, 145, 155 valuation and share prices 174
roll-up strategy 159 SpeedCast 73, 138
Romney, Mitt 29, 213 Spotify 168
Russell 2000 62–3 Stein, Jeremy 25
Russell, Austin 175 Stern, Léa 210n19
Stiglitz, Joseph 139
Sachdev, Ravi 153 stock- and option-based
Sadun, Raffaella 33 compensation 36
S&P 500 52, 56, 62, 63 strategic sales 177–8
Sarin, A. 140 Strömberg, P. 34, 35, 114, 182
Schoar, A. 52, 54, 65 Stucke, R. 53
secondary buyouts 47 Summit Partners 73
sector-focused operating partners 5 Sun Country 157, 160
Securities Act of 1933 110 systematic risk 19
Sell, Steve 153
Selling Securityholders 165 “take private” transactions 138
senior management recruitment 132 Tambe, Prasanna 33
senior secured debt 99, 123 Thiel, Peter 175
asset-backed loans (ABLs) 101–3 Thorndike, Will 159, 216
leveraged loans 103–13 top global PE firms 16, 18
senior debt-to-EBITDA levels 100 Towery, Erin M. 30, 31
Sheen, Albert 33 trade-off theory 114, 116, 119
sheer scale 116 Transnorm 154, 155
Silver Lake Partners 4 trip wires 127
Sino-IC Capital 12
Sippel, Ed 73, 138 Umaran, Martin 168
Slack 168 underwriters 164, 165, 168, 170,
Sorensen, M. 54, 152 172–4
special purpose acquisition United Kingdom, buyouts (1999 to
companies (SPACs) 2004) 31, 32
acquisition target 170, 172
characteristics 173–4 Valor Equity Partners 156, 158
financial sale 178–9 value bridge 19, 20, 22–4
Gores Metropoulos, Inc. 175, 177 value creation
IPO shareholders 172–3, 175 Alpine’s value creation 215
issuing stock and raising capital capital asset pricing model
169–70 (CAPM) 19
Luminar Technologies 175, 177 deal sourcing 46
merger target 170 earnings before interest,
number of IPOs 169, 170 taxes, depreciation and
post-merger returns 175, 176 amortization (EBITDA)
private investment in public 20–24, 26, 27
equity (PIPE) 170, 173 enterprise values 20
 Index 249

Fama–French model 19 profiles 215

internal rate of return (IRR) 21 roles in 216–19
multiple expansion 23 staffing structures 220–21, 223
multiple on invested capital
(MOIC) 21 Wadsworth, Eliot 216
operational engineering 149 Wardlaw, Malcolm 33
pre-investment (expected) Wasserstein, A.J. 159
sources of value creation Watkins, Timothy 158
42 Weaver, Graham 215
public-private arbitrage 23, 24 weighted average cost of capital
public-to-private buyouts 31 (WACC) method 84–5, 89
sources of 41, 149 Weisbach, Michael S. 114, 140
systematic risk 19 Weiss, Andrew 139
total enterprise values (TEV) Williamson, Oliver E. 140
20–21 winnowing process 71, 74
value bridge 19, 22, 24 World Triathlon Corporation (WTC)
van Reenen, John 33 180
Venkatachaliah, Girish 153 Wozny, Matt 193n17
venture capital 2, 4, 8, 9, 47, 65, 194–5 Wright, Michael 30
Verdi, Mark 160 Wright, Mike 32
Visma Software 138, 139
Vistria Capital 212 Yasuda, Ayako 203
employees’ educational and Yermack, David 140
employment background
227, 229–30 Zephyr Asset Management 178
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