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Practitioner: "Things are really tough because the banks are only lending 4 times cashflow, when they used to lend 6 times cashflow. We can't make our deals profitable anymore.“
Academic: "Why do you care if banks will not lend you as much as they used to? If you are unable to lever up as much as before, your limited partners will receive lower expected returns on any given deal, but the risk to them will have gone down proportionately."
Practitioner: "Ah yes, the Modigliani-Miller theorem. I learned about that in business school. We don't think that way at our firm. Our philosophy is to lever our deals as much as we can, to give the highest returns to our limited partners."
Overinvestment in good times – some mediocre deals get taken.
Underinvestment in bad times – some good deals cannot get financed.
Average deal made in bad times is actually better quality than the average deal in good times.
But this is not because the market is crazy. Rather it is a necessary ’loss’.
Private equity can finance many valuable deals but financing imperfections lead to some mistakes.
Why don’t LPs have veto rights over individual investments? Wouldn’t this help to solve the governance problems?
If LPs were given veto rights over individual investments, they would use them whenever they are concerned about governance, especially when there have been few investments earlier in the fund and the GP has incentives to invest, even if potential investments are poor quality.
This would dilute the positive incentive effects of comingling investments within funds.
Third party financing (bank, syndication from other investors) is critical.
Why does the deal have to be exited within a fixed time frame?
Further check on the GP
Desire to raise next fund improves incentives for existing ones.
Cost: Some investments require more time, sometimes the exit market (IPO) is cold.
Secondaries (selling to another LBO firm) have become a more and more common alternative.
Is this just passing around a hot potato or is it good practice?
Michael Jensen predicted ”The Eclipse of the Public Corporation” 20 years ago.
Does Sarbanes/Oxley imply that some firms should always be private?
The financial / organizational structure of private equity firms (LBO’s, Venture capital) appears successful and robust.
Strong evidence that they contribute value to the world
Frictions between GPs and LPs seem crucial for explaining organizational structure and investment behavior.
Boom/Bust cycles in the private equity industry are a natural consequence of this investment process.
Not necessarily ’behavioral’.
Likely are an unavoidable outcome of the investment process that nonetheless allows for investments that could not be undertaken by other types of organizations like public corporations.
Ongoing Empirical Study of LBO Capital Structure
We are collecting a database of large buyouts in both the US and Europe.
What determines capital structures of portfolio firms? Does it appear to be something like the ‘traditional tradeoff model’ from corporate finance, or the newer theory based on financing cycles proposed here?
Can we measure the effect of debt cycles on the quantity, pricing, and ultimate performance of deals?
What other factors affect deals? Early vs. late in a fund? Geographic differences?