Essays in Private Equity DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Ji-Woong Chung Graduate Program in Business Administration The Ohio State University 2010 Dissertation Committee: Professor Isil Erel Professor Berk A. Sensoy Professor Michael S. Weisbach, Advisor Copyright by Ji-Woong Chung 2010 ii Abstract This first essay, “Leveraged Buyouts of Private Companies,” studies the motivations and the consequences of leveraged buyouts of privately held companies. Over the last two decades, the number (enterprise value) of leveraged buyout transactions involving privately held targets totals 10,013 ($855 billion), accounting for 46% (21%) of the worldwide leveraged buyout market. Yet the vast majority of academic studies focus on the buyouts of publicly held targets. This chapter investigates the effects of leveraged buyouts on privately held targets. I find that, unlike the corporate restructuring process of public firms after the buyouts, private targets sponsored by private equity firms grow substantially after the buyouts. The overall evidence suggests that private equity firms, through leveraged buyouts, facilitate private targets’ growth by alleviating targets’ investment constraints. In the second essay, “Incentives of Private Equity General Partners from Future Fundraising” which is co-authored with Berk Sensoy, Lea Stern, and Mike Weisbach, we model and estimate the total incentives facing private equity general partners. Incentives from the explicit fee structure (“two and twenty”) of private equity funds understate the actual incentives facing private equity general partners because they ignore the rewards stemming from the effect of current performance on the ability to raise larger funds in the future. We evaluate the importance of these implicit incentives in the context of a iii learning model in which investors use current performance to update their assessments of a general partner’s ability, and, in turn, decide how much capital to allocate to the partners’ next fund. Our estimates suggest that implicit incentives from expected future fundraising are about as large as explicit incentives from carried interest in the current fund. This implies that the performance-sensitive component of revenue is about twice as large as suggested by previous estimates based only on explicit fees. Consistent with the model, we find that these implicit incentives are stronger when abilities are more scalable and weaker when current performance is less informative about ability. Overall, the results suggest that implicit incentives from future fundraising have a substantial impact on general partners’ welfare and are likely to be an important factor in the success of private equity firms. In the last chapter, I study performance persistence in the private equity industry. Contrary to what has been known in the literature, I find that performance persistence in private equity is short-living. Current fund performance is positively and significantly associated with the first follow-on fund performance, but not with the second or third follow-on funds. Even the statistically significant association between two consecutive funds’ performance is not economically large. The returns of the best performing quartile portfolio drops by about half, and those of the worst performing portfolio improve substantially from one fund to the next fund. There is no difference in the performance of the second (and after) follow-on funds of current top and bottom performing quartile portfolios. Performance converges in the long run. The commonality of relevant market iv conditions between two consecutive funds largely explains performance persistence. Also, excessive fund growth conditional on past performance erodes performance and reduces persistence. v Dedication To my parents, Dong-Jo Chung and Wol-Sun Kim vi Acknowledgments I am grateful to my advisor, Mike Weisbach, and the members of my committee, Isil Erel and Berk Sensoy, for their constant encouragement, support and guidance. I also thank my colleague Ph.D. students for their companionship and having spent countless hours discussing with me on various matters, and the faculty in the Department of Finance for their guidance. Lastly, I thank the Fisher College of Business for providing generous financial support. vii Vita 2003 B.A. Economics and Applied Statictics, Yonsei University, South Korea 2003-2005 Graduate Associate, Department of Business Administration, Yonsei University, South Korea 2005 to present Graduate Associate, Department of Finance, The Ohio State University Fields of Study Major Field: Business Administration viii Table of Contents Abstract ii Dedication v Acknowledgments vi Vita vii Fields of Study vii Table of Contents viii List of Tables xii List of Figures xiv Chapter 1: Leveraged Buyouts of Private Companies 1 1.1. Introduction 1 1.2. Hypothesis development 7 1.3. Data and summary statistics 9 1.3.1. Data sources and some institutional background 9 1.3.2. Sample selection 13 1.3.3. Construction of control sample 14 ix 1.3.4. Ownership structure of private targets 16 1.4. Post-buyout growth of target firms 18 1.5. Analysis of Deal rationales 21 1.6. Pre-buyout investment constraints and post-buyout growth 23 1.7. Operating performance after buyouts 25 1.8. Conclusion 27 Chapter 2: Incentives of Private Equity General Partners from Future Fundraising 29 2.1. Introduction 29 2.2. Model 36 2.2.1. Setup 37 2.2.2. Cross-sectional implications 38 2.2.3. Lifetime compensation of GPs 42 2.3. Data 47 2.4. The Empirical Relation between today’s Returns and Future Fundraising 52 2.4.1 Calculating indirect incentives for different types of funds 52 2.4.2. Indirect incentives of older and younger partnerships 55 2.4.3. Indirect incentives and fund size 56 2.5. General Partner Incentives Implied by the Regression Estimates 56 2.5.1. Basic results 56 [...]... buyouts of private firms is that private equity firms may be able to improve a target’s value by mitigating inefficiencies coming from various investment constraints facing small private firms In fact, unlike the image reflected in the media as “asset-strippers,” private equity firms often claim that they take this growth strategy to help the target firms grow and increase firm value This paper finds evidence... new investment opportunities Often owners of private firms tend to have different goals, such as preserving wealth, keeping the business stable, maintaining stable income flows, and providing employment opportunities for their descendants Private equity firms, through leveraged buyouts, can alleviate these investment constraints by providing the owners with a whole or partial exit (thereby lowering... margins This deterioration of operating efficiency could be the result of worse investments on the part of private equity firms However, it could also be that private equity firms are increasing, i.e., optimizing, investments by taking positive NPV but less profitable projects which were not previously exploited prior to buyouts due to investment constraints Therefore, we observe the decrease in the... buyouts of private firms, transactions which account for a large fraction of the leveraged buyout market Importantly, I show the importance of private equity sponsors and leveraged buyouts in alleviating the investment constraints facing private firms With the existing findings on the buyouts of public firms, the overall evidence suggests that private equity firms attempt to reorganize target firms in a... with private equity sponsors experience an increase in operating performance: industry-adjusted EBITDA increases by 12% during the first three years post-buyout Not surprisingly, the industry-adjusted ratio of operating income to sales drops by 35% The reason is because the rate of sales growth exceeds that of EBITDA after buyouts This pattern implies that buyouts with private equity sponsors result in. .. reduces inherent the targets’ inefficiencies—agency problems in public targets and investment constraints in private ones A closely related study to this paper is Boucly et al (2009) From the examination of French leveraged buyouts transactions, they document substantial growth in assets, sales, and employment They interpret that private equity and leveraged buyouts can provide “niche” financing for... an efficient investment in response to the expected demand shock in chemical industry Also, Bargeron et al (2008) finds that private equity firms tend to pay less acquisition premium than public firms when acquiring a similar target firm, which suggests that private equity firms tend to make investments in a most cost saving way To my knowledge, this is the first academic study to examine the effects... targets of private equity In addition, to a certain extent, unobservable economic forces leading to leveraged buyout decision can be controlled by using this sample Second, I construct non-LBO target private firms which have similar characteristics as private equity led LBO target firms using propensity score matching From all U.K companies in Amadeus, I first exclude private firms which have engaged in leveraged... general information about the company, including the details of key personnel, the registered office, share capital and shareholdings 17 1.4 Post-buyout growth of target firms If private firms face investment constraints which can be alleviated by a leveraged buyout led by private equity firms, we expect to observe increases in firm size and investment post-buyout Measuring firm size surrounding the... findings can be driven by selection bias In other words, private equity firms may be acquiring private firms which could have grown even without private 4 U.K company laws require all limited liability companies (both private and public) to file periodic reports with the Companies House See the U.K Companies House for the Companies Act 3 equity led leveraged buyouts Indeed, I find that targets of private . total incentives facing private equity general partners. Incentives from the explicit fee structure (“two and twenty”) of private equity funds understate the actual incentives facing private equity. of private firms is that private equity firms may be able to improve a target’s value by mitigating inefficiencies coming from various investment constraints facing small private firms. In. performance persistence in the private equity industry. Contrary to what has been known in the literature, I find that performance persistence in private equity is short-living. Current fund performance