Leveraged Buyouts

Analyzing a large sample of gross fund-level and deal-level returns in Private Equity (PE), we study systematic differences in investment skills across PE firms and what investors can learn about the true skill of PE firms from past performance. We extend the framework of Korteweg and Sorensen (2017) and establish a flexible variance decomposition model that estimates heterogeneity in returns, idiosyncratic risk-taking, and default risk. Our results show that investment skills are systematically different across PE firms with an estimated interquartile spread of returns ranging from 23% to 26% for deals and 17% to 21% for funds, relative to the market. Further, we find significant heterogeneity in idiosyncratic risk and default risk, but higher idiosyncratic variation does not explain higher expected returns. Since returns inherit substantial noise and spurious correlations from overlapping investments, investors require a considerable number of observations to learn about the true skill of PE firms.

This study investigates the effects of economic cycles on abnormal value creation of buyouts (BO) and on the investment activity of the corresponding Private Equity (PE) funds. We benchmark a large sample of BO transactions with closely matched public companies from 1986 to 2017. Our results show that BO transactions have created significantly more value overall, but abnormal value creation has disappeared in more recent periods. However, BO transactions are considerably less sensitive to adverse shocks in the real economy than their public counterparts. The adverse impact of a 1% increased exposure to economic distress is between 0.4% and 0.5% lower for BO than for public benchmarks. Using the quarterly cash-flow data of the corresponding PE funds, we find that investment activity of initial fund flows is slightly pro-cyclical, while reinvestment activity is highly countercyclical to the real economy. Our results imply that PE funds act as liquidity providers during economic distress by providing 45% to 49% more capital to their existing portfolio companies than in undistressed periods.

Understanding value creation at the transaction level is at the heart of explaining private equity (PE) returns. Taking advantage of a proprietary sample of 2,029 international buyout deals executed between 1984 and 2013 we provide detailed evidence on financial, market and operational value creation drivers. Additionally, we unravel the differences in value creation between regions, industries, transaction sizes and over time, providing limited and general partners with the opportunity to compare their past transactions with those of their respective peer groups.