The investment behavior of buyout funds: Theory and evidence

• Author: Daniel Wolfenzon,Matthew Richardson,Alexander Ljungqvist
• Published date: 01 March 2020
• Date: 01 March 2020
• DOI: http://doi.org/10.1111/fima.12264

DOI: 10.1111/fima.12264

ORIGINAL ARTICLE

The investment behavior of buyout funds: Theory

and evidence

Alexander Ljungqvist1Matthew Richardson2Daniel Wolfenzon3

1Stockholm School of Economics and Swedish

House of Finance and CEPR, Stockholm, Sweden

2Stern School of Business, New YorkUniversity

and NBER, New York,New York

3GraduateSchool of Business, Columbia

University and NBER, New York,New York

Correspondence

AlexanderLjungqvist, Stockholm School of Eco-

nomics,Drottninggatan 98, 111 60 Stockholm,

Sweden.

Email:alexander.ljungqvist@hhs.se

Abstract

We analyze the determinants of buyout funds’ investment deci-

sions. We argue that when there is imperfect competition for private

equity funds, the timing of funds’ investment decisions, their risk-

taking behavior, and their subsequent returns depend on changes

in the demand for private equity, conditions in the credit market,

and fund managers’ ability to influence perceptions of their tal-

ent. We investigate these hypotheses using a proprietary dataset of

207 U.S. buyout funds that invested in 1,957 buyout targets over a

30-year period. Our dataset contains precisely dated cash inflows

and outflows in everyportfolio company, links every buyout target to

an identifiable buyout fund, and is free from reporting and survivor

biases. Thus, we are able to characterize everybuyout fund’s precise

investment choices. Our findings are as follows. First, established

funds accelerate their investment flows and earn higher returns

when investment opportunities improve, competition for deal flow

eases, and credit market conditions loosen. Second, the investment

behavior of first-time funds is less sensitive to market conditions.

Third,younger funds invest in riskier buyouts, in an effort to establish

a track record. Finally,following periods of good performance, funds

become more conservative, and this effect is stronger for first-time

funds.

KEYWORDS

alternative investments, buyout funds, fund management, private

equity

1INTRODUCTION

Over the past four decades, private equity has grown into a sizeable asset class, with more than 9,000 funds raising

in excessof $1.9 trillion from institutional and other investors (source: Venture Economics). Buyout funds account for

63% of this amount. In contrast to venture funds (which havereceived more academic attention), buyout funds usually

c

2019 Financial Management Association International

Financial Management. 2020;49:3–32. wileyonlinelibrary.com/journal/fima 3

4LJUNGQVIST ETAL.

purchasea controlling interest in an established corporation or one of its product lines, often involving large amounts of

debt(i.e., leveraged buyouts). Despite their important role in financing firms and reallocating capital to more productive

sectors of the economy,relatively little is known about the investment behavior of buyout funds. This paper provides

a comprehensive analysis of the optimal investmentplans of buyout funds in a setting where funds compete for target

companies, there is imperfect competition for funds so that buyout managers have bargaining power,and future fund-

raising is sensitive to performance.

We develop a simple model of a buyout fund deciding how to investits capital over time when faced with a choice

between “safe” and “risky” buyout targets. In response to demand shocks, we assume there is imperfect competition

for funds (e.g., the supply of capital to buyout funds is sticky), which temporarily increases an existingfund manager’s

bargaining power relative to target companies. Not surprisingly, funds generallymake acquisitions when investment

opportunities are good, their bargaining power is high, and debt is cheap. However,if fund manager skill is not observ-

able, the optimal dynamic investmentplan of a less established fund manager can involve making risky bets even if their

expectedreturns are lower than for safe investments. This is akin to buying an option, in the sense that a successful bet

enables a first-time fund manager to raise a follow-on fund by creating a “positive”track record. First-time managers

may also invest at the wrong time, that is, when competition, investmentopportunities, or credit conditions are not at

their most favorable. An important feature of the model is that its assumptions are chosen to be consistent with care-

fully documented empirical facts found in Gompers and Lerner (1998, 2000), Kaplan and Schoar (2005), Kaplan and

Stein (1993), Lerner and Schoar (2004), and Axelson,Jenkinson, Stromberg, and Weisbach (2013), among others.

Wetest the predictions of the model with a unique and proprietary dataset made available to us by one of the largest

institutional investors in private equity.It includes, among other items, precisely dated cash flows representing invest-

ments in 1,957 portfolio companies by 207 U.S.buyout funds that were started between 1981 and 2000 and that were

active through 2007. The dataset accounts for 35% of all buyout fund capital raised over the period and so affords a

comprehensive view of investmentbehavior in the U.S. buyout industry.

The dataset has several advantages over others used in the literature. First, unlike commercial databases such

as Venture Economics, VentureOne, or Asset Alternatives, it is free of self-reporting and survivor biases: we know

the complete portfolio composition of every fund in the sample as well as the ultimate fate of each investment. This

obviates the need to remove reporting and survivor biases through the use of structural econometric models (as in

Cochrane [2005], Hwang, Quigley, and Woodward [2005], or Phalippou and Gottschalg [2009], among others). Sec-

ond, we know the timing and magnitude of both cash outflows and cash inflows associated with every portfolio com-

pany,enabling us to compute not just fund-level performance measures but also returns for each portfolio company. In

contrast, commercial databases generally keep fund-levelperformance data secret, and portfolio company returns are

impossible to compute with any certainty from commercially available data, because the precise contractualstructure

of the investments (which determines the division of cash flows at exit)is not recorded.1Third, we can map every buy-

out target to an identifiable buyoutfund, which enables us to track each fund’s precise investment choices. Commercial

databases frequently do not know which fund in a manager’s family of funds made an investment and so credit many

investments to a category of “unspecified funds” instead.

Our empirical results support the predictions of our model. We find that fund managers speed up their investments

as investment opportunities improve, competition eases, and the cost of credit falls. More importantly,as predicted,

the investment behavior of first-time funds is significantly less sensitiveto market conditions. Their investment sensi-

tivities increase relative to those of older funds following a string of early successes that reduce the need for strategic

investmentbehavior. In terms of the returns on invested capital that fund managers earn on individual buyout deals, we

find that performance is significantly greater in the same circumstances that favor fast investment: when investment

opportunities are good, competition is low,and debt is cheap. First-time funds invest in riskier buyouts, consistent with

our assumption that they seek to establish a trackr ecord.Following periods of good performance, funds become more

conservative, and this reduction in risk-taking is stronger among first-time funds.

1SeeKaplan and Schoar (2005), Phalippou and Gottschalg (2009), and Ewens, Jones, and Rhodes-Kropf (2013) forexceptions.