University of Texas Roundtable on The State of the U.S. Private Equity Market

In this discussion that took place at the 2017 University of Texas Private Equity conference, the moderator began by noting that since 2000, the fraction of the U.S. GDP produced by companies that are owned or controlled by global private equity firms has increased from 7% to 15%. What's more, today's PE firms have raised an estimated $1.5 trillion of capital that is now available for investing. And thanks in part to this abundance of capital, the prices of PE transactions have increased sharply, with EBITDA pricing multiples rising from about 8.8X in 2012 to 11.5X at the beginning of 2017. Partly as a consequence of such abundant capital and high transaction prices, the aggregate returns to U.S. private equity funds during this four‐year period have fallen below the returns to the stockholders of U.S. public companies. Nevertheless, the good news for private equity investors is that the best‐performing PE firms have continued their long history of outperforming the market. And the consistency of their performance goes a long way toward explaining why the overwhelming majority of the capital contributed by limited partners continues to be allocated to funds put together by these top‐tier PE firms. In this roundtable, a representative of one of these top‐tier firms joins the founder of a relatively new firm with a middle‐market focus in discussing the core competencies and approaches that have enabled the best PE firms to increase the productivity and value of their portfolio companies. Effective financial management—the ability to manage leveraged capital structures and the process of readying their companies for sale to potential strategic or financial investors—is clearly part of the story. But more fundamental and critical to their success has been their ability to find undervalued or undermanaged assets—and either retain or recruit operating managements that, when effectively monitored and motivated, are able to realize the potential value of those assets through changes in strategy and increases in operating efficiency.     

CARE Conference Hong Kong Polytechnic University,June 9, 2014: Equity Financing for Early‐Stage Companies in China

Many of the smaller private‐sector Chinese companies in their entrepreneurial growth stage are now being funded by Chinese venture capital (VC) and private equity (PE) firms. In contrast to western VC markets, where institutional investors such as pension funds and endowments have been the main providers of capital, in China most capital for domestic funds has come from private business owners and high net worth individuals. As relatively new players in the market who are less accustomed to entrusting their capital to fund managers for a lengthy period of time, Chinese VCs and their investors have shown a shorter investment horizon and demanded a faster return of capital and profits. In an attempt to explain this behavior, Paul Gompers and Josh Lerner of Harvard Business School have offered a “grandstanding hypothesis” that focuses on the incentives of younger, less established VCs to push their portfolio companies out into the IPO market as early as they can—and thus possibly prematurely—to establish a track record and facilitate future fundraising. This explanation is supported by the under‐performance of Chinese VC‐backed IPOs that has been documented by the author's recent research. Although they continue to offer significant opportunities for global investors, China's VC and PE markets still face many challenges. The supervisory system and legal environment need further improvement, and Chinese funds need to find a way to attract more institutional investors—a goal that can and likely will be promoted through government inducements.     

The Future of Private Equity

A distinguished University of Chicago financial economist and longtime observer of private equity markets responds to questions like the following:

• ? With a track record that now stretches in some cases almost 30 years, what have private equity firms accomplished? What effects have they had on the performance of the companies they invest in, and have they been good for the economy?
• ? How will highly leveraged PE portfolio companies fare during the current downturn, especially with over $400 billion of loans coming due in the next three to five years?
• ? With PE firms now sitting on an estimated $500 billion in capital and leveraged loan markets shut down, are the firms now contemplating new kinds of investment that require less debt?
• ? If and when the industry makes a comeback, do you expect any major changes that might allow us to avoid another boom‐and‐bust cycle? Have the PE firms or their investors made any obvious mistakes that contribute to such cycles, and are they now showing any signs of having learned from those mistakes?

Despite the current problems, the operating capabilities of the best PE firms, together with their ability to manage high leverage and the increased receptiveness of public company CEOs and boards to PE investments, have all helped establish private equity as “a permanent asset class.” Although many of the deals done in 2006 and 2007 were probably overpriced, the “cov‐lite” deal structures, deferred repayments of principal, and larger coverage ratios have afforded more room for reworking troubled deals. As a result of that flexibility, and of the kinds of companies that get taken private in leveraged deals in the first place, most troubled PE portfolio companies should end up being restructured efficiently, thereby limiting the damage to the overall economy. Part of the restructuring process involves the use of the PE industry's huge stockpile of capital to purchase distressed debt and inject new equity into troubled deals (in many cases, their own). At the same time the PE firms have been working hard to rescue their own deals, some have been taking significant minority positions in public companies, while gaining some measure of control. Finally, to limit overpriced and overlev‐eraged deals in the future, and so avoid the boom‐and‐bust cycle that appears to have become a predictable part of the industry, the discussion explores the possibility that the limited partners and debt providers that supply most of the capital for PE investments will insist on larger commitments of equity by sponsors to their own funds and individual deals.     

Toward a New Corporate Reorganization Paradigm

Chapter 11 is becoming an increasingly flexible, market‐driven forum for determining who will become the owners of financially troubled enterprises. With increasing frequency, distressed companies are sold in Chapter 11 as going concerns. At the same time, distressed investors, including hedge funds and private equity investors, are actively trading the debt of such companies in much the same way that equity investors trade the stock of solvent companies. Market forces drive the troubled company's debt obligations into the hands of those investors who value the enterprise most highly and who want to decide whether to reorganize or to sell it. One way or the other, the Chapter 11 process is used to effect an orderly transfer of control of the enterprise into new hands, whether the creditors themselves or a third party. But if the market‐oriented elements of this new reorganization process promise to increase creditor recoveries and preserve the values of corporate assets, other recent developments could present obstacles to achieving these goals. In particular, the increased complexity of corporate capital structures and investment patterns—including the issuance of second‐lien debt and the dispersion of investment risks among numerous parties through the use of derivatives and other instruments—threatens to increase inter‐creditor conflicts and reduce transparency in the restructuring process. These factors, coupled with provisions added to the Bankruptcy Code that selectively permit “opt‐out” behavior by favored constituencies, could interfere with the ability of troubled companies to reorganize as the next cycle of defaults unfolds.     

Morgan Stanley Roundtable on The State of Global Private Equity

In this discussion led by Alan Jones, Morgan Stanley's head of Global Private Equity, the University of Chicago's Steve Kaplan begins by surveying 25 years of academic research on private equity. Starting with Kaplan's own Ph.D. dissertation on leveraged buyouts during the 1980s, finance academics have provided a large and growing body of studies documenting the ability of private equity firms to make “sustainable” (that is, maintained over a three‐ or four‐year period) improvements in the operating performance of their portfolio companies, whether operating abroad or in the U.S. Even more impressive, the findings of Kaplan's new study (with Tim Jenkinson of Oxford and Bob Harris of the University of Virginia) suggest that these improvements have been large enough to enable PE funds raised between 1990 and 2008 to deliver returns to their limited partners that have averaged 300 to 400 basis points higher per year than the returns to the S&P 500. And given the “persistence” of PE fund returns—the tendency of the funds of the same PE firms to show up in the top quartile of performers year after year—that Kaplan has documented in earlier work, the performance of private equity seems notably different from that of mutual funds and hedge funds, where there has been little if any consistency in the returns provided by the top performers. Following Kaplan's overview of the research, four representatives of today's leading private equity firms explore questions like the following:

• ? How do the best PE firms, after paying premiums to acquire their portfolio companies and collecting large management fees, provide such consistently high returns to their limited partners?
• ? How did PE portfolio companies perform during the last recession, when many popular business publications were predicting the death of private equity—and what, if anything, does that tell us about how private equity adds value?
• ? What can PE firms do to avoid, or at least limit the damage from, the overpricing and overleveraging that tend to occur near the end of the boom‐and‐bust cycle that appears to be a permanent feature of private equity?

As Jones notes in his opening comments, the practitioners' answers to such questions “should help investors distinguish between the alpha that the firms represented at this table have generated through active management from the ‘closet beta’ that critics say results when private equity firms simply create what amounts to a levered bet on the public equity markets.”     

The Case for Secondary Buyouts as Exit Channel

Do private equity firms have a clear pecking order when deciding on exit channels for their portfolio companies? Are secondary buyouts—that is, sales to other PE firms—always an exit of last resort? And are there company‐ or market‐related factors that have a clear and predictable influence on decisions to pursue secondary buyouts? Using a proprietary dataset of over 1,100 leveraged buyouts that exited in North America or Europe between 1995 and 2008, the authors attempt to answer these questions by analyzing the returns associated with public, private, and secondary (or “financial”) exits. Based on their analysis of the realized returns, there is no clear pecking order of exit types. Secondary buyouts deliver rates of return that are the equal of those achieved through public exits. In addition, the authors assess the relationship between the likelihood of choosing a financial exit and certain company‐related as well as market‐related factors. Portfolio companies with greater debt capacity are more likely to be sold in secondary buyouts. Furthermore, increases in both the liquidity of debt markets and the amount of undrawn capital commitments to the private equity industry increase the probability of exit through secondary buyouts.     

Private Equity,the Rise of Unicorns,and the Reincarnation of Control‐based Accounting

This article discusses the rise of intangibles‐intensive companies and private equity (PE) since the late 1970s, and the role of both in bringing about the creation of a streamlined, more flexible set of accounting rules that, since their approval by the IASB and FASB in 2009, have been used by private companies and their investors. The PE industry comprises both venture capital (VC) firms that fund high‐growth enterprises and leveraged buyout (LBO) firms that fund more traditional, cash‐generating operations. Mainly because of the greater risks associated with both VC‐backed firms and LBOs—risks that make them ill‐suited for most public investors—such companies tend to require the more direct and active oversight provided by PE investors. And as the author goes on to argue, the more direct and active ownership of PE investors, as compared to the governance provided by most public‐company boards, suggests that financial accounting and reporting play a fundamentally different role in private than in public companies. Whereas the primary role of public‐company GAAP has increasingly (since the creation of the SEC in 1933) been to provide information for outside investors when valuing companies, the most important function of accounting reports in private companies is internal control—more specifically, ensuring that the interests of the managers of their portfolio companies are aligned with those of all the providers of capital. And recognizing this difference in the role of accounting, both the IASB and FASB responded to the requests of various parties (including private companies) by approving in 2009 the use by private companies of a streamlined and more flexible set of accounting standards. To the extent that the workings of PE markets continue to reduce the numbers of U.S. public companies, the author predicts that the resulting increase in the use of private‐company GAAP will continue to shift the primary role of accounting away from valuation and back toward its traditional roots in internal control and corporate governance.     

Private Equity and Portfolio Companies: Lessons from the Global Financial Crisis

Critics of private equity have warned that the high leverage often used in PE‐backed companies could contribute to the fragility of the financial system during economic crises. The proliferation of poorly structured transactions during booms could increase the vulnerability of the economy to downturns. The alternative hypothesis is that PE, with its operating capabilities, expertise in financial restructuring, and massive capital raised but not invested (“dry powder”), could increase the resilience of PE‐backed companies. In their study of PE‐backed buyouts in the U.K.—which requires and thereby makes accessible more information about private companies than, say, in the U.S.—the authors report finding that, during the 2008 global financial crisis, PE‐backed companies decreased their overall investments significantly less than comparable, non‐PE firms. Moreover, such PE‐backed firms also experienced greater equity and debt inflows, higher asset growth, and increased market share. These effects were especially notable among smaller, riskier PE‐backed firms with less access to capital, and also for those firms backed by PE firms with more dry powder at the crisis onset. In a survey of the partners and staff of some 750 PE firms, the authors also present compelling evidence that PEs firms play active financial and operating roles in preserving or restoring the profitability and value of their portfolio companies.     

Private Equity: Accomplishments and Challenges

The authors provide an overview of the main accomplishments of private equity since the emergence of leveraged buyouts in the 1980s, and of the challenges now facing the industry—challenges that have been encountered before during three major growth waves and two full boom‐and‐bust cycles. In so doing, the authors review a large and growing body of academic studies responding to questions like these:

• (1) How have PE buyout companies performed relative to their public counterparts? And to the extent there have been improvements in operating performance and productivity gains, how have such gains been achieved? What role have PE firms played in this process?
• (2) Especially in light of the large fees and profit shares paid to the PE firms, or GPs, and the significant “control” premiums over market paid to the selling companies, how have the returns to the LPs that provide the bulk of the funding for PE funds compared to the returns earned by the shareholders of comparable public companies?
• (3) Apart from the high fees earned by its GPs, why is PE so controversial? Beyond their effects on productivity and benefits for investors, what are the employment and other social effects of buyouts and PE?
• (4) What are the prospects for future PE returns to their LPs, especially in light of the volume of capital commitments and high purchase multiples that were being paid, at least until the onset of the COVID pandemic? And what role, if any, should PE activity be expected to play in the recovery from the pandemic?

     

Re‐equitizing Corporate Balance Sheets: Choosing Among the Alternatives

Companies are generally reluctant to issue new equity because it can be expensive capital. Among the largest costs of an equity offering are so‐called “market‐impact” costs. To the extent the typically negative market reaction to a stock offering causes an issue to be underpriced, such underpricing dilutes the value of current shareholders. Despite such costs, many companies—particularly financial institutions—are raising equity capital to “delever” balance sheets that have been squeezed by the credit crunch and economic slowdown. And far from transferring value from existing shareholders, these offerings can preserve and even increase the value of highly leveraged companies by shoring up their capital bases and providing the flexibility to get through a difficult period. According to recent studies, announcements of equity offerings by distressed companies have been accompanied by positive stock returns in excess of 5 %. The challenge for CFOs is to determine why and when issuing equity is the value‐maximizing strategy. The kinds of companies that are most likely to benefit from equity offerings are those that score low on credit metrics, have experienced cyclical declines in operating performance, and have growth opportunities as part of their recovery. There are a number of options for raising equity capital, but no set rules for identifying the optimal one. Nevertheless, the author offers a number of suggestions designed to help CFOs make smarter decisions: Communicate clearly to investors the intended uses of the proceeds from the equity offering and how they are expected to create value; Consider judicious cuts to the dividend to preserve capital; Involve current shareholders to minimize dilution, perhaps by considering a rights offering, and strengthen their commitment; Seek out “smart money” such as private equity or SWFs as long‐term investors; Get the offer size right the first time so a second offering can be avoided; and Monetize volatility in uncertain markets by issuing convertible securities.     

Leveraged Buyouts in the U.K. and Continental Europe: Retrospect and Prospect

The markets for management buyouts in the U.K. and continental Europe have experienced dramatic growth in the past ten years. In the U.K., buyouts accounted for half of the total M&A activity (measured by value) in 2005. And as in the U.S. during the‘80s, the greatest number of U.K. buyouts in recent years have been management‐ and investor‐led acquisitions of divisions of large corporations. In continental Europe, by contrast, the largest fraction of deals has involved the purchase of family‐owned private businesses. But in recent years, increased pressure for shareholder value in countries like France, Netherlands, and even Germany has led to a growing number of buyouts of divisions of listed companies. Like the U.K., continental Europe has also seen a small but growing number of purchases of entire public companies (known as private‐to‐public transactions, or PTPs), including the largest ever buyout in Europe, the €13 billion purchase this year of the Danish corporation TDC. In view of the record levels of capital raised by European private equity funds in recent years‐which, until 2005, exceeded the amounts invested in any given year‐we can expect more growth in private equity investment in the near future. In continental Europe, the prospects for buyouts remain especially strong, given both the pressure from investors to restructure larger corporations and the possibilities for adding value in family‐owned firms. But, as the authors note, today's private equity firms face a number of challenges in earning adequate returns for their investors. One is increased competition. In addition to the increased activity of U.S. private equity firms, local private equity investors are also facing competition from hedge funds and new entrants such as government‐sponsored operators, family offices, and wealthy entrepreneurs. Another major challenge is finding value‐preserving exit vehicles. Although an IPO is an option for the largest buyouts with growth prospects, most buyout investments are harvested either through sales to other companies or, increasingly, other private equity firms. The latter transactions, known as “secondary” buyouts, now account for a significant share of new funds invested by private equity firms across Europe.     

Private Equity and the COVID‐19 Economic Downturn: Opportunity for Expansion?

The coronavirus‐related global economic downturn poses a significant risk to PE portfolio companies, but also represents a significant opportunity to purchase quality companies at a discount. Because the industry is today much larger, as well as more diversified and experienced, than at the time of the 2008 downturn, it is better positioned not only to weather the severe economic storm, but emerge with an even larger and stronger asset base. Compared with PE at the time of the global financial crisis, today's $3.9 trillion private equity industry has considerably more dry powder, with more heavily capitalized strategies, including private credit and “secondaries,” more permanent capital, and stronger operational capabilities. In contrast with the pre‐crisis hyper‐competitive market environment in which purchase multiples were at record highs and returns faced significant downward pressure, the fear and uncertainty that characterize current market conditions have put PE in a position to grow its asset base at bargain prices. The advantages of scale, diversification, adaptability, and access to longer‐term capital are all expected to help today's larger alternative asset groups, which have in recent years achieved greater diversification in terms of strategy as well as geography and investors.     

Private Equity,Corporate Governance,and the Reinvention of the Market for Corporate Control

In the early 1980s, during the first U.S. wave of debt‐financed hostile takeovers and leveraged buyouts, finance professors Michael Jensen and Richard Ruback introduced the concept of the “market for corporate control” and defined it as “the market in which alternative management teams compete for the right to manage corporate resources.” Since then, the dramatic expansion of the private equity market, and the resulting competition between corporate (or “strategic”) and “financial” buyers for deals, have both reinforced and revealed the limitations of this old definition. This article explains how, over the past 25 years, the private equity market has helped reinvent the market for corporate control, particularly in the U.S. What's more, the author argues that the effects of private equity on the behavior of companies both public and private have been important enough to warrant a new definition of the market for corporate control—one that, as presented in this article, emphasizes corporate governance and the benefits of the competition for deals between private equity firms and public acquirers. Along with their more effective governance systems, top private equity firms have developed a distinctive approach to reorganizing companies for efficiency and value. The author's research on private equity, comprising over 20 years of interviews and case studies as well as large‐sample analysis, has led her to identify four principles of reorganization that help explain the success of these buyout firms. Besides providing a source of competitive advantage to private equity firms, the management practices that derive from these four principles are now being adopted by many public companies. And, in the author's words, “private equity's most important and lasting contribution to the global economy may well be its effect on the world's public corporations—those companies that will continue to carry out the lion's share of the world's growth opportunities.”     

CHOOSING THE RIGHT FINANCIAL SYSTEM FOR GROWTH

Well‐functioning financial systems promote economic growth by channeling funds from those who save to those who invest in the productive capacity of economies. What are the main features of a well functioning system? Are well developed capital markets essential to the process? Or are commercial banks and other “private” sources of capital capable of bringing about the same levels of growth and prosperity? In this article, the authors use information about the financial systems of a large number of both developed and developing countries to examine various relationships between a country's financial structure and its overall economic performance. Perhaps most important, the authors report a significantly positive correlation, using data for 34 countries, between the size of a country's financial system—measured by the total of commercial bank assets, equity market capitalization, and bonds outstanding—and economic development (as measured by GDP per capita). At the same time, the authors also provide evidence that banks (or loans) and capital markets (or securities) are complements, not substitutes, in promoting economic development, and that the presence of foreign‐owned banks (though not state‐owned banks) has a positive association with growth. In other words, both private banks and capital markets are likely to play important, though different roles in channeling funds from savers to investors.     

What drives leverage in leveraged buyouts? An analysis of European leveraged buyouts’ capital structure

This paper examines leverage in European private equity‐led leveraged buyouts (LBOs). We use a unique, self‐constructed sample of 126 European private equity (PE)‐sponsored buyouts completed between June 2000 and June 2007. We find that determinants derived from classical capital structure theories do not explain leverage in LBOs, while they do drive leverage in a control group of comparable public firms. Rather, we document that leverage levels in LBOs are related to the prevailing conditions in the debt market. In addition, our results indicate that reputed private equity sponsors use more debt and that secondary buyouts have higher leverage levels.     

Private equity and Covid-19

We survey more than 200 private equity (PE) managers from firms with $1.9 trillion of assets under management (AUM) about their portfolio performance, decision-making and activities during the Covid-19 pandemic. Given that PE managers have significant incentives to maximize value, their actions during the pandemic should indicate what they perceive as being important for both the preservation and creation of value. PE managers believe that 40% of their portfolio companies are moderately negatively affected and 10% are very negatively affected by the pandemic. The private equity managers—both investment and operating partners—are actively engaged in the operations, governance, and financing in all of their current portfolio companies. These activities are more intensively pursued in those companies that have been more severely affected by the Covid-19 pandemic. As a result of the pandemic, they expect the performance of their existing funds to decline. They are more pessimistic about that decline than the venture capitalists (VCs) surveyed in Gompers et al. (2021). Despite the pandemic, private equity managers are seeking new investments. Rather than focusing on cost cutting, PE investors place a much greater weight on revenue growth for value creation. Relative to the 2012 survey results reported in Gompers, Kaplan, and Mukharlyamov (2016), they appear to give a larger equity stake to management teams and target somewhat lower returns.     

Morgan Stanley Roundtable on Private Equity and Its Import for Public Companies

The role of private equity in global capital markets appears to be expanding at an extraordinary rate. Morgan Stanley estimates that there are now some 2,700 private equity funds that either have raised, or are in the process of raising, a total of $500 billion. With this abundance of available equity capital, the willingness of private equity firms to participate in “club” deals, and the leverage that can be put on top of the equity, private equity buyers now appear able and willing to pay higher prices for assets than ever before. And thanks in part to this new purchasing power, private equity transactions reportedly account for a quarter of all global M&A activity as well as a third of the high yield and IPO markets. The stock of capital now devoted to private equity reflects the demonstrated ability of at least the most reputable buyout firms to produce consistently high rates of returns for their limited partners. Although a talent for identifying and purchasing undervalued assets may be part of the story, the ability to produce such returns on a consistent basis implies an ability to add value, to improve the performance of the operating companies they invest in and control. And in this round‐table, a small group of academics and practitioners address two main questions: How does private equity add value? And are there lessons for public companies in the success of private companies? According to the panelists, the answer to the first question appears to have changed somewhat over time. The consensus was that most of the value added by the LBO firms of the‘80s was created during the initial structuring of the deals, a process described by Steve Kaplan as “financial and governance engineering,” which includes not only aggressive use of leverage and powerful equity incentives for operating managements, but active oversight by a small, intensely interested board of directors. In the past ten years, however, these standard LBO features have been complemented by increased attention to “operational engineering,” to the point where today's buyout firms feel obligated, like classic venture capitalists, to acquire and tout their own operating expertise. In response to the second of the two questions, Michael Jensen argues that much of the approach and benefits of private equity‐particularly the adjustments of financial policies and stronger managerial incentives‐can be replicated by public companies. And although some of these benefits have already been realized, much more remains to be done. Perhaps the biggest challenge, however, is finding a way to transfer to public companies the board‐level expertise, incentives, and degree of engagement that characterize companies run by private equity investors.     

The Impact of Sovereign Wealth Funds on Corporate Value and Performance

The last few years have seen a remarkable increase in the participation of sovereign wealth funds (SWFs) in global capital markets. In this article, the author draws on a unique dataset of SWF international holdings—one that dates back to the year 2002 and includes individual SWF holdings in more than 8,000 companies in 58 countries—to provide evidence of the impact of SWFs on corporate values and operating performance. Contrary to claims that SWFs expropriate minority investors and pursue political agendas, the main finding of the author's study is that SWF ownership is associated with positive changes in both corporate market values and operating returns. In support of these findings, the author also identifies three important ways that SWFs work to increase the performance and value of the companies they invest in: (1) as long‐term holders that provide a stable source of financing; (2) as representatives of deep pools of international capital in search of global diversification opportunities that are likely to provide companies with a lower‐cost (as well as more “patient”) source of equity capital; and (3) as politically well‐connected strategic investors that enable their companies to leverage important connections when accessing new product markets.     

Strategic Financial Management: Lessons from Seasoned Equity Offerings

Each of today's three dominant academic theories of capital structure has trouble explaining the financing behavior of companies that have seasoned equity offerings (SEOs). In conflict with the tradeoff theory, the authors’ recent studies of some 7,000 SEOs by U.S. industrial companies over the period 1970‐2017 notes that the vast majority of them—on the order of 80%—had the effect of moving the companies away from, rather than toward, their target leverage ratios. Inconsistent with the pecking‐order theory, SEO issuers have tended to be financially healthy companies with low leverage and considerable unused debt capacity. And at odds with the market‐timing theory, SEOs appear to be driven more by the capital requirements associated with large investment projects than by favorable market conditions. The authors’ findings also show that, in the years following their stock offerings, the SEO companies tend to issue one or more debt offerings, which have the effect of raising their leverage back toward their targets. Whereas each of the three theories assumes some degree of shortsightedness among financial managers, the authors’ findings suggest that long‐run‐value‐maximizing CFOs manage their capital structures strategically as opposed to opportunistically. They consider the company's current leverage in relation to its longer‐run target, its investment opportunities and long‐term capital requirements, and the costs and benefits of alternative sequences of financing transactions. This framework, which the authors call strategic financial management, aims to provide if not a unifying, then a more integrated, explanation—one that draws on each of the three main theories to provide a more convincing account of the financing and leverage decisions of SEO issuers.     

Hedge Fund Involvement in Convertible Securities

Convertible arbitrage hedge funds combine long positions in convertible securities with short positions in the underlying stock. In effect, hedge funds use their knowledge of the borrowing and short‐sale market to hedge themselves while distributing equity exposure to a large number of well‐diversified investors through their short positions. The authors argue that many “would‐be” equity issuers that would otherwise pay high costs in a secondary equity issue choose instead to issue convertible debt to hedge funds that in turn distribute equity exposure to institutional investors. This allows companies to receive “equity‐like” financing today at lower cost than a secondary equity offering. The authors' findings also suggest that more convertibles will be privately placed with hedge funds when issuer and market conditions suggest that shorting costs will be lower.