The market for buying out businesses by private equity firms is enormous, totaling $xx billion over the 1990&2002 period. These purchases range from the now legendary Beatrice and RJR Nabisco acquisitions by KKR in the 1980s, to the current market in which private equity partnerships buy both large firms like Burger King to small businesses such as funeral homes. While buyouts originally were focused in the United States, they have become increasingly common in Europe; the Wall Street Journal recently estimated that 40% of M&A activity in Germany in 2004 is from private equity firms.(WSJ, Sept. 28, 2004, p. C1) These buyouts are generally highly leveraged; indeed, when most people refer to buyouts, they invariably include the adjective "leveraged" in their description.

Buyouts, as well as other private equity investments, are generally made by funds that share a common organizational structure. Typically, these funds raise equity at the time they are formed, make investments that are levered whenever possible using the assets of the portfolio firm but not the fund as collateral, and have a finite life (see Sahlman (1990), or Fenn, Liang and Prowse (1997) for more discussion). The funds are usually organized as limited partnerships, with the limited partners (LPs) providing the capital and the general partners (GPs) making investment decisions and receiving a substantial share of the profits (most often 20%). While the literature has spent much effort understanding some aspects of the private equity market, it is very surprising that there is no clear answers to the basic questions of how funds are structured financially, and what the impact of this structure is. Why are most private equity investments made by funds that are financed by equity and have a finite life? Why are their investments financed by debt backed by the assets of the investment and not the fund? What should we expect to observe about the relation between bank lending practices, and the prices and returns of private equity investments? Why are booms and busts in the private equity industry so extreme?

According to the Modigliani&Miller theorem, capital structure decisions, including both fund structure and the financing of individual deals, is relevant only to the extent to which taxes, transactions costs, or real investment decisions are affected. Certainly the deductibility of interest payments is part of the reason why leverage is valuable at the portfolio firm level but not at the fund level since portfolio firms pay corporate taxes and funds can pass through profits to their partners tax free (see Kaplan (1989)). Yet, it seems unlikely that taxes are a complete answer: there is no evidence that buyouts are less levered when firms have tax shields limiting their corporate income taxes, and the same tax advantages are present in the targeted firms prior to the buyout, when firms typically have relatively modest leverage. Another commonly&cited explanation for leverage at the portfolio-firm level are the implicit incentives associated with leverage, in particular the fact that the commitment to pay interest limits managements discretion to waste the firms excess cash flows (Jensen (1988)). Yet, managers of firms that are bought by private equity partnerships are monitored heavily and often replaced (Lerner 1995). It seems likely that direct monitoring by a knowledgeable practitioner personally receiving 20% of the profits would likely lead to better controls on managers than the more ad hoc constraints imposed by leverage. Furthermore, neither tax nor incentive benefits explain why the equity capital invested in portfolio firms is raised through a fund rather than deal by deal.

In this paper, we propose a new explanation for the financial structure of private equity firms. We present a model that explains a number of features of private equity markets, including the fact that private equity investments are generally done through funds that pool investments across the fund, the typical financial structure of raising equity at the fund level and supplementing it whenever possible with debt at the deal level, the payoffs to GPs of a "carry-like" structure in which they receive a fraction of the profits but one that is junior to that received by the LPs, the extreme "boom and bust" nature of investments by private equity firms, and the observed empirical regularity of investments made during busts outperforming investments made during booms on average.

The model is relatively stratightforward, relying mainly on one market friction that serves as the underlying source of deviations from the Modigliani&Miller benchmark. The friction we model is the notion that GPs making investment decisions have better information about the quality of their potential investments than their LPs or any potential lenders. This assumption seems plausible, given that GPs are specialists in evaluating companies who have substantial incentives to discover any relevant information.

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