Private Equity Fund Characteristics and Their Role in Acquisitions

This dissertation consists of three independent research papers that are presented in three chapters. All three chapters share the topic of private equity funds and their activities. The first chapter considers time frictions induced by the limited life of private equity funds. We analyze how this time dimension impacts a private equity fund’s strategies and valuation of a target. To facilitate our analysis, we develop a dynamic model of a private equity fund’s acquisition of a target, including investment in the target’s growth option and the fund’s exit. The fund has the skills to exploit the full potential of the target’s growth option by developing it to become more valuable. However, the fund may not have the time to complete this and collect information that credibly signals a valuable transformation of the target to a third-party. In contrast, a more traditional strategic buyer is not subject
to the same frictions as the private equity fund. From our analysis, we make a normative assessment of when a target firm becomes more valuable for a private equity fund than for a strategic buyer. We show that a private equity fund is more interested in a target with a growth option that has the potential to be developed into a high-growth option, and in which the fund expects to be able to mitigate information frictions in time. In contrast, a target firm with a more valuable intrinsic embedded growth option is more likely to attract a strategic buyer than a private equity fund.


Chapter two analyzes the impact of macroeconomic risk on a private equity fund’s valuation of a target. By building on the framework in the first chapter, I incorporate macroeconomic risk by adding an aggregate shock that affects a target’s future earnings. Thus, the value of the target depends on the state of the economy. In addition, I include debt financing by modelling a private equity fund’s acquisition of a target through a leveraged buyout. In my analysis, I use the combined equity value and the value from debt issuance as the fund’s initial valuation of the target; the fund’s maximum willingness to pay. I compare this to the acquisition price, which is defined as the reservation price
of the target with the addition of an exogenous premium. Implications of my model show that valuations are higher during booms because the equity value is higher and debt is less risky. This enables the fund to pay a larger premium, however, it might overpay for deals. In recessions, debt tends to be riskier and this can limit acquisitions.


In chapter three, we study the differences between private equity funds and strategic buyers in their valuations of target firms. In our theoretical framework, we consider a target firm with growth options. However, the target is financially distressed due to its
debt. A private equity fund has committed capital and the skills to obtain information that facilitates more efficient decision making by exerting costly effort. A strategic buyer has a firm with assets in place and existing debt. We analyze the role of private equity
funds jointly with the effect of debt overhang and the effect of cross-subsidization with a strategic buyer’s firm. We show that the strategic buyer’s debt also gives rise to a debt overhang friction when its debt is risky. Our model predicts that a private equity fund is more likely to win over a strategic buyer when a target’s growth option has a lower and more moderate success probability. In contrast, a target a with growth option that has a high success probability attracts a strategic buyer, in particular, when synergies are possible. However, strategic buyers with high leverage are less active in acquiring targets since their valuations are sensitive in leverage.