The Investment Behavior of Buyout Funds: Theory and Evidence

TLDR: In this paper, the authors analyzed the determinants of buyout funds' investment decisions and found that established funds accelerate their investment flows and earn higher returns when investment opportunities improve, competition for deal flow eases, and credit market conditions loosen.

Abstract: This paper analyzes the determinants of buyout funds' investment decisions. In a model in which the supply of capital is 'sticky' in the short run, we link the timing of funds' investment decisions, their risk-taking behavior, and the returns they subsequently earn on their buyouts to changes in the demand for private equity, conditions in the credit market, and funds' ability to influence their perceived talent in the market. Using a proprietary dataset of 207 buyout funds that invested in 2,274 buyout targets over the last two decades, we then investigate the implications of the model. Our dataset contains precisely dated cash inflows and outflows in every portfolio company, links every buyout target to an identifiable buyout fund, and is free from reporting and survivor biases. Thus, we are able to characterize every buyout fund's precise investment choices. Our empirical findings are consistent with the model. 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. Fourth, following periods of good performance, funds become more conservative, and this effect is stronger for younger funds.

Figures

Table 8. Changes in portfolio risk

Table 3. Draw Downs and Capital Distributions by Vintage Year

Table 4. The Determinants of Draw Down Rates

Table 7. Determinants of portfolio risk The dependent variable is the standard deviation of the log returns of investments undertaken by fund i in fund-year t. Returns are defined as in Table 6. To get meaningful estimates of the dependent variable, we discard fund-years with fewer than five investments. The panel runs till the last year a fund makes new investments. We estimate weighted least-squares regressions, to account for the fact that the precision with which we measure investment risk varies with the number of investments a fund undertakes in a given year. The regressions are estimated over different sample periods, beginning with all funds raised between 1981 and 1993 (the mature funds in our dataset) and adding later vintage years one by one. The explanatory variables are listed in the table. Heteroskedasticity-consistent standard errors are shown in italics. Intercepts and fund-year fixed effects are included but not reported. We use ***, **, and * to denote significance at the 1%, 5%, and 10% level (two-sided), respectively.

Table 5. Change in Investment Sensitivities by Fund Age

Table 1. Summary Statistics