The Future of Private Equity

An Interview with Steve Kaplan, Neubauer Professor of Finance and

Entrepreneurship, University of Chicago, July 20, 2009

The relative attractiveness of being a public company CEO is as low as

it’s ever been, with the downward pressure on pay and the increasing
invasiveness from government on all dimensions. On the private equity
side, by contrast, there continues to be very high pay for performance for top
executives and much less regulatory pressure, particularly while the company
is private. And today’s CEOs can also benefit from the operating and
strategic capabilities supplied by the better PE firms.
Don Chew: Thanks for joining us again, Steve. It’s been almost • How will highly leveraged PE portfolio companies
two years since we last talked with you about the state of the fare during the current downturn, especially with over $400
private equity markets. That was in July of 2007, when we billion of loans coming due in the next three to five years?
were seeing the first signs of the trouble in credit markets And what will happen to future PE returns and commitments
that would help end “the second great wave” of U.S. private of capital by the limited partners?
equity. Now, it’s July of 2009, and the private equity market • With PE firms now sitting on an estimated $500 billion
is clearly down—in the “bust” phase of what looks like a in capital and leveraged loan markets shut down, what kinds
recurring industry pattern of boom and bust. With the lever- of investments are the firms now contemplating?
aged loan market all but frozen, the large public-to-private • If and when the industry makes a comeback, do you
deals we saw in 2006 and 2007 have disappeared. And even expect any major changes that might allow us to avoid another
the smaller- and middle-market transactions are down a lot. boom-and-bust cycle? Have the PE firms or their investors
But with the recent signs of life in the high yield market, and made any obvious mistakes that contribute to such cycles,
economists predicting an end to the recession, now may be a and are they now showing any signs of having learned from
good time to start talking about a possible resurgence of the those mistakes?
PE market—about when it’s likely to happen and what form • And, finally, how are finance professors like you
the new deals will take. responding to the popular claim that efficient market theory
But before we look at the future, I’d like to start by revis- and the principles of “modern finance” taught at places like
iting some of the questions we explored two years ago: the University of Chicago are in some way responsible for the
• What can you tell us about the second big wave of U.S. financial mess we’re now working through?
private equity deals and how it compared to the first wave in So that’s the ground we want to cover in the next hour or
the 1980s? so. Can you start by giving us a quick overview of the high
• Based on a track record that now stretches over 25 years, points of the just ended second wave of private equity?
what have the PE firms really accomplished? What effects
have they had on the performance of the companies they Steve Kaplan: It’s easy to identify the peak of the first great
invest in, and have they been good for the economy? wave of U.S. private equity deals: it was KKR’s $30 billion
After getting your thoughts on these questions, we’ll then purchase of RJR Nabisco in 1989, which was then by far the
move on to the major issues and challenges now facing the largest deal ever done. That record was not broken until 2007,
industry: which turned out to be the peak of the second great wave of

8 Journal of Applied Corporate Finance • Volume 21 Number 3 A Morgan Stanley Publication • Summer 2009
U.S. deals—a wave that ran from 2005 to 2007. The volume
of PE transactions in 2006 and 2007 has been estimated at
about $400 billion in each of the two years. To put these
numbers in context, they amounted to over 2% of the total
capitalization of the U.S. stock market. What’s notable about
this 2% number is that it’s twice as much as U.S. markets
have ever experienced in any one year—with the exception
of 1989, when KKR’s huge RJR deal pushed the number to
a similar level. And where 1989 was pretty much dominated
by this one deal, 2006 and 2007 saw a cluster of very large,
public-to-private transactions, including buyouts of compa-
nies like Alltel, First Data, HCA, and TXU, all with purchase
prices of more than $25 billion.
While the number and size of the deals slowed markedly
in 2008, the fundraising efforts of the PE firms continued to
be very successful, especially those of the largest firms. For
example, institutional investors reportedly made new capital
commitments to U.S. PE firms of $180 billion in 2008, not
much below record levels in 2007. Expressed as a percent-
age of the total value of the U.S. stock market, the capital
commitments in each of the three years from 2006 through
2008 amounted to more than 1.0%. By comparison, investor
commitments during the peak of the first wave in the late ’80s
never amounted to more than 0.6% of the total market cap.
So the increase in the capital available to the industry over
the past 20 years or so has been really astonishing.
Chew: Why did the limited partners continue to contrib-
ute so much capital to private equity in 2008, after the clear
evidence of problems in the credit market?
Kaplan: Much of the investor commitments in ’08 reflected a
kind of inertia—momentum from previous years. The credit
market problems of ’07 did not really affect the capital alloca-
tions by institutional investors among different asset classes. It
was not until the stock market plunged and the credit markets
froze in the fall of ’08 that investors began to cut back sharply
on their commitments to private equity.
What’s particularly interesting, though, is that not only
were the commitments to PE as a fraction of the stock market
in 2008 the second highest ever—after those in ’07. But if you
measured the total capital commitments relative to the stock
market value at the end of last year instead of the beginning,
2008 was the highest ever ! In other words, in terms of what
might be called its “relative purchasing power,” the capital
committed to private equity was the highest in our history
at the end of 2008. And even now, in July of 2009, the total
capital committed to private equity as a fraction of the value of
the stock market continues to be at or near an all-time high.
So the bottom line here is that, although PE fundrais-
ing has slowed dramatically along with deal activity, PE
firms—especially the largest ones—are now sitting on a huge
stockpile of capital.
Journal of Applied Corporate Finance • Volume 21 Number 3
Returns to Limited Partners
Chew: So we saw record dollar amounts of transactions in
’06 and ’07, and record levels of capital commitments and
purchasing power in ’06, ’07, and ’08. And the purchasing
power of PE funds remains at or near its all-time high even
today. What if anything can you tell us about the returns to
PE funds in 2006 through 2008, as compared to either histor-
ical averages or the returns just before that?
Kaplan: Let me start by talking about what we know histori-
cally. In a study published in the Journal of Finance in 2005,
Antoinette Schoar of MIT and I used detailed data from
Venture Economics on private equity returns to answer a
few basic questions:
• What are the returns to private equity investors over a
long period of time, and do they consistently beat the overall
stock market?
• Is their persistence in PE returns; in other words, do
the best PE sponsors seem to outperform the market on a
consistent basis?
• How does performance affect the survival and future
capital-raising of sponsors?
We found, first of all, that the average return on all the
private equity or buyout funds raised between 1980 and
1995 in our sample was about equal to the return investors
would have earned on the S&P 500 over that period. Later
papers have reported pretty much the same result. So that’s
the not-so-great news.
The better news is that since these returns are net of
fees—and fees paid to PE firms effectively run at least 3%
a year—it’s safe to conclude that the average private equity
fund does beat the S&P gross of fees. However, in the average
case, our finding implies that the outperformance accrues
entirely to the sponsors—and to the selling shareholders in
the individual deals.
So that is what we know about average PE returns. But
before moving on, let me offer one caveat: No one has the
data on returns to all PE funds. And for that reason, none
of the conclusions of these studies—mine included—are
completely definitive, or known with certainty. The findings
are all conditional on the data available.
What about the persistence of returns? When we divided
all the private equity firms into superior and underperform-
ing partnerships, we found a clear tendency for the better
performers to repeat their performance and outperform the
market on a consistent basis and net of fees. That finding
is worth noting for a couple of reasons. First, we don’t see
that kind of persistence in studies of other kinds of funds.
In the case of mutual funds, today’s best performers are no
more likely than today’s average or worst performers to be the
best performers tomorrow. And that also seems to be true of
hedge funds: there is not much evidence of persistence in their
returns. But there is clear historical evidence of persistence
A Morgan Stanley Publication • Summer 2009 9
in the data on private equity, both for buyout funds and for
venture capital funds.
Now, let’s consider what is likely to happen going
forward—and what the returns to the most recent wave of
deals are likely to be. The place to start this analysis is with
the “vintage year returns”—the return to all funds raised in
a particular year over the life of the funds—that have been
reported by Venture Economics for each year from 1984 to
2005. The reason not to go beyond 2005 is that most deals
done after that year have not “exited.” And it’s important to
keep in mind that vintage year returns are likely to change
over time, and they can change a lot.
Vintage year returns have varied substantially over time.
They were highest in the early 1980s—around 25% per
year—and they were lowest in the late 1990s—below 10%.
My regression models have shown that there is a very strong
negative relationship between the vintage year return and the
capital committed to private equity funds—again, measured
as a fraction of the overall stock market—in the same year
and the years immediately preceding. What does that mean
for future returns? Record amounts of capital were allocated
to PE funds in the years 2005 through 2008. If the historical
relationships hold, the returns to the 2006 and 2007 vintages
will be negative. A year and a half ago, I would have doubted
the regressions and told you that was highly unlikely. Today,
of course, it looks as though history will repeat itself.
The 2008 vintages are a little harder to predict. The histori-
cal relationships, again, predict poor returns because a lot of
capital was committed to private equity in 2008. Relative to
the stock market, it was the second highest year on record.
And that was before the stock market dropped. But on the
positive side, there are two countervailing forces: the purchase
multiples in the more recent deals were lower and the economy
is depressed, making it more likely that the earnings that get
capitalized in the purchase multiples have been lower as well.
The Performance of PE-Controlled Companies and
their Economic Effects
Chew: Steve, I know that we’ve covered this ground before,
but for the benefit of those who haven’t read your studies or
heard you speak, would you briefly summarize the main find-
ings of academic research on how PE firms have managed to
add value? There’s a widespread perception that the invest-
ments of even the best PE firms represent highly leveraged
bets on public equities, and that the returns to LBOs are
mainly the result of high leverage. At the same time, critics
of private equity, both in the U.S. and abroad, continue to
claim that LBOs destroy jobs while creating short-term prof-
its at the expense of long-run corporate values. How do you
typically respond to these claims?
Kaplan: Let’s start with what we know about the first wave
of U.S. LBOs in the 1980s. When I was doing my Ph.D.
10 Journal of Applied Corporate Finance • Volume 21 Number 3
thesis at Harvard at the end of the ’80s, I gathered as much
data as I could find about the operating performance of all
the companies larger than $50 million that were bought
by U.S. private equity firms from 1981 to 1986—data that
were then and are still hard to come by. My main finding
was that these larger LBOs and management buyouts were
followed by significant and sustained increases in operating
margins and cash flows, both in absolute terms and relative
to their industries—and by “sustained” I mean over a three-
or four-year period following the buyout. For those deals in
my sample that were later sold or went public, these operat-
ing gains resulted in large increases in enterprise and equity
values. And, according to my estimates, the gains from these
deals were divided pretty evenly between the selling share-
holders and the new investors.
More recently, we have begun to get data on deals in the
’90s and early 2000s in the U.S. and Europe. Overall, the
main finding from these more recent studies is consistent
with what we found for U.S. firms in the 1980s—namely,
measurable improvements in the operating performance of
private equity-funded companies. But there is one exception
to the general results. Studies of U.S. and U.K. public-
to-private transactions in the ’90s and early 2000s have
reported similarly high returns to investors, but only modest
operating gains. And this is a bit of a puzzle to those of us
who study private equity. The operating gains are smaller
than those in other kinds of PE deals done in the same
period and smaller than those for public deals in the 1980s.
But thanks to the flurry of large public-to-private deals in
2005 to 2007, we will be getting a lot more data in the
next few years. One thing that seems clear is that favor-
able financial markets drove some of the private-to-public
transactions much more than the opportunity to improve
operations. On the other hand, in recent years the private
equity firms have greatly increased their abilities to realize
operating improvements.
Chew: Where do the operating improvements come from?
And what if any role does high leverage play in all this?
Kaplan: I think the answer to that question has changed over
time. In the ’80s, the process of adding value in LBOs was one
that I call “financial and governance engineering.” It has three
main components. One is strengthening operating manag-
ers’ incentives by giving them significant equity stakes in
their businesses, and making these holdings completely illiq-
uid until a good exit opportunity materializes. The second
component is active oversight of operating management by
the firm’s largest investors. The third piece is the use of high
leverage—the debt-to-capital ratio of the average LBO firm in
my sample jumped from 20% to 90%—to impose operating
and investment discipline on mature businesses with limited
investment opportunities and capital requirements.
A Morgan Stanley Publication • Summer 2009
 Since the 1980s, public companies have gotten better at
the first two components. CEOs are not only paid more, but
a much higher percentage of pay is equity-based. And boards
have gotten tougher on CEOs, with average CEO tenure
declining by roughly 40%.
So, in today’s buyouts, this kind of financial and gover-
nance engineering continues to be important, but it’s not the
main differentiating factor that it used to be. To augment
their financial and governance engineering capabilities, the
best buyout firms have worked hard to develop what I call
“operational engineering.”
Starting in the late 1980s, with buyout firms increasingly
bidding against each other to do the financial and gover-
nance engineering, more of the value in the deals was going
to the sellers. The best PE firms responded to these changes
by developing industry and operating expertise they could use
to add value to their investments. To help them in building
their industry and operating capabilities, they have created
networks of “operating partners”—in many cases, highly
regarded former CEOs—to ensure that their portfolio firms
have the best managers and advice.
This increased focus on operations, as I said two years
ago, is a very important change. And I continue to think
that this combination of financial and governance expertise
with operational engineering will help the portfolio compa-
nies of the best PE firms achieve significant operating gains.
But whether such gains will be large enough to produce
high exit values and returns for PE limited investors in the
next few years is a somewhat different question—one whose
answer depends on the future state of the economy and credit
markets.
Chew: Let’s hold off on that for the moment—we’ll come back
to it later—and return to your point about the lower profit-
ability of public-to-private deals since the end of the 1980s.
What’s your explanation for that?
Kaplan: I think there are two things going on here. One is that
the new studies provide more evidence that conditions in the
financing markets are an important—perhaps the single most
important—driver of public-to-private deals. When spreads
and interest rates get really low, as they did in 2006 and 2007,
you see an inordinate amount of public-to-private deals. So,
to a far greater extent than other kinds of deals, public-to-pri-
vates are driven by the availability of low-cost financing. And
this could mean that the operating improvements needed to
justify such deals are smaller than in other kinds of deals.
The second part of my explanation is that, thanks to the
rise of institutional investor activism and increases in CEO
pay in the ’90s, large public companies in the U.S. and U.K.
have become much more sophisticated about governance and
better run than they were in the ’70s and ’80s. Both manage-
rial incentives and board monitoring at public companies have
Journal of Applied Corporate Finance • Volume 21 Number 3
improved significantly in the last two decades, and that means
there’s less room for improvement in these companies.
Chew: Is there other information you would point to in
making the case that public companies are now better run
than they were in the ’80s?
Kaplan: There is a very good paper by John Van Reenen at the
London School of Economics and Nick Bloom at Stanford.
Using surveys, the authors compare management practices
at all kinds of manufacturing companies, public as well as
private and buyout companies. They find that the manage-
ment practices at the public companies are almost as good as
those at the buyout-funded companies, and that the practices
of both are far superior to those at other kinds of compa-
nies—a category that includes private, closely held companies
and government-owned companies. In identifying effective
management practices, the surveys place a lot of emphasis on
systematic attention to process improvements, performance
reviews, and incentives.
Chew: So your argument suggests that there is just more
room to add value in a management buyout that involves,
say, a private, family-run company, or the subsidiary of a
large public company. There are more things that need fixing
in such companies, and in that sense there are lower-hang-
ing fruit?
Kaplan: That’s consistent with the findings. But, as I said
earlier, these recent studies also report that the returns on
the public-to-private deals have been as good as those on
the private company deals. And, as I suggested, these find-
ings are a bit of a puzzle, so I’m not sure they will turn out to
be the last word. Those papers focus on operating margins,
and there are other ways to improve operating efficiency and
add value that don’t involve increasing operating margins.
The companies may have grown more quickly, or made other
improvements that were expected to take longer to show up
in margins or profits.
Chew: Now that we’ve covered the accomplishments or
benefits of private equity, let’s talk a bit about the costs. One
possible consequence of PE deals and their use of high lever-
age is lower job growth. With unemployment expected to hit
10% this year, what do you have to say to all the people who
are understandably concerned about the effects of private
equity on employment?
Kaplan: Most studies that have looked at employment, includ-
ing my own, have found that employment increases during a
three- or four-year period after buyouts, though generally by
less than in the rest of the industry. The one exception is the
case of France, where PE-owned firms have clearly outper-
A Morgan Stanley Publication • Summer 2009 11
formed their industry competitors, both in terms of operating
gains and overall employment.
But let’s go back to the effects on U.S. employment. The
finding that employment growth at PE-controlled compa-
nies lags the industry shouldn’t come as a surprise because an
important part of what buyouts do is to cut costs. In the most
comprehensive study to date, a 2008 paper by my colleague
Steve Davis, Josh Lerner, and a number of others has shown
that the employment record of U.S. private equity is charac-
terized by significant job cuts and job creation that are going
on at the same time—and in some cases even within the same
companies. In this sense, the PE companies are showing the
same kind of dynamism that characterizes the rest of the U.S.
economy.
Looming Challenges (or the Expected Costs
of High Leverage)
Chew: Let’s move on to the present and the challenges facing
the industry. And let’s start with the one that is on most
people’s minds: the high leverage in combination with
the depressed state of the economy and financial markets.
Although the corporate credit markets have started to thaw
and the high-yield market has opened up again, default rates
on loans backing private equity deals are now reportedly over
9% and expected to go higher, and the leveraged loan market
is pretty much frozen. At the same time, thanks to the large
PE deals done mainly in 2006 and 2007, there’s some $500
billion of debt coming due in the next three to five years that
needs to be refinanced.
With this in mind, many people expect the default
rates on private equity deals to go much higher—I’ve heard
numbers as high as 50%. Some observers also have argued
that, with the stock market down by 40% from 2007 levels,
and with much of the bank debt trading well below par, the
equity in the most recent wave of deals has become essentially
worthless. How big a problem are the PE firms now facing,
and what do you see as the solution?
Kaplan: Although the situation is clearly a serious one, there
are some good reasons to believe the damage will be a lot less
than people now fear. In fact, to the extent we can use my
own research and others’ about the restructuring of the ’80s
deals as a guide to the future, the costs could turn out to be
relatively modest.
For starters, as I mentioned earlier, the deals done
in recent years were less leveraged than those done in the
’80s. Where the average debt-to-enterprise value in the late
’80s deals was close to 90%, the average in the most recent
wave of transactions, including the public to private deals of
2006-2007, was somewhere between 70% and 80%. And in
the mostly smaller, middle market transactions now being
done, the leverage is 60% or less.
Along with the larger equity cushions, the coverage ratios
12 Journal of Applied Corporate Finance • Volume 21 Number 3
in the recent wave of deals were considerably higher than
they were in the ’80s. In many of the large deals done at the
end of the decade, the EBITDA-to-interest ratio was barely
above 1.0X. By comparison, even in the more leveraged deals
done in 2006 and 2007, the coverage ratios typically stayed
between 1.5X and 2.0X.
The third important difference between the ’80s and the
recent wave is that, in the case of the senior debt or term
loans in the 1980s, companies were required to start repaying
principal almost right away and typically had to repay all of
it in six or seven years. In the recent wave, the requirements
to repay principal were pushed out considerably. During the
first half of 2007, there were a number of “covenant-lite” deals
where the firms didn’t have to repay much if any principal
for six or seven years.
These three differences mean that companies today have
more time and flexibility to work out their problems than
they did in the early ’90s, when we saw a large number of
defaults. In fact, a study I did with Jeremy Stein found that
about one-third of the late ’80s deals larger than $100 million
defaulted.
Chew: But, to go back to your point about the “covenant-lite”
deals, it seems to be that kind of flexibility that’s now got a
lot of people worried—along with the $400 billion of debt
coming due between 2012 and 2014.
Kaplan: I understand. What I’m saying is that, thanks to
their more forgiving capital structures, these companies are
facing less short-term pressure to make debt payments in a
downturn. Now, it’s true that some companies may not be
able repay the principal when it comes due three years from
now. But three years is a considerable amount of time—not
an eternity, but certainly enough to reorganize any compa-
nies that have fundamentally good operating prospects and
significant going-concern value.
Think back to what we saw in 2002, when people were
wringing their hands and saying the buyout market was
dead forever. As things turned out, many of the problem
deals were reorganized through refinancings—and by the
end of 2004, the buyout market was starting to operate
on all cylinders. So, although I think the current concern
is warranted, we do have some time to work out these
problems.
Chew: When we talked two years ago, you said that private
equity had established itself as a “permanent asset class.” You
also said that because these PE firms expect to be around in
the future, when there’s trouble in their portfolio companies,
the firms have strong incentives to work hard to minimize
the damage. By so doing, they will be protecting their own
reputations and preserving the value of the franchises they
have created. Have the PE firms been doing this?
A Morgan Stanley Publication • Summer 2009
Kaplan: In the last year and a half, they’ve been working hard
on their portfolio companies—and for two main reasons.
Number one, they have these operational engineering capa-
bilities that they have invested a lot of money in. So they have
people at the companies who have industry experience and are
working as hard as they can to fix things. And that effort is
being aided by the fact that the PE firms are not doing many
new deals; in other words, they now have more bandwidth
to work out their troubled deals.
Number two, and more important, are the reputational
concerns. When the PE firms come back to raise money in
a couple of years for their next funds, the investors are going
to look at the returns to the ’05, ’06, and ’07 vintages. Even
though those returns may not be good, the LPs are going
to want to put money in the ones that are relatively good. If
they can say that their fund lost only 20% during a period
when the public equity markets lost 40%, that’s a major
selling point when raising their next fund. And restructuring
problem deals is a way to limit those losses to 20%.
Chew: What else can they do besides cut costs in this situ-
ation?
Kaplan: Besides improving the companies any way they can,
they can buy themselves more time by refinancing some of
the debt that matures in the next three or four years. Some
companies have taken advantage of the improvement in the
high yield market to issue longer-term bonds to retire bank
loans due in 2012 and 2013. But there is a cost to this, of
course, in the form of higher interest rates.
At the same time, I also expect to see the PE firms using
their stockpiles of capital to inject more equity into their
own, or others’, deals, particularly if they can use the equity
to buy back the bank debt at a significant discount. Putting
new equity into their own troubled deals is a way for the PE
firms to use their capital to increase the value of the equity
they already have in place.
Chew: That’s what I thought Leon Black and Apollo were
going to do in the case of Linens ’n Things, the retailer that
recently ended up in bankruptcy. Without knowing much
about the situation, I assumed that if Apollo thought the
company was worth saving, they would put in more equity
to rescue the deal. My assumption was based in part on the
idea that, if a portfolio firm needs to be recapitalized, the
sponsor is the most logical buyer of the depressed debt. But
I turned out to be wrong.
What do you think happened in that case? Did Apollo
decide the company was worth more dead than alive?
Kaplan: I think you’re right, both about Apollo being the logi-
cal buyer of the discounted debt and about its decision not to
recapitalize that deal. The sponsor is the most logical buyer of
Journal of Applied Corporate Finance • Volume 21 Number 3
the depressed debt because it presumably has the best informa-
tion about the prospects for the firm. And the fact that Apollo
chose not to put in more money tells me that they thought
that Linens ’n Things no longer had a positive going-concern
value. Given the sudden change in the outlook for retailing, the
company was now worth more dead than alive, worth more in
liquidation with the proceeds distributed to the creditors.
For PE firms with distressed portfolio companies, then,
the critical question is whether the companies still have real
operating or going-concern value. If the main problem is
an overleveraged capital structure that is weighing down a
sound business, the probable outcome is that the firm gets
restructured by the PE firm. And with private equity purchas-
ing power at an all-time high, you’re going to see the firms
putting in more equity to pay off the banks, in some cases at
significant discounts. But, in some of these cases, the banks
may resist—and those deals could end up being restructured
in Chapter 11. But my prediction is that many, if not most, of
today’s troubled deals will end up getting restructured, either
inside or outside of Chapter 11.
So, in this sense, companies like Linen ’n Things—and I
would put Mervyn’s and Chrysler in that category too—are
likely to be exceptions. It’s unusual for a company that has
been purchased by a private equity firm to have no going-
concern value. In the study I just mentioned, Jeremy Stein
and I found that most of troubled deals in the late ’80s were
successfully reorganized, in some cases in Chapter 11 and in
others through private workouts. The main reason that most
of these deals were restructured relatively efficiently in the
early ’90s was that they continued to have significant operat-
ing value, even though the economy was then in recession.
And I’m willing to bet that most of the PE-funded companies
in this last wave will also prove to have large going-concern
values, even in the current recession.
Now, one place where the going-concern values have
disappeared or become questionable is in retailing, where
demand has fallen off a cliff. And the same has happened to
some of the restaurants. So, some of the retail and restaurant
deals are vulnerable, though I still think many of them will
survive. But now let’s consider another PE business: casino
firms. They have taken a hit, but they clearly continue to have
going-concern value—that is, positive operating cash flows.
So you are unlikely to see a lot of casinos liquidated; they will
restructure their debt.
The Social Function of Chapter 11
Chew: Steve, you said that even some companies with going-
concern value will probably wind up in Chapter 11. We also
know that while a large number of the troubled deals in the
’80s were reorganized outside the courts, a lot of them ended
up in Chapter 11. Can you give us a brief summary of your
work on the costs associated with workouts and Chapter 11
in the early ’90s?
A Morgan Stanley Publication • Summer 2009 13
Kaplan: For some kinds of companies, particularly those
whose value consists mainly of growth opportunities rather
than current earnings or cash flows, Chapter 11 can be pretty
destructive. But for the mature, cash-generating compa-
nies that tend to be involved in LBOs, the costs or value
loss incurred during reorganizations are typically not that
high. That was the conclusion that my colleague Gregor
Andrade and I came to after studying a sample of LBOs and
other highly leveraged deals that defaulted in the early ’90s.
From the time the companies started to experience financial
distress, we found that they lost between 10% and 20% of
their value—an amount that turned out to be less than the
value added by the deals from the time of the buyout bid up
until distress began to set in.
To illustrate what I mean, take the case of Robert
Campeau’s acquisition of Federated Stores in the late ’80s,
which was viewed by the press as one of the worst deals of all
time. Although Campeau overpaid by hundreds of millions
of dollars using large amounts of debt, and the firm wound
up in Chapter 11 as a result, my study of the deal found
that the entire process of leveraging the firm and running it
through Chapter 11 actually created a fair amount of value.
The success of the Federated restructuring had a lot to do
with the manager hired to replace Campeau, a guy named
Allen Questrom.
The bottom line of my study of restructurings is that
overleveraging and bankruptcy, while certainly not pleas-
ant, are not the end of the world. And indeed, from a broad
economic standpoint, the costs of overleveraging mature,
LBO-type companies are relatively modest. The debthold-
ers suffer some losses; much if not all of the private equity
investment gets wiped out; and some employees lose their
jobs. But the value of the operating assets generally remains
intact. Companies get reorganized, in many cases ownership
changes hands, and life goes on.
Chew: Are there any caveats or qualifications attached to your
forecast, any reason to think things could be worse this time?
Kaplan: In some respects, the prospects are better than in the
’80s. Since then, the players in the distressed debt markets
have become more experienced at restructuring troubled
companies. Along with the efforts of PE firms to refinance or
recapitalize their portfolio companies, there are distress funds
and hedge funds taking positions in distressed companies
with the aim of reorganizing them or, in some cases, taking
control. For those companies that wind up in Chapter 11, the
prepackaged bankruptcy mechanism that got its start in the
’90s incorporates many of the benefits of the private workout
process into what are nominally court-supervised reorganiza-
tions. And the fact that the PE funds and distress funds still
have a lot of money means that more companies are likely to
be saved, and more value and jobs preserved.
14 Journal of Applied Corporate Finance • Volume 21 Number 3
But there are also at least two reasons to fear that things
might be worse this time. First of course is the depth of the
current recession. It has been worse than the downturn in
the early ’90s, particularly in consumer-facing businesses like
retail and restaurants. Another concern is the difficulty that
companies in Chapter 11 have faced in getting DIP financ-
ing—a problem that can attributed to the weakened condition
of the banks. This shortage of DIP funding has caused some
to worry about an increase in the number of companies that
end up in Chapter 7, or liquidation. But, again, I would be
willing to bet that most companies in Chapter 11 that have
clear going-concern value will manage to find funding from
some source, banks or otherwise.
So, a lot can happen between now and when the debt
comes due. And I will offer two scenarios. On the one hand,
the economy gets better, the banks become more stable, which
they’re in the process of doing, and the loans get refinanced
in 2012 and 2013. The other possibility is that the economy
struggles for the next few years and, although some companies
end up in liquidation, most get restructured and refinanced,
with hedge funds and PE funds in many cases playing major
roles and perhaps supplanting the banks.
PE Investments in the Future
Chew: With the debt markets for leveraged deals pretty much
frozen, and all that idle capital, what kinds of investments do
you expect to see by PE firms in the next year or so? We’ve
already talked about refinancing and recapitalizing existing
deals. But are there other, less traditional ways of putting this
capital to work that don’t require lots of leverage? And is all
the time and capital devoted to fixing troubled deals going to
get in the way of reviving the larger, public-to-private deals?
Kaplan: To take your last question first, the focus on workouts
is not the cause of the drying up of the larger public-to-private
deals. The large public-to-privates, as I said earlier, appear to
be very dependent on having liquid debt markets and rela-
tively low risk spreads—and neither of those is likely to come
back soon. And that’s why even the largest PE firms will have
to focus on smaller private companies and divisions of public
companies. Those deals will also start out with less leverage
than in the past—the average ratio in today’s deals is less than
60%—with the expectation that they may be able to take on
more leverage over time if conditions improve and the debt
markets open up.
Chew: Given the disruption of the leverage markets, what
do you think about the growing practice of PE firms taking
minority or controlling equity positions in public compa-
nies in the form of PIPES? In a number of cases, PE firms
have purchased equity stakes in highly leveraged, or possi-
bly overleveraged, industrial companies, and the equity has
been used at least in part to retire debt. And there have been
A Morgan Stanley Publication • Summer 2009
a number of PIPES investments in distressed financial insti-
tutions. What have these PIPES accomplished and what role
are they likely to play in the future?
Kaplan: That’s a very interesting question, and it’s one that
would be a fruitful area for research. One of the attractions
of PIPES for the PE firms is that the investments are rela-
tively liquid. A second advantage for PE firms today is that
if the target company already has a fair amount of debt, the
leverage is already in place. In a PIPE deal involving a highly
leveraged public company, you effectively get to make a lever-
aged investment without raising new debt.
But along with those positives, there are a few questions
about whether PIPES will really work for private equity firms.
First, can you exert the same kind of control with a minority
position that you can when you have a majority position?
Second, is it possible for a public company to make the same
kinds of cuts and investments in growth as a private company
would make, without the distortions caused by public scrutiny
and the need to meet quarterly earnings targets?
I think the jury is out on this. I know some private equity
firms who do not think that PIPES are a viable strategy. But
there are other firms that clearly think they are—particularly
the ones doing them, of course. My guess is that PIPES are
more likely to be successful in cases where the PE investor
can exert enough control to discipline companies when they
get off track. But such changes can be harder to do in PIPES
than in a typical private equity setting with total control.
Chew: One change that was supposed to have taken place in
the past year or so was that PIPES investors were demand-
ing and getting multiple board seats and contingent control
rights. Have you detected anything like that in talking with
sponsors or in looking at the data?
Kaplan: At this point, I haven’t seen any systematic study of
this. I think it’s fair to say that sponsors are better off the stron-
ger the control rights they can negotiate. The question is, will
a public company board let you invest under those conditions?
It’s all a negotiation, and the outcome clearly depends on how
badly the firm needs the equity capital. In the current envi-
ronment, you would expect investors to have more bargaining
power than they had before the financial crisis.
Chew: Besides helping to rescue overleveraged companies,
PIPES have also been used by private equity firms in a couple
of other interesting ways. For example, in part because of
the restrictive credit environment, financial sponsors have
been invited to contribute equity to and partner with public
companies in strategic acquisitions. In one case, Warburg
Pincus bought $100 million of new equity issued by Nuance
Communications to help fund its acquisition of eScription. In
addition to partnering with public companies in acquisitions,
Journal of Applied Corporate Finance • Volume 21 Number 3
PE firms have also taken significant positions—majority as
well as minority ones—in spun-off businesses or divisions
in transactions known as “sponsored spins.” Do you have
the same mixed feelings about these deals as the other kinds
of PIPES?
Kaplan: These are all interesting, and potentially valuable,
applications of private equity methods to the governance of
public companies. As I said earlier, many of the best private
equity firms have developed operating capabilities to go along
with their traditional finance and governance capabilities.
The big question is the extent to which they can use those
capabilities effectively without buying complete control.
So, I agree that we’re likely to see some of these kinds of
collaboration between private and public equity, particularly
if the leveraged loan market remains unsettled. But having
said that, I still think that for many of the changes that private
equity firms want to make, they very much prefer to do them
when the company is private rather than public.
Chew: What can you tell us about the receptiveness of public
company CEOs to private equity these days? Do you think
CEOs today are more or less receptive to PE investments than
they were, say, two years ago?
Kaplan: Let’s broaden the question from public CEOs to
talented executives in general. If I’m a talented executive
and have the choice between becoming the CEO of a public
company or the CEO of a PE-funded company, private equity
looks increasingly good. The relative attractiveness of being
a public company CEO is as low as it’s ever been, with the
downward pressure on pay and the increasing invasiveness
from government on all dimensions. On the private equity
side, by contrast, there continues to be very high pay for
performance for top executives. There is less regulatory pres-
sure, particularly while the company is private. And today’s
CEOs can also benefit from the operating and strategic capa-
bilities supplied by the better PE firms. Although the risk of
being fired is probably higher with the private equity firms,
that difference is smaller, possibly much smaller, than it used
to be. There is plenty of turnover in public companies these
days, far more than in the past.
So, working for a PE firm rather than a public company
is increasingly attractive.
Chew: Provided you think you’re one of the best at what
you do.
Kaplan: Right, that’s a given.
Conflicts of Interest?
Chew: During our last talk, we focused on the possible
conflict of interest faced by top executives of public compa-
A Morgan Stanley Publication • Summer 2009 15
nies when faced with offers to sell their firms to PE firms and
then go to work for and receive large equity stakes in the new
companies. As you predicted, those concerns have proved to
be pretty much groundless. There are safeguards in place to
protect against self-dealing; and, as you suggested two years
ago, the shareholders who sold out in public-to-private deals
in 2006 and 2007 now seem to have done very well, given
what has happened to the values of most public companies
since then.
But there’s another conflict in the PE world that’s now
getting attention. And that’s the potential conflict faced by
sponsors with one fund that holds equities and another fund
that holds debt in the same portfolio company. When the
companies are doing well, there is no obvious problem. But
if the company gets in trouble, the sponsor may find itself in
a situation where it has to choose between the interests of its
equity and debt funds. Do you see a big problem here?
Kaplan: I don’t think this conflict will prove any less manage-
able than the CEO self-dealing problem we were talking
about two years ago. I’m aware of one case like this where a
legal issue has been raised, and the sponsor has responded by
saying that its people are not the main negotiators on the debt
side; they have ceded that role to the other partners. And I
don’t see why that isn’t a workable solution in this case.
But having said that, I can see the potential problem in
cases where a PE firm has made an equity investment in a
company with its ’06 fund, and then plans to restructure it
with its ’08 fund. The potential conflict here is between the
investors in ’06 and ’08. I think the main concern for LPs is
that the PE firms may have an incentive to shift returns from
the ’06 fund, where they’re unlikely to get any “carry” or share
of the profits—because there are none to be shared—to the
’08 fund, where they may get some carry. That is something
to watch out for.
But, again, I think these kinds of problems can and will
be overcome. As Mike Jensen likes to say, there are conflicts of
interest and “agency costs” everywhere you look in business.
Effective management means making sure that you identify
all the major conflicts and then manage them.
Asset/Liability Matching and the Permanence of PE
Chew: To sum up your argument, then, PE is down but far
from out. In fact, private equity, as I’ve heard you say more
than once, has established itself as “a permanent asset class.”
In making that case, you’ve pointed to the increased operat-
ing capabilities of the PE firms, and the growing receptiveness
of public company CEOs and boards to investments by PE
companies. You’ve also told us that, although many of the
deals done in 2006 and 2007 were probably overpriced, the
deal structures have provided more room for error; and partly
as a result of that flexibility, and of the kinds of companies
that get taken private in leveraged deals in the first place, the
16 Journal of Applied Corporate Finance • Volume 21 Number 3
costs of reorganizing troubled PE portfolio companies should
turn out to be fairly small, especially relative to the increases
in efficiency and operating values.
Now in addition to these benefits and capabilities, I’ve
also heard you say that private equity has another impor-
tant advantage over most other asset classes—namely, the
matched maturity of its assets and liabilities. In your words,
“the duration of PE firm capital matches the duration of
its assets.” What do you mean by this, and why is it impor-
tant?
Kaplan: When a PE firm raises a fund, it has that money for
anywhere from 10 to 13 years. The funds are set up that way
for an important reason: it takes a while to invest the money,
and then it takes a while to make the investment work. You’re
making investments that take five or sometimes ten years
to pan out; and because your capital is in place for ten to
13 years to give you the time to make things work, you’ve
matched the duration of your assets and liabilities. You’re not
going to be in a situation where your investors are going to
ask for their money back before you’ve done what you need
to do on your investments.
Now contrast that with what happened at investment
banks like Bear Stearns and Lehman. They had a huge
mismatch. At the margin, they were using repos—very short-
term debt—to fund investments with considerably longer
payoffs. And when liquidity dried up, the banks proved to
be very vulnerable to that mismatch.
Hedge funds have a similar problem. In many funds,
you can ask for your money back at any time—and that can
cause problems for a hedge fund whose strategy is predicated
on, say, long-short pairings that are likely to require a year
or two to pay off. If it takes a year for an arbitrage trade to
“converge,” and your capital is callable immediately, you have
a potentially problematic mismatch between the duration of
your assets and the duration of your liabilities. That mismatch
hurt many hedge funds last year.
So, my point here is that private equity is an asset class
where the asset manager—in this case, the PE firm—has the
LPs’ money for as long as it needs to carry out its strategy.
Chew: Some hedge funds have been successful in locking
up funds from their LPs? Would you say that, as a general
rule, the hedge funds with longer-run strategies have been
successful in gaining lockup commitments from their inves-
tors—more successful than, say, than hedge funds involved
in very short-term quant strategies?
Kaplan: I don’t know the answer to that. I do know that
some of the quant funds have had problems, but also some of
the longer-term long-short funds as well. And I don’t know
the extent to which lock-ups have been used to limit these
problems.
A Morgan Stanley Publication • Summer 2009
 What we do know is that the stock of capital at the hedge
funds is down significantly, and that the funds also now get
less leverage from their prime brokers. So their buying power
has gone down measurably. And to the extent that private
equity competes with hedge funds, that’s good news for the
PE firms, which do have money.
Chew: Is there much of a discussion going on now about
lock-up provisions with hedge funds? Are the funds having
more difficulty locking up funds—or have they pretty
much given up on the attempt? They used to say, “We need
two-year money so we can lengthen our horizon.” But I was
never completely convinced they needed to lock up money
in that way. In a sense, their willingness to redeem at any
time was a statement of their confidence in their own invest-
ment strategy.
Kaplan: I agree that their willingness to redeem was consis-
tent with, and backed up, their claim to be absolute-return,
“all weather” funds, with no net market exposure.
Investors have clearly not been happy to see the hedge
funds put the gates down. And my sense is that there have
been a lot of negotiations about hedge fund compensation
going on. It’s always puzzled me why the hedge funds don’t
have a multi-year carry structure. The way many hedge funds
have been set up, if you get a big carry one year but your
returns are negative the next year, then in future years you
have to meet a high water mark, but you don’t have to give
back the carry you earned earlier. By contrast, in the case of
each private equity fund, the PE firm earns a carry only after
netting the winners and losers over the entire ten-year-or-
more life of the fund. So if a PE fund has one great investment
early in the fund followed by a number of bad ones, the fund
doesn’t end up receiving any carry.
So, I suspect you’ll see more pressure in that regard on
the hedge funds, especially those that are asking to lock up
the money longer. That’s what I would do as an LP.
But do hedge funds really need longer-term money? It
depends on what the hedge funds are doing. Some of what the
hedge funds were doing was essentially private equity. Now
you can—and I think you should—question whether hedge
funds have the capabilities to do it. But if they’re going to do
it, they should be paid like private equity investors, not like
hedge fund investors.
Ending the Boom-Bust Cycle (or Does PE
Learn from its Mistakes?)
Chew: I think it’s time to start wrapping up. Private equity, as
we started by saying, is now in the “bust” phase of what looks
like a recurring industry pattern of boom and bust. Why do
these cycles continue to take place in which easy credit seems
to lead in an almost predictable way to far too many over-
priced deals? We saw that in the ’80s with LBOs and HLTs,
Journal of Applied Corporate Finance • Volume 21 Number 3
we saw it in venture capital in 2000, and we’re now seeing it
in private equity today? Why don’t the main players in the
PE markets—the sponsors and their LPs—learn from the
mistakes made in the past?
Kaplan: There does seem to be a surprisingly large element
of predictability in these cycles. As I mentioned earlier, my
own simple model of PE investing predicts that vintage-year
returns will be a negative function of the previous years’ capi-
tal-raising. And that model has proved to have a great deal of
predictive power. The historical record shows clearly that the
higher the level of commitments to private equity in a given
year, the lower the level of returns in the next few years.
Given the large negative returns now being reported
for 2008, the model appears to have predicted the effects
of the large capital commitments in ’06 and ’07. And it also
predicted the horrendous returns to venture capital in 2000,
after the very large fundraisings by the VCs in the preceding
years. So the question you raise, then, is do people recognize
this pattern and try to learn from what happened?
In terms of the LPs, we are seeing decreases in their
commitments to private equity in the next couple of years for
two reasons. First, many LP portfolios have declined by 20%
to 30%, so they have less money to invest. This is the denomi-
nator effect. Second, the LPs did not fully anticipate the costs
of illiquidity in PE investments—and this illiquidity surprise
is also likely to dampen commitments in the near term.
The interesting question, though, is what will happen to
the LPs’ allocations to private equity. I have no doubt that
some LPs will reduce their allocation targets. But at the same
time, more LPs understand the boom and bust cycle and, as a
result, the drop in allocations to PE may not be quite as large
as expected. And so there are signs of learning here, of some
investors recognizing the cycle and trying to profit from it by
shifting their investment to the down part of the cycle.
Chew: I wasn’t thinking so much about the LPs as about
the financial sponsors, the PE firms that raise the capital
and then put it to work in the individual deals. In an article
published in this journal in 1991, just after the first wave of
PE deals had gone bad, Mike Jensen provided an explana-
tion for boom-and-bust cycles of all kinds—in real estate and
venture capital as well as private equity—that I find pretty
persuasive. Jensen’s argument was that the ability of dealmak-
ers to do deals without making significant commitments of
their own equity to the deals effectively ensured that there
would be too many of them. For Jensen, the tell-tale sign of
big problems in private equity were the many LBO deals in
the late ’80s where sponsors were pulling out more in fees
than their own equity investments in those deals. In such
cases, the sponsors were giving themselves what amounted
to “free options”; with their fees and 20% carry, the spon-
sors were getting a large share of the upside while the LPs and
A Morgan Stanley Publication • Summer 2009 17
the creditors effectively had all the downside. In this kind of
arrangement, all that was keeping dealmakers from doing
deals they suspected were overpriced was concern about their
reputations and franchise values. And while that concern may
have troubled the larger, established PE firms, it wasn’t likely
to constrain the newer players—the ones, Steve, that you like
to refer to as “the transients.”
So, my question is whether the entire PE system—the
network of sponsors, LPs, and creditors—has recognized
this “free option” problem and made some changes in their
contractual arrangements to deal with it? You mentioned the
larger amounts of equity being put into deals by all inves-
tors, and the larger coverage ratios and delayed repayments
of principal. But like Jensen, I think the key factor is likely
to be the percentage of the equity that is committed by the
PE firm that puts together the deal.
Kaplan: I’m not sure I can answer that. One way that a lot
of these PE funds became so large was through conscious
decisions to lower their expected returns on investment in
individual deals from 25-30% down to 15-20%. Lowering
their expected returns enabled them to do more and bigger
deals, particularly the large public-to-privates. The firms
said to themselves, “We make a lot more money having 18%
returns on a $10 billion fund than 30% returns on a $2
billion fund.”
Now, although it’s conceivable that these deals could end
up providing adequate risk-adjusted returns for their LPs,
my guess is that the main beneficiaries of these large deals
will turn out to be the PE firms—as well as the shareholders
of the public companies that sold—and not their LPs. And
so I think the answer to your question is “no.” In other words,
I would guess that Jensen’s objection to the ’80s LBOs—
too much taken out in fees and too little committed by the
sponsor as equity—will turn out to apply to many of the deals
done in ’06 and ’07 as well.
But having said that, LPs do pay attention to the amount
of money the GPs commit to their funds. Increasingly, LPs
want to see GPs commit amounts that are significant in
relation to their net worth. On the other hand, given the
large size of the funds and deals, it is not easy for the PE
firms to commit enough of their own equity in such cases to
counteract their incentive just to do deals.
Chew: But doesn’t that mean that it will have to be the LPs
and the lenders who rewrite the contracts and establish the
discipline? And isn’t it the LPs’ job to make sure that the
sponsors have the right incentive arrangement?
Kaplan: That’s part of it. And although I don’t really see that
happening quickly, the LPs do appear to be growing less
enthusiastic about the mega funds. In the next few years,
we’re likely to see the mega funds report lower returns because
18 Journal of Applied Corporate Finance • Volume 21 Number 3
of their focus on the larger, lower-return deals—the large
public-to-privates—with the greater leverage. And I do think
the fund sizes got a little too big. At the same time, we might
also see a little bit more pressure on the management fee, and
we’ve seen some pressure on the deal fees.
One other limiting factor in all this is likely to be the
debt markets. Without the very favorable financing environ-
ment, PE funds—and megafunds in particular—will find it
hard to make deals work economically without adding real
economic value. Put another way, the PE funds will not be
able to do deals based just on financial engineering—and this
will reduce the number and size of the deals they can do, at
least relative to the last wave of deals.
Understanding the Financial Crisis
Chew: I also think it’s worth suggesting that if we want to
understand the roots of the current financial crisis, we can
learn a lot just by looking more carefully at the incentives
of the parties that have been identified as major contribu-
tors to the problem. I make this suggestion because I’m not
convinced that most people are looking in the right place.
As I’m sure you’re aware, Steve, business schools like the
University of Chicago have been taking a lot of heat for a
free-market philosophy that is now being identified by many
as playing a role in the crisis. Today’s top business bestseller,
a beautifully written book by Justin Fox called The Myth
of the Rational Market, goes so far as to suggest that part of
the responsibility for the crisis rests with efficient markets
theory and what we like to call “modern finance.” In the
so-called “behavioralist” view of recent events, investor
irrationality in the form of excessive confidence in market
pricing caused not just gullible homebuyers but investors
and corporate risk managers and federal regulators to drop
their guards. And when trouble started, excessive confidence
was replaced by panic, causing prices to plunge and nearly
taking down the system.
While this explanation is plausible up to a point, what’s
almost completely missing is the role of incentives throughout
the system—of the conflicts of interest and agency costs that
finance professors have been pointing to for years. It seems
to me that most of the problems we’ve seen attributed in the
past few years to “irrational” markets and investors can be
better explained by viewing the same people as responding in
completely predictable or “rational” ways to limited informa-
tion and badly designed incentives.
Kaplan: That’s right. There were “free option” and princi-
pal-agent problems in a number of areas. You saw them with
homebuyers who bought houses with no money down, with
lenders who originated mortgages, collected fees, and sold
off all the loans, and with the rating agencies that collected
up-front fees for their ratings. And I think this issue is worth
talking about because there are many people who view the
A Morgan Stanley Publication • Summer 2009
financial crisis as clear evidence that the business schools have
failed in their mission of training executives.
Now, to be fair to the critics, there is probably some
confusion about what the business school finance programs
teach their students. For many years now, there have been two
distinct “wings” in finance: one is known as “asset pricing” or
investments, and the other is corporate finance. The people
who study and teach asset pricing often use the working
assumption that markets are efficient and “in equilibrium.”
But, for people who teach in the corporate finance wing,
market “imperfections,” particularly information and agency
problems, need to be recognized and managed. And corpo-
rate finance begins by paying a lot of attention to incentives
and information. That’s what Jensen and Meckling did over
30 years ago in their seminal agency cost paper. Designing
financial and governance structures to address that problem—
along with the information or “lemons” problem raised by
Stew Myers—has been a major focus of modern finance for
at least the past 30 years.
So, when people tell me that modern finance caused the
crisis, I remind them, “Many of the people involved in the
crisis didn’t remember what they learned in corporate finance.
We taught that when somebody’s selling you a security and
they have no skin in the game, you have to be very careful.”
A lot of people forgot this lesson.
The Latest News from the Financial Crisis:
Markets Can Work
Chew: While we’re on the subject of agency and informa-
tion problems, I think there’s one very important lesson that
we have now learned from the financial crisis—and it’s one
that could even become a standard part of corporate finance
courses in the future.
What I have in mind is the recent success of so many
banks in raising new equity, and the market reaction to the
announcements of the offerings. About six to nine months
ago, you could hear economists like Nouriel Roubini talking
about the likely collapse of the U.S. financial sector. After
looking at the mounting losses and hundreds of billions of
dollars that would have to be raised by the financial sector
to fund them, Roubini basically concluded that the capital
markets would be overwhelmed by the amounts of equity
needed to restore solvency to the banks.
But with the possible exception of Citi—and even
here I think his thesis will be wrong—his projections have
been well off the mark. After reporting positive operat-
ing earnings and getting assurances of support from the
government—including infusions of equity and demands
from regulators to issue more—most of the largest banks
were able to issue new equity on their own in a matter of a
few months. And even more remarkable for market analysts
and economists, the market reaction to the offerings—
even for stock issued at discounts from current value—was
Journal of Applied Corporate Finance • Volume 21 Number 3
strongly positive, causing some issuers to increase the size
of their offerings.
Kaplan: Before coming to any conclusions about the current
period, I would like to see some careful empirical studies. That
said, the banks have been able to raise a lot of equity capital.
The explanation seems relatively straightforward, at least with
hindsight. The banks found themselves overleveraged and in
need of more equity. The big question was whether the exist-
ing equity was worth anything. And in February, when bank
stock values bottomed, the markets did not appear to believe
the bank equity was worth very much.
The typical problem in that situation—and in the standard
corporate setting too—is that announcements of equity offer-
ings tend to be bad news, in some cases very bad news. New
equity is usually interpreted as a sign that the issuer believes it
is overvalued and trying to use a run-up in the stock to raise
cheap equity. Otherwise, the issuer would issue some other
security or decide not to raise money at all. In other words,
the usual assumption about equity issues is that investors are
at an informational disadvantage to management, and that
managers may be trying to raise overpriced equity. And this
market suspicion should have made it very hard for the banks
to raise equity.
In this case, the banks, the Fed and the Treasury needed
to convince the markets not only that there was no additional
negative information, but that the situation—and current
equity values—was better than the market thought it was.
This was done in two ways. First, the U.S. government—both
the Fed and Treasury—significantly reduced concern about
the bank equity’s downside risk by effectively promising
that the government would not let the large banks fail—and
thus let the equity become worthless. Second, the stress tests
concluded that the bank equity was not worthless and effec-
tively forced the large banks to raise equity, reducing any
uncertainty about whether they needed to or not. The net
effect was to increase the perceived value of the bank equity
and to substantially reduce the negative information in the
bank equity issues. But, of course, a huge amount of negative
information had already come out—and that was why the
equity values had become so low.
Chew: But I think it’s also important to keep in mind the
point you made earlier about the kinds of companies that get
restructured rather than liquidated. You said that the critical
condition was that the companies demonstrate that they are
profitable, or at least potentially profitable, going concerns.
With some help from the Treasury and the Fed, the banks
were able to show this. And, under those conditions, as the
theory predicts, the markets provided the capital. And as the
theory also suggests, stock prices went up in response to equity
offerings that were clearly designed to rebalance overleveraged
capital structures, and not to take advantage of investors.
A Morgan Stanley Publication • Summer 2009 19
Kaplan: I think that’s right. In terms of corporate finance
theory, the Fed and the Treasury can be seen as managing
what we call the “adverse selection problem.” In a world where
the markets feared the worst, the Fed and Treasury under-
took their own examination and, partly on that basis, were
able to convince the markets that the banks were profitable,
or potentially profitable, going concerns.
Chew: And I think that somebody like your former colleague
Merton Miller, despite his misgivings about regulators, would
have applauded the Fed’s decision to make the banks raise
equity. There was a lawsuit in the late 1990s in which an S&L
was suing the Resolution Trust Corporation for destroying
its value by forcing it to raise equity at a tough time. And
when the RTC, which is of course a government agency, hired
Miller to be its expert witness, he defended the government’s
position by showing why, in reasonably well-functioning
20 Journal of Applied Corporate Finance • Volume 21 Number 3
markets, the costs of raising equity should be pretty manage-
able. And judging from what we’ve just seen with the banks,
I think Mert got it right. When presented with positive-NPV
projects, the markets tend to respond.
Again, thanks for joining us, Steve—and better times
ahead.
steve kaplan is the Neubauer Family Professor of Entrepreneurship
and Finance, as well as Faculty Director of the Polsky Entrepreneurship
Center, at the University of Chicago’s Graduate School of Business. Along
with his many published papers on private equity and entrepreneurial
finance, and on corporate governance and M&A, Steve has been recog-
nized as one of the top-rated business school teachers in the country.
He serves on the boards of three companies: Accretive Health, Columbia
Acorn Funds, and Morningstar.
A Morgan Stanley Publication • Summer 2009