384 10 Exit of Shareholders
The financial rewards of the management firm thus depend on volume, and the
fee structure gives an incentive to use very high leverage.
For example, LTCM raised plenty of money from investors, took big positions, and used
extreme leverage. The partners of the management firm took 25% of the profits in addition
to a yearly 2% charge on assets and required that investors commit for at least three years
(lock-up).^268
Business model of private-equity firms. Apart from fees, the business model of
private-equity firms consists of a highly leveraged buy-out (LBO) combined with
refinancing and exit.
Refinancing has two core functions. First, it enables the buyer to finance the
takeover from the assets of the target. Second, refinancing enables the buyer to re-
lease capital after the takeover and distribute assets to investors.
Because of high leverage, investors can earn a high return on the capital that
they have invested – at least in the short term and provided that everything goes
according to plan.
Steps of refinancing. Refinancing consists of three or four main steps.
First, the buyer (for example, a private-equity firm) founds a new company and
calls it, for example, Newco. Newco raises a loan and buys all shares in the target
company. After a successful leveraged takeover, Newco and the target company
will be combined in a merger into a single corporate entity. After the merger, all
property owned by each constituent company is vested in the surviving company.
It is just as important that all liabilities of each constituent company are vested in
the surviving company. The loan originally raised by Newco will then be repaid
from assets that originally belonged to the target company.
Second, the assets that can be distributed to shareholders (in this case, the pri-
vate-equity firm) will be increased by reducing share capital to the legal mini-
mum. Distributions to shareholders will be financed in many ways: by selling off
assets such as subsidiaries, plants and real estate; by reducing costs, for example
research and development costs; and by raising new loans.
Third, the second step can be repeated. The company will distribute as much as
it legally can to shareholders.
The last step will be exit. As the owners (the private-equity firm) have already
profited from the repayment of loans from assets that originally belonged to the
target and from the distribution of its distributable assets, the price that outsiders
are prepared to pay for the shares is less crucial than in normal share sales. – This
technique can also be described as follows.
(^268) Lowenstein R, When Genius Failed. The Rise and Fall of Long-Term Capital Manage-
ment. Fourth Estate, London (2001) p 27.