LBO Financing

We rationalize why leverage in buyouts differs from corporate leverage at large by merging two strands of buyout theory that focus on problems of public ownership: the Berle-Means problem (lack of incentives) and the Grossman- Hart problem (free-riding). We derive in such a framework the novel result that the combination of bootstrapping, very high leverage, and upfront cashouts is socially optimal and increases buyout premia. This buyout structure mimics a management contract, paying a bidder (e.g. a private equity firm) upfront cash and stock to manage the target, with the cash portion funded by debt imposed on the target.