There was an editorial in the New York Times over the weekend talking about the likelihood of bankruptcies among companies that have gone through buyouts during the time when credit was flowing too freely.  I agree with the column that this is highly likely as we are facing a significant slowdown in economic activity and these companies have way too much leverage (and given the credit crunch, no real option to refinance).  Why did the companies wind up with so much leverage?  That reminded me that I meant to write a post about why Wall Street firms wound up with too much leverage.  The answer is of course the same in both cases: wrong incentives.

Lets start with the buyouts.  With credit super easy to obtain, a frequent deal pattern was that LBO funds would have the company pay a special dividend shortly after the deal which recouped most or all of the equity put up by the fund (more was generally reouped via management fees imposed on the company).  Sometimes these dividends were in fact funded by additional debt.  This completely disables the normal incentives that keep leverage down.  Regular equity holders have real equity at stake which would get wiped out in a downturn when there is too much leverage.  But if you don’t have any equity at stake to begin with, then why would you care?  Much the same logic applies to leverage in investment banks.  Most individuals inside the bank have comparatively small equity stakes in the overall enterprise.  Yet some of these individuals can create outsize gains for themselves through leverage (on the way up), that is a much bigger portion of the upside accrues to them than they face downside risk.

Some of the same incentive issues arise in startups.  While startups don’t have the obvious financial leverage due to debt, they can easily have payoff profiles for founders that will have similar effects.  Take a startup that has raised $20 million in preferred stock.  At any outcome below $20 million the founders make nothing.  Near $20 million there is huge “leverage” in the founders payoff.  For instance, in a $22 million exit the founders keep $2 million (this assumes straight, not participating, preferred), whereas in a $21 million exist they keep only $1 million or 50% less.  In the meantime there is no impact on the venture funds which get their money back in both cases.  Add to that the fact that most founders have their stakes for sweat equity which has quite different psychological implications from founders having invested cash.  The incentive result of this payout pattern is that with a high preferred overhang founders will take big risks to get to high payoffs.