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entitled 'Private Equity: Recent Growth in Leveraged Buyouts Exposed 
Risks That Warrant Continued Attention' which was released on October 
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Report to Congressional Requesters: 

United States Government Accountability Office: 
GAO: 

September 2008: 

Private Equity: 

Recent Growth in Leveraged Buyouts Exposed Risks That Warrant Continued 
Attention: 

GAO-08-885: 

GAO Highlights: 

Highlights of GAO-08-885, a report to congressional requesters. 

Why GAO Did This Study: 

The increase in leveraged buyouts (LBO) of U.S. companies by private 
equity funds prior to the slowdown in mid-2007 has raised questions 
about the potential impact of these deals. Some praise LBOs for 
creating new governance structures for companies and providing longer 
term investment opportunities for investors. Others criticize LBOs for 
causing job losses and burdening companies with too much debt. This 
report addresses the (1) effect of recent private equity LBOs on 
acquired companies and employment, (2) impact of LBOs jointly 
undertaken by two or more private equity funds on competition, (3) 
Securities and Exchange Commission’s (SEC) oversight of private equity 
funds and their advisers, and (4) regulatory oversight of commercial 
and investment banks that have financed recent LBOs. GAO reviewed 
academic research, analyzed recent LBO data, conducted case studies, 
reviewed regulators’ policy documents and examinations, and interviewed 
regulatory and industry officials, and academics. 

What GAO Found: 

Academic research that GAO reviewed generally suggests that recent 
private equity LBOs have had a positive impact on the financial 
performance of the acquired companies, but determining whether the 
impact resulted from the actions taken by the private equity firms 
versus other factors is difficult. The research also indicates that 
private equity LBOs are associated with lower employment growth than 
comparable companies. However, uncertainty remains about the employment 
effect—in part because, as one study found, target companies had lower 
employment growth before being acquired. Further research may shed 
light on the causal relationship between private equity and employment 
growth, if any. 

Private equity firms have increasingly joined together to acquire 
target companies (called “club deals”). In 2007, there were 28 club 
deals, totaling about $217 billion in value. Club deals could reduce or 
increase the number of firms bidding on a target company and, thus, 
affect competition. In analyzing 325 public-to-private LBOs done from 
1998 through 2007, GAO generally found no statistical indication that 
club deals, in aggregate, were associated with lower or higher prices 
paid for the target companies, after controlling for differences in the 
targets. However, our results do not rule out the possibility of 
parties engaging in illegal behavior in any particular LBO. Indeed, 
according to securities filings and media reports, some large club 
deals have led to lawsuits and an inquiry into the practice by the 
Department of Justice. 

Because private equity funds and their advisers typically claim an 
exemption from registration as an investment company or investment 
adviser, respectively, SEC exercises limited oversight of these 
entities. However, in examining some registered advisers to private 
equity funds, SEC has found some control weaknesses but generally has 
not found such funds to pose significant concerns for fund investors. 
The growth in LBOs has led to greater regulatory scrutiny. SEC, along 
with other regulators, has identified conflicts of interest arising in 
LBOs as a potential concern and is analyzing the issue. 

Before 2007, federal financial regulators generally found that the 
major institutions that financed LBOs were managing the associated 
risks. However, after problems with subprime mortgages spilled over to 
other markets in mid-2007, the institutions were being exposed to 
greater-than-expected risk. As a result, the regulators reassessed the 
institutions’ risk-management practices and identified some weaknesses. 
The regulators are monitoring efforts being taken to address weaknesses 
and considering the need to issue related guidance. While the 
institutions have taken steps to decrease their risk exposures, the 
spillover effects from the subprime mortgage problems to leveraged 
loans illustrate the importance of understanding and monitoring 
conditions in the broader markets, including connections between them. 
Failure to do so could limit the effectiveness and ability of 
regulators to address issues when they occur. 

What GAO Recommends: 

GAO recommends that the federal financial regulators give increased 
attention to ensuring that their oversight of leveraged lending at 
their regulated institutions takes into consideration systemic risk 
implications raised by changes in the broader financial markets. In 
line with the recommendation, the regulators acknowledged the need to 
factor in such implications into their approach to overseeing their 
regulated institutions’ activities. 

To view the full product, including the scope and methodology, click on 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-885]. For more 
information, contact Orice M. Williams at (202) 512-8678 or 
williamso@gao.gov. 

[End of section] 

Contents: 

Letter1: 

Results in Brief: 

Background: 

Research Suggests Recent LBOs Have Generally Had a Positive Impact on 
the Financial Performance of Acquired Companies, but LBOs Were 
Associated with Lower Employment Growth: 

Club Deals Have Raised Questions about Competition, but Our Analysis of 
Such Deals, in the Aggregate, Shows No Negative Effect on Prices Paid: 

SEC Exercises Limited Oversight of Private Equity Funds, but It and 
Others Have Identified Some Potential Investor-Related Issues: 

Recent Credit Events Raised Regulatory Scrutiny about Risk-Management 
of Leveraged Lending by Banks: 

Conclusions: 

Recommendation for Executive Action: 

Agency Comments and Our Evaluation: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Pension Plan Investments in Private Equity: 

Appendix III: Overview of Tax Treatment of Private Equity Firms and 
Public Policy Options: 

Appendix IV: Case Study Overview: 

Appendix V: Neiman Marcus Group, Inc., Case Study: 

Appendix VI: Hertz Corp. Case Study: 

Appendix VII: ShopKo Stores, Inc., Case Study: 

Appendix VIII: Nordco, Inc., Case Study: 

Appendix IX: Samsonite Corp. Case Study: 

Appendix X: Econometric Analysis of the Price Impact of Club Deals: 

Appendix XI: Comments from the Board of Governors of the Federal 
Reserve System: 

Appendix XII: Comments from the Securities and Exchange Commission: 

Appendix XIII: Comments from the Office of the Comptroller of the 
Currency: 

Appendix XIV: GAO Contact and Staff Acknowledgments: 

Bibliography: 

Tables: 

Table 1: Number and Value of Private Equity LBOs with U.S. Targets, 
2000-2007: 

Table 2: Number and Value of Club Deals, 2000-2007: 

Table 3: The 10 Largest Club Deals and Their Private Equity Firm 
Sponsors: 

Table 4: Top 10 Commercial and Investment Banks Providing Syndicated 
Leveraged Loans for LBOs by Private Equity Funds, U.S. Market, 2005- 
2007: 

Table 5: Extent of Defined Benefit Plan Investments in Private Equity: 

Table 6: Comparison of Income Earned by an Employee and General Partner 
by Effort, Capital, and Risk: 

Table 7: Companies Selected for Private Equity Buyout Case Studies: 

Table 8: Descriptive Statistics of the Sample (Averages), 1998-2007: 

Table 9: Primary Variables in the Econometric Analysis: 

Table 10: Correlations Between Independent Variables: 

Table 11: Multivariate Regression Analysis of Premium, 1998-2007: 

Table 12: Multivariate Regression Analysis of Premium, Select 
Sensitivity Analyses: 

Figures: 

Figure 1: The Stages of a Private Equity-Sponsored LBO: 

Figure 2: Inflation-Adjusted Capital Commitments to Private Equity 
Funds, 1980-2007: 

Figure 3: Club Deal Ties among Private Equity Firms Involved in the 50 
Largest LBOs, 2000-2007: 

Figure 4: Premium Paid for Target Companies in Public-to-Private 
Buyouts: 

Figure 5: Pension Plans with Investments in Private Equity by Size of 
Total Plan Assets: 

Figure 6: Overview and Time Line of the LBO of Neiman Marcus: 

Figure 7: Overview and Time Line of the LBO of Hertz Corp. 

Figure 8: Overview and Time Line of the LBO of ShopKo Stores, Inc. 

Figure 9: Overview and Time Line of the LBO of ShopKo Stores, Inc. 

Figure 10: Overview and Time Line of the LBO of Samsonite Corp. 

Abbreviations: 

BDC: business development company: 

CDF: cumulative distribution function: 

CD&R: Clayton, Dubilier & Rice: 

CSE: Consolidated Supervised Entity: 

DOJ: Department of Justice: 

EU: European Union: 

FRBNY: Federal Reserve Bank of New York: 

FSA: Financial Services Authority: 

IOSCO: International Organization of Securities Commissions: 

IPO: initial public offering: 

IRS: Internal Revenue Service: 

LBO: leveraged buyout: 

M&A: Merger and Acquisitions: 

ML: maximum likelihood: 

NAICS: North American Industry Classification System: 

NYSE: New York Stock Exchange: 

OCC: Office of the Comptroller of the Currency: 

OLS: ordinary least square: 

PDF: probability density function: 

PWG: President's Working Group on Financial Markets: 

SEC: Securities and Exchange Commission: 

[End of section] 

United States Government Accountability Office:
Washington, DC 20548: 

September 9, 2008: 

The Honorable Byron L. Dorgan: 
Chairman: 
Subcommittee on Interstate Commerce, Trade, and Tourism: 
Committee on Commerce, Science, and Transportation: 
United States Senate: 

The Honorable Tim Johnson: 
Chairman Subcommittee on Financial Institutions: 
Committee on Banking, Housing, and Urban Affairs: 
United States Senate: 

Over the past several years, an increase in buyouts of U.S. companies 
by private equity funds has rekindled controversy about the potential 
impact of these deals. Such funds borrow significant amounts from banks 
to finance their deals--increasing the debt-to-equity ratio of the 
acquired companies and giving rise to the term "leveraged buyouts" 
(LBO).[Footnote 1] From 2000 through 2007, private equity funds 
acquired nearly 3,000 companies, with a value totaling more than $1 
trillion. Helping to fuel the increase in LBOs has been a strong demand 
for private equity investments by pension plans and other institutional 
investors and relatively low borrowing rates, according to market 
observers. Some academics and others view such LBOs as revolutionizing 
corporate ownership by creating new funding options and corporate 
governance structures, as well as by providing investors with 
attractive, longer term investment opportunities. However, some labor 
unions and academics have a less favorable view--criticizing LBOs for 
harming workers, such as through job losses and lower benefits; 
providing private equity fund managers with, in effect, a tax subsidy; 
or burdening companies with too much debt. 

The operations of private equity firms and the funds that they manage 
generally are subject to limited federal and state regulation, but the 
transactions done by the funds may be subject to a number of federal 
and state regulations depending on the nature of the transaction. 
[Footnote 2] LBOs generally involve the takeover of a corporation. 
State corporation statutes impose broad obligations and specific 
procedural requirements on a corporation's board of directors with 
respect to the sale or change of control of a corporation. For example, 
directors have an obligation to act in the best interest of the 
corporation's shareholders, and the discharge of that duty may require 
taking steps to resist a takeover that they reasonably believe is 
contrary to the best interests of the corporation and its shareholders. 
Also, in certain circumstances, directors are required to maximize 
shareholder value and are precluded from considering the interests of 
any groups other than the shareholders.[Footnote 3] Furthermore, 
takeover transactions that involve proxy solicitations, tender offers, 
or new securities offerings are subject to federal securities laws. 
[Footnote 4] Under the Clayton Act, persons contemplating certain large 
takeover transactions must give advance notice of the proposed 
transaction to the Federal Trade Commission and the Antitrust Division 
of the U.S. Department of Justice and wait a designated time before 
consummating the transactions.[Footnote 5] 

Around mid-2007, the credit markets for LBOs contracted sharply and 
brought new LBO activity to a near standstill, especially for larger 
deals. This contraction has raised significant challenges for some 
banks because of their commitments to help finance pending LBOs but 
difficulties in finding investors to buy such debt. Nonetheless, market 
participants generally expect private equity-sponsored LBOs to continue 
to occur but at slower rate in light of the billions of dollars that 
private equity funds raised from investors in 2006 and 2007. Given that 
private equity-sponsored LBOs are expected to continue to be an 
important part of the U.S. capital markets and your interest in the 
oversight of such activity, you asked us to address the following 
objectives: 

* determine what effect the recent wave of private equity-sponsored 
LBOs had on acquired companies and employment, based largely on a 
review of recent academic research; 

* analyze how the collaboration of two or more private equity firms in 
undertaking an LBO (called a club deal) could promote or reduce 
competition, and what legal issues have club deals raised; 

* review how the Securities and Exchange Commission (SEC) has overseen 
private equity firms engaged in LBOs under the federal securities laws; 
and: 

* review how the federal financial regulators have overseen U.S. 
commercial and investment banks that have helped finance the recent 
LBOs. 

In addition, we provide information on pension plan investments in 
private equity in appendix II and information on the tax treatment of 
private equity firm profits in appendix III. We also present case 
studies to illustrate various aspects of five LBOs in appendixes IV 
through IX. 

To address these objectives, we reviewed and analyzed relevant 
examinations and related guidance and documents from the Board of 
Governors of the Federal Reserve System (Federal Reserve), the Federal 
Reserve Bank of New York (FRBNY), the Office of the Comptroller of the 
Currency (OCC), and SEC. We reviewed academic research that included 
analysis of recent LBOs. We also analyzed merger-and-acquisition, 
syndicated loan, and related data from Dealogic, which compiles data on 
mergers and acquisitions, as well as the debt and equity capital 
markets. Dealogic estimates that it captures about 95 percent of 
private equity transactions from 1995 forward but is missing the value 
of some of the deals when such information is unobtainable. We assessed 
the procedures that Dealogic uses to collect and analyze data and 
determined that the data were sufficiently reliable for our purposes. 
We also analyzed relevant laws and regulations, regulatory filings, 
speeches, testimonies, studies, articles, and our reports. We 
interviewed staff representing the U.S. regulators identified above and 
the Federal Deposit Insurance Corporation, the Department of the 
Treasury, and the Department of Justice. We also selected and 
interviewed representatives from 2 large commercial banks and 3 large 
investment banks based on their significant role in helping to finance 
LBOs; 11 private equity firms of various sizes to obtain the views of 
small, medium, and large firms; 3 credit rating agencies that have 
analyzed leveraged loans or recent LBOs; a trade association 
representing private equity firms; 2 associations representing 
institutional investors that invest in private equity funds; 4 
academics who have done considerable research on LBOs; 2 labor unions 
based on their concerns about private equity-sponsored LBOs; and a 
consulting firm that analyzed the private equity market. We selected 
five LBOs for in-depth case study to illustrate various aspects of such 
transactions that ranged in size and scope of the target companies, 
level and type of debt used to finance the transaction, or degree to 
which the news media focused on the transaction. We conducted this 
performance audit from August 2007 to September 2008 in accordance with 
generally accepted government auditing standards. Those standards 
require that we plan and perform the audit to obtain sufficient, 
appropriate evidence to provide a reasonable basis for our findings and 
conclusions based on our audit objectives. We believe that the evidence 
obtained provides a reasonable basis for our findings and conclusions 
based on our audit objectives. Appendix I provides a detailed 
description of our objectives, scope, and methodology. 

Results in Brief: 

Academic research that we reviewed on recent LBOs by private equity 
firms suggests that the impact of these transactions on the financial 
performance of acquired companies generally has been positive, but 
these buyouts have been associated with lower employment growth at the 
acquired companies. The research generally shows that private equity- 
owned companies outperformed similar companies across certain financial 
benchmarks, including profitability and the performance of initial 
public offerings (IPO), but determining whether the higher performance 
resulted from the actions taken by the private equity firms is often 
difficult due to some limitations in the academic literature. While 
some observers question whether private equity fund profits result less 
from operational improvements made by private equity firms and more 
from the use of low-cost debt by the firms, private equity executives 
told us that they use various strategies to improve the operations and 
financial performance of their acquired companies. Some evidence also 
suggests that private equity firms improve efficiency by better 
aligning the incentives of management with those of the owners. For 
example, private equity firms pay a higher share price premium for 
publicly traded companies with lower management ownership--indicating 
their expectation of having greater impact on performance in 
transactions where existing management may have less incentive to act 
in the interest of owners. Regarding the potentially broader impact of 
LBOs on public equity markets, a study found that roughly 6 percent of 
private equity-sponsored LBOs from 1970 to 2002 involved publicly 
traded companies, but 11 percent of private equity-owned companies were 
sold through IPOs during this period. This study suggests that the 
number of companies going public after an LBO exceeded the number of 
companies taken private by an LBO. Some critics contend that buyouts 
can lead to job reductions at acquired companies. Two academic studies 
found that recent private equity-sponsored LBOs were associated with 
lower employment growth than comparable companies. Nonetheless, 
uncertainty remains about the impact of such buyouts on employment, in 
part because, as one study found, target companies had lower employment 
growth than comparable companies before being acquired. 

In the past several years, private equity firms increasingly have 
joined together to acquire target companies in arrangements called 
"club deals," which have included some of the largest LBOs. For 
example, of the almost 3,000 private equity-sponsored LBOs we 
identified as completed from 2000 through 2007, about 16 percent were 
club deals. However, with a value around $463 billion, these club deals 
account for about 44 percent of the roughly $1 trillion in total 
private equity deal value. Since 2004, club deals have grown 
substantially in both number and value, particularly club deals valued 
at $1 billion or more. According to various market participants, 
private equity-sponsored LBOs are the product of a competitive process. 
However, club deals could affect this process and increase or reduce 
the level of competition. Club deals could increase competition among 
prospective buyers by enabling multiple private equity firms to submit 
a joint bid in cases where the firms would not have the resources to 
independently submit a bid. Indeed, private equity executives told us 
the principal reason they formed clubs was that their funds did not 
have sufficient capital to make the purchases alone. Club deals also 
could reduce competition and result in lower prices paid for target 
companies if the formation of the club led to fewer firms bidding on 
target companies or bidder collusion. While club deals can be initiated 
by private equity firms, they also can be, and have been, initiated by 
the sellers, according to private equity executives we interviewed and 
securities filings we reviewed. To examine the potential effect that 
club deals may have on competition among private equity firms, we 
developed an econometric model to examine prices paid for target 
companies. Our analysis of 325 public-to-private LBOs done from 1998 
through 2007 generally found no indication that club deals, in the 
aggregate, are associated with lower or higher prices for the target 
companies, after controlling for differences in targets. However, our 
results do not rule out the possibility of parties engaging in illegal 
behavior, such as collusion, in any particular LBO. Moreover, our 
analysis draws conclusions about the association, not causal 
relationship, between club deals and premiums. We also found that 
commonly used measures of market concentration generally suggest that 
the market for private equity-sponsored LBOs is predisposed to perform 
competitively and that single firms do not have the ability to exercise 
significant market power. Nevertheless, some large club deals have led 
to an inquiry into this practice by the Department of Justice's 
Antitrust Division, according to media reports and securities filings, 
and several shareholder lawsuits against private equity firms. 

Because private equity funds and their advisers (private equity firms) 
typically claim an exemption from registration as an investment company 
or investment adviser, respectively, SEC exercises limited oversight of 
these entities. Private equity funds generally are structured and 
operated in a manner that enables the funds and their advisers to 
qualify for exemptions from some of the federal statutory restrictions 
and most SEC regulations that apply to registered investment pools, 
such as mutual funds. Nonetheless, some advisers to private equity 
funds are registered and thus are subject to periodic examination by 
SEC staff and other regulatory requirements. For example, about half of 
the 21 largest U.S. private equity firms have registered as advisers or 
are affiliated with registered advisers.[Footnote 6] From 2000 through 
2007, SEC staff examined all but one of the private equity firms' 
advisers at least once. In the examinations we reviewed, SEC found some 
compliance control deficiencies, such as weak controls to prevent the 
potential misuse of inside information or to enforce restrictions on 
personal trades by employees. Despite such deficiencies, SEC and others 
have said that they generally have not found private equity funds to 
have posed significant concerns for fund investors. Since 2000, SEC has 
brought seven enforcement actions against private equity firms for 
fraud--five of which involved a pension plan investing money in private 
equity funds in exchange for illegal fees. An SEC official said that 
the Division of Investment Management has received more than 500 
investor complaints in the last 5 years, but none involved private 
equity fund investors. Similarly, officials representing two 
institutional investor associations and two bar associations said that 
fraud has not been a significant issue with private equity firms. 
However, in light of the recent growth in LBOs by private equity funds, 
U.S. and foreign regulators, including SEC, have undertaken studies to 
assess risks arising from such transactions and have identified some 
concerns about potential market abuse and investor protection, which 
they are studying further. 

Federal banking and securities regulators supervise the commercial and 
investment banks that financed the recent LBOs, and recent credit 
market problems have raised risk-management concerns. A small number of 
major commercial and investment banks have played a key role in 
financing recent LBOs: 10 U.S. and foreign commercial and investment 
banks originated around 77 percent of the nearly $634 billion in 
leveraged loans used to help finance U.S. LBOs from 2005 through 2007. 
Of these banks, four are national banks overseen by OCC; four are 
investment banks that have elected to be supervised on a consolidated 
basis by SEC as a consolidated supervised entity; and two are foreign 
banks.[Footnote 7] Before the leveraged loan market began to experience 
problems in mid-2007, in the aftermath of problems that originated with 
subprime mortgages, OCC and SEC staff found through their examinations 
and ongoing monitoring that the major commercial and investment banks, 
respectively, generally had adequate controls in place to manage the 
risks associated with their leveraged finance activities. However, OCC, 
the Federal Reserve, and SEC raised concerns about weakening 
underwriting standards from 2005 through 2007. According to OCC and SEC 
staff, the major banks generally were able to manage their risk 
exposures by syndicating their leveraged loans, whereby a group of 
lenders, rather than a single lender, makes the loans. However, after 
the problems related to subprime mortgages unexpectedly spread to the 
leveraged loan market in mid-2007, the banks found themselves exposed 
to greater risk. The banks had committed to provide a large volume of 
leveraged loans for pending LBO deals but could no longer syndicate 
some of their leveraged loans at prices they originally anticipated. 
For example, four commercial banks at the end of May 2007 had more than 
$294 billion in leveraged finance commitments, and four major 
investment banks at the end of June 2007 had more than $171 billion in 
leveraged finance commitments. Since then, the commercial and 
investment banks have reduced their total loan commitments and had 
commitments at the end of March 2008 of about $34 billion and $14 
billion, respectively. However, because the banks could not syndicate 
some of the loans as initially planned, the banks held on their balance 
sheets a considerable share of the loans they funded when the LBO deals 
closed. In light of such challenges, OCC, SEC, and other regulators, 
separately or jointly, have reviewed the risk-management practices of 
major commercial and investment banks and identified weaknesses at some 
banks. The regulators said that they plan to continue monitoring the 
efforts being taken by the banks to address risk-management weaknesses 
and are continuing to consider the need to issue related guidance. 

Given that the financial markets are increasingly interconnected and in 
light of the risks that have been highlighted by the financial market 
turmoil of the last year, we recommend that the Federal Reserve, OCC, 
and SEC give increased attention to ensuring that their oversight of 
leveraged lending at their regulated institutions takes into 
consideration systemic risk implications raised by changes in the 
broader financial markets, as a whole. 

We provided a draft of this report to the Federal Reserve, OCC, SEC, 
Treasury, and the Department of Justice and a draft of the case studies 
to the private equity firms we interviewed for the case studies. The 
Federal Reserve, OCC, and SEC provided written comments on a draft of 
this report; their comments are included in appendixes XI through XIII. 
In their written comments, officials from the three agencies generally 
agreed with our conclusions and, consistent with our recommendation, 
acknowledged the need to ensure that regulatory and supervisory efforts 
take into account the systemic risk implications resulting from the 
increasingly interconnected nature of the financial markets. To that 
end, they stated that they will continue to work closely with other 
regulators to better understand and address such risk. We also received 
technical comments from the Federal Reserve, SEC, OCC, Department of 
the Treasury, and the private equity firms, which we have incorporated 
into this report as appropriate. 

Background: 

A private equity-sponsored LBO generally is defined as an investment by 
a private equity fund in a public or private company (or division of a 
company) for majority or complete ownership. Since 2000, the number and 
value of LBOs of U.S. target companies completed by private equity 
funds have increased significantly, as shown in table 1. According to 
market observers, three major factors converged to spur this growth: 
(1) the increased interest in private equity investments by pension 
plans and other institutional investors; (2) the attractiveness of some 
publicly traded companies, owing to relatively low debt and 
inexpensively priced shares; and (3) the growth in the global debt 
market, permitting borrowing at relatively low rates. As discussed 
below, credit market problems surfacing in mid-2007 have led to a 
significant slowdown in LBOs by private equity funds. 

Table 1: Number and Value of Private Equity LBOs with U.S. Targets, 
2000-2007 (Dollars in millions): 

Year: 2000; 
Number of deals: 203; 
Value of deals: $29,019. 

Year: 2001; 
Number of deals: 113; 
Value of deals: 17,050. 

Year: 2002; 
Number of deals: 143; 
Value of deals: 27,811. 

Year: 2003; 
Number of deals: 209; 
Value of deals: 57,093. 

Year: 2004; 
Number of deals: 326; 
Value of deals: 86,491. 

Year: 2005; 
Number of deals: 615; 
Value of deals: 122,715. 

Year: 2006; 
Number of deals: 804; 
Value of deals: 219,052. 

Year: 2007; 
Number of deals: 581; 
Value of deals: 486,090. 

Year: Total; 
Number of deals: 2,994; 
Value of deals: $1,045,321. 

Source: GAO analysis of Dealogic data. 

Note: Deals that were announced before December 31, 1999, but completed 
after that date are excluded from our totals. 

[End of table] 

As the private equity industry has grown, private equity-sponsored LBOs 
have become an increasingly significant subset of all merger-and- 
acquisition activity--accounting for about 3 percent of the total value 
of U.S. mergers and acquisitions in 2000 but growing to nearly 28 
percent in 2007. In recent years, large buyouts of publicly traded 
companies, valued in the tens of billions of dollars, have received 
considerable public attention. Such deals, however, are not 
representative of most private equity-sponsored LBOs. For example, 
among nearly 3,000 private equity-sponsored LBOs we identified from 
2000 through 2007, the median deal value was $92.3 million, according 
to Dealogic data.[Footnote 8] In addition, LBOs of publicly traded 
companies (called "public-to-private" buyouts) accounted for about 13 
percent of the total number of buyouts during this period but about 58 
percent of the total value of the buyouts. 

Private Equity-Sponsored LBOs Have Evolved Since the 1980s: 

Since the 1980s, private equity-sponsored LBOs have changed in a number 
of ways. Some LBOs in the 1980s were called "hostile takeovers," 
because they were done over the objections of a target company's 
management or board of directors. Few of the recent LBOs appear to have 
been hostile based on available data.[Footnote 9] Two private equity 
executives told us that their fund investors, such as pension plans, 
typically do not want to be associated with hostile takeovers. In such 
cases, the private equity partnership agreements include a provision 
prohibiting the fund from undertaking certain acquisitions.[Footnote 
10] Another way in which the private equity-sponsored LBOs have changed 
is that the scope of LBOs has expanded to include a wider range of 
industries--not only manufacturing and retail--but also financial 
services, technology, and health care. In addition, private equity 
funds have expanded their strategies for enhancing the value of their 
acquired companies. In the 1980s, LBO funds sought to create value 
through so-called "financial and governance engineering," such as by 
restructuring a company's debt-to-equity ratio and changing management 
incentives. Later, the acquiring firms sought to improve operations to 
increase cash flow or profitability. Today, private equity firms often 
use a combination of these strategies. Finally, the size of private 
equity funds and buyouts has increased. For example, the 10 largest 
funds--ranging in size from about $8 billion to $21 billion--were 
created since 2005, according to a news media report. Similarly, 9 of 
the 10 largest buyouts in history were completed in 2006 or later. 

Overview of an LBO Transaction by a Private Equity Fund: 

As illustrated in figure 1, a typical private equity-sponsored LBO of a 
target company and subsequent sale of the company takes place in 
several stages and over several years. 

Figure 1: The Stages of a Private Equity-Sponsored LBO: 

[See PDF for image] 

This figures provides the following information along with several 
illustrations: 

A typical private equity buyout involves these stages: 

1) A private equity firm creates a fund that obtains capital 
commitments from investors; (Investors: pension funds, endowment, 
wealthy individuals,etc.) 

2) Through its own research or information from intermediaries such as 
investment banks, private equity firm identifies “target” company for 
its buyout fund to acquire. 

3) Private equity firm, on behalf of the buyout fund, obtains a loan 
commitment which is used, along with the fund’s capital, to finance the 
acquisition. Commercial or investment banks typically provide the 
commitment but syndicate the loans–meaning they share the loans among a 
group of lenders. 

4) After takeover is completed, the buyout fund typically holds the 
acquired company for 3 to 5 years. During this time, it seeks to 
increase the value of the company, such as through operational and 
financial improvements, in hope of realizing a profit when it sells the 
company. 

5) The buyout fund “exits” investment by selling the company, such as 
through an IPO of stock, or to a “strategic” buyer or another private 
equity firm. Profits from the sale, if any, are returned to the fund 
and generally distributed to fund investors and private equity firm. 

Sources: GAO analysis of information provided by private equity firms, 
investment banks, and commercial banks; Art Explosion (images). 

[End of figure] 

In the first stage, a private equity firm creates a private equity fund 
and obtains commitments from investors (limited partners) to provide 
capital to its fund. Later, when the firm undertakes buyouts, it calls 
on the investors to provide the capital. Investors in private equity 
funds typically include public and corporate pension plans, endowments 
and foundations, insurance companies, and wealthy individuals. (See 
app. II for additional information on the investment in private equity 
by pension plans.) As shown in figure 2, private equity funds have 
increased their capital commitments from around $0.4 billion (inflation 
adjusted) in 1980 to nearly $185 billion (inflation adjusted) in 2007. 

Figure 2: Inflation-Adjusted Capital Commitments to Private Equity 
Funds, 1980-2007 (dollars in billions, in 2008 dollars): 

[See PDF for image] 

This figure is a vertical bar graph depicting the following data: 

Year: 1981; 
Amount: $0.3 billion. 

Year: 1982; 
Amount: $1.2 billion. 

Year: 1983; 
Amount: $2.6 billion. 

Year: 1984; 
Amount: $6.3 billion. 

Year: 1985; 
Amount: $5.2 billion. 

Year: 1986; 
Amount: $8.4 billion. 

Year: 1987; 
Amount: $25.9 billion. 

Year: 1988; 
Amount: $18.4 billion. 

Year: 1989; 
Amount: $18.6 billion. 

Year: 1990; 
Amount: $11.8 billion. 

Year: 1991; 
Amount: $8.9 billion. 

Year: 1992; 
Amount: $15.6 billion. 

Year: 1993; 
Amount: $22.3 billion. 

Year: 1994; 
Amount: $27.6 billion. 

Year: 1995; 
Amount: $35 billion. 

Year: 1996; 
Amount: $37.9 billion. 

Year: 1997; 
Amount: $52.8 billion. 

Year: 1998; 
Amount: $77.4 billion. 

Year: 1999; 
Amount: $66.3 billion. 

Year: 2000; 
Amount: $92.5 billion. 

Year: 2001; 
Amount: $54.9 billion. 

Year: 2002; 
Amount: $28.9 billion. 

Year: 2003; 
Amount: $33 billion. 

Year: 2004; 
Amount: $54.8 billion. 

Year: 2005; 
Amount: $104 billion. 

Year: 2006; 
Amount: $128.2 billion. 

Year: 2007; 
Amount: $184.9 billion. 

Sources: National Venture Capital Association and Thompson Financial. 

Note: Capital commitments are defined as funds that private equity 
limited partnerships raise from their limited partners (the investors 
in private equity funds). The data include commitments made to buyout 
and mezzanine funds but not venture capital funds. 

[End of figure] 

In the second stage, the private equity firm identifies potential 
companies for its fund to acquire. According to private equity 
executives, their firms routinely research companies and industries to 
stay abreast of developments and to identify potential acquisitions. 
Moreover, they make regular contact with managers or owners of both 
potential targets and other companies. Two private equity executives 
told us it can take years of contacts before managers or owners might 
agree to sell. Further, private equity firms can spend significant 
amounts of time and money to research potential targets, including 
incurring costs for consulting and other professional fees. In addition 
to using their own contacts, private equity firms identify potential 
targets through investment banks, attorneys, and other such 
intermediaries. Companies interested in selling frequently hire 
investment banks or other advisers to help them sell their companies. 

In the third stage, the private equity firm obtains a loan commitment, 
typically from commercial or investment banks, that it then uses to 
help finance its fund's acquisition of the target company. A loan 
commitment is a promise by the lender to make available in the future a 
specified amount of credit under specified terms and conditions. Loans 
are an essential component of an LBO because private equity firms 
typically contribute through their funds only a fraction of the capital 
needed to complete a takeover. The use of borrowed money, or debt 
capital, makes up the difference. Importantly, the legal agreements 
supporting the debt financing are often between the lender and target 
company, not the private equity firm. In 2000, private equity LBOs were 
financed, on average, with 41 percent equity and 59 percent debt, 
according to a consulting firm report.[Footnote 11] By 2005, LBOs 
became more leveraged, with the average deal financed with 34 percent 
equity and 66 percent debt. 

Private equity executives told us they typically seek offers for loan 
commitments from multiple banks in an effort to obtain the best terms 
through competition. If its offer to buy a target company is accepted, 
a private equity firm will select one of the loan commitment offers, 
which the respective bank will fund at the time the acquisition is to 
be completed. LBO loans commonly are syndicated loans--meaning that 
they are shared by a group of banks and other lenders. The lead bank 
finds potential lenders and arranges the terms of the loan on behalf of 
the syndicate, which can include commercial or investment banks and 
institutional investors, such as mutual and hedge funds and insurance 
companies.[Footnote 12] However, each lender has a separate credit 
agreement with the borrower for the lender's portion of the syndicated 
loan. Further, syndicated loans can be categorized as investment grade 
or leveraged loans.[Footnote 13] Syndicated loans for LBOs typically 
are leveraged loans, reflecting the lesser creditworthiness of the 
borrowers. 

In the fourth stage, after completing its buyout of the target company, 
the private equity firm seeks to improve the financial and operational 
performance of the acquired company. The aim is to increase the value 
of the company, so that the private equity firm can sell the company 
(fifth stage) at a profit and earn a return for its fund investors. (We 
discuss in detail how private equity firms seek to improve the 
performance of their acquired companies in the following section of 
this report.) 

In the fifth stage, the private equity firm exits its fund's investment 
by selling its acquired company. Private equity funds typically hold an 
acquired company from 3 to 5 years before trying to realize their 
return. A private equity fund typically has a fixed life of 10 years, 
generally giving the private equity firm 5 years to invest the capital 
raised for its fund and 5 years to return the capital and expected 
profits to its fund investors. Executives told us they often have an 
exit strategy in mind when their firms buy a company. The executives 
identified the following options to exit their LBOs: 

* make an IPO of stock; 

* sell to a "strategic" buyer, or a corporation (as opposed to a 
financial firm); 

* sell to another private equity firm; or: 

* sell to a "special purpose acquisition company," which is a publicly 
traded "shell" company that allows its sponsor to raise capital through 
an IPO for use in seeking to acquire an operating company within a 
fixed time frame.[Footnote 14] 

Research Suggests Recent LBOs Have Generally Had a Positive Impact on 
the Financial Performance of Acquired Companies, but LBOs Were 
Associated with Lower Employment Growth: 

Academic research on recent LBOs by private equity firms suggests that 
the impact of these transactions on the financial performance of 
acquired companies generally has been positive, but these buyouts have 
been associated with lower employment growth at the acquired companies. 
The research generally shows that private equity-owned companies 
outperformed similar companies across certain financial benchmarks, but 
it is often difficult to determine whether the higher performance 
resulted from the actions taken by the private equity firms. Private 
equity executives told us that they seek to improve the operations of 
their acquired companies through various strategies, but some observers 
question whether such strategies improve performance. Some evidence 
suggests that private equity firms improve efficiency by better 
aligning the incentives of management with those of owners. We also 
found some evidence that recent private equity-sponsored LBOs were 
associated with lower employment growth than comparable companies. 
However, uncertainty remains about the impact of such buyouts on 
employment, in part because, as one study found, target companies had 
lower employment growth than their peers before acquisition. 

Private Equity-Owned Companies Usually Outperformed Similar Companies 
Based on Several Financial Benchmarks: 

Academic studies analyzing LBOs done in the 2000s suggest that private 
equity-owned companies usually outperformed similar companies not owned 
by private equity firms across a number of benchmarks, such as 
profitability, innovation, and the returns to investors in IPOs. 
[Footnote 15] Recent research finding that private equity-owned 
companies generally outperformed other companies is consistent with 
prior research analyzing earlier LBOs.[Footnote 16] However, it is 
often difficult to determine why the differences in economic 
performance occur. Specifically, because private equity firms choose 
their buyout targets, it is difficult to determine whether the 
performance of the acquired companies after the buyout resulted more 
from the characteristics of the chosen companies or actions of the 
private equity firms.[Footnote 17] Executives of a private equity trade 
group told us that private equity firms typically choose their targets 
from among four general categories: (1) underperforming or declining 
companies; (2) "orphan" divisions of large corporations--that is, a 
division outside a company's core business that may be neglected as a 
result; (3) family businesses, where family owners are looking to exit; 
and (4) fundamentally sound businesses that nevertheless need an 
injection of capital to grow. The executives also said that private 
equity firms may specialize by industry. Other common limitations of 
academic studies are samples of buyouts that are small or not 
representative of all LBOs, resulting from the general lack of 
available data on private equity activities. Moreover, most empirical 
work on buyouts in the 2000s is based on European data because more 
data on privately held companies are available in Europe.[Footnote 18] 

Comparing private equity-owned companies to other companies of similar 
size in the same industry in the United Kingdom, one study found that 
operating profitability was higher at private equity-owned companies. 
[Footnote 19] Similarly, two studies, one of U.S. LBOs and the other of 
European LBOs, found that growth in profitability was higher at 
companies owned by private equity firms.[Footnote 20] A study of U.S. 
patents found that private equity-owned companies pursued more 
economically important innovations, as measured by how often the 
patents are cited by later patent filings, than similar companies. 
[Footnote 21] This finding also suggests that private equity-owned 
companies are willing to undertake research activities that can require 
a large up-front cost but yield benefits in the longer term. An 
analysis of 428 IPOs of private equity-owned companies in the United 
States between 1980 and 2002 found that they consistently outperformed 
other IPOs and the stock market as a whole, over 3-and 5-year time 
horizons.[Footnote 22] A study of the IPO market in the United Kingdom, 
covering 1992 to 2004, found that returns on the first day of the 
offering of 198 private equity-owned IPOs were on average lower than 
other IPOs, although 3-year returns (excluding the first day) were 
higher than other IPOs.[Footnote 23] Regarding LBOs' potentially 
broader impact on public equity markets, critics have expressed concern 
about the loss of transparency when public companies are taken private, 
since the bought-out companies cease making securities filings required 
of publicly held companies.[Footnote 24] However, one study of LBOs and 
their exits from 1970 to 2002 found that 6.3 percent of private equity- 
sponsored LBOs were public-to-private transactions, but 11 percent of 
the exits, or sales, of the acquired companies by private equity firms 
were accomplished through an IPO.[Footnote 25] This study suggests that 
"reverse LBO" transactions resulted in more companies entering public 
markets during this period than exiting following private equity 
acquisitions. 

Private Equity LBOs Seek to Enhance Performance through Techniques Such 
as Improving Management Incentives: 

According to the standard economic rationale for buyouts, LBOs enhance 
value because, among other things, the debt used to finance the buyout 
forces management to operate more efficiently, and private equity 
owners vary compensation schemes to better align management incentives 
with owners.[Footnote 26] For example, greater debt can limit 
management's ability to undertake wasteful investments because free 
cash flow is committed to service the debt. Also, providing management 
with a higher ownership stake in the company can link its compensation 
more closely to shareholder returns.[Footnote 27] Academic research 
analyzing the share price premium that private equity firms pay to 
shareholders over market prices in public-to-private buyouts is 
consistent with this view. Studies have shown that the buyout premium 
averages 20-40 percent over stock prices preceding a takeover. In 
theory, the premium paid over market prices should reflect the enhanced 
value private equity firms expect to realize after a buyout.[Footnote 
28] One study of UK buyouts estimated an average premium of 40 percent, 
and found that higher premiums were associated with lower recent share 
price performance, lower leverage, and lower management equity stakes 
at target companies.[Footnote 29] A study of buyouts in European 
countries reported an average premium of 36 percent and also found that 
higher premiums were associated with lower recent share price 
performance at targets, as well as less concentrated ownership among 
external shareholders.[Footnote 30] Finally, a study of U.S. buyouts 
done from 1995 through 2007 found average premiums of roughly 25 
percent in public-to-private LBOs.[Footnote 31] Similarly, our analysis 
of public-to-private transactions from the Dealogic database determined 
that the average premium paid to shareholders in private equity- 
sponsored LBOs in the United States from January 2000 through October 
2007 was about 22 percent.[Footnote 32] Our analysis also corroborated 
studies of European buyouts in finding that lower premiums were 
associated with more concentrated ownership (in the form of management 
or external shareholders) in U.S. publicly traded companies prior to 
acquisition by private equity firms. On the whole, these results 
suggest that private equity buyers anticipate greater value enhancement 
in target companies when existing shareholders are more dispersed and 
thus have less incentive to monitor or improve performance. 

Executives from private equity firms told us that improving the 
financial performance of their acquired companies is a key objective. 
The intent is to allow the companies, when later sold during the exit 
phase of the private equity cycle, to command a price sufficient to 
provide the desired returns to a private equity fund's investors. The 
executives told us they use strategies that include the following: 

* formulating strategic plans to monitor progress and performance; 

* retooling of manufacturing or other operations for greater 
efficiency; 

* reducing the workforce to cut costs; 

* acquiring other businesses that complement the acquired company's 
operations; 

* reducing the cost of goods and supplies by consolidating purchasing; 

* selling nonperforming lines of business; and: 

* developing new sources of revenue and improving marketing and sales 
for good, but under-supported, products. 

We found that the private equity firms included in our case studies 
used some of these strategies in an effort to improve the financial 
performance of their acquired companies. For example, the private 
equity owners of Samsonite sought to reinvigorate the company's image 
and products, in part by creating a new label for higher priced luggage 
and implementing a high-end marketing campaign. (See app. IX for 
discussion of this buyout.) As another example, following their buyout 
of Hertz, the private equity firms involved sought not only to reduce 
costs by buying more cars for the company's fleet, rather than leasing 
them, but also to increase the company's share of the leisure car 
rental segment partly by creating self-service kiosks for customers. 
(See app. VI for discussion of this buyout.) Also, to increase 
revenues, the private equity owners of Nordco acquired a competitor as 
an add-on acquisition. (See app. VIII for discussion of this buyout.) 

According to the private equity executives, they typically do not 
become involved in the day-to-day management of the acquired companies; 
rather, they exercise influence at the board level, such as by setting 
policies and goals. For example, after the Hertz takeover, the lead 
private equity firm installed one of its partners as the Chairman of 
the board of directors. However, executives said they will replace an 
acquired company's senior management, if necessary. As owners of 
private companies, the executives said they can make strategic 
decisions that might be more difficult for public companies, given 
their focus on quarterly earnings performance. ShopKo's new private 
equity owners, for instance, planned to spend about $70 million 
annually--up from about $35 million in the year before the takeover--to 
remodel the stores. (See app. VII for discussion of this buyout.) 
Overall, the executives said that boosting their companies' performance 
rests more on improving operations and less on financial engineering, 
such as the use of debt to leverage returns and the tax deductibility 
of interest on such debt. 

Altering compensation schemes is another important strategy for 
improving financial performance, according to the private equity 
executives we interviewed. Executives of one private equity firm told 
us that aligning incentives is a primary strategy they use to boost the 
performance of their companies. The firm has acquired companies that 
were divisions of larger companies, but the incentives of the division 
management were tied to the performance of the companies, not to the 
divisions. According to the executives, the key is providing management 
with equity ownership in a specific area over which managers have 
control. They note that when incentives are properly aligned, managers 
tend to work harder and improve profitability. Similarly, in the Nordco 
buyout, the private equity firm has sought to give the management team 
an opportunity to own a significant portion of the company and expects 
management to own 30 percent of the company by the time it exits the 
investment. 

Another area that has received considerable attention has been the use 
of debt by private equity firms. Overall, several executives told us 
that boosting their companies' performance rests more on improving 
operations and less on financial engineering, but we did not 
independently assess such assertions. Private equity executives told us 
debt financing plays an important role in private equity transactions, 
but it is not in their interest to overburden a target company with 
debt. According to the executives, if an acquired company cannot meet 
its debt payments, it risks bankruptcy; in turn, the private equity 
fund risks losing the equity it has invested. If that happens, the 
private equity fund will be unable to return profits to its limited 
partner investors. Moreover, such a failure would cause reputation 
damage to the private equity firm, making it harder for the firm to 
attract investors for its successor funds. While default rates on loans 
associated with private equity have remained at historically low 
levels, one credit rating agency found that being acquired by a private 
equity fund increases default risk for some firms.[Footnote 33] 
However, the extent to which LBO and other firms will suffer financial 
distress under the current credit cycle remains to be seen. 

Some market observers question how and the extent to which private 
equity firms improve their acquired companies. For example, a credit 
rating agency acknowledged that private equity firms are not driven by 
the pressure of publicly reporting quarterly earnings but questioned 
whether the firms are investing over a longer horizon than public 
companies.[Footnote 34] A labor union agreed, saying even if a private 
equity firm planned to hold an acquired company from 3 to 5 years, that 
period would not be long enough to avoid pressure to forego long-term 
investment and improvements. The rating agency also questioned whether 
there was sufficient evidence to support claims that private equity 
returns were driven by stronger management rather than by the use of 
the then readily available, low-cost debt to leverage returns. 
Similarly, a recent study estimates that private equity firms do not 
earn their income primarily by enhancing the value of their companies. 
[Footnote 35] The study, based on one large investor's experience with, 
among other investments, 144 private equity buyout funds, estimated 
that private equity firms earned about twice as much income from 
management fees as from profits realized from acquired companies. 

Private Equity-Sponsored LBOs Were Associated with Lower Employment 
Growth, but Causation Is Difficult to Establish: 

Our review of academic research found that recent private equity LBOs 
are associated with lower employment growth than comparable companies, 
but a number of factors make causation difficult to establish. Labor 
unions have expressed concern about the potential for a buyout to leave 
the acquired company financially weakened because of its increased debt 
and, in turn, to prompt the private equity firm to cut jobs or slow the 
pace of job creation. At the same time, job cuts may be necessary to 
improve efficiency. One study of private equity LBOs in the United 
Kingdom found that the acquired companies have lower wage and 
employment growth than non-LBO companies.[Footnote 36] Research on U.S. 
buyouts in the 1980s also found that LBOs were associated with slower 
employment growth than their peers.[Footnote 37] In addition, a 
comprehensive study of roughly 5,000 U.S. buyouts from 1980 to 2005 
found that private equity-owned "establishments" (that is, the physical 
locations of companies) had slower job growth than comparable 
establishments in the 3 years after an LBO, but slightly higher job 
growth in the fourth and fifth years.[Footnote 38] The net effect of 
these changes is lower employment growth than comparable establishments 
in the 5 years after the LBOs.[Footnote 39] Furthermore, private equity-
owned companies undertake more acquisitions and divestitures and are 
more likely to shut down existing establishments and open new ones. The 
researchers noted that these results suggest private equity owners have 
a greater willingness to restructure the company and disrupt the status 
quo in an effort to improve efficiency. However, the study also found 
that target establishments were underperforming their peers in 
employment growth prior to acquisition. This suggests that LBO targets 
are different from non-LBO companies prior to acquisition, making it 
difficult to attribute differences in employment outcomes after 
acquisition to private equity.[Footnote 40] Further uncertainty is due 
to the limited number of academic studies of the impact of recent 
buyouts on employment and difficulty faced by the studies in isolating 
the specific impact of private equity. 

Private equity executives told us that a chief concern generally is 
improving efficiency, not necessarily job creation. For example, 
executives from one private equity firm said that following an 
acquisition, the acquired company eliminated 300 jobs after a $100 
million spending reduction in one department. Although jobs were lost, 
the executives said it is important to realize that the goal was to 
produce an overall stronger company. Executives from another private 
equity firm told us that following an acquisition, employment fell when 
it closed some outlets. But at the same time, jobs were created 
elsewhere when new outlets were opened. One private equity executive 
told us that while his firm is sympathetic to calls to do such things 
as offer health insurance to workers at acquired companies, "market 
economics" sometimes stands as a barrier, because to do so would 
produce unacceptably lower investment returns. This challenge, however, 
is not unique to private equity-owned companies. As illustrated by our 
case studies, strategies implemented after a buyout can lead to either 
employment growth or loss. Of the five buyouts we studied, two 
experienced job growth, while three experienced job losses (see apps. V 
through IX). As noted previously, the LBOs we selected were not 
intended to be a representative sample of all LBOs. 

Club Deals Have Raised Questions about Competition, but Our Analysis of 
Such Deals, in the Aggregate, Shows No Negative Effect on Prices Paid: 

In the past several years, private equity firms increasingly have 
joined together to acquire target companies in arrangements called club 
deals, which have included some of the largest LBOs. Some have 
expressed concern that club deals could depress acquisition prices by 
reducing the number of firms bidding on target companies. However, 
others have posited that club deals could increase the number of 
potential buyers by enabling firms that could not individually bid on a 
target company to do so through a club. In addition, sellers of target 
companies, as well as potential buyers, can initiate club deals. In an 
econometric analysis of publicly traded companies acquired by public 
equity firms, we generally found no indication that club deals, in the 
aggregate, were associated with lower or higher per-share price 
premiums paid for the target companies, after controlling for 
differences among target companies. (A premium is the amount by which 
the per-share acquisition price exceeds the then-current market price; 
private equity buyouts of public companies typically take place at a 
premium.) We also found that commonly used measures of market 
concentration generally suggest that the market for private equity- 
sponsored LBOs is predisposed to perform competitively and that single 
firms do not have the ability to exercise significant market power. 
Nevertheless, some large club deals have been the object of several 
recent shareholder lawsuits and, according to media reports and 
securities filings, have led to inquiries by the Department of 
Justice's Antitrust Division. 

Club Deals Have Grown Substantially in Recent Years, Especially Those 
Involving Large LBOs: 

In recent years, private equity firms increasingly have joined to 
acquire companies through LBOs, resulting in some of the largest LBO 
transactions in history.[Footnote 41] These club deals involve two or 
more private equity firms pooling their resources, including their 
expertise and their investment funds' capital, to jointly acquire a 
target company. From 2000 through 2007, we identified 2,994 private 
equity-sponsored LBOs of U.S. companies, based on Dealogic data, of 
which 493, or about 16 percent, were club deals. These club deals 
accounted for $463.1 billion, or about 44 percent, of the $1.05 
trillion in total LBO deal value we identified. As shown in table 2, 
club deals have grown substantially both in number and value since 
2004, particularly club deals involving companies valued at $1 billion 
or more. Between 2000 and 2007, there were 80 club deals valued at $1 
billion or more--accounting for about 16 percent of the total number of 
all club deals but almost 90 percent of the total value of the club 
deals. These large club deals peaked in 2007, with 28 deals valued at 
about $217 billion. Among the club deals we identified, the number of 
private equity firms collaborating on a transaction ranged from two to 
seven. 

Table 2: Number and Value of Club Deals, 2000-2007 (Dollars in 
billions): 

Year: 2000; 
All club deals: Number: 47; 
All club deals: Value: $8.8 billion; 
Club deals valued at $1 billion or more: Number: 2; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
4.3%; 
Club deals valued at $1 billion or more: Value: $4.2 billion. 

Year: 2001; 
All club deals: Number: 37; 
All club deals: Value: $7.9 billion; 
Club deals valued at $1 billion or more: Number: 2; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
5.4; 
Club deals valued at $1 billion or more: Value: $3.0 billion. 

Year: 2002; 
All club deals: Number: 34; 
All club deals: Value: $10.1 billion; 
Club deals valued at $1 billion or more: Number: 2; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
5.9; 
Club deals valued at $1 billion or more: Value: $4.4 billion. 

Year: 2003; 
All club deals: Number: 37; 
All club deals: Value: $18.9 billion; 
Club deals valued at $1 billion or more: Number: 5; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
13.5; 
Club deals valued at $1 billion or more: Value: $10.4 billion. 

Year: 2004; 
All club deals: Number: 68; 
All club deals: Value: $30.8 billion; 
Club deals valued at $1 billion or more: Number: 13; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
19.1; 
Club deals valued at $1 billion or more: Value: $22.4 billion. 

Year: 2005; 
All club deals: Number: 97; 
All club deals: Value: $64.6 billion; 
Club deals valued at $1 billion or more: Number: 11; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
11.3; 
Club deals valued at $1 billion or more: Value: $56.1 billion. 

Year: 2006; 
All club deals: Number: 110; 
All club deals: Value: $100.8 billion; 
Club deals valued at $1 billion or more: Number: 17; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
15.5; 
Club deals valued at $1 billion or more: Value: $92.9 billion. 

Year: 2007; 
All club deals: Number: 63; 
All club deals: Value: $221.2 billion; 
Club deals valued at $1 billion or more: Number: 28; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
44.4; 
Club deals valued at $1 billion or more: Value: $217.4 billion. 

Year: Total; 
All club deals: Number: 493; 
All club deals: Value: $463.1 billion; 
Club deals valued at $1 billion or more: Number: 80; 
Club deals valued at $1 billion or more: Percentage of all club deals: 
16.2%; 
Club deals valued at $1 billion or more: Value: $410.8 billion. 

Source: GAO analysis of Dealogic data. 

[End of table] 

According to private equity executives, the principal reason they 
formed clubs to buy companies was that their funds did not have 
sufficient capital to make the purchase alone or were restricted from 
investing more than a specified portion of their capital in a single 
deal. For example, an executive of a large private equity firm told us 
that, under its agreements with limited partners, the fund may invest 
no more than 25 percent of its total capital in any one deal, which 
equated to a limit of $750 million for its then-current fund. Another 
executive said his firm stops short of such formal limits. For example, 
even though its per-investment limit in a recent fund also was $750 
million, the executive said, the firm limited its investment in one 
acquisition to $500 million because that was thought to be more 
prudent. Because of these constraints, the firms needed to partner with 
other private equity firms to make recent acquisitions requiring 
several billion dollars in equity.[Footnote 42] Other factors leading 
private equity firms to pursue club deals, according to executives and 
academics, include the benefits of pooling resources for the pre-buyout 
due diligence research that private equity firms perform, which can be 
costly, and of getting a "second opinion" about the value of a 
potential acquisition. Several private equity executives told us that 
club deals promote competition because they enable bids to be made that 
would not otherwise be possible. 

Although more prevalent in recent years, club deals may not always be 
the preferred option for private equity firms. According to an academic 
we interviewed, this is largely due to control issues. The academic 
said that private equity firms joining a club may have to share 
authority over such matters as operating decisions, which they 
otherwise would prefer not to do. Executives of a large private equity 
firm agreed, saying that their firm ordinarily has one of its partners 
serve as the Chairman of the board of directors in an acquired company. 
They said that in a club deal, this could be a contentious point. An 
executive of a midsize private equity firm told us that his firm was 
offered, but declined, a minority stake in a technology company buyout 
because his firm prefers to be in control. A consultant told us that 
private equity firms are finding club deals less attractive and, as a 
result, turning more frequently to other arrangements, such as 
soliciting additional limited partners, including sovereign investors, 
to co-invest in deals, rather than co-investing with another private 
equity firm. 

Table 3 shows the 10 largest completed club deal LBOs of U.S. target 
companies since 2000. As shown, these buyouts have involved companies 
in a range of industries. Overall, reflecting their large value, club 
deal transactions represent 6 of the 10 largest LBOs done since 2000. 

Table 3: The 10 Largest Club Deals and Their Private Equity Firm 
Sponsors (Dollars in billions): 

Target company (industry): TXU Corp. (utility); 
Value: $43.8 billion; 
Private equity sponsors: TPG Capital LP (Texas Pacific); Goldman Sachs 
Capital Partners; Kohlberg Kravis Roberts & Co.; 
Completion date: October 2007. 

Target company (industry): HCA Inc. (health care); 
Value: $32.7 billion; 
Private equity sponsors: Bain Capital Partners LLC; Kohlberg Kravis 
Roberts & Co.; Merrill Lynch Private Equity; 
Completion date: November 2006. 

Target company (industry): Alltel Corp. (communications); 
Value: $27.9 billion; 
Private equity sponsors: Goldman Sachs Capital Partners; TPG Capital LP 
(Texas Pacific); 
Completion date: November 2007. 

Target company (industry): Harrah's Entertainment Inc. (gaming); 
Value: $27.4 billion; 
Private equity sponsors: TPG Capital LP (Texas Pacific); Apollo 
Advisors LP; 
Completion date: January 2008. 

Target company (industry): Kinder Morgan Inc. (energy); 
Value: $21.6 billion; 
Private equity sponsors: AIG Global Investment Group Inc.; 
Carlyle/Riverstone Global Energy & Power; Carlyle Group Inc.; Goldman 
Sachs Capital Partners; 
Completion date: May 2007. 

Target company (industry): Freescale Semiconductor Inc. 
(electronics/integrated circuits); 
Value: $17.6 billion; 
Private equity sponsors: Carlyle Group Inc.; TPG Capital LP (Texas 
Pacific); Blackstone Group LP; Permira Ltd; 
Completion date: December 2006. 

Target company (industry): Hertz Corp. (car and equipment rental); 
Value: $15.0 billion; 
Private equity sponsors: Carlyle Group Inc.; Clayton Dubilier & Rice 
Inc.; Merrill Lynch Private Equity; 
Completion date: December 2005. 

Target company (industry): Univision Communications Inc. (Spanish 
language media); 
Value: $13.6 billion; 
Private equity sponsors: Saban Capital Group Inc.; Thomas H Lee 
Partners; Madison Dearborn Partners LLC; TPG Capital LP (Texas 
Pacific); Providence Equity Partners Inc.; 
Completion date: March 2007. 

Target company (industry): SunGard Data Systems Inc. (software and 
information technology services); 
Value: $1.8 billion; 
Private equity sponsors: TPG Capital LP (Texas Pacific); Blackstone 
Group LP; Goldman Sachs Capital Partners; Silver Lake Partners LP; 
Providence Equity Partners Inc.; Bain Capital Partners LLC; Kohlberg 
Kravis Roberts & Co.; 
Completion date: August 2005. 

Target company (industry): Biomet Inc. (medical products); 
Value: $11.4 billion; 
Private equity sponsors: TPG Capital LP (Texas Pacific); Blackstone 
Group LP; Goldman Sachs Capital Partners; Kohlberg Kravis Roberts & 
Co.; 
Completion date: September 2007. 

Source: GAO analysis of Dealogic data. 

Note: Includes transactions completed through first week of April 2008. 

[End of table] 

The extent to which private equity firms were involved in club deals 
for large LBOs is shown in figure 3, which depicts the relationships 
among the firms involved in the 50 largest U.S. LBOs from 2000 through 
2007. These LBOs had a total value of around $530 billion and involved 
33 private equity firms. Of the 50 LBOs, 31 were club deals. Most (31 
of the 33) of the private equity firms were involved in these club 
deals. For example, as shown in the figure, Goldman Sachs Capital 
Partners (upper left corner) entered into club deals that involved 14 
other private equity firms, including Apollo Advisors, Blackstone 
Group, and CCMP Capital. Moreover, it entered into more than one club 
deal with some of the other firms, such as Blackstone Group. 

Figure 3: Club Deal Ties among Private Equity Firms Involved in the 50 
Largest LBOs, 2000-2007: 

[See PDF for image] 

This figure is an illustration of club deal ties among private equity 
firms involved in the 50 largest LBOs, 2000-2007. Indicated on the 
illustration are lines connecting the firms that represent the 
following: 
One deal between firms; 
More than one deal between firms. 

Source: GAO analysis of Dealogic data. 

[End of figure] 

Private equity executives with whom we spoke had differing opinions on 
the future trend in club deals. One executive said that private equity 
funds will continue to face constraints in acquiring large companies 
alone, suggesting a continued role for club deals. Some noted that 
private equity firms have been raising larger funds from limited 
partner investors and thus should be able to acquire larger target 
companies alone. Credit market conditions will also play an important 
role, some executives said, because as long as credit is in relatively 
tight supply due to the problems in the credit markets, it will be 
difficult to get the debt financing necessary to support large club 
deals. 

LBOs Commonly Involve a Competitive Process and Club Deals Could 
Support or Undermine This Process: 

Private equity firms commonly acquire target companies through a 
competitive process in which interested parties bid on the target 
companies, according to academics, executives of private equity firms, 
and commercial and investment bank officials.[Footnote 43] For example, 
two private equity executives said that selling companies or their 
advisers use an auction process to try to increase the companies' sale 
price. The nature and formality of the process can vary from deal to 
deal, depending on the level of interest in the target company and 
other factors. For example, sellers might solicit bids from any 
interested buyer or ask only select would-be buyers to bid. After an 
initial round of offers, bidders judged to be more capable of working 
together or bringing a deal to completion might be invited to submit 
revised offers. Additionally, even when the parties have agreed on the 
principal terms of a buyout transaction, executives said that the 
agreement may include a "go-shop" provision that allows the seller to 
seek a better offer from other potential buyers within a certain 
period.[Footnote 44]In general, the auction process and go-shop 
provision seek to produce higher sales prices for sellers and to allow 
sellers to fulfill legal duties to obtain best prices for their 
shareholders.[Footnote 45] Those involved in the process also note that 
sellers need not ultimately accept even the highest bids for their 
companies, if they believe prices offered are inadequate. 

For LBOs involving an auction process, club deals can be formed by 
either buyers or sellers. First, private equity firms can form clubs on 
their own before making an offer to buy a target company. For example, 
executives of one firm told us that they might approach other firms 
with whom they have dealt effectively in a prior deal or who would 
bring advantageous experience or skill to the particular deal. An 
executive of another firm cited geographic or industry experience that 
a partner could bring. Second, the target company or its advisers can 
play a role in organizing private equity firms into clubs to bid on the 
company. For instance, in the private equity-sponsored LBO of retailer 
Neiman Marcus, the company's adviser organized bidders into four clubs 
after receipt of an initial round of proposals. According to the 
company, it formed the bidders into clubs because of the size of the 
transaction and to maximize competition among the competing groups. 
(See app. V for additional details about this LBO.) 

Private equity executives said that sellers or their advisers can 
influence the formation of bidding clubs by controlling the flow of 
information. Before bidding on a target company, potential buyers 
typically want detailed information about the company's operations and 
finances. Sellers may provide this information under a nondisclosure 
agreement, which bars the potential buyers from discussing such 
information with others. Executives from private equity firms told us 
that by using this control of information as a lever, sellers sometimes 
encourage potential buyers to form clubs for several reasons. A seller 
may realize that the deal size is too large for one private equity firm 
to undertake alone. Also, negotiating the sale of a company can be time-
consuming and distracting, so management of the target company may wish 
to limit the number of offers it entertains. Sellers also might 
encourage club deals among particular buyers for strategic purposes; 
that is, to increase the price paid to acquire their companies. For 
example, a seller might pair up a private equity firm offering a lower 
bid with another firm offering a higher bid. The expectation is that as 
bidding goes forward, prices offered will go up from earlier bids. 
Thus, if the starting point for a new round of bids begins at a higher 
price, the seller would expect to receive more. 

The recent growth of club deals, particularly the larger ones, has 
given rise to questions and concerns about joint bidding's potential 
effect on buyout competition. If each private equity firm that is part 
of a club deal could and would bid independently on a target company, 
but instead chooses to bid jointly, this could reduce price 
competition. In an auction process, a greater number of bidders, all 
else being equal, should lead to a higher purchase price. Thus, if club 
deals lead to fewer bidders participating in an auction for target 
companies, then such deals could result in lower prices paid for target 
companies than would otherwise be true. Even if joint bidding does not 
reduce the number of potential bidders for a particular target company, 
club deals could still lead to lower prices paid for target companies. 
For example, bidders could collude, such as by agreeing on which bidder 
will submit the highest offer and potentially win the auction and 
allowing the losing bidder to join in later on the LBO. 

Our Analysis Indicates That Public-to-Private Club Deals, in Aggregate, 
Generally Are Not Associated with Lower or Higher Prices Paid for 
Target Companies, and the Private Equity Marketplace Is Predisposed to 
Perform Competitively: 

To examine the potential effect club deals may have on competition 
among private equity firms, we developed an econometric model to 
examine prices paid for target companies in a subset of all private 
equity deals--that is, those transactions where the target company is 
publicly traded.[Footnote 46] We selected these transactions because 
pricing and other information necessary for the analysis was publicly 
available. We examined these transactions as a group, while 
incorporating individual characteristics associated with each 
acquisition. The analysis generally found no statistically meaningful 
negative or positive relationship between the price paid for a target 
company and whether the buyout was the product of a club deal.[Footnote 
47]That is, public-to-private club deals, in the aggregate, generally 
are not associated with lower or higher per share price premiums, once 
important characteristics of target companies are factored into the 
analysis. Thus, to the extent that potentially anticompetitive effects 
of such club deals would be reflected in the acquisition price, we do 
not find evidence of such an effect in the aggregate. However, our 
results do not rule out the possibility that, in any particular 
transaction, parties involved could seek to engage in illegal behavior, 
such as bid-rigging or other collusion. We caution that we draw 
conclusions about the association, not casual relationship, between 
clubs deals and premiums. Accordingly, our results showing no 
association between club deals and price paid should not be read as 
establishing that club deals necessarily caused acquisition prices to 
be higher or lower. To the extent that the nature of the firms and 
transactions we examined differ from the overall population of club 
deals, our results may not generalize to the population. (See app. X 
for details on our methodological and data limitations.) 

For our econometric model, we initially identified 510 "public-to- 
private" U.S. buyouts from 1998 through 2007, in which private equity 
firms acquired publicly held companies. By number, this type of 
transaction represents about 15 percent of all deals but accounts for 
about 58 percent of total reported deal value. We examined price paid 
using the premium paid over a target company's prebuyout stock price. 
Premiums are common in buyouts, because it is the premium over current 
stock price that helps persuade current owners to sell. By itself, the 
size of this premium can vary significantly among buyouts overall, as 
well as for club versus nonclub deals, depending on how it is measured. 
For example, comparing a publicly held target company's stock price 1 
day before announcement of a buyout to the final price paid shows that 
the premium in club deal acquisitions is slightly smaller--by roughly 1 
percent--than for other buyouts (fig. 4). On the other hand, using 
stock price 1 month before announcement shows that the premium paid in 
club deals is significantly larger--about 11 percent higher.[Footnote 
48] Neither of these differences is statistically significant in our 
econometric models run on the full sample.[Footnote 49] 

Figure 4: Premium Paid for Target Companies in Public-to-Private 
Buyouts: 

[See PDF for image] 

This figure is a multiple vertical bar graph depicting the following 
data: 

Average of premium prior to announcement of buyout: 1 day; 
Nonclub deal: 23.2%; 
Club deal: 22%. 

Average of premium prior to announcement of buyout: 1 week; 
Nonclub deal: 25%; 
Club deal: 26.1%. 

Average of premium prior to announcement of buyout: 1 month; 
Nonclub deal: 29.6%; 
Club deal: 40.6%. 

Note: "Premium, 1 Day" is the premium offered based on a target 
company's share price 1 day before announcement of a buyout; "Premium, 
1 Week" is the premium offered based on share price 1 week before 
announcement; "Premium, 1 Month" is the premium offered share price 1 
month before announcement. 

[End of figure] 

Academic research in this area is limited, but our finding that club 
deals are not associated with lower per share price premiums in the 
aggregate is consistent with two other studies done on U.S. data. 
[Footnote 50] However, our results are inconsistent with another recent 
study that found large club deals before 2006 led to lower premiums 
paid for target companies.[Footnote 51] This study also found that 
target companies with high institutional ownership did not experience 
the same effect, suggesting that such institutional investors are able 
to counter the potentially negative price effect of club deals. 
Moreover, we also found evidence, consistent with the literature, that 
larger companies, companies with larger debt burdens, and companies 
with large block and managerial holders of equity, received smaller 
premiums upon takeover.[Footnote 52]. 

Given concerns about the potential exercise of market power in private 
equity transactions, we also employed two commonly used measures of 
market concentration to assess the potential for anticompetitive 
behavior in the private equity marketplace generally; that is, among 
buyouts of both publicly and privately held target companies. One of 
these measures is known as the Four-Firm Concentration Ratio. It is the 
sum of the market shares by the four largest participants. A four-firm 
concentration ratio of less than 40 percent generally indicates 
"effective competition," although it does not guarantee competition 
prevails. Markets are considered tight oligopolies if a four-firm 
concentration ratio exceeds 60 percent.[Footnote 53] For the private 
equity marketplace, we estimate the concentration ratio at about 32 
percent, below the 40 percent threshold. 

The second measure of market concentration we employed is the 
Herfindahl-Hirschman Index, which the Federal Trade Commission and the 
U.S. Department of Justice (DOJ) use to assess market concentration and 
the potential for firms to exercise market power. The index is 
calculated as the sum of the squares of each participant's market 
share.[Footnote 54]According to guidelines issued by DOJ, Herfindahl- 
Hirschman Index values of below 1,000 indicate an unconcentrated 
marketplace, which is more inclined to perform competitively. For the 
private equity marketplace, we estimate the index value at 402. 

We note that the private equity marketplace is likely even less 
concentrated, and more inclined to perform competitively, than our 
analyses indicate. Both concentration measures are sensitive to the 
definition of the "market," and we have assumed that the marketplace is 
comprised only of private equity firms as potential buyers. In 
actuality, nonprivate equity buyers, often called "strategic" 
purchasers, also can seek to acquire companies. Were such buyers 
reflected in our analyses, the market shares of the private equity 
firms would be lower, producing lower calculations of market 
concentration. 

Some Large Club Deals Reportedly Have Attracted the Interest of the 
Department of Justice and Have Prompted Lawsuits against Some Private 
Equity Firms: 

Beginning in October 2006, news media reports said that DOJ's Antitrust 
Division sent letters of inquiry to a number of large private equity 
firms, asking them to voluntarily provide information about their 
practices in recent high-profile club deals.[Footnote 55] As of May 
2008, DOJ staff told us they could not disclose any details of their 
activities and neither confirmed nor denied the agency's inquiry. At 
least one private equity firm, Kohlberg, Kravis, Roberts & Co., 
disclosed receipt of a DOJ letter related to the inquiry in a 
registration statement filed with SEC. 

Beyond the reported DOJ inquiry, we identified four shareholder 
lawsuits that have been filed in connection with private equity firms' 
club deals. In their respective complaints, shareholders of target 
companies acquired by a consortium of private equity firms alleged 
generally that the private equity firms acted in concert to fix the 
price paid for the target companies at below competitive prices and in 
violation of federal antitrust laws. 

One of these cases has been dismissed and, in another, an antitrust 
claim stemming from the club deal was dismissed.[Footnote 56]. Two 
other cases filed in federal district court, Davidson v. Bain Capital 
Partners, LLC, and Dahl v. Bain Capital Partners, LLC, were recently 
consolidated into a single action.[Footnote 57] The consolidated case 
was pending as we completed this report. 

SEC Exercises Limited Oversight of Private Equity Funds, but It and 
Others Have Identified Some Potential Investor-Related Issues: 

Because private equity funds and their advisers generally have 
qualified for exemptions from registration under the federal securities 
laws, SEC exercises limited oversight of these entities. Nonetheless, 
several advisers to some of the largest private equity funds are 
registered, and SEC routinely has examined these advisers and found 
some compliance control deficiencies. At the same time, SEC and others 
historically have not found private equity funds or their advisers to 
raise significant concerns for fund investors--in part evidenced by the 
limited number of enforcement actions SEC has brought against such 
funds or their advisers. Nonetheless, in light of the growth in LBOs by 
private equity funds, U.S. and foreign regulators have undertaken 
studies to assess risks posed by such transactions and have identified 
some potential market abuse and investor protection concerns that they 
are studying further. 

Private Equity Funds and Their Advisers Typically Qualify for an 
Exemption from Registration with SEC: 

Private equity funds typically are organized as limited partnerships 
and structured and operated in a manner that enables the funds and 
their advisers (private equity firms) to qualify for exemptions from 
some of the federal statutory restrictions and most SEC regulations 
that apply to registered investment pools, such as mutual funds. 
[Footnote 58] For example, SEC staff told us that private equity funds 
and their advisers typically claim an exemption from registration as an 
investment company or investment adviser, respectively.[Footnote 59] 
Although certain private equity fund advisers may be exempt from 
registration, they remain subject to antifraud (including insider 
trading) provisions of the federal securities laws.[Footnote 60]In 
addition, private equity funds typically claim an exemption from 
registration of the offer and sale of their partnership interests to 
investors.[Footnote 61] 

Because private equity funds and their advisers typically claim an 
exemption from registration as an investment company or investment 
adviser, respectively, SEC exercises limited oversight of private 
equity funds and their advisers. SEC's ability to directly oversee 
private equity funds or their advisers is limited to those that are 
required to register or voluntarily register with SEC. For example, 
funds or advisers exempt from registration are not subject to regular 
SEC examinations or certain restrictions on the use of leverage and on 
compensation based on fund performance and do not have to maintain 
their business records in accordance with SEC rules. 

A number of investment companies serving to facilitate venture capital 
formation also are engaged in LBOs, like traditional private equity 
funds. These companies have elected to be regulated under the 
Investment Company Act as business development companies (BDC), which 
are investment companies, or funds, operated primarily for the purpose 
of investing in eligible portfolio companies and that offer to make 
significant managerial assistance to such portfolio companies.[Footnote 
62] BDCs are permitted greater flexibility than registered investment 
companies in dealing with their portfolio companies, issuing 
securities, and compensating fund managers.[Footnote 63] However, BDCs 
must have a class of their equity securities registered with SEC and 
thus are required to file periodic reports with SEC. Moreover, BDCs are 
subject to SEC examinations. In 2004, a number of private equity firms 
created or planned to create BDCs. For example, Apollo Management 
created the most significant BDC during that period, raising around 
$900 million. According to data provided by SEC staff, 76 investment 
companies had elected to be classified as BDCs as of June 2007. 
However, around 50 of them were active, and they held about $19.5 
billion in net assets. In comparison, a consulting firm estimated that 
U.S. private equity funds had $423 billion of assets under management 
at the end of 2006.[Footnote 64] 

SEC Examinations of Registered Advisers to Private Equity Funds Have 
Identified Deficiencies in Some Compliance Controls: 

Private equity fund advisers that are registered with SEC are subject 
to the same regulatory requirements as other registered investment 
advisers. These advisers are required to maintain books and records and 
are subject to periodic examinations by SEC staff. They also must 
provide current information to both SEC and their investors about their 
business practices, disciplinary history, services, and fees but are 
not required to report specifically whether they advise a private 
equity fund exempt from registration under the Investment Company Act. 
As a result, SEC staff do not know which and, in turn, how many, of the 
registered advisers advise exempt private equity funds. The SEC staff 
said that they can determine whether a registered adviser advises a 
private equity fund when examiners go on-site to do an examination and 
through other information sources, such as an adviser's Internet site. 

Using publicly available sources, we compiled a list of 21 of the 
largest private equity firms based on their assets under management and 
amount of capital raised from investors. From this list, SEC staff 
identified 11 private equity firms that were registered as investment 
advisers or affiliated with registered investment advisers during the 
period from 2000 through 2007. During this period, SEC examiners 
conducted 19 routine examinations involving 10 of the 11 
firms.[Footnote 65] We reviewed 17 of the examinations.[Footnote 66] In 
each of these examinations, SEC examiners identified one or more 
deficiencies. In 6 examinations, they found internal control weaknesses 
related to preventing the potential misuse of material nonpublic or 
insider information. In 4 examinations, they found that the adviser had 
weak controls related to monitoring or enforcing restrictions on 
personal trades by employees. Less commonly found deficiencies included 
the adviser using testimonials to endorse its private equity fund, 
weaknesses in its marketing materials, or lack of a contingency plan. 
These types of deficiencies are not unique to private equity firms that 
are registered investment advisers, according to SEC staff, and none of 
the deficiencies involved abuses that warranted referring them to SEC's 
Division of Enforcement. Nonetheless, SEC examiners sent the advisers a 
deficiency letter after completing the examinations, and SEC staff said 
that the advisers responded in writing about how they would address the 
deficiencies. 

From 2000 through 2007, SEC examiners also did 7 "sweep examinations" 
that included 4 of the 11 private equity firms' registered advisers, 
but it did not conduct any cause examinations of the registered 
advisers.[Footnote 67] We reviewed 6 of the sweep examinations. 
[Footnote 68] In 4 of the examinations, SEC examiners found 
deficiencies concerning internal control weaknesses, including a 
failure to obtain clearance for personal trades by employees. In 2 of 
these examinations, SEC staff sent the advisers a deficiency letter; in 
the other 2 examinations, SEC staff told us that examiners discussed 
the deficiencies with the advisers. SEC staff did not find any 
deficiencies in its other two sweep examinations. 

Growth in Private Equity-Sponsored LBOs Has Led to Greater Regulatory 
Scrutiny: 

SEC and others generally have not found private equity funds or their 
advisers to have posed significant concerns for fund investors. In a 
2004 rule release, SEC stated that it had pursued few enforcement 
actions against private equity firms registered as investment advisers. 
[Footnote 69] In commenting on the 2004 SEC rule, officials from 
committees of the American Bar Association and Association of the Bar 
of the City of New York noted that enforcement actions involving fraud 
and private equity firms have not been significant. In addition, an SEC 
official told us that the Division of Investment Management had 
received more than 500 investor complaints in the past 5 years but none 
involved private equity fund investors. In reviewing SEC enforcement 
cases initiated since 2000, we identified seven cases that involved 
investments in private equity funds (excluding venture capital funds) 
and fraud. Five of the cases involved officials associated with a 
pension plan who invested the plan's money in private equity funds in 
exchange for illegal fees paid to them by the private equity firms. In 
one of the other two cases, SEC alleged that a private equity firm 
official misappropriated money that was meant to be invested in the 
firm's private equity funds. In the other, SEC alleged that a private 
equity firm official engaged in insider trading based on information 
received about a potential acquisition. 

Officials from a labor union told us that one of their areas of concern 
regarding private equity funds was the level of protection provided to 
fund investors, particularly pension plans. They said that general 
partners (or private equity firms) must be accountable to investors, 
particularly in terms of their fiduciary duties to investors and 
protections against conflicts of interest. An association representing 
private equity fund limited partners, such as pension plans, found that 
the vast majority of members responding to an informal survey had not 
encountered fraud or other abuse by a general partner and viewed the 
funds as treating them fairly. Although the vast majority of survey 
respondents viewed themselves as sophisticated and able to protect 
their interests, they identified areas where funds needed to improve, 
such as fees, valuation of fund assets, and timeliness in reporting 
fund performance. An official from another association representing 
institutional investors, including public, union, and corporate pension 
plans, told us that its members generally do not see a need to subject 
private equity funds, or their advisers, to greater regulation. 
Additionally, the official was not aware of any cases of a private 
equity fund adviser defrauding investors. In a recent report, we found 
that pension plans with which we spoke, some of which had been 
investing in private equity for more than 20 years, indicated that 
these investments had met their expectations and, as of late 2007 and 
early 2008, planned to maintain or increase their private equity 
allocation.[Footnote 70] Nevertheless, we also found that pension plans 
investing in private equity face challenges beyond those associated 
with traditional investments, such as stocks and bonds. The challenges 
included the variation of performance among private equity funds, which 
is greater than for other asset classes, and the difficulty of gaining 
access to funds perceived to be top performers, as well as valuation of 
the investment, which is difficult to assess before the sale of fund 
holdings. 

In light of the recent growth in private equity-sponsored LBOs, some 
regulators have undertaken efforts to identify potential risks raised 
by the activity and assess the need for additional regulation. For 
instance, the UK Financial Services Authority (FSA) issued a private 
equity study in November 2006, and a technical committee of 
International Organization of Securities Commissions (IOSCO), which 
included SEC, issued a study in November 2007.[Footnote 71] In its 
study, FSA raised concerns about, among other things, the potential for 
market abuse (for example, insider trading) to result from the leakage 
of price-sensitive information concerning private equity transactions. 
It noted that a main cause of the increased potential for information 
leaks in the private equity market is the number of institutions and 
people involved in private equity deals, especially ones involving 
publicly held companies. FSA further noted that the development of 
related products traded in different markets, such as credit 
derivatives on leveraged loans, increases the potential for this abuse. 
[Footnote 72]The IOSCO technical committee also raised concerns about 
the potential for market abuse in its study. It stated that market 
abuse, such as insider trading, which is not limited to the private 
equity industry, remains a key priority for IOSCO and individual 
regulators. In that regard, the committee noted that the issue is 
relevant to other ongoing work by IOSCO but not to its further work on 
private equity. 

In their reports, the regulators also identified potential concerns 
raised by private equity transactions that related to the protection of 
fund investors. FSA stated that conflicts of interest may arise between 
fund management and fund investors even though fund management seeks to 
align its interests with the interests of fund investors by investing 
its capital in the fund. It stated that both sets of interests may 
become misaligned in a number of situations, such as if management is 
allowed to coinvest with the fund in a particular deal. The IOSCO 
technical committee also commented that private equity transactions, 
along with other merger-and-acquisition activities, can present 
conflicts of interest for a number of parties, including private equity 
firms, fund investors, and target companies. For example, it noted that 
when management is participating in a buyout, it may not have an 
incentive to act in the best interests of existing shareholders by 
recommending a sale at the highest possible price. According to the 
committee, where public companies are involved, regulators and 
investors (including fund investors and public shareholders) emphasize 
the controls that firms have in place to ensure that potential 
conflicts do not undermine investor confidence. In that regard, the 
committee is pursuing additional work to analyze conflicts of interest 
that arise in private equity transactions, as they relate to the public 
markets, and policies and procedures used to manage such conflicts. 

Recent Credit Events Raised Regulatory Scrutiny about Risk-Management 
of Leveraged Lending by Banks: 

A small number of commercial and investment banks have played a key 
role in providing leveraged loans to help finance the recent U.S. LBOs. 
Before the problems related to subprime mortgages spread to the 
leveraged loan market in mid-2007, the regulators generally found that 
the major commercial and investment banks had adequate risk-management 
practices but noted some concerns, such as weakening of underwriting 
standards and significant growth in leveraged loan commitments. In 
general, the major banks managed their risk exposures by providing the 
loans through a group of lenders rather than by themselves, but after 
the problems surfaced in mid-2007, the banks were no longer able to do 
so, exposing them to greater risk. In light of this situation, 
regulators have reviewed the risk-management practices of commercial 
and investment banks and identified some weaknesses. As the regulators 
continue to ensure that their respective institutions correct 
identified risk-management weaknesses, it will be important for them to 
evaluate periodically whether their guidance responds to such 
identified weaknesses and to update their guidance, as appropriate. 

Major Commercial and Investment Banks Have Played a Key Role in 
Financing U.S. LBOs: 

A small number of major commercial and investment banks have helped to 
finance the majority of recent LBOs in the United States. Under their 
loan commitments, banks usually agree to provide "revolvers" (or 
revolving lines of credit) and term loans to private equity funds when 
their LBO transactions close.[Footnote 73] A revolver is a line of 
credit that allows the borrower to draw down, repay, and reborrow a 
specified amount on demand. A term loan is a loan that the borrower 
repays in a scheduled series of repayments or a lump-sum payment at 
maturity. Although banks fund the term loans when the LBO transactions 
are completed, the revolvers usually are not funded at that time but 
rather are saved to meet future financing needs. As discussed in the 
background, loans issued to finance LBOs are typically syndicated-- 
provided by a group of lenders--and categorized as leveraged, rather 
than investment-grade, loans. 

Banks and other lenders provided, in total, nearly $2.7 trillion in 
syndicated, leveraged loans in the U.S. market from 2005 through 2007, 
according to Dealogic. Of this total, around $1.1 trillion, or 42 
percent, was used to finance transactions sponsored by private equity 
funds. More specifically, private equity funds used nearly $634 
billion, or 56 percent, of the leveraged loans to finance a total of 
956 LBOs and the remainder for other purposes, such as the refinancing 
of companies held in the funds' investment portfolios.[Footnote 74] 
Table 4 shows that 10 commercial and investment banks arranged and 
underwrote nearly $489 billion, or 77 percent, of the U.S. syndicated 
leveraged loans used to finance 700 private equity-sponsored LBOs from 
2005 through 2007[Footnote 75]. Four were U.S. commercial banks--JP 
Morgan Chase, Citibank, Bank of America, and Wachovia; four were U.S. 
investment banks (or broker-dealers)--Goldman Sachs, Lehman Brothers, 
Merrill Lynch, and Morgan Stanley; and two were foreign banks. 

Table 4: Top 10 Commercial and Investment Banks Providing Syndicated 
Leveraged Loans for LBOs by Private Equity Funds, U.S. Market, 2005- 
2007: 

Commercial or investment bank: JP Morgan Chase; 
Deal value: $95.3 billion; 
Number of deals: 272; 
Market share based on deal value: 15.0%. 

Commercial or investment bank: Goldman Sachs; 
Deal value: $58.3 billion; 
Number of deals: 129; 
Market share based on deal value: 9.2%. 

Commercial or investment bank: Citigroup; 
Deal value: $56.2 billion; 
Number of deals: 107; 
Market share based on deal value: 8.9%. 

Commercial or investment bank: Credit Suisse; 
Deal value: $54.9 billion; 
Number of deals: 189; 
Market share based on deal value: 8.7%. 

Commercial or investment bank: Bank of America; 
Deal value: $49.6 billion; 
Number of deals: 192; 
Market share based on deal value: 7.8%. 

Commercial or investment bank: Deutsche Bank; 
Deal value: $47.4 billion; 
Number of deals: 103; 
Market share based on deal value: 7.5%. 

Commercial or investment bank: Lehman Brothers; 
Deal value: $40.2 billion; 
Number of deals: 95; 
Market share based on deal value: 6.4%. 

Commercial or investment bank: Merrill Lynch; 
Deal value: $33.5 billion; 
Number of deals: 151; 
Market share based on deal value: 5.3%. 

Commercial or investment bank: Morgan Stanley; 
Deal value: $28.9 billion; 
Number of deals: 61; 
Market share based on deal value: 4.6%. 

Commercial or investment bank: Wachovia; 
Deal value: $24.4 billion; 
Number of deals: 122; 
Market share based on deal value: 3.9%. 

Commercial or investment bank: Subtotal; 
Deal value: $488.7 billion; 
Number of deals: 700; 
Market share based on deal value: 77.1%. 

Commercial or investment bank: Total; 
Deal value: $633.8 billion; 
Number of deals: 956; 
Market share based on deal value: 100.0%. 

Source: GAO analysis of Dealogic data. 

[End of table] 

Before 2007, Federal Banking Regulators Generally Found Risk Management 
for Leveraged Financing to Be Satisfactory: 

The banking regulators have been addressing risk-management for 
leveraged financing for two decades and, before the credit market 
problems in mid-2007, a key concern was underwriting standards. Since 
the LBO boom in the 1980s, the Federal Reserve and OCC periodically 
have issued regulatory guidance on financing LBOs and other leveraged 
transactions. For example, in 1989, the regulators jointly defined the 
term "highly leveraged transaction" to establish consistent procedures 
for identifying and assessing LBOs and similar transactions.[Footnote 
76] In guidance that they jointly issued in 2001, the regulators stated 
that banks can engage in leveraged finance in a safe and sound manner, 
if pursued within an appropriate risk-management structure.[Footnote 
77]According to the guidance, such a risk-management structure should 
include a loan policy, underwriting standards, loan limits, a policy on 
risk rating transactions, and internal controls. 

OCC is responsible for supervising national banks, which include the 
four U.S. commercial banks that played a key role in financing recent 
LBOs. According to OCC staff, they have continued to supervise the 
financing of LBOs by these banks through examinations and ongoing, on- 
site monitoring. Moreover, each of these banks is a subsidiary of a 
bank or financial holding company supervised by the Federal Reserve. 
[Footnote 78] Because of the complexity of leveraged transactions and 
restrictions on commercial bank finance activities, various parts of a 
leveraged financing package may be arranged through the bank, its 
subsidiaries, or its holding company. According to OCC examiners, OCC 
works with the Federal Reserve to assess a banking organization's total 
participation in and exposure to leveraged finance activities. 

OCC examiners told us that each year they have examined the leveraged 
lending activities of the four banks as part of their ongoing 
supervision. In large banks, most examination-related work is conducted 
throughout a 12-month supervisory cycle. The objectives of the 
examinations covering the banks' leveraged lending activities included 
assessing the quantity of risk and quality of risk management, 
reviewing underwriting standards, and testing compliance with 
regulatory guidance. To meet these objectives, examiners, among other 
things, sampled and reviewed loans and related documentation, reviewed 
management reports, and interviewed bank staff. OCC examiners told us 
that they also monitor the banks' risk management of their leveraged 
lending activities on an ongoing basis throughout the year. For 
example, they meet with bank managers from various bank operations on a 
regular basis to discuss issues such as portfolio trends, market 
conditions, underwriting practices, and emerging risks. In addition, 
they periodically review management reports to identify changes in 
portfolio performance, composition, and risk and audit reports to 
assess the effectiveness of the programs and identify deficiencies 
requiring attention. 

We reviewed 17 examinations that OCC examiners conducted between 2005 
and 2007 that included some aspects of the leveraged finance activities 
at two major banks. Each of the examinations generally covered 
different portfolios that included leveraged loans, such as special 
credits, North American leveraged loans, and syndicated credits. The 
examiners found that underwriting standards for leveraged loans had 
been easing every year since at least 2005, evidenced by increased 
leverage, liberal repayment schedules on term loans, and erosion of 
loan covenants.[Footnote 79]However, the examiners generally found the 
quality of risk management at the two banks to be satisfactory for the 
processes reviewed, at least until mid-2007. For one of the banks, 
examiners noted that bank management understood the key risks and 
implemented appropriate strategies and controls to manage those risks. 
For instance, the bank retained a relatively small percentage of its 
leveraged loans. Likewise, examiners at the other bank noted that 
underwriting and distribution volume in leveraged loans was significant 
and increasing, but the bank retained a small position in leveraged 
loans. Nevertheless, in 2006 and 2007 internal documents that outlined 
planned examinations and other supervisory activities, examiners at one 
bank identified a key risk--the potential for investor demand for 
leveraged loans to slow and adversely affect the bank's ability to 
syndicate loans and manage risk by retaining only small positions in 
leveraged loans. The examiners noted that they would continue to 
monitor the bank's leveraged lending activities through ongoing 
monitoring and examinations, and they conducted such examinations in 
subsequent years. 

The Federal Reserve and OCC also supervised the financing of LBOs by 
the major banks through other types of reviews and surveys. Each year, 
they jointly review shared national credits, which include syndicated 
leveraged loans.[Footnote 80] In 2006, the review found that the volume 
of leveraged loans rose rapidly, in part because of the rise in mergers 
and acquisitions. It also found that strong market competition had led 
to an easing of underwriting standards in leveraged loans, evidenced 
partly by minimum amortization requirements and fewer maintenance 
covenants. The 2007 review continued to find weakened underwriting 
standards in leveraged loans, and regulators stated in their joint 
press release that banks should ensure that such standards are not 
compromised by competitive pressures.[Footnote 81] Furthermore, the 
review noted that banks had a backlog of leveraged loan commitments 
that could not be distributed without incurring a loss and may need to 
be retained by the banks. Similarly, in OCC's 2006 and 2007 survey of 
underwriting practices, the regulator also found that banks were easing 
their credit standards for leveraged loans and cautioned them about 
their weakening standards.[Footnote 82] Finally, in the Federal 
Reserve's 2006 and 2007 "Senior Loan Officer Opinion Survey on Bank 
Lending Practices," responding banks generally reported that the share 
of loans related to mergers and acquisitions, including LBOs, on their 
books was fairly small.[Footnote 83] For example, in 2007, around 85 
percent of the large banks responding to the survey said that LBO loans 
accounted for 20 percent or less of the syndicated loans on their 
books. 

SEC Began to Supervise Financing of LBOs by Investment Banks around 
2005: 

As noted earlier, four of the major underwriters of leveraged loans 
used to help finance LBOs are investment banks (broker-dealers), all of 
which have elected to be supervised by SEC under its Consolidated 
Supervised Entity (CSE) program.[Footnote 84] SEC's supervision of CSEs 
extends beyond the registered broker-dealers to their unregulated 
affiliates and holding companies. SEC staff said that the CSEs usually 
originate their leveraged loans in affiliates outside of their 
registered broker-dealers to avoid capital charges that otherwise would 
be assessed under SEC's capital rules. Between December 2004 and 
November 2005, selected broker-dealers agreed to participate in the CSE 
program, and SEC has been responsible for reviewing unregulated 
affiliates of the broker-dealers.[Footnote 85] 

According to SEC staff, they reviewed guidance issued by, and talked 
to, federal bank regulators in developing their approach to supervising 
the securities firms' leveraged lending. SEC staff said that they focus 
on credit, market, and liquidity risks associated with the leveraged 
lending activities of the CSEs to gain not only a broad view of the 
risks but also insights into each of the different areas, because these 
risks are linked. For example, under their approach, SEC staff can 
monitor how a firm's credit risk exposure from its leveraged loan 
commitments can increase the firm's liquidity risk if the firm cannot 
syndicate its leveraged loans as planned. Because management of these 
three risks generally involves different departments within a firm, the 
staff said that they routinely meet with the various departments within 
each firm that are responsible for managing their firm's credit, 
market, and liquidity risk exposures. They also said that they review 
risk reports and other data generated by the firms. 

In fiscal year 2006, SEC reviewed the leveraged lending activities 
across each of the CSEs. As part of the review, SEC analyzed the 
practices and processes of leveraged lending, management of the risks 
associated with leveraged lending, and the calculation of capital 
requirements for loan commitments. SEC found that the CSEs, like the 
major commercial banks, used loan approval processes and loan 
syndications to manage their risks. According to an SEC official, the 
review generally found that the firms were in regulatory compliance but 
identified areas where capital computation and risk-management 
practices could be improved. Moreover, the SEC official said four firms 
modified their capital computations as a result of feedback from the 
leveraged loan review. Like other consolidated supervisors overseeing 
internationally active institutions, SEC requires CSEs to compute 
capital adequacy measures consistent with the Basel standards.[Footnote 
86] 

2007 Market Events Increased Risk Exposures of Banks That Financed LBOs 
and Raised Some Concerns about Systemic Risk That Warrant Regulatory 
Attention: 

Before June 2007, the major commercial and investment banks were able 
to use an "originate-to-distribute" model to help manage the risks 
associated with their leveraged finance, according to OCC and SEC 
staff. Under this model, a bank or group of banks arrange and 
underwrite a leveraged loan and then syndicate all or some portion of 
the loan to other institutions, rather than holding the loan on their 
balance sheets.[Footnote 87] Leading up to June 2007, strong demand by 
nonbank institutions (such as collateralized loan obligations, 
insurance companies, mutual funds, and hedge funds) that invest in 
leveraged loans fostered the growth of the leveraged loan market. 
[Footnote 88] According to officials representing four major banks, 
they typically were able to syndicate their leveraged loans when the 
LBO deals closed. As a result, the banks generally were able to limit 
their leveraged loan exposure to the amount that they planned to hold 
when they initially committed to make the loans. The bank officials 
said that their banks typically held portions of the pro rata loans, 
not the longer term and, thus, potentially more risky institutional 
loans.[Footnote 89] In addition, the bank officials said that, before 
mid-2007, high-yield bond offerings used to help finance some LBOs 
normally were completed by the time the deals were closed. This 
eliminated the need for the banks to provide bridge loans for those 
LBOs, according to the bank officials. 

After June 2007, investor concerns about the credit quality of subprime 
mortgages spread to other credit markets, leading to a sudden and 
significant decline in demand for leveraged loans. Not expecting market 
liquidity to change so suddenly, the major banks were left with a large 
number of unfunded loan commitments for pending LBO deals. The four 
major commercial banks had more than $294 billion in leveraged finance 
commitments at the end of May 2007, and the four major investment banks 
had more than $171 billion in commitments at the end of June 2007. When 
market conditions changed, the banks were no longer able to syndicate 
some of their leveraged loans at prices they had anticipated when the 
LBO deals closed. The banks also had to fund some of the bridge loans 
for such deals. As a result, the banks held on their balance sheets 
considerably more loans than originally planned, including leveraged 
loans intended to be syndicated to institutional investors. For the 
major commercial banks, the amount of leveraged loans that exceeded the 
amount that they planned to hold increased from around zero at the end 
of May 2007 to around $62 billion at the end of December 2007. 
Similarly, the total amount of leveraged loans held by the major 
investment banks increased from almost $9 billion to around $59 billion 
from June to December 2007. Because the decrease in demand for 
syndicated loans caused prices to decline, the banks had to mark down 
some of their leveraged loans and loan commitments to reflect the lower 
market prices, resulting in substantial reductions to earnings. 
[Footnote 90] For example, a credit rating agency estimated that the 
major U.S. banks suffered around $8 billion in losses (before fees and 
hedges) on their leveraged loans and loan commitments in the third 
quarter of 2007. 

Since then, the major banks have made progress in reducing the number 
of unfunded leveraged loan commitments but continue to face challenges 
reducing their loan holdings. First, the major commercial banks have 
reduced their leveraged finance commitments from about $294 billion to 
about $34 billion from the end of May 2007 through the end of March 
2008. Likewise, the major investment banks have reduced their 
commitments from about $171 billion to about $14 billion from the end 
of June 2007 through the end of March 2008. According to a credit 
rating agency, the banks have been able to slowly reduce their 
commitment volume, as liquidity gradually has returned to the leveraged 
finance market, and as some LBO deals have been cancelled, 
restructured, or repriced. Second, the banks are continuing to work to 
reduce their holdings of leveraged loans. At year-end 2007, the 
commercial banks held about $62 billion more in leveraged loans than 
they planned to hold but had reduced the amount to around $53 billion 
at the end of March 2008. During the same period, the total amount of 
leveraged loans held by the investment banks decreased from around $59 
billion to around $56 billion. Bank officials told us that they are 
continuing to look for market opportunities to syndicate or otherwise 
sell their leveraged loans. Additionally, the banks can, and some do, 
manage their leveraged loan risk exposures through hedging, such as 
with credit derivatives. 

During the third quarter of 2007, federal bank examiners and a credit 
rating agency assessed the exposures of banks to their leveraged loans 
and commitments under various market scenarios. Such analyses generally 
indicated that the banks had sufficient capital to absorb potential 
losses. In March 2008, OCC noted that the major commercial banks 
continued to be well capitalized, despite adding a sizeable amount of 
leveraged loans onto their balance sheets and taking significant write- 
downs on these and other assets. Importantly, the default rate for 
leveraged loans has remained at a historically low level to the benefit 
of banks holding leveraged loans. However, in January 2008, a credit 
rating agency forecasted that the default rate for U.S. leveraged loans 
will increase to approximately 3 percent from its current 0.1 percent 
by the end of 2008, in part driven by the weaker economy.[Footnote 91] 

Although the regulators consistently told us that individual banks were 
not exposed to significant risk from their leveraged lending 
activities, some broader concerns about systemic risk have arisen. In 
its June 2006 study on private equity, FSA stated that market 
turbulence and substantial losses among private equity investors and 
lenders potentially raised systemic risk. It noted that such risk could 
be greater if leveraged debt positions were concentrated and could not 
be exited during a turbulent market. Although the originate-to- 
distribute model has served to disperse risk, it also has made it more 
difficult to determine which financial institutions or investors have 
concentrated leveraged debt exposures. Federal bank regulators told us 
that they know the amount of leveraged loans held by banks and nonbank 
investors through their review of shared national credits. However, 
they said that although they know the concentrated leveraged debt 
exposures of their supervised banks, they lack data to determine 
whether, if any, of the nonbank investors have such exposures. The 
regulators said that it would be difficult to collect and track such 
data because leveraged loans could be traded or securitized, such as 
through collateralized loan obligations. Moreover, they said that it is 
unclear whether the benefits of collecting such information would 
exceed the costs, which could be high--in part because it is unclear 
what they could do with the information with respect to nonbank 
investors. In its November 2007 report on private equity, an IOSCO 
committee highlighted the potential for a large and complex default, or 
a number of simultaneous defaults in private equity transactions, to 
create systemic risk for the public debt securities markets. To assess 
this risk, the committee plans to do a survey of the complexity and 
leverage of capital structures employed in LBOs across relevant IOSCO 
jurisdictions. Because the survey would include issues of interest to 
banking regulators, the technical committee recommended that the survey 
be done under the Joint Forum, which postponed making a decision until 
a related study on leveraged finance of LBOs was completed (which was 
issued in July 2008). 

Although the commercial and investment banks have taken steps to 
decrease their leveraged lending exposures, the unexpected increase in 
risk faced by these banks illustrates one of the ways in which problems 
in one financial market can spill over to other financial markets and 
adversely affect market participants. Accordingly, it highlights the 
importance of understanding and monitoring the conditions in the 
broader markets, particularly potential connections between markets. 
Should regulators fail to fully understand and consider such 
interconnections and their potential systemic risk implications, the 
effectiveness of regulatory oversight and the regulators' ability to 
address such risk when market disruptions that have potential spillover 
effects occur could be limited. 

Pursuant to Recent Credit Market Problems, Regulators and Others Have 
Raised Concerns about the Risk Management of Leveraged Finance: 

As a result of the recent credit market problems, financial regulators 
and others have conducted a number of special studies on leveraged 
lending or raised specific concerns. Based on a special review of the 
leveraged finance activities of four banks, FRBNY examiners reported in 
September 2007 that the banks needed to improve their risk-management 
practices. Confirming the findings of earlier examinations, FRBNY 
examiners found that the banks generally had a robust credit risk 
approval process for evaluating individual deals, but underwriting 
standards had weakened in response to competitive market conditions. 
The examiners noted that the banks used the same standards to 
underwrite loans held by banks and loans that the banks traditionally 
would syndicate because of their more risky characteristics. According 
to the examiners, the banks could have worked through their pipeline of 
leveraged finance commitments if liquidity had declined gradually, but 
the sudden shock highlighted the negative impact of weakened 
underwriting standards and certain risk-management practices. Although 
the examiners found that the banks had recently changed some of their 
risk-management controls and were continuing to review their controls 
for any additional changes that might be appropriate, they concluded 
that the banks needed to set or improve limits on their pipeline 
commitments and test such exposures under different market scenarios. 
Although the examiners noted that such risk-management controls are not 
addressed in detail in the 2001 regulatory guidance on leveraged 
finance (discussed earlier), they recommended waiting until the 
leveraged finance market adjusted to the current market events to 
revisit the guidance. 

In an October 2007 speech, the Comptroller of the Currency said that he 
asked examiners to encourage the major banks to underwrite their 
leverage loans in a manner more consistent with the standards they 
would use if they held the loans. He said that the originate-to- 
distribute model has led banks to move too far away from the 
underwriting standards they would have used if the banks held onto the 
loans. The Comptroller said that the banks need to strengthen their 
standards, but the standards need not be identical to what they would 
be if banks held the loans. He noted that there are legitimate 
differences in risk tolerances that are useful in matching willing 
lenders with risky borrowers. Nonetheless, he said that the banks 
should have risk-management systems to measure, monitor, and control 
underwriting differences between syndicated loans and loans to be held 
in their loan portfolios. In its 2008 survey of underwriting practices, 
OCC found that underwriting standards for leveraged loans changed 
significantly. According to OCC, since the disruption in financial 
markets that began last summer, most banks have responded to investor 
concerns and the negative economic outlook by tightening underwriting 
terms, particularly those relating to pricing, covenants, and maximum 
allowable leverage. 

In a March 2008 policy statement, the President's Working Group on 
Financial Markets (PWG), working with FRBNY and OCC, issued its 
findings on the cause of the recent market turmoil and recommendations 
to help avoid a repeat of such events.[Footnote 92] According to PWG, 
the financial markets have been in turmoil since mid-2007, which was 
triggered by a dramatic weakening of underwriting standards for U.S. 
subprime mortgages. This and other developments, such as the erosion of