(Over)-leveraged buyouts of private equity: Myth or reality?

Private equity finance (PE) is a crucial element of the nonbank economic climate. In the finish of 2020, PE funds that execute leveraged buyouts (LBOs) held around USD 2.6 trillion in assets globally. However, PE has additionally generated considerable debate through the years. The most typical critique is the fact that PE fund managers place an excessive amount of debt on their own acquired portfolio companies, creating debt overhang and raising personal bankruptcy risks. Detractors reason that this behavior comes from the fund manager’s option-like payoff, which captures a lot of increases from the profits on their own investments but largely insulates them from the losses, resulting in excessive risk-taking incentives. For instance, in case of personal bankruptcy, the PE fund manager doesn’t have to market private assets to repay debtholders. Motivated through the substantial debt burden put on portfolio companies, Senator Elizabeth Warren has opined that “my plan would put private equity investors responsible for that financial obligations from the companies they’re buying, which makes them accountable for the down-side of the investments.”1

Using data from Bureau Van Dijk on the large and global sample of firms that went through LBOs between 2000 and 2019, figure 1 implies that leverage indeed increases drastically following PE possession in the median and also the interquartile range. If the rise in leverage reflects excessive leverage in portfolio companies, PE-backed leveraged buyouts can result in socially inefficient outcomes for example misallocation of sources and default risks. However, it’s unlikely that debtholders would purchase overleveraged companies.

Figure 1. Leverage Ratio in Companies pre and post PE Investment

A regular chart showing Figure 1. Leverage Ratio in Companies pre and post PE Investment

Do PE funds systematically overleverage portfolio companies? Standard trade-off theory informs us that firms optimally select a leverage ratio that weighs the advantages of debt, for example tax shields and agency advantages of reductions in free income, from the costs of monetary distress. Applying this canonical framework, within my employment market paper, I reason that PE possession results in greater amounts of optimal leverage (maximizes expected value) by altering the expense and advantages of debt.2

However, showing this hypothesis is challenging since we don’t observe optimal leverage within the data. Existing papers that empirically take a look at buyout leverage use standard mix-sectional regressions of leverage on various factors that proxy the expense and advantages of debt (firm size, tangible assets, industry characteristics, and so on). However, the regression approach unconditionally assumes that firms will always be optimally levered, thus coming to a interpretations on overleveraging implausible.

Consequently, I suggest something-maximization approach. I create a unique model that introduces key characteristics of non-public equity right into a canonical framework of firm value and look at proof of overleveraging by evaluating model believed optimal leverage with actual data. PE characteristics include managing expertise and corporate governance leading to greater expected future growth. Yet, fund managers may overinvest, taking value-decreasing investments because of their option-like compensation.3 I solve the fund manager’s problem (who chooses your debt) to acquire a manifestation for optimal leverage. The model is believed while using sample pointed out above. I’ve found the model carefully replicates both level along with the alternation in optimal amounts of leverage following PE takeover, as proven in figure 2.

Figure 2. Leverage Ratio: Model versus Data

A regular chart showing Figure 2. Leverage Ratio: Model versus Data

Since model is quantitatively in conjuction with the data, I’m able to perform a couple of things. First, I’m able to decompose the relative need for key model parameters that may explain greater optimal leverage. I’ve found (i) a sizable decrease in cashflow volatility (risk), (ii) greater expected future returns, and (iii) lower personal bankruptcy costs, which could explain a lot of the variation in leverage pre and post private equity finance gets control a business. Alterations in these parameters increase the advantages of debt especially lower the expected costs of monetary distress under PE possession, in line with trade-off theory. Second, I’m able to answer key counterfactual questions: for example, what will be the cost to portfolio companies if PE chose lower leverage like the majority non-PE companies rather from the high levels we have seen within the data? I’ve found the median firm stands to get rid of greater than five percent of worth from selecting a leverage ratio comparable to half its believed optimal level. Third, I reveal that my answers are not responsive to selection concerns, using some matched (that’s, comparable) non-PE companies.

Finally, I examine default risk. Given high amounts of debt, both Bank of England and also the European Central Bank have voiced concerns associated with financial fragility and systemic risk stemming from PE investments. Since LBO financing is usually syndicated to several banks, a number of corporate insolvencies in portfolio companies might have severe effects for that banks that issued your debt. However, when the greater degree of leverage is optimal, default risk shouldn’t deteriorate. To look at default risk and financial fragility, I estimate a personal bankruptcy measure known as the “Distance-to-Default.” As proven in figure 3, I’ve found the Distance-to-Default really increases after PE possession, implying that firms are less inclined to default, that is in line with greater amounts of optimal leverage minimizing expected distress costs. An upswing is a lot bigger in contrast to matched controls in the median and also the third quartile, showing unique value creation from PE possession.

Figure 3. Distance-to-Default pre and post PE Possession

A regular chart shwoing Figure 3. Distance-to-Default pre and post PE Possession

Policy Implications

My results raise two key policy implications. First, new policies controlling leveraged loans elevated by PE funds should concentrate on figuring out optimal risk in the portfolio-company level. Second, enforcing PE funds to become directly responsible for buyout debt may reduce PE investment and connected business activities associated with innovation and growth by altering lengthy-term incentives. Future research would reveal the quantitative impact on social welfare of these policies.

References

1 Warren, Elizabeth. 2019. “End Wall Street’s Stranglehold on the Economy.” This summer 18.

2 Haque, Sharjil. 2020. “Does Private Equity Finance Over-Lever Portfolio Companies?” October 18. Offered at SSRN.

3 Axelson, Ulf, Tim Jenkinson, Per Stromberg, and Michael Weisbach. 2013. “Borrow Cheap, Buy High? The Determinants of Leverage and Prices in Buyouts.” Journal of Finance.

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