Private Equity (PE) has become a vital component of the financial system. At the end of 2020, global assets under management in PE funds that execute leveraged buyouts (LBO) mushroomed to $2.6 trillion. Despite its role as a vital source of capital in private markets that can potentially lead to greater employment and shared prosperity, PE generates considerable controversy. The most common criticism of the industry is that PE fund managers tend to overleverage their portfolio companies, perhaps driven in part by their option-like compensation scheme. As figure 1 shows, the leverage ratio in PE-owned companies rises drastically from just around 30 percent prior to PE investment to above 50 percent following a PE-sponsored LBO. If this substantial increase in debt reflects the overleveraging of portfolio companies, PE-sponsored LBOs could lead to a wave of defaults with implications for systemic risk in the financial system.
Whether companies under PE ownership are over-levered depends entirely on the optimal level of leverage, i.e., the level of leverage that maximizes firm value. Standard corporate finance theory tells us the optimal leverage ratio balances tax benefits of debt with potential costs of bankruptcy. Drawing on this canonical trade-off, in a new paper, I argue that PE ownership leads to higher levels of optimal leverage by lowering the expected cost of distress. However, proving this hypothesis is challenging since the optimal level of leverage is not something we can readily observe in the data.
Formally, I ask if PE funds systematically over-lever portfolio companies. While anecdotal evidence may suggest a fund manager occasionally picks the leverage ratio incorrectly (i.e., a leverage ratio that is different from the optimal leverage), it is both empirically interesting and important from a regulatory perspective to document if this is happening systematically. To answer this question, I develop a unique theoretical model that can be used to estimate the optimal level of leverage for companies under PE ownership. My model includes key features of PE ownership including both the benefits and risks that fund managers bring to the table. These benefits include managerial expertise, better corporate governance, or higher efficiency that leads to higher future growth. On the other hand, fund managers may overinvest, taking value-decreasing investments in addition to value-increasing ones because of their option-like compensation. These opposing forces shape the optimal level of leverage under PE ownership by changing the benefits and costs of debt. Which force dominates is thus an empirical question the model can help us answer.
Figure 1 Leverage Ratio in PE-owned Companies. Source: Author calculations
Armed with this model, I estimate optimal leverage using data from a large, global sample of companies that underwent leveraged buyouts between 2000 and 2019. First, I verify that data from my sample is quite comparable to data in another recent paper that is widely known to have high-quality and reliable information on LBOs. By comparing model-estimated optimal leverage with actual leverage ratios from my sample, we can identify if PE-backed firms are overleveraged or not. Although there is a wide range in estimated optimal leverage depending on individual firm characteristics, the model predicts that median optimal leverage (Debt/Value) is around 50 percent. I find that this is broadly consistent with median leverage ratios in the raw data. Recall from Figure 1, the median leverage ratio in the sample hovers around 50 percent for several years following an LBO. Moreover, the model can also predict that optimal levels of leverage nearly double following PE ownership. In other words, the analysis suggests PE ownership indeed raises the optimal level of leverage.
What changes resulting from the PE-ownership structure bring about this substantial increase in the optimal level of leverage? I find a combination of lower asset risk, higher expected future growth of the portfolio company’s cash flows, and lower deadweight costs of bankruptcy explain this difference. Together these factors raise tax benefits and in particular, lower expected distress costs associated with debt. In addition, my model can answer counterfactual questions that are of particular interest to academics, as well as policymakers. For instance, a key question is what would be the difference for portfolio companies if fund managers did not lever up to these exceptionally high levels that generate all the controversy and instead chose lower leverage like most non-PE companies? For example, many studies have shown the average leverage ratio in U.S. publicly owned companies is around 30 percent. Since PE fund managers can improve governance and efficiency, is the massive change in capital structure necessary?
As it turns out, the answer is yes. I find the typical firm stands to lose as much as 5.8 percent of firm value from choosing a leverage ratio equal to half of the optimal level. Figure 2 depicts a histogram to show the distribution of this loss across all the firms in my sample. As shown in the figure, some firms stand to lose as much as 10 percent (and more) in my benchmark analysis. In other words, it is costly for a firm to choose a leverage ratio much lower than the optimal leverage ratio under PE ownership.
Meanwhile, considering the high levels of debt, both the Bank of England and U.S. regulators have voiced concerns related to systemic risk stemming from PE investments. Since LBO financing is typically syndicated to a group of banks that are connected to each other through other loans, a wave of corporate insolvencies in portfolio companies could have dire consequences for the large number of banks that issued that debt.
Figure 2 Loss in Firm Value if PE chose lower leverage ratios: Source (Author Calculations)
However, if the higher level of leverage is optimal, we can logically argue default risk should not deteriorate since firm value is greater, corresponding to the higher optimized leverage ratio. To uncover evidence of default probability and systemic risk, I compute a popular measure called Distance-To-Default. This measure shows how far a company’s asset value is from reaching a level at which bankruptcy is unavoidable. I find that Distance-To-Default increases after PE ownership, implying that firms are less likely to default—consistent with the notion that PE raises the optimal level of leverage and not just leverage alone. I find reduction in default risk is particularly pronounced among relatively larger portfolio companies (or larger LBO deals), which are more likely to generate systemic risk. My analysis also reveals that credit spreads decline substantially across-the-board following PE investment, driven primarily by lower bankruptcy costs. Overall, I find little evidence that PE creates any serious threats to financial stability or raises systemic risk.
I end the analysis by documenting two final facts. First, PE ownership generates excess returns relative to a set of comparable public companies. To be specific, the estimated return on assets and return on capital invested in PE-owned companies is at least 2.5 and 3.2 percentage points, respectively, higher in PE-owned firms relative to identical control firms. Second, I show that PE-owned firms receive greater equity injections when they fall into financial distress. This is intuitive since funds often keep “dry powder” on hand, as investments are made sequentially throughout the life of a fund. Equity injection during financial distress is one explanation of how PE lowers distress costs. These findings confirm the view that PE carefully chooses a leverage ratio based on different distress costs, instead of over-levering companies that could have destabilizing effects on the financial system. By identifying the optimal level of leverage of PE-owned companies, this study improves our understanding of capital structure in private equity.
Sharjil M. Haque is a PhD Candidate in Economics at the University of North Carolina at Chapel Hill
