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

This blog is part of this year’s series of posts by PhD students on the job market.

Private equity (PE) is a vital component of the nonbank financial system. At the end of 2020, PE funds that execute leveraged buyouts (LBOs) held around USD 2.6 trillion in assets globally. However, PE has also generated considerable controversy over the years. The most common criticism is that PE fund managers place too much debt on their acquired portfolio companies, creating debt overhang and raising bankruptcy risks. Detractors argue that this behavior arises from the fund manager's option-like payoff, which captures much of the gains from any profits on their investments but largely insulates them from any losses, leading to excessive risk-taking incentives. For example, in the event of bankruptcy, the PE fund manager does not have to sell private assets to pay off debtholders. Motivated by the substantial debt burden placed on portfolio companies, Senator Elizabeth Warren has opined that “my plan would put private equity firms on the hook for the debts of the companies they buy, making them responsible for the downside of their investments.”¹

Using data from Bureau Van Dijk on a large and global sample of companies that underwent LBOs between 2000 and 2019, figure 1 shows that leverage indeed rises drastically following PE ownership both in the median and the interquartile range. If this increase in leverage reflects excessive leverage in portfolio companies, PE-sponsored leveraged buyouts can lead to socially inefficient outcomes such as misallocation of resources and default risks. However, it is unlikely that debtholders would invest in overleveraged companies.

Figure 1. Leverage Ratio in Companies before and after PE Investment

Do PE funds systematically overleverage portfolio companies? Standard trade-off theory tells us that firms optimally choose a leverage ratio that weighs the benefits of debt, such as tax shields and agency benefits from reductions in free cash flow, against the costs of financial distress. Drawing on this canonical framework, in my job market paper, I argue that PE ownership leads to higher levels of optimal leverage (maximizes expected value) by changing the costs and benefits of debt.²

However, proving this hypothesis is challenging since we do not observe optimal leverage in the data. Existing papers that empirically look at buyout leverage use standard cross-sectional regressions of leverage on various factors that proxy the costs and benefits of debt (firm size, tangible assets, industry characteristics, and so forth). However, the regression approach implicitly assumes that firms are always optimally levered, thus making any interpretations on overleveraging implausible.

Consequently, I propose a value-maximization approach. I develop a unique model that introduces key characteristics of private equity into a canonical framework of firm value and examine evidence of overleveraging by comparing model estimated optimal leverage with actual data. PE characteristics include managerial expertise and better corporate governance that leads to higher expected future growth. Yet, fund managers may overinvest, taking value-decreasing investments due to their option-like compensation.³  I solve the fund manager’s problem (who chooses the debt) to obtain an expression for optimal leverage. The model is estimated using the sample mentioned above. I find that the model closely replicates both the level as well as the change in optimal levels of leverage following PE takeover, as shown in figure 2.

Figure 2. Leverage Ratio: Model versus Data

Given that the model is quantitatively consistent with the data, I can do a few things. First, I can decompose the relative importance of key model parameters that can explain higher optimal leverage. I find (i) a large reduction in cashflow volatility (risk), (ii) higher expected future returns, and (iii) lower bankruptcy costs, which can explain much of the variation in leverage before and after private equity takes over a company. Changes in these parameters increase the benefits of debt and particularly lower the expected costs of financial distress under PE ownership, consistent with trade-off theory. Second, I can answer key counterfactual questions: for instance, what would be the cost to portfolio companies if PE chose lower leverage similar to most non-PE companies instead of the high levels we see in the data? I find that the median firm stands to lose more than 5 percent of value from choosing a leverage ratio equal to half its estimated optimal level. Third, I show that my results are not sensitive to selection concerns, using a set of matched (that is, comparable) non-PE companies.

Finally, I examine default risk. Given high levels of debt, both the Bank of England and the European Central Bank have voiced concerns related to financial fragility and systemic risk stemming from PE investments. Since LBO financing is typically syndicated to a group of banks, a series of corporate insolvencies in portfolio companies could have severe consequences for the banks that issued that debt. However, if the higher level of leverage is optimal, default risk should not deteriorate. To examine default risk and financial fragility, I estimate a bankruptcy measure called the “Distance-to-Default.” As shown in figure 3, I find that the Distance-to-Default actually rises after PE ownership, implying that firms are less likely to default, which is consistent with higher levels of optimal leverage and lower expected distress costs. The rise is much larger compared with matched controls at the median and the third quartile, showing unique value creation from PE ownership.

 Figure 3. Distance-to-Default before and after PE Ownership

Policy Implications

My results raise two key policy implications. First, new policies regulating leveraged loans raised by PE funds should focus on determining optimal risk at the portfolio-company level. Second, enforcing PE funds to be directly liable for buyout debt may reduce PE investment and associated economic activity related to innovation and growth by changing long-term incentives. Future research would shed light on the quantitative effect on social welfare of such policies.

References

¹ Warren, Elizabeth. 2019. “End Wall Street's Stranglehold on Our Economy.” July 18.