The private equity and venture capital investment model is first and foremost about creating value for investors, through investment selection, improving productivity and introducing better management practices.
Credit, or debt financing is an important tool across financial services and business in general to fund investment at a lower cost of capital than equity. It is frequently referred to as leverage, as it can enable and enhance (“levering up”) the returns from value creating investment. While businesses of all shapes and sizes may consider using debt as part of their financing package – to invest in new factories or to fund overseas expansion for instance – private capital investors have the experience to negotiate better terms with lenders than businesses could do alone, and are experts at understanding the best financing structure for a particular business. Across all ownership models debt financing can lead to increased financial risk for companies, but private capital investors are particularly well placed to manage and mitigate this risk, though better management practices, close monitoring of investments and, if necessary, interventions with lenders.
Not all segments of the private capital industry use leverage uniformly as part of their value creation strategy. Evidence suggests that leverage effects on value creation are higher for larger deals as big buyouts tend to be more leveraged compared to mid-market companies. There have also been observed some differences in leverage levels across companies operating in different industries. While historically, leverage or financial structuring has been considered as one of the primary drivers of equity value creation, it has become less significant in recent years, with the focus shifting towards operational improvements and efficiency.
Recent research also highlights that debt ratios, as represented by Debt/ Enterprise value (D/EV), have fallen since the 2010s, while leverage ratios (Net Debt/EBITDA) have risen over time. Moreover, leverage is not always positively associated with returns or risk, as suggested by academic evidence.
Academic research finds that the risk of business failure for a given level of leverage is lower for PE backed firms than the business population as a whole, owing to better access to capital markets and the injection of capital provided by their PE owners. This suggests that, while leverage can introduce risk, it can be managed effectively within the private equity model.
The papers in this section outline key themes related to the use of leverage and financial structuring in private equity, with a particular emphasis on:
- Metrics commonly used to assess debt levels
- Leverage as a value creation driver
- Leverage and risk of insolvency
- Determinants of leverage
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A white paper from 2021 jointly produced by the Private Equity Research Consortium and the Research Council of the Institute for Private Capital provides a summary of the use of leverage within the private equity buyout market and a review of existing academic literature on PE capital structure. The paper distinguishes between two metrics widely used to assess what debt financing the business can sustainably support, and how they measure distinct aspects of financial structure at deal-level. These metrics are: debt as a proportion of total enterprise value (D/EV ratio) and a leverage ratio defined as debt divided by EBITDA. The paper finds that while some measures of leverage ratios have increased in recent years post the Global Financial Crises (GFC) the important D/EV ratios have dropped in the 2010s. The authors of the study conclude that is “not necessarily the case that measures of leverage are positively associated with returns or risk” having found a weak negative relationship between returns and the leverage ratio and a strong positive relationship between returns and the D/EV ratio.
Brown and Yi (2023) find that the proportion of value creation attributed to high leverage at PE-backed companies has been decreasing in recent years. The opposite has been observed in investor contribution to revenue growth, indicating a shift towards a greater emphasis on operational improvements. They document that contribution of excess leverage to overall value creation varies across different industries represented in the study. The findings are based on nearly 3,000 exited deals globally between 1984 and 2018.
Achleitner, Braun, Engel, Figge and Tappeiner (2010) analysed value creation drivers in European buyouts (including Continental Europe and the UK) based on 206 realised transactions between 1991 and 2005. They concluded that one third of the private equity sponsors’ returns can be attributed to the leverage effect with the remaining two thirds of value creation down to operational improvements and market effects. Moreover, they observed that the leverage effect is higher for larger deals, whereas revenue growth plays a more significant role for smaller deals.
Puche, Braun, Achleitner (2014) examined over 2,000 international buyout transactions between 1984 and 2013 and found that leverage has played a lesser role in PE returns post the 2008s, while the relative importance of operational improvements has increased over time. Furthermore, they document that a significant difference in value creation observed across various industries was likely due to the greater use of leverage in these industries alongside other drivers such as transaction multiple and sales effect.
Hotchkiss, Strömberg, Smith (2021) analyse a sample of 2,151 US firms that obtained leveraged loan financing between 1997 and 2010 of which 965 were owned by PE investors at some point during the period. The study shows that while PE-owned companies are no more likely to default compared to other firms with similar leverage characteristics, PE-owned companies appear to be better equipped to deal with financial distress. The authors find that “when PE-backed firms do become financially distressed, they are more likely to restructure out of court, take less time to complete a restructuring, and are more likely to survive as an independent going concern, compared to financially distressed peers not backed by a PE investor.”
Wilson and Wright (2011) in their ‘Private Equity, Buy-outs, and Insolvency Risk’ study analysed a sample of UK companies filling statutory accounts during 1995-2010 (thus covering the recession period) and the buyout data from CMBOR to compare the insolvency risk of the range of buyout types over time. Controlling for size, age, sector and macro-economic conditions, the paper shows that PE-backed companies do not carry more insolvency risk than other distressed companies and other buyout types. Leverage is not the feature that differentiate failed buyouts from the rest. Moreover, the authors conclude that PE-backed companies are in better position because of active ownership and governance, to adjust capital structure over the economic cycle and, therefore manage insolvency risk and protect assets”.
But what determines leverage levels in the context of PE?
Axelson, Jenkinson, Stromberg and Weisbach (2012) find that variation in debt market conditions is the main determinant of leverage in buyouts. The authors document that buyout leverage is pro-cyclical, meaning that leverage increases when debt is cheap. In contrast, during the same market conditions, public companies exhibited a countercyclical leverage pattern.
In line with the above paper, De Maeseneire and Brinkhuis (2009) also report that when credit market liquidity is high (low credit spreads and low leverage loan spreads), LBO transactions have higher leverage.
Malenko and Malenko (2015) develop a theoretical framework which highlights the impact of reputation of PE sponsor in securing debt financing for portfolio companies. They show that buyout leverage is driven by economy-wide and PE sponsors specific factors which is distinct from leverage of independent firms that is driven by firm-specific factors.
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Bibliography
Achleitner, Ann-Kristin and Braun, Reiner and Engel, Nico and Figge, Christian and Tappeiner, Florian, Value Creation Drivers in Private Equity Buyouts: Empirical Evidence from Europe (January 12, 2010). The Journal of Private Equity, Spring 2010, Available at SSRN: https://ssrn.com/abstract=149623
Axelson, Ulf and Jenkinson, Tim and Stromberg, Per and Weisbach, Michael S., Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts (October 10, 2012). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1596019
Brinkhuis, Samantha and De Maeseneire, Wouter, What Drives Leverage in Leveraged Buyouts? An Analysis of European LBOs' Capital Structure (February 15, 2009). Available at SSRN: https://ssrn.com/abstract=1343871 Brown, Gregory and Yi, Lu (2023), How do private equity create value? Available at How_do_private_equity_firms_create_value_.pdf (luluyi.net)
Hotchkiss, Edith S. and Stromberg, Per and Smith, David Carl, Private Equity and the Resolution of Financial Distress (July 7, 2021). AFA 2012 Chicago Meetings Paper, ECGI - Finance Working Paper No. 331/2012, Available at SSRN: https://ssrn.com/abstract=1787446
Debt and Leverage in Private Equity: A Survey of Existing Results and New Findings, IPC-PERC_PE-Debt-Leverage.pdf (uncipc.org)
Puche, Benjamin and Braun, Reiner and Achleitner, Ann-Kristin, International Evidence on Value Creation in Private Equity Transactions (August 29, 2014). Journal of Applied Corporate Finance, 2015, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2496899
Malenko, Andrey and Malenko, Nadya, A Theory of LBO Activity Based on Repeated Debt-Equity Conflicts (September 1, 2015). Journal of Financial Economics (JFE), 117 (3), 607-627, September 2015, Available at SSRN: https://ssrn.com/abstract=2251169
Wilson, Nicholas and Wright, Mike, Private Equity, Buy-Outs and Insolvency Risk (June 24, 2011). Available at SSRN: https://ssrn.com/abstract=1871651
Learn more about the BVCA's Research Advisory Group
These studies have been compiled with the support of the BVCA Research Advisory Group, a committee of senior academics and practitioners who enable us to access a wider pool of research. The BVCA Research team would like to thank all members of the Group for their input, guidance and advice.
