Banking

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

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.

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

Source : blogs.worldbank.org

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