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Home > Blogs > All About Alpha > Guest blog: Private Equity As Victim: Leverage takes back seat to value creation

Guest blog: Private Equity As Victim: Leverage takes back seat to value creation

PE industry | Private Equity As Victim: Leverage takes back seat to value creation All About Alpha

There is no clear-eyed view on the culprits behind the Great Liquidity Meltdown of 2008-2009. But there is a gimlet-eyed view: everybody. That’s a fancy euphemism for “systemic.” And so the regulatory Leviathan grinds forward, with tighter strictures for the banks that are already regulated, and now to draw the so-called shadow banking system into its grips.

Ah yes, the shadow banking system: investment banks now converted into regulated bank holding companies … and hedge funds and leveraged buyout firms that may have had a passing acquaintance with them.

In a wide-ranging working paper draft, "Private Equity in a Deleveraged Economy: Lessons from the Financial Crisis", Harvard Law School researcher Lawale Nicholas Lapado suggests these concerns have been misplaced. It wasn’t the shadow banking system that brought the lending system to its knees – or at least not private equity funds – it was subprime mortgages. (One casualty of which is the Office of Thrift Supervision, the regulator not only for mortgage companies, but AIG.)

That’s not to say private equity firms didn’t take out loads of leverage – when they could get it. And that debt has implications. “The enormous amount of debt loaded on to portfolio companies may make them more fickle and more susceptible to default and bankruptcies particularly in an era where financial projections upon which the buyouts were carried out may have become blatantly misleading,” he writes. “But it appears exaggerated to propose that there would be such a string of bankruptcies of portfolio companies on so large a scale as to result in a credit crisis.”

Why no systemic danger? Well, private equity fund management companies are legally quite different from the partnerships they manage as the general partner. Each partnership is a separate entity, and it’s at the partnership level that the impact of default will be felt. While that will affect the returns of each partnership, each portfolio company is also a distinct, ring-fenced obligation (providing the debt covenants are done right). Let’s call it a contained default. Even in the worst case, private equity leverage accounts for only 2% of all U.S. debt outstanding – about $1 trillion.

As Lapado explains, “these debts are debts of the portfolio companies against whose assets the loan is advanced. PE firms and the funds floated typically do not take on any debt.” Still, a rash of defaults in a partnership might lead to a spree of second-guessing. But equally important is that “since LPs are locked in for a considerable length of time with no redemption opportunities, this prevents something analogous to a bank run on the PE fund.”

Nevertheless, the era of expansive leverage is over, he thinks. “With the leverage loan market still pretty much frozen, resulting in the costs of debt going up and the quantity going down, the PE industry must find a way to function with less leverage. Surprisingly investment by LPS in 2008 was still at an all time high, and after a gloomy year in 2009 there appears to be returning investor appetite.” (See Figure 2 from the paper below.)

US PE Fundraising

As evidence of that appetite, one could cite the recent foray by the Canada Pension Plan Investment Board – a $120 billion entity – into making loans to leveraged buyout firms, first with KKR. That’s an advance on the backdrop to the 2008 meltdown, when players such as Apollo and Blackstone began to buy leveraged loans at a 90% discount as investment banks sought to bleach their balance sheets.

Bank leverage is a topic examined in a recent Harvard Business School working paper, “Unstable Equity? Combining Banking with Private Equity Investing,” by Lily Fang, Victoria Ivashina and Josh Lerner.

They report that “the share of banks in the private equity market and of private equity as a percent of bank equity is substantial. Over the period between 1983 and 2009, over one-quarter of all private equity investments involved bank-affiliated private equity groups. Between 1997 and 2006, the total amount of transactions done by bank-affiliated private equity firms represented on average 9.4% of the bank’s total equity during this period.” (See Panel B from the paper below.)

Dollar Volume of PE Deals

But these are not sticky assets, and investment banks no more resist the urge to buy high than do other mortal investors. Or, as the researchers note, “The share of transactions affiliated with banks is pro-cyclical, peaking at times of big capital inflows into the private equity market.”

As a result, the availability of leverage fluctuates. Is that fatal to leveraged buy outs? Not necessarily. Reviewing the literature, Lapado says: “recent research on value creation drivers in private equity show that two-thirds of value creation can be attributed to operational and market effects, such that deals completed in recessionary environments can still result in attractive returns, and conclude[s] that operational improvements are more important than leverage.”

So the future for private equity lies not in leverage, but in three words: management, management, management. Oh, and timing.

This guest blog was first published on

Tags: banking , financial crisis , fund management , investment banking , leverage , private equity
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