Monday, October 26, 2009

Value, a levered affair

A recent news coverage on PE returns is generating quite a buzz - Private equity’s love affair with leverage. The article cites research on 240 odd PE transactions in the European market to present some interesting findings:

“The analysis found that the value of a company typically rose by 2.71 times during the period it was owned by a private equity house, on average 3.5 years. Of this 0.88 resulted from the use of leverage. Of the remaining 1.83, 0.87 came from growth in earnings before interest, tax, depreciation and amortisation (Ebitda), some 80 per cent of this from sales growth and 20 per cent from improved margins.

Improvements in free cash flow accounted for 0.42 and the effect of a rising multiple (i.e a company being sold for a higher price/earnings multiple than it was bought for) was responsible for 0.51. However, the data suggest the importance of leverage has grown; while it accounted for 28 per cent of value creation between 1989 and 2000, this figure rose to 36 per cent between 2001 and 2006.”

The interesting point is the outcome that a private equity investor could increase a firm's value by a whopping 80 odd percent by merely increasing leverage of the firm.

Now, how does leverage create (so much) value? Valuation theory tells us that debt increases value because its exploits the available tax shield benefit. At a more deeper level, debt increases fiscal discipline in managers as they are forced to commit to a fixed claim on cash flows, preventing them from frittering around with excess cash.

The interesting question is - how could leverage have so much of an impact? And why couldn't firm managers not act on it in the pre-PE days?

One possible reason is that private equity investors have greater risk appetite than internal firm managers, causing them to be more amenable to extensive leverage. This is quite possible - not every manager is incentivized to lever his/her firm to the point where he needs to sweat the business to avoid bankruptcy risks (that arise out of high debt). It is often easier to avoid making those tough project financing decisions than to risk his/her job security from a potential bankruptcy. PE investors, on the other hand, are incentivized to do the opposite. (Note though, at a higher risk).

For another, it is likely that the PE investors went after those firms which had a poor capital structure in the first place, so they could add 'value' by levering the balance sheet. If true, it shows how poorly a number of firms manage their capital structure decisions.

The other interesting note in the article is the (last) point about PE firms being able to time their exit enough to raise exit valuations by ~50 percent! Imagine being able to time valuation cycles in a 3.5 year average time-frame - possibly the function of a rising market in the time-period of the research?
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