Does Private Equity Over-Lever Portfolio Companies?

Sharjil Haque

No 2023-009, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: Detractors have warned that Private Equity (PE) funds tend to over-lever their portfolio companies because of an option-like payoff, building up default risk and debt overhang. This paper argues PE-ownership leads to substantially higher levels of optimal (value-maximizing) leverage, by reducing the expected cost of financial distress. Using data from a large sample of PE buyouts, I estimate a dynamic trade-off model where leverage is chosen by the PE investor. The model is able to explain both the level and change in leverage documented empirically following buyouts. The increase in optimal leverage is driven primarily by a reduction in the portfolio company's asset volatility and, to a lesser extent, an increase in asset return. Counterfactual analysis shows significant loss in firmvalue if PE sub-optimally chose lower leverage. Consistent with lower asset volatility, additional tests show PE-backed firms experience lower volatility of sales and receive greater equity injections for distress resolution, compared to non PE-backed firms. Overall, my findings broaden our understanding of factors that drive buyout leverage.

Keywords: Private Equity; Capital Structure; Default Risk; Trade-off Theory (search for similar items in EconPapers)
JEL-codes: G23 G30 G32 G33 (search for similar items in EconPapers)
Pages: 62 p.
Date: 2023-02-03
New Economics Papers: this item is included in nep-cfn, nep-fmk and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2023-09

DOI: 10.17016/FEDS.2023.009

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