A new study, released at the EVCA mid-market forum in Budapest this week, undermines perceived return advantages of loading businesses with debt. Deals with the highest debt-to-EBITDA ratios only had median return multiples of 0.2 above those with the lowest ratios. The sample was of 332 full-exited European mid-market private equity investments funded between 1990 and 2011.
The investments sampled proved successful over this time, with average enterprise value at entry €125 million, and average exit value €278 million.
Leverage is not as important as it has been qualified in the past.
Christoph Kaserer, professor at the Technical University of Munich, also predicted the leverage findings would be replicated if the study had sampled companies that were part of larger leveraged buyouts. He noted there have only been a small number of studies concerning the effect of leverage in larger market deals and he suggested that “leverage is not as important as it has been qualified in the past”.
However, Kaserer did suggest that one economic explanation for this finding could be that the benefits of leverage in amplifying returns were taken into account at the point of sale, therefore raising the price for a private equity buyer. He also said that the private equity model could not just “start using no leverage tomorrow.”
The data showed that a portfolio’s growth in earnings was the biggest generator of returns for private equity. It found that doubling the earnings of a portfolio company increased IRR by 7.9 percent. Earnings growth appeared to account for up to 75 percent of overall deal return, with rises in sale figures being the biggest contributor to the increased earnings.
These figures seem to confirm the value-add aspect of private equity investing. Firms concentrating on growth and increasing revenues should therefore experience the best returns in the market. The report also stated that the more control a private equity firm has in a business, the more that business will improve.
The high returns delivered by exits to secondary buyers also suggested that businesses with even more potential for growth at the point of sale are the most valuable portfolio companies. These secondaries showed a median multiple average of 3, whereas trade sales and IPOs produced a median multiple of 2.4. Kaserer suggested that “the leverage effect” is significant in this finding, as private equity firms are willing to deploy more leverage in a deal than a strategic buyer, which means they would be willing and able to pay a higher price for a company.