The ‘red herring’ of debt

The private equity model of business has already proven itself as “a creator of wealth”, but has been too reliant on credit markets, says Ulf Axelson, head of the recently created MSc in finance and private equity at the London School of Economics and Political Science (LSE).

Speaking at a launch event at the University in late September, Axelson pointed to research conducted this year. The research showed that the amount of leverage loaded onto portfolio companies by financial sponsors bore no correlation to the target company’s suitability for leverage.

The only thing that drove leverage was how cheap credit was at that time

Ulf Axelson

In other words: “The only thing that drove leverage was how cheap credit was at that time,” Axelson noted, adding the finding was surprising considering businesses in some sectors should be naturally less leveraged, such as software companies.  

Axelson in part drew his conclusions from his 2010 report: Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts; a study he conducted alongside fellow researchers Tim Jenkinson from Oxford University, Per Strömberg from the Stockholm School of Economics and Michael Weisbach from Ohio State University.

Analyzing over 1100 private equity deals from 1980 to 2008, the four academics investigated what drove the financial structure of large buyout deals, and found “the economy-wide cost of borrowing is the main driver of both the quantity and the composition of debt in these buyouts”.

Unlike public companies, which gauge how much debt to carry based on profitability, cash flows and growth opportunity, for example, leverage used on private equity portfolio companies is much more pro-cyclical. During boom years when credit was cheap (2006-2007 for example), leverage was piled on portfolio companies, while during downturns (post 2008, for example), leverage ratios were lower.


GPs have often made the case as to why financial sponsors should be able to use leverage more effectively than other business owners.

GPs are uniquely positioned to arbitrage debt markets compared to public market players due “to superior access to debt financing”, as one argument goes. In explaining why public companies cannot simply utilise the same arbitrage strategy, Axelson says the private equity business model carries inherent advantages over other models.

Firstly, private equity-backed businesses are often able to tolerate high leverage ratios compared to other ownership structures due to the availability of dry powder or uncalled capital. Axelson describes a GP in this context as “an informed owner”, who has the ability to provide further equity injections should a company need saving.

[GPs are] better at negotiating with banks

Ulf Axelson

Secondly, GPs are frequently repeat borrowers in the debt market, meaning they are “better at negotiating with banks”, added Axelson.

However, the research also highlighted some more sinister incentives facing GPs when deciding how much to leverage a company. There is an asymmetry of returns between LPs and GPs, explains Axelson, which encourages the GP to use more leverage and disregard risk. “When investments go well, the returns are endless, but limited partners share a much greater cost burden when a deal goes sour,” Axelson tells PEI.

Axelson also points to the trend that funds using more leverage, such as those invested during times of cheap credit, tended to produce lower returns than those invested during periods of tighter credit.


Nonetheless, Axelson defended debt as “an integral part of value creation”, stating a high leverage ratio “creates a sense of urgency” in a company, and described managers of companies with high levels of debt as less likely to shirk and unnecessarily spend money. Equally importantly, leverage allows “GPs to leverage their expertise”, meaning managers can spread equity across a greater number of companies than would be possible under an all equity investment approach.

The private equity model may also be able to handle greater debt levels due to “an ability to apply the screws tighter on company management”, says Jonathan Trower, a managing director at DC Advisory Partners. “If you’ve got a single owner or couple of owners, your ability to influence the company’s management is much less constrained”, says Trower, adding that the diverse ownership of a public company means that shareholders often struggle to impose their views.


With financial sponsors historically using as much leverage as is available, the providers of credit should act as “an external check” on debt hungry private equity firms, and themselves judge how much to lend. “Overheated debt markets” provide too much capital for buyout funds, said Axelson.

This was certainly the case a couple of years ago, says Andy Gray, senior partner and head of investment at UK mid-market firm Graphite Capital. “The market was so inflated that one would get an information memorandum through, value the business at £40 million (€40 million; $63 million), and then later learn that figure was what a bank was offering in debt alone”, he says.  

“What happened was bank advisors were pushing debt providers in such fierce competition that they made offers making no sense whatsoever,” says Gray.

“If banks were doing their job, they wouldn’t give money to a deal that didn’t make sense,” added Axelson, who said it wasn’t leverage per se that was a problem for the industry, but the availability of too much leverage during credit booms.

To solve this over-supply, Axelson makes two suggestions: that debt providers are regulated more strictly and that highly leveraged transactions are subjected to the approval of a fund’s limited partners.


The first of these proposals is likely to be addressed in part by incoming banking regulation. “The amount of regulation coming down the pipeline, especially Basel III, could already impact the level of leveraged finance from banks in the future,” says Paul Bail, director of debt advisory at banking group Investec. 

The Basel III accords are the latest global agreements on capital requirements for banks following the financial crisis. The rules, set to be endorsed this month by nations at the G20 summit, will introduce higher capital requirements for banks.

New bank regulations could also mean alternative sources of finance becoming increasingly important. “A number of investment funds have been raised in the market specifically targeting leveraged debt,” says Bail.

The second solution proposed – that LPs could veto capital structures – is problematic for a number of reasons, according to buyout professionals. Capital structures are “very difficult to judge remotely”, said Kurt Björklund, co-managing partner of Permira, during a panel discussion following Axelson’s speech.

Arif  Naqvi

“Limited partners are meant to be limited,” added Arif Naqvi, founder and group chief executive officer of Abraaj Capital, the sponsors of the LSE programme. Naqvi said such a move would the put the LP’s “limited” status at risk.

Furthermore, many highly leveraged buyouts have proved themselves to have sufficient flexibility in their capital structures to weather even the unprecedented economic conditions of the last two years. Björklund, whose firm has channelled considerable resource into recalibrating the capital structures of some portfolio companies, added that they had proved themselves able “to trade out of inappropriate capital structures”. He added that “strategically bad investments” cause more of a problem than over-leveraged ones.

Harvard Business School professor of management practise Felda Hardymon, chairing the panel, concluded that leverage could be considered a “red herring” given how little academic study had been conducted on the subject.

Naqvi also reminded delegates that the use of leverage is not unique to private equity. “As far as I’m aware, Greece is not a private equity firm,” he said. “And Lehman Brothers wasn’t a private equity firm either.”

If firms do get overcome by debt burdens and succumb to bankruptcy, evidence suggests that the effect is not all that catastrophic. “During the buyout boom in the late ‘80s, 20 percent of buyout deals done went into financial default. But if you look back at how costly that really was to society, the numbers show not a lot of value was destroyed. Companies just had too much debt”, said Axelson.

The highly leveraged buyout deals done just prior to the recent crisis could escape with little harm done as well, said Axelson. Relative to the most recent boom, deals done during the late ‘80s were “at much looser conditions”, carried more leverage and had fewer covenants, said Axelson.

It puts today’s buyout market in “a very interesting period”, said Axelson, who added that “almost half of all deals that have ever been done historically were done in the boom from 2004 to 2007. Many of these deals have not been exited yet, so we don’t really know whether they will go into bankruptcy”.