Study: Buyout firms pose no systemic capital markets risk

The failure of a large private equity firm would not pose a systemic risk to the US capital markets despite the growth of highly leveraged buyouts in the past decade, according to a study from the Private Equity Council.

Private equity-backed companies that fail generally only have a local effect, isolated to the company in which the firm has invested, and the firm’s investors, the study said. Failures of private equity-backed companies are not likely to spread into the broader financial markets.

“The failures of firms held by private equity are confined to those companies’ direct liabilities and product prices,” the study found. “Investors’ losses in such instances, or even if a number of private equity-held firms failed, pose little risk of a systemic effect.”

The study was authored by Robert Shapiro, chairman of advisory firm Sonecon, and Nam Pham, president of NDP Group, an economics consulting firm. The study addresses concerns that if a large private equity firm like The Blackstone Group failed, it would trigger a catastrophic failure throughout the US capital markets because borrowed funds provide the majority of financing for private equity transactions.

Concerns have been heightened by the meltdown of the global financial markets, in which the interconnectivity of companies’ investments in mortgage-backed securities and derivatives have resulted in a systemic crisis.

The amount of leverage used in private equity deals in the past several years is actually less than the amount of leverage seen in some recently failures related to mortgage-backed securities, the study found.

Borrowed funds accounted for 70 percent of the value of the assets purchased in the 63 out of 70 largest transactions by eight large private equity firms from 2002 to 2005. The level of leverage used in the deals, including several more recent deals that used even higher leverage, is “noticeably” less than the average leverage of the five largest investment banks and the average leverage of the five largest US commercial bank holding companies in the late 1990s. Leverage used in those deals also is less than the leverage of Bear Stearns’ and Lehman Brothers’ holdings in mortgage-backed securities and derivatives.

The study also noted that private equity invests in companies with “real physical …assets, rather than the derivative instruments associated with recent systemic problems”. Large firms maintain investment portfolios that are highly diversified across economic sectors, further limiting their exposure to downturns in specific industries.

It also emphasised restrictions that prevent private equity investors from withdrawing their funds prevents the cascading “panic responses” seen in systemic capital market crises.

“Modern private equity funds present little if any realistic prospect of triggering cascading losses and systemic problems in US capital markets,” the authors said.