Private Equity at Work: Limit Leverage to Limit Risk

June 09, 2014

The 2008-2009 financial crisis ended well for Wall Street, with little in the way of financial reform and Wall Street veterans in positions of influence on regulatory bodies. Perhaps, though, the provisions of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and more recent financial reform efforts, modest as they are, have begun to bite. The limited oversight the Dodd-Frank Act provides to the Securities and Exchange Commission (SEC) has already led to suspicions of misbehavior or even fraud. Half the reviews conducted by the SEC to date revealed a failure of PE firms to share fees charged to portfolio companies with investors in their PE funds. Of even greater consequence, perhaps, are actions taken by regulatory agencies in the last year to limit the excessive use of debt in leveraged buyouts of Main Street companies.

Post-mortems of the financial crisis make clear the dangers to the financial system of gambling with other people’s money, making excessive use of debt (leverage), and shifting the risks of failed investments to others. This could as well describe today’s private equity business model.

As Rosemary Batt and I show in Private Equity at Work: When Wall Street Manages Main Street, leverage is at the core of the private equity business model. Private equity partners put up $1 to $2 for every $100 that pension funds and other investors in their PE funds contribute. They typically finance the buyout of a Main Street company with 30 percent of the money coming from the PE fund and 70 percent borrowed from creditors. They use the assets of the company they are buying as collateral for this debt, and put the burden of repaying the loans on the acquired company. The private equity firm has very little of its own money at risk – less than 1 percent of the purchase price of companies it acquires (2 percent of 30 percent is .02*.3 = .006 or 0.6 percent). Yet it claims 20 percent of any gains from the subsequent sale of these portfolio companies.

Private equity firms play with other people’s money – money contributed by investors in its funds and borrowed from creditors. Leverage magnifies investment returns in good times – and PE firm partners collect a disproportionate share of these gains. With the debt loaded onto the acquired company, however, it is the company and its workers and creditors that bear the losses if the economy sours and the debt cannot be repaid. This risk-reward calculus leads private equity firms to load up portfolio companies with excessive amounts of debt.

The results are predictable. When the economy falters, the high debt levels of highly leveraged companies make them much more likely to default on their loans or go bankrupt. One study of more than 2,000 highly leveraged companies found that roughly a quarter of them defaulted on their debts in the period from 2007 to the first quarter of 2010. In April 2012 The Deal magazine [acquired by in 2012 and shut down] reckoned that 260 private equity-owned companies entered bankruptcy during the 2008 to 2011 period. Even highly leveraged companies that did not experience distress or bankruptcy often faced painful restructuring in order to meet their debt payments. Harrah’s Entertainment with 30,440 unionized employees was acquired in 2006 by Apollo Global Management and Texas Pacific Group (TPG Capital). By June of 2007 the casino chain’s long-term debt had more than doubled. The gambling industry slumped in the recession, and Harrah’s (now known as Caesar’s Entertainment Corporation) struggled under its debt burden. The company cut staff, reduced hours, outsourced jobs, and scaled back operations (see here, here and here.)

The financial crisis is over, but the pain continues. In April of this year, Energy Future Holdings (EFH), acquired in 2007 by KKR, TPG, and Goldman Sachs’ private equity arm, set a record when it filed for bankruptcy. EFH defaulted on $35.8 billion in bonds and institutional loans – the largest default ever on a leveraged buyout. But EFH was not alone. Other recently failed leveraged buyouts include Momentive Performance, James River Coal, Guitar Center, Allen Systems Group, and River Rock Entertainment. By mid-May of this year, nine companies other than EFH acquired in leveraged buyouts defaulted on $6.5 billion in bonds and institutional loans. Defaults on the high yield and leveraged loans that financed the boom in leveraged buyouts in 2004 to 2007 have affected a total of $120 billion (out of nearly $500 billion) in bonds and institutional loans.

Regulatory agencies’ failure to limit leverage is widely understood to have contributed to the crisis. It is a mistake that regulators do not want to repeat. In March 2013 the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp jointly issued guidelines that encourage banks to refuse to make loans that would raise the debt levels of a company beyond 6 times earnings before interest, taxes, depreciation and amortization (ebitda).

Predictably, private equity firms objected. At a conference in Manhattan earlier this year, Apollo Global Management chief Leon Black complained publicly that regulators were engaged in “micromanaging” the industry. Black aired his complaint on the same day that the New York Post broke the story that the heavily indebted Caesar’s casino chain faces interest payments of about $1.9 billion in 2014 but anticipates earnings (ebitda) of just $1.4 billion.

Concerned about the loss of lucrative fees on these leveraged loans, banks were slow to take the guidelines seriously. But in April regulators began an annual review of the loans banks make, and this has encouraged greater compliance. KKR’s request for a $725 million buyout loan, for example, was refused in May by three banks with which it had long-standing relationships on the grounds that regulators would find the loans too risky.

The guidelines limiting excessive debt will crimp banks’ fee income and may reduce the profits of private equity funds that are required to put up more of their own cash. But regulators are intent on reducing the number of risky leveraged buyouts that might lead to losses for creditors. While not explicitly a goal of regulators, this will have the desirable effect of reducing the likelihood that companies acquired by private equity will be forced to restructure operations, close facilities, and lay off workers in order to meet payments on their debts.


Eileen Appelbaum is Senior Economist at CEPR and co-author, with Rosemary Batt, of Private Equity at Work: When Wall Street Manages Main Street

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