The essence of maximizing the interior rate of return (IRR) lies in the full amount of leverage agreed to finance a transaction. The less equity a buyout company has to boost, the greater its potential profits.
This mechanical process is illustrated within the table below using three hypothetical investments. The higher the leverage ratio, the upper the return on equity and the cash-on-cash multiplier at exit:
Table 1: LImpact of Average on Private Equity Return, in $1,000
Understandably, private equity executives wouldn’t consider increasing their performance through other means without first negotiating the biggest and least expensive debt package possible. Another factor, the time value of cash (TVM), takes center stage.
Leverage and TVM: A strong combination
So why do PE investors act like this? The following exercise is meant to reveal the underlying logic. The following tables show the range of returns that a leveraged buyout (LBO) could achieve. There are eight scenarios with three variables:
- Variable 1 is the quantity of leverage – net debt/equity or net debt/total capital – at first. We use two different scenarios: 60% or 90% debt.
- Variable 2 is the time of dividend recapitalization throughout the term of the buyout. Again, we consider two options: achieving summaries in Year 2 and Year 3 or in Year 3 and Year 4 while keeping all other money flows unchanged.
- Variable 3 is the time of exit. We assume complete disposal in yr 5 or yr 6.
All of those scenarios assume that no a part of the debt might be repaid throughout the lifetime of the transaction. The assumption that there might be no repayment makes it easier to match the scenarios.
The first scenarios in Table 2 include dividend repayments in Year 3 and Year 4 and an exit of the PE owner in Year 6. Both scenarios have the identical entry and exit company values (EVs). These two scenarios only differ in a single respect: scenario A is structured with 90% debt, scenario B with only 60%.
Table 2: Exit within the sixth yr with dividend distributions within the third and 4th years, in 1,000 US dollars
In the following two scenarios in Table 3, dividend distributions occur in Year 2 and Year 3 and realization by the buyout firm in Year 6. Again, the one difference between these two scenarios is leverage: Scenario C uses 90% and Scenario D only 60%.
Table 3: Exit within the sixth yr with dividend distributions within the 2nd and third years, in 1,000 US dollars
Table 4 shows dividend distributions in years 3 and 4 in addition to a sale by the financial sponsor in yr 5. These two scenarios also only differ by way of debt: scenario E is financed with 90% debt and scenario F with only 60%.
Table 4: Exit within the fifth yr with dividend distributions within the third and 4th years, in 1,000 US dollars
The final set of scenarios in Table 5 deals with dividend recoveries in Year 2 and Year 3 and an exit in Year 5. The only difference between them is again the extent of leverage.
Table 5: Exit within the fifth yr with dividend distributions within the 2nd and third years, in 1,000 US dollars
From these scenarios we will draw several conclusions:
- It is best to leverage the balance sheet as much as possible because, assuming all other parameters remain constant, a 90% debt capital structure yields significantly higher IRRs for shareholders than a 60/40 debt-to-equity ratio : Scenario A beats B, C beats D, E beats F and G beats H.
- Dividend distributions are best made as early as possible within the term of the LBO. A payout in yr 2 generates higher average annual returns than one in yr 4: Scenario C outperforms A, D outperforms B, G outperforms E, and H outperforms F.
- The earlier the exit occurs, the greater the profit – if we assume a continuing EV between yr 5 and yr 6 and due to this fact no value creation within the further yr – which in fact doesn’t reflect all real situations. Still, scenarios with earlier exits generate higher returns than those with later realizations, which is why “quick flips” are popular: Scenario E beats A, F beats B, G beats C, and H beats D.
Our first point highlights the mechanical effect of leverage shown in Table 1. However, there are two other advantages related to debt financing:
- The second profit pertains to taxes. In most countries, debt interest repayments are tax deductible, but dividend distributions usually are not. This preferential treatment was introduced within the United States in 1918 as a “temporary” measure to offset an excess tax introduced after the First World War. The loophole was never closed and has since been adopted by many other jurisdictions.
Taking out loans helps an organization reduce its tax liability. Instead of paying taxes to governments and using those taxes to finance infrastructure, public schools and hospitals, the borrower would somewhat pay back the debts of his creditors and improve his financial position. The PE fund manager’s only duty is to its investors, to not other stakeholders, be it society as a complete or the tax authorities. At least that is how financial sponsors see it.
Previously we referred to the concept of TVM. Despite protestations on the contrary, PE fund managers need to get their a refund as quickly as possible. There are quite a few conflicts of interest between the financial sponsor – for whom an early exit means windfall profits due to a better IRR – and the investee’s ongoing management and employees who care concerning the company’s long-term viability.
However, financial sponsors can easily persuade senior company leaders – and key employees – by offering them life-changing equity stakes within the leveraged business.
The role of leverage in value creation
To proceed attracting capital, PE fund managers use many tools to spotlight their performance. The value bridges developed by fund managers to reveal their wealth creation capabilities are, as illustrated in Part 1, deeply flawed and merely emphasize operational efficiencies and strategic improvements within the fund manager’s profitable operations.
Another major shortcoming is that leverage is totally excluded in value bridges. As KPMG explained: “The value bridge makes no connection between the amount of debt a buyout repays and the amount of initial equity investment in the business.”
The complexity of determining how LBOs create economic value explains the big discrepancies in research on the contribution of leverage to investment performance.
The study “Value Creation in Private Equity” found that “The leverage component in value creation for deals made throughout the last buyout boom (2005-2008) was 29%“But within the years before the boom, the impact of debt was as high as 33%.
Other evaluation has found that leverage plays a bigger role in achieving outperformance. In “Corporate Governance and Value Creation: Insights from Private Equity“The authors analyzed the value bridges of 395 PE transactions and found that leverage accounted for almost half of the total IRR. Another study: “How vital is leverage in private equity returns?“ suggested that using debt could account for greater than half of value creation.
Value creation in PE can’t be broken down, meaning managers have the liberty to make grandiose statements about their operational capabilities. That is comprehensible. We would all prefer to be often known as wealth generators somewhat than mere financial engineers. Still, debt-driven boosting of investment returns is an inevitable PE trading ploy, because the studies mentioned above show.
Indeed, Sequoia Partners Michael Moritz once observed it that the asset class was called “leveraged buyouts” “before some marketing genius focused on ‘private equity’ to obscure the fact that the company was still sitting on a mountain of debt.”
By downplaying the critical role of leverage, the worth bridge exaggerates a fund manager’s operational capabilities to secure commitments from capital providers.
Parts of this text were adapted from by Sebastien Canderle.
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