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Why private equity loves debt

Robert Peston | 08:36 UK time, Thursday, 15 February 2007

The GMB trade union has been campaigning against the way that private equity finances its takeovers largely with borrowed money.

But why does private equity love debt so much? Well it’s all about maximising returns in a rising market.

Here’s how the maths works. Assume for a second that you are lucky enough to have £1m and that you bought a whole company for £1m four years ago. That’s when the stock market was near its low after the last stock market bubble was pricked.

Now share prices have in general surged 95% since then. So if you sold that company today, you could expect to make a profit of 95%, or £950,000. Not bad, you might think.

But now let’s do it the way that private equity would do it. They would have used your £1m and borrowed a further £4m from banks and other financial institutions. That gave them £5m to spend, which is why they bought a bigger company for £5m.

Since then, if the intrinsic value of the business simply tracked what has happened to the stock market, it too would have risen 95% in value, from £5m to £9.75m.

What’s the gain on the £1m of your money, the return on equity? That return is calculated after the £4m of borrowed money is repaid. After the business has been sold and the £4m of debt has been paid back, £5.75m would be left.

Here’s why it’s time to open the Krug. Through the magic of what’s called leverage or gearing, the private-equity approach has turned your £1m into £5.75m. Instead of a 95% profit, you’ve made a 475% profit.

I have simplified what goes on in a real private equity deal. In particular, I’ve taken no account of the costs of paying interest on the loan, or the cash-flows and profits (or losses) generated by the company along the way, or the risks of owning and operating a company.

But the basic principle holds, that it’s hard not to make a substantial profit if you borrow money to buy an asset in a rising market. Many millions of British homeowners, who’ve taken out mortgages to buy their homes, are beneficiaries of this principle.

So the apposite question for any critic of private equity is this one: are the profits they’ve made simply the consequence of using debt to buy companies in benign market conditions, or do they create substantial additional wealth by actually managing these businesses in a superior way?

The answer is that a minority of good ones do a lot more than employ the simple financial engineering that I’ve described. How can that be proved? Well, their returns exceed the so-called “leveraged” returns of the stock market as a whole.

But that’s certainly not true of all of them – which, of course, begs the question whether they are worth the colossal fees they charge.

And with tens of billions of pounds gushing into private equity houses right now, even the better private equity firms will find it harder to identify companies capable of generating returns superior to the stock market as a whole.

Comments   Post your comment

  • 1.
  • At 09:17 AM on 15 Feb 2007,
  • jon wrote:

Enjoying your pieces.

I think it is worth mentioning the debt vs equity principle; that debt is cheaper than equity.

Why would you buy a car with 3 other people, when you could borrow to buy it outright yourself. You could then choose how to run the car, choose what extras you want, and choose when to sell it. Whereas if you had a shared ownership of the car, a consensus would be needed for each and every decision.

In the world of finance and business, it is those would can implement change, and make good decisions quickly, who will thrive and earn $$$ !

  • 2.
  • At 09:32 AM on 15 Feb 2007,
  • si wrote:

In the above example, roughly how much would the private equity firm take in fees out of the £5.75m?

  • 3.
  • At 09:45 AM on 15 Feb 2007,
  • Phil wrote:

This article powerfully illustrates the attractions of debt in a rising market. It also shows how easy it has been for some private equity investors to make lots of money. However, asset values fall as well as rise and this is the main danger facing the economy due to the growth in private equity. Cheap money combined with huge amounts of leverage have inflated asset prices and have led to a significant increase in financial risk. When the asset bubble bursts, the fallout will be messy as borrowers default and lenders turn off the supply of easy money. What happens to the economy then?

  • 4.
  • At 11:04 AM on 15 Feb 2007,
  • Simon Stephenson wrote:

"The answer is that a minority of good ones do a lot more than employ the simple financial engineering that I have described. How can that be proved? Well their returns exceed the so-called "leveraged" returns of the stock market as a whole"

What do you mean by "good"? Good for the funds' investors, in so far as they've outperformed the competition, or good for society generally? Are you able to demonstrate that each of the devices used to push up individual share prices are to the overall benefit of us all? Fine if you can, but if it's that simple why are we having this discussion at all?

  • 5.
  • At 11:10 AM on 15 Feb 2007,
  • Simon wrote:

PE's/VC's are parasites who feed off other peoples good ideas and hard graft, take a disproportionate equity stake and are first out with the majority of their original stake if it all goes wrong. Other peoples graft makes these faceless pinstripes extremely wealthy!

  • 6.
  • At 12:10 PM on 15 Feb 2007,
  • William wrote:

Further to Simon's comment that PEs and VCs are paracites who feed off other people's good ideas. This is an outdated (and very European!) viewpoint. Private equity houses streamline companies and create wealth in the long term.

Additionally, it is impossible to buy a disproportionate equity stake in a business- disproportionate to what exactly, the price paid reflects the equity stake, simple.

  • 7.
  • At 12:29 PM on 15 Feb 2007,
  • Jon wrote:

Simon, (comment 6),

Perhaps a little clarification needed on your luimping together of VC/PE – VC being best described a subset of PE (private equity representing the entire asset class as opposed to public equity)

To call early stage VC investors “parasites” is perhaps a little unfair. They may seem to exploit the equity gap by taking disproportionate stakes in early stage companies, but ultimately this reflects both market forces and the risk inherent in early stage investing. We can argue about valuation till the cows come home but an asset is only worth what someone will pay for it. If the only person willing to invest in your venture wants 30% for a £1m stake, and the banks won’t lend you anything, then ask yourself whether you want 100% of nothing, or 70% of something that has a shot at success.

Overall though, I am a little unclear why you would raise the issue of venture capital in a debate about the use of leverage in private equity deals – a pure VC investment should contain no debt element, for the reason that an early stage company has no assets other than potential, to secure against. Still, why let the facts get in the way when there’s an excuse to have a pop at the “faceless pinstripes”?

  • 8.
  • At 01:17 PM on 15 Feb 2007,
  • Nasir wrote:

Does this mean that whoever aquired the company has no due diligence process in place and is simple dum?

  • 9.
  • At 01:20 PM on 15 Feb 2007,
  • Nazrul wrote:

'Debt is cheaper than equity'
No it is not. The price of debt is the depriation in the value of money. This is nothing more than an exercise in inflation. Think of it like this: the price of an asset e.g property, shares has not gone up. Rather it the value of our money that has gone down. The reason, an increase in the money supply. Too much money leading to an increase in prices. PE & VC are parasites working in tandem with the banks. The issue of debt is nothing more than legalised counterfeiting. The banks dont actually have this money. They create it out of thin air (licence to print money) and then to add insult to injury they charge interest. The loser in all this is the general public on fixed incomes. The creation of debt leads to a loss in the purchasing power our money. This is nothing more that a redistribution of wealth which is why the VC and PE and banks are parasites.

  • 10.
  • At 01:26 PM on 15 Feb 2007,
  • Simon Turner wrote:

There are actually potential broader macro-economic benefits to private equity, in providing a mechanism for recycling risk capital from mature ex-growth businesses into better growth opportunities. Because the target business is acquired with a combination of equity and debt, the equity invested in the business is reduced with the balance provided by debt which earns a lower rate of return. The vendors can then reinvest the proceeds into better equity investments. (Alternatives are dividends and share buy-backs, but they take a long time to take effect).

  • 11.
  • At 01:39 PM on 15 Feb 2007,
  • Steve wrote:

Private equity houses make large returns because they are able to buy companies cheaply - if the incumbent management team had the nouse, they could surely implement the same idea's themselves and drive up the value of companies, making them more expensive for private equity to buy. Surely we should lambasting the competance of British managers, rather than complaining about companies buying assets cheaply and selling them for profit.

For example - Ford bought Kwik Fit for £1billion pounds in 1999, sold it to private equty firm CVC for £330 million 3 years later, who sold it on 3 years later to PAI for ~ £800million last year. To right CVC should be cracking open the champers.

  • 12.
  • At 04:47 PM on 15 Feb 2007,
  • Steve Jones wrote:

This is all very well, but unfortunately for private equity, these firms have to find someone willing to lend them money, e.g., me. And I also know that you can make more money by leveraging it, and won’t lend it to them unless there is a better upside foreseen for myself! So although private equity loves debt, debt also loves private equity, and I’ll quite rightly change them through the nose for it. Nobody gets a free lunch, and it either comes out as higher risk of loosing everything, or higher charges. Let the private equity firms take their pick!

To reply to Si's direct question, private equity firms tend to charge 2 per cent per annum on managed money and they take a so-called carried interest of 20 per cent of the capital gain (over a basic threshold). So in this fictional example, they would have made something in the order of £1m to be shared among their partners. But my example is tiny compared with some real-life deals - which can generate literally hundreds of millions of pounds in fees and personal gains to be divided between the partners of private equity firms.

  • 14.
  • At 08:10 PM on 15 Feb 2007,
  • Bob wrote:

Nasir's comments above are factually incorrect and misleading. The cost of debt to fund a private equity backed deals is typically 8-15% pa whereas the cost of private equity is typically in excess of 20% pa. This is because the debt is secured against the business acquired and is therefore lower risk, whereas the private equity capital is unsecured and very high risk and therefore justifies high returns.

It is worth noting that the vast majority of private equity investors are in fact pension funds managing the pensions for both blue and white collar workers and not the private equity fund managers. This means the majority of UK citizens benefit from this form of investment through their pensions and all benefit from the considerable tax contributions from corporation tax to NI.

  • 15.
  • At 09:14 PM on 15 Feb 2007,
  • Nick Woodward wrote:

The incumbent management team are usually working in concert with the PE firms and in the interests of their own ends, not the existing shareholders. A lot of the PE deals involve management buy outs where the management team will have a lot more to gain by selling the price down before the acquisition. Surely a conflict of interest for existing boards doing deals with PE firms.

  • 16.
  • At 09:10 AM on 16 Feb 2007,
  • D Walmsley wrote:

When will the apparently bottomless pit of money from which PE borrow run out? Secondly, who actually provides the funding for this bottomless pit - one gets the feeling that it is the obverse of pyramid selling and should one "card" fall the whole lot could come down : naive thoughts maybe but scary if possibly true..

  • 17.
  • At 10:21 AM on 16 Feb 2007,
  • Bryan McGrath wrote:

The use of gearing is nothing new, some Investment Trusts and done it for decades. The infamous crash of split-capital Investment Trusts was in part caused by Trusts breaching banking covenants in a falling market.

I still can not work out how much of the money leaving Japan, the so-called 'carry trade' is ending up in Private Equity debt finance.

  • 18.
  • At 10:28 AM on 16 Feb 2007,
  • Paul Temperton wrote:

That's a very good description of how leverage works in private equity. In fact, the principle is exactly the same as that employed by anyone buying a house with a mortgage. In that case, the "deposit" is the equity stake; and the mortgage is the debt. Anyone taking out a large mortgage to buy a house in a rising market can quickly see an appreciation in their equity stake. Those with memories of the early 1990s realise, of course, that in a falling market the mechanics go into reverse: negative equity, repossessions and, for the lenders, rising bad debts can result.

  • 19.
  • At 01:03 PM on 16 Feb 2007,
  • robert wrote:

I was under the impression that leverage was one of the reasons for the 1929 stock market crash and subsequently lead to the outlawing of borrowing money to invest on the American stock market. I'm probably wrong, but would love to hear comment on this.

  • 20.
  • At 12:49 AM on 17 Feb 2007,
  • Chris wrote:

Robert, I correctly guessed that you that you (probably) don't actually know or care what yield your investment is making, as long as the value goes up. The market's collective lack of interest in what the assets actually earn (yield), in favour of preoccupation with capital gains, is classic bubble behaviour. Higher prices caused by higher prices. You are the bubble-man, my friend!

A similar decision is made by first time buyers, when they disregard the fact that renting is cheap (the opposite side of the yield equation), and that real interests are not as low as you might think, because they expect to make capital gains if they can only "get on the ladder".

I believe what politicians and others are fretting most about, is a shortage of *affordable* accommodation. You could view this as a sign that we don't have enough houses in this country for everyone to own one, but it can equally be a sign that the houses we have are priced too highly (ie. at bubble levels). The first would require more houses, and this takes a long time. The second requires that the market come to its senses, and this can happen fast.

I'd be interested to know, if your 10% gain per year turns into 5% loss, do you think you might want to check those yield numbers?

  • 21.
  • At 01:36 PM on 17 Feb 2007,
  • Chris wrote:

I think Robert's explanation is good, but it is in danger of simplifying away the real rationale here. Firstly, it seems to imply that PE firms invented gearing, which of course is not true. The example does not discuss what the existing gearing (debt to equity ratio) is of these companies, but most companies borrow at least some money, and the 95% return described goes only to those who do.

Companies set their gearing (or at least they should) at the optimum between the cost of debt, ie. interest, which goes up with higher gearing, and the cost of equity, or expected profits. What the PE firm is doing is increasing the gearing, by leveraging this with further debt on top of that already in the company.

In order to make these numbers work, they have either spotted that the company is not geared optimally, or they have convinced lenders that, in their capable hands, the risk has gone down, and they can therefore achieve cheaper debt financing than could the existing managers, and the optimum changes.

Both add wealth, and both should be to their credit. A company that is undergeared is paying over the odds for its debt, which is to say it is destroying wealth. No different from paying too much for its widgets. If the new lenders recognise them as better managers, this is also value added by them.

To imply that this is something that PE firms can magically do because the markets are "benign" is to say that they have a crystal ball that the existing management does not. If this is the case, it's a great insight that they should be allowed to make money from, as it adds value by eliminating risk. Unfortunately, I don't think it's the case.

  • 22.
  • At 10:19 AM on 19 Feb 2007,
  • Mel Snyder wrote:

It's useless to conduct this debate on a biased platform such as BBC. I listened to a "discussion" on PE/VC on BBC (via XM Radio) Feb 17 evening, and the bias was ludicrous. The charge was absence of transparency; the investment banker correctly refuted it with facts. The British union executive fired a barrage of claims he could not substantiate when challenged -- and the BBC moderator simply chimed in as an "A-men chorus." Peter Day uses the tactic to illuminate -- but this interview simply used the program as a platform to attack capitalism.

  • 23.
  • At 11:00 AM on 19 Feb 2007,
  • Tom Taylor-Duxbury wrote:

All well and good, semantics apart, is anyone actually making anything? Adding value? I’m no socialist but it seems to me the only poor guys working to pay back the debt will be the ones on the shop floor. And if you don’t add value you create inflation. Simple A level economics, or even O level!

  • 24.
  • At 12:28 PM on 19 Feb 2007,
  • Chris. Hardy wrote:

So if a company wants to protect itself from takeover, especially by private equity firms, it should try to maximize its borrowings! The exact opposite of good traditional management methods and ethics.

  • 25.
  • At 12:46 PM on 19 Feb 2007,
  • Martyn wrote:

As other posters have alluded to, gearing works both ways.

If you had £1million , and borrow a further £4million to give £5million which you then use to buy a company, but the market then falls a mere 10% (rather than rising 95%), you now have a company that is worth £4.5million. After you've repaid the borrowed money, you've managed to turn your original £1million into £500,000. You've lost half your money with just a 10% fall in the market.

As you pointed out, this is very similar to buying a house. In today's massively indebted market, falls of just a few percent will spell financial disaster for millions of people. Gearing increases potential gains, but increases risk too. Its all fine whilst the market goes up (largely driven by feverish borrowing), but inevitably it will turn at some point, and when it does, gearing will greatly increase the fallout.

  • 26.
  • At 01:33 PM on 19 Feb 2007,
  • Mark wrote:

William, since when was "streamline" a verb?

Ah, you're a manager....

  • 27.
  • At 02:08 PM on 19 Feb 2007,
  • Chris wrote:

Apologies, a response has gone onto the wrong forum. Please ignore response 21 or read it in context of the Evanomics house price forum.. Different Robert!!

  • 28.
  • At 02:55 PM on 19 Feb 2007,
  • William wrote:


A journalist actually - I think that 'streamline' can be used a verb with an object.

Especially in the field of financial journalism where management speak rules supreme!

  • 29.
  • At 05:05 PM on 19 Feb 2007,
  • Simon Barnes wrote:

Britain has got an industry to be proud of. Let's all celebrate its success.

  • 30.
  • At 06:23 PM on 19 Feb 2007,
  • Anthony Brennan wrote:

This article misses the key issue. Currently the UK and US are financing Government spending with large deficits. That is they spend more than they earn in taxes. To finance this operation they increase the money supply effectively by printing more money.

In the UK the money supply has increased by over 40% in the last three years. Mr Bush has borrowed more money that all other US presidents combined.

The effect is to dilute the value of money. A true measure of money is gold which is an international currency the value of which cannot be altered by Government manipulation. The price of Gold in US Dollars has trebled in the last 7 years or another view is the value of Dollars priced in Gold has lost 60% of value.

With GB Pounds the cost of borrowing at 5.25% and the money supply inceasing at 13% the cost of borrowing money is negative by 7.75%.

Hence private equity funds take the GBP 1m and Borrow GBP 4m. They are now short money by GBP 4m. The money falls in value in money terms. They use the money to buy assets any assets. Because the money supply is increasing asset values will rise to compensate. Hence in Isolation the assets should rise by 13% if the fund picks a good asset it will rise by more. Meanwhile the money they borrowed is falling in value as the country prints more and more.

The net effect is that the funds make huge profits. But energy prices and asset prices rise. The people see house prices rise and wealth inequality also rise. The Government then blames a small number of city traders rather than the real reason which is the fact that they have diluted the value of money by spending more than they have earned.

This gives the Government a scapegoat and a target

The next stage will be the government will convince the people that these people should pay more taxes. Tax rates will then rise. The problem then is the city traders are mobile and small in number. Therefore their trade will move offshore or to a better tax regime. The money the govenment recieves will fall not rise and they will then borrow more and the currency will lose more value.

A clear example of this was Zimbabwe where the Government convinced the people it was a good idea to nationalise the farms which both fed the people and generated FX earnings.
The net result was that earnings plummeted the currency lost 99.99% oof its value inflation is at 1,400% and 80% of people are unemployed.

none of this would be a problem if we had a free market for interest rates.

  • 32.
  • At 10:17 AM on 23 Feb 2007,
  • W. Byrne. wrote:

I really wish I could fully understand precisely where all this money is coming from. We, (our company) actually manufacture things that we can sell. We buy raw materials and through a modicum of skill and physical labour produce something that has added value and is worth something to the purchaser. They then use that item they have purchased from us to create something else that has further added value, eventually to be sold to the end user. That's how I see things. What has puzzled me for most of my life is, where does all this other money come from. No matter how people in pinstripes defend their activities, they, and a great deal more in our society seem to be cheating their way through life by manipulation and no matter what justification they give, it rings hollow with me. They use language and terminology that are beyond me and I have to say, I and many others like me get lost in their 'simplified examples'. It is beyond me how we as a country are paying for the apparent wealth (slush fund) that is being 'created' when I know that money (that is not real or physically earned) is being shifted from pillar to post to pay for things. I own up to being party to this sham. A wife who works for a city council in a job that has been literally created, whose salary then pays the council tax with that money 'earned'. Perhaps I am dim but I think it is not long before we will be bust.

  • 33.
  • At 09:58 AM on 28 Feb 2007,
  • Frank Schmidt-Hullmann wrote:

In fact not the PE firm (A) has to pay back the debt. The debt is burdened on the company (B) they buy. B tries to squeeze more money out of their staff. This is done by job losses, wage cuts etc. which are often required by the guys from A in an ultimative tone. A sees to it that they get back far more than their one million within the first years from B. Masked as an "extraordinary profit return" though B in fact now will make huge losses due to high debts and interest payments on the long run. The new debt is not used for investment activities of B. It is simply used for paying back the price to be bought to the buyer! This often results in insolvency of B after some years. Then the remaining workers of B are dismissed and their last wages remain unpaid. Third parties can't cash in their bills for services delivered to B etc. Tax and social contributions arrears remain unpaid. Parts of the debts will remain unpaid but the bank got their interest rate, provisions, fees and can deduct the loss from the taxes. The winner is A who will now look for the next victim. The public pays the price. This is not only unsustainable. It is a modern form of business crime: if you would do such things as a private person the police would arrest you soon.

  • 34.
  • At 09:45 PM on 28 Feb 2007,
  • Mark Bell wrote:

For W. Byrne's illumination (post 33). The profits are generated by a method called 'usuary'. You (or perhaps they) are confusing the value of real assets (your product) with the value of promised credit (money).

Take banks as an example. You start with a million and form a bank. You can now lend out a multiple of the cash on hand providing you with 5 million. You then accrue partners who invest in the bank by first borrowing from the bank. The bank's reserves are seen to diversify as the 'fresh' capital flows in and so more credit is issued to it by other banks that you also own. So long as no one actually goes and gets their money in cash then no one is ever the wiser that it only exists as accounting credits and voila! you have a modern fiat banking system.

  • 35.
  • At 12:34 PM on 20 Mar 2007,
  • EJS wrote:

I lost my house, car and family to a private equity investment that went horribly wrong. These people are animals that prey on weak unsuspecting individuals who are simply seeking what appears to be an unmatchable return. I got sold the idea of private equity far too easily and wish i had given it the time and research I have now done in my attempt to hunt them down.

Good site - you're a pretty good writer..... Very creative...

  • 37.
  • At 07:30 PM on 03 Jul 2007,
  • Cheryl wrote:

All you have to do is look at the housing market in the US. Some people who wanted homes and could not afford them, barrowed money say 1 million dollars and they only earned $60,00 per year. The first year they only had to pay the interest which they were able to do. The second year they had to also pay the principal which they could not do so they lost their home. Others like people in California never intended to live in the homes as home prices were going up so fast they just bought them to sell them for a profit the next week. Ahhhh and where does that leave everyone...Well if the private equity was made up of Retirement funds say from companies, those companies no longer have the money to pay the people who are or about to retire. And houses sit empty which them affects everyone in the building trades and anyone involved in anything that is used by home owner ie appliances, carpeting, etc.
Like the man said, we are paying higher and higher prices for gas at the pump because of private equity in that market...the private equity holder wants a high return on his money and we pay it the pump. Any thing these funds invest in will mean the rest of us will pay for it. In the U.S this also means interest rates will be held down artificially to protect that group and the politicians will make sure of it because that is where they are getting the money to run their campaigns. It will only stop when people from other countries who are financing the U.S debt decide to stop buying the debt.
HOld on to your hats when that happens. P.S. The private equity people are looking to Asian countries to invest in next....

  • 38.
  • At 04:19 PM on 03 Aug 2007,
  • paul taylor wrote:

I think you have to look at business finance in the round.The management of a business borrows money form investors and repays them by making promises of future cash returns.It doesn't really matter whether this return is some sort of fixed rate of interest or a fixed percentage of profits or any combination of the two.At the end of the day the managemant just need the money to fund their business and they will raise it from any type of investor that will give it to them.Obviously they obtain it as cheaply as they can which usually happens to be part equity part loan.If there was a mug prepared to give it to them all by way of loan they would take it that way.The important thing is to raise the money. Without that there is no business, no jobs, no product, no customers.

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