Leveraged buyouts by private equity funds have been a constant, and growing, phenomenon in corporate finance over the last two decades and their importance is likely to increase in the post-COVID world. Empirical literature on this subject has explored various angles, but one unanswered question is whether the high leverage used in private equity (PE) buyout transactions contributes to the disproportionately high default rates among buyout targets. In the paper “Private Equity and the Resolution of Financial Distress,” Edith S. Hotchkiss, Per Strömberg and David C. Smith investigate how PE ownership correlates with the probability of default and resolution of financial distress, a relationship that is, theoretically speaking, unclear. One can argue that actions that boost the short-term returns to PE owners, increasing leverage to pay large dividends as an example, could drain liquidity and put PE-owned firms at higher default risk. But there is an opposite argument to be made as well: PE sponsors could help avoid defaults or resolve financial distress, thus preserving firm value, because of their expertise and skill. The authors find a series of interesting results that will help the literature understand better this relationship. First, they find that PE-backed firms have higher leverage and default at higher rates than other companies borrowing in leverage loan markets. This said, conditional on contemporaneous leverage, default rates are not significantly higher for PE-owned firms. These results suggest that it is leverage, rather than PE-backing specifically, that could be the key driver of default probabilities. Second, among leveraged borrowers that experience a default, PE-backed firms restructure more quickly and are less likely to be liquidated. Third, PE owners are more likely to retain control post-restructuring than other pre-default owners, often by infusing capital as firms approach distress. Overall these results suggest a very nuanced view of PE investors and their potential impact on subsequent target firms’ default: while PE investors contribute to more defaults due to the high leverage they put on companies’ balance sheets, such cost is reduced by the PE investors’ intrinsic abilities and skills in dealing with and managing financial distress.
Spotlight by Andrew Ellul
Photos courtesy of Edith S. Hotchkiss, David C. Smith, and Per Strömberg