Leverage in Private Equity: A Potential Source of Systemic Risk?

Project Start: 01/2013
Status: Completed
Researchers: Christian Rauch, Uwe Walz
Category: Corporate Finance, Systemic Risk Lab

Topic & Objectives

After the financial crisis, regulatory authorities increased their focus also on the leveraged lending market and specifically on leveraged buyouts (LBOs). These are seen as potentially harmful to the financial system. Still, the LBO market is well and alive: 2014 alone saw a worldwide total of 802 Private Equity sponsored LBOs with a total volume of over 60 billion US dollars. Especially European LBOs have grown increasingly strong after the end of the financial crisis, climbing to an average per-deal volume of 350 million US dollars in 2014, from only 80 million US dollars in 2009. These numbers are reflected in investor sentiment: fundraising for Private Equity funds with a European focus have reached pre-crisis levels with a total of 100 billion US dollars in 2014.

The aim of this project is to investigate various aspects of the implications of leveraged buyouts on the financial system but also on the real sector.

SAFE Working Paper No. 101 asks whether LBO loan exposures impact the systemic risk of the banks investing in these loans. Given the high riskiness of the LBO business model and the huge amount of bank-provided debt to finance these deals, it is stunning that the link between LBOs and bank systemic risk has not been emphasized so far.

Although past research has shed light on many details of these transactions, one aspect has remained largely opaque: the influence LBOs have on direct competitor companies of the LBO target company. Given the increasing number of deals, and the growing fundraising volumes triggering more LBOs in future years, answers need to be found: are LBOs a desirable activity in financial markets which perhaps cause positive externalities, or are these transactions harmful even for unrelated third parties? SAFE Working Paper No. 99 addresses these questions.

Key Findings

SAFE Working Paper No. 99

  • LBOs work through the product markets as well; they have clear-cut consequences for the LBO target’s competitor depending on the governance changes implemented in the course of the LBO..
  • LBOs have a strongly significant and negative effect on competitors’ revenue growth. This effect is especially pronounced the larger the size of the LBO is.
  • Different restructuring mechanisms in LBOs affect the LBO targets’ competitors in different ways. Whereas increases of leverage beyond optimal levels have a negative effect on the competitors, strategic restructuring methods like M&A deals benefit the operating performance of the competitors.
  • Overall, the single restructuring mechanisms applied in LBOs affect competing companies through product market competition.

SAFE Working Paper No. 101

  • LBO loan exposures have a significant influence on bank systemic risk with banks having higher levels of systemic risk when financing more LBOs.
  • LBO loans are the only loan purpose that impact systemic risk adversely.
  • Several drivers of this impact on systemic risk exist: It increases in the size of the LBO banking network a financial institution is connected to and in the bank size. However, the impact of LBO loan exposure on systemic risk decreases if the bank had a lending relationship with the PE sponsor in the past, more experience in the LBO financing market or a higher credit rating.
  • The influence of LBO loan exposure on systemic risk cannot only be measured on a cross-sectional level but also on a national level when using a country-wide measure of systemic risk.

SAFE Working Paper No. 100

  • Non-banks are able to compete against banks in arranging syndicated loans due to three reasons:

    • Some of them benefit from looser regulatory requirements enabling them to compete for loans when banks are constraint.
    • Non-banks have specialized expertise in industry niches helping them to succeed with their loans.
    • Non-banks focus on a special group of borrowers that are not asking for cross-selling of other services which is a crucial aspect in lending by bank lead arrangers. These borrowers tend to be more opaque, less experienced but not more risky than borrowers affiliated to bank lead arrangers.

  • In terms of loan syndicate composition, non-banks syndicate less often than banks. If they syndicate, however, they prefer, to a higher degree than banks, participants that help them to reduce information asymmetries.
  • Non-banks charge 105 basis points more than banks, which is a markup of around 38% compared to an average bank spread of 274 basis points. This markup is a compensation for serving more opaque borrowers, for higher information asymmetries between lead arranger and participants and it is countercyclical as it decreases if lending competition is lower and vice versa.

Policy Implications

The Private Equity market is largely unregulated, as both investors and PE firms are seen as ‘sophisticated’ by the regulator. Given the fact that LBOs create strong – sometimes adverse – effects on markets, this lack of regulation should be seen with some scrutiny.

The results of SAFE Working Paper No. 101 could provide guidance for regulatory authorities to identify exactly the type of banks that are putting the financial stability with their LBO debt underwriting at risk. Additionally, it provides evidence for the recent changes in regulation , increasing the attention on LBO and leveraged lending business.

However, LBOs can also create desirable effects in markets and might therefore contribute to economic welfare. The fact that these positive effects also benefit other, seemingly unrelated companies, is a new revelation and must be taken into consideration when evaluating the market for LBOs, and especially its regulation.

Related Working Papers

No. Author/s Title Year Research Area Keywords
99 Marcel Grupp, Christian Rauch, Marc Umber, Uwe Walz The Influence of Leveraged Buyouts on Target Firms’ Competitors 2015 Corporate Finance, Systemic Risk Lab Product Market Competition, Peers, LBOs, Restructuring
100 Marcel Grupp Taking the Lead: When Non-Banks Arrange Syndicated Loans 2015 Corporate Finance, Systemic Risk Lab Non-bank lead arrangers, syndicated loans, spread premium
101 Marcel Grupp On the Impact of Leveraged Buyouts on Bank Systemic Risk 2015 Corporate Finance, Systemic Risk Lab Leveraged buyouts, syndicated loans, systemic risk

 

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