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Why private equity loves debt

• Robert Peston
• 15 Feb 07, 08:36 AM

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.

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