Gearing and Performance in Private Equity

Abstract

This thesis examines the relationship between leverage and performance within the Private Equity (PE) industry, which has seen significant growth over recent decades. Utilizing a unique dataset of 1,097 PE transactions by 28 American PE managers from 1998 to 2022, as well as interviews with eight experts from the Danish PE industry, this thesis investigates the drivers of high leverage in PE and whether PE funds are rewarded for this high leverage with better investment performance. The study reveals six main factors influencing leverage: (1) company size, (2) cost of debt, (3) EBITDA multiple at entry, (4) growth strategies, (5) manager experience, and (6) a fixed range that changes over time. While company size has a positive impact on leverage, the cost of debt has the opposite effect, aligning with prior research and insights from industry experts. For the remaining factors, the impact on leverage could be both positive and negative, depending on the situation. In terms of performance, a significant positive relationship was identified between D/E and IRR, suggesting higher financial leverage at acquisition is associated with better investment return. However, no significant link was found between D/EBITDA and IRR, indicating that EBITDA-gearing does not influence return outcomes. The results generally hold across different divisions of the dataset except for the lowest leveraged companies. Additionally, it appears that industry-specific factors within both the Financials and Information Technology sectors result in leverage having no impact on IRR. In terms of risk-adjusted returns, there was no significant relationship between D/E and Treynor Ratio, suggesting that higher returns from increased leverage merely compensate for the higher risk associated with leverage without yielding extraordinary rewards. Furthermore, the results show a significant negative relationship between D/EBITDA and Treynor Ratio, suggesting that the riskreturn relationship is, in fact, negatively affected as leverage increases relative to EBITDA. Thus, the marginal gain in IRR from increasing leverage diminishes as EBITDA leverage rises, hence PE funds do not receive extraordinary rewards from high leverage but rather a worse risk-return trade-off.