Study: Leverage accounts for one-third of returns

As buyout firms adapt to a low-leverage investment climate, research suggests that debt has never been the dominant driver of private equity returns.

The use of leverage by private equity firms to grow companies’ enterprise value accounts for one-third of the total growth, according to a report released today.

The study provides evidence to counter the argument that since private equity firms are heavily reliant on leverage, they will face significant difficulties operating in a post-credit crunch market in which leverage is scarce.

Of the value created by private equity owners, two-thirds can be attributed to operational enhancements and increasing market multiples, says research conducted by European private equity adviser and investor Capital Dynamics in conjunction with the Centre for Entrepreneurial and Financial Studies at the Technical University of Munich.

The universe of 241 private equity-owned businesses studied experienced an average increase in value of 2.72x during an average holding period of three and a half years. Of this growth, 0.89x is accounted for by the use of leverage, while a further 0.88x resulted from positive EBITDA growth.

The remainder is made up of cash flow improvements and growth in multiples, representing 0.42x and 0.47x respectively. The growth in EBITDA was predominantly driven by sales growth – 80 percent – with the remainder resulting from improved margins.

The study examined companies owned by private equity firms between 1989 and 2006 predominantly in Europe.

As the study only included investments exited by 2006, some of the most highly leveraged investments, completed at the height of the credit boom during 2006 and early 2007, will not be accounted for.

Nico Engel, a researcher at the Technical University of Munich and co-author of the report, said that if the study was repeated in two or three years' time, the effect of leverage would be “significantly increased”.

Since leverage has become scarce and expensive, many private equity firms are adjusting their investment strategies to make entirely unleveraged transactions.

UK-headquartered Permira in September agreed its first all-equity acquisition: the £225.5 million (€245 million; $369 million) take-private of specialist financial services group Just Retirement. Advent International this month agreed to acquire German debt collection company GFKL Financial Services in an unleveraged deal for an undisclosed amount.