Private Equity and Financial Fragility During the Crisis

Shai Bernstein is Assistant Professor of Finance at Stanford Graduate School of Business. This post is based on a recent paper by Professor Bernstein; Josh LernerJacob H. Schiff Professor of Investment Banking at Harvard Business School; and Filippo Mezzanotti, Assistant Professor of Finance and Donald P. Jacobs Scholar at the Kellogg School of Management. 

The recent global financial crisis increased the attention paid by policy makers, regulators, and academics to financial stability. While much attention has been devoted to deficiencies in the banking system, high levels of corporate debt have also triggered concerns. Highly leveraged firms may enter financial distress during a crisis, exacerbating cutbacks in investment and employment and contributing to the persistence of the downturn. As such, the practices of the private equity (PE) industry, which raised close to $2 trillion in equity before the crisis, raised significant concerns.

Nevertheless, the impact of PE investment patterns on the economy during periods of financial turmoil remains poorly understood. On the one hand, the cyclicality of private equity activity, combined with the leveraging of their portfolio companies, may exacerbate the negative effects of shocks to the financial sector, aggravating the boom and bust dynamic of the economy. In line with this idea, the Bank of England suggests that buyouts should be monitored for macro-prudential reasons, because “the increased indebtedness of such companies poses risk to the stability of the financial system.” [1] Moreover, the pressure to complete deals during boom times may lead to the financing of lower-quality firms (Kaplan and Stein, 1993), leaving PE-backed companies more exposed to changes in underlying economic conditions. Finally, the increased fundraising and investment during boom periods may reduce the ability of private equity groups to effectively monitor and fund their portfolio companies once economic conditions deteriorate.

Alternatively, PE-backed companies may be resilient to downturns, and therefore play a stabilizing role during bad times. In particular, these companies may be better positioned to obtain external funding when financial markets are dysfunctional. First, PE groups have strong ties with the banking industry (Ivashina and Kovner, 2011) and may be able to use these relationships to access credit for their firms during periods of crisis. Second, because PE groups raise funds that are drawn down and invested over multiple years—commitments that are very rarely abrogated—they may have “deep pockets” during downturns. These capital commitments may allow them to make equity investments in their firms when accessing other sources of equity is challenging.

Motivated by these alternative hypotheses, this paper seeks to understand whether private equity contributed to the fragility of the economy during the recent financial crisis in the United Kingdom, which had the largest private equity market as a share of GDP before the crisis. In particular, the paper compares the activity of almost five hundred companies that were backed by PE prior to the financial crisis to a control group of non-PE companies that operate in the same industry and were characterized by similar size, profitability, and leverage in 2007. This approach allows us to explore differences in the way firms performed during the crisis that stem from this organization structure, rather than their balance sheet or investment characteristics.

We find that PE-backed companies decreased investments less than non-PE-backed companies did during the financial crisis. The two groups did not differ significantly in the pre-crisis period, but the investment rate of the PE group substantially diverged from the control group beginning in 2008. In fact, the divergence of the PE group occurs exactly when aggregate investments and credit growth in the UK started to decline sharply.

We argue that this difference in investment can be explained by the fact that private equity firms can help relax the financial constraints of portfolios, making them less by bound by financial constraints. Consistent with this hypothesis, we document three results. First, PE-backed companies were able to issue relatively more equity and debt than the control group during the financial crisis. At the same time, the cost of debt was relatively lower for PE-backed companies during the crisis. Second, the positive effect on investment is particularly large among companies that were ex-ante more likely to be financially constrained during the crisis. Lastly, the increase in investment is larger when the private equity sponsor had more resources available at the onset of the crisis to help the portfolio company. To proxy resource availability, we measure the amount of dry powder—capital raised but not yet invested—that is available to investors at the time of the financial crisis and we look at to whether their most recent fund was at an earlier stage at the time of the financial crisis.

Finally, we examine the performance of PE-backed companies during the financial crisis. We find that PE-backed companies experienced a greater growth in their stock of assets in the years after the crisis, consistent with the greater investment seen above. Similarly, we find that PE-backed companies increased their market share in the industry during the crisis. At the same time, PE-backed companies did not underperform their peers: that is, they did not become relatively less profitable, whether measured by the ratios of EBITDA to revenue or net income to assets. Lastly, we also find that PE-backed companies were not more likely to go bankrupt. These findings are contrary to what would be expected if companies were pursuing value-destroying investments during this period.

Taken together, these results illustrate that PE-backed companies do not appear to be more sensitive to the onset of the financial crisis. Rather, during a period in which capital formation dropped dramatically, PE-backed companies invested more aggressively than peer companies did. This ability to maintain a high level of investment appears related to the superior access of PE-backed companies to financing, in terms of both equity and debt issuances, and the lower cost of debt. Stronger funding and investment led to some improvement in the performance in the post-crisis period.

The complete paper is available for download here.


1Bank of England Quarterly Bulletin, 2013Q1(go back)

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One Comment

  1. Victor Vadaneaux
    Posted Monday, December 4, 2017 at 5:37 pm | Permalink

    Dear Josh,
    While I agree with your findings that PE-backed companies have been more resilient during the crisis, there is no doubt that the high leverage in many of these companies made them more fragile in the first place. In the previous boom years, leverage multiples increased as PE firms had to pay up to win deals. The question is whether PE-induced increased fragility, combined with active PE assistance during the crisis makes PE more or less of a good thing. Regards, Victor