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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 .

But why does private equity love debt so much? Well it鈥檚 all about maximising returns in a rising market.

Here鈥檚 how the maths works. Assume for a second that you are lucky enough to have 拢1m and that you bought a whole company for 拢1m four years ago. That鈥檚 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 拢950,000. Not bad, you might think.

But now let鈥檚 do it the way that private equity would do it. They would have used your 拢1m and borrowed a further 拢4m from banks and other financial institutions. That gave them 拢5m to spend, which is why they bought a bigger company for 拢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 拢5m to 拢9.75m.

What鈥檚 the gain on the 拢1m of your money, the return on equity? That return is calculated after the 拢4m of borrowed money is repaid. After the business has been sold and the 拢4m of debt has been paid back, 拢5.75m would be left.

Here鈥檚 why it鈥檚 time to open the Krug. Through the magic of what鈥檚 called leverage or gearing, the private-equity approach has turned your 拢1m into 拢5.75m. Instead of a 95% profit, you鈥檝e made a 475% profit.

I have simplified what goes on in a real private equity deal. In particular, I鈥檝e 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鈥檚 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鈥檝e 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鈥檝e 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鈥檝e described. How can that be proved? Well, their returns exceed the so-called 鈥渓everaged鈥� returns of the stock market as a whole.

But that鈥檚 certainly not true of all of them 鈥� 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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