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Do Limitations on Private Equity Leverage Make Sense?

Ulf Axelson and colleagues

Monday 17 May

Today the European Parliament is set to vote on the proposed Directive for regulation of Alternative Investment Fund Managers (AIFMD). The directive's measures are aimed at curbing the excessive leverage and risk taking considered being responsible, in part, for the current financial crisis.  Specifically targeted are private equity and hedge funds, with the discussion centering (among other things) around limits on the amount of leverage that funds can use in their investments.

From our perspective as academic researchers, we believe that the proposed regulation is at best ineffective and at worst will impose significant costs on the European economy. Private equity and leveraged buyouts are a vital component in the European industrial and financial landscape for sustaining future growth and competitiveness.

One argument for imposing leverage restrictions on private equity investors concerns fears that excessive leverage might lead to costs that have to be borne by the rest of the economy.  If, for example, a private equity fund acquires a company and forces it to take on large amounts of debt, causing the company later on to become financially distressed or go bankrupt, this imposes cost on employees, suppliers, customers, and tax-payers alike.

However, there are problems with this argument on several levels. Firstly, research shows that firms run by private equity funds tend to do at least as well or better than their industry peers when it comes to operating performance, and neither employment levels nor long-term investment seem to suffer as a consequence. Research also shows that private equity firms use "best in class" corporate governance, and part of the improvements in efficiency can be tied to the disciplinary role debt has on managers. Even in the case where leverage buyout (LBO) firms do go into financial distress due to excessive leverage, they typically emerge stronger than they had been pre-LBO ownership.

Furthermore, even if we do think leverage causes damage to the economy, why single out private equity owned firms rather than impose leverage restrictions on all firms? There are reasons to believe that a private equity owned firm is better equipped to handle leverage than other public or private firms, since they typically have better access to additional capital which can be used to support a distressed company.

And the "one size fits all" limit on leverage does not fit the needs of heterogeneous firms. While a certain level of debt may be excessive for, say, a biotech company, the same level of debt may be perfectly justified for a hotel operator. 

Another motive behind the proposed regulation is the claim that highly levered private equity transactions increase systemic risks and contribute to financial instability. But existing research fails to find any relation between private equity activity and the severity of economic downturns, and most private equity investments are simply not large enough to cause serious systemic risks. 

The costs to the economy of imposing leverage restrictions on private equity could potentially be quite significant. It will likely lead private equity funds to abandon investment in certain sectors, regions and countries, often those in most need of the capital infusion, advice, and turnaround strategies provided by private equity firms. Small and medium-sized private companies – the prime targets for much of private equity activity – have a particularly hard time attracting funds to finance their investment and growth, especially during economic downturns. To further limit the capital flows to European SMEs, during a period when banks are still recovering from the crisis and are lending cautiously, is likely to have a large, negative impact on long-term economic growth in Europe.

Finally, it is not clear that the proposed regulation will be effective in limiting leverage. Funds will try to by-pass regulation by replacing debt with off-balance sheet financing, such as securitization of revenues or leasing, or by other types of financial engineering. These implicit leverage methods lead to the same financial distress risks as debt, but are more costly to set up and harder to restructure in distress situations. Also, since the proposal only targets European private equity funds, it is likely that investment activities will be taken over by investors with a different organizational form such as subsidiaries of pension funds and sovereign wealth funds, or other investment vehicles registered outside of the EU. The competitive disadvantage that could be imposed on EU-based private equity managers is very unfortunate, since these domestic investors have unique skills in adding value to European firms thanks to their local knowledge and competencies.

Rather than continuing with the ineffective AIFMD proposal, we favour two more direct regulatory routes if one is worried about excessive leverage. First, remove the tax deductibility of interest on company loans existing in most countries. This would reduce an artificially created incentive to lever up, avoid the one-size-fits-all rigidity of the AIFMD proposal, and apply equally to all firms irrespective of their ownership structure. Second, increase the amount of regulatory capital that banks and other financial institutions need to hold against risky loans. Regulating the providers of debt capital is much more likely to get at the root of the problem of systemic risk relative to a narrow focus on private equity funds.

Ulf Axelson, Reader/Associate Professor in Finance, London School of Economics and Political Science

Carsten Bienz, Associate Professor, Norwegian School of Economics and Business Administration & Research Associate, London School of Economics and Political Science

Francesca Cornelli, Professor of Finance, London Business School

Marco Da Rin, Associate Professor of Finance, Tilburg University

Jose Miguel Gaspar, Associate Professor of Finance, ESSEC Business School, France

Ulrich Hege, Associate Professor of Finance, HEC Paris

Ludovic Phalippou, Associate Professor of Finance, University of Amsterdam

Armin Schwienbacher, Associate Professor of Finance, Univérsité de Louvain & University of Amsterdam

Per Strömberg, Director of the Institute for Financial Research (SIFR) & Professor of Finance at the Stockholm School of Economics

Uwe Walz, Professor of Economics, Goethe University Frankfurt