Key findings
- Understanding the leverage used by buyout portfolio companies is crucial for investors to comprehend the drivers of private-equity performance and risk, a topic even more pertinent in today's shifting economic landscape.
- Over the last decade, global buyout companies had an average leverage ratio of 1.74, with a decrease in leverage since COVID-19, while public companies’ leverage has increased, narrowing the leverage gap.
- There were notable regional and sectoral differences in excess leverage, with the U.S. and sectors such as information technology and health care showing higher excess leverage.
Understanding how much leverage is used in buyouts is essential for several reasons. Leverage can be a key driver of returns in buyout investments, and while high leverage can amplify investment gains, it can also amplify losses, leading to significant risk. Second, investors can better attribute performance to operational improvements rather than financial engineering. Third, investors can better anticipate how buyout portfolios might perform under changing economic scenarios. Additionally, comparing leverage levels in buyouts to those in public equity can provide insights into the relative risk and return profiles of these investment types, helping investors decide where to allocate their capital.
Deciphering the trends in private markets has previously been a challenge due to the lack of transparency. Now, examining MSCI's universe of private-capital data, we can discern private equity's use of leverage over the last decade.
In the 10 years through 2023, global buyout companies had an average leverage ratio of 1.74; that is, on average, 74 cents of borrowing for every dollar of equity investment.[1] By comparison, global small-cap public companies had an average leverage ratio of 1.4 over the same period. Buyout companies' leverage has come down slightly since the onset of the COVID-19 crisis, as shown in the exhibit below.
Compared with small-cap public companies, buyout companies used more than 25% excess leverage on average.[2] However, the excess leverage dropped from almost 36% in 2014 to 11% in 2023. Both the decrease in buyout companies' leverage and the increase in public companies' leverage contributed to the drop in excess leverage, but the change for public companies played a slightly bigger role. The drop in buyout companies' leverage suggests that buyout firms may be growing more cautious with their use of debt, possibly in response to changing economic conditions or increased scrutiny from investors and regulators.[3]
The gap between buyout- and public-company leverage has shrunk
Leverage is represented as an exponentially weighted moving average with a half-life of four quarters.
There have been substantial differences in excess leverage across regions and sectors. As illustrated in the exhibit below, buyout companies in the U.S. have shown the most aggressive excess leverage, followed by those in Europe. Buyout companies in the rest of the world, meanwhile, have borrowed only 5% more than their public-market counterparts. In all regions, excess leverage has come down to varying degrees since 2014. The most dramatic decrease was in the U.S., where excess leverage dropped by about 27 percentage points.
Buyout companies' excess leverage has declined globally
Excess leverage of buyout companies over public small-cap companies.
As for sectoral differences, we show in the exhibit below the excess leverage in sectors that buyout funds are heavily invested in. The average excess leverage is 45% in information technology and health care, 25% in industrials and 24% in consumer discretionary.[4] Even though excess leverage in all four sectors has declined over time, buyout companies in information technology and health care still borrow about 30% more than public companies in the same sectors.[5]
Wide variation in excess leverage across sectors
Excess leverage of buyout companies over public small-cap companies by sector. "All sectors" is the average of all sectors, not only the four sectors shown.
The regional and sectoral variations highlight potential differences in returns and risk that investors should expect from investment strategies based on geographic and sectoral considerations. For instance, the higher excess leverage in the U.S. and in sectors like information technology and health care suggests that these areas might offer higher potential returns but also come with increased risk.
As the global economy has shifted to a new interest-rate regime, institutional investors should be aware of potential changes to buyout performance and risk. Investors should conduct careful ongoing monitoring of buyout funds and their portfolio companies to understand potential risks and returns from specific leverage levels and debt structures. Investors may also consider diversifying their portfolios across different asset classes and regions to mitigate risk. In addition, investors should focus on general partners' ability to generate returns from improving buyout companies' fundamentals and operations rather than relying solely on financial engineering.
Investors can make more informed decisions and better navigate the complexities of private-equity investments by understanding the nuances of buyout leverage and its implications.
1 Buyout companies in this article refers to private companies held in buyout funds' portfolios. Leverage is measured as the ratio of total enterprise value to the value of equity.2 Excess leverage is calculated as the ratio of buyout-company leverage to public-company leverage minus 1. To eliminate the impact of allocation differences between private and public markets on excess leverage, we compute the average public-company leverage based on buyout-allocation weight in each sector by region.3 John Plender, “Private equity has become hazardous terrain for investors,” Financial Times, July 15, 2024.4 Sectors are defined by the Global Industry Classification Standard (GICS®), the industry-classification standard jointly developed by MSCI and S&P Global Market Intelligence.5 While the decrease in excess leverage is consistent across sectors, the main driver was different, especially after the COVID-19 crisis. For consumer discretionary and industrials, the post-crisis decrease was primarily driven by an increase in public-company leverage. For health care and information technology, a decrease in buyout-company leverage was the main cause.
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