As far as investing funds in private equity, is debt (the majority constituent of such funds) more or less risky? Debt being senior to equity should have less risk; however, these investments consist of more than 70% debt which raises the probability of default.
There are tricky situations
1. If Debt is more WACC (Weighted Average Cost of Capital) comes down, so most businesses prefer Debt over Equity
2. Especially when BEP (Break Even Point) is low Debt could be used in good effect, also, the credit Risk, Default Risk, Deferment Risk and Re investment Risk due to interest rate fluctuations makes it difficult to predict too.
3. Equity on the other could be predicted better using Sharpe Ratio, or, Risk adjusted return measures along with dispersion from the mean and R Squared.
Now the question is, the country as a whole, if emerged countries are in question then both could be less risky and more predictable, but for emerging and nations below that both could be equally unpredictable.
I hope it will help you.
Hi,
Yes equity in buyouts is more volatile than senior debt or even junior debt. But even if there are a lot of debts Inside the capital structure of the financial set-up, the reputation of the private equity firm compells it to protect the target firm against bankruptcy. In fact, at the next financial round, it could be difficult for the private equity firm to explain its limited partners that its choice was wrong concerning the target firm. So except some cases, they will try to rescue the target firm, even if they have to buyback some of the debt of the target company.
Greetings.
Hi,
To have an idea of the financial pressure born by fund managers in LBO, you could read:
"Fund managers under pressure: rationale and determinants of secondary buyouts", Journal of Financial Economics 2015, 115, p 102-135.
Best regards.
Thank you Patrick for your reply! Is there an upper limit to the debt that can be advanced to the target? Will an institution lend more than the total value of the borrower's assets?
Hi,
Usually the financial set-up for a LBO is 70% debt and 30% of equity. In some circumstances it could be 80% of debt (in the1980's), or less than 70% when fund managers need to invest soon the money (equity) they got from their limited partners. But, i think that 80% of debt is a maximum.
Best regards.
HI,
Default risk is not so important for LBOs, while still existing. This is because private equity funds want to preserve their reputation on the Financial market. So when there is a problem in a target LBO firm, they are ready to buyback some debts or/and to inject new funds Inside the firm. You may also be interested by this paper:
F degeoprge, J Martin, L Phalippou, "On secondary buouts", Journal of Financial Economics 2016, 120, p 124 -145.
Best regards.
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