Leverage Multiples in Private Equity
December 3, 2018
December 3, 2018
Leverage in Private vs. Public Equity
Leverage, which is typically measured through ratios such as Net Debt / EBITDA, or as a percentage of total enterprise value, is inseparable from private equity. The asset class was born on leveraged buyouts, after all. However, leverage is not exclusive to the private markets1, as the chart below highlights. In fact, since 2000, private markets have higher leverage multiples than the global public markets only in the last few years.
But, why are leverage multiples useful? Let’s take a further look.
Leverage Multiples: The Basics
Net Debt / EBITDA, commonly called a leverage multiple, is a ratio that compares a proxy for the company’s free cash flow to its debt load (less cash) and can be used to judge the financial health of a company. Companies with high leverage multiples are generally considered to be higher risk investments, as there is a greater chance they may have trouble servicing their debt should trouble arise. Excessive debt loads can also reduce a company’s ability to invest in growth initiatives or survive a downturn. As compensation for increasing the financial risk of an investment, higher leverage increases the returns to equity holders if the company performs well.
How do you know if a company’s leverage multiple is “high” or “low”? The most straightforward way is to compare an individual company’s leverage multiple to other leverage multiples across the private markets industry. Ideally, you can filter the industry data to show only deals with similar characteristics, as different sectors or geographies may have different “normal” leverage levels. To date, this type of information has been difficult to come by.
Technology solutions, like Cobalt LP, are providing this industry level benchmark data to investors. Through the Cobalt LP platform, users are able to access Hamilton Lane’s deal level benchmarks. These benchmarks allow LPs to compare how an individual Net Debt / EBITDA ratio compares to an industry-wide Net Debt / EBITDA ratio, which can be filtered by sector, geography and/or industry. See below for an example:
Source: Hamilton Lane Data via Cobalt LP. For illustrative purposes only.
Is Private Equity Just Leveraged Public Equity?
Now that we have an understanding of how leverage multiples work, let’s turn to an ongoing debate around leverage usage and private markets returns. Some observers have argued that private equity is simply leveraged public equity. In other words, the excess returns yielded by private equity investments are solely the result of private markets companies using more leverage than their public markets counterparts. Applying leverage to a public markets index could replicate private markets returns, these observers argue.
To test this claim (and putting aside that a leveraged public index investment holds leverage at the LP level rather than the company level as in a leveraged buyout), Hamilton Lane compared the returns of a two-times levered S&P5003 ETF to net private equity2 returns over the latest full market cycle. As the chart below shows, despite one of the best public equity bull runs in history, the leveraged public markets index is still lags private equity.
But maybe that isn’t the right comparison. Some observers point out that private equity2 owned companies tend to be smaller than the component companies of the S&P 500. Rather than using the S&P 500 as a benchmark, an index that tracks companies of a more comparable size should be used.
Hamilton Lane conducted the same analysis using a levered Russell 20004 ETF. The analysis yield similar results: private equity has outperformed even this small cap index. The small cap index actually lags even further behind, as the additional leverage exacerbates losses during market corrections.
Leverage Multiples: Key Takeaway
Leverage multiples are an important statistic for LPs to consider when assessing risk in their portfolio. For context on how leverage on the underlying investments in their portfolio compares to the industry, LPs can use tools like Cobalt LP’s Deal Level Benchmarks (powered by Hamilton Lane data).
1 All Private Markets – Hamilton Lane’s definition of “All Private Markets” includes all private commingled funds excluding fund-of-funds, and secondary fund-of-funds.
2 Private Equity – A broad term used to describe any fund that offers equity capital to private companies.
3 S&P 500 Index – The S&P 500 Index tracks the 500 largest companies based on market cap of companies listed on NYSE or NASDAQ.
4 Russell 2000 Index – The Russell 2000 Index is composed of the 2000 smallest companies of the Russell 3000 Index. The Russell 3000 Index is composed of 3000 large U.S. companies, as determined by market capitalization.