Debt is a tool, not a strategy

Most buyouts use borrowed money. That is normal, and it is not wrong in itself. The question is how much, and what the company has to look like for the debt to be safe.

More debt, more failures

Researchers from EMLYON Business School looked at more than ten million company-year records of UK private firms between 1995 and 2009, of which over 140,000 ended in failure. They found that companies with higher debt were significantly more likely to fail, buyout or not. Buyouts failed more often than other companies after adjusting for risk, but private equity-backed deals were not more prone to failure than other buyouts.¹

Two things stand out. Debt is a real risk for any company. And who owns the company matters less than how much it has borrowed.

Steady businesses can carry more

A 2022 Federal Reserve staff paper asks whether private equity over-borrows. Using a model of the cost of financial distress and data on 1,383 buyouts, it finds that companies after a buyout carry about half their value in debt, and that this is close to what the model considers best for them. The main reason is that their cash flows became steadier under private equity ownership, which makes borrowing less risky.²

Treat this with some care. It is a staff working paper, not a peer-reviewed article, the answer depends on assumptions in the model, and the author could match only about half the firms to comparable public companies. The point we take from it is narrower: how much debt is sensible depends on how steady the business is.

Do not count on valuations

Bain & Company's 2024 global private equity report says that over the past decade many buyout funds relied heavily on rising valuations, which owed more to favourable markets than to improvements in the companies. It adds that if interest rates stay high, that source of return may not come back, and that the best deals get a larger share of their value from better margins.³

For us this is a reason to buy at a price that works on today's numbers, and to keep debt low enough that a flat market is survivable.

How we think about it

• We size debt so the company can pay it in a weak year, not only in a good one.
• We borrow more against steady, repeat income than against lumpy, project-based income.
• If a deal only works with a lot of debt, we usually walk away.
• We would rather own a good business with a little debt than a fragile one with a lot.

Key takeaway: debt can help a good business, but it should follow the business and not drive the deal.

If you want to talk about how a sale or investment could be funded without putting the company under strain, we would like to hear from you.