Leverage drives up prices, not returns

Despite a reputation for the contrary, it turns out that private equity pays more of a premium for assets than its strategic counterparts. According to recent research, money multiples in Europe's mid-market stand around 3x for businesses exited via a sale to a financial backer, versus just 2.4x for trade sales or IPOs. The figures are based on a recent study led by Professor Christoph Kaserer of the Technical University of Munich and released this week at the EVCA Mid-Market Forum in Budapest.

The study canvassed financial information on 332 European fully exited mid-market buyout deals undertaken by 18 different EVCA member firms between 1990 and 2011. The average deal size is €125m and the average debt ratio was 35%.

There may be different reasons why PE buyers pay more. Cynics cite a capital overhang and LP pressure to deploy capital driving up prices "Under specific market conditions it may be related to the "money chasing deals" phenomenon. However, a more general point is that PE buyers are willing to exploit the leverage effect to a larger extent than strategic buyers are. Therefore, everything else held constant, PE buyers are attaching a higher value to a target because of the benefit of leverage," Kaserer explained to unquote". Others suggest it may be the result of multiple arbitrage as mid-market firms sell upmarket to larger buyout houses. Which is how any healthy secondary (or tertiary) makes sense.

The data also proved a more widely accepted norm: that earnings growth is the main component of returns in the mid-market. On average, it accounted for up to three quarters of the overall return with sales growth deemed the most crucial enhancer of returns. Multiple enhancement may be negative according to the study.

More controversially, higher leverage levels do not necessarily translate to higher returns. It suggests that leverage - despite its reputation as a returns enhancer - actually has minimal impact. Explains Kaserer: "On average we find that about one third of the overall return comes from leverage. However, if we look more carefully into this result, it turns out that is rather unstable. That means that the variation of this leverage contribution from deal to deal is very high. Therefore, from a statistical point of view we are not even sure whether there is an impact of leverage at all."

The study reveals that the multiple of the 50% of deals with the highest debt-to-EBITDA multiples was 2.5x, while it was just marginally lower at 2.3x for those with the lowest levels of leverage. This variance of just 0.2x is deemed statistically insignificant. In fact, the study goes on to suggest that higher leverage levels actually line the pockets of vendors, rather than the buyers. This is likely the result of leverage allowing a bidder to win via the highest price.

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