Six Disadvantages of Highly Levered Firms

In a recent blog I talked about the ways Acquisition Finance creates value.  To be sure, I believe that private equity firms and free enterprise in general have been greatly misunderstood and unfairly criticized in the popular press and in political ads during this election year.  To be fair, however,  I focus this blog on some of the disadvantages of the high leverage often associated with acquisition finance.  Six disadvantages are listed below:

• ·      Leverage is a double-edged sword
• ·      Increased risk of default
• ·      Overpaying
• ·      Political risks
• ·      Less access to capital markets
• ·      The need to cash-out

Put simply, leverage is a double edged sword.  It will magnify owner returns in good times and diminish them in bad times.  It is a sword that cuts both ways.  In general, we have two ways to finance a business: debt or equity.  In a physical sense, debt (leverage) magnifies our ability to lift an object.  Here, that object is the equity rate of return.  In good times, we pay off the fixed cost of debt (interest) and divide the profit pie among fewer shares producing a greater rate of return.  But in bad times, the reverse is true – we must pay the fixed interest charge regardless of profits.  Equity rate of return declines. 

In the U.K., leverage is known as gearing.  Similarly, one can imagine how using the proper or improper gearing on a bicycle could help – or hinder performance.  Correspondingly, increased leverage brings an increased probability of default.

Easy access to debt facilitates overpaying, which is probably the key factor responsible for less than adequate acquisition returns  (the other candidate is lack of proper integration).

Political risks arise as leveraged deals face adverse commentary in the financial press.  The result can be increased costs through higher levels of governmental regulation.

If a highly levered firm is also going private, there is generally less access to capital markets.

Finally, the typical private equity model assumes a five to seven year cycle.  The private equity firm doesn’t want to be a long term owner, but it does want to work its magic (see the blog on the ways acquisition finance creates value) and then cash out.  But cashing out at a desirable price may not be possible for many reasons.  First, anticipated increases in value may not materialize.  Second, the cyclical nature of industry or financial markets may work against a timely sale.  Third, in spite of best efforts, a suitable buyer may not materialize or may disagree on the value of the firm to be acquired. 

All of these factors produce problems for deals involving acquisition finance.  In later blogs, we will talk about ways acquiring and selling firms can a) have more confidence they are using the proper amount of leverage and b) protect themselves against the risks commonly associated with mergers and acquisitions.

All the best,

Ralph