Question

32.Use of Financial Leverage by Private Equity Funds

Explain why private equity funds use a very high degree of financial leverage and how this affects their risk and potential return on investment.

Answer 1

Private equity funds use a very high degree of leverage as they want to expand their overall return on capital by expanding their capital.

Leverage is highly pervasive in private equity markets as they mostly buy and sell companies which are not traded as it is mostly into leveraged buyout to inflate it's returns.

There is a direct relationship between the risk in leverage and Return associated with it as more the amount of leverage, the more is the probability of making higher rate of return .

The risk associated with leverage are that of credit risk and Default risks as credit risk is about the probability of default on overall principal while default risk is about the probability of default on periodic repayments.

In case of private equity, they have to earn such Return of capital that can easily beat the cost of debt to help them stay in the game & make more profits. If their Return on capital is lesser than cost of debt , they will face difficulty in repayments of their debt

So, Debt is like a double edged sword for private equity firms, if used widely it can magnify overall returns, If not, the existence of the firm will be endangered.