Do Private Equity Owners Increase Risk of Financial Distress and Bankruptcy?

There is some controversy regarding the key sources of success in the private equity business model and on how this business model affects the portfolio companies. Does this success come from value creation or from value transfer? On the one hand, scholars agree that private equity investors create value by implementing a superior corporate governance mechanism and due to the disciplining role of additional debt resulting from the transaction financing. On the other hand, some scholars and especially some politicians point out potential negative effects of increased indebtedness of portfolio companies and argue that private equity investors rather transfer value from stakeholders or taxpayers than create it. Political debates are often led by concerns about harmful effects of excessive debt levels and higher bankruptcy risks in companies which undergo buyout transactions.

We investigate financial distress risks of European companies around their buyout event in the period 2000 - 2008. In addition, we analyze whether private equity-backed companies go bankrupt more often than comparable companies without private equity investments. Our paper suggests that private equity investors select companies which are less financially distressed than comparable companies prior to the transaction and that the distress risks increase after the buyout. However, the distress risk in private equity-backed companies does not exceed the distress risk in comparable companies three years after the buyout. Despite this risk increase, private equity-backed companies do not suffer from higher bankruptcy rates than the control group. Even those companies subject to buyouts in years with favorable debt market conditions do not suffer from higher bankruptcy rates than other private equity-backed and non-private equity-backed companies. Our results further lend support to the hypothesis that firms backed by experienced private equity investors achieve even lower bankruptcy probability compared to firms backed by inexperienced investors and to firms without private equity investments. Experienced investors seem to be better able to manage distress risks than their inexperienced counterparts.

Tykvova, Tereza and Mariela Borell (2011), Do Private Equity Owners Increase Risk of Financial Distress and Bankruptcy?, ZEW Discussion Paper No. 11-076, Mannheim.