The Benefits of LeverageBy Scott Dickes
Using debt (borrowing) to finance a leveraged buy-out is often maligned by the media or politicians and frequently positioned as risky, destructive, or even dangerous. Others view the tax deductibility of interest payments to be unfair or bad for society. (I never hear these same people saying the taxes paid on interest income to be destructive or bad for society – but that is a discussion for another post.)
Sayings like: “Neither a borrower nor a lender be” ring true to many people. Great Americans like Benjamin Franklin and Andrew Jackson have been quoted as saying “I’d rather go to bed supper-less than rise in debt” and “when you get in debt you become a slave.”
Hadley Capital believes that debt, when properly used, is an important and useful tool. If the capital structure is poorly organized and if the business unexpectedly underperforms, leverage can compound problems. But if done right, there are benefits to leverage.
[Note: This post does not look at the negatives of leverage or how to determine the proper capital structure. This post simply looks at the benefits of leverage assuming that it is the right capital structure and that the business performs to expectations.]
As proponents of leverage, Hadley Capital sees four main benefits of using term debt to finance a portion of a transaction’s purchase price. I will talk about the first benefit in this post and benefits #2–4 in a follow up post.
Benefit #1: Interest Tax Shields.
Because interest expense is deductible for income tax purposes, paying interest lowers your income tax liability. Sophisticated financiers can determine the expected net present value of the income tax shield associated with the interest payments.
While Hadley Capital’s portfolio company gets to deduct the interest tax expense, it is important to note that this benefit does not really accrue to the portfolio company – it generally accrues to the person who sold the business to Hadley Capital. Why? Because the tax deductibility of interest payments is universal and available to all buyers. Since all buyers have access to the value of the interest tax shield, all buyers are willing to increase their purchase price by a like amount. So the interest tax shield benefits accrue to the business seller. Don’t believe me? There are many excellent academic studies confirming this point. Here is an abstract from an Oxford Business School study for your enjoyment. Following the abstract is a link to the full study.
“Tax savings associated with increased levels of debt are often thought to be an important source of returns for private equity funds conducting leveraged buyouts (LBOs). However, as leverage is available to all bidders, the vendors may appropriate any benefits in the form of the takeover premium. For the 100 largest U.S. public-to-private LBOs since 2003, we estimate the size of the additional tax benefits available to private equity purchasers. We find a strong cross-sectional relationship between tax savings and the size of takeover premia; and on average the latter are around twice the size of the former. Consequently, the tax savings from increasing financial leverage essentially accrue to the previous shareholders rather than the private equity fund that conducts the LBO. It is, therefore, unlikely that (ex ante predictable) tax savings are an important source of returns for private equity funds. Furthermore, policy proposals that aim to restrict leverage or the tax deductibility of debt are likely to have their impact mainly on existing owners of companies.”