Private Equity Owns the Bank
Private equity-owned businesses have advantages when taking on leverage — Public companies, without these advantages, should use less debt — Ignoring the difference can leave public shareholders exposed.
PRIVATE EQUITY OWNS THE BANK
Using debt to finance a business in the public markets is markedly different from using it in the private markets. Private equity firms routinely lever businesses at 4, 5, or even 6x EBITDA, while a public company with anything much above 3x is considered too risky for many investors.
Management teams that cite their private peers’ leverage expose themselves as having misread the differences between the two forms of ownership. The gap in leverage is real, and there are logical reasons for it, even if they are not widely appreciated.
One vs. Many
The most important difference between private and public equity ownership, as it relates to financing, is the relationship with debt providers. Private equity-backed companies typically sit inside a broader fund, and the creditor's relationship is with the sponsor as opposed to the portfolio company.
For the lenders, the recurring fees from underwriting ongoing deals with a specific sponsor are a key driver of revenue and profit. Access to future deals matters to the creditor's business. It matters more, in fact, than the performance of any one loan.
When a business within a private equity portfolio runs into distress, the lender is likely to be flexible, amending the debt agreement and playing nice with the sponsor. Taking a hard line on any one deal, at the cost of a multi-deal relationship, makes no commercial sense.
This dynamic is completely different in the public markets. Each business is a single relationship for a lender. Particularly for small caps, which may only raise debt every few years, there is no book of future business to protect, and no reason to treat any borrower preferentially. In times of stress, lenders may not be nearly as flexible.
Public Debt
Both private and public businesses often have publicly traded bonds. Once listed, those bonds expose the business to potentially predatory debt holders. In distress, they can end up in the hands of investors who would rather push a business into bankruptcy to extract value than wait for a recovery.
Private equity-backed businesses, again with the backing of a larger fund, have a simple solution. A private equity fund can inject equity into the business at any time, essentially selling itself more shares. If the equity is worth saving, the fund can protect its prior investment from predatory debt investors.
A public company cannot reliably do the same. New equity means a dilutive raise at the worst possible moment. This asymmetry is well understood by activist debt investors, which makes public companies the likelier target.
When activists do target private equity-owned companies, and a fund chooses not to add equity to protect its investment, the activist should pause. An owner with far better information has decided the equity isn’t worth saving. Maybe the potential returns are lower than the debt investor believes.
Control
The entire business of private equity is built on using leverage to accelerate equity returns, and the industry has decades of experience operating under highly levered conditions. Contrast this with most public companies, where high leverage is a temporary phenomenon. Private equity-backed companies are set up to handle debt properly.
A private equity-owned business has a single controlling owner. Under pressure, the owner has every possible tool available to protect its equity from creditors: cutting capex, restructuring, selling off assets, extracting working capital. The business can completely and rapidly redirect its daily cash flow.
A public business has these same tools on paper, but executing is harder given the varying demands of shareholders. If the public valuation is low, some shareholders may call for buybacks over debt paydown. Others may want the dividend held, or a sale process. The board mediates, and time passes. None of this happens in a privately held business, where there is one owner and one mandate.
Institutional Knowledge
Private equity funds also understand how to structure their debt. Covenants, maturities, spreads, currencies — issuing debt properly is not an easy task, and having experience across a portfolio of businesses is valuable. The pitfalls are well known. A new CFO has substantial support from the sponsor, on top of the relationship advantages already mentioned. Creative workouts, amendment opportunities, and sponsor-backed solutions are all in the playbook.
Public small-cap teams take on high leverage far less often, and when they do, they are often learning on the job, with a board and a banking group learning alongside them.
Timelines
Private equity sponsors also match the duration of their debt to their exit timing. Lender, sponsor, and management are all working inside roughly the same window. Public shareholders share no such clock. Passive investors may have an infinite horizon, while active managers, pod shops, and hedge funds want quarterly results.
Some public investors know they will not be around when the debt comes due. Their incentive is to extract as much value as possible before disaster strikes. That dynamic does not exist in private markets.
Know Your Weaknesses
Most publicly traded businesses, particularly small caps, are at a disadvantage when it comes to using debt. Private equity-owned players are simply better equipped to raise, manage, and amend debt when necessary. They have the bank relationship, the control, the playbook, and a timeline that lines up with the liabilities.
A public company that imports a private equity leverage profile without the corresponding creditor relationships and expertise is borrowing someone else’s playbook without the conditions that make it work. Publicly listed businesses need to acknowledge these differences. For most of them, that means carrying less leverage than their private peers, not catching up to them.
