Job market paper
Detractors have warned that Private Equity (PE) funds tend to over-lever their portfolio companies because of an option-like payoff, building up debt overhang and widespread bankruptcy risks. Drawing on standard trade-off theory, this paper argues PE-ownership leads to higher levels of optimal (value-maximizing) leverage. I develop a dynamic trade-off model where a firm's capital structure and default decisions are made by the PE fund manager, whose payoff captures the PE institutional fee structure. PE-ownership can endogenously change tax benefits of debt and expected cost of financial distress though differences in (i) asset volatility (ii) expected future return and (iii) deadweight bankruptcy costs. Key model parameters are estimated using balance sheet data from a large sample of PE-sponsored leveraged buyouts (LBO). I find the estimated model is able to explain both the level and change in leverage ratios documented empirically following LBOs, driven primarily by changes in the portfolio company hypothesized above. Counterfactual analysis reveals significant loss in firm value if PE sub-optimally chose lower leverage. Post-LBO, I estimate Distance-to-Default increases by 28 percent and credit spreads narrow by 3.6 percentage points for the median firm, suggesting concerns about default risks may have been overstated. Additional tests show PE-backed firms receive equity injections from sponsoring funds if they fall into financial distress, corroborating the lower distress cost channel. My results suggest new policies regulating leveraged loans should focus on the borrower's optimal capital structure.