Private equity is leveraged equity

How risky is all that debt?

Robert Armstrong


Is anyone reading this? 

I kind of hope not. 

It is the Friday before the Labor Day weekend and I prefer to imagine all Unhedged readers on a beach, with a detective novel and a beer. 

But I suppose today’s letter — another stab at interpreting private equity’s middling performance over the past decade — will still be interesting if read later in September.


What’s so great about private equity? (part two)

On Wednesday, I wrote about this data from Cliffwater, and other data like it. 

It shows the realised returns of a whole bunch of state pension plans from various asset classes:


Stocks investments and private equity investments, industry-wide, have delivered about the same annual returns after fees over the past decade, when compared on a like-for-like basis. 

Everyone seems to agree on this basic point (if you have evidence to the contrary, please do send it along). 

If I’m running a big pension fund, how should I feel about this? 

Should I be happy? 

After all, compounding for 10 years at 13 per cent a year is a good way to get rich. 

Or should I be disappointed, because the whole reason I got into PE is because it’s supposed to outperform stocks? 

One standard case for disappointment is that PE has delivered equity index-like returns recently, but also made some PE fund managers amazingly rich, and this is dumb and annoying, because the managers didn’t really do much to earn all the treasure. 

But Unhedged doesn’t really care if managers get rich, whether they deserve it or not. 

What matters is returns to investors.

But there is another argument for being disappointed, an argument about debt. 

According to Bloomberg, the average debt/ebitda ratio for companies in the S&P 600 small cap index (most PE deals involve small companies) is about 3. 

The average debt/ebitda ratios of PE deals, according to PitchBook, is twice that. 

If my maths is right (assuming an enterprise value/ebitda ratio of 13) that means that a manager could lever the equity index up by about a third and create a sort of synthetic PE — call it “leveraged equity”. 

That is, they could buy each dollar of the index with 70 cents of their own money, and thirty cents of margin debt. 

And their returns would have been better than PE over the past decade. 

This is the same as arguing that PE’s risk-adjusted returns were worse than equities, because PE is a lot more leveraged and leverage is risk.

But this argument is at least partly wrong. Say there is a recession and the stock market goes down by 30 per cent. 

The owner of the leveraged equity portfolio gets a margin call and is wiped out. 

But the investor in the private equity fund gets a nice gentle markdown from the wimp of an accountant on the fund’s payroll, and their investment survives. 

The cash flows of the companies owned by the PE fund fall too, but cash flows are not as volatile as stock prices, making the chance of a wipeout lower. 

And if any of the companies in the portfolio do threaten to go bust, the fund can prop them up, either with uninvested cash, or by putting new money in — diluting the investors, but protecting them from bigger losses, if the companies eventually recover. 

Generalising the point, a lot of the value that PE creates (Most? All?) comes from the fact that the investors’ money is locked up for many years and the investments themselves are not marked to market. 

This gives the PE manager an option of when to buy, when to sell, when to invest cash, and when to pull cash out. 

Public companies, hostage to the share price, don’t enjoy this optionality. 

This optionality is valuable because it allows the PE fund to use more leverage. 

It is real value. 

What I can’t figure out how much of it is merely optical value — the fact that PE investments just look less volatile than public equity investments, because they get easy marks — and how much of it is real. 

And without figuring that out, it’s hard to know if, or by how much, PEs reported returns should be risk-adjusted.

But we know the apparent volatility of PE is very low, and that institutional investors care about that a lot, whatever the underlying risks are. 

Here is a slide from a presentation about PE investing put together by a very, very large pension manager (sent to me by a reader). 

Whoever made the slide has gone through the effort of calculating the volatility of levered small caps (the little blue diamonds), and compared it to that of PE (maroon square):


Note the text in the big blue arrow. 

What the manager is excited about is the low observed volatility of PE compared to leveraged equities. 

It’s interesting that the slide does not note how leveraged the private equity is. 

Neither does the rest of the presentation. 

In other words, if the observed volatility is low, leverage is not a relevant risk.

Yet leverage is obviously a big contributor to PE returns, and competent management of leverage is the main way PE fund managers provide value. 

The industry is not always keen to point this out. 

In 2016, KPMG published an excellent report, written by Peter Morris, about the “value bridge” methodology of decomposing sources of return, popular with some in the PE industry. 

Amazingly, it leaves out leverage as a source of return almost entirely.

Here’s how it works. A PE fund buys a company for X and sells it some years later for Y. 

The value bridge breaks down that increase in value (Y-Z) into three parts: the increase in profits of the company while the PE firm owned it, the increase in the multiple of profits, and the amount of debt the company added or repaid, adjusted for any dividends paid to the managers. 

This is all true and fair as far as it goes. 

The problem is it does not treat the leverage used to buy the company as a source of return. 

Compare this to a home purchase. 

If I buy a house for $1m, get an $800,000 mortgage, and later sell the house for $1.2m, I’ve doubled my money (not including interest payments). 

I did not double the value of the house, though. 

Most of the value was created by the leverage. 

In assessing my genius as a real estate investor this fact bears mentioning.

I know what you are thinking: that the value bridge, as a way of describing where value comes from in private equity, sounds so jejune that proper companies can’t possibly use it any more.

Well, here is a passage from the IPO prospectus of the London-listed PE firm Bridgepoint, which came out in July:

From 2000 to 2020, an estimated 77 per cent of value creation across profitable investments has been driven by revenue growth and earnings improvement in the Bridgepoint private equity funds, with a further 25 per cent driven by multiple expansion at exit as a result of the repositioning of portfolio companies for growth and professionalisation, slightly offset by (2) per cent from deleveraging.

That’s the value bridge all right, and as such, leverage in the purchase of the investments is not even mentioned as a source of return. 

Everything in the paragraph is true. 

It’s just really weird.

Does the heavy use of leverage by private equity mean that investors should discount the industry’s reported returns, or can PE firms manage the leverage risk away? 

I’m not sure. 

But now that the industry’s reported returns are all but indistinguishable from those available in public markets, it’s the right question for investors to ask.  

China’s changing role in the world economy

Delta variant and supply chain problems are slowing the global recovery

The editorial board

The Caixin manufacturing purchasing managers’ index points to a contraction in China’s manufacturing sector © AFP/Getty


It was inevitable that the pace of the global recovery from the coronavirus pandemic would slow. 

Reopening an economy may often happen in stages but it can only happen once. 

The sudden surge of growth that follows a resumption of economic activity after a lockdown cannot be repeated, and the easing of less stringent restrictions will not lead to the same sort of boost. 

But recent softening in some key data is a concern. 

Not only does it reflect the spread of the more infectious Delta variant and supply chain worries but also a slowdown in China.

The rapid growth of an industrialising China — aided by government stimulus — helped the global economy to recover from the 2008 financial crisis. 

Last year, too, a strong rebound in the country’s industrial production made it one of the few to register positive growth in 2020. 

Now, however, there are signs that its recovery is losing momentum. 

This is due partly to the re-emergence of longstanding worries over levels of consumer and corporate debt as well as the changing priorities of the governing Communist party.

On Wednesday, the Caixin manufacturing purchasing managers’ index, one of the most closely watched independent indicators of the strength of what is on some measures the world’s largest economy, pointed to a contraction in China’s manufacturing sector. 

This is the first since April 2020, when large parts of the world went into lockdown to cope with the pandemic.

In part, the slowdown in activity reflects the same factors hampering the recovery elsewhere. 

The spread of the Delta variant has pushed many parts of China back into lockdown and the government has reintroduced regional travel restrictions. 

Supply chain problems, too, are preventing manufacturers from being able to respond to higher orders as quickly as they would like. 

Shortages of semiconductors and shipping containers have combined with a Covid-19 outbreak in Vietnam, itself a manufacturing powerhouse, to limit industrial production.

In the US, delta has similarly led to slower growth, where increasing case numbers have sapped consumers’ appetite to spend. 

In Europe, supply chain woes have contributed to rising inflation. 

The pace of price growth in the eurozone reached its highest level for a decade in July, according to the official figures published earlier this week. 

Partly that is due to “base effects” as the annual figures are compared to unusually low prices last year, but manufacturers are also being held back by the same shortages as their counterparts in China.

In China, however, there is the added concern over debt and the potential end of a long housing boom in the country. 

Property developer Evergrande, the most indebted of China’s homebuilders, has warned it is on the edge of default. 

Developers across the board are now facing higher interest costs. 

Partly that is the intended outcome of last year’s moves by the Communist party to reduce the economy’s dependence on real estate and limit the use of debt among property developers.

Across the board, China’s government is not prioritising growth as it once did but instead trying to rein in unbridled capitalism, whether the power of big technology companies or rising economic inequality. 

That may be understandable — a slowdown in aluminium production has been blamed on a determination by the government to cut pollution — but it will mean the country is not the engine of global growth it was after the 2008 financial crisis. 

This time the rest of the world will have to find other engines to power the recovery. 

What is America’s debt ceiling?

And what would happen if Congress failed to raise it?


AT SOME POINT in October—precisely when is uncertain—America’s federal government will be unable to pay its bills, and may default on its debt. 

That is not because the country is in a financial crisis or starved of revenue. 

It is instead due to a toxic combination of America’s dysfunctionally polarised politics and a legal quirk known as the debt ceiling. 

What is it, and why is it important?

The debt ceiling is the legal cap that Congress sets on the amount that the Treasury can borrow. 

It does not authorise any new spending; it simply lets the government pay for what Congress has approved. 

The debt ceiling came into being in 1917; before then, Congress tended to authorise borrowing for specific purposes. 

But when raising money to support America’s entry into the first world war, Congress granted the Treasury more flexibility, eventually setting a comprehensive debt ceiling in 1935.


For many years, raising or adjusting the debt limit was a pro forma congressional function. 

Since 1960, it has done so 78 times: 49 times under Republican presidents, and 29 times when a Democrat was in the White House. 

During Donald Trump’s presidency, a bipartisan congressional majority raised the ceiling three times, and Democrats agreed to a two-year suspension of the ceiling as part of a budget agreement in 2019. 

That suspension expired in late July; since then, the Treasury has been taking “extraordinary measures”, which included suspending investments in some federal retirement and disability funds, to conserve cash.

These measures are nearing the end of their efficacy. 

Janet Yellen, the treasury secretary, warned in 2019 that failing to raise the ceiling would result in “economic catastrophe”. 

In the near term soldiers and pensioners could go unpaid, and America’s extraordinary gains in reducing child poverty could stall or reverse. 

The long-term consequences of defaulting on Treasury securities would be more harmful. 

Defaulting on Treasury securities would be still more harmful. 

The dollar is the world’s reserve currency and much of the global financial system is built on the assumption that Treasuries are risk-free; the abrupt reversal of that assumption could trigger a financial crisis. 

American consumers would face higher borrowing costs, making everything they buy with debt—homes, cars, anything on a credit card—more expensive. 

The last time America flirted with a default, Standard & Poor’s, a ratings agency, stripped America of its AAA rating.

This time, the brinkmanship is part of a broader battle over spending. 

On September 21st Democrats in the House of Representatives passed a bill to lift the debt ceiling, extend government funding through December and pay for relief from recent natural disasters. 

Senate Republicans say they will not approve an increase, but Democrats want to test that resolve: they believe Republicans will cave rather than cause a default and government shutdown, and they also believe they may be able to pick up a few votes from Republicans representing states hit by hurricanes. 

Republicans want Democrats to pass the bill on a party-line vote, which is possible with the right sort of parliamentary manoeuvres, and which would let them keep their powder dry and paint Democrats as the party of irresponsible spending (never mind that raising the debt limit simply lets the government pay bills racked up under previous administrations). 

Which party blinks first remains unclear, but someone will. 

Provoking a financial crisis and a government shutdown at the same time would be an extraordinary act of self-sabotage.

Evergrande and financial contagion 

Robert Armstrong


Here’s a chart, drawn using data from the Bank for International Settlements:

 No alt provided


The debts of China’s companies are, relative to its economy, twice as large as those of American companies. 

I do not think of American companies as being particularly shy about using debt, so this impresses me. 

Looking at that chart, it is natural to wonder whether China’s corporate economy might be rather fragile. 

After all, if American companies doubled their debt from where it stands now, that would scare everyone to death. 

As we have all learnt in recent weeks, the property developer Evergrande is exactly the kind of thing one might be worried about in a highly indebted corporate economy. 

Consider the numbers. 

In August last year, the central government imposed “three red lines” on property developer balance sheets, demanding liability/asset ratios below 70 per cent, net debt/equity ratios below 100 per cent, and cash/short-term debt ratios of at least 1. 

If developers fail all three of these tests, they are forbidden from adding additional debt. 

Here is how Evergrande was faring at the end of June:

 No alt provided


These are some big, ugly numbers, and it seems that Evergrande will miss debt payments this week. 

It may not survive long in its current form. 

Shouldn’t there be systemic implications when a highly leveraged company of Evergrande’s size defaults? 

You might think so, but the overwhelming consensus is that while China’s property sector might be hurt, its financial system will be fine: 

Ming Tan, a director at the credit rating agency Standard & Poor’s who follows Chinese banks, said Evergrande defaulting on its debts was unlikely to cause a credit crisis in the world’s second-largest economy “by itself”. 

“Banks’ exposure to Evergrande is quite distributed across the sector,” he said. 

The main risk for China’s financial system would be “other highly leveraged developers to default at the same time”, he added.

That is not very reassuring. 

Property developers do not tend to default alone. 

Speculative excess in property is not, as a rule, confined to single companies. 

But the main reason so few people think that Evergrande will become a systemic event is that they believe the Chinese government can solve debt problems more or less at will. 

The Communist party can tell the state-owned commercial banks to roll the debt over, restructure it, forgive it or whatever. 

Here, for example, are Joachim Klement and Susana Cruz of Liberum:

In our base case scenario, China Evergrande will be allowed to collapse with the most profitable parts of its business bought up by rivals and the debt underwritten by either the [People’s Bank of China] directly, or by a consortium of Chinese commercial banks with the help of a liquidity injection by the PBOC.

Something like this is almost surely correct. 

The whole point of China’s mostly self-contained financial system is that most of the debt is owned by one part of the country to another. 

The party is in control of all of those parts, and so the debt is, essentially, whatever the party says it is.

At the same time, it seems to me that the official intervention might have to extend quite a bit further than chopping up Evergrande for parts and restructuring away its bank debt. 

The ugliest number on Evergrande’s balance sheet is not captured in the red lines ratios at all. It is, instead, Evergrande’s Rmb951bn ($142bn) in short-term payables. 

There are a lot of companies that sell cement, rebar, floor tiles and copper pipe, all across China, who are freaking out right now, and they are going to have to be dealt with, too. 

There is another non-bank constituency to worry about, too. 

What if the Evergrande mess shakes confidence in the property market? 

A little under a year ago the FT ran this chart: 

 No alt provided


If my house has gone up in value by 50 per cent in five years, I start to think of myself as rich. 

Maybe I borrow against the house, or maybe I retire early, or whatever. 

In any case, if I wake up one morning and my house is worth 25 per cent less than it was, I’m going to be grouchy, and my anger is going to have political as well as economic repercussions. 

The Chinese authorities, of course, have clamped down on the real estate industry precisely because they do not want an economy built on paper profits on houses. 

But, from the point of view of social and economic stability, they are riding a tiger, and it is not totally obvious to me that they can dismount safely. 

Again, the point is that dealing with Evergrande’s debts looks like the easy part. 

The analogy with credit crises in western economies is probably not very useful when thinking about Evergrande. 

The risk that broken financial plumbing leads to a general flight from risk seems small. 

But it’s not hard to see how a prolonged, messy and psychologically costly mop-up could kill growth in the most important part of the Chinese economy. 

America Is Giving the World a Disturbing New Kind of War

By Samuel Moyn

Credit...Ariel Davis



In a speech on Tuesday, President Biden identified his decision to withdraw from Afghanistan with his desire to end the “forever war.” 

But he also promised that America will “maintain the fight against terrorism in Afghanistan and in other countries.” 

The reality today, he said, is that “we don’t need to fight a ground war to do it.”

In this, Mr. Biden’s speech made explicit what was already obvious. 

With the last American troops now out of the country, it is clearer what America’s bequest to the world has been over the past 20 years: a disturbing new form of counterterrorist belligerency, at once endless and humane. 

This has transformed American traditions of warmaking, and the withdrawal from Afghanistan is, in fact, a final step in the transformation.

The desire to fight more-humane war would not have made sense to prior generations of Americans. 

Originating in constant and pitiless wars against Native people, American fighting was brutal even before it went abroad. 

Similar violence was later extended against Filipinos in the country’s first overseas imperial counterinsurgency. 

Air war only intensified American traditions of brutality, and in World War II, the Korean War and Vietnam, few limits were respected, either in principle or practice. 

Asian foes were regularly compared to Native Americans — and were legitimate targets of the same violence — by commentators and soldiers.

Those traditions hardly evaporated after Sept. 11, 2001. 

The Middle East was sometimes treated as a new frontier; Osama bin Laden was reportedly code-named Geronimo by the forces who killed him in 2011. 

But by that point American culture was already giving rise to a newer tradition — one that continues to characterize the war on terror.

The groundwork was laid after the Vietnam War, which had left many Americans ashamed of their country’s overseas violence. 

At the same time, global activism pushed to make the laws of war, either ignored or permissive before, more humane in content and honored in practice. 

In the 1970s, for the first time, the obligation not to target civilians — especially in aerial bombardment — was put on paper, along with a new requirement to strike only when the expected military advantage outweighed collateral damage.

Humanitarian groups began to monitor the ethics and law of fighting. 

Human Rights Watch, for example, began to do so in 1980s conflicts in Latin America. 

Even more important, the reputational damage caused by Vietnam led some within the U.S. military to conclude that fighting more humanely and legally was vital. 

Law became more and more central to the warrior’s code. 

As the political theorist Michael Walzer remarked, our armed forces had discovered “the usefulness of morality,” which was “something radically new in military history.”

By the end of the Cold War, the die was cast. 

The 1991 gulf war was the first international conflict that Human Rights Watch examined for violations of the law of war and the first in which military lawyers helped pick targets.

But these developments occurred as antiwar energy, which Vietnam inspired, dissipated. 

And the rise of legal probity restricted humanitarians and militaries to bickering about whether the United States was following the rules well enough, rather than whether the wars should be fought in the first place.

More humane war became a companion to an increasingly interventionist foreign policy. 

Earlier wars had not needed to appear humane to win legitimacy from the public, but new ones returned in an altered moral climate. 

By the post-Cold War era, both American political parties were committed to a more principled use of American power. 

Doctrines like democracy promotion and human rights became elaborate rationales for doubling down on militarism.

Then came the years after Sept. 11. 

The specter of torture, like the treatment of detainees at black sites and the detentions at Guantánamo, crystallized a moral sensibility according to which it mattered most to dissidents within George W. Bush’s administration as well as a growing chorus of critics outside not where war went and how long it lasted but whether the laws governing the conduct were respected.

In the wake of the release of the Abu Ghraib photos in April 2004, humanitarian concern helped remove the bug of torture and other indignities from the program of endless war, thereby rebooting it: After all, a critique of a war focused on its egregious conduct can lead to a different and improved version of that war, rather than its end. 

That is precisely what happened.

In the first years of his presidency, Barack Obama capitalized on the emphases of the years just before. 

After running as a peace candidate in 2008, he promised in his critical first months to treat prisoners well and earned plaudits for doing so. 

His administration deleted noxious memos permitting torture and left the ones permitting war.

But it is easier not to mistreat prisoners if you no longer capture them. 

Mr. Obama vastly expanded the war on terror in scope, taking it beyond the two countries on which Mr. Bush had focused to more than 10, relying on drone strikes and special forces raids. 

He also went beyond Mr. Bush in formalizing a humane framework for endless war, announcing in policy that it was not the brutal war of the past but one corrected by the new sensibility.

Astonishingly, Mr. Obama even went beyond what the new laws of war required, promising never to strike off battlefields if there was any risk of collateral damage, a standard that was revealing of a new moral sensibility even if it was — like so many such rules — never adhered to in practice.

In his Nobel Peace Prize address at the end of his first year as president, Mr. Obama offered an almost metaphysical case for America fighting forever, while promising to do so humanely: “We must begin by acknowledging the hard truth: We will not eradicate violent conflict in our lifetimes,” he explained. 

But its humane conduct was “a source of our strength.”

To a striking and unanticipated extent, the humanization of American might is something even President Donald Trump was forced to retain. 

True, he called in 2016 to “bring back waterboarding,” but to the extent that he tried he was held in check. 

(“He better bring his own bucket,” Michael Hayden, the former director of the C.I.A., remarked.) 

And while Mr. Trump decreased transparency around drone strikes and loosened top-down authority, other humane requirements largely remained in place.

It is natural to think that humane war is an oxymoron, and understandable to indict “dirty wars.” 

But that is to miss that a “humane” form of control and surveillance is taking place beyond America’s borders, with death and injury increasingly edited out of public view. 

And the improved humanity of our wars, ostensible and real, is not without its vices. 

Old empires justified brutal acts in the service of human civilization and progress. 

Our version of “humanity” helps compensate for our wars’ extension in time and expansion in space.

When defending withdrawal from Afghanistan, Mr. Biden made clear that he has no plans to give up counterterrorism. 

The infrastructure of drone and missile strikes and special forces raids is indeed ramping up again after the fall of Afghanistan, an antiseptic Frankenstein monster loosed even as the gory laboratory that birthed it closes down.

The continuation of America’s war on terror — with strikes from afar and from overhead and in visits to Afghanistan and many other places for the indefinite future — has many authors. 

But the attempt to make America’s military ways less obviously brutal has contributed decisively to making our wars more acceptable to many and difficult to see for others. 

That is a syndrome we are only pretending to stop.


Samuel Moyn (@samuelmoyn) is a professor of law and history at Yale and the author of the forthcoming book “Humane: How the United States Abandoned Peace and Reinvented War.”