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The banking system bore plenty of scrutiny for its part in the financial crisis of 2008. But what was the impact of other financial entities? Did they dampen or exacerbate financial fragility during the Great Recession?

SIEPR Faculty Fellow Shai Bernstein set out to explore these questions, focusing on private equity (PE) investors. In the wake of the crisis, central bank officials in Europe and the United States debated leverage caps and other constraints to regulate private equity firms. Such firms — which raise multi-billion dollar funds to invest in and buy entire companies — had become a dominant player in the financial sector. The policy debate continues today and Bernstein’s research — conducted with Harvard economist Josh Lerner and Filippo Mezzanotti of Northwestern — provides a better understanding of the role of private equity in times of economic turmoil.

Bernstein, an associate professor of finance at the ��ɫApp Graduate School of Business, shows that contrary to what some think, the PE industry overall enhanced the resiliency of their portfolio companies, which even managed to grow during the 2008 crisis.

In this Q&A, Bernstein discusses his research, the role of policymakers and the good guys and bad guys of the financial crisis.

What were you trying to figure out with this research?

The question we were seeking to answer is fairly simple: Did private equity firms contribute to — or enhance — the financial fragility of the economy during the 2008 financial crisis?

Our motivation to explore this question came from the fact that much attention was devoted to the banking system and how its deficiencies played a role in affecting the fragility of our economic system. However, besides the banking sector, corporations themselves — particularly those with high levels of borrowing — could be yet another reason for the amplification of the financial crises. Highly leveraged firms may be more likely to become distressed during a crisis, leading them to curtail investments, cut jobs, and therefore contribute to the persistence of a downturn.

When one thinks about highly leveraged corporations, the private equity (PE) industry immediately comes to mind.

Why is that? What’s the role of private equity firms?

In the three years preceding the crisis, the PE industry had become a dominant player in the economy. Global PE groups raised almost $2 trillion in equity — with each dollar typically leveraged through the portfolio companies with more than two dollars of debt. And in the United Kingdom, which is where we conduct our study, total PE assets constituted about 11 percent of GDP; PE-backed firms issued an estimated 10 percent of all of the non-financial corporate debt in the U.K.

And that made policymakers take notice?

Yes. The growth of the PE industry — combined with the devastating consequences of the crisis — prompted more policymakers to pay careful attention to the industry. For example, the Bank of England claimed that “the increased indebtedness of such companies poses risk to the stability of the financial system.” These concerns have led to efforts to cap the amount of leverage used in PE transactions. Yet the policy debate lacked systematic evidence about the performance of PE-backed firms during the crisis. Our research set out to address that void.

Why did you base your research on British firms?

We focused on the U.K. for several reasons. First, the U.K. had the largest PE market as a share of GDP before the crisis, and one of the largest markets in absolute value. Second, it is possible to get financial information for private firms in the U.K., unlike in the U.S. This access allowed us to better understand changes in investment behavior and financial strategy during the crisis.

We explored the investment patterns of more than 500 companies that were backed by PE-firms at the onset of the 2008 financial crisis. We compared their behavior to a control group of non-PE-backed companies — other privately held companies that were in the same industry, and were similar in size and profitability.

And what did you find?

During the crisis, corporate investment in the U.K. economy tanked (as in many other countries around the world). This was the case also for the PE-backed firms in our sample. However, it was interesting to note that the decline in investment for PE-backed firms was significantly smaller than the comparable firms. Specifically, we find that in the years leading to the crisis, both the PE-backed firms and the control group followed a very similar trend in terms of investments. But this trend diverged in 2008, at the onset of the financial crisis, when the decline in investment among PE-backed firms was much smaller. Moreover, we find that PE-backed firms increased their assets more rapidly relative to the control group, and also enhanced their market share during the crisis.

We did not find evidence that PE-backed companies were more sensitive to the onset of the financial crisis. Rather, during a period in which capital availability dropped dramatically, PE-backed companies invested more aggressively than peer companies did and grew faster.

What was behind their resilience to the downturn?

Our findings suggest that PE-backed companies had better access to capital and were less bound to financing constraints during the crisis. We find that relative to their peers, PE-backed companies issued more debt and equity, and thus had more resources to finance their operations during the crisis, a period of financial turmoil during which credit markets completely froze.

I think there were a couple of reasons that allowed PE-backed companies to gain better access to financing resources, and, as a consequence, invest more and grow more rapidly relative to their peers. First, the longer time horizon of the PE firms’ funds (average fund life is 10 years) allowed the PE investors to support their portfolio companies during the crisis. Moreover, the PE firms themselves still had capital available to deploy — capital they had raised before the crisis. Consistent with this notion, we indeed find that PE firms with more “dry powder,” or non-deployed capital, at the onset of the crisis, were more able to alleviate financing constraints of their portfolio companies during the crisis.

Another potential explanation is the relationship of PE firms with the banking sector. PE firms repeatedly interact with the banks, raising capital for their portfolio companies. This robust, repeat business may have allowed them to raise debt for their portfolio companies during a tough economic environment, relative to non PE-backed companies.

If you were to characterize the good guys and the bad guys during the ugly financial crisis of 2008, do your findings suggest that the private equity sector didn’t deserve getting a bad rap?

It is hard to characterize the behavior of different players during the financial crisis as “good guys” versus “bad guys.” Ultimately, I believe that different investors and firms were facing different incentives that led to their behavior.

During the crisis, there were clearly a handful of anecdotes that did not portray the PE industry in a positive light, and some firms definitely deserve their bad rap. The beauty of a large-scale statistical analysis is that we can try to evaluate the industry as a whole and explore their overall effect during the crisis on the economy. Our evidence is not consistent with the overall negative view of the PE industry. We did not find evidence that PE-backed companies struggled more than their peers because of their high leverage. To the contrary, we find that they managed to invest and grow more rapidly during the crisis.

How should policymakers think about regulating private equity transactions?

During the crisis, there were significant concerns by policymakers regarding the potentially detrimental consequences of the growth of the private equity industry and its implications on the financial fragility of the economy. These concerns definitely led to efforts to cap the amount of leverage used by PE firms by both the U.S. Federal Reserve Bank, and the European Central bank.

Our findings are inconsistent with these conclusions. Our study highlights that, on average, the long horizon of PE funds allowed them to support their portfolio companies, despite of their high leverage. But you also have to remember that our study did not capture all potential effects of PE buyouts on the economy. There may be other aspects during the crisis that we did not explore — for example, the impact of PE firms on employment and wages. I think there is room for more research on this topic before we draw strong conclusions in either direction.