This post is presented as part of Money Talks, our ongoing series of educational content aimed at educating our wider linguist and client community on the finance industry.
If I buy something for $100 today and sell it for $100 in five years, I haven’t made money, right? In fact, with inflation and the time value of money, I’ve actually lost money. To the savvy private equity investor, however, this scenario can actually be a profitable one.
If you’ve read or seen the term leveraged buyout (LBO) but haven’t fully understood how it works, then read on. Early in my career, I was supporting due diligence efforts for leveraged buyouts in the ebullient 2007 market. But it wasn’t until a few months in that I actually understand how private equity firms make money.
The premise of a leveraged buyout is simple: pay full price for an asset, but use someone else’s money to pay for the majority of it. In the example earlier, if I fully finance a purchase of something for $100, and it returns $100 five years later, my return is $100 / $100 - 1 = 0%.
But what if I borrow $10 at a 5% interest rate and then put up $90? If (and this is a big ‘if’) the company can service that debt, then we’ve paid $90 for an asset that returns $100, and I have a total return of 11% across five years.
If the private equity firm can grow the company even modestly (say, a $105 exit), then the returns are amplified that much more.
The flip side is that the inability to service debt can cause catastrophic losses. In a traditional waterfall, debt holders are more senior than equity holders. So a private equity firm who chips in some equity becomes subordinated behind whatever debt they arrange to finance the deal. So a modest downturn in performance could mean that all excess cash flow is swept to the debt holders, leaving the equity holders with nothing.
If this sounds familiar to readers as they think about their personal finances, it should! A leveraged buyout functions very similarly to a mortgage. In a mortgage, a buyer funds a down payment which is the same as equity, and uses a loan from a bank to finance the remainder of the purchase price. A mortgage becomes problematic if the debt cannot be serviced (i.e., the monthly payment); the interest rate of the loan is a huge swing factor in the size of the mortgage.
Beyond the Buyout
More traditional ways in which private equity firms can make money are as follows:
- Operational improvements: This is the more idealistic way of making money. Regardless of how a deal was financed, if the overall profitability and efficiency improves under the ownership of a private equity firm, that alone allows the owners to reap financial returns.
- Dividend recap: This is a cheeky and brazen but entirely logical strategy. Some private equity firms will buy a company and, if it accumulates cash, it will simply pay out that cash to its private equity owner. This is called a dividend recapitalization.
- Multiple expansion: When we say multiples, we’re referring to EV/EBITDA multiples typically. If a company’s peers typically trade at an EV/EBITDA of 10x, but the sector suddenly becomes in favor among investors, it may trade at 12 or 15x. In this case, the PE firm achieves a higher valuation based purely on multiple expansion.
If you only remember one thing, it is that private equity firms’ success is extremely dependent on the financial performance of their companies. Whereas hedge funds and venture capital firms can make an investment and have little hands-on impact on the performance of their companies, it is the opposite for private equity firms.
Still have questions on how PE firms make money? Check out our Money Talks webinar on private equity.