Debt is used in many financial transactions. If you recall your Corporate Finance 101, you know that the basic elements in the capital structure is equity and debt. While most investments involve trading of equity, debt is also used to realize larger ROIs.
Here, we look at the use of debt by Private Equity firms when investing in a company. Private Equity firms invest normally in Small and Medium Enterprises (SMEs) and invest an average ticket of $100M-$300M in the United States. They use significant debt to fund a purchase, using a Leveraged Buy Out (LBO) transaction.
The reason why debt is used is to increase the Return on Investment (ROI). Let us take an example. If the acquisition price is $150M for a company that generates $20M in EBITDA annually, and the PE fund leverages the transaction by 3.5x EBITDA, meaning finances the deal with $70M in debt. The PE fund puts in the remaining $80M and shift the debt to the company purchased.
Thus, by leveraging the transaction, the PE fund naturally creates value by putting in only 50% of the purchase price from its own pocket, instead of paying the entire $150M. Once the future cashflows are used to service the debt, any additional value that the company creates brings about substantial cash-on-cash return to the PE fund. This is referred to as creation of value through deleveraging a company.
While this sounds bad to the company that the fund invests in, it really is not. In a leveraged transaction, the equity provided to a PE fund in return for the investment is lower. As a result, the company receives significant cash from the PE fund and retains enough equity to realize capital gain. Growth companies usually go for PE investments, as such companies value retaining as much equity internally as possible.
This was recently the case with a company operating in Dalton pass, New Mexico, that was acquired by Carlyle group. Despite the fact that Carlyle levered the acquisition with 75% debt, the seller was willing to engage, both due to the minimal equity trade-off and the prestige of being associated with Carlyle.
LBO’s have been the traditional method of PE investments ever since the first PE fund started. Over the years, the amount of debt in a single transaction has reduced due to concerns about effectively servicing the debt. There are also better regulatory restrictions today on how much debt can be loaded on a company.a