How private equity works
Private equity returns come from three places: leverage, operational improvement, and buying cheap. The first is doing more work than the industry admits.
Understand the leveraged buyout, and why debt is the engine.
How private equity works works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
Why the debt is the engine
Put in 30, borrow 70, secure the loan against the company you are buying. A 30% rise in the business doubles your money. The same arithmetic works in reverse, which is why buyouts fail loudly.
- 1
The fund buys a company with mostly borrowed money
A typical buyout might use 30% equity from investors and 70% debt. Crucially, the debt is secured against the acquired company, not against the fund. The company borrows the money used to buy itself.
- 2
Leverage magnifies the return on the equity
If you put in 30 and borrow 70, and the business rises in value by 30, you have doubled your money. The same rise on an all-equity purchase would have earned you 30%. That is the whole engine, and it is arithmetic, not genius.
It magnifies losses identically. A modest decline in value can wipe the equity out entirely, which is why buyouts fail loudly.
- 3
The debt is repaid out of the company's cash flow
Which is why private equity likes stable, cash-generative, unglamorous businesses, and why it puts them under such pressure to produce cash. The interest bill is not optional.
- 4
Then it is sold, and the fee structure does the rest
Managers typically charge 2% of assets annually plus 20% of profits. That structure rewards taking risk with other people's money, and it is why the industry is so profitable for the people running it, somewhat regardless of outcomes.
You can explain why a buyout firm prefers a boring laundry business to an exciting startup.
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Private equity returns come from three places: leverage, operational improvement, and buying cheap. The first is doing more work than the industry admits.
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