Why Private Equity Uses Debt: The Mechanics of Leverage

I recently described why the credit crisis is impacting M&A transactions done by private equity groups (PEGs). Although we all know that using debt “leverage” is common, the best way to understand why PEGs use debt in the first place is to look an example of what leverage does to investment returns.

Let’s say you raise a $50 million fund from a couple of your drinking buddies.  You tell them you hope to be able to get them 15% annual return on their money, and of course you are hoping to make even more than 15% in order to take home some for yourself. You find quite an excellent $10 million dollar service company that has earnings of $1 million before taxes, interest, depreciation and amortization (EBITDA).   Since it is in the “quite excellent” category, it is probably represented by the Woodbridge Group.  You buy that company for a multiple of five times earnings, and seven years later sell it for the same price, $5 million.  (You could have invested more money in the company in order to grow it, but you didn’t).

Let's look at some scenarios:

100% Cash, No Debt = 11% ROI
You figure you have $50 million to spend, and your dad told you to always pay cash if you can, so you don’t use any debt at all.  You invest $5 million, enjoy $600K or so of earnings each year (after tax), and get your money back in seven years.  The ROI on this is around 11% if everything goes right.  Your drinking buddies demand the remaining $45 million back in year one once they realize the investment you made.

50% Debt = 16% ROI

Let’s say you get a simple interest 10% balloon acquisition loan based on the assets of the business.  Now you invest $2.5 million, use $2.5 million in debt, and have $450K of earnings each year after interest payments and taxes.  The return on your investment in this case is 16%.  Better, but now you have the tough decision to keep some for yourself, or pay everything to your buddies to keep them happy.

80% Debt = 33% ROI

Now you understand leverage, so you get the seller to carry some paper, you get an asset loan based on the equipment, a credit line based on the accounts receivable and also use the stability and cash flow of the company to get a loan with warrants attached.   After interest payments and taxes the earnings are only $360K, but you only need to put in a little over $1 million (including expenses) of your buddies’ money.  The ROI in this case is 33%.  Now you take a healthy cut, and your buddies are happy and want to give you $150 million next time around.    

This is obviously a simplistic example, but it does show that leverage works, and quite dramatically.  For most PEGs, not being able to raise much debt in the current environment has put a kink in their business model.  For some it’s a small kink and for others it is a pretty darn big kink. The bright side of this is that there is obvious risk in having too much debt, and many believed some PEGs were over-leveraging their acquisitions. 

There isn’t any doubt the credit markets will come back, though not to the same easy-money levels, and the PEGs will once again be as active in the market as they were last year – and at more reasonable debt levels.