Private equity is the business of acquiring companies using a significant amount of leverage, or borrowed money.
Unlike trading public equities (hedge funds, mutual funds, etc.), which involves buying and selling publicly traded securities on an exchange like the NASDAQ or NYSE, private equity tends to deal with privately listed companies, whose equity is not available for purchase to the broader public. Note that private equity firms have the ability to purchase entire public companies as well and delist them from an exchange, which is called a “take-private” transaction.
So why do private equity firms use leverage? In short, leverage can 1) magnify returns on an investment and 2) allows firms to buy bigger assets than they could with just the equity investment from their funds.
For example, if a fund has $100 million but uses no leverage in its deals, the biggest investment it could make is $100 million. However, if the typical acquisition this fund does uses 50% equity and 50% debt, then the biggest investment it could make is $200 million. This expands the universe of possible investments for a fund!
Below is a basic example to illustrate how the use of leverage can magnify returns:
Scenario 1: Pure equity investment
Jim wants to invest more of his savings to earn income. To start experimenting with the stock market, Jim invests $10 on Robinhood. Somehow, this investment doubles to $20, and Jim sells his investment. Ignoring any tax implications, what was Jim’s return?
Starting equity: $10
Ending equity: $20
Return: $20/$10 = 2x return
Jim doubled his money, or made a 2x return.
Scenario 2: The use of debt in investments
Jim wants to invest the same $10 in the stock market as in Scenario 1. However this time, Jim asks his friend Pam for a $5 loan, so that he can dig into less of his savings. Jim then goes out and makes the same investment on Robinhood as above, except this time instead of using $10 of his own money, he uses $5 of his own money and $5 of Pam’s money.
In other words, Jim is using leverage in this investment. In his new $10 investment, $5 is using debt (the amount he borrowed from Pam that he has to pay back) and $5 is using equity (his own money). The total $10 he invested somehow doubles to $20, and Jim sells his investment. Ignoring any tax or interest implications, what was Jim’s return?
Starting equity: $5
Starting debt: $5
Total initial investment: $10
Ending investment: $20
Debt payback: $5
Ending equity: $15
Return: $15 / $5 = 3x return.
Jim tripled his money, or made a 3x return.
Jim made a 3x return instead of a 2x return on the same investment! The above example is extremely rudimentary, but it illustrates how the use of leverage can magnify returns. This is one of the most basic examples of financial engineering.
Of course, real world leveraged investments are more complicated and have to account for interest, tax, risk, and other considerations. Nevertheless, the key insight here is that using debt can yield a higher mathematical return on the same exact investment.
Note on the Origin of LBO’s and Private Equity
In the 2020’s, private equity is everywhere. However, this wasn’t always the case. The use of significant leverage in the acquisition of a company is called a leveraged buyout, or LBO. Although LBO’s have been around as early as the 1960’s, this type of acquisition took off in the 1980’s after Michael Milken of Drexel Burnham invented the junk bond (high yield bonds).
Junk bonds spurred the LBO boom of the 1980’s because they provided LBO firms with the enormous amounts of capital needed to finance multi-billion-dollar deals.
A word of caution: leverage is a double-edged sword. It magnifies returns when your investments go up, but you also lose more money if your investments go down. Many LBO’s from the 80’s went bankrupt and lost its investors their money. For this reason, private equity has regulatory restrictions on who can trade this asset class.
Now that you understand why private equity firms use debt when they acquire companies, we can dive deeper into the current private equity landscape. Stay tuned for the next part of this series!