Leveraged Buyouts

Portfolio companies are rarely purchased using only the equity of the buyout firm. In order to increase the number of transactions a particular fund can make, as well as to increase returns and spread risk, the private equity firm uses debt—or leverage—to finance a significant proportion of each deal.

A leveraged buyout is a lot like buying a house with a mortgage. With a down payment of 20 percent in cash, an individual can get a mortgage for the remaining 80 percent of the cost of the house, using the house itself as collateral. Similarly, a private equity firm could take $200 million raised from investors to buy out a company worth $1 billion. To complete the deal, the buyout firm uses the $200 million in equity plus the value of the company as collateral to borrow the remaining $800 million needed to finance the purchase of the company.

Like mortgage lenders who check that borrowers have sufficient income to cover their mortgage payments, lenders who provide the debt to finance leveraged buyouts seek to ensure portfolio companies have sufficient cash flows to service the payments on the debt. If a portfolio company that has undergone a leveraged buyout cannot make its debt payments, the company can be forced into bankruptcy by its creditors. Under most circumstances however, in contrast to a home mortgage, the private equity firm and its investors who funded the equity portion of the deal are not liable to repay this debt.

How Money is Made

Unlike a typical investment in shares of a publicly traded company, which may provide periodic dividend payouts or which can be sold at any time, an investor in private equity makes money only when the firm sells or “exits” the portfolio companies that make up the fund. Such exits can include partial sales, complete sales, or “recapitalizations.” In a recapitalization, the private equity firm pays itself a special dividend typically funded by having the portfolio company borrow more money.

The limited partners in a given private equity fund typically receive together about 80 percent of the profits from the deal. The remaining 20 percent is kept by the private equity firm as its fee for making a profit for the investors. This profit is typically called “the carry,” or “carried interest.” In addition to the carry, private equity firms charge a 1.5 percent to 2 percent annual management fee. Many private equity firms also charge management fees to the portfolio companies in which they invest, though this revenue is usually shared with investors. Some firms have also begun charging transaction fees where the private equity firm receives a percentage of the value of any acquisition or sale of a portfolio company. For the largest buyouts, these transaction fees alone can be worth hundreds of millions of dollars.