The most common analogy used to explain an LBO is: “Buying a house with a cash down payment and a mortgage.”<\/p>\n
But that is a misleading way to think about it – because an LBO is more like buying a house to rent out to *tenants* i.e. an asset that you earn cash flow from, as opposed to a place to live in yourself.<\/p>\n
An LBO “works” mathematically because leverage reduces the UPFRONT cost of buying a company (or a house)… and then you use the company’s cash flows to pay off debt principal and interest rather than collecting them for yourself.<\/p>\n
You still have to repay debt at the end when you sell the company… just like repaying a mortgage when you sell a house…<\/p>\n
BUT it still benefits you to use debt in the beginning because money today is worth more than money tomorrow, and because it’s MUCH easier to get a high return on, say, $150 invested than it is on, say, $500 invested.<\/p>\n
In this example with purchasing a house, we see how 100% cash used for a $500K house produces an IRR of 9% with a 1.5x returns multiple.<\/p>\n
By contrast, when only 30% cash is used, the IRR increases to 15% and the returns multiple increases to 1.9x.<\/p>\n
Most private equity firms aim for IRRs of at least 20% (sometimes less than that in a weak market), so normally you can come close to or exceed 20% only by using leverage.<\/p>\n
Exceptions apply for fast-growing companies and cases where the exit multiple or margins have expanded, but in general most PE firms rely on leverage to achieve IRRs in that range…<\/p>\n
Well, assuming the company doesn’t blow up and go bankrupt due to the high debt load – but that’s another lesson for another day…<\/p>\n