The secret to the private equity model is that private equity funds – also known as financial sponsors or financial buyers – can borrow most of the purchase price to acquire businesses from investment banks. And in lower interest rate environments (like today), private equity can afford to pay more (or can generate higher returns. Indeed, traditionally banks would loan up to five (5) times a target company’s annual EBITDA in an acquisition; today it’s not uncommon to borrow up to seven (7) times EBITDA in an acquisition. But regardless of market conditions, the model is fairly simple. Let’s use a very simplified example to illustrate.
Assume the following:
- Manufacturing Company (YourCo) has annual sales of $5 million and annual EBITDA of $1 million.
- Private Equity Co (PEC) buys YourCo for $5 million, or 5 times its annual EBITDA.
- Bank lends four (4) times YourCo’s EBITDA to PEC in the purchase ($4 million). PEC invests the remaining $1 million in equity.
- For simplicity, assume that YourCo’s revenues and expenses stay flat. Also assume that the interest rate on YourCo’s debt is 10%, its tax rate it 10%, and that all of its “free” cash (the cash it generates after making interest and tax payments) is used to pay down debt.
Here’s what YourCo’s equity and debt positions look like over time:
|Debt at Year End||$3,500,000||$2,950,000||$2,345,000||$1,680,000||$948,000||$143,000||0|
|Equity at Year End||$1,500,000||$2,050,000||$2,655,000||$3,320,000||$4,052,000||$4,857,000||$5,000,000|
The chart depicts an extremely simplified financial position that doesn’t exist in real life (all industrial businesses need some capex, and inflation in labor markets will eat into your margins over time, for example), but the ability to borrow most of the purchase price – even at 10% interest – results in significant financial returns for PEC.
If we assume that YourCo is still worth $5 million after year 7 from PEC’s acquisition, then PEC (should it sell YourCo) has received $5,742,000 ($5 million to sell YourCo plus the $742,000 in cash generated in year 7 after debt repayment) for its investment of $1 million dollars.
That’s a 474% return or an annualized return of 31% before PEC’s capital cost! Simply for buying and holding onto a business that PEC wasn’t able to grow!
The example we’ve provided isn’t real. Businesses aren’t this static, they need capital expenditures (for repairs, equipment, facilities), margins may be compressed due to inflation in raw materials, labor or utilities, and so on. And nearly all private equity funds will have a growth strategy for your business that will require investment. But the example does make clear why your company’s earnings are so critical to enterprise value (what your business commands in a sale). The more cash your business generates, the more debt it can support, and the more private equity investors can pay while still generating attractive returns.