3.2 How a buyout is financed

In a buyout, a private equity fund doesn't pay for a company only with its own money. It combines equity from the fund with a large loan, which the company itself will repay out of its future cash. That is why these deals are called leveraged buyouts (LBOs): leverage means using borrowed money to fund an investment.

How a deal is financed shapes almost everything that follows: how big a cheque the fund writes, how much cash the company must set aside for its lenders, and how wide the range of outcomes is for investors. This lesson looks at the equity side. For the lender's view of the same debt, see PC101 3.1 (The capital structure).

Pricing a buyout: multiples of EBITDA

Buyout prices are usually discussed as a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization), a rough measure of a company's cash profit. If a company earns $20m of EBITDA and the buyer pays $200m, the price is 10.0x EBITDA.

That price is the company's enterprise value (EV): the value of the whole business, before deciding how it is funded. Equity value is what is left for the owners after debt:

Equity value = enterprise value − debt

Deals are commonly agreed on a "cash-free, debt-free" basis, meaning the seller pays off the company's existing debt from the proceeds, and the buyer puts new debt in place. Multiples vary widely with the industry, the company's growth and quality, interest rates and how much competition there is for the deal, so a "normal" multiple for one business can be expensive for another.

Sources and uses: the Northfield deal

In lesson 3.1, Ashcombe Capital agreed to buy Northfield Components through Ashcombe Capital Fund I. Here are the terms. The example is illustrative, in $m, and ignores transaction fees, taxes and interest to keep the arithmetic simple.

• Northfield's EBITDA is $20m.
• Ashcombe pays 10.0x EBITDA, an enterprise value of $200m.
• A direct lender provides a $100m unitranche loan: one first lien loan with a single interest rate (PC101 3.1 explains unitranche in detail). That is 5.0x EBITDA.
• The fund provides the other $100m as equity.

Deal teams summarize the financing in a sources and uses table. Sources show where the money comes from; uses show what it pays for. The two totals must match.

In a real deal, uses would also include advisers' fees, financing fees and sometimes cash left in the company for day-to-day needs, and the equity is sometimes shared with co-investors or managers who reinvest. The principle is the same.

Who provides the debt? In mid-market deals like this one, the loan commonly comes from a private credit fund acting as a direct lender, often as a unitranche. Larger buyouts may instead use loans arranged by banks and sold to many investors, or bonds. Either way, the buyer usually lines up committed financing before it makes a final bid, so the seller knows the money is there (lesson 3.1).

The loan is made to Northfield, or to a holding company set up to buy it, not to the fund. Northfield's own cash flow pays the interest and repays the debt. The fund is not normally a guarantor: if Northfield fails, the fund can lose its equity, but it doesn't usually have to repay the loan (see PC101 2.1).

Two words you will hear: the equity is the equity cheque, and here it is 50% of the price. The debt, measured as debt ÷ EBITDA, is the deal's leverage, here 5.0x.

Why leverage magnifies returns

Fast-forward five years. Under Ashcombe's ownership:

• EBITDA grows from $20m to $26m.
• Northfield is sold at the same 10.0x multiple, for an enterprise value of $260m.
• The company's cash flow has paid the debt down from $100m to $60m.

The fund receives the enterprise value minus the debt still owed: $260m − $60m = $200m. It put in $100m, so its MOIC (multiple of invested capital: money out ÷ money in) is 2.0x. Its IRR (internal rate of return, the annual rate that links the money in to the money out over time) is about 14.9% a year, since 2.0^(1/5) − 1 ≈ 14.9%. Lesson 4.2 explains both measures.

Now imagine Ashcombe had bought Northfield with no debt at all. The fund pays the full $200m. The company is still sold for $260m, and the $40m of cash that would have repaid the lender instead builds up in the company and goes to the fund at exit.

The business performed exactly the same in both columns. The fund made $100m either way, but with debt it made that gain on half as much equity. Leverage also frees the rest of the fund's money for other deals.

In reality the debt isn't free. The company pays interest, which reduces the cash available to repay debt and so narrows the gap. Leverage helps returns only when the business earns more on its assets than the debt costs.

...and magnifies losses

Leverage works in both directions. Suppose Northfield struggles instead: EBITDA falls to $16m, buyers become cautious, and the company sells at 8.0x, for $128m. The debt has still been paid down to $60m.

The fund loses twice as much, in percentage terms, with debt. The lender, meanwhile, is repaid in full, because it ranks ahead of the equity. That is the trade: shareholders take the first loss in exchange for keeping all the upside.

This example is still gentle, because Northfield kept paying its debt. A real downside can be harsher. Interest must be paid in bad years as well as good. If the company can't pay, or breaches the terms of its loan, lenders may be able to demand changes and, in the worst case, take control of the company, leaving the equity with little or nothing.

Why lenders limit leverage

If debt improves returns, why not borrow more? Because lenders won't lend unlimited amounts, and the company has to be able to carry the debt.

The equity below a loan is the lender's cushion. With $100m of equity under a $100m loan, Northfield's value could roughly halve before the lender lost money. A lender asked for 7.0x would have a much thinner cushion and far less room for error. So lenders typically size loans as a multiple of EBITDA, check that the company can comfortably pay its interest, and set covenants: promises in the loan agreement, such as a maximum ratio of debt to EBITDA, that give the lender early warning and a say if things go wrong. PC101 3.1 to 3.4 cover the capital structure, loan pricing and covenants from the lender's side.

How much leverage lenders will offer varies with interest rates, market conditions, the industry and how stable the company's cash flows are. A business with steady, predictable earnings can usually support more debt than a cyclical one. The sponsor's job is to choose a structure the company can live with through a bad year, not just the one that looks best in the base case.

Key terms

• Leveraged buyout (LBO): buying a company with a mix of equity and a large amount of borrowed money.
• Leverage: using debt to fund an investment; in a buyout, often measured as debt ÷ EBITDA.
• EBITDA: earnings before interest, taxes, depreciation and amortization, a rough measure of cash profit.
• Enterprise value (EV): the value of the whole business, regardless of how it is funded.
• Equity value: enterprise value minus debt; what belongs to the owners.
• Purchase multiple: the price paid divided by EBITDA, such as 10.0x.
• Sources and uses table: a summary of where a deal's money comes from and what it is spent on.
• Equity cheque: the amount of equity the fund puts into a deal.
• MOIC: multiple of invested capital; money received ÷ money invested.
• IRR: internal rate of return; the annual return that links cash invested and cash received over time.

Key takeaways

• Buyouts are commonly priced as a multiple of EBITDA, which sets the enterprise value.
• The price is funded with the fund's equity plus debt; equity value is enterprise value minus debt.
• In the illustrative Northfield deal, debt turns a 1.5x, 8.4% return into 2.0x and about 14.9%.
• The same leverage deepens losses: 0.68x instead of 0.84x in the downside case.
• Lenders limit leverage to protect their equity cushion and make sure the company can pay interest; see PC101 3.1 to 3.4 for their side.