Why do Private Equity Firms Put Debt on an Acquisition?

Most entrepreneurs are allergic to debt. And for good reason. I’ve written before about how much debt your business can afford to take on. If you approach a bank about taking on a loan, they’ll typically ask for a personal guarantee in return. That means you’ll need to risk your personal wealth for the sake of growing the business. That’s why most savvy entrepreneurs avoid taking on debt if they can.

But, if you’re contemplating selling your company to a private equity (PE) buyer, you may need to get comfortable with the notion that your company will soon be loaded up with debt. That’s the first play many PE firm will run–even if they buy your company for cash. It’s an industry standard to see PE firms borrow up to 2-4 times EBITDA, or the net profits, of a business. Sometimes, that number is even higher. For the reasons I’ve stated, this can make entrepreneurs nervous. I get asked all the time about why PE firms do this. The answer is easy: They’re trying to maximize their returns.

Let’s start by recognizing how PE firms make their money. It comes in two parts–what’s often called the “2 and 20 rule.”

The “2” refers to the 2% that PE companies earn as a management fee of the money or assets they have raised. If the PE firm raised $100 million, for example, they charge their investors $2 million a year to pay for their salaries and expenses. While that might sound like decent money, it’s not going to make the PE firm or the partners rich.

That’s where the “20” comes in–which refers to the percent of the gains the PE will earn once they’ve met their promises to their investors, which is typically a 12% to 15% return. That means that the PE firm earns a 20% cut from anything they earn over that baseline–which gives them a lot of motivation to drive those returns as high as they can. That’s where the power of debt comes into play.

Let’s use an example where a PE firm buys a company with $1 million in EBITDA for six-times earnings–or $6 million. If the business continues to earn $1 million in profit a year, that means it will generate a 16% annual return ($1 million/$6 million) if they used all cash to make the purchase.

But now let’s say the PE firm makes the purchase using $3 million in cash–and another $3 million in debt. Now, to calculate the return on capital, we divide the $1 million in earnings by the $3 million in cash–which is a 33% return. In other words, by using debt to finance the deal, the PE doubled its cash on cash return. If they promised their investors a 13% return, they would now earn 20% of that gain of everything over 13% or an additional 4% return to the firm. This is the power of financial engineering in action.

The PE firm can now compound those earnings further by slashing costs inside the business while helping it grow. If those changes result in, say, another $1 million in earnings, their return on that initial $3 million investment in cash looks even more impressive at 66.6%. They’ve essentially double their investment in 18 months.

While this might seem like the PE firm is somehow using the rules to its advantage, consider how you can use the same principle to generate extra returns on your home with the help of a mortgage. While you might finance the majority of the cost of a house–likely 80% after putting down 20% in case–you will eventually pay down the debt even as the appraised value of your home increases over time.

If you buy a home for $300,000, that means you put down $60,000 in cash, and finance the remaining $240,000.

In a few years, you might be able to then sell your house for more than you paid for it–generating a high return for yourself with the help of that initial mortgage debt if you measure the cash on cash return.

So, when you think about PE firms use debt so freely when it comes to making acquisitions, just remember it’s often about generating the maximum possible return.  And why do they? Because they can.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.

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