Why leverage increases returns in an LBO, and when it doesn't

“Why does using debt increase returns?” comes up in almost every private equity interview. Most candidates give half the answer: debt is cheaper than equity, so you put in less of your own money and the return goes up. That's true. It's also exactly what the interviewer expects you to say before they ask the follow-up.

The follow-up is some version of “so why not use 100% debt?” To answer that well you need to see both sides of leverage in numbers. Here's one simple deal done twice.

The same deal with and without debt

A fictional business, Wrenfield Packaging, makes £50m of EBITDA. You buy it at 10x for £500m. Over five years EBITDA grows to £70m and you sell at the same 10x. The business generates £30m a year of free cash flow before interest. To keep it simple we ignore tax and fees.

In the all-equity deal the cash simply builds up on the balance sheet. In the levered deal it pays the interest and the rest repays debt. (Interest falls slightly as debt is repaid. Ignore that in an interview unless asked.)

Same company, same growth, same exit multiple. The levered deal returns about 18% against about 11%. Nothing about the business changed. Only the way it was paid for.

Why it works

The business earns roughly 11% a year on the whole £500m. The debt costs 6%. On every pound you borrow you keep the gap between the two. Borrow £300m and that gap all goes to a £200m equity cheque, which is what pushes the return up.

That's the sentence interviewers want: leverage increases equity returns when the return on the business is higher than the cost of the debt. Debt repayment adds a second effect. Each pound of debt repaid from the company's own cash is a pound of value that moves from lenders to you.

Two more points are worth a mention. Interest is usually tax deductible, so in real life the debt is cheaper than its headline rate. And a smaller cheque frees the fund's capital for other deals.

When leverage doesn't help

Now run the downside. Trading weakens: EBITDA falls to £40m, free cash flow drops to £20m a year and buyers will only pay 9x at exit.

The all-equity investor loses 8% of their money. The levered investor loses 65%. Leverage didn't create value. It magnified whatever happened to the business, in both directions.

And that's the generous version. In a real deal the lenders would have covenants. A business making £40m of EBITDA with £300m of debt is at 7.5x leverage, well above where it started. Long before exit the lenders could be asking for more equity or taking the keys.

So why not 100% debt?

Pull the threads together and you have a complete answer:

1. Debt gets more expensive as you add more of it. Each extra turn of leverage carries a higher rate. At some point the cost of the last pound borrowed is above what the business earns and leverage starts to destroy returns.
2. Cash flow has to cover interest. If interest eats all the free cash flow there's nothing left to repay debt or invest in the business.
3. Risk of losing everything rises. Small dips in trading become covenant breaches. A cyclical business can't carry the debt a stable one can.
4. Lenders won't offer it. The market caps leverage based on the company's cash flow and stability.

If you're asked which business suits high leverage, describe the features rather than naming a sector: steady recurring revenue, low capex, little cyclicality and strong cash conversion. Those are the businesses that can pay interest in a bad year.