Question

Which of the following statements below are TRUE regarding why an LBO works conceptually?

a. By using debt, the PE firm reduces up-front cash required, thereby boosting returns

b. Using cash flows produced by the company to pay down debt and make interest payments produces a better return for the PE firm than simply keeping the cash flows

c. Since the PE firm sells the entire company in the future, it's guaranteed to at least get back 100% of its original capital

d. The PE firm sells the company in the future, which allows it to get back (at least some of) the funds that it used to acquire the company in the first place.

Answer 1

There are more than one correct answers Statements A, B, and D are all true.

By using little of its own cash and borrowing heavily to purchase the company, the PE fund significantly boosts its returns for the simple reason that money today is worth more than money tomorrow due to the interest that it could earn. In an LBO, the PE fund uses the cash flows of the company it acquires to pay debt principal and debt interest, which is a much better use of those funds than keeping the money for itself, again boosting returns. The other reason LBOs work in practice and earn such high returns is because the PE fund only operates the company for 3 to 5 years before it sells it off and regains its money plus profit; if the PE fund were to keep the companies it purchased indefinitely, it would not be possible to earn the returns that PE funds seek. C is incorrect because there's no "guarantee" that the PE fund will get back 100% of its original capital - if the company's EBITDA declines or if the exit multiple declines significantly, for example, that may not happen.