Borrowed money can nearly triple your money until it chokes the business
Private equity firms put up as little cash as possible, so lenders watch two ratios to judge whether the debt can be repaid.
The Wall Street Skinny · Private Equity Knows Something Private Credit Doesn't | This $30B LBO Holds the SecretImagine buying a $10 million house with $3 million of your own cash and a $7 million mortgage. If the house rises to $15 million, you still owe the bank $7 million, so your $3 million stake is now worth $8 million. You nearly tripled your money, even though the house rose only 50 percent.
That is the math behind a leveraged buyout. A private equity firm buys a company mostly with borrowed money, puts up as little of its own cash as it can, and hopes the value grows. The debt magnifies the gain because lenders get only what they are owed, while owners keep everything left over. The same debt becomes a noose if values fall, because interest still comes due even when business slows.
Bankers measure that risk with two simple ratios. The leverage ratio is total debt divided by EBITDA, or earnings before interest, taxes, depreciation, and amortization, a rough proxy for yearly operating cash flow. It answers how many years of cash flow it would take to repay the debt. Eight times leverage means about eight years, assuming cash flow stays the same.
The coverage ratio divides that same cash flow by the yearly interest bill. Sometimes analysts subtract capital spending to be more conservative, which means counting only the cash left after paying for equipment and buildings. It answers whether the company can afford its loans. A coverage ratio of 1.5 means the company's yearly cash flow covers one and a half years of interest, a thin cushion if anything goes wrong.
When cash flow shrinks, both numbers turn fast. Debt can stay flat while leverage soars, because a smaller cash flow must support the same loans. In the Caesars buyout of Harrah's in 2008, leverage climbed from eight times to about 18 times after earnings collapsed, until operating cash flow could not cover even one year of interest.
Questions people ask
If the company cannot pay, does the private equity firm have to pay the debt itself?
No. The debt belongs to the company being bought, not to the private equity firm. If the company fails, lenders can seize the company, but they generally cannot seize the buyout firm's other funds.
What kind of company can handle a lot of buyout debt?
It looks at steady cash flow, because that cash pays interest and repays principal. Businesses with predictable sales, like established consumer or service companies, can support more debt than volatile or fast changing businesses.
What is a loan covenant, and why does it matter here?
A covenant is a promise written into a loan, such as maintaining a maximum leverage ratio or a minimum coverage ratio. If the company breaks it, lenders can demand repayment, charge higher interest, or force a renegotiation.