Private equity once referred mainly to buyouts. Although other private equity strategies have grown in importance, buyouts remain the largest segment of the asset class¹. A buyout occurs when an investor or group of investors acquires the equity of a company to gain control of it.

Analysts generally divide buyouts into two categories: management buyouts and leveraged buyouts². In a management buyout, the existing management team takes control of the company. In a leveraged buyout, a private equity firm uses a mix of its own capital and borrowed money to acquire the business.

What Is a Leveraged Buyout?

A leveraged buyout, often called an LBO, is defined by its use of debt. A key feature of the structure is that the acquisition loans are typically secured by the assets of both the private equity firm and the target company. Because the acquired company usually takes on a significant amount of additional debt, often about 40% to 60% of the purchase price, the transaction is known as a leveraged buyout.

This structure can reduce the amount of capital the private equity firm must commit compared with an all-equity purchase. It may also lower the overall cost of financing. Those advantages can increase the potential return on the investment. They can also increase the risk.

Why Private Equity Firms Pursue Buyouts

Unlike most investors in publicly traded companies, buyout groups generally seek full control. Their thesis is usually straightforward: they believe they can increase the value of the target company.

That value creation can come from several sources. A buyer may cut inefficiencies, bring in new management, contribute specialized operating expertise, expand the company’s network, or add resources that support growth. In some cases, the private equity firm replaces part or all of the company’s management team after the acquisition. In others, the acquired company uses the buyer’s capital, capabilities, or relationships to expand its business.

Buyouts can also play a role in rescuing companies that have viable underlying businesses but are under financial strain. In those cases, the new owner may provide capital and strategic direction that help stabilize operations and restore growth.

The Risks of Leveraged Buyouts

Leveraged buyouts can create value, but they can also create serious pressure for the acquired company. A sharp increase in debt can strain cash flow even when the new owners improve operations elsewhere in the business.

Conflicts of interest can also arise. A private equity firm may view an acquisition as a shorter-term project and focus more on generating a quick gain than on building a durable business over time. That tension has been evident in some periods of heavy buyout activity.

During the buyout wave of the late 1980s, for example, some buyers loaded target companies with debt, sold divisions or hard assets, used the proceeds to reduce a portion of that debt, and then issued new debt to fund dividends to shareholders. That strategy allowed buyers to recover capital and generate profits, but in many cases it left acquired companies with debt burdens they could not sustain.

How Private Equity Firms Exit Buyouts

Once a private equity firm acquires a company and makes operational or strategic changes, the next goal is usually an exit at a profit. The most common exit routes are a strategic sale and an initial public offering, or IPO.

In a strategic sale, the private equity firm sells the company to another business that wants to enter the industry or strengthen its position in it. A competitor may also be a buyer. If the target were a small specialty car company, for instance, a larger automaker such as Ford or General Motors could be a logical acquirer.

Another possibility is a sale to a different private equity firm. In some cases, the firm may instead take the company public through an IPO. That route can be effective when the business has enough scale, performance, and market recognition to attract public investors.

Private Equity Returns and Investor Considerations

Over long periods, private equity has generated strong returns relative to publicly traded stocks. For the 20 years ended December 2021, private equity funds returned 14.65%³ annually, compared with 9.72%⁴ for the Russell 3000, a broad measure of U.S. stocks.

Even so, investors should treat headline comparisons with caution. Reported private equity volatility can appear lower than public equity volatility, but the comparison is not always clean. Private equity returns are typically measured quarterly, while public market volatility is measured more frequently. That difference can make private equity performance appear smoother than it really is.

¹ https://online.hbs.edu/blog/post/types-of-private-equity
² Ibid
³ https://www.titan.com/articles/private-equity-returns
⁴ https://www.investing.com/indices/russell-3000-tr-historical-data

*See Disclosures