Private equity buyout is the most popular private markets strategy and it has historically achieved very attractive returns. We’re frequently asked how the buyout process works and how value is created. In contrast to Hollywood mythology, private equity buyers typically seek to grow and expand companies to achieve profits rather than sell their assets and lay off employees.
The most common form of private equity acquisition strategy is a leveraged buyout (LBO). In an LBO, the private equity firm will use a relatively modest amount of equity capital and then borrow the rest of the funds necessary to complete the acquisition by using the target company’s own assets as collateral for the loans. The term ‘leveraged’ refers to the use of borrowed funds.
Upon acquiring a company, a private equity firm will generally focus on improving the company's operational efficiency and financial performance in order to increase the company’s overall value. We describe the three key value creation levers available to private equity firms below:
- Operational improvements: After the acquisition, the private equity firm will often implement operational improvements in the acquired company. This may include cost-cutting measures, operational improvements, and implementing better management practices to achieve efficiencies. The goal is to make the company more competitive in the market and increase its profitability.
- Strategic growth: Private equity firms will frequently seek to grow the acquired company both organically and through acquisitions. This may involve entering new markets, expanding product lines, or acquiring smaller competitors to strengthen the company's market position and thereby increase its overall value.
- Financial engineering: The private equity firm may restructure the acquired company's finances to optimize its capital structure and reduce costs. This can include refinancing debt, recapitalizing the business, or implementing tax-efficient strategies.
The ultimate goal of the private equity manager is to create enough value to be able to sell the company and achieve a return on its invested capital that meets or exceeds its target performance. It is critical, of course, not to overpay for the company in the first place, as this may in fact be the biggest determinant of the profitability of the deal: the exit multiple versus the entry multiple. The private equity manager has no control over the market or the prevailing multiples acquirers may be willing to pay when the PE manager seeks to exit its acquisition, but it can control how much it pays for a company at the outset by exercising discipline.
Exit strategies that the PE manager may pursue include selling the company to another PE manager, selling it to a strategic acquirer (which may itself be a PE-backed company), or take the company public through an initial public offering (IPO).
It's important to note that the private equity industry has evolved over the years, and the strategies employed can differ between firms and individual deals. While some firms may focus on operational improvements and growth, others may prioritize financial engineering or other strategies to create value. Ultimately, private equity firms aim to acquire companies, improve their performance, and exit with a profit.
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