LBO Returns - Increasing Leverage Doesn't Increase Returns?
I've heard a lot of people say that increasing leverage will generally increase your returns in a LBO scenario as long as the cost of debt is cheaper than the cost of equity.
That makes sense, but what I don't understand is what the cost of equity is in a LBO. Is it the levered IRR (so your return on equity will increase as long as it is higher than the cost of debt)? Having some trouble wrapping my head around this, any insight much appreciated
Key is to not confuse return on equity (aka IRR) with COST of equity. Cost of equity is not something you normally think about much when modeling an LBO, but to answer this question, think about what cost of equity would represent in a private equity LBO.
Think about it like this. You can use debt and pay the cost of debt (interest/principal payments), or you can use equity. Where is the equity coming from? The PE fund. And where does the PE fund get the capital to make these equity investments? The LPs. So in this instance, the cost of equity that you are comparing the IRR to would be the return that the LPs demand, which is nearly always higher than the cost of debt.
As you take on more debt, the business becomes riskier as you have less cash flows to service the debt and increase your risk of bankruptcy. Therefore, your LPs would expect a higher return to compensate for the increased risk. At a certain threshold, that expected return could exceed the cost of debt.
To bring it closer to the way you're currently thinking about it, think about a non-LBO situation. If a company wants to finance a project, they can raise debt or issue equity. The cost of equity per CAPM represents the return that investors expect when they buy that equity. If you take on a ton of debt, your cost of equity is going to increase because investors aren't going to buy your issued equity if you suddenly raise your risk from debt that much. To tie this back to the paragraph above, in an LBO, who is going to buy the issued equity? Answer is another private investor, AKA another PE fund with its LPs.
Do appreciate the thoughtfulness of this response and a few below - private equity funds certainly have return thresholds to ensure they are meeting LP's investment objectives / continue to get LP commitments in a competitive marketplace.
However, let me gently disagree - in an LBO model, the cost of equity is equal to the IRR, which is equal to the rate of return an equity investment generates. The PE firm may determine that the IRR / cost of equity for an individual investment does not meet its return objectives (partially because as Yasuo points out, LPs evaluate the cost of equity of investing in a given PE fund vs. other capital allocation decisions).
To answer the original question - when cost of debt > cost of equity (IRR), interest payments grow faster than equity returns, so the more debt you put on at close (more leverage), the lower your equity returns become. Conversely, when cost of equity > cost of debt, equity grows faster than interest, so when TEV grows, more $'s go to equity vs. debt, and with lower initial equity, % growth on that equity goes up.