Hi,
I realize that debt acts as a multiplier. The more debt an LBO uses reduces their upfront cost and boosts returns. My questions is better understanding the mechanical aspect of that? Is it because Debt reduces WACC and is cheaper than equity? If so, and we're looking from an equity perspective, the financial sponsor or PE firm, how does this make sense.
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Correct me if I'm wrong, but isn't it because the PE firm pays off the debt with the acquired company's cash flows?
You measure your return on the equity you put in. So if you increase the debt share you decrease the equity share, meaning you will calculate your return on a lower equity base resulting in higher returns
.
One, and admittedly somewhat qualitative, way to think about it, is that lenders/debt investors don't participate in upside, while equity holders do. If you lend money at 10% and the company doesn't grow at all, or turns into the next facebook, the only thing you're getting back is your principal and interest. Different story, obviously, for equity investors.
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