Adam Sand explains how private equity firms buy companies with borrowed money, grow their earnings over several years, then sell them for profit. A $10M EBITDA company bought at 8x leverage grows to $16M in five years; debt shrinks from $40M to $8M while equity balloons from $40M to $120M, and the PE firm takes 20% of the gain.
Questions this video answers
Three to seven years ("three, four, five, six, seven years").
$10 million per year.
8× EBITDA, implying a purchase price of $80 million.
Approximately 50% debt and 50% equity (debt ≈ $40M, equity ≈ $40M).
About 10% per year.
Chapters
What is private equity? It is an investment approach that is about buying entire companies, holding them for three, four, five, six, seven years, selling the entire company, and then generally using leverage to do that. You're not buying a stock, you're buying the entire thing. You're committed to holding it for a number of years and you're using leverage to buy it, so you're more involved. The goal of these firms is they invest equity upfront and then when they sell the business, they get a return on their equity. That is, the return they generate is how the business performs. And when they put money in and they take money out at the end, when they sell it, how much did they earn? This is not that dissimilar from buying a house. Flipping a house, you buy the entire house. You take out a mortgage to do it. Unique mortgage amount varies based on housing versus business. But use leverage to buy the house. You spend time trying to improve the house. You might get tenants, increase the lease, add on a new deck, make the house more valuable. You use the cash flow from the house to pay down the mortgage and eventually you sell the entire house. And whatever you sell it for money, minus all your investments, is how much you make. So it is really as straightforward and simple as that. And here is kind of example, walking through a specific house. In this example, we have a business that makes $10 million a year in EBITDA, which is the earnings metric that a lot of investment firms look at when they value businesses. It was bought for eight times, so $80 million. In this example, it was bought with half debt, half equity. So this equity came from the private equity fund. This debt came from probably like a bank, similar to how you mortgage. So they buy it 50% debt, 50 equity. You try and grow the business over time. You use all the earnings of the business to pay down that debt over time. So in this example, we have this business growing its EBITDA 10% a year. So it goes from 10, 11, 12, 1, 13, 3 eventually to 16, 1. So in five years, they grew from 10 million of EBITDA to 16 million of EBITDA and they paid debt down from 50, 40 million to 8 million. While a business owner might look at this and think this is a great performance, we increase the business from 10 to 16 million of EBITDA. That is a 60% growth rate. Their investment increased significantly faster. Their investment went up 200%. Because they use leverage to do that. They grew 40 million into $120 million as the return, as their kind of proceeds. So very similar to a house, but it's just applied to a business. Let's dive in. So that's kind of what they do. Buy entire businesses using large amounts of debt from a bank, similar to how you buy a house. They hold it over a three to seven year period to grow earnings, and they use those earnings to pay down debt. After their whole period, they will turn around and sell the entire business to realize their profit. The profit to them is their equity value at exit, less all the money they invested. And then they get 20% of that, so it's 20% of the gain of their investment. So they basically put money in at the very end, they sell it. They've got the pot of money they earned, they turn around, they send the initial capital back their investors and say, all right, this is everything we earned from what we did. And they get 20% of that as the kind of fee for generating that return. Their model is built around increasing the value of that business over time, because that is what enables you to sell the business for significantly more than what they bought it for. Someone's got to turn around and pay to buy the entire thing and see the value in the next three to seven years to continue this. And they will do this multiple times in one fund. Some firms do it eight to nine times or different strategies, but they'll do eight or nine or 10, maybe 12 platforms in one fund. And that is what they do to generate their returns. The business is predicated on increasing the value of the companies they buy. Some people think they just want to like destroy businesses and milk them for all they're worth and go back and sue people. And the reality is, if nobody is willing to pay more for the business at the end than they bought it for, they don't make money. And that's a key driver in what they do.
