What is Leverage?

In finance, leverage refers to the use of borrowed money for the investment of an asset. Utilizing leverage allows investors to purchase assets they would not normally be able to afford. This is beneficial for the investors as it allows them to capture any benefits associated with the economies of scale. Large companies generally have more organizational structure in place as compared to startups, and the larger firms benefit by having more influence in their industry.

Leverage also plays an important role in helping investors receive higher returns. By utilizing leverage, investors can receive higher payoffs of owning a large asset while only putting in a small amount of their own money. However, the use of leverage will also greatly increase the downside risk of an investment. Understanding the concept of leverage is key in a leveraged buyout.

What is a Leveraged Buyout?

A leveraged buyout refers to the acquisition of a company that is funded by a large portion of debt. Specifically, a leveraged buyout will utilize approximately 90% debt and 10% equity. Oftentimes, a leveraged buyout strategy will target established and stable firms to help mitigate the added volatility of leverage. A critical risk factor of the leveraged buyout is the large debt payments that result from high leverage. If a debt payment is missed, the investor will incur a huge loss or even be forced to liquidate the acquisition. If the acquisition is already performing poorly, it is likely that the value of the asset will not cover the debts and the lenders will absorb this loss. The lenders in response charge much higher interest rates to offset this added risk, these loans are referred to as junk bonds.

Importance of Leverage in Private Equity

PE firms are usually structured in a way that their compensation is based on hitting a specific return metric. The leveraged buyout strategy allows a PE firm to magnify their returns by using less equity. The higher percentage return the PE firm can make on an investment, the more they get paid, and the leveraged buyout strategy offers a higher return potential that traditional investments cannot normally reach.

Conclusion

In finance, a whole array of investment strategies exist that each carry their own risk and return relationship. Often, we see that the risk and return relationship is dependent on the asset and its qualities, but outside an asset’s performance, leverage poses its own unique set of risks. No matter which asset you choose, the application of leverage will magnify both potential upside and downside.

Before founding 3E in 2016, Managing Member Eric Bergin was Director at Rockpoint Group, where he was responsible for for the Finance Group, as well as acquisitions, asset management, and investor reporting activities.