In an LBO, why would a PE firm use debt rather than financing entirely with equity?

In an LBO, why would a PE firm use debt rather than financing entirely with equity?

• A. Because debt has no cost
• B. Because leverage boosts returns and the debt is borne by the company after closing
• C. Because it guarantees a higher exit price
• D. Because equity is always expensive

Answer: (B)

Leverage is the key idea being tested. In an LBO, a private equity firm finances part of the purchase with debt so it can buy a larger business with a smaller amount of its own money. The debt is cheaper capital than equity and, because interest is tax-deductible, it adds value as well. Most importantly, after closing the deal, the company itself carries the debt, not the PE fund. If the business performs well and generates steady cash flow, the equity holder’s return is amplified: a smaller initial equity investment captures a larger share of the upside as the enterprise value grows and debt remains to be serviced. This is the core reason leverage boosts potential returns in an LBO. Debt isn’t free, so it doesn’t guarantee anything. It doesn’t ensure a higher exit price, which depends on performance and market conditions. And equity isn’t always prohibitively expensive in every situation, but using debt allows financing more with cheaper capital and can magnify equity returns when things go well.

Leverage is the key idea being tested. In an LBO, a private equity firm finances part of the purchase with debt so it can buy a larger business with a smaller amount of its own money. The debt is cheaper capital than equity and, because interest is tax-deductible, it adds value as well. Most importantly, after closing the deal, the company itself carries the debt, not the PE fund. If the business performs well and generates steady cash flow, the equity holder’s return is amplified: a smaller initial equity investment captures a larger share of the upside as the enterprise value grows and debt remains to be serviced. This is the core reason leverage boosts potential returns in an LBO.

Debt isn’t free, so it doesn’t guarantee anything. It doesn’t ensure a higher exit price, which depends on performance and market conditions. And equity isn’t always prohibitively expensive in every situation, but using debt allows financing more with cheaper capital and can magnify equity returns when things go well.