What Happens to Return on Equity in a Leveraged Buyout?

Leveraged buyouts involve buying companies primarily with debt.

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Private equity offers investors an opportunity to diversify their portfolios while potentially enhancing their returns. Leverage buyouts, or LBOs, represent a specific type of investment strategy that involves buying entire companies with heaps of debt. LBO funds aim to deliver a strong return on equity, or ROE, by paying down debt, making operational improvements and selling companies for more than they cost to buy. Well-known LBO firms include Kohlberg Kravis Roberts, Bain Capital, TPG Capital, The Blackstone Group and The Carlyle Group.

ROE Is a Measure of Corporate Performance

Most investors are familiar with the basic concept of investment returns -- the money earned on top of an original investment over a specific period. ROE operates under the same principle, only it considers an entire company's financial performance. To calculate ROE, divide a company's net income after tax by its shareholders' equity -- or the money put in by shareholders. If a company generated a net income of $10 million with shareholders' equity of $100 million, its ROE would equal 10 percent ($10 million / $100 million).

LBOs Enhance ROE Through Efficient Capital Structures

The main way that LBOs seek to generate returns is through "leverage," or using borrowed funds to buy companies. The principle is the same as buying a home with a mortgage. Suppose that the Joneses finance a $1 million house with an $800,000, 30-year mortgage and $200,000 down payment, while their neighbor, the Smiths, buy an identical home with cash. If after 30 years home prices have doubled in value, the Joneses will have earned a profit on their down payment -- their equity -- of $1,800,000 ($2,000,000 - $200,000), whereas the Smiths will have earned a profit of $1 million ($2 million - $1 million). The same concept applies when buying companies with debt, with the added benefit that lenders demand lower returns than shareholders.

LBOs Enhance ROE Through Operational Improvements

Some LBO fund managers will roll up their sleeves and make operational improvements to their portfolio companies. Traditionally, these improvements fall under two categories: revenue growth and cost cutting. To grow revenues, LBO fund managers might engage in strategic mergers and acquisitions or expand the company's presence in new markets. To reduce costs, the LBO managers might lay off employees, redesign the production process to be more efficient or outsource certain functions to low-cost providers. The goal of these changes is to expand profit margins and grow the company's bottom line.

LBOs Enhance ROE Through Multiple Expansion

The third major component of LBO returns is a classic one: "Buy low, sell high." The idea is that even if the LBO managers didn't change the capital structure or make any operational improvements, they would still make a profit by timing the market. In the same way that individual companies trade at specific multiples, such as price to earnings, so do entire industries and their segments. LBO firms hope to buy a company at a relatively cheap multiple and sell the same company for a higher multiple as an industry gains favor with investors. For example, an LBO fund might buy a car maker at an 8.5 P/E multiple and sell it three years later at a 9.5 P/E multiple.