The Mechanics in Plain Terms

A private equity fund identifies a target company. It puts up 30 to 40 percent of the purchase price as equity. The remaining 60 to 70 percent is borrowed, with the company itself serving as collateral. The debt sits on the acquired company's balance sheet. Cash flow from the business pays the interest and gradually reduces the principal. After five to seven years, the fund exits by selling the company, listing it, or selling to another sponsor. The sale proceeds first repay any remaining debt, then return capital to the fund and its investors.

Why Leverage Drives Returns

Leverage is the mechanism by which a 2x return on enterprise value can produce a 5x return on the fund's equity. The maths is simple. Buy a business for £100, financed with £30 of equity and £70 of debt. Five years later, sell it for £160. Pay down the debt to £40 using cash generated along the way. The £160 sale price minus £40 of remaining debt leaves £120 of equity value. The fund turned £30 into £120, a 4x money multiple, even though the underlying business value only grew 60 percent.

This is the engine of private equity returns. It also explains why entry multiple matters so much. Pay £120 for the same business instead of £100 and the same exit price only produces a 2x money multiple. The deal economics change dramatically with one turn of multiple expansion or compression.

What Can Go Wrong

The same leverage that amplifies upside amplifies downside. If the company underperforms, cash flow may not cover interest payments. Covenants get tripped. Restructuring conversations begin. In the worst cases, the equity is wiped out and the lenders take over. Industry observers estimate that approximately 5 to 10 percent of LBOs end in some form of distress, with the rate higher for deals done at peak multiples or with aggressive leverage.