How do Private Equity Investors Generate Returns? (2024)

In short, private equity firms invest in private companies to make money by improving their financial performance and ultimately selling them for a profit. Investors typically use a combination of debt and equity financing to acquire a controlling stake in a company and then work closely with management to implement changes that increase the company's value. Traditionally, a private equity investor’s value creation playbook includes three main return drivers: EBITDA growth, multiple expansion and debt repayment.

From an operational perspective, the primary driver of returns is the growth of EBITDA, an acronym for 'earnings before interest, taxes, depreciation, and amortization'. EBITDA is a profitability metric that measures a company's ability to generate cash flows. While revenue growth is one avenue to bolster EBITDA, it can also be enhanced by addressing cost inefficiencies and operational weaknesses, often a more secure and preferred approach. Acquisition multiples are frequently computed based on a company's EBITDA, implying that any surge in EBITDA translates into a corresponding increase in the company's valuation and, consequently, the investor's equity.

Private equity firms seek to increase the value of their companies by selling them at a higher exit multiple than the original purchase multiple. However, investors do not have complete control over their exit multiples. Factors such as investor sentiment and macroeconomic conditions like higher interest rates can affect the exit multiple. Fortunately, investors can influence the exit multiple by creating favorable transaction conditions. This includes showcasing the company in the best possible light to command a premium over industry peers and conducting a competitive auction led by strategic bidders.

Investors often use leverage or debt to boost the returns on invested equity. The more debt you employ, the less equity you need. The leverage you use to purchase a company will depend on its ability to repay the debt through its operating cash flow. Deleveraging refers to gradually reducing a company's debt during the holding period. As the company's debt balance decreases, the value of the investors' equity increases.

In conclusion, private equity investing can be very profitable for financially savvy investors with expertise in the industry and operations. To generate attractive returns, investors must use leverage intelligently, have the ability to identify and improve operational weaknesses, and strategically position the company to maximize the exit multiple.

Raul Treviño is the Managing Director of Craft M&A, a lower middle-market M&A boutique firm that offers specialized financial services to entrepreneurs, businesses, and family offices.