How Private Equity Buys Companies With Borrowed Money and Makes a Fortune

Buying a Company on a Mortgage

A leveraged buyout is essentially the same idea as buying a house with a mortgage scaled up to entire corporations. A private equity firm puts up some of its own money often about a third of the price and borrows the rest using the company it's buying as collateral for the loan. The company then puts that debt on its own balance sheet and pays it off with its own cash flow. The company turns the business around in a few years and sells it ideally for much more than it paid. It's one ofdominant forces in modern finance and right now companies have approximately $1.3 trillion of committed but uninvested cash known as dry powder waiting to be used

Why Borrowing Amplifies the Return

Leverage is the whole point because debt magnifies the return on the small equity portion of the company. Imagine buying a $100 company with $30 of your own money and $70 of debt. If you then sell it for $130 and have paid back part of the loan the gain accrues almost entirely to your small share of stock turning a modest increase in the company's value into a large percentage gain on the cash you actually invested.It's the same reason why a small down payment on an appreciating house can double your money. The flip side is just as real. If the business stumbles the debt doesn't care and the equity disappears first

The Three Levers

Each purchase generates money through a combination of three levers. The first is paying down debt where the company's cash flow steadily draws down the loan and over time delivers more of the company's value to the equity owner. The second is to improve the business increase revenue reduce costs and increase margins so that the company is simply worth more. The third is multiple expansion selling the company at a valuation multiple higher than what was paid for it which is the least reliable lever because it depends on the market

A Worked Example: Where the Money Actually Comes From

The three levers are often described and rarely quantified hiding the fact that they are not equally reliable and that one of them is currently pointing in the wrong direction

Set the deal at today's prices. Buy a company with $100 million in annual operating profits at a record average of 11.8 times in 2025 i.e. an enterprise value of $1.18 billion. Finance it with about a third of equity $390 million and $790 million of debt

Run it for five years. Increase earnings by 5 percent annually so 100 million becomes approximately 127.6 million. Use the free cash flow after interest to pay off 40 million of debt per year so that 200 million is paid off and the balance falls to 590 million

Come out at the same multiple you paid. 127.6 million times 11.8 is approximately 1,506 million of business value. We subtract the remaining 590 million of debt and the equity is worth about 916 million

Against 390 million invested that is 2.35 times the money in five years an internal rate of return of around 18.6 percent. A good result and one worth breaking down

Note that this deal produced a return of 18.6 percent without any help from the multiple. This is what a well-underwritten buy should look like

Now change one entry and only one. Entry multiples are at a record high. If they revert even part of the way to a historical norm the exit multiple is lower than the entry multiple

Losing 1.8 multiple returns from 11.8 to 10 costs 6.6 percentage points of annual returns. Losing 2.8 returns takes the deal from great to worse than a passive index has historically delivered before fees are charged

That is the honest state of the acquisition market at record entry prices. The third lever is not a source of return it is a liability that operational improvement must overcome. A company that pays 11.8 times today is implicitly betting that multiples will remain at record levels for five years or that it can grow earnings fast enough to absorb the compression. These are illustrative figures with a clean structure and the sensitivity does not depend on particulars

The Market in 2026

The acquisition business is back with a vengeance. While the number of deals in early 2026 was lower than the previous year those that closed were much larger with a handful of giant transactions driving most of the activity. In 2025 just 13 deals above $10 billion accounted for $274 billion in purchase value capped by the $56.6 billion deal fortake video game maker Electronic Arts private a new record for a leveraged buyout. The price companies were willing to pay also hit a record with a typical buyout valued at 11.8 times the company's annual operating profits

Case Study: TXU and Hilton, Same Year, Opposite Endings

The two big lessons about leverage were taught by deals signed in 2007 at the height of the last credit cycle by sophisticated companies paying record prices. The difference in outcome is what is most instructive in private equity

TXU. In October 2007 KKR TPG and Goldman Sachs took Texas utility TXU private for approximately $45 billion including assumed debt the largest leveraged buyout ever made. The thesis was that natural gas prices would remain high as TXU generated much of its power from coal and nuclear plants and sold it into a priced gas market. High gas prices meant big margins for more generationcheap

Then fracking came on a massive scale and natural gas prices collapsed. The margin on which the entire deal depended disappeared and the company renamed Energy Future Holdings was saddled with tens of billions of dollars of debt that it didn't care about. It filed for Chapter 11 in April 2014 with about $40 billion of debt the largest takeover bankruptcy in history. The sponsors lost about $8 billion of capital

Consider what went wrong. The operating business was not mismanaged. The thesis was a bet on the price of a commodity wrapped in leverage that eliminated any chance of being wrong for a time

Hilton. The same month October 2007 Blackstone privatized Hilton Hotels for some $26 billion also at its peak also heavily leveraged and directly on the path of a financial crisis that would devastate business travel. By 2009 Blackstone had written off the investment very substantially and at the time it was widely described as one of the worst deals of the time

Blackstone did three things instead of giving up. It negotiated a debt restructuring in 2010 buying back some of it at a discount and extending maturities. It invested in the business expanded the brand internationally and developed the franchise model which required capital rather than cost cutting. And it waited taking Hilton public in December 2013 and gradually selling off until it fully exited in 2018 with a reported profit of about 14billion dollars one of the most profitable private equity investments ever made

Same vintage same price cap same leverage opposite results. Three differences explain it. Hilton's problem was cyclical demand that would return while TXU's was a permanent structural change in the price of gas. Hilton's capital structure was able to restructure because lenders believed in recovery. And Blackstone had the life of the fund and the will to hold it for eleven years about double a normal holding period

The lesson is not that leverage is good or bad. It is that leverage eliminates the ability to be wrong about the thesis so the only version that can survive is one in which what went wrong can come back

The Criticism

Private equity draws heavy criticism and some of it lands. Loading a company with debt makes it fragile and when a buyout goes wrong job losses and bankruptcies are real. Critics point to cases where companies have stripped assets and cut to the bone for short-term profits. Proponents counter that debt discipline and concentrated ownership often force necessary changes that public companies have eluded for years and that on average acquisitions have generated strong returns to funds.of pensions and endowments that invest in them. As with most financial tools the purchase is neither good nor bad. The result depends on how it is used

Where Both Sides Overreach

This is an unusually polarized argument with both sides making claims that the evidence does not support

Critics go overboard on the employment issue. The asset stripping narrative is vivid and the research is genuinely varied. Large studies of the employment effects of takeovers find concentrated job losses in retail and publicly traded targets and job gains in private targets and some other sectors with an overall increase in productivity. The widespread claim that takeovers destroy jobs is not what the evidence says and the honest version is that the effect depends largely on the type of company acquired

The defenders exceed the returns. The acquisitions have generated strong gross returns. Without taking into account the fee structure which takes something like a third of the gross profit in a good fund and more than half in a mediocre one the comparison with public equity over the past decade is much closer than industry marketing suggests and several large studios find little or no excess returns after adjusting for leverage

The measure is really controversial. Internal rates of return are aided by underwriting lines of credit that delay capital calls from investors and follow-on funds increasingly allow a company to sell an asset to itself generating a return without ever testing an external price. Both practices are legal disclosed and make the reported track record look better than money

And the input multiple solves more than either party admits. The table above shows that at 11.8 times a deal needs everything to go right to produce a good return. Whatever you think about the social effects of the industry the arithmetic says that the returns of this crop will have to come from operations because the multiple leverage has already been spent

My view is that the model works that it works less well than the marketing claims and that record entry prices make the next few years the true test of whether operational improvement is a genuine skill or is mostly cheap debt in a rising market

Why the Exit Is Everything

A buyout is only as good as its exit because the company doesn't make anything until it sells. That's been the recent tension with companies holding companies longer than planned in a slow market which is why exits and secondary sales have become a focus reaching record levels as companies look for ways to return cash to their own investors. Understanding that the entire model depends on buying well improving the business and selling at the right time is the key to understanding private equity

How I Would Actually Read an LBO

The mechanics of model building are taught everywhere. Less taught is what results really matter and my order is more or less the inverse of how the model is built

I would go first to the return attribution the breakdown in the table above. Any deal where multiple expansion accounts for a significant portion of the projected return is a deal that bets on the market rather than the business and I would consider that portion to be worth zero

Second I would run the exit multiple sensitivity before reading the operating case because it establishes how much of the performance is a forecast about other buyers. If the deal only works with a fixed or higher exit multiple from a log entry the operating plan is decoration

Third I would look at the debt schedule and ask what happens if earnings stay flat instead of growing. The equity in the example worked survives because the cash flow pays off the debt. A flat year means fewer payments higher exit leverage and a much lower equity value and no change is not a disaster scenario

Fourth I would like to ask what the thesis depends on that management cannot control. TXU depended on the price of natural gas. Hilton depended on the recovery of business travel. One of them was recoverable and the other was not and identifying which category a thesis falls into is more important than any model

Fifth I would review the pact package and the maturity wall because the ability to survive being wrong for two years is worth more than two points of projected performance

That's more of a method than advice and I have no involvement in any of these companies

Why It Matters for the Role

The LBO model is one of the most demanding pieces of analysis in finance because it ties debt cash flow operations and valuation into a single model that must be maintained for several years. Even well beyond private equity the discipline it teaches - how leverage amplifies both returns and risk how operational improvement creates value and how exit drives everything - is exactly the way serious finance people learn to think about any investment

The Bottom Line

A leveraged buyout puts up about a third of the equity borrows the rest against the company being bought and pays off the debt with that company's own cash flow. The companies own about $1.3 trillion in dry powder 13 deals above $10 billion represented a purchase value of $274 billion in 2025 and the $56.6 billion Electronic Arts transaction set a record

The arithmetic shows where the profits must come from now. Buying at a record 11.8 times growing earnings by 5 percent a year and paying down 200 million of debt in five years produces about 2.35 times the money and a return of 18.6 percent of which 62 percent comes from earnings growth and 38 percent from deleveraging. Instead go out 10 times and the return will fall to12 percent.It comes out at 9 times and falls to 7.5 percent.At record entry multiples the third lever is a liability rather than an asset

TXU and Hilton signed contracts in October 2007 at peak prices and with heavy leverage. One filed the largest acquisition bankruptcy in history in 2014 because natural gas prices never rose again. The other was brutally written off restructured held for eleven years and returned approximately $14 billion. Leverage eliminates the ability to make mistakes so the only thesis that can survive is one in which whatgoes wrong it can be recovered