Let’s compare two hypothetical scenarios to understand how debt loading can affect the profits of a private equity (PE) firm upon exiting an investment. For simplicity, we’ll assume the PE firm is buying and then selling a company, and we’ll ignore factors like operational improvements, tax impacts, and market fluctuations.
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Purchase Price of Company: $100 million
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PE Firm’s Equity Investment: $100 million (100% equity, no debt)
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Selling Price of Company after 5 Years: $150 million
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Profit: Selling Price – Purchase Price = $150 million – $100 million = $50 million
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Return on Investment (ROI): Profit / Equity Investment = $50 million / $100 million = 50%
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Purchase Price of Company: $100 million
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PE Firm’s Equity Investment: $30 million
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Debt Used to Purchase Company: $70 million
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Interest on Debt: Let’s say 5% per annum (simplified for this example)
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Total Interest Over 5 Years: 5% of $70 million x 5 years = $17.5 million
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Selling Price of Company after 5 Years: $150 million
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Profit: Selling Price – (Purchase Price + Interest) = $150 million – ($100 million + $17.5 million) = $32.5 million
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Return on Equity (ROE): Profit / Equity Investment = $32.5 million / $30 million ≈ 108.3%
In the first scenario, the PE firm makes a $50 million profit on a $100 million investment, a 50% ROI. In the second scenario, after accounting for interest, the firm makes a $32.5 million profit on a $30 million investment, which is a 108.3% ROE.
Despite the absolute profit being lower in the second scenario ($32.5 million vs. $50 million), the return on the equity investment is much higher due to the use of debt. This demonstrates the leveraging effect of debt loading: it can significantly increase the return on the PE firm’s actual cash investment, though it also adds the risk of interest payments and potential financial distress.
