Broader than buyouts
Private equity is private capital invested in privately held companies. The asset class includes buyouts, growth equity, and other private-company strategies—buyouts are simply the best-known part.
Lesson 04 · Markets
Private equity.
Private equity buys stakes in companies that are not listed on a stock exchange, usually through a professionally managed fund. In a buyout, the fund takes control of a mature business, finances the purchase partly with debt, works to improve the company, and sells it years later. This lesson walks through that cycle step by step, with one worked example carried from entry to exit.
Back to all topicsBUYOUTS ✦ LPS & GPS ✦ ENTERPRISE VALUE ✦ EBITDA ✦ LEVERAGE ✦ SOURCES & USES ✦ MOIC ✦ IRR ✦ DUE DILIGENCE ✦ EXIT
BEFORE YOU START
Buy, improve, sell.
Private equity is ownership of companies that do not trade on a stock exchange. The investor usually gets involved in running the business, and plans from day one for how it will eventually sell.
Control and involvement
Private equity funds often take controlling stakes in operating companies and take an active part in how those companies are managed and directed.
One repeated cycle
Acquire a company, improve the business or its capital structure, increase the value of the equity, and exit the investment. Every section below fits somewhere in that loop.
UNIT 01 · ACROSS THE LIFE CYCLE
Three stages, three kinds of return.
Private capital backs companies at every age. The more mature the company, the more the return depends on cash flow and structure rather than on future growth alone—so each stage needs its own analysis.
Invests in: Companies in early development, often before they are profitable.
Returns
Depend heavily on future growth and market expansion
Invests in: Established businesses with proven products and markets that need capital to expand.
Returns
Come from scaling a model that already works
Invests in: Mature businesses where investors can acquire control of the company.
Returns
Built on cash flow, debt capacity, valuation, and operating improvements
UNIT 02 · THE ECOSYSTEM
Who puts the money in, and who runs it.
A private equity fund sits between two groups: the institutions that supply the capital, and the firm that decides what to buy and how to run it.
Limited partners (LPs)
Provide the capital but generally do not manage individual investments.
- Pension funds, endowments, and foundations
- Insurers and family offices
- Sovereign wealth funds and other institutions
The fund
Pools the LPs’ capital and invests it in a portfolio of companies.
- Typical investment horizon of 10 years or more
- Investments are relatively illiquid
- Fees, expenses, and potential conflicts of interest need to be understood
General partner (GP)
The private equity firm that runs the fund and makes the investment decisions.
- Sources investments and performs due diligence
- Negotiates transactions
- Manages portfolio companies and realises investments
UNIT 03 · THE INVESTMENT LIFECYCLE
Eight stages from fund to exit.
Every deal moves through the same sequence. Each stage carries its own risk, and a strong idea can still fail at any one of them.
Fundraising
The GP raises commitments from limited partners to form a new fund.
Sourcing
The team looks for companies that could be bought, through networks, advisers, and its own research.
Screening
Most opportunities are rejected quickly. Only those that fit the fund’s strategy move forward.
Due diligence
A detailed investigation of the business, its market, its finances, and the risks that could break the case.
Valuation
The team decides what the business is worth and what price it can afford to pay.
Transaction
The deal is negotiated, financed with debt and equity, and closed.
Ownership and value creation
Over several years the fund works with management to grow earnings, improve operations, and repay debt.
Exit
The investment is sold—to a strategic buyer, another financial sponsor, or through a public-market transaction.
How a strong thesis still fails
UNIT 04 · THE BUILDING BLOCKS
Value, earnings, and cash.
Two distinctions sit underneath every buyout: the company versus the shareholders’ slice of it, and reported earnings versus the cash that can actually repay debt.
Enterprise value and equity value
- Enterprise value
- The value of the operating business, independent of how it is financed. Enterprise value = equity value + debt − cash.
- Equity value
- What belongs to shareholders after debt is paid and cash is added back. Example: €500M − €200M debt + €50M cash = €350M.
- Net debt
- Debt minus cash. In the example, €200M of debt less €50M of cash leaves €150M of net debt.
EBITDA and free cash flow
- EBITDA
- Earnings before interest, taxes, depreciation and amortisation. Used to compare operating performance and set valuation multiples.
- EV / EBITDA
- A company with €500M of enterprise value and €50M of EBITDA is valued at 10.0x.
- Not cash flow
- From EBITDA, subtract taxes, interest, capital expenditure, and any increase in working capital to find the cash actually available to repay debt.
- Why it matters
- Strong cash conversion is what lets a leveraged company support its financing and build equity value.
UNIT 05 · THE LEVERAGED BUYOUT
Borrow to buy, then repay from cash flow.
- A leveraged buyout (LBO) buys a company using a mix of debt and the sponsor’s own equity. The company’s cash flow then repays that debt over time.
- At purchase: enterprise value €500M, financed with €300M of debt and €200M of equity. After €100M of debt is repaid, enterprise value is still €500M—but debt is €200M and equity is €300M.
- Sources must equal uses. Uses include buying the target’s equity, refinancing existing debt, and transaction costs. Sources include sponsor equity, term loans, bonds, and other financing. If €600M is needed and €350M is debt, the sponsor puts in €250M.
- Leverage cuts both ways. If performance weakens, the fixed debt obligations remain: less value is left for equity, and refinancing or covenant pressure can follow.
The complete LBO example
Exit equity = (Exit EBITDA × Exit multiple) − Remaining debt- At entry
- €50M EBITDA × 10x = €500M EV
- Financing
- €300M debt + €200M sponsor equity
- Five years later
- €70M EBITDA × 10x = €700M EV
- Less remaining debt
- €700M − €200M = €500M equity
- Where the gain came from
- €200M from EBITDA growth, €100M from debt paydown
- MOIC
- €500M ÷ €200M = 2.5x
UNIT 06 · WHERE RETURNS COME FROM
Four sources, two measures.
A company bought and sold at the same 10x multiple can still produce an attractive return if its earnings grow and its debt falls. Splitting the return into parts shows whether it came from a better business or a better price.
The four sources of LBO returns
- EBITDA growth
The business is worth more because it earns more. At an unchanged 10x multiple, lifting EBITDA from €50M to €70M adds €200M of enterprise value.
- Multiple expansion
The company is sold at a higher valuation multiple than it was bought at. Useful when it happens, but a robust case should not depend on it.
- Debt paydown
Operating cash flow reduces debt, so more of the enterprise value belongs to the sponsor. In one example, €100M of the €250M equity gain comes from deleveraging alone.
- Operational improvement
Better pricing, procurement, sales productivity, technology, and wider distribution. The savings must be durable, not temporary, and worth the investment they require.
Measuring the return
- MOIC
Multiple on invested capital: total proceeds divided by total capital invested. Turning €100M into €200M is 2.0x, whether it takes three years or seven.
- IRR
Internal rate of return: the annualised return implied by the timing of the cash flows. The same 2.0x earns a much higher IRR over three years than over seven.
- Timing can flatter IRR
The SEC notes that techniques such as subscription credit lines can raise a fund’s reported IRR by changing when investors’ cash moves, without raising its total economic return.
UNIT 07 · ENTRY AND EXIT
The price you pay, the price you get.
The same earnings can cost very different amounts depending on the multiple paid. And the way a sponsor sells shapes what it can expect to receive.
Entry and exit multiples
- Entry multiple
- Purchase enterprise value ÷ EBITDA. Two identical businesses with €50M EBITDA cost €400M at 8x but €600M at 12x.
- Is the price justified?
- A high multiple can still work if the company grows quickly, but it raises the burden on future performance. Test it against growth, cash generation, competitive position, and realistic exit assumptions.
- Exit multiple
- Exit EV = exit EBITDA × exit multiple. €70M × 11x = €770M. The gap between entry and exit multiples can change returns materially.
Four ways to exit
- Strategic sale
- Sold to another operating business, often a competitor or supplier.
- Sponsor-to-sponsor
- Another private equity firm buys the company.
- IPO
- The company lists on a stock exchange; the sponsor sells its shares over time, subject to restrictions.
- Recapitalisation
- A new financing structure that can return capital to investors without a full sale.
UNIT 08 · DUE DILIGENCE
Looking for what could break the case.
Due diligence is not only about confirming a company is attractive. Its purpose is to find the assumptions that could make the investment fail—before the money is committed.
Commercial
Is the market and the company’s position in it as strong as it looks?
- Market, customers, and competitors
- Pricing and market share
- Growth opportunities
Financial
Are the reported numbers real and repeatable?
- Historical earnings and revenue quality
- Margins, working capital, and capex
- Whether EBITDA is sustainable
Operational
How does the business actually function day to day?
- Processes, systems, and suppliers
- Where costs and productivity can improve
Legal, tax and regulatory
What liabilities or constraints could affect the investment?
- Contracts, disputes, and licences
- Tax exposures and regulatory limits
Management
Can the leadership team deliver the plan?
- Capabilities and track record
- Incentives to execute
UNIT 09 · EARNINGS QUALITY AND RISK
Debt is repaid in cash, not in EBITDA.
Reported EBITDA is adjusted into sustainable earnings before it is used for valuation. A business can show strong EBITDA and still produce weak free cash flow if it needs heavy capex or working capital.
Quality of earnings: what gets adjusted
- Unusual revenue
- One-time expenses
- Customer concentration
- Accounting adjustments
- Acquisitions
- Claimed cost savings
The four main risks
Debt increases fixed obligations and magnifies any change in the value of the equity, in either direction.
Growth, margin, or cost-reduction targets are missed, leaving less cash to repay debt.
The purchase price was too high, or the exit multiple turns out lower than expected.
Private companies cannot be sold as easily as listed shares, and fund investors are locked in for years.
Also worth watching
- Refinancing
- Interest rates
- Customer concentration
- Regulation
- Management
- Execution
The investment committee asks: what if…
What if EBITDA growth is lower than planned?
What if margins do not improve?
What if the exit multiple contracts?
What if interest rates rise or refinancing costs more?
UNIT 10 · THE COMPLETE FRAMEWORK
Eight questions before any deal.
A strong investment does not need every assumption to be optimistic. It should stay attractive under a range of reasonable scenarios.
Business
Is it fundamentally attractive and defensible, with sustainable cash generation?
Market
Is the market growing, stable, or structurally deteriorating?
Entry valuation
Is the price justified by EBITDA, cash flow, growth, and comparable deals?
Financing
How much debt can the company carry without excessive financial risk?
Value creation
Which specific actions can raise EBITDA and cash flow?
Deleveraging
How much debt can realistically be repaid during ownership?
Exit
Who could buy the company, at what valuation, and in what conditions?
Return
Is the risk-adjusted return attractive after price, leverage, fees, and timing?
THE CORE RELATIONSHIP
Three lines that hold the whole lesson.
- Attractive returns should ideally come from improving the underlying business and generating cash, not from depending entirely on leverage or a higher valuation multiple.
Formulas
- Exit enterprise value
- Exit EBITDA × Exit multiple
- Equity value at exit
- Exit enterprise value − Net debt
- Investor return (MOIC)
- Exit equity value ÷ Initial equity investment
Private equity owns a large share of the companies people work for and buy from, yet it rarely shows up in a share price you can check.
Understanding how a buyout is financed and paid back explains why these owners focus so closely on cash flow, debt, and the exit—and why the best returns come from improving the business itself rather than from leverage or a higher multiple.
HOW TO USE THIS
Improve the business, then follow the cash.
- Separate the business from its financing. Enterprise value is the company; equity value is what is left after debt.
- EBITDA is a starting point, not cash. Debt is repaid from what remains after taxes, interest, capex, and working capital.
- Break every return into its parts—EBITDA growth, multiple change, and debt paydown—so you can see which ones the case really relies on.
- Read MOIC and IRR together. A multiple says how much; an IRR says how fast, and timing can flatter it.
- Test the downside before the upside. A good deal stays attractive when growth, margins, or the exit multiple disappoint.
Lesson 04 slides
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