The process that most Private Equity firms go through to buy companies is called a Leveraged Buyout, or LBO.

Let’s break down what this means 📚

Leverage = taking on debt, or borrowing money

Buyout = “buying” and taking control of a company

💡 Leveraged Buyout, = using borrowed money, or debt, to buy a company.

LBOs take advantage of something called the Leverage Effect to amplify investment returns – but also risk! ⚖️

Let’s say you buy a chocolate company with $100 of your own money 🍫

After 5 years, the company’s value grows to $200. If you sell the company for $200, you’ve doubled your money – not bad!

Now, let’s say you buy the chocolate company using $50 of your own money PLUS $50 that you borrowed from a friend.

If the company’s value grows to $200, what happens when you sell the company now? 🤔

After selling the company you’d have $200, but you’d need to pay $50 to the friend you borrowed from.

So, you’d have $150 left, meaning you turned $50 into $150, TRIPLING your money! 🚀

In this case, borrowing money helped amplify your returns 🌟

As you might have guessed, LBOs basically follow this same playbook!

But, what happens if your chocolate company LOSES value? Let’s say it fell in value from $100 to $50 💔

If you bought the company with $100 of your own money and sold it for $50...

You’d still have $50 left, a 50% loss on your original $100 investment 🤧

But if you bought the company with $50 of your own money PLUS $50 that you borrowed from your friend, and then sell it for $50...

You'd have $50 after the sale, but you'd need to use it to pay back your friend.

So after paying your debts, you'd be left with $0 -- a 100% loss on your investment! 😳

As you can see, debt can amplify both investment profits and losses.

This is why LBOs are risky, and why leverage is a double-edged sword ⚔️