Three engines: profit growth, debt paydown and a higher exit multiple

Buyout returns come from growing earnings, using cash flow to repay debt, and selling at a higher valuation multiple - and only the first is reliably within the manager's control.

13 min read · Level 4

The point

A long period of falling interest rates lifted buyout multiples almost everywhere, and I think a large share of the asset class's celebrated historical returns came from that rather than from the operational improvement the industry emphasises. That does not make private equity worthless; it means the next decade will reward managers who actually improve businesses, and their track records need to be read with that lens rather than taken at face value.

What is it?

Take the buyout from the previous lesson: bought at 10x EBITDA of 20,000,000 for 200,000,000, funded with 120,000,000 of debt and 80,000,000 of equity.

Five years later:

EBITDA grows to 30,000,000 Sold at 10x EBITDA 300,000,000 Debt repaid from cash flow 50,000,000 remaining debt 70,000,000 Equity value 230,000,000 (300,000,000 - 70,000,000)

The fund put in 80,000,000 and gets back 230,000,000: a 2.875x multiple. Over five years that is an annual return of roughly 23.5%.

Where the 150,000,000 of equity gain came from:

EBITDA growth: 10,000,000 x 10 100,000,000 Debt paydown 50,000,000 Multiple expansion (10x to 10x) 0 Total 150,000,000

If the exit multiple had risen to 12x, the sale price would be 360,000,000, equity 290,000,000, and the multiple 3.625x. The extra 60,000,000 (30,000,000 x 2) came purely from buyers paying more for the same earnings.

For comparison, the same deal with no debt: 200,000,000 of equity, the company keeps the 50,000,000 of cash, and sells for 300,000,000. Equity worth 350,000,000 on 200,000,000 is 1.75x. Leverage lifted the result from 1.75x to 2.875x.

Why does an investor care?

Because knowing which engine produced a return tells you whether it can happen again. Earnings growth reflects the company and management. Debt paydown is largely mechanical. Multiple expansion is mostly the market: in periods of falling interest rates, buyers paid higher multiples for everything, and many funds benefited without improving their companies much.

It also shows what leverage does. The same business performance produced 1.75x unlevered and 2.875x levered - but the next lesson on risks shows the same arithmetic running the other way.

And it explains why buyout funds report IRR so prominently: returning money quickly raises IRR even if the multiple stays the same.

This is educational information, not investment, securities or financial advice. Rules differ by country and change — get advice from a qualified professional in your jurisdiction before acting.

Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.

Sources: U.S. SEC - Investor.gov; CFA Institute; FINRA - Investor Insights

Example

Two funds with identical 2.5x results on their best deal.

Engine Fund A Fund B EBITDA growth 70% of gain 15% of gain Debt paydown 25% 25% Multiple expansion 5% 60%

Fund A improved the company: margins, new markets, better operations. Fund B bought in a low-multiple year and sold in a high-multiple year. On paper they look the same. An investor choosing between them for the next decade should weight Fund A's record far more, because a similar rise in market multiples may not happen again.

The common mistake

Crediting the manager for multiple expansion. When market valuations rise broadly, almost every buyout benefits. Only the part of the return that came from improving the business is good evidence of skill.

How it works

Step 1: Split each deal's gain into the three engines

Ask for or compute the change in EBITDA, the debt repaid and the entry and exit multiples. Allocate the equity gain across them as in the example.

Step 2: Compare entry and exit years to market multiples

If exits happened in a period when all multiples were high, discount the multiple expansion part.

Step 3: Recompute the deal without leverage

Seeing the unlevered result shows how much of the return came from borrowing rather than the business.

When to use this

When reviewing a buyout manager's track record or judging whether a reported return reflects skill.

When not to use it

Do not treat the illustrative figures as typical. Real deals vary widely, and many produce far lower returns or losses.

How investors actually did it

A recurring pattern: value creation reports that separate the engines

Some large institutional investors and academic studies attempt to attribute buyout returns to earnings growth, leverage and multiple expansion. Their published findings commonly show multiple expansion as a significant contributor in periods of falling rates, with its share varying by period and study.

Ask managers for their own value-creation bridge and compare it to what market multiples did over the same years.

Do this now

For any PE return you have seen quoted, ask how much came from multiple expansion
Recompute the example with a 9x exit multiple and note the result

Create a free account to read the rest and apply it to your own investing.

Related lessons

IRR: the measure that knows about time, and what it assumes — IRR is the rate at which every cash flow discounts back to zero. It is the right tool for irregular timings, and it systematically flatters anything held briefly. (14 min)
Comparables and multiples: what the market is already paying — A multiple is not a shortcut past valuation. It is somebody else's valuation, compressed into one number, and using it means inheriting every assumption inside it. (12 min)
Buying a whole company, mostly with somebody else's money — A private equity fund buys control of established companies, usually financing much of the price with debt the company itself must repay. (9 min)