Why private equity matters: How a leveraged buyout works

The financial advisor-focused take on “The Lead Left” newsletter series, authored by Randy Schwimmer, Vice Chairman and Chief Investment Strategist at Churchill Asset Management, is dedicated to help financial advisors stay informed about developments, and movements in private capital investing.

Bottom-line for advisors upfront

1. Private equity offers high-net-worth clients portfolio diversification potential¹ beyond public markets, access to the growth potential of middle market companies, and returns that have historically compared favorably to public benchmarks.²
2. As you discuss alternatives allocations, emphasize that PE isn't passive investing — it's active value creation through operational improvement, strategic growth, and professional management.
3. For clients seeking wealth preservation with growth potential, understanding the fundamentals of how PE firms generate returns through leveraged buyouts provides essential context for sophisticated portfolio construction conversations.

Private equity as an asset class has historically delivered strong returns to investors, often better than public market benchmarks.² It also can help diversify investor portfolios¹ with access to smaller high-growth private companies. As PE becomes available to high-net-worth investors, understanding how these investments work is essential for a sophisticated wealth program — and for the conversations you're having with clients exploring alternatives.

While the first buyers of middle market companies were not strictly PE firms, so-called leveraged buyouts (LBOs) quickly became their focus. To understand how a leveraged buyout works, think of PE sponsors as investment businesses that buy private companies (or take public companies private) using a combination of debt and equity, boost their value, and sell them for a profit — typically within three to seven years. The first thing to understand about buyouts is why would a company agree to a leveraged buyout. Families or entrepreneurs can be challenged to grow their companies without outside capital, especially those too small to go public or issue bonds. Banks provide working capital, but not equity. It's also difficult for founders to realize value in cash without selling their businesses to a competitor. A PE firm can buy some or a majority of that ownership, allowing the seller upside.

Another key feature is how private equity firms finance leveraged buyouts. For LBO PE firms use debt the way homeowners use mortgages — to stretch their equity cash farther to buy the property while enhancing returns. Unlike 20% cash-down residential mortgages, sponsors' share is typically 40–60%. Private credit managers finance the purchase with loans secured by assets and cash flows of the company.

Leveraged buyouts make money as the PE firm works with the management team to grow the company's earnings while also using cash flow to pay down on the borrowed money. When the company is eventually sold, the debt is repaid first, with the remaining profit split between the private equity firm and its investors.

That's the third critical point. PE raises capital from limited partners (LPs) — insurance companies, pension funds, family offices — who commit to general partner (GP) funds. GPs operate on behalf of the LPs, sharing gains and losses based on how well portfolio companies and funds do. Those investors have full access to all performance data for those businesses. How transparent the GPs are is a major factor as to whether LPs invest in the next fund.

What makes PE attractive is how firms create value during their ownership. They don't buy, then sit back and watch. They increase revenues and enhance margins by streamlining operations, cutting unnecessary costs, implementing better systems and reporting, upgrading management talent, and pursuing strategic growth opportunities. Many firms invest meaningfully in enterprise resource planning systems, customer relationship management platforms, and other technologies that professionalize the business.

And that's the final point. Despite how they are sometimes portrayed, PE firms don't buy businesses to strip assets and fire employees. The goal is to take a good business and make it better, so that when it's finally sold, everyone — investors, owners, and employees — benefits.