What are the three ways private equity firms create value?

Returns in a leveraged buyout come from three levers. The first is EBITDA growth: increasing revenue through pricing, new products or add-on acquisitions, and improving margins through cost savings or better purchasing. If EBITDA grows from $100M to $130M and the exit multiple is unchanged, enterprise value grows by 30%.

The second is multiple expansion: selling at a higher multiple than you paid. That can happen because the company becomes larger, faster-growing or less risky, or simply because market conditions improve. Private equity firms usually do not count on it when they underwrite a deal, because it depends heavily on the market at exit.

The third is debt paydown. The company uses its free cash flow to repay the acquisition debt, so even if enterprise value stays flat, the equity's share of that value grows. Leverage amplifies all three, because equity is a small share of the capital: a modest increase in enterprise value becomes a larger percentage gain on equity. When I evaluate a deal, I want most of the projected return to come from EBITDA growth and paydown, which the firm can influence, rather than from multiple expansion.