Private Equity & Corporate Debt: Understanding the Risks

Private Equity Playbook: Debt and Risk

Leveraged Buyouts

Private equity firms use a strategy to acquire companies without risking much of their own capital. For example, to buy a company for 100,000,000, a private equity firm might only contribute 20,000,000 of their own money and borrow the remaining 80,000,000 from a bank. The acquired company is then responsible for repaying the 80,000,000 debt.

Extracting Cash

After acquiring the company, the private equity firm arranges for the company to take out a second loan, not for growth or improvement, but to pay the private equity firm, increasing the company's debt burden.

Collateralized Loan Obligations (CLOs)

Banks, holding these risky loans, create CLOs to transfer the risk to other investors, which involves bundling loans from various companies into a single package which is then sold to investors.

CLO Layers

To attract different investors, CLOs are divided into layers based on risk:

• Top Layer: Rated "triple A safe" to appear low risk.

• Middle Layer: Considered medium risk, typically sold to insurance companies.

• Bottom Layer: Considered junk, and sold to hedge funds that are seeking large payouts.

The Cycle

Private equity firms load companies with debt, extract cash for their own benefit, and leave the company vulnerable to collapse. This strategy parallels the risky mortgage practices of 2008, but involves entire companies.