How can a private equity (PE) firm benefit from using debt in a leveraged buyout (LBO)?

Using debt in a leveraged buyout enables a private equity firm to enhance its returns by leveraging borrowed funds alongside its own capital. This approach allows the firm to purchase a company with a smaller initial investment of equity. The profits generated from the acquired company can then significantly exceed the cost of servicing the debt, resulting in a higher return on equity for the investors.

When a PE firm uses debt, it amplifies its potential returns because the firm can use the profits generated from the investment itself to pay down the debt while retaining a larger share of the profits. This strategy is effective particularly when the acquired company performs well, as the equity portion of the investment can lead to substantial gains relative to the initial investment made by the PE firm.

Other options do not correctly capture the primary financial benefit of using debt in an LBO. For example, reducing operational costs is not a direct consequence of leveraging debt; instead, it might be a strategy implemented post-acquisition. Improving company morale is unrelated to the financial structuring through debt, and securing immediate market dominance may result from strategic actions taken post-acquisition, rather than being a direct benefit of financing through debt.