A breakdown of how PE firms drive returns through EBITDA growth, multiple expansion, and leverage.
Most people outside the industry think private equity is just about buying companies, loading them up with debt, and cutting costs. And sure, leverage plays a role. But the real formula behind PE returns is far more nuanced—and much more strategic.
Private equity firms generate returns through three core levers: operational improvements, multiple expansion, and leverage. Understanding these levers is key whether you’re an investor, a professional in the industry, or someone looking to break in.
1. Operational Improvements (The Real Engine)
This is often the most controllable and sustainable lever. Operational improvements focus on increasing a company’s EBITDA through strategic changes that improve revenue, reduce costs, or both.
PE firms help portfolio companies grow by:
- Bringing in stronger management teams
- Optimizing pricing, product mix, or go-to-market strategies
- Cutting unnecessary costs and improving efficiency
- Investing in systems and processes that enhance scalability
One illustrative case from Gompers and Kaplan’s “Advanced Introduction to Private Equity” involves the Japanese PE firm Advantage Partners, which invested in a struggling retailer. Through simple but effective changes like implementing best practices in inventory and sales tracking (called Dia Kanri), they were able to significantly improve profitability without radical restructuring. That’s operational value creation in action.
2. Multiple Expansion (Buy Low, Sell High)
Multiple expansion refers to buying a company at a certain valuation multiple and selling it at a higher one. This doesn’t necessarily reflect changes in the company itself—it often reflects better timing, improved market conditions, or finding a strategic acquirer who sees more value in the asset.
Common drivers of multiple expansion include:
- Acquiring companies from less competitive, inefficient markets
- Selling into a frothy or bullish public market
- Strategic acquirers willing to pay more due to cost or revenue synergies
Proprietary sourcing can unlock discounts, allowing PE firms to buy at a discount. Later, when the company is positioned for growth or fits strategically with a larger buyer, the exit multiple can be significantly higher.
3. Leverage (The Amplifier)
Leverage is what most people associate with private equity—and yes, it plays a big role. By using debt to finance a large portion of the acquisition, firms can amplify equity returns.
Leverage alone doesn’t create value. In fact, used improperly, it can destroy it.
How smart leverage adds value:
- Create discipline and focus due to debt service obligations
- Unlock tax benefits via interest deductibility
- Reduce required equity capital, increasing return on equity
But overreliance on leverage without operational improvement or a favorable exit environment is risky.
Putting It All Together: The PE Value Bridge
The best private equity investments combine all three levers:
- EBITDA grows due to operational improvement
- The exit multiple increases due to better positioning or market timing
- Leverage amplifies returns on the equity invested
This is the essence of the “value bridge” framework. It’s not just about financial engineering—it’s about building better businesses and exiting smartly.
Why This Matters
If you’re trying to break into private equity, understanding this framework is more valuable than memorizing LBO model shortcuts. If you’re already in the industry, it’s a reminder that real value creation happens beyond the spreadsheet.
In future posts, I’ll break down each of these levers further—with examples, modeling tips, and real-world insights.
Stay tuned for more posts on how PE really works—from the inside out.