The only clean way to measure leverage is to run the identical deal without it. The answer depends on one spread: the unlevered return over the after-tax cost of debt.
Measure it by buying the same company without debt. On an illustrative buyout at 9.0x EBITDA, the all-equity deal returns 12.2 per cent and the same deal with 5.5x of debt returns 18.1 per cent, so leverage adds 5.9 points of IRR, about a third of the return. The other two thirds come from the company. How much leverage adds depends on one spread: the unlevered return over the after-tax cost of debt, here 12.2 against 6.0 per cent.
Worked in full in The Buyout Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A fictional industrial company, figures in millions. Both versions of the deal pay the same price, follow the same plan and sell at the same multiple. Only the financing differs.
| Input | Value |
|---|---|
| Entry EBITDA, entry and exit multiple | 50.0 at 9.0x |
| Enterprise value and fees (3.0%) | 450.0 + 13.5 |
| EBITDA growth a year, hold | 6.0%, 5 years |
| Capex equal to depreciation, % of EBITDA | 20% |
| Working capital, % of the EBITDA increase | 10% |
| Tax rate | 25% |
| Debt in the levered deal, 5.5x, interest | 275.0 at 8.0% |
The fund pays 463.5 in cash. With no debt to repay, each year's free cash flow is paid out as a dividend, and at exit the whole enterprise value belongs to the fund.
Flows: −463.5, then 31.5, 33.4, 35.4, 37.5 and 642.0 (602.2 of exit value plus the year 5 dividend of 39.8)
Total received = 779.8; MOIC = 1.68x; IRR = 12.2%
Excel: =IRR(B1:B6) on the six flows
This 12.2 per cent is the company's own return at this price: EBITDA growth, cash generation and the exit, with nothing borrowed. It is the number to beat.
Lenders provide 275.0, so the fund writes a cheque of 188.5. Interest of 95.7 over five years absorbs part of the cash flow, of which 24.0 comes back as a lower tax bill, and every remaining dollar repays debt.
Free cash flow after interest over five years = 105.8, all used to repay debt
Exit equity = 602.2 − 169.2 of remaining debt = 433.0
MOIC = 433.0 / 188.5 = 2.30x; IRR = 18.1%
| Line | All equity | 5.5x debt |
|---|---|---|
| Equity invested | 463.5 | 188.5 |
| Cash generated after interest, 5 years | 177.6 | 105.8 |
| Interest paid | 0.0 | 95.7 |
| Total returned to the fund | 779.8 | 433.0 |
| Gain | 316.3 | 244.5 |
| MOIC | 1.68x | 2.30x |
| IRR | 12.2% | 18.1% |
The levered fund makes a smaller gain, 244.5 against 316.3, on a much smaller cheque. That is what leverage does: it does not create value, it lets the fund own the company's return on less money, at the price of the lenders' interest. The 5.9 points it adds are 32 per cent of the levered IRR; 68 per cent would have been earned anyway.
The textbook shortcut, levered return = unlevered return + (unlevered return − after-tax cost of debt) × debt / equity, gives 12.2% + 6.2 × 1.46 = 21.4 per cent. It overstates, because it holds debt to equity at its entry level of 1.46 for five years when the paydown and the growth in equity value cut it every year. Use it for intuition, not for the investment memo.
| Scenario | All equity | Levered | Leverage adds |
|---|---|---|---|
| EBITDA flat | 6.0 | 5.9 | −0.1 |
| Growth 3% a year | 9.1 | 12.3 | 3.2 |
| Base, growth 6% | 12.2 | 18.1 | 5.9 |
| Growth 9% a year | 15.4 | 23.4 | 8.0 |
| Exit at 8.0x | 10.1 | 14.2 | 4.1 |
| Exit at 10.0x | 14.2 | 21.5 | 7.3 |
| Interest at 12% | 12.2 | 15.6 | 3.4 |
The flat case is the one to remember. With no growth the company returns 6.0 per cent, in line with the 8.0 per cent coupon after 25 per cent tax, and five and a half turns of debt add nothing at all: the fund takes the risk of a leveraged balance sheet for a return it could have had unlevered. Leverage is a multiplier of the spread between what the business earns and what the debt costs. When the plan works it multiplies upwards; when it stalls it multiplies a spread of zero, and below that it subtracts. Higher rates shrink the spread from the other side: at 12 per cent interest the contribution falls to 3.4 points, and at the interest cap the tax shield shrinks too, as how the 30 per cent EBITDA interest cap affects LBO returns shows.
Reading the deleveraging bar of a value creation bridge as the contribution of leverage. In the levered deal 105.8 of debt is repaid, and a bridge shows it as a source of equity value. But the all-equity owner collects 177.6 of cash from the same business, 71.8 more, which is precisely the after-tax interest of 71.7 the levered owner paid to the lenders. Paydown is the company's cash flow, not a gift from the capital structure, which is also why more debt shrinks the deleveraging bar rather than the operating one, as shown in whether higher leverage dilutes the operating contribution. The only honest measure of leverage is the comparison with the same deal unlevered, and the bridge that separates operating growth from multiple change is a different tool, set out in how to split EBITDA growth and multiple expansion.
The book runs its own case the same way, with the all-equity purchase on its own sheet beside the levered deal, in the free workbook for this case.
Run the same company, price, plan and exit with no debt: the free cash flow is paid out as dividends each year and the whole exit value goes to equity. The difference between that IRR and the levered IRR is the leverage effect. In the illustrative case it is 18.1 per cent against 12.2, so leverage adds 5.9 points.
When the unlevered return falls to the after-tax cost of debt. With 8.0 per cent interest and a 25 per cent tax rate that cost is 6.0 per cent. In the illustrative case flat EBITDA gives an all-equity return of 6.0 per cent and a levered one of 5.9: the debt multiplies nothing and only adds risk.
No. The deleveraging bar shows cash that repaid debt, 105.8 in the illustrative case, but the all-equity buyer collects 177.6 of cash from the same business because it pays no interest. The leverage effect is the higher return on a smaller cheque, 5.9 points of IRR here, not the size of the paydown bar.
This article is one calculation from The Buyout Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: private equity and private markets → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.