What Does Leverage Mean?
Leverage is the use of credit or borrowed funds to increase one's investment capacity and increase the rate of return on a buyer's equity investment. Investing with borrowed funds amplifies potential gains while also increasing the risk of losses. Buyers analyze various capital structures of a transaction at a given price and evaluate the investment opportunity with respect to return on equity based on varying levels of leverage.
Divestopedia Explains Leverage
In an acquisition, adding leverage allows a buyer to use a smaller proportion of their own equity to fund the remaining consideration to be paid to the seller. The buyer can then afford to pay for the target company and still realize an adequate return on their invested capital. The higher the amount of leverage, the higher the potential return on equity.
The use of leverage, however, increases the assumed risk over and above the operating risk. Debt servicing costs resulting from higher debt levels can force a firm to default on its payment. The amount of leverage available to fund an acquisition depends on:
- Type of industry
- Competition scenario
- Firm's strategic positioning
- Growth opportunity
- Potential for margin improvement
- Tangible asset coverage
- Working capital requirement
- Ability to service the debt
- Ability of management
Although leverage entails risk, significant equity returns are possible without material growth. For example, a buyer acquires a company with EBITDA of $10 million for an enterprise value of $40 million. The acquirer uses $30 million debt and $10 million of their own equity. In five years, the firm's EBITDA stays at $10 million, but they pay down debt of $15 million. So the acquirer's equity has also increased by $15 million, assuming the enterprise value has remained the same. The return on equity is approximately 20% (initial investment of $10 million increasing to $25 million over five years)
If the purchaser initially uses only $5 million of their own capital, the return on equity would have to be significantly higher at 32% (initial investment of $5 million increasing to $20 million over five years). But in this higher leveraged scenario, the additional debt could negatively impact the company's free cash flow if there is a decrease in profitability, which can have potentially disastrous implications.