Debt can amplify returns, but it can also amplify mistakes. Three real situations — a 1990s buyout, a hospitality company recapitalised for twenty years, and an ice cream business with a hidden cash peak — show when leverage creates value and when it destroys it.
Key takeaways
- Debt is a tool, not a strategy. Leverage can amplify value creation; it cannot replace it.
- Recapitalisations can return capital without selling the company — but only if the business can carry the extra debt.
- A company can be profitable and still run out of cash. The right amount of debt is what the business can support through the cycle, including when the model is wrong.
Debt is one of the most powerful tools in M&A. Used correctly, it can significantly enhance equity returns. Used incorrectly, it can do exactly the opposite.
It can magnify losses, create liquidity problems, force difficult decisions — and in extreme cases, push a perfectly viable business into default or even bankruptcy.
This is particularly relevant in private equity transactions, where leverage is often an important part of the investment thesis.
The basic logic is straightforward. If you acquire a company using a combination of debt and equity, and the company generates enough cash flow to repay the debt, the equity value can increase significantly even if the underlying enterprise value does not change. That is the power of leverage.
But there is an important question that is sometimes overlooked: what happens if the assumptions behind the leverage do not materialise?
Over the years, I have seen very different answers to that question. Here are three situations that illustrate three very different ways in which debt can affect an M&A investment.
1. When debt was the investment thesis
At the beginning of my career in M&A, back in the 1990s, many of the transactions I saw were buyouts where the investment thesis was remarkably simple:
- Create a 50/50 capital structure between equity and debt.
- Repay the debt over five years.
- Exit the company at the same valuation multiple five years later.
No multiple expansion. No major operational transformation. No sophisticated value creation plan. Just deleverage the company.
The logic seemed compelling. If you invested 50 and borrowed another 50, and five years later the debt had been repaid, the equity would be worth 100. You had doubled your investment without needing the company to increase its valuation. According to the models, this could generate an IRR of around 20%.
At the time, this was often presented as a relatively low-risk way of creating value.
Five years later, when I already had many more transactions under my belt, reality looked rather different. Many of these transactions significantly underperformed. And some ended in default.
The problem was not leverage itself. The problem was the assumption that debt repayment alone could be the investment thesis.
Businesses do not always generate the cash flow that the model predicts. Interest rates change. Margins deteriorate. Working capital increases. Capex requirements emerge. Markets change. And unexpected events happen.
Over time, buyouts became much more demanding in terms of analysis and value creation. Operational improvement, revenue growth, margin expansion, strategic repositioning and multiple considerations became increasingly important. Debt remained a key component of many transactions. But it stopped being the main value creation thesis.
Leverage could amplify value creation. It could not replace it.
2. When debt becomes a value creation tool: recapitalisations
Years later, I saw a very different approach.
A well-known private equity fund had an investment in its portfolio in the hospitality sector. They held the company for around ten years. During that period, they carried out a recapitalisation every three years. The business continued to perform. The debt structure was actively managed. And capital was returned to investors through these recapitalisations.
When the fund eventually reached the end of its life and the investment needed to be realised, something unusual happened. Instead of selling the company to a third party, the fund carried out a rollover and transferred the company into another fund managed by the same organisation.
The investment was then held for another ten years. And the same approach continued, with recapitalisations approximately every three years.
According to the fund's own management team, that investment became one of the most successful transactions they had ever completed.
Why? Because the value creation did not depend exclusively on selling the company. The business generated value over time, and the capital structure allowed the shareholders to realise part of that value without necessarily giving up ownership.
It is an important distinction. Selling the company is not the only way to create value. And debt does not necessarily have to be used to finance an acquisition. It can also be used, when the business and its cash flows support it, as a tool to optimise the capital structure and return capital to shareholders.
But there is an important caveat. Recapitalisation only works when the underlying business can support the additional debt. Otherwise, what looks like value extraction can quickly become value destruction.
3. When the structure does not fit the business: the ice cream case
The third situation is perhaps the most important.
We were analysing the acquisition of an ice cream manufacturing company. The proposed transaction had a very aggressive and highly leveraged financial structure. On paper, the business looked perfectly capable of supporting the acquisition financing.
The analysis was based on an annual business plan. The financial year ran from 1 November to 31 October, and the projections were calculated as of 31 October each year. Capex had been considered. Working capital had also been considered. Everything appeared to be covered.
But there was a problem. The business plan was annual. The business was not.
When we broke the projections down month by month, we discovered something that the annual model had hidden. Working capital increased significantly from November through May. It then started to decline from June onwards, as the company generated around 80% of its annual sales over just three months.
The reason was simple. The company manufactured throughout the year, building inventory and tying up working capital. Then, during the peak sales period, it sold the inventory and collected the cash, progressively releasing that working capital.
By 31 October, the balance sheet looked relatively normal again. But that was not the point. The company had a significant funding requirement several months earlier.
When we identified the peak in May, it became clear that the proposed acquisition financing would not have been sufficient to finance the company's working capital needs at that point.
The business could have been performing exactly as expected. Revenue could have been on budget. EBITDA could have been on budget. Margins could have been on budget. And yet the company could still have faced serious cash flow pressure.
The problem was not the business. The problem was the financial structure.
In the end, the acquisition financing was reduced. More equity was put into the transaction. And a working capital facility was negotiated to cover the company's seasonal funding requirements.
The company did not need less debt because the business was weak. It needed a different financial structure because the business had a specific cash flow profile.
What these three situations taught me
These three situations happened in very different circumstances. But they all lead to the same conclusion: debt is a tool. It is not a strategy.
In the first case, leverage was expected to create the return almost by itself. It didn't.
In the second, debt was used as part of a broader capital allocation strategy, allowing shareholders to realise value while retaining ownership. It worked because the underlying business could support it.
In the third, the issue was not the company's ability to generate profits. It was the mismatch between the company's cash flow cycle and its financing structure.
And that distinction is critical. A company can be profitable and still run out of cash. A company can generate strong EBITDA and still default. And a transaction can have an attractive equity IRR on paper and still be built on an unsustainable capital structure.
Three questions for any leveraged acquisition
This is why, in any leveraged acquisition, I believe there are three questions that should always be asked:
- How much debt can the business support?
- How much risk are we willing to take with the business?
- And perhaps most importantly: can the business continue to operate comfortably if things do not go exactly according to plan?
Because leverage works in both directions. It amplifies returns when things go well. But it also amplifies mistakes when they don't.
Perhaps the most important lesson I have learned is that the right amount of debt is not the maximum amount the model can support. It is the amount the business can support through the cycle, including the moments when the model is wrong.
Leverage should amplify a good business. It should never be asked to rescue a bad investment thesis.
And when designing acquisition financing, the objective should not be to maximise debt. It should be to build a capital structure that gives the business enough room to execute, grow and withstand the inevitable surprises that come with owning a company. (Timing matters too: see what happened to valuations in 2007 in Should you sell your company now or wait?)
A final thought
Ultimately, in M&A, the best financial structure is not the one that produces the highest return in the perfect scenario. It is the one that still works when the scenario is not perfect.
Warren Buffett once said: "You only find out who is swimming naked when the tide goes out."
Leverage can make a good investment look exceptional when everything goes according to plan. But the real test of a capital structure is not what happens in the good times.
It is what happens when the tide goes out.
Frequently asked questions
How does leverage increase returns in a buyout?
When part of the purchase price is financed with debt and the company's cash flow repays that debt, the equity grows even if the company's value stays the same. For example, 50 of equity and 50 of debt fully repaid in five years leaves equity worth 100 — roughly a 20% IRR.
What is a recapitalisation in private equity?
A recapitalisation adds new debt to a company that has paid down its existing debt, and uses the proceeds to return capital to shareholders. It lets owners realise value without selling — but only works if the business can comfortably carry the additional debt.
Why can a profitable company run out of cash after a leveraged acquisition?
Because annual figures can hide seasonal cash needs. A seasonal business may build up inventory and working capital for months before its peak sales, so its funding need at the low point can exceed what the acquisition financing allows — even if EBITDA is on budget.
Debt structures, LBOs, recapitalisations and working capital are covered in the leveraged transactions sessions of the M&A Training Program and in my book Mergers & Acquisitions: Strategy, Execution, and Decision-Making.
First published in Inside Corporate Finance, my LinkedIn newsletter. Subscribe here.
