Executive summary - Udo Bullmann

employed 21 . Leverage effect explains how it is possible for a company to deliver a return onequity exceeding the rate of return on all the capital invested in the business, i.e. its return oncapital employed. However, there is also a risk of a loss if the cost of borrowing the capitaloutweighs the profit - but due to the LBOs’ short-term investment profile, this is rare.Since private equity firms also extract equity from the business they acquire in exchangefor credit in order to satisfy their own investors and fund managers, there is a great risk thatthey may use up their equity on the business that they acquire. By the time refinancing hasbeen completed, private equity companies will frequently have refinanced their equity, i.e.they will have got it back before reselling.Furthermore, liquidity and earnings capability are used to service debts; the company is nolonger available to invest in its further development. This risk rises further followingreselling of the company, which is frequently also funded by borrowed capital; in this case,more of the cash flow is used to service debt.In addition to the burden caused by servicing borrowed capital, the acquired businessfrequently has to mortgage its assets in order to secure loans. Banks providing money forcredit-financed buyouts are increasingly allocating what are known as second-lien loans.These are secondary loans which, in the event of the business becoming bankrupt, are notrepaid until the debts owing to other creditors have been. However, the creditors are offeredhigher rates of interest because of this. This means that the LBO company can achievegreater returns than first-rank creditors 22 .Evolution of recycled LBO (secondary + recap.) in total activity of LBOfinancing in EuropeSource : Standard & Poor’s LCDPrivate equity assumes unrestricted liability for losses. It is not repaid until the business’ssources of borrowed capital (creditors) have been satisfied. Given the higher risk involved,private equity companies demand higher rates of return than creditors.21 For more details, see Glossary22 Cf. Handelsblatt of 12.5.2005, p. 23.40