Ans. A high percentage of borrowed money is typically used to finance an LBO, and the private equity sponsor contributes just a modest amount of equity to the deal. The sponsor will be able to earn more money when selling the investment because the debt’s principal will be reduced throughout the course of the holding period.Because debt has a lower cost of capital than equity, it is advantageous for sponsors to invest little equity. The fact that debt is positioned higher in the capital structure and that the interest paid on it is tax deductible, creating an attractive “tax shield,” are two factors contributing to the lower cost of debt. As a result, the firm can more easily exceed its returns level thanks to the enhanced leverage.In order to reduce the danger of bankruptcy, private equity firms optimise their use of leverage while maintaining a reasonable level of debt.The firm will have more unused cash (sometimes known as “dry powder”) after employing larger debt levels, which can be used to make additional investments or buy expansions for theirportfolio companies.
