You are Gonzalo Herrán-Vega, operating partner at a private equity fund in Madrid. You're about to buy Conservera Mediterránea with an LBO. The investment committee is pushing to maximize debt: "more leverage, more return." True on paper. The question is what happens the day EBITDA disappoints.
The situation
Conservera has an EBITDA of €100M and you're buying it at 8× = €800M. The financing splits between debt and the fund's equity. The more debt you put in, the less equity you invest —and since the return is measured on that equity, the multiple (MOIC) shoots up—. That's the magic of leverage: in 5 years, with EBITDA growing to €130M and debt being repaid, the equity multiplies.
But debt comes with a bill: fixed interest that must be paid no matter what. If a recession hits and EBITDA falls 30%, interest coverage tightens and, past a certain leverage point, you can't pay —default, restructuring, equity wiped to zero—. RJR Nabisco and the first Hertz LBO taught that the leverage that maximizes expected return is also the leverage that kills you in the bad scenario. The art of the LBO is leveraging up to the point where the return is large and you survive a bad year.