Private Equity Deal Mechanics: A Step-by-Step Walkthrough

In our previous article, we provided a high-level overview of how private equity firms operate, evaluate businesses, and create value. Today, we’re going deeper by walking through the actual mechanics of private equity deals with concrete examples to show exactly how these transactions work and how they generate returns.

How Companies Are Valued: The Basics

Before diving into the mechanics of private equity deals, it’s important to understand how companies are valued in these transactions. At its core, business valuation typically comes down to two key components:

A Financial Metric: Most commonly revenue or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
A Multiple: A number that, when multiplied by the financial metric, determines the company’s value

For our examples in this article, we’ll use EBITDA as our financial metric. EBITDA provides a clearer picture of a company’s operational performance by removing the effects of financing decisions, accounting choices, and tax environments. It’s often considered a proxy for cash flow and is the preferred valuation metric for most private equity transactions, particularly in established businesses.

The basic valuation formula is: Enterprise Value = EBITDA × Multiple

For example, a company with $5 million in EBITDA valued at an 8x multiple would have an enterprise value of $40 million.

What determines the multiple a business receives is complex and merits its own discussion. We’ll explore the factors that influence valuation multiples in a future article.

Now, let’s explore how private equity firms work with these valuation principles to create returns.

Fundamentals: The Three Ways Private Equity Firms Can Create Value

Before diving into our examples, let’s establish the three core elements that drive private equity returns:

Cash Flow from the Business: PE firms use the company’s own cash flow to pay down acquisition debt over time, increasing equity value even without growing the business.
Multiple Expansion: Buying companies at lower multiples and selling them at higher multiples.
EBITDA Growth: Increasing the company’s earnings through revenue growth and/or margin improvements.

Now, let’s see these elements in action through two realistic scenarios.

Scenario 1: Value Created Despite No EBITDA Growth or Multiple Expansion

Let’s examine a fictional landscaping business called “GreenScape Services” that was acquired by a private equity firm.

The Initial Acquisition

GreenScape Services at Purchase:

Annual EBITDA: $6 million
Purchase Multiple: 10x EBITDA
Enterprise Value: $60 million

Deal Structure:

Equity Investment: $30 million (50%) – this is the investment by the PE firm
Debt: $30 million (50%, or 5x EBITDA) – this is typically provided by a bank or the private credit market

A structure like this is typical in private equity transactions. The firm puts in equity and finances the rest of the transaction with debt. The leverage (or amount of debt) in these transactions can get quite high and it’s a key contributor to the higher risk (but also higher return) from these investments.

The Value Creation Period

During the holding period, the PE firm implemented several strategic initiatives:

Professionalized Sales & Marketing: Introducing modern CRM systems, digital marketing, and structured sales processes.
Operational Efficiencies: Optimizing crew routing, implementing inventory management systems, and standardizing procedures.
Strategic Pricing: Implementing value-based pricing and focusing on higher-margin services.

However, despite these efforts, the business faced unexpected challenges:

A recession impacted consumer spending on landscaping services
Increased competition entered the market
Weather patterns created several difficult seasons

As a result:

EBITDA remained flat at $6M throughout the holding period
BUT the company was still able to pay down debt to the tune of $4M per year ($20M total over holding period)

The Exit

After the holding period, GreenScape is sold:

Final Year EBITDA: $6 million (unchanged from purchase)
Exit Multiple: 10x (unchanged from purchase)
Enterprise Value at Exit: $60 million (unchanged from purchase)

Here’s the intriguing question: The business was bought for $60 million and sold for $60 million five years later. The operational initiatives didn’t increase EBITDA. The exit multiple remained the same.

Did the private equity firm make any money on this deal? If so, how much and how?

Initial Investment: $30 million equity
Exit Proceeds: $50 million equity value ($60M enterprise value – $10M remaining debt)
Total Return: $20 million ($50M initial investment – $30M exit proceeds)
Return Multiple: 1.67x ($50M ÷ $30M)
IRR (Internal Rate of Return): 10.8% annually (assuming a 5-year hold period)

The PE firm still generated a positive return despite no growth in the business value. How? Through debt pay-down. This is a foundational driver of returns for the majority of private equity funds.

Scenario 2: Platform + Add-on Strategy

Now, let’s explore a more aggressive “buy and build” strategy. In this scenario, the PE firm still acquires GreenScape but then executes a roll-up strategy by acquiring five smaller competitors.

The Initial Platform Acquisition

Same as Scenario 1:

Purchase price: $60M (10x $6M EBITDA)
Equity: $30M
Debt: $30M

Add-on Acquisitions

Over the 5-year period, the PE firm acquires five smaller landscaping businesses. Each add-on company:

EBITDA: $2 million
Purchase Multiple: 6x EBITDA
Purchase Price per company: $12 million
Total for all five add-ons: $60 million

Why the lower multiple? Smaller companies typically trade at lower multiples due to increased risk, less diversified customer bases, and fewer economies of scale. This multiple arbitrage is a key value creation lever.

Additional Financing:

New Debt: $30 million
Additional Equity: $30 million

Integration and Synergies

After integrating these acquisitions, the combined business achieves cost synergies:

Elimination of redundant overhead (accounting, HR, etc.)
Shared equipment and facilities
Bulk purchasing power
Optimized routing and crew deployment across a broader geography

These synergies improve the EBITDA margins of the acquired businesses, adding an additional $3M of EBITDA ($0.6M per acquisition).

The Combined Business at Exit

Original Business EBITDA: $8M (after growth)
Add-on Businesses EBITDA: $10M (5 companies at $2M each, assumes 1 acquisition per year)
Synergy Value: $3M ($0.6M per acquisition)
Total EBITDA: $21M
Exit Multiple: 14x (premium for scale and market leadership)
Enterprise Value: $294M (14x $21M)
Remaining Debt: $25M (after debt paydown of $4M per year from the platform acquisition and another $1.5M per year per acquisition during the holding period)
Equity Value: $269M

The Returns Analysis

Year 0: Initial equity investment of $30M

Year 1-5: Additional equity investments of $6M each year for add-on acquisitions

Exit (end of Year 5): $269M equity value

Total Equity Invested: $60M ($30M initial + $30M for add-ons)

Exit Proceeds: $269M

Total Return: $209M ($269M – $60M)

Return Multiple: 4.48x ($269M ÷ $60M)

IRR: 45.6% annually (accounting for the timing of equity investments)

This analysis assumes that equity investments were made for each add-on acquisition. In reality, after the first add-on, the combined business would likely generate enough cash flow to support subsequent acquisitions with just incremental debt and no additional equity needed. This debt-only financing approach for later acquisitions would increase returns even further, as the same exit value would be achieved with significantly less total equity invested.

Private Equity Firm Economics

Let’s examine how the private equity firm itself makes money in this scenario (we have assumed the $60 million is all invested day 1 for simplicity):

Management Fees: PE firms typically charge an annual management fee of 1.5-2.5% on committed or invested capital. In this scenario:

Committed equity capital: $60M
Annual management fee (at 2%): $1.2M
Total fees over 5 years: $6M

Carried Interest: PE firms typically earn “carried interest” (usually 20%) on profits generated above a certain return threshold (known as the “hurdle rate,” often 8%). Most larger private equity firms use what’s called a “catch-up” structure, which works as follows:

Total equity proceeds: $269M
Investors collect the first $60M (equity investment) + the preferred return (8% compounded over 5 years on $60M): ~$28M. In total, the PE investors collect the first $88M
The “catch up” then kicks in and the PE firm receives 100% of distributions (percentages and specifics of this catch up provision can vary by fund) after the hurdle until reaching their 20% share of total profits (the catch up is “satisfied” at $95M of total proceeds with the PE firm collecting the incremental dollars between $88M and $95M), so the next $7M goes to the PE firm. At this point PE firm has collected $7M (20%) and PE investors have collected $28M (80%) of the gain above their original investment.
After the PE firm has received its full 20% share, remaining profits (if any) are split 80/20 between investors and the PE firm
In this scenario, after the preferred return and catch up have been paid, there is another $174M to distribute. The PE firm collects $35M and investors collect $139M
Investors total proceeds (including return of original investment): $221M (after factoring in $6M management fees)
PE firm total proceeds: $42M

Combined Economics for PE Firm:

Management fees: $6M
Carried interest: $41.8M
Total economics: $47.8M

Below outlines a graph as to how these proceeds flow in a wide range of equity values at exit:

Comparing the Two Scenarios

Let’s compare the economics for investors and the PE firm across both scenarios:

This comparison illustrates why private equity firms are incentivized to pursue more aggressive growth strategies like the roll-up approach in Scenario 2. The significant dollars of value creation in Scenario 2 benefits the employees, sellers (to the extent they had rollover equity), investors in the private equity firm, and the private equity firm employees / partners as well. That’s one reason these growth-oriented strategies are so attractive in private equity.

What Drives the Enhanced Returns in Scenario 2?

Multiple Arbitrage: Buying smaller companies at 6x and selling the combined entity at 14x
Operational Synergies: $3M in additional EBITDA from cost savings
Scale Premium: Larger companies command higher multiples due to decreased risk, more diverse customer base, and stronger market position
Leverage: The use of debt to fund portions of the acquisitions amplifies equity returns

Implications for Business Owners

If you own a business that could be an attractive acquisition target, understanding these mechanics can help you:

Position as a Platform: Larger businesses with strong infrastructure often become platforms that command premium multiples.
Consider Your Role in the Ecosystem: Are you positioned to be a platform or an add-on acquisition? This positioning affects valuation significantly.
Create Transferable Value: Systems, processes, and management teams that can operate without the owner increase enterprise value.
Focus on Growth and Margins: PE firms value predictable, growing EBITDA with strong margins.
Understand Rollover Equity: Many deals include an opportunity for owners to “roll” some equity into the new entity. In Scenario 2, this would have generated substantial returns for original owners who maintained a stake. Scenario 1 would have turned out OK, but it also could have gone south and the rollover equity could have become worth substantially less or even $0 depending on the leverage situation and results of the business. There is more to unpack here on how much rollover equity owners should be looking to take which we’ll discuss further in a future article.

Conclusion

Private equity firms create value through financial engineering, operational improvements, and strategic growth initiatives. By understanding these mechanics, business owners can better prepare their companies for a potential transaction and negotiate from a position of knowledge.

Whether you’re considering selling your business in the near future or simply planning for eventual succession, understanding how buyers evaluate and create value can help you build a more valuable enterprise today.

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Panoramic Capital Partners (“Panoramic”) is a registered investment advisor.

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