Why do private equity firms want to invest the least amount of money into a deal?

Don’t private equity firms have a lot of money to invest? Yes.

Isn’t it because they want to diversify their holdings? Maybe.

But, the real reason is math.

By that, I mean that mathematically you generate the highest relative returns when you invest the smallest dollar amount.

For instance, say you bought an asset for $100.

Over the next year, you generate a return of $10 on that asset.

What was your return? 10% ($10 / $100).

Now, instead of spending $100 of your own money, say you borrowed $20 from the bank.

So, you invest $80 and the bank contributes $20.

If your asset returns the same $10 over the first year, how much do you make?

Well, say you sell the asset for $100, pay off the $20 of bank debt.

How much are you left with? $100 – $20 + $10 = $90.

Making $90 on an $80 investment is a 12.5% return.

That seems better than 10%.

Now, instead of spending $80 of your own money, say you borrowed $50 from the bank.

So, you invest $50 and the bank contributes $50.

If your asset returns the same $10 over the first year, how much do you make?

Well, say you sell the asset for $100, pay off the $50 of bank debt.

How much are you left with? $100 – $50 + $10 = $60.

Making $60 on a $50 investment is a 20% return.

I’d take that over 12.5%.

Now, instead of spending $50 of your own money, say you borrowed $80 from the bank.

So, you invest $20 and the bank contributes $80.

If your asset returns the same $10 over the first year, how much do you make?

Well, say you sell the asset for $100, pay off the $80 of bank debt.

How much are you left with? $100 – $80 + $10 = $30.

Making $30 on a $20 investment is a 50% return.

I’d take that any day.

So, what’s the pattern? It’s mathematical. The numerator stays the same. A $10 absolute return. The denominator (amount equity invested) falls.

So what happens? Your returns increased.

Now, it makes sense why private equity firms want to invest as little of their own money into a deal.

And they do so by maximizing the amount of debt they can take on.