Debt as the Engine, Company Pays Its Own Ransom

"The high interest costs incurred are paid by the acquired company. This can happen, for example, by the private equity firm creating a company that takes out a loan to buy a target, and once the purchase is completed, the acquired and acquiring companies are merged. Then the debt ends up with the acquired company, and its profits go to pay interest. In practice, the new company is paid for with its own money, since only a small part of the purchase price comes from the fund that investors have contributed to."

"Debt interest arises because the owners create a structure where all the costs of a company purchase as well as the loans are transferred to the acquired company. Hasse takes as an example a purchase with a loan of five billion kronor. For simplicity’s sake, let’s say it’s financed by a single bank, in reality it is usually several types of credits."

"A venture capital company creates a fund, in which outside parties, in Sweden mainly insurance companies and pension funds, invest capital. The money is used to buy out companies from the stock exchange, or to buy unlisted companies. A large part of the purchase price, usually around 60–70 percent, is borrowed from a bank. This allows venture capital funds to buy much larger companies than if they had only used their own money. A listed company that is profitable is considered to be able to have a debt corresponding to 2–3 times its annual profit, in the private equity companies’ firms the debts rather amount to 4–6 times the profit. The interest on the loans is paid with the company’s profits. The companies are not owned directly by the fund, but the venture capitalists form a holding company, an owner company, which manages financing and operations. The goal is usually to sell an acquired company onward after 3–7 years; profitability and size should then have increased significantly. Upon sale, the profit consists of the new company’s higher price, minus investment costs and remaining debt. The model is based on spreading risks by having each fund own around ten different companies."

"From there, he moved on to the investment bank Bear Stearns’ “corporate finance” department, dealing with corporate transactions, where his cousin George Roberts worked. The head of the department was Jerome Kohlberg, and as the eldest of the three, he would become the first K in KKR. While they were still at Bear Stearns, they developed a form of business that was named “leveraged buyout,” or purchase with financial leverage. The leverage was the loan, which made it possible to buy a larger company and thereby generate greater profit. Leveraged company purchases had been done before in various ways, but never in this structured way or with such a high proportion of debt. The reason why it is more effective to use borrowed money than your own capital is that interest on debt is tax-deductible."