Why Private Equity Bankrupts the Businesses It Buys

Key Takeaways

• Most companies that fail after a buyout die from debt written against earnings they can't produce in a bad year, not from greed alone.
• The key metric is debt service coverage ratio (DSCR) or fixed charge coverage ratio (FCCR): your worst year's earnings divided by the debt payment.
• The closer your worst year sits to your average year, the more a bank will lend and the more a buyer will pay.
• Sale-leasebacks and dividend recaps both shrink the cushion; whether that's fatal depends on whether the business needs the building to run.
• Sellers keep skin in the game through rollover, earnouts, and notes, and lose it if the company can't survive its loan.
• The same predictability a lender lends against is what a buyer pays a premium for, so raising your worst-year floor pays off whether you sell or not.

Why do private equity buyouts really bankrupt companies?

Most companies that fail after a private equity buyout die from one thing: a loan written against earnings the business could not produce in its worst year. The popular story is greed, a fund strips a company for parts and walks away rich. Plenty of that happens. But it skips the mechanism that actually decides which companies survive being bought.

The year before it was sold, Toys R Us made $252 million in profit. Thirteen years later it filed for bankruptcy. Amazon usually gets the blame, but the interest payments got there first. Red Lobster went the same way. So did a grocery chain in Indiana that had fed two states since 1931. Every one of them was carrying a loan the company itself never signed for.

I've spent about 20 years in private equity, and loans like that get signed by people like me. The size of that loan gets decided in a room the owner is never invited into. Reporters cover these businesses after they fail. I'm across the table from the bank years before that, asking for the money.

How a leveraged buyout puts debt on the company you sold

When a fund buys your company, it doesn't wire the full price from its own account. It puts up part of the price and borrows the rest, and the borrowed portion usually lands between half and two-thirds of the deal. My firm will go up to 50% cash. The loan closes in the company's name, not the fund's.

The reason for the borrowing is arithmetic. A fund that puts up the full $25 million and sells later for $50 million has doubled its money. A fund that puts up $10 million and borrows $15 million walks away from that same sale having more than tripled it. Leverage multiplies the return, which is exactly why buyers use it.

Picture an owner who has built a $5 million-profit business over 30 years. He's borrowed for trucks and equipment, and that's the whole of his experience with debt. A fund offers $25 million and he says yes. On closing day he has his money and a business he no longer owns, while the company has new owners and $15 million of debt that didn't exist the week before. That payment now comes out ahead of new trucks and ahead of raises every month, whether the year is going well or not. In a good year, nobody feels it. In a bad year, the payment stays exactly the same.

The one-minute test a bank runs before it lends

Before a lender agrees to a loan that size, it runs a single test: what does this company earn in its worst year, and does that still cover the payment? The metric is called the debt service coverage ratio (DSCR), or fixed charge coverage ratio (FCCR). It takes about a minute to run, and you can run it on your own company years before anyone offers to buy it.

The bank goes back through three to five years of financials looking for the bottom, the low-water mark of earnings. Then it divides that worst-year number by the total debt payments. The worst year has to cover the payment with room left over. When it doesn't, the loan gets smaller or the deal dies right there. On my firm's deals, I want that room to be about 1.4x. Many lenders will go to 1.2x.

Every restaurant in America found out what its floor looked like in 2020. That's the kind of year a lender underwrites to. So the closer your worst year sits to your average year, the more a bank will lend against you. Predictability isn't a soft virtue here. It's the number that sets your borrowing capacity, and as you'll see, your price.

The two legal moves that shrink your cushion

Once the loan is written, two common and legal moves can make the cushion smaller. The first is the real estate. Many of these companies own their buildings, and a building is often worth more on its own than as part of the business. A company might sell for five times earnings, while that same property sold to a real estate investor at a 7.5% cap rate trades at over 13 times the rent it produces.

The new owner sells the property, leases it back, and puts the cash against the loan. That's real math and, on the right building, good business. But the company now pays rent it never used to pay, and that rent climbs every year on a schedule written into the lease. Everything depends on whether the business needed that building in order to work.

The second move is simpler: the company borrows again and the new money goes out to the owners as a payment. Same cushion, more debt. Both moves lower the floor the bank measured. Whether that's smart or fatal comes down to one question, whether the thing being sold was holding the business up.

Red Lobster vs. Burger King: the same move, opposite outcomes

The move that put Red Lobster under is the same move that doubled Burger King. The difference was whether the asset being sold was load-bearing for the business. That's the whole lesson in two cases.

Toys R Us was bought in 2005 for $6.6 billion, only about a fifth of it cash. The interest alone ran around $400 million a year. To make the payments, the company cut back on cleaning its stores and thinned its staff while Amazon was teaching America to buy toys online. In 2017 it tried to sell and lease back its real estate, and the deal fell apart. Red Lobster made that same trade at the start instead of the end: bought for $2.1 billion in 2014, its new owner sold almost all the land for $1.5 billion and leased it back with rent rising 2% a year. But a restaurant chain lives or dies on the corners it sits on. By 2023, rent across 687 locations cost $190 million, much of it above market on restaurants that weren't busy enough to carry it. The Indiana grocery chain sold its headquarters for around $28 million and signed a 20-year lease rising 7% every five years; it closed every store in 2017 and left its employees' pension about $32 million short.

Burger King was bought twice, and the deals ended in completely different places. The first group borrowed about 86% of the price in 2002; over eight years the chain grew roughly 1% a year while its owners took around $500 million in dividends and fees. The second group bought it in 2010, borrowed around 63%, and sold off nearly every company-owned restaurant. It worked, because Burger King runs on franchises: the franchisee pays the rent on his own building, so selling that real estate took nothing out from under the company. By 2022 the chain had close to 20,000 locations, roughly double what it had at purchase.

Why the bank's number is also your valuation

The number a bank writes down is your predictability, priced, which makes it the same number that says what your company is worth. A buyer pays for your earnings multiplied by how certain he is those earnings hold. A lender lends against that same certainty. One number, two decisions.

This is why raising your worst-year floor pays off whether you ever sell or not. If your bad year is still a pretty good year, a bank lends more and a buyer discounts less. If your worst year makes you uncomfortable, you've just found the exact reason a lender will cap what he funds and a buyer will discount what he pays.

So run the test on yourself now, before anyone makes an offer. Go back 10 years, find your worst year, and look at what the company earned. Then work out whether it would still be standing while carrying debt equal to half of what the business is worth. That takes years to build and about a minute to check, and no buyer is ever going to build it for you.

Why the seller has more at stake than the employees

Owners watch these stories and think about the employees, but the seller usually has his own money in the fire too. When you sell a company, part of your price typically stays behind. Some rolls into equity in the new company, some sits in an earnout, and sometimes you carry a note the buyer pays off over years.

Every one of those is a claim on a business that has to survive the loan first. When one of these companies files for bankruptcy, the former owner stands in line with the other creditors and usually walks away with nothing. He sold a healthy business, and years later the last part of his price was gone because of a loan he was never asked about.

So when someone makes you an offer, three questions are worth asking before you sign anything. How much of the price are you borrowing? A real buyer gives you a number without hesitating. What earnings number are you lending against? If the bank is underwriting your best year, or savings the buyer hopes to find later, the cushion is imaginary, and your rollover is riding on it. And what happens to the real estate? Either it stays with the company, or the buyer can explain exactly why the business runs fine without it. Any buyer worth dealing with answers all three without flinching, and the owners who ask are the ones I take most seriously.

Frequently Asked Questions

Nick McLean

Managing Partner at Four Pillars Investors. PE investor. 10 companies in the portfolio (and counting). Creator of Pre-Sale Prep.