Debt does not take work away from the operating partner; it shrinks the one bucket in the bridge that the operating partner never filled.
No. Run the same deal at four entry leverage levels and organic operating improvement contributes 59.85 million at every one of them — identical at 3.5 times and at 6.5 times, because it is a property of the business rather than of the balance sheet. Its share of the value created moves the opposite way from the belief: from 39.7 per cent at 3.5 times to 44.1 per cent at 6.5 times. More debt means more interest, less free cash flow, and a smaller deleveraging bucket.
Worked in full in The Private Equity Operating Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The worked case is a home healthcare staffing platform. It enters at 14.0 million of EBITDA on a 9.5 times multiple — an enterprise value of 133.0 million. Over a five-year hold EBITDA reaches 24.5 million: 6.3 million of organic operating improvement, 3.0 million bought through add-on acquisitions, and 1.2 million of market tailwind that would have arrived whatever anyone did. Debt carries 8.5 per cent, capital expenditure runs at a quarter of EBITDA, cash tax is 25 per cent, and every dollar of free cash flow sweeps against the debt. Exit is at 10.2 times, an enterprise value of 249.9 million.
Only the entry leverage changes between the four runs below. The operating plan, the exit multiple and the EBITDA path are identical in every one, so any difference in the shares is caused by the capital structure and nothing else.
| Entry leverage | Equity invested | Equity at exit | Money multiple | Internal rate of return | Deleveraging | Organic share |
|---|---|---|---|---|---|---|
| 3.5 | 84.0 | 234.8 | 2.80 | 22.8 | 33.90 | 39.7 |
| 4.5 | 70.0 | 215.7 | 3.08 | 25.3 | 28.83 | 41.1 |
| 5.5 | 56.0 | 196.7 | 3.51 | 28.6 | 23.76 | 42.5 |
| 6.5 | 42.0 | 177.6 | 4.23 | 33.4 | 18.69 | 44.1 |
Leverage does not add a bucket to the bridge. It shrinks one. More debt means more interest, less free cash flow, and therefore less debt retired over the hold: deleveraging falls from 33.90 million at 3.5 times to 18.69 million at 6.5 times. Organic operating improvement does not move at all. It contributes 59.85 million at every level tested, because it is a property of the business rather than of the balance sheet.
The belief runs backwards. Heavy leverage is usually described as the thing that lets the capital structure do the work and makes operating improvement matter less. The arithmetic says the opposite: the operating share of value created rises from 39.7 per cent at 3.5 times entry leverage to 44.1 per cent at 6.5 times, and the only reason it rises is that debt service has eaten the one bucket no operating partner ever filled.
What leverage does change is the equity base. Equity invested falls from 84.0 million to 42.0 million across the four runs, the money multiple rises from 2.80 times to 4.23 times, and the internal rate of return rises from 22.8 per cent to 33.4 per cent. The same operating work, measured against a smaller cheque, looks better. It is not worth more.
The two effects are easy to conflate at a board table. A deal levered at 6.5 times returns 4.23 times money against 2.80 times at 3.5 times, and the temptation is to read that gap as evidence that the structure created value. It did not. The exit EBITDA and the exit multiple are the same in all four runs. What changed is how much equity went in at entry and how much of the enterprise still belonged to the lender at the end.
At 4.5 times entry leverage the equity value rose 145.73 million over the hold, and it decomposes with no residual into six pieces.
| Driver | Value created | Share |
|---|---|---|
| Organic EBITDA growth at the entry multiple | 59.85 | 41.1 |
| Acquired EBITDA at the entry multiple, gross | 28.50 | 19.6 |
| Deleveraging | 28.83 | 19.8 |
| Market-driven EBITDA at the entry multiple | 11.40 | 7.8 |
| Multiple expansion on entry EBITDA | 9.80 | 6.7 |
| Cross-term, growth × expansion | 7.35 | 5.0 |
| Equity value created | 145.73 | — |
Read the shape rather than the numbers. The operating work accounts for 41.1 per cent of the value created. Deleveraging, which no operating partner performs, accounts for 19.8 per cent, almost as much. And 14.5 per cent came from the market and the multiple, which is to say from nothing anyone in the firm did.
The acquired line is the one to distrust. The add-ons cost 12.00 million of cash, and that cash came out of free cash flow that would otherwise have paid down debt, which is why the deleveraging bucket is 28.83 million rather than roughly 41. Net of what was paid, the acquisitions contributed 16.50 million, not 28.50. The gross figure overstates the buy-and-build programme by 73 per cent, and the gap between 19.6 per cent of value created and 11.3 per cent is something a buyer’s diligence team will find in an afternoon.
One sentence is worth carrying into a compensation discussion. Leverage does not change what the operating work is worth; it changes the size of the equity base that work is measured against, which changes the multiple of money and changes nothing about the value created. An operating partner whose contribution is argued down because the structure did the heavy lifting can put the 59.85 million on the table and show that it is identical at 3.5 times and at 6.5 times.
Two practices follow. Build the bridge incrementally through the hold rather than reconstructing it once a sale process has begun, because the precise timing of a price increase and the exact synergies realised from an add-on are far easier to document in real time than to recover afterwards. And show the cross-term as its own line: 7.35 million here, 5.0 per cent of value created, and assignable to growth, to the multiple, or split in proportion. The multiple bucket swings 75 per cent depending on which convention is chosen. A bridge that discloses the joint term is more credible than one that has quietly absorbed it, and the credibility is worth more than the 7.35.
In the worked case, organic operating improvement accounts for 41.1 per cent of the 145.73 million of equity value created. Deleveraging, which no operating partner performs, accounts for 19.8 per cent, almost as much. A further 14.5 per cent came from the market and the multiple, which is attributable to nobody in the firm.
Not once the cash is netted off. The add-ons carried 3.0 million of EBITDA, worth 28.50 million at the entry multiple, but they cost 12.00 million of cash that would otherwise have paid down debt. Net contribution is 16.50 million, so the gross figure overstates the programme by 73 per cent.
Nowhere, by rule. When EBITDA and the multiple both move, the joint term — 7.35 million here, 5.0 per cent of value created — can be assigned to growth, to the multiple, or split in proportion. The multiple bucket swings 75 per cent between conventions, from 9.80 to 17.15 million. Show it as its own line.
This article is one calculation from The Private Equity Operating Partner. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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