Chart of the Week #55: Historical Buyout Return Decomposition

The sources of return for buyout transactions can be decomposed into simple buckets: return on assets (“ROA”) at entry, growth, multiple expansion, and the impact of leverage. The chart below estimates the contribution from each of these buckets to the estimated gross return for buyout deals over the last 25 years. When plotting this analysis over time, there are two noticeable trends: (i) implied gross IRRs tend to hit trough levels just before market downturns (1999, 2007), and (ii) implied returns are often strongest right after a period of market distress, driven by lower purchase price multiples (higher ROAs) and post-crisis interest rate cuts (i.e., cheaper leverage).  

Perhaps the most interesting takeaway from the chart is the implied gross IRR for deals completed from 2021-2023. While it’s unsurprising that implied returns bottomed out in 2021, when purchase price multiples reached all-time highs, we have not seen a rebound in implied returns following the 2022 market correction. We believe this is due to high purchase price multiples, buoyed by a swift recovery in public equity markets, and the persistently high cost of debt following the Fed’s rate hikes in 2022.

High entry multiples and cost of leverage mean that GPs must generate alpha through operational improvements (i.e., revenue growth and margin expansion) to achieve go-forward IRRs consistent with the last decade. While there are reasons to believe growth and profitability could accelerate (AI-driven efficiency gains, deregulation, etc.), we believe these factors alone are unlikely to drive returns comparable to the post-GFC era. In fact, early signs indicate that growth is already slowing to pre-COVID levels, compounding the challenge.

We explore the implications of the current environment, and our views for 2025, in detail in our recently published Keystone 1Q 2025 Market Update. You can access the piece by subscribing to our newsletter, Katmai Labs, here.