The answer is that.

The private equity fund has to look for companies that are somehow underlevered,

companies that can increase their debts by a significant amount.

If the companies are already very highly leveraged,

it's going to become much more difficult to finance this deal.

So private equity funds are typically going to be searching for

companies with strong cash flow and strong collateral, but

also companies that have low current debt.

This is going to allow the private equity fund to issue more debt at the time of

acquisition and help finance this deal.

In the data, we actually see that very clearly.

Remember, the data by Korteweg where it's this quantitative

trade-off model that we talked about in module one.

Korteweg shows that leverage by all targets are on average underlevered

consistent with our intuition.

In an average LBO, in fact, value can increase by 1 to 2% if

the target moves to the optimal capital structure.

So, this is what it looks like.

In the data, the actual target of a leverage buyout

is on average to the left of the optimal capital structure.

So, that allows the private equity funds to increase leverage a bit without

changing value and maybe even overdoing a bit without destroying value.

Because if you go over the optimal, but you don't fall too much,

you might still be better than what the company was at the current leverage ratio.

So private equity funds are definitely going to look for companies that are to

the left of their optimal leverage ratio, but that's not going to always happen.

You might ask, but why would the company have suboptimal leverage and

the answer is that it may not.

Many good targets may actually already have optimal leverage.

The private equity fund will then not really have sufficient equity

to move to the optimal leverage.

If you cannot issue a lot of debt,

then you're going to have to finance this deal using your own money.

The money may not be enough.

So in some cases, leverage can become to high.

For example, Dell.

If we look at Dell, the leverage of Dell prior to the LBO was 26%.

And if we think that Dell is like the median firm, again,

this is not something we can state for sure.

But if we just use the median firm here for comparison,

Dell was actually close to the optimal capital structure.

Whereas post-LBO, you're moving way to the right,

so you're probably destroying some value here by issuing so much debt and

this is the question that we need to think about.

So, how do private equity funds address this high leverage problem?

If leverage is too high, the risk of financial distress increases as well learn

and it might become more important in the tax benefit of them.

So, the risk that private equity company face is that companies are going to have

difficulty making future interest payments.

So, it's very important at a time of private equity acquisition to think about

all the ways that private equities can address this high leverage problem.