Key Takeaways

  • In 1983, the entire institutional private equity market was smaller than $1 billion, split among fewer than ten firms.
  • Corporate M&A at Goldman Sachs focused almost entirely on whether an acquisition was accretive or dilutive to reported earnings per share.
  • Early leveraged buyout practitioners built their edge by stripping out accounting metrics like depreciation to price deals on cash flow.
  • Buyout pioneers underwrote corporate balance sheets like residential mortgages, backing debt with real cash generation rather than GAAP accounting profit.

The 1983 Earnings Illusion

When Michael Fisch arrived on Wall Street at Goldman Sachs in 1983, corporate dealmaking ran on a single question: will this transaction make our earnings per share go up or down? Public corporate boards and their advisors evaluated targets through an accounting lens. An acquisition was either accretive or dilutive to EPS. If an asset had high depreciation charges, its reported net income looked depressed, and public acquirers walked away or marked down their bids.

A tiny pocket of investors saw this as an opening. As Fisch recalled: “And for the rest of our Goldman Sachs M&A activity, most of the clients and the buyers were public companies. And the complete focus of the financial analysis was is it accretive? Which is to say, if we do the acquisition, will our earnings per share go up creative versus down dilutive? And these other people weren't looking at that. They were looking at cash flow.”

At the time, the buyout sector was barely visible. Institutional private equity accounted for less than $1 billion across the globe. Fisch noted that “you could name on less than two hands the number of players.” These buyers ignored public market conventions and zeroed in on the difference between reported accounting profit and actual cash. Depreciation was an accounting entry on a ledger, not cash leaving the bank account.

Fisch saw the split clearly: “And the depreciation isn't cash. And I don't care about EPS, earnings per share, net income. I care about cash flow. And this, you call it a religious war if you want, just looking at it from a different perspective was interesting to me.”

The Mortgage Model for Corporate Assets

By refocusing valuation on cash generation and real capital expenditure needs, early buyout sponsors unlocked a new underwriting logic. They realized an industrial company could be financed the same way an investor finances physical property.

“The metaphor to mortgage is a very easy way to understand private equity leverage buyouts,” Fisch explained. “Because you got to have a purchase price and a seller like a house. You finance it with debt and equity typically like a house.”

Public companies could not bid aggressively on capital-heavy industrial businesses because high depreciation dragged down reported EPS. Buyout sponsors, unburdened by quarterly public earnings scrutiny, used predictable cash flow to secure and amortize term debt. The debt service acted like a fixed mortgage payment, while the equity captured the compounding value as the principal balance fell.

This valuation divergence created mispriced industrial assets across the market. Sponsors bought high-cash businesses at low accounting multiples, applied leverage that conservative corporate treasuries refused to carry, and proved that cash generation mattered far more than reported accounting net income.

Why It Matters

The gap between cash flow and accounting income created the entire modern buyout industry. When public acquirers screen targets using GAAP net income or EPS accretion, sponsors who evaluate real capital expenditure requirements and discretionary cash flow can consistently spot valuation mismatches. Capital migrates to the underwriting structure that reflects the actual cash a company produces.