Asset Allocation: Ahead of the Curve - Sales drive private-equity alpha
A recent study of 450 realised private-equity deals finds that sales growth is a key component for alpha generation, according to Ian Roberts
The term ‘value creation’ is often used in relation to private equity, and it brings to mind the potential advantages of the leveraged buyout (LBO) financing model.
A seminal article by Michael Jensen in the Harvard Business Review in 1989 suggested that LBOs offer to align the interests of owners and management, potentially leading to value-adding operational improvements that otherwise would not occur. This makes it important that we, as investors, are able to identify which of our general partners (GPs) are consistently delivering value creation, and how they are doing it.
Pantheon conducted a study using a unique dataset of 450 realised private equity deals, mostly buyouts, and with entry vintages spanning from 2001 to 2010. We believe the results demonstrate value creation and, surprisingly, we found that sales growth was the primary driver of this value creation.
Given the importance of value creation, our first step was to research how best to measure it. It turns out that the most commonly used method in the industry, the ‘value bridge’, has limitations, as it does not really distil how GPs are generating value. Looking at it another way, it credits GPs with beta, or market returns, when we believe they are only adding value when they deliver alpha.
Instead, we based our approach on recent academic research by Acharya et al. (2013, Review of Financial Studies). We enhanced this with an econometric method that, in our view, had the advantages of applying more sophisticated risk adjustments, as well as allowing us to explore the relationship between value creation and the business cycle.
The benefit of our analysis was that we were able to see through absolute performance figures and attribute annualised total returns to:
• Financial engineering;
• Sector-geography exposures;
‘Alpha’ measures the portion of the financial performance of a deal – that is, the investor returns, that could not have been obtained by taking a leveraged position in a basket of publicly listed equities from the same sector, and geography (the ‘comparables’). It is the performance relative to the benchmark, and calculating this is the first step towards understanding whether a GP has created value.
What we found was that, for the average deal in our sample, 32% of returns was attributable to financial engineering, 30% to sector-geography exposures, and 38% to alpha. That alpha suggests that the GPs backing these deals created value by delivering financial outperformance relative to the sector and geography.
Moreover, using our econometric approach, we were able to identify the alpha for each vintage in the sample, providing an insight into how this sample of deals delivered alpha throughout the business cycle. We believe value creation indicated skill rather than luck, which is, in our view, of great relevance when assessing GPs.
The next step was to establish -precisely what was driving this alpha in terms of economic fundamentals.
We examined this by attributing the alpha of deals to operating improvements observed in excess of the comparables.
For our sample, it was sales growth in excess of the sector geography that was the key driver of alpha, delivering 71% of financial outperformance, while margin growth and multiple expansion delivered 1% and 28%, respectively.
This result is surprising. The vast majority of deals in our sample are buyouts and in this study we did not consider any venture-capital investments.
Jensen, in his 1989 article, suggested that low-growth companies are the ideal candidates for the LBO model. In contrast, these results suggest that our sample of deals increased sales significantly more than their comparables and that this was the key driver of alpha.
In unreported results, we find that this is not being driven by deals that experienced inorganic growth. And if you remove all deals associated with a M&A event during the holding period, the numbers look similar.
Ian Roberts is senior research associate at Pantheon. Value Creation and the Business Cycle is available at www.pantheon.com and includes a full description of the sample, method and results of the study