Joseph Mariathasan considers London Business School research aiming to quantify PE’s true value
A key plank of private equity (PE) investment has been the claim PE firms can create more value through ownership than owners of publicly listed companies. Professor Florin Vasvari and his colleagues at the London Business School (LBS) have recently published some research that attempts to quantify evidence of how value is being added. This research is important in the ongoing debate as to whether and how PE adds value, and whether PE firms can justify the fees they charge.
Because general partners (GPs) of private equity firms usually control the boards of their portfolio companies, they are generally more actively involved in governance than the directors and shareholders of publicly listed companies. Many GPs would also try to use their own industry and operating expertise to add value while structuring strong equity-based incentive schemes for the company senior management.
Many recent studies quoted by LBS provide strong evidence that LBOs create value by significantly improving the operating performance of acquired companies. Some also argue that leverage can improve performance through the discipline it imposes on management, putting pressure on them not to waste money or misappropriate resources.
GPs, it is generally held, can add value in three ways. The first is by leveraging the transaction and repaying the debt before selling the company. If the enterprise value remains unchanged, replacing debt by equity by using internal cashflows to pay off debt would make the equity holders better off.
The second way is by improving the operations of the portfolio company, and the third is by selling the company at a higher price/earnings valuation multiple than the multiple for which it was bought.
According to Vasvari, the LBS research is based on greatly improved datasets than were available in the past. These are primarily from Standard & Poor’s Capital IQ database, supplemented by a number of other sources. The private equity dataset is improving all the time – US pension funds have been forced to disclose information on their PE investment cashflows and fees, and more GPs are realising there is value to be gained indirectly, at least for them, by creating greater transparency. As a result, the conclusions are not only more robust but overthrow, the LBS team argues, some of the negative results of previous studies comparing listed and private equity.
The LBS report argues that value creation is initiated at the moment of acquisition, as, on average, private equity funds pay EBITDA multiples that are more than 8% lower than the valuation multiples paid by public corporations for similar deals. These discounts are particularly significant at the smaller end of the market, where there is less competition. This is perhaps unsurprising, as trade buyers may be prepared to pay higher prices because they can generate synergies with their existing businesses PE firms cannot (although another reason suggested is that GPs are likely to be better negotiators than their public peers).
LBS also finds that GPs managing smaller funds of less than $500m (€448m) tend to generate the most post-acquisition sales growth at portfolio companies. They attribute this to a strategic focus on effective investments in growth, and capital expenditures without increasing leverage. In contrast, GPs managing large funds pursue greater operational improvements, as opposed to growth strategies, as their companies show much greater EBITDA growth than the companies owned by smaller funds.
The report finds evidence of persistence of outperformance. Established GPs with management of 10 or more funds achieve significantly higher EBITDA and asset growth than the less-established GPs. They also make greater investments partly funded by debt. LBS attributes this to GPs with more funds under management having developed deeper knowledge on the operational side, whereas newer GPs appear to focus on sales growth.
Another interesting finding is that, relative to benchmark non-PE-owned firms, matched year by year, industry and other characteristics, companies acquired by private equity firms increase their leverage, operating profitability, assets and sales over the first three years of PE ownership. LBS argues that this shows that GPs, while focused on growth, are also generating significant operational improvements.
The LBS research is interesting as a statistical exercise in providing evidence of value creation. For investors, the question that was not asked may be just as relevant – would a passive listed equity fund leveraged to the same extent as the average private equity fund covering the same region underperform or outperform the average private equity fund net of fees? If that can ever be proven, then private equity may be an asset class in which every pension fund should invest.
Joseph Mariathasan is a contributing editor at IPE