Value Creation in Private Equity
Evolution of Private Equity
Private Equity has evolved from investors just piling large amounts of debt (leverage) with the purpose of just selling companies at a higher EBITDA multiple to actually improving companies from an operational perspective. It’s not just about making profits like it was 30+ years ago, but rather how to capitalize on creating value by helping high-performing firms thrive.
Let’s take a moment to think about what’s really going on here: In the olden days, leverage was the keyword (and still is). It simply means that private equity/buyout firms bought companies using significant amounts of debt relative to equity. The reason investors leverage their investments is to enhance returns — after all, it was a money making game, right? Having borrowed funds would thereby increase the IRR (internal rate of return), giving investors a higher return.
Leverage should not justify returns, it should enhance returns.
However, there are instances where too much leverage can take things for the worse. An example of this — although somewhat recent — would be the downfall of Toys “R” Us, where mega funds like KKR and Bain Capital over-leveraged the firm in 2005 and rather than investing towards operational improvement, the cash mainly went towards paying off the new debt from the buyout, leading to bankruptcy. Furthermore, leverage doesn’t come for free — every year interest accumulates, causing Earnings Before Taxes (EBT) and Net Income margins to be crushed even further. Determining the appropriate amounts of leverage for an investment requires significant due diligence, including making sure that the company would be able to generate enough free cash flow (FCF) to be able to pay down debt, interests, and the amortization of financing fees as well as ensuring a strong economic moat for the company to protect itself from competition.
Overtime, there was a shift in focus to multiple arbitrage; that is, purchasing companies at a lower multiple and selling companies after x years at a higher multiple. Let’s take a look at a barebones example:
In this hypothetical investment, you can see that the company was purchased at a valuation of a 7.0x EBITDA multiple with EBITDA being $100 million. This would result in a purchase price of $700 million, but only $300 million is actually coming out of the private equity firm’s pocket, the remaining is debt. Fast forward 5 years later, and the private equity firm is looking to exit by selling the company to a strategic buyer, but instead of a 7.0x EBTIDA multiple, they will sell it for an 8.0x EBITDA multiple. In this case, the EBITDA value stayed the same primarily to highlight the purpose of multiple arbitrage, but generally the EBITDA would be higher than what the company was purchased for which would result in a higher valuation. Now, the company is valued at $800 million, and after subtracting the existing debt on the table, the private equity firm would receive $400 million in proceeds, as opposed to the $300 million it cost them 5 years prior. This would be a 1.3x cash on cash return($400/$300) — clearly not a great investment here, but at least it highlights the point.
Despite the fact that leverage and multiple arbitrage still drive investor’s decision-making today, investment firms around the world have steered towards operational value creation, whether that be cutting costs to allow for margins to breathe or to grow the topline organically or inorganically.
Here’s a crystal clear definition as to what this even means: Value Creation focuses on improving processes in a company to make it more efficient and profitable. Think about it: after 5–7 years, private equity firms want to exit while making a substantial return. To do so, drastic improvements are certainly a prerequisite to sell a company at a premium in the future.
To push for growth, careful use of resources from the investor as well as the portfolio company need to be made in just a few particular domains, whether it be sales, finance, technology, operations, human capital/executive search amongst others. And this makes sense — an investor would rather double down on areas with high potential of improvement that can be achieved in the shortest amount of time rather than spreading thin across the value chain and produce small increments of growth.
If the topline isn’t growing, your bottom line will soon be affected as such. A company can only reduce expenditures to a certain level, so revenue must be growing in order for the business at large to survive. Although easier said than done, here are a few strategies private equity firms can seek to implement:
- Strengthen distribution channels
- Personalize experiences and foster exceptional customer service to reduce churn
- Hire top talent that is committed to the business’s growth while promoting positive company culture that encourage learning and development
- Embrace technology-enabled solutions that enable data-driven decisions throughout the company’s value chain
Efficient use of Capital
The way capital is deployed in a portfolio company is multi-dimensional. For leveraged buyouts, investors need to be wary about generating enough cash to repay debt as interest can accumulate unsuspectingly. In addition, capital is injected into the meat of the business, whether it be cutting costs where needed or improving the product line.
Margin Expansion for EBITDA Growth
Since gross profit margins are just north of EBITDA on a financial model, it is essential to strengthen margins as much as possible since valuations are tied to EBITDA. Higher gross profit margins will result in higher EBITDA margins if all else equal. To improve gross margins, attention needs to shift toward:
- increasing prices
- selling higher quantity
- reducing cost of goods sold
People are the driving force for companies. When private equity gets involved, they leverage their existing network and portfolio companies to perform business services and outsourcing needs for other portfolio companies. This allows for stronger control of negotiation and pricing strategies, thereby optimizing for costs.
A major decision private equity firms need to make are whether to have value creation teams in-house or outsourced. Although in-house resources may allow for transparent communication, it can end up being fairly costly and require more resources that may result in internal conflict. Outsourcing has its own drawbacks as well, including a loss of control and lower quality results. This decision is made on a deal by deal basis, depending on the portfolio company and the portfolio environment. It’s also important to consider the number of portfolio companies a private equity firm may invest in at a given time. Some firms invest in just a handful where resources are less sparse while larger ones have the resources to invest in a multitude of companies.
Human Capital & Expenditures
Moreover, private equity firms look for ways to optimize salaries, general, and administrative (SG&A) costs since this factor directly affects EBITDA, and therefore valuations. Since many of these tasks aren’t directly related to business growth, these functions tend to be outsourced. Research and development, however, is an integral part of the business, so investors tend to dump a lot of cash here as needed to fuel growth.
Here is an easy way to look at what would increase enterprise valuations. To maximize EBITDA:
- increase the topline (revenue)
- decrease cost of goods sold
- decrease salaries, general, and administrative costs
- decrease research and development costs
The challenging part here is for private equity firms to optimize the costs so that the portfolio companies are still bringing products to the market efficiently and effectively and meeting customers’ needs while pushing back on aspects that aren’t worthwhile for profitability and EBITDA growth.
Clearly, private equity firms demand most decision making on the high-level, but don’t mistake this for the day to day operations which is managed by the portfolio company’s management team. As private equity firms establish the infrastructure needed for fast growth and set the goals for a company, it is essential to track the key performance metrics and ensure the company is meeting targets. Because private equity firms are seeking for ways to generate high returns with their invested capital at risk, they demand a substantial level of power in board meetings.
Though we’ve been discussing organic methods of value creation, there are other inorganic ways for portfolio companies to grow, and that is through add-on acquisitions. Once a private equity firm makes their initial large investment, also known as a platform company, an alternative strategy to grow is to acquire smaller businesses, or add-ons, to scale quicker. This rapid growth oftentimes includes acquihiring, where a company now has the resources of additional talent that is needed to grow the existing platform company, or can include acquiring the customers of the add-on company and merge into the platform company, or possibly even geographic expansion opportunities into new markets where the add-ons were serving.
The whole is greater than the sum of the parts (1+1+1=8)
When a private equity firm invests in an add-on, the marginal value added on the platform company is not equal to the value of the additional add-on itself. It, in fact, increases the value of the platform company by much more. The rationale behind this is that the existing company can command much more value as the add-ons allow to strengthen the rusty screws in the platform company. So rather than add-on acquisitions being thought of as 1+1+1=3, it is more appropriate to consider the whole being greater than each individual add-on, hence 1+1+1=8. This is why investors look for actionable opportunities when sourcing for deals; that is, is there an opportunity that would be actionable within the next 6 months? And for companies that are looking to be rolled-up, investors are looking for:
- Established track record
- Existing contacts
- Strong chemistry and trust
- Investment-criteria fit
Measuring Value Creation
Value creation is multi-dimensional — the number of levers private equity firms can pull to add value are a handful. Here are some quantitative metrics that is used to measure value creation from purchase to sale:
- Change in EBITDA — have EBITDA margins increased?
- Change in Net Debt — was enough free cash flow generated to pay down debt from investment and other sources of funding?
- Change in EBITDA Multiple — is there indication of firm-wide rapid growth as well as the industry it is in?
From leverage to multiple arbitrage to EBITDA growth, the industry has transformed to generate superior returns for LPs as well as building better businesses across the world.