It has long been suspected that private-equity funds generally make more profitable company acquisitions than their opposites in the corporate world. Our research now proves that this is indeed the case.
More intriguingly, perhaps, is how they achieve this, and whether different types of private-equity firms and their general partners (GPs) focus on different aspects of post-acquisition performance.
The answers, we believe, are of interest not only in the areas of private-equity firms and corporate acquisition departments but across the business world in general. They have much to tell about priorities and about the creation of value for investors.
We have found that private-equity funds pay lower valuations for their acquisitions than corporate acquirers. Looking at a range of European deals, we calculated that on average private-equity funds pay multiples of earnings before interest, tax, depreciation and amortisation (EBITDA) about 8.3% lower than those paid when a similar company is bought by a corporate acquirer.
From this we can deduce that GPs are either first-class negotiators, or that they are skilled at identifying under-valued companies.
Not only do private-equity funds manage to strike purchase prices at significantly more advantageous valuations than those achieved by corporate acquirers, but during the first three years of private-equity ownership, in comparison with similar non-private-equity owned companies, they increase their leverage, operating profitability, assets and sales.
The fact profitability and sales have increased at the same time suggests that private equity firms are able to bring about significant efficiencies while also pursuing growth.
Three types of private-equity funds
There are, however, important variations as to the different priorities and performances of different types of private-equity funds. For ease of reference, we can put these differences into three groups:
1. Larger funds versus smaller ones
We noted that smaller funds, those of $500 million or below, target higher expansion as their top priority. Hence they show the most significant sales growth. In contrast, GPs managing larger funds tend to put the emphasis on operational improvements and efficiency gains, thus the companies in their charge display far greater growth in earnings than those owned by the smaller funds.
2. Funds with a good performance history versus those with a less impressive track record
Our findings in this category are perhaps less surprising. They suggest that “success breeds success”, and that the former type of fund is more successful at improving the performance of acquired companies than are those with a less impressive history. There is also some evidence that a focus by these better-regarded funds on sales growth may help to maintain their outperformance with regard to the rest.
3. Established funds versus newcomers
Because our definition of ‘well established’ comprises firms that manage 10 or more funds, there is obviously some overlap with our first category, size. We found that these well-established funds make larger investments, often bankrolled by leverage, and achieve significantly higher earnings and asset growth than the newcomers. This suggests that well-established funds have built up a bank of expertise in terms of bringing about operating efficiencies. Smaller funds, by contrast, perhaps because they lack this know-how, are more focused on driving sales growth.
From the boom years to the financial crisis
Before climbing down into the engine room and looking at this issue in more detail, two points ought to be made about the comparison with the performance of corporate as opposed to private-equity acquisitions. The first is that our deal sample stretches from 1998 to 2014, taking in both the boom years and the financial crisis. While on average across that period, private-equity funds paid 8.3% less on average in terms of multiples than their corporate equivalents.
This valuation discount was 10.6% prior to the financial crisis compared with the prices paid by corporate acquirers; after the credit crisis it has been about 11.6%. So how can these figures average at 8.3%? Put simply, because during the credit crisis there was practically no difference at all between the valuations paid by private-equity and corporate acquirers.
As an aside, it is fascinating to note that the valuation discounts enjoyed by private equity in comparison with its corporate counterparts is larger when the deal itself is smaller. This suggests that funds specialising in smaller companies have an edge in terms of creating value for investors.
Can you compare apples with oranges?
The second point is that, to some extent, comparing private-equity valuations with those paid by corporate acquirers may not strictly be comparing like with like. A corporate acquirer may be prepared to pay extra in return for the sort of corporate synergies that neither show up on the radar in the same way as valuations nor would tend to feature in private-equity deals.
That said, it is worth reminding ourselves of the nuts and bolts of how private equity works. For firms and their GPs, there are three parts to the creation of value for their investors. Part one is to make the best possible selection of deals and to ensure they are structured in the most efficacious manner, not least with regard to the price paid. Once the acquisition is completed, part two involves improving the performance of the company concerned, either in terms of operating efficiency or sales growth – or, indeed, both. Then comes the exit, where the company is sold on to a new owner at a higher valuation multiple than applied at the time of the original purchase by the private-equity fund and the investors, it is hoped, gain their reward.
What are the behavioural lessons from buyouts?
It is what happens in the intervening period that will often dictate the extent to which the exit meets investors’ expectations or not. In particular, it is the different behaviours of private-equity owners as against their corporate equivalents that is of special interest.
What did we find in this respect? Private-equity GPs are focused first on sales growth and investments in tangible assets, frequently funded by taking on new debt – their debt levels on average rose 9% over a three-year period against just 3% for similar companies in non-private-equity ownership. Sales grow on average by about 110% over three years of private-equity ownership and total assets by about 85%.
This increased leverage can be seen in funds both large and small.
Second, at the same time as growing sales, private-equity GPs are engaged in driving substantial operational improvements in comparison with firms that are not private-equity owned. In three years of private-equity ownership, earnings as measured by EBITDA increased on average by close to 100%.
As we have seen, different-sized firms tend to pursue different investment strategies. Larger and better-established GPs, with their focus on operating efficiencies and improvements, expand earnings on average by 100% relative to those managing smaller funds, where the increase is between 37% and 41%.
Established GPs make bigger investments, often borrowing money to increase the assets of the acquired company by more than 120%. When it comes to sales growth those managing smaller funds run away with 118% expansion against 63%.
Regardless of the differing strategies involved, and bearing in mind that corporate acquirers may sometimes have different incentives, our research shows that the performance of private-equity-owned companies is driven by two things. Private-equity firms have the ability to buy companies at lower valuations, thus keener prices, than non-private-equity owners. Two, there are specific actions taken after the purchase and before the exit sale to increase sales, operating efficiencies and tangible assets.