Strategies for value creation in private equity investing
December 7, 2016
Over the years, private equity buyout funds outperformed public markets in all major regions over longer time horizons. Both the number of buyout funds and the value of buyout capital sought were up in 2015. Finally, positive cash flow from distributions supported new PE buyout fund commitments in all major regions. The trends outlined are a direct function of value creation by private equity funds. Some of the strategies for value creation are outlined below.
Transparency: the solution to asymmetric information
In private equity, management are legalized insiders, so there is a lot more transparency[i] According to Partner’s Group founder Urs Wietlibach, it is better to invest in PE than public markets because PE managers have access to all information, while there is asymmetric information in public markets.
Aligned Interests: the solution to the agency problem:
In PE, GPs take board seats, meaning they commit with their own money, not free equity options like in public markets. Investors can rest assured knowing that GPs will require management to own equity in some form.[ii] The longer hold period in PE vs public markets means less short term focus on hitting Wall Street estimates by management, shifting focus to long term value as PE firms do not have to be concerned about being scrutinized by analysts every quarter.
A) Company level: PE sponsors inject discipline to management to optimize operations and strategy.
B) Portfolio Company level: PE funds have the discipline to opt out of a good businesses that is being banked to a broad base of buyers, so PE funds know when to pay the right price for the right asset.
Cross-Portfolio Synergies/ Developing sector focus and expertise in house[iii]
More and more GPs are looking into businesses they know well – similar to companies already in their portfolios.
By adding on enterprises in the same or related business to a portfolio holding, GPs can target companies that often are too small to attract the attention of big corporate acquirers and can be bought at reduced prices, driving value through with add-ons through multiple arbitrage, - a good way to average down a PE firm’s entry multiple and a proven way to increase returns from a sale. Particularly, as economies slow, owners of smaller companies will be increasingly motivated to sell at lower prices.
Example: Buy and build is especially well suited to today’s PE environment, and the numbers from 2015 reflect this. Globally, the value of add-on acquisitions by PE-backed companies more than doubled to a record $267 billion in 2015. Sizeable acquisitions, such as Kraft’s acquisition of Heinz in the food industry and Dell’s acquisition of EMC in computing, dominated the buyout scene.[iv]
Example: London-based PE firm Cinven is pursuing this strategy to roll-up medical laboratories, a fragmented sector that the firm sees as ripe for consolidation. Over the past year, Cinven acquired French medical diagnostics company Labco for 1.2 billion Euros and just weeks later bolted on German company Synlab, giving the combined business a respectable enterprise value of 2.9 billion Euros.[v]
Finding bargains in the middle markets (MM)
At the lower end of the MM, GPs like the relative bargains that are available, because the small size of MM companies puts them off the radar of corporate acquirers. Buying these lower-cost assets also affords GPs opportunities to pursue buy and build strategies, enabling them to assemble several low-multiple companies into a larger entity that can command a far higher multiple upon exiting. As these lower multiples are likely to persist, look for PE funds to continue fishing in middle-market waters in 2016.[vi]
Teaming up with strategic buyers to mitigate risk
Many GPs are finding ways to partner with big companies in buyouts that suit the needs of both. For PE funds, having a strategic co-investor provides a built–in exit strategy, enabling them to sell their stakes to the corporate partner when the timing is right.
Example: Permira, the Canada Pension Plan Investment Board (CPPIB) and strategic partners Microsoft and Salesforce.com bought Informatica, a data integration software provider, for $5.3 billion.
Private equity returns have been able to exceed those of public equity in part due to the value creation strategies outlined above. While empiricism and a track record of success is enough to keep the demand of reputable PE companies at a high level, economic theory suggests that there is a more fundamental driver for the services of PE firms. In Das Kapital, Marx argued that idle capital will always need to be redeployed to prevent the crisis of capital accumulation – the decreasing purchasing power of depreciating capital due to inflation. It is especially hard to generate consistently high returns for large quantities of capital, suggesting PE will be around for a while.
[i] Partners Group, Urs Wietselbach, YouTube talk. Retrieved from https://www.youtube.com/watch?v=kgUhDjSBzxQ
[ii] Partners Group, Urs Wietselbach, YouTube talk. Retrieved from https://www.youtube.com/watch?v=kgUhDjSBzxQ
[iii] Bain and Company Global Private Equity Report 2016. (Bain page 15). Bain report section: Buy and Build Strategies gain in popularity.
[iv]Bain and Company Global Private Equity Report 2016. (Bain Page 15). Bain report section: Buy and Build Strategies gain in popularity.
[v] Bain and Company Global Private Equity Report 2016. (Bain page 16). Bain report section: Buy and Build Strategies gain in popularity.
[vi] Bain and Company Global Private Equity Report 2016. (Bain page 17). Bain report section: Finding bargains in the middle market