Investor faith in the genius of private equity (PE) fund managers has soared amid new records in fundraising, transaction volume and asset valuations. These trends have continued into 2022 despite, or perhaps because of, global public market losses.
In addition to maximizing fee income, the ultimate goal of LBOs is to optimize the return on capital they manage on behalf of LP investors. While subtlety of the trade isn’t limited to financial trickery, success in PE has long been marketed through masterful delivery and internal rate of return (IRR) subtlety.
What’s in an IRR?
PE companies have a repertoire of tools at their disposal to achieve their profitability goals. The following factors represent the five pillars of value creation from a fund manager’s point of view:
1. Maximize leverage at startup and refinance the capital structure frequently
That is, recapitalize by increasing debt to pay dividends, hence the term “dividend recapitulation.” With this movement, the PE firm partially realizes its investment. This can be controversial. Excessive borrowing and frequent recapitalizations can stretch a borrower’s balance sheet and inhibit the borrower’s ability to meet loan obligations or adequately finance growth.
2. Complete Complementary Acquisitions
This is best done with lower down payment multiples than what was originally paid to purchase the portfolio company, making these add-ons increase in value. Value can then be reaped through the synergies achieved by merging the acquirer and targets. This is typically the main rationale for buy and build strategies for LBOs in the $50 million to $500 million enterprise value range.
3. Improve performance and strengthen cash flows
This is vital during the ownership period. Operating profit may be affected by:
- Increased margins through better cost management (relocation of production facilities to lower cost countries, for example) and economies of scale by increasing volume.
- Drive cash generation by lowering working capital requirements, reducing capital expenditures, minimizing cash leaks, and entering into sale and leaseback agreements.
- Discontinue or get rid of unprofitable or low-margin activities. This practice earned some early LBO players the nickname “asset wiper” and was common in the 1970s and 1980s when underperforming, unrelated divisional conglomerates were being sold off piecemeal. Few lenses today suffer from the same lack of focus.
- Increase sales through refined price point strategies, new product launches, etc.
4. Aim for Positive Multiple Arbitrage
This involves exiting a portfolio company with a higher valuation multiple than what was paid at the initial investment stage. Said arbitrage depends on the economic cycle. In up cycles, PE managers will emphasize their skills to secure any gains. However, when such arbitrage turns negative, they will blame poor market conditions. Frankly, multiple expansion is highly cycle dependent.
5. Optimize the investment holding period
This is perhaps the most important pillar. Due to the time value of money, most fund managers seek to get part or all out of investments as soon as they can. What is meant by the time value of money? That time has value and that a dollar today is worth more than a dollar a year from now. Because? Because that dollar can be put to work over the next 12 months, earning interest or, through productive investments, growing to more than a dollar over the course of the year. You may also lose some of your purchasing power due to increases in the cost of living during the same period, a critical point today amid rising interest rates and high inflation.
This value driver also explains why financial backers are obsessed with dividend statements. Although all experienced PE firms place this parameter at the center of their investment strategy, it is both controversial and paradoxical. How can PE companies claim to be long-term value creators if they are looking for a quick exit at the first opportunity? Portfolio realization early, whether in whole or in part, goes a long way to achieving outperformance.
Building the Value Bridge
PE firms include a graphic called a “value bridge” in private placement memos. Fund managers use these documents to raise money by demonstrating how they will apply the above factors to create value for their LP investors.
One of my previous employers, Candover, was one of the top 10 European PE workshops before being liquidated four years ago. Candover used slightly different metrics from the five pillars listed above in its value bridges, preferring to break down value accretion into four dimensions: sales growth, margin improvement, cash generation, and multiple arbitrage, or some combination thereof. Using this procedure, a value bridge might resemble the following chart:
Vintage Fund 2012: Notional Bridge Value, in Millions of US$
Without precise methodologies for spreading value across the various drivers, value bridges can be built and calculated in myriad ways. In his 2016 “Private Equity Performance Assessment”, KPMG described a value bridge that only looked at value creation along three dimensions: EBITDA increase, multiple increase and change in net debt and interim distributions.
Swedish investment group EQT gave a concise indication of how the improvement in portfolio value was derived. in its 2019 IPO prospectus, explaining that “98 percent. . . as a result of business development (ie, sales growth, strategic repositioning, and margin expansion) versus 2 percent debt repayment.”
When it went public last year, the British firm declared bridging point that “From 2000 to 2020, approximately 77% of value creation in profitable investments has been driven by revenue growth and earnings enhancement . . . with an additional 25 percent driven by multiple expansion in exit as a result of portfolio company repositioning for growth and professionalization, slightly offset by (2) percent deleveraging.”
Beware the recession
Excluding losing investments from the value bridge is a common trick among fund managers to manipulate performance reports. Candover rationalized this behavior, stating that “attributing the loss in value to the different value drivers would be an arbitrary exercise.” He could not explain why attributing the gain in value to different value drivers would not itself be arbitrary!
Bridgepoint’s public filing describes “value creation through profitable investments,” implying that unprofitable transactions were also left out of the analysis. However, in the aftermath of the Global Financial Crisis (GFC), many PE companies recorded more losing investments than profitable ones. Candover’s experience shows what can happen to PE-backed and overleveraged companies in a severe downturn:
Candover’s 2005 Vintage Fund: Last 10 Offerings
|Transaction||Date of realization||company value
(Millions of €)
|cash against cash
|DX group||September 2006||654||-89%|
|hilding anders||October 2006||996||-95%|
|reunited parks||January 2007||935||+25%|
|security capital||June 2007||415||+183%|
|Soul Consulting||December 2007||800||-91%|
The current sustained rise in interest rates, the ongoing market correction, and the portfolio write-offs that could result could render value bridges unfit for purpose. The methodology can hardly reflect the true performance of fund managers in bear markets.
The lack of proper instructions, let alone auditing standards and procedures, for building value bridges explains why it is one of the favorite marketing ploys of private equity firms. Fund managers can easily manipulate the numbers and make questionable claims about expanding EBITDA and enhancing growth to “prove” their capabilities in terms of operating efficiency. Your existing and potential LP investors may not challenge the Value Bridge formulas, calculations, and reporting formats, but they are likely to be positively influenced by them, even if unconsciously.
However, the biggest flaw of the value bridge is not the lack of guidelines or the exclusion of unprofitable investments. Rather, by focusing on absolute capital gains, it does not show how private equity’s central value-creation instrument, leverage, impacts returns. That will be the topic of the next article in this series.
Parts of this article were adapted from The Debt Trap: How Leverage Affects Private Equity Returns by Sebastien Canderle.
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All messages are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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