Please note the following insight is related solely to private equity buyout investments, primarily in the large cap space across North America and Western Europe. The insight is not related to broader private markets but focuses on one subset of the industry – private equity buyouts.
Value creation
ROYC research indicates that value creation in private equity buyout deals (not to be confused with venture capital, growth equity and other private markets strategies) has and will continue to be increasingly attributable to operational improvements as opposed to leverage.
Driven by more competitive deal-making dynamics, evolving macroeconomic landscapes and investors increasingly focussing on committing to fund managers with proven operational expertise.
Private equity managers play an active role in managing their portfolio companies to generate returns for investors. Through operational improvements,financial engineering, strategic initiatives, and governance enhancements,private equity managers drive growth, improve profitability, and enhance overall organizational performance.
- Strategic initiatives are mainly aimed at diversifying revenue streams and expanding businesses into new markets
- Strong governance through institutional ownership plays a vital role in fostering risk management and efficient capital allocation
- Operational improvements such as supply chain optimization and technology upgrades are core to growing enterprises
- Financial engineering such as debt restructuring and refinancing at lower interest rates also play a role in enhancing return
Portfolio companies
These initiatives at the portfolio company level are intended to create value for shareholders, which can largely be attributed to:
- Multiple expansion, which refers to an increase in the valuation multiples of a portfolio company from entry to exit.
- Margin expansion by either driving top-line revenue growth or optimizing cost structures for a portfolio company from entry to exit
- Leverage, which enhances returns by combining equity investments with debt to optimize the capital structures from entry to exit
Revenue growth playing a key role
Recent studies (1) show that revenue growth has been the most persistent source of value creation for private equity backed businesses since 2000, as noted by Goldman Sachs’ October 2023(2).
Along with multiple expansion, which has been particularly key since the global financial crisis (2008), with private equity buyout deals experiencing 2-4x turns of EBITDA expansion from entry to exit(2).
Leverage
Leverage has also played a key role in creating value in private equity buyout deals, however primarily in pre-1990s era, given the emergence of the private equity industry as whole during that period underpinned by the widespread adoption of leveraged loans(2).
That is to say, the association of private equity and over levered deals is one that is attributable to a period of deal-making consisting largely of the pre-1990s era. As the industry has evolved, the impact of leverage on private equity buyout performance has shrunk, with private equity managers having had to develop operational value-add capabilities to deliver returns to investors.
Operational value creation
In the current “higher-for-longer” interest rate environment, amidst a competitive private equity market, operational value creation levers are destined to become increasingly important in generating shareholder value for investors.
In line with the emergence and widespread adoption of operating partner groups at the most institutional private equity managers. These have evolved to meet investor expectations of having access to operating resources to drive value creation, in lieu of relying on financial engineering to generate returns(3).
Access to operating resources has also become key for private equity managers’ fundraising success, as these play into the storytelling element for investors, who increasingly value them when deciding as to which private equity manager to commit to(3).
We at ROYC have seen this first hand as we meet and diligence fund managers – this rhetoric is one that has been repeated to us countless times by private equity managers both in Europe and North America.
The final key consideration to keep in mind is that leverage is largely only utilized in buyout deals (involving mature companies with proven business models). Other segments of private equity, such as venture capital and growth equity invest on a largely debt-free basis given the unprofitable or near-profitable nature of the underlying businesses, which cannot sustain leverage at the balance sheet level.
Conclusions
- Leverage, has played a key role in value creation across buyouts but not incrementally more than operational improvements
- Value Creation, in the current economic environment is going to require more specialized operational expertise by buyout managers, which are inevitably going to have to rely less on leverage compared to operational improvements
- Manager Selection, remains key in private equity, with LPs increasingly focussing on managers with proven operating capabilities permitting them to grow businesses and position them for exit, in addition to also enhancing returns with leverage
Sources
(1) Murpy, D., Gelfer, J., & Hadas, J. (2023, October 31). The new math of private equity value creation. Goldman Sachs Asset Management
(2) Bartlett, J. (2015, June 15). Operational approaches: The limited partner perspective. In The Operating Partner in Private Equity, Volume 2. Parthenon-EY
(3) Binfare, M., Brown, G., Ghent, A., Hu, W., Lundblad, C., Maxwell, R., Munday, S., & Yi, L. (2022, February 12). Performance analysis and attribution with alternative investments. Institute for Private Capital
