Value Creation
The Private Equity Firm’s New Role
Historically, private equity firms have been focused on the deal – the buy and the sell – as they could acquire businesses for less than their intrinsic value and employ significant leverage at the point of the transaction. This type of deal focus was effective given the relative immaturity of the private equity industry, characterized by fewer competitors and sellers with less knowledge of how private equity firms operated. As the competitive landscape changed and sellers, and their advisors, became more conversant in M&A, private equity firms needed to look beyond buy/sell arbitrage and leverage and more towards creating value in their businesses to drive returns. There are obviously exceptions to this change in tactic, but they are in the minority.
This paper will outline some of the different ways that private equity firms create value in the businesses they buy. The areas which will be discussed are the board of directors, strategic planning, human resources, measurement and information, mergers and acquisitions and the employment of capital. But first, we will briefly review the current state of the private equity market. This overview will help you understand the motivation of private equity firms and the markets that underpin them as a first step in comprehending private equity’s singular focus on creating value.
The issues discussed in this paper dwell on the role of the private equity firm in creating value. It is important to note, for the record, that management is critical, invaluable and integral in this success. While this is written from the perspective of the private equity firm, management can not be separated from any aspect of the value creation chain. While the private equity firm will bring different skill sets to the equation, it is the partnership with management that drives success.
Private Equity Market Landscape
From its early days as a cottage industry, private equity has become a well established, high profile market participant. Private equity’s share of mergers and acquisitions continues to rise as it becomes more entrenched in the tapestry of global markets. Competition is fierce amongst firms for market share, the best deals, the most capital under management and the best returns.
Private equity invests money on behalf of large institutional investors and wealthy individuals. These investors will only invest in the most promising new funds and the most successful established funds. To drive the best overall return for the investor’s money, considerable time and effort is spent benchmarking private equity funds against one another as well as other types of investment opportunities. There are two common performance metrics. The first is internal rate of rate (IRR) or, more plainly, the annual growth of the money invested. The second is cash-on-cash returns or, more plainly, how much more money was returned than invested as represented by a multiple of the initial investment. In order to capture continued institutional investment, a private equity firm’s returns need to beat their peers. The chart below shows the amount of capital being invested in private equity in the United States and Europe.
Compensation for the private equity firm comes in two forms. One form is a management fee equal to a small percentage of the funds managed paid on an annual basis. This fee is to pay for the costs of running the firm. The second form of compensation is a share in the profits generated on the sale of the businesses the firm bought. This profit sharing has the potential to be the predominant portion of the compensation for the private equity firm and therefore is the firm’s focus.
All of these factors lead to a virtuous cycle and a singular focus on value creation. If a firm can create significant value it can: attract the most capital; win the largest quantity of the highest quality deals; and create the most significant gains for itself and its investors thereby generating superior investment returns and cementing its longevity.
Creating Value
At a macro level, value is in the eye of the buyer. This statement applies to both a qualitative and quantitative view of the business. It is the job of the private equity firm to make the holistic view of the business as attractive as possible. This means that the business should be well positioned competitively, provide compelling opportunities for growth in both sales and profits, be efficient in its use of resources and capital, and have a strong management team who aggressively uses systems and information to improve the company. A tall order for any management team and owner to achieve.
The most important driver of value is growth in earnings and the quality of those earnings. Quality earnings are those that are repeatable year-after-year. Private equity firms will bring significant resources to bear to increase top line growth through new product introductions, expansion into new markets and geographies, greater market penetration and better pricing power to name a few. They will also look to improve the efficiency of the operations and leveraging of infrastructure to drive greater profitability. The private equity firm will challenge the company to deliver the highest quality sales and earnings possible. Improving visibility and likelihood leads to greater certainty and greater value. As is shown below, value creation far outdistances other factors in driving appreciation in private equity-backed businesses.
Levers
The levers that the private equity firm will pull largely relate to strategy, people, resources and execution. Private equity firms help companies build value by ensuring the management teams have the right tools at their disposal to execute their strategic plan. Let’s start at the top and work our way through the value chain.
The Board
At the highest level, this value creation journey begins at the Board of Directors. The board of a privately held company is generally made up of executives from the private equity firm, outside directors with domain experience and broad and deep relationships, and senior executives from the company. The private equity firm will be instrumental in creating a dynamic and motivated board and will spearhead the recruitment of outside directors. The board provides governance and oversight and is an experienced sounding board for management. They will apply lessons learned across a broad spectrum of businesses, will help management adopt the best business models and practices and take advantage of the best and highest value opportunities. The board will also be a catalyst for change and will use their extensive business experience and contacts to help drive the business.
Strategic Planning
The board also sets the strategic direction for the business. Before an acquisition is closed, the private equity firm completes a detailed review (called due diligence) of all aspects of the company including the company’s prospects, projected performance, the markets it serves and the opportunities it is afforded. As the board is formed shortly after the acquisition, it is a best practice to use the information gleaned during the due diligence period as a springboard for the development of a strategic plan. This plan will set a specific financial goal for the business and support that goal with analysis around the market, the company’s competitive positioning, its strengths and weaknesses, its opportunities and threats, and will provide tactics for achieving the financial projections included in the plan. This plan is often developed under the guidance of an outside advisor engaged to work with management to develop the plan for board approval. Once approved, the strategic plan is a living document and is the cornerstone for the majority of the activities of the company.
People
One of the most crucial components of success is human capital. Within the four walls of the business, the private equity firm will work with senior management on improving the look, feel and performance of the business. A smart, focused and aggressive management team aligned around a true leader is a critical ingredient. The private equity firm will ensure that the management team is fully developed with complementary skill sets covering all functional areas including strategy, marketing, sales, operations and finance. The firm will round out a management team utilizing their networks to fill open positions as well as making introductions to key executives to allow for effective networking.
A Common Goal
The private equity firm will then look to align their interests with those of the management team by tying value creation in the business to the creation of personal wealth and opportunity for the management team. This critical component of the value creation cycle, developing a situation where the firm and its investors as well as the management and key employees share in the success of a business in a tangible way, increases the likelihood of a successful outcome. This aligns interests around a common constituent – the shareholder. Such alignment is most often achieved through option programs providing incentive equity, often called sweat equity, to management and key employees, paying bonuses based on a successful sale, and encouraging investment in the business by management along side the private equity firm.
Quantitative Analysis
Improving efficiency within the business is also a valuable component of value creation. The private equity firm drives improvement through measurement and analysis. Information is gathered most efficiently through technological solutions making robust systems and information technology a high priority. The private equity firm will demand that the collection and use of information drive better, timelier and more fact based decisions. They will develop corporate reporting dashboards, mandate robust and timely financial reporting, and evaluate information through unique and innovative analysis. Better understanding of market dynamics and competition is also a high priority.
Mergers and Acquisitions
Supplementing organic growth and expansion through acquisition is often a key strategy for the private equity firm to employ. Acquisitive companies can accelerate their growth to reach important sales and profit thresholds as well as become more dynamic businesses able to be more critical to their customers and more important to the markets they serve. Growth through acquisition can expand the scope and breadth of the business in terms of enhanced distribution, increased access to new markets and geographies, products offered, and customers served to name a few.
Mergers and acquisitions is an area of domain expertise for a private equity firm. Most companies do not have a dedicated corporate development arm. With their mergers and acquisitions expertise, the private equity firm is uniquely positioned to act in this role. This activity will be in partnership with management as both the private equity firm and the management team need to be comfortable with the transaction. On the private equity side, they will be primarily responsible for evaluating the deal related aspects. Management will be primarily responsible for evaluating the target company as it relates to the core business and how they can integrate the two. This is critically important as post transaction management will be responsible for the performance of not only the core business but also the newly acquired company. Without management buy-in during the acquisition stage, an acquisition is much more likely to fail. The other M&A activity where the private equity firm can be invaluable is during the sale of the business. This is the final act to unlock the value that has been created in the business and the better the sale execution the better the outcome for the shareholders.
Capital Markets
Access to capital is critical for businesses looking to grow and expand. Debt is the least expensive source of capital and is very effective in driving equity returns. Private equity firms are experts at tapping the capital markets to raise funds not only to acquire businesses but also for all types of expansion. This could include acquisitions, capacity expansion, development or purchase of IT systems, or international growth to name a few.
The private equity firm will act as private placement agent and adviser on senior and subordinated debt, equity capital and structured finance products. Financing can also come in the form of alternatives such as structured leases and receivables management. As the private equity firm is constantly in the debt markets, the investment professionals have forged key relationship with financial institutions enabling the financing to be closed expeditiously and effectively. In the majority of cases, the private equity firm will look to optimize the capital structure while not placing too high a burden on the company.
The private equity industry has gone through significant change over the last 20 years. The industry players have migrated from relatively unknown esoteric financing vehicles to mainstream, well chronicled players in the global mergers and acquisitions market. Increased competition has become a way of life for private equity firms and mandated that firms adapt their business models to continue to drive returns for their investors. This necessitated private equity firms become active participants and catalysts for value creation in the businesses they buy. These activist owners use the board of directors to impact strategic direction and governance, empower management, utilize acquisitions and optimal capital structures to increase growth, and focus on the shareholder as the critical constituent. We hope this paper has provided a helpful overview of the current business practices within the private equity industry.
Conclusion
As we discussed in the introduction, the partnership between the private equity firm and management is critical. Everything discussed in this paper is the result of hard work on the part of both the private equity firm and management. Without this collaboration, no company will be able to reach its potential.