This Friday, the London Business School Private Equity and Venture Capital Club hosts its annual Private Equity Conference. I will moderate the closing panel discussion called “Value Creation: Overtaking Leverage?” that will explore how buyout firms can create value not by piling on debt, but by improving the operating performance of their portfolio companies. This is a particularly topical issue right now, as debt has become more expensive, financing terms more onerous, and market conditions more challenging for portfolio firms.
In preparation for the panel, I have reviewed recent research–largely by financial economists–on private equity, operational improvement, and value creation. Recent papers provide some very helpful, and in some cases surprising, insights into how late-stage private equity firms add value. Below is a selective review of papers that bear on a set of questions related to how leveraged buyout firms create economic value through operational improvements. (For comprehensive reviews of private equity trends, see papers by Cumming et al. and Kaplan and Stromberg).
- Do leveraged buyout firms create economic value? Excluding fees, leveraged buyout firms outperform broad indices of public firms. In a recent paper, Ludovic Phalippou and Oliver Gottschalg find that LBO firms outperform the S&P 500 by 3% per year, which suggests that LBO firms create value compared to their public counterparts. This does not mean, however, that limited partners who invest in late-stage private equity funds earn an attractive return relative to other investments. Adjusting for fees, Phalippou and Gottschalg find that LBO firms under-perform the public market by nearly 4% per year. In a 2005 paper, Steven Kaplan and Antoinette Schoar, analyze 746 private equity funds between 1980 and 2001, using data from Venture Economics. They find that net of fees, the buyout firms on average provide returns ranging between 93-97% of those earned on investments in the S&P 500.
- Do all leveraged buyout firms create value? Kaplan and Schoar report large differences in performance among private equity firms, with those in the top quartile providing their limited partners with an IRR (cash on cash) of 24% versus a 6% IRR generated by firms in the bottom quartile. In contrast to mutual funds, these differences in performance among firms persist over time. The persistence of differential performance suggests that the top quartile firms outperform due to skill rather than luck. To date, no one has systematically examined what factors cause differential performance among more and less successful private equity firms, but Oliver Gottschalg is currently researching this topic.
- How important are operational improvements in value creation? In a recent working paper, my colleague Viral Acharya and his co-authors study 110 large leveraged buyouts done by fourteen mature private equity firms between 1995 and 2005. They find that the deals in their sample do create value, which is not surprising since they chose their sample from established private equity firms with strong past performance. Of the value created (relative to comparable public firms), 56% is attributable to financial leverage (in excess of what their public peers would have on their balance sheet), 22% results from how the firms’ portfolio of business units exposed them to growing sectors, and 22% from operating improvements. They found that portfolio companies without major M&A activity while owned by the LBO firm saw EBITDA rise by two percentage points.
- Are operational improvements growing more or less important over time? One recent study of 192 leveraged buyouts between 1990 and 2006, finds that operational improvements account for 23% of value creation, in line with Acharya’s findings. The gains in operational performance by leveraged buyout firms in these more recent deals are substantially lower than improvements reported in deals done during the 1980s. The operational improvements achieved by portfolio companies owned by LBO firms are not consistently superior to those achieved by their public peers in this sample. These findings suggest that LBO firms may no longer enjoy an advantage in their ability to create value through operational improvements relative to public companies. The authors report wide variation in operational improvements achieved by LBO firms, which implies that private equity firms have the potential to create significant value by improving portfolio firms.
- How do leveraged buyout improve the operations of portfolio companies? The traditional answers to this question are that higher debt improves management discipline, concentrated private ownership enhances the quality of governance, and significant equity stakes provide executives with the incentives to do the take actions that create value. These are not satisfying explanations. Differences in leverage, governance, and incentives still exist between private and public firms, and yet the gap in operational improvements is narrowing. Moreover, top and bottom quartile LBO firms employ similar practices, yet achieve very different results. At present, I don’t think we really understand how buyout firms add value through operational improvements. Some recent research provides intriguing clues. A working paper by Steven Kaplan and co-authors finds that a CEO’s ability to execute is more important than team building skills in creating economic value in a portfolio firm. A comprehensive study of over seven thousand investments by 250 private equity firms over 30 years finds that deals lasting two years or less are much more profitable than investments held for a longer period. This finding suggests that however LBO firms add value, they typically do so in the first two years. The same study finds evidence of dis-economies of scale among private equity firms. The more investments a firm holds at a point in time, the lower the likely return on each individual deal. This result implies that attention from deal partners influences value creation, although it does not explain how deal partners add value.
Looking forward to the panel!