Looking into the future of Private Equity strategies?
Private equity (PE) funds, the larger cousins of venture capital funds, typically invest in more mature companies. Larger, more stable companies have a lower chance to outright fail, since most of the time they already have an established team and structure and have proven their market and business model. Instead, PE funds face the challenge to grow their portfolio companies the best way, achieve maximum profitability and generate high returns – generally expected by their investors. In this article, we will look into the past, present and future of private equity strategies. The evolution of private equity is driven by accidentally discovered effects that our team of experts and analysts identified recently. Before that, however, we first need to take a trip through history and explore what PE strategies were used since the inception of the industry, how they developed, and how it all eventually led to the formulation of the new idea.
The beginnings – LBOs
How do private equity funds create value and generate returns for their investors? The traditional answer to this question would be through financial engineering, or put more simply, leverage. The traditional way of financing a private equity transaction is through a leveraged buyout (LBO). In an LBO, significant amounts of debt are used to acquire a company, with the assets of the acquired company often used as collateral. Then, the cash flows of the acquired company are used to service the debt payments. As the debt is repaid, the equity proportion of the capital structure grows, generating gains for equity holders. This was a favorite strategy of PE funds since their boom and proliferation in the 1970s and 1980s.
However, after the 2008 financial crisis and the resulting credit crunch, the cost of debt went up and as a result the LBOs went down in popularity. This was coupled with the fact that LBOs generally have a bad rep, often being considered a predatory tactic done without the consent of the company being acquired. Here is a good chart of overview of global financial sponsor–backed LBO volume.
Moving forward – Multiple expansion
After the decline of LBOs, private equity firms turned to other ways of creating value. Economists and researchers have discovered one interesting phenomenon when analyzing transaction data – larger companies, on average, command higher multiples. GF Data published a report and prepared a table of EBITDA multiples for various transaction sizes where this trend can be well observed.
This phenomenon – now coined as multiple expansion, also makes intuitive sense. A multiple can be thought of (at least partly) as a measure of risk, serving the function of a discount rate for future cash flows. Larger companies are less risky than their smaller counterparts – their cash flows are more stable, they are more diversified in their product offering and customers, they have management and key personnel in place, and a myriad of other factors. Therefore, all else being equal, larger companies are sold for higher multiples than smaller companies. So, what is the easiest way to grow a company?
The answer for many private equity managers was mergers & acquisitions – and that is when the buy-and-build strategy was born. It revolves around making a majority investment in a cornerstone, “platform” investment, and then building on it by performing strategic “add-on” acquisitions. These acquisitions are meant to leverage synergies between the cornerstone company and the add-ons mainly through expanding product/service range, scaling up in existing and new markets, and technological improvements. This strategy allows a manager to acquire smaller companies relatively cheaper, bringing down the average cost of acquisition, and then use scale and synergy to achieve multiple expansion, generating returns to their investors after selling the larger company. In the following graph, we can see the proliferation of the buy-and-build strategy throughout the years.
Apart from buy-and-build, and often alongside it, PE managers also utilised operational improvements to fuel multiple expansion. Operational improvement is an umbrella term for a more hands-on approach and includes increasing sales effectiveness, cutting costs, change in manufacturing processes, supply chain optimisation, working capital optimisation, and others. It is about putting the right people in key positions and setting up structures and processes that improve the efficiency of the underlying business. As previously mentioned, these operational improvements were often used in combination with buy-and-build and other strategies and are generally considered as one of the hallmarks of PE-backed companies driving value gains within the portfolio.
Looking into the future – Synergy gearing
One of the most cited examples of the buy-and-build strategy is that of Berlin Packaging. Acquired by Investcorp in 2007, the company proceeded with making over 8 acquisitions of smaller companies within the packaging industry, rapidly growing in size and generating large returns to its investors. This example can be though of as one cluster, where the cornerstone company (Berlin Packaging) was built upon with strategic acquisitions in the same sector, with synergies and economies of scale between them.
In most cases, a single private equity fund either has one specific cluster in its portfolio, or, in the case it has more, they are largely independent and disconnected. However, what if there was a way to create synergies not just within a cluster, but also between clusters? Let’s think of a growth portfolio – a specific field of software (maybe “cyber security applications”), where buy and build makes sense and multiple expansion is likely. Such a portfolio based on a buy-and-build strategy, would no doubt generate synergies and economies of scale, and ultimately lead to business within acquired or invested companies within the portfolio. If there was a similar cluster built around a cyber-security group, maybe a fintech, the leverage through business within the portfolio would increase as invested money would not only work in the targets, but circle through the portfolio in addition. We call this effect “Synergy Gearing”. Now, if more and more companies have an opportunity to cross-sell their products or services, they will be boosting the revenues within the portfolio and driving multiple expansion even higher than usual. This effect can be measured with our newly developed “Synergy Gearing Ratio”.
The benefits of synergies between the companies in a cluster as well as between clusters can be expressed using a metric that we developed, called a “synergy gearing ratio” – contact our experts for details. This ratio shows by which amount the returns of the strategy are superior to a comparable portfolio of uncorrelated companies. It is made up of sums of individual company synergy ratios, which show how much a specific company benefits from others in its cluster, as well as how much different clusters benefit from each other. It gets more complex however, once we factor in the number of companies within the portfolio and their weights within a cluster, the holding period, and other factors.
It goes without saying that it is exceedingly difficult to pull off a successful buy-and-build strategy, as it requires substantial expertise to identify the correct industry and companies. Best suited are unconsolidated industries with fragmented players without a clear leader, which have a lot to gain from technological improvements. The platform company needs to be scalable with a high potential for growth, availability for international expansion and clear benefits from vertical/horizontal integration. The problem naturally gets even more complex once we introduce different clusters and how they could synergise between each other. Yet accepting this complexity and focusing on the leverage of synergy gearing will increase a funds likelihood to outpace peers significantly.