Private equity (PE) companies are firms that buy, fix and resell other companies (Leslie & Oyer, 2009). A positive outperformance has been noted in large PE investments. In order to eliminate higher influence at PE firms and obtain a measure of factual fiscal outperformance, referred to as abnormal performance, deal returns are evaluated.
According to Hahn (2009), PE companies create value via strong incentives, high leverage, radical improvement of the acquired companies’ operating performance, as well as via cash distribution in high arrears payments manner. It is argued that public organizations have well-established management that is vulnerable to diversions of cash-flow and that reluctantly takes on efficient risk levels. In comparison, PE funds, which usually instigate leveraged buyouts and manage the majority of the resultant private entities, generate funds – like pension funds – for their investors. In large and mature PE firms, which exist and operate for more than five years, median performance has been noted to comprise 150 per cent of S&P 500 return and a higher rate of 170 per cent. In addition, this performance is constant – an attribute linked with potential availability of ‘expertise’ in fund management. Interestingly, such constancy is rarely present in mutual funds, and, if present, is seen in worst performers.
Looking at the returns earned by PE firms and at the deal-level equity return in particular, measured by Internal Rates of Return (IRR), it becomes evident that the abnormal performance of deals captures the returns linked with human capital factors and operational strategies employed. According to Hahn (2009), approximately 16-24% of standard deal IRR are generated from abnormal performance, 56-58% from high fiscal leverage, and the remainder from quoted sector exposure. Although there is a significant discrepancy across deals for abnormal performance, it is statistically considerable and reliable with the observation that large PE companies produce higher returns at the enterprise level, when compared with benchmarks. In deals’ cross-section, abnormal performance has positive correlation to IRR and public-market equivalent, even if it is imperfect.
In relation to operational improvements, affirmative impact of PE possession on operating performance has been identified. PE ownership has been found to increase deal margin, the ratio of EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) to sales by approximately two per cent, while deals with mergers and acquisition record a multiple increased ratio of EBITDA to enterprise value of approximately 18-24 per cent. This proves that abnormal performance in deals’ cross-section is linked to more significant improvements in the operations comparative to cited peers.
In general, for deals without mergers and acquisition events in the leading two years of private stage, abnormal performance is facilitated by margin improvements. On the other hand, for deals with mergers and acquisition events in the private stage, abnormal performance is facilitated by amplification of EBITDA multiple. Therefore, the strong abnormal performance determinants in large PE firms are multiples and margins improvements. These measures particularly control duration of deals and sub-periods of acquisition time.
Analysis of Human Capital Factors at Play in PE Transactions
From the above analysis it is evident that PE firms create consistent value via operational improvements. However, such improvements require skills, which may explain consistent returns earned. Certainly, a successful PE company requires human capital skills at the partner deal level. But how do they affect PE deal performance?
There is heterogeneity in expertise, combined strategies for value creation and different backgrounds for partners that correlate to deal-level performance. Depending on the value creation strategy, there can be organic and inorganic deal strategies. Organic strategies entail deals with major merger and acquisition events at private stage. Further, depending on the partner’s professional experience, there can be Finance Partners (FPs), who include ex-accountants and ex-bankers, and Operations Partners (OPs), who include ex-industry and ex-consultant experts. With this categorization, a distinct picture of how human capital factors affect PE deal performance can be drawn.
According to Hahn (2009), OPs with extensive operational experience generate substantially greater abnormal performance in organic deals. Having already worked in those industries, they seem to better improve a firm internally. In contrast, FPs with strong financial experience follow inorganic (merger and acquisition) strategy more successfully and repeatedly. In addition, OPs regularly conduct managerial changes, plan revisions and show strong instance loyalty. These measures positively contribute to the organic strategy deal’s abnormal performance. FPs, on the other hand, allot equity shares to the first two managerial lines and plan new key performance indicators frequently – measures that never contribute to inorganic strategies’ abnormal performance. This does not lead to a stand that OPs perform better than FPs, particularly in organic strategies. Although they seem less active in organic deals for practices that relate to fiscal abnormal performance, they are active in practices not related to outperformance, as proved by the following human capital factors.
The first factor is management turnover and incentives. As argued by Hahn (2009), when a Chief Executive Officer is replaced during buyout period, operating improvement is commonly increased at PE firms. In a similar instance, FPs appear to be less active in the first 100 days. This difference points out skills heterogeneity that leads to higher performance because early managerial changes occur regularly in the organic strategies’ top level. However, no converse pattern between top outperformance deals and offering lofty cash multiple directionally relate to value creation.
The second factor is support and control. FPs seem to take less time in the organic deals management interactions, while OPs, at the same time, take much more time in management interactions. Great abnormal performance requires over 79% management interactions.
The last factor is interventions and initiatives. OPs revise managerial plans in organic strategies more than FPs. However, FPs devise key performance indicators more than OPs. In general, OPs with extensive experience generate greater financial performance in deals with organic strategies, since they are better suited for internal corporation improvement. In addition, FPs, when employing inorganic strategies, generate greater returns, since they are familiar with mergers and acquisitions.
Non-random Target Selection Pattern and Risk Limiting Role of Debt Providers in PE Investment Decisions
It is argued that PE firms experience difficult periods during economic distress due to extra debt acquired on acquisition. However, when using non-random target selection, it becomes clear that PE owned companies target organizations that have constant pre-acquisition operating performances and they do not show downward or upward pattern pre-acquisition. In addition, selection pattern does not rely on profitability because target companies are not unprofitable or profitable at acquisition.
In non-random target selection, PE companies take a costly and long target invention as well as due diligence process when they obtain and process both qualitative and quantitative data to verify if investment presents an optimistic net present value. They select targets depending on company size and profitability, where they acquire companies within profitability and size brackets because of upside-but-low-downside criteria and depending on performance trends, where companies with falling performance or already above sector are eliminated (Hahn, 2009).
Following this non-random target selection, PE firms initiate deals that show and maintain great operational stability throughout PE ownership. This is because such deals posses statistically considerable lower volatility in comparison to similar peers and sectors. In addition, deals’ debt coverage ratio, given by EBITDA/Debt Service needs, does not surpass sector average irrespective of whether or not the deal possesses statistically a lower ratio than peers. This is why PE firms choose companies within the segment where EBITDA levels and compensates are relatively high for the rise in leverage in the duration of PE ownership.
In a risk standpoint, risks at acquisition and those brought by debt provider’s influence during acquisition decision are prevented in advance. PE selection companies present high profitability and possess a debt coverage ratio that corresponds with the PE firm’s sector. Further, deals present lower volatility in performance operations before and at ownership and improve performance in operations throughout PE ownership.
In conclusion, PE funds analytically purchase companies. They avoid organizations that have large variation in operational margin pre-acquisitions and acquire those that pledge upside potential and still indicate adequate profitability for debt servicing. Additionally, PE firms show lesser operational volatility compared to the sector. Debt coverage ratio does not go below that of the sector’s level. They pick highly profitable and stable companies which enable them to augment leverage ratios of acquired companies without surpassing debt coverage levels of the sector. Lastly, debt providers manage to restrict the PE’s large control risk yearning. This is the reason why PE firms as sector corporations present identical default rates in spite of high leverage at the period of PE ownership.