Tricks of Private Equity Trading, Part 1: Value Drivers

Investor confidence within the ingenuity of personal equity (PE) fund managers has reached ever-higher heights amid recent records in fundraising, deal volumes and asset valuations. These trends have continued in 2022 despite – or perhaps due to – global public market declines.

In addition to maximizing fee income, the final word goal of leveraged buyout (LBO) operators is to optimize the return on the capital they manage on behalf of LP investors. While the intricacies of the craft should not limited to financial tricks, success in PE has long been marketed through masterful execution and intricacies of internal rate of return (IRR).

What is included in an IRR?

PE firms have a repertoire of tools to realize their goal returns. From the fund manager’s perspective, the next drivers represent the five pillars of value creation:

1. Maximize startup leverage and commonly refinance the capital structure

That is, you recapitalize by taking up more debt to pay dividends – hence the term “dividend recapture.” With this step, the PE company partially realizes its investment. This may be controversial. Excessive leverage and frequent recapitalizations can strain a borrower’s balance sheet and impair its ability to fulfill its loan obligations or adequately fund its growth.

2. Complete complementary acquisitions

This is best done at a lower entry multiple than what was originally paid to buy the portfolio company, making these add-ons accretive. Value can then be created through the synergies that arise from the merger of buyer and goal company. This is commonly the first reason for buy-and-build strategies for LBOs within the $50 million to $500 million enterprise value range.

3. Improve performance and strengthen money flow

This is crucial through the ownership period. Operating profits may be achieved through:

• Increasing margins through higher cost management – ​​for instance by relocating production facilities to countries with lower costs – and economies of scale through growing volume.
• Increasing money generation by reducing working capital requirements, reducing capital expenditures, minimizing money losses and stepping into sale and leaseback agreements.
• Discontinuation or divestment of unprofitable or low-margin activities. This practice earned some early LBO players the nickname “asset strippers” and was common within the Seventies and Eighties when conglomerates with independent and underperforming divisions were sold off piecemeal. These days, few goals suffer from the identical lack of focus.
• Increasing sales through refined pricing strategies, introducing recent products, etc.

4. Aim for positive multiple arbitrage

This implies exiting a portfolio company at the next valuation multiple than that paid within the initial investment phase. Such arbitrage relies on the economic cycle. During up cycles, PE managers will emphasize their skills to generate profits. However, when such arbitrage turns negative, they blame poor market conditions. Honestly, multiple expansion is very cycle dependent.

5. Optimize investment holding period

This is maybe a very powerful pillar. Due to the time value of cash, most fund managers attempt to exit some or all of their investments as quickly as possible. What is supposed by the point value of cash? That time has value and that a dollar today is price greater than a dollar a 12 months from now. Why? Because that dollar may be used for the following 12 months, earn interest, or grow to greater than a dollar through productive investments over the course of the 12 months. It might also lose a few of its purchasing power on account of rising living costs over the identical period – a critical point today given rising rates of interest and high inflation.

This value driver also explains why financial sponsors are obsessive about dividend recaps. Although all experienced PE firms place this parameter at the guts of their investment strategy, it’s each controversial and paradoxical. How can PE firms claim to be long-term value creators in the event that they seek a fast exit at the primary opportunity? Early portfolio realization, whether complete or partial, contributes significantly to higher returns.

Building the worth bridge

PE firms include a graphic called a “value bridge” in private placement memoranda. Fund managers use these documents to lift money by demonstrating how they apply the above aspects to create value for his or her LP investors.

One of my previous employers, Candover, was previously certainly one of the ten largest European PE shops was liquidated 4 years ago. Candover used barely different metrics in its value bridges than the five pillars listed above, preferring to interrupt down value growth into 4 dimensions: revenue growth, margin improvement, money generation and multiple arbitrage, or a mix thereof. Using this process, a price bridge could resemble the next graphic:

Vintage Fund 2012: Hypothetical value bridge, in thousands and thousands of US dollars

Without precise methods for allocating value across the assorted drivers, value bridges may be constructed and calculated in countless ways. In his 2016 “Evaluating Private Equity PerformanceIn the report, KPMG outlined a price bridge that analyzed value creation in just three dimensions: increase in EBITDA, increase in multiplier, and alter in net debt and interim distributions.

Swedish investment group EQT gave a succinct indication of how the rise in value of a portfolio was achieved Its 2019 IPO prospectus states: “98 percent. . . resulted from corporate development (i.e. sales growth, strategic repositioning and margin expansion) versus 2 percent from debt repayment.”

When the British company went public last 12 months Bridgepoint explained that “From 2000 to 2020, an estimated 77 percent of value creation in profitable investments was driven by sales growth and profit improvement.” . An extra 25 percent is on account of a multiple expansion in exit because of this of the repositioning of portfolio corporations for growth and professionalization and is barely offset by (2) percent from deleveraging.”

Watch out for the downturn

Excluding losing investments from the worth bridge is a standard trick utilized by fund managers to enhance performance reporting. Candover justified this behavior by saying that it could be “arbitrary to attribute the loss of value to the various value drivers.” It couldn’t be explained why it could not be arbitrary to assign the rise in value to different value drivers!

Bridgepoint’s public filing describes “creating value through profitable investments,” meaning unprofitable deals were also excluded from the evaluation. However, after the worldwide financial crisis (GFC), many PE firms saw more loss-making investments than profitable investments. Candover’s experience shows what can occur to PE-backed, overleveraged corporations in a severe downturn:

Candover’s 2005 Vintage Find: The Last 10 Deals

The current ongoing rise in rates of interest, the continued market correction and the associated portfolio write-downs could make value bridges unusable. The methodology can hardly reflect the true performance of fund managers in bear markets.

The lack of proper instruction – not to say scrutiny of standards and procedures – when constructing value bridges explains why that is one of the popular marketing strategies utilized by PE firms. Fund managers can easily manipulate the numbers and make questionable claims about EBITDA expansion and growth with a view to “demonstrate” their capabilities in operational efficiency. Your existing and potential LP investors may not query the Value Bridge’s formulas, calculations and reporting formats, but are still prone to be positively influenced by them, albeit unconsciously.

However, the best weakness of the worth bridge just isn’t the shortage of guidelines or the exclusion of unprofitable investments. Rather, the deal with absolute capital gains doesn’t show how the core instrument of value creation in private equity – leverage – affects returns. This will probably be the subject of the following article on this series.

Parts of this text were adapted from by Sebastien Canderle.

If you enjoyed this post, do not forget to subscribe.

Photo credit: ©Getty Images/ra2studio