Friday Letter Driving returns the old fashioned way

The outsized returns of years past, boosted through the liberal use of leverage, can still be replicated though it takes a lot more effort.  

Generating the kind of returns for which private equity is famous is a lot harder in today’s environment, where the lack of available debt and general economic gloom has meant private equity firms can no longer rely on returns driven by multiple expansion and gearing. Firms must roll up their sleeves and build value through operational improvement.

We see this as a good thing. But we recognise it doesn’t come without challenges.

Boston Consulting Group has argued in a recent study that to achieve an internal rate of return of 25 percent in the current climate, a private equity fund’s portfolio needs to experience average annual EBITDA growth of 11 percent.

That’s a big number. At the larger end of the market – i.e. for the kind of businesses that typically interest the mega-funds – this kind of annual growth would be exceptional. And even for the majority of smaller, growing firms, it would still represent an impressive rate.

“Asking a business to deliver double-digit year-on-year EBITDA growth is a big ask even at the best of times,” admits Paul Zwillenberg, one of the co-authors of the report. “It's even more difficult when the economy is growing at low single-digit rates and inflation is higher than we've been used to.”

Nonetheless, the good news is that he believes operational value creation does provide private equity with the ability to deliver numbers like this. The key, he suggests, is for GPs to leave no stone unturned in their efforts to drive growth – and once they find approaches that work, to make sure these get embedded and replicated throughout the portfolio.

There’s another interesting aspect to all this: what is the best set-up to ensure value-building success? Is it better for firms to use external operating partners, in-house operating teams, or both? Or something else altogether?

There is no right answer in terms of the correct approach. The key is to find the model that works best for each firm and its culture and then implement that model flawlessly. In other words: it’s less about the what, and more about the how.

Each month, Private Equity International’s ‘Deal Mechanic' column takes an up-close, in-depth look at how value was created at a portfolio company. Learn how three successive periods of private equity ownership turned UK retailer Pets at Home into retail giant in the upcoming April issue.