More than just leverage merchants

Study shows operational value creation > leverage

In the business world, there's still a widely-held view that leverage is private equity's primary method of generating outperformance (perhaps with a bit of clever market timing thrown in).

Most of the industry's critics would accept that this hasn't been as easy as it used to be since the crisis. And they might accept that some firms have responded by boosting their operational value creation capabilities. But they’d probably still argue that private equity only really outperforms when it can use leverage to ‘juice’ its returns.

That's why new research released this week by Capital Dynamics is worthy of attention. The alternative asset manager has done an in-depth analysis of 701 exits of private equity-backed companies between 1990 and 2013, looking at sales, EBITDA, multiples, net debt, cash flows and so on. Its findings? That leverage actually accounted for less than a third (31 percent) of the value created at these businesses during the period of private equity ownership.

Instead, more than half the value uplift – 51 percent – came from operational improvements, much of which was attributable to EBITDA growth (which in turn was more driven by sales growth than cost-cutting). And of the multiple expansion that accounted for the remaining 18 percent, the majority was due not to general market movements, but to improvements in the overall quality of the specific asset under private equity – which is part of the operational piece too. 

What’s more, if you just take the deals done during the boom years of 2005-2008, a time when leveraged lending was going through the roof – i.e. in theory, the period when GPs had the most opportunity to juice returns – the contribution from leverage actually went down relative to pre-boom deals (from 31 percent to 29 percent), while the contribution from EBITDA growth went up (from 31 percent to 40 percent).

Was this just a case of a rising tide lifting all boats? Apparently not. The authors compared the private equity-backed companies in the sample with similar publicly-traded companies (similar in terms of size, financials etc). They found that if you compared annualised returns over the same period, private equity’s operational alpha amounted to 14 percent, even after stripping out the effect of leverage (which, incidentally, boosted the differenc to 26 percent). Again, EBITDA growth was the big difference.

Why is this important? First, because it helps refute the idea that private equity is over-reliant on leverage. Second, because it shows that even in an environment like today – when rising debt levels are again driving up valuations – that GPs still have the ability to create additional value through operational improvement, even if they’re forced to pay a high entry price. And third, because it reassures LPs that private equity can still outperform the public market across the cycle.

Sceptics may argue that the data set must be skewed somehow, perhaps because only successful exits were included. CapDyn points out the sample included at least 55 absolute failures, and also excluded all home-run deals (i.e. those more than two standard deviations above the mean); but it’s true that the average money multiple on these deals – 2.5x – does feel a bit high for an industry average. Equally, it might also be argued that the strong EBITDA growth these companies enjoyed (particularly the boom years deals) will be much harder to replicate if developed economies are essentially flatlining for the next few years.

Nonetheless, the results do make a good case that while leverage can indeed bolster returns, operational improvement is actually by some distance the most important value-add private equity brings. And that’s precisely the message that the industry could do with getting out to a wider audience.

P.S. Speaking of which, a reminder: our 2014 Operational Excellence Awards, which are designed to recognise the year’s best private equity value creation stories, are now open for entries. Click HERE to apply.