Over the years there has been plenty of research showing that private equity investment at the fund level generally outperforms public markets. But a new study from the Private Equity Institute at London Business School in association with Swiss asset manager Adveq reveals that even down at the portfolio company level, private equity performs better.
The study – Value Creation in Buyout Deals: European Evidence – analysed more than 1,500 European buyouts from 1998 to 2014 and found that in the first three years of private equity ownership, relative to benchmark non-private equity owned firms matched by year, industry and other characteristics, private equity portfolio companies increase their leverage, operating profitability, assets and sales.
This, the study claims, indicates that “while GPs are focused on growth they also generate significant operational improvements”.
The London Business School research found that private equity-owned companies more than double their sales in the first three years, compared to more modest growth in the benchmark groups, while EBITDA growth is also significantly higher (see chart).
“We are showing that private equity owners potentially contribute to the performance of these companies significantly more than other owners. Better sales, better EBITDA. It might sound pretty basic, but really there was no clear evidence before at the portfolio company level,” says Florin Vasvari, a professor of accounting at London Business School and one of the authors of the study.
“At least over the first three years, there are signs that [private equity] owners do much better than other owners. There is a sense of urgency, there's an increase in sales, there's improvement in EBITDA, investments, so obviously they're shaking things [up] a bit.”
Total assets growth and fixed assets growth are also markedly higher, suggesting that “GPs increase leverage following acquisitions to pursue growth strategies through significant capital investments,” the study says.
The research also discovered that private equity buyers tend to pay less for portfolio companies than corporate buyers, by around 10 percent.
They buy businesses cheaper, then, and make them work harder, leading to better returns, and – potentially – a justification for the high levels of fees firms charge investors.
To conduct its analysis, the LBS team relied on a range of data providers and publicly-available information. Even today, private equity firms themselves are not particularly forthcoming with data – even when it paints the industry and the individual firms themselves in a more positive light.
“One issue with this is they might be concerned that by revealing this data they show their competitors how they make money,” Vasvari says. “The solution in my view would be to be as transparent as possible. Investors, especially the very large investors, the pension funds and the sovereign wealth funds, they need more information about how performance is achieved in private equity.”
Investors are placing ever higher importance not just on the returns generated by firms, but the way these returns are generated.
“Private equity investing is about repeatedly building and developing companies and creating attractive returns,” says Jan Rådberg, head of private equity at AP Fonden 1, the first Swedish national pension fund.
“It is only possible to do this consistently if you have high ethical standards, a skilled team with strong industry expertise. Such teams typically build companies that will prosper after the ownership period ends.”
The LBS research makes a strong case to justify private equity's existence. But as Mike Sommers, president and chief executive officer of US trade association the American Investment Council says, as useful as such evidence is to support the industry's narrative of superior business ownership, to truly paint a picture of the benefits private equity can bring, one must go beyond the numbers.
“We also have to tell the stories, we have to tell the anecdotes about what private equity has meant for workers, those that actually benefit from private equity investment,” he says. “There are 11 million American jobs that depend on private equity investment, and we constantly have to tell that story to lawmakers and the public.”
Unfortunately, the stories that make the headlines of most mainstream newspapers tend to be the ones where it all went wrong – City Link, EMI, Simmons Bedding. Our Operational Excellence Special is a chance to do the opposite, to draw attention to private equity firms who have excelled in transforming portfolio companies from humble beginnings to significant players, grappling with a host of challenges ranging from macro-economic turbulence to personnel issues and everything in between.
Across the globe private equity firms have taken great strides in transitioning from a model based almost entirely on financial engineering to one focused on driving growth through value creation initiatives, boosting economies and employment figures as they go.
Now in their fifth year, our Operational Excellence Awards show just how far the industry has come. But there's still work to be done.
“Given the increasing importance of the private equity industry as business owners in many countries, I think the industry could benefit from being more open about its investments and value creation,” Rådberg says.
“I think that private equity has many good and successful stories to tell, which may not always come across to all stakeholders.”