Sales growth drives value creation more than margin growth or multiple expansion, according to a new Pantheon study.
The study, “Value Creation and the Business Cycle”, authored by senior research associate Dr Ian Roberts, observed 450 realised private equity deals to see how value was created in the industry and compared them to public market benchmarks. After accounting for leverage, meaning returns were adjusted in proportion to the debt used by the GP, it found that these deals created sales-driven value not only for investors, but also for the economy.
“I was surprised to find sales growth was such an important driver of financial outperformance,” Roberts told Private Equity International, citing that the original theory of leveraged buyouts held that the ideal candidates for LBO transactions were firms exhibiting low growth.
The deals observed in the study had a median sales growth rate of 8.2 percent, compared with 2.2 percent for the listed companies, showing that this is the key factor in realising alpha, or financial outperformance.
His study found that concentrated equity ownership in private equity drives sales growth and multiple expansion that beats publicly-listed benchmarks. This PE model creates value for not just the investors but the economy as a whole, he said.
The study initially tested the traditional ‘value bridge’ method, which measures leverage against performance based on the quantity of debt repaid. This, the study said, “misses the point of leverage completely” because leverage contributes to performance through tax shields and incentives, and the spread between unlevered asset returns and debt costs.
Instead of ‘value bridge’, the study decided to take an economic analysis approach by looking at PE returns in relation to financial engineering, sector-geography exposure and ‘alpha’ which is the investor return. This method adjusts for leverage to show how much of the gross profit in a deal is actually ‘alpha’ which differs from ‘beta’ or returns that simply result from exposure to the benchmark.
Using this new method, Pantheon found returns of 32 percent attributable to leverage, 30 percent to sector/geography factors and 38 percent to GP-generated alpha, resulting in 9.8 percent of gross alpha per year.
“Another interesting result from the study was how consistently alpha was delivered throughout the cycle,” Roberts said. “Considering the volatile, challenging macroeconomic environments over that period, the steady value creation observed is interesting because it’s indicative of skill rather than luck, which is an important distinction to make when assessing general partners.”
The deals observed were from direct private equity funds with a focus on either North America or Europe and were entered between 2001 and 2010. Some 82 percent were buyouts, 14 percent were special situations and 4 percent growth equity.