The 2010 exits showed that private equity owners were proactively seeking potential buyers and engaging with them well in advance of a sale.
Private equity – owned businesses still out-perform
Private equity continues to out-perform equivalent public companies, notwithstanding the challenging conditions we have seen over recent times.
Our returns attribution analysis shows that, over the long term, 40% of the gross investment return on PE exits comes from out-performance, 31% from stock market returns and 29% from additional leverage (over public company benchmarks).
Put another way, the gross return on the PE exits is over 3x the public market return. This has been achieved as PE exits have outperformed public companies on all key value drivers — +2.1% in EBITDA growth, +0.1% in employment growth and +0.7% in productivity growth. Analyzing these results further by country, sector and deal size shows positive investment returns and out-performance.
Carving out these exits between 2008 and 2010 — the worst of the recession — we found that, even though the other sources of return — stock market and additional leverage — were negative because of poor economic conditions, PE exits still generated positive returns overall because of its ability to add value to portfolio companies through strategic and operational improvement.
Organic revenue growth drives returns
As with North America, our analysis of European exits shows that EBITDA growth has risen in importance as a driver of PE’s value creation compared to the pre-crisis years. This is in part a reflection of the fact that it is harder to generate returns through multiple expansion in difficult markets.
However, it also provides strong evidence of PE’s increased focus on growing portfolio companies. While this has always been an important component of PE’s toolkit for value creation, recent times have seen firms place much greater emphasis on growth than was previously the case.
We analyzed the sources of EBITDA growth in companies exited in our database. The most striking finding is that organic revenue growth is proportionally the largest contributor, accounting for 46% of profit growth across the period, but that it is also more significant for companies exited in 2010.
Cost-reduction and bolt-on acquisitions accounted for a much smaller share of EBITDA growth over the five-year period and in particular in 2010. In aggregate, bolt-on acquisitions outweigh disposals on this measure by 2.3 to 1.
Sources of EBITDA growth 2006 - 10, by year of exit
Strategies used for organic revenue growth
PE is using a number of strategies for achieving organic revenue growth and we found evidence that PE ownership is leading to fundamental changes in its portfolio companies. Over half of this growth comes from initiatives that changed the business model or strategy.
Changing a company’s offering by, for example, repositioning it in the market, developing and selling new products and expanding geographically were all highly important factors in driving organic revenue growth for companies in our research and particularly in 2010. Indeed, in aggregate, they accounted for more organic revenue growth than the more functional improvements to pricing and selling.
Our study demonstrates the more fundamental changes that PE investors are able to achieve in portfolio companies, the greater the impact on profit growth. It is a harder route, but generates better results for companies and, ultimately, enhanced returns for PE.
The share of growth from market demand is lower than in prior years, reflecting the adverse effect on a number of businesses of the recession.
Drivers of organic revenue EBITDA growth: PE exits 2007 - 10
Achieving change under PE ownership
To achieve fundamental change, our study shows that PE is using a variety of approaches, includingworking more closely with its portfolio companies.
This suggests that PE is willing and able to support portfolio companies’ strategies to position them for future growth and that it will put in the time to re-evaluate and adapt business plans in response to a changing economic environment.
As we found in last year’s report, getting the management right at the outset remains key to an investment’s success and to achieving organic revenue growth. Our analysis for 2010 confirms that backing top teams or identifying them before the deal and putting them in place on completion are highly important.
A strong PE management team generates returns
The penalties for getting this wrong are severe. Based on exits achieved between 2005 and 2010, we found that replacing management during the investment adds up to 1.6 years to the holding period and reduces returns. However, it should be noted that PE’s active ownership and ability to replace executives enables it to drive improvements in the companies it backs.
Without this level of engagement, the companies may have suffered a worse fate, particularly in the difficult times we have witnessed over the last few years. Clearly, a focus on getting the right team from the start is essential, particularly as we have highlighted that PE is increasingly seeking to implement far-reaching and profound changes to a business.
PE uses a variety of strategies for this and our research found that it was investing significant time up front on ensuring they back the right people by: tracking the company before investment so that PE could observe the management at work; building strong relationships with the management team so that PE could understand their strengths and ambitions and — importantly — identifying any weaknesses that needed to be dealt with; and backing a management team that had successfully executed a similar strategy.
In last year’s report, we pointed to an increased use of 100- day plans, operating partners and consultants by PE as other enablers of profit and value growth. This year, we sought to understand how they were being used to drive value. Our analysis shows that all these initiatives added value to profits growth for companies exited in 2009–10, with some interesting variations.
Consultants were used in more than 60% of exits, with a skew towards larger businesses. Operating partners were used at about half the frequency of consultants overall, mostly when the incumbent management team was retained. 100-day plans were commonly used at the outset and more likely if there was a new management team.
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