Private equity value creation in Europe
Our eighth annual study of private equity value creation in Europe is framed slightly differently than reports in previous years.
This year’s report debunks certain myths put forward by the industry’s detractors — namely that PE cuts jobs, strips assets and relies on leverage for returns. To the contrary, PE grows employment, creates more valuable businesses and generates returns through strategic and operational transformation.
The report also highlights challenges for PE and offers an outlook for the rest of 2013.
Myth #1: PE-backed businesses cut jobs
Across good times and bad, PE makes a net contribution to employment growth. In our sample (which includes the economic downturn), employee numbers increased annually by 2% from entry to exit.
PE also increases productivity — by over 7% annually from entry to exit in our sample. This is supported by the latest British Private Equity and Venture Capital Association (BVCA) report on the performance of portfolio companies, which found the UK’s largest PE portfolio companies grew capital productivity 11% annually since acquisition.
Taken together, it’s clear that the productivity gains created by PE do not come at the expense of employment numbers. On the contrary, PE’s focus on productivity creates fitter, more profitable companies that are in the best position to grow and thus increase headcount.
Myth #2: PE houses strip assets
PE reaps rewards only when its portfolio companies are successful. At exit, there must be a strong, sustainable business for PE to sell in order to generate returns for investors.
Nearly half of our sample made add-on acquisitions to build scale and/or add new markets. By contrast, just 10% of businesses owned by PE in our sample made disposals.
PE’s combination of investment and hands-on support creates value. Four out of five PE-backed businesses in our sample were more valuable at exit than acquisition, and more than one-third doubled entry EV at exit.
Exit EV* as percentage of entry EV
* Exit EV is of the last business exited i.e., excludes proceeds from disposals during the hold period
Myth #3: PE relies on leverage for returns
In each of our eight annual studies, strategic and operational outperformance has always made up the largest proportion of returns generated by PE. Overall, PE gross returns on exits outperformed comparable public companies during 2005-12 by a factor of 3.6x.
PE generates this outperformance by buying the right companies, at the right price, and partnering with high-quality management teams. PE investors, such as pension funds and insurance companies, benefit from this outperformance at a time of low interest rates and volatility in other asset classes.
PE has demonstrated greater resilience than many expected in the immediate aftermath of the financial crisis, but it is not immune to the sustained challenges of a low-growth economy.
Annual EBITDA growth in European PE-backed companies exited between 2010 and 2012 was 5.3% — a significant drop from historical levels and a clear indicator of the prolonged economic downturn.
PE is using the tools at its disposal to improve the businesses it backs, but the effects of challenging economic conditions are inescapable. There will be some PE houses that will not raise another fund; others are scaling back teams and retrenching in the face of smaller fund sizes.
Low activity levels
Not surprisingly, 2012 was a disappointing year for new investments and exits. In our sample, entry activity fell to 92 new deals (from 100 in 2011), and exit activity fell to 61 (from 85 in 2011).
Reduced exit activity has exacerbated the problem of exit overhang. The average hold period in our sample increased to 4.7 years, the longest period recorded in our series of studies.
Based on this rate of exits, it will take 13 years to exit the current portfolio, resulting in an average ownership period of more than 11 years. This will stretch the patience of LPs, management teams and PE firms alike.
Outlook for PE
Despite the challenges, there is much the European PE industry is doing well. Firms are making good progress preparing for the Alternative Investment Fund Managers Directive (AIFMD), which will enhance PE’s reputation with investors once the Directive is fully implemented.
The smaller deal space (€150m to € 500m) is relatively active, but PE needs to generate more realizations. Unfortunately, it seems unlikely the market in 2013 will support increased exits.
PE needs to beat the wider M&A market by stimulating strategic interest from trade buyers, particularly those outside Europe. Generating successful exits will be crucial to securing future funding from investors, who can be patient for only so long.
The PE houses that perform in bad times will be in an enviable position to attract capital when good times return.