Spot the difference

Spot the difference

For investors, private equity is often considered a special case, requiring specialist knowledge and understanding to be successful. New research lifts the lid on some of the PE practices that differ between individual firms and from other types of ownership, and sheds some light on how the industry has changed over time. By Greg Gille.

What do PE firms actually do? While there is a large body of academic research that looks into issues such as performance and risk, the industry’s job-creation record and management practices, not much has been said about how PE firms operate and how they approach investment strategies.

This was the starting point for Paul Gompers, Steven Kaplan and Vladimir Mukharlyamov when they surveyed 79 PE firms about their valuation, capital structure, governance and value creation strategies for their paper, What Do Private Equity Firms Say They Do? Kaplan, of the University of Chicago’s Booth School of Business, presented his findings as a keynote speaker at the Coller Institute of Private Equity’s 7th annual Private Equity Findings Symposium in June 2014. Private Equity Findings caught up with him to discuss the results.

What, in your view, are the key highlights of the study, and, more importantly, was there anything that particularly surprised you?

“On the capital structure side, we got the interesting result that PE firms are engaged both in market timing and looking at the fundamentals of the business and the industry to put in an optimal capital structure. That makes quite a bit of sense, so it should not technically be that surprising, but we didn’t know what we were going to find there.

“Another result that is not at all surprising to practitioners, but would be to academics, is that PE firms do not use discounted cash flows at all. If you talk to PE practitioners, you would know that is the case, and this was confirmed by the results.

“The third outcome that came as a bit of a surprise to me was that nearly a third of the companies go in with their own management teams on deals, rather than sticking with the incumbents. So this tells us there are very different strategies from the different firms, and it was unexpected to see the extent of that.”

Your last observation ties in with another finding from the study: that for a significant number of the firms surveyed, the underlying business is more important than the management team – isn’t this at odds with PE’s mantra of backing management teams?

“Indeed, and I suppose it is consistent with Warren Buffett’s quote: ‘When a management team with a reputation for brilliance joins a business with poor fundamental economics, it is the reputation of the business that remains intact.’ To be fair, they care about both, but ultimately what ranked higher was the state of the business itself.”

One of the main findings is that PE managers seem to depart from the valuation and capital-budgeting methods most commonly used in finance theory. Why do you think that is?

“My guess is that they do that because it works – using discounted cash flows wouldn’t necessarily lead to better outcomes. One of the reasons for that has to do with the debt involved; in some sense, the cost of capital is being accounted for there, as you have to have enough cash flows to pay off the debt. 

“That immediately puts a floor on your present value, and looking for a 20% return on equity is going to get you close to the same result you would get using a discounted cash flow. The big value comes from figuring out whether cash flows are going to be bigger than debt payments. If that is the case, good things are going to happen, and then, whether you are looking for a 2.5x multiple or a certain net present value, your decisions are going to be pretty similar.”

What about the operational engineering results of the study? Do PE firms really focus on this?

“First of all, PE firms have resources devoted to operational engineering, so it’s not just talk. They have in-house people and use advisors, so they have clearly invested in that. I was also a little surprised that the number-one thing PE firms are looking at is the opportunity to grow the businesses they buy. This is the big value driver they are looking for – cost-cutting is important, but secondary. 

“Another that ranked highly is change in incentives. We found that PE investors allocate on average 17% of company equity to employees and management, including 8% to the CEO – much higher than what one would assume are key PE tools, such as leverage and multiple arbitrage. PE firms are clearly not betting on such methods.”

We could argue that PE firms are tempted to overemphasise these value creation techniques to paint the industry in a more positive light. To what extent is there a potential bias here?

“We touched upon this in the study. Certainly on the growth question it is possible that they want the world to know that they are growing businesses rather than cutting costs. 

“The interesting thing in the data is that when we looked at the difference in what respondents thought was going to have an impact before the investment, as opposed to what happened afterwards, cost-cutting turned out to be more important than they initially thought. If they were deliberately downplaying cost-cutting as a value creation driver, this wouldn’t have happened. That made us a bit more comfortable that they weren’t deliberately skewing the responses.

“Another thing that seems a little high is firms putting the net returns they are selling to their limited partners at 20%. But I have asked LPs what general partners tell them and it is broadly similar, even though they rarely get it – so at least they are consistent on this as well!”

Your research also suggests that PE houses believe LPs focus on absolute returns, as opposed to other comparable metrics. 

“That was another very surprising finding. That said, LPs do look at relative performance as well – not necessarily relative to a public benchmark, but they do look at how the PE funds do relative to other funds of the same vintage. I guess we picked up on the fact that the public pension funds need to earn something like 7%-8% returns to pay their pensions, and that is why PE is attractive, with the absolute floor of the 8% return hurdle.”

Based on similarities in their characteristics, you were able to sort PE firms into wider groupings. What do you think the findings tell us about how the industry has developed in recent years?

“There is more differentiation within PE than there used to be. Most firms started out as financial engineers, and we are now seeing a much wider set of skills and backgrounds across the industry. After all, different strategies have been successful over the years, so it makes sense that there is not necessarily one best way to do PE.

“It was also pretty interesting to find that the firms that have spun out of other PE outfits tend to be more centred on operational engineering, which is consistent with the wider PE world becoming increasingly operationally focused.”

What other research could be generated from this paper? Could you track the same sample over time and compare the actual performance generated and the value creation drivers against the GPs’ original claims?

“Definitely. What you don’t want to do is take data and look backwards at performance, assuming the results are the cause of the past performance, because then you would have a selection bias. 

“But we now have all these data points, and three or four years from now we could look and see which of these things are actually related to how the funds performed, if they are at all. We’ll now put this sample to bed and look at it in a few years.

“Also, there is more work to be done on the details of what these firms do, particularly on the operational engineering side: what impact does this really have, and can we measure it? Coming up with the accurate measurements would be the challenging part.”

THE RESEARCH

What Do Private Equity Funds Say They Do? by Paul Gompers, Steven Kaplan and Vladimir Mukharlyamov surveyed 79 buyout and growth equity firms managing a total of over $750bn to explore how they determine capital structures, value transactions and source deals and look into their governance and operational engineering practices. More than half of the firms (44) only have offices in the US, while 35 operate offices outside of the country. A quarter of the firms have assets under management (AUM) under $750m, while a quarter have AUM above $11bn.

The research uncovered that PE firms do not follow some best practices taught in academic finance courses: unlike most CFOs, few of them use discounted cash flows and net present value techniques to assess investments, with IRRs and money multiples being firm favourites instead. A vast majority (70% of respondents) also incorporate comparable company multiples. In addition, PE firms discount management forecasts, viewing them as overly optimistic – the median and average discount, according to the survey, is 20%.

Another finding that seems to go against the grain of traditional practices is that PE firms believe that their LPs value an absolute measure of performance. With PE fund managers competing against both asset class allocation decisions and other PE firms for investment from LPs, one could assume that relative performance against a public benchmark would be key. Yet fewer than 8% of respondents believe that LPs view performance relative to public markets as the most important performance benchmark.

The survey finds that, in selecting deals, PE firms place greatest emphasis on the business model and the company’s competitive position, followed by the management team, the firm’s ability to add value, and valuation, all three of which are of equal importance. When asked about how they create value, increasing revenue is the most cited strategy, with firms saying that it was important in over 70% of their deals, and follow-on acquisitions are important in over 50%. Reducing costs, however, was important in only 36% of deals. Other important techniques were redefining the company’s strategy, changing the CEO, and multiple arbitrage.