By John Colley
With risks being inherent in investing especially in today’s business climate where they are emerging at ever-increasing speeds, there seems little prospect of previous performance being achieved again in the future, take for example the case of private equity. As the author argues, the sheer volume of money at PE’s disposal is slowly degrading the key elements of PE value generation – PE is becoming a victim of its own success.
There is little doubt that Private Equity (PE) has performed well since the 1980s when it first emerged. Whilst there is always conjecture over the extent,1 there seems little doubt that it has outperformed the main stock market indices over that period.2 Consequently, the returns are attracting significant money to the industry from rich individuals and institutions such as pension funds. The number of partnerships has quadrupled over the last 20 years and current “dry powder” is now estimated at $1 trillion, and with a similar amount being raised through new funds. Ironically, funding is now being rejected as there are insufficient suitable investment opportunities. This creates a problem for the PE industry as the model is focussed on raising funds to buy, improve and sell businesses. At this point, funds plus profits less the partners’ commission are returned to investors. The lack of suitable targets and the sheer volume of money raised are resulting in the original premise of the industry being stretched. This is increasingly resulting in the dilution of the disciplines which have made the industry so successful; PE is becoming a victim of its own success. As funds generally have a life cycle of 10 years before performance is assessed, it may be some time before reducing returns become apparent in industry performance studies.
If one contrasts the performance of corporate trade buyers with PE then the advantage is obviously with PE. PE adheres to certain disciplines, in this way avoiding the value destruction so frequently experienced by corporates. It is known that around 60% of corporate deals destroy value and 50% are re-sold within 5 years. 60% to 80% materially fail to meet expectations.3 There are a number of reasons for this including simply paying too much, often to avoid competitors acquiring the target company. The rationale that it won’t become available again can drive the price up. There is often a significant disconnect between what a business is worth and what has to be paid to buy it.
Timing is also an issue as when to sell is determined by the seller to maximise proceeds. The business has usually been prepared for sale with reduced costs and deferred investment.
Integration is often problematic as it is a very inward looking and stressful process frequently resulting in lost market share and key employees. It rarely goes to plan. Plans are often rudimentary, lacking detail and produced as an afterthought late in the acquisition process when the operational people are introduced to the process (acquisitions are almost invariably dominated by financial and legal people). Synergies from integration are frequently overestimated to justify the high price necessary to win the bid. Assumptions about subsequent performance are often optimistic at best and provide little leeway for error.
The PE Approach
In contrast, PE looks at many potential deals and chooses to run only with those able to deliver an adequate return, usually 2.5 times the original investment. This may be one in ten of those examined. The key question of who will ultimately buy the business from PE also has to be answered at the start of the process.
PE is disciplined over what the business is worth and what they will pay. They also construct a very clear strategy to add value which only occasionally involves integrating businesses. This approach avoids much execution risk. As the partners keep 20% of any gain, they treat the investment as their own money and carefully align the management to the shareholders cause by giving them a significant proportion of the equity which can be anything between 15% and 40%. In contrast, corporate management have very little real “skin in the game”. Hence, there can be a tendency to treat the money as if it belonged to someone else.
PE businesses are funded predominantly by high interest debt which provides a strong incentive to manage cash and costs carefully. This approach minimises expensive borrowings and increases equity value. Efficient cash management also leads to great care when making investments. Unless investment opportunities will be high yielding and low risk then they will not proceed. Working capital management and cost control are the real hallmarks of PE with generated cash used to reduce debt rather than invested in risky capital schemes or acquisitions. Similarly, executive pay and bonuses are tightly controlled so that the value of the equity is maximised. This allows both PE and management to share in capital gains when the business is sold. The business will be sold on a multiple of earnings so in effect, the increase in earnings through reduced bonuses and salaries is multiplied by the sale multiplier.
However, the key critical difference is that PE requires a clear and simple strategy. Whether it is expansion of a winning format, perhaps rolling out a new technology or marketing concept, major cost reduction, or entering new market segments, the strategy has to be clear.
The vast bulk of PE’s activities are “buyouts” which involve acquiring divisions and companies that corporates no longer want. This might be due to underperformance or that they are no longer categorised as core business. Either way, they are corporate off loads which PE simply runs better.
The Threats to PE
However, the key elements responsible for PE’s historic success are coming under stress. They are being diluted under the weight of available investment funds and the lack of opportunities which fully meet the disciplines. In effect, the net has to be spread wider to include opportunities which previously would not have made the grade. The result is lower grade acquisitions and investment strategies, higher prices, and less management equity involvement which may mean less “skin in the game” and commitment.
First of all, the “wall of money” chasing opportunities have pushed up prices over the last 10 years. In the U.S., prices have increased by almost 50% since the financial crisis whilst in Europe the increase has been more modest at 10% to 15%.4 In the U.S.A., debt to Ebitda has increased from 3.5 to 5.0. The higher debt risk makes the industry much more exposed to recessions, trade downturns or higher interest rates. Higher prices make it harder to achieve historic levels of return. We know that acquisition prices tend to follow deal volumes and hence any subsequent loss in confidence or restricted liquidity will bring volumes and prices down, to which PE will have a significant exposure. 2018 is likely to reach an all-time high on deal activity (previous high was 2015 at $4.7Tn). Can the market continue going higher or is it set for a fall?
2. Management Equity
As prices push higher, the PE model is still looking to achieve a hurdle rate of return on investment. One way to maintain this return is to ascribe less equity to management. In effect, PE keeps more of the generated return.
Hence, management are being given less equity to motivate them. A consequence is that management may be more willing to go elsewhere for a better opportunity, or become more focussed on bonuses and salaries which are often not aligned with equity performance. This is a sad feature of listed corporate businesses. A consequence is likely to be reduced management focus and energy in pursuit of equity.
3. Integration Risk
Another issue is that in the earlier part of 2018, there has been a move towards “buy and build” type of strategies which are currently making up a majority of PE acquisitions.5 In effect, this is a variant of “roll up” strategies in which a number of businesses are acquired in a particular industry sector. The objective is to reduce overhead and distribution costs through integration, and increase market power through greater market share and influence. There are two problems with this approach; firstly, it drives up prices for remaining businesses in the sector as the choice of opportunity becomes limited to an industry and sector. Others in the same sector may also follow to create competing scale and scope economies and market power. Secondly, integration is necessary to create synergies which introduces significant execution risk. The loss of key staff and market share becomes much more likely.
4. Secondary Acquisitions
There has necessarily been a major move to acquiring secondary acquisitions. In effect, PE is buying businesses from other PE houses that have already been through the PE process. A consequence is that there is likely to be less potential for improvement as cash and costs will have been squeezed. Another value-adding strategy will be needed. In addition, there may be the issue of motivating management who have acquired affluence through their equity involvement in the previous deal. Secondary acquisitions have increased rapidly in recent years. It is likely that “less has been left on the table” following previous PE activity and that returns are likely to be lower.
For each of the key areas in which PE generates value, there is evidence that the modus operandi is becoming diluted with implications for the extent of future value creation. In effect, the PE model has reached capacity limited by acquisition availability and too much money chasing limited opportunities. Higher target prices is bad news for PE as it means more debt risk, and a greater likelihood that they may have to sell into a market with lower multiples in the event of a downturn in deal activity. Greater numbers of secondary deals are likely to also result in lower returns as much of the opportunity on cost reduction and cash control have already been exploited. Similarly, readily available value-adding strategies have already been applied. “Buy and build” strategy introduces execution risk which PE has done well to avoid in the past. Certainly, corporates have found this area to be a ready means of destroying value. Can PE really avoid the same fate? Reduced management alignment through more limited equity participation will also introduce greater risk in retaining and motivating key management. What we are seeing is the sheer volume of money at PE’s disposal slowly degrading the key elements of PE value generation. There seems little prospect of previous performance being achieved again in the future.
About the Author
John Colley is Professor of Practice in Strategy and Leadership, Pro Dean, at Warwick Business School. Following an early career in Finance, John was Group Managing Director of a FTSE 100 business and then Executive Managing Director of a French CAC40 business. Currently, John chairs two businesses and advises private businesses at board level. Until recently he chaired a listed PLC.
1. “Private Equity Benchmarking: Where Should I Start?,”Towers Watson, 2012, https://www.towerswatson.com/-/…/Towers-Watson-Private-Equity-Benchmarks.pdf?
3. Martin RL (2016), “M&A: The One Thing You Need to Get Right,” Harvard Business Review, https://hbr.org/2016/06/ma-the-one-thing-you-need-to-get-right; Christensen et al (2011), “The Big Idea: The New M&A Playbook,” Harvard Business Review, https://hbr.org/2011/03/the-big-idea-the-new-ma-playbook
4. Financial Times Alphaville, 2017.
5. “Bain and Company’s Global Private Equity Report 2018,” https://www.bain.com/insights/global-private-equity-report-2018/.