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.
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/.