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PE delivers outperformance through more formalised value creation strategies

North American private equity firms have pivoted from cost-cutting and value-preservation to more of a growth agenda for the companies they back.

 
This shift has set the stage for positioning companies well at the outset of the deal to achieve successful, higher value exits while also driving higher returns, according to Ernst & Young’s latest study on value creation, "Clear direction, focused vision."
 
Now in its seventh year, the study examines how private equity investors create value and how PE firms have adjusted their core model in the last cycle of owning, buying and selling.
 
In a volatile M&A environment, PE firms have consistently proven to be opportunistic investors, using readily available financing to acquire businesses and refinance portfolio companies. They have also been able to capitalise on high growth markets and areas for product offerings, make fundamental operational improvements to companies, back the right management teams and effect sustainable value creation.
 
"Behind-the-scenes work to improve portfolio companies during this wave of low growth has really strengthened private equity firm’s value-creating capabilities," says Jeffrey Bunder (pictured), global private equity leader at EY. "As the average holding period for portfolio companies exceeds five years, PE firms have expanded their skills to focus more on growth agenda to ultimately create sustainable value in these businesses."
 
PE continues to outperform comparable public market returns with strategic and operational improvements delivering a large share of the returns over the entire study period as evidenced by the growth in earnings before interest, taxes, depreciation and amortization (EBITDA).
 
While leverage and stock market performance accounted for some returns, the majority was driven by PE strategic and operational improvements, which drove 50 per cent of total cash return for the companies in our sample.
 
PE firms have pivoted the way they work with companies. Cost-cutting and efficiency gains were imperative in the immediate aftermath of the crisis, but PE firms are increasingly focused on organic revenue growth as the key means of creating value. PE firms are concentrating their efforts on investing in portfolio companies to support growth in new markets, product lines and business areas and through add-on acquisitions – cost cutting is no longer an imperative.
 
Over the entire 2006-2012 study period, geographic expansion accounted for 26 per cent of total organic revenue growth. In the three years since the recession, such expansion has accelerated and now accounts for over 40 per cent of total EBITDA growth.PE firms are increasing use of operating partners and portfolio management teams, and developing a clear understanding of what buyers will want from the business in the early stage of the deal. According to the study, the increasing use of 100-day plans has driven fundamental changes to companies from day one of an investment. Also, operating partners were used in some capacity in 40 per cent of deals analysed.
 
"All of this has required a standardisation of PE value-creation techniques that enable PE firms to closely monitor profits at the portfolio company level," says Tom Taylor, co-leader of private equity value creation advisory at EY. "However, firms with multiple deal terms still struggle to unify best practices and this will remain an area of focus for firms in the future. Increased standardisation will lead to a more effective leveraging of best practices."
 
In 2011 and 2012, exit activity was dominated by IPOs – particularly larger exits. Annual exit value was up 49 per cent as compared with 33 per cent in 2010. The IPO strategy lent itself well to PE firms working to take time to create more value for the company, and make operational changes while waiting for the right conditions in the market to exit and generate maximum value for investors. While companies that exited over the past two years have been in the portfolio for longer than in pre-recession times, which could impact returns, it also points to the increased commitment by PE owners in the companies they back.
 
"PE firms continue to reinvent themselves in a challenging economy, using the time to regroup and redirect efforts. The key factors of success for PEs are still the same – buying well, executing well, and selling well – but the processes and resources have been strengthened to ensure portfolio companies are in the best shape possible, positioned to capitalise on an improving economy and ultimately exit," says Bunder.

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