The Relationship Between Private Equity Returns, Duration and Firm Size & Skill

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What is the relationship between private equity

transaction return, duration and firm size/skill?

What are its implications for the current

understanding of the nature of private equity?

HEMAL THAKER

ST EDMUND HALL

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ABSTRACT

This paper investigates the relationship between private equity transaction returns, durations,

firm motivations and firm size/skill to suggest that the existing conclusion to the debate on

the nature of private equity - the heterogeneous view - is limited, shallow and incomplete.

The paper argues that a private equity firms skill is the most important factor that

determines its success and suggests that private equitys nature is one of short-term shock

therapy; but that the majority of private equity transactions are prevented from embodying

this state to the limitations of their sponsoring private equity firms skill in achieving high

transaction returns and short transaction durations.

A three-pronged approach is taken to provide evidence for this theory: examining secondary

literature on the private equity industry and corporate governance to develop the context of

the research question; analysing empirical evidence on a global database of 11,704 private

equity transactions from 1969-2012 to investigate it; and analysing case-study evidence to

provide supplementary information on specific aspects of the study. Practical

recommendations for the Oxford Private Equity Institute, private equity firms and

corporations are proposed along with further research possibilities.

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ACKNOWLEDGEMENTS

I would like to thank my supervisor, Dr. Ludovic Phalippou for his advice and feedback

throughout my project at the Oxford Private Equity Institute, Said Business School.

I would also like to thank the anonymous limited partners who provided the Institute with

their private placement memoranda, without which the empirical research within this study

would not have been possible.

This paper does not necessarily reflect the views of the Institute.

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TABLE OF CONTENTS

1. INTRODUCTION ..................................................................................................................................... 5

1.1 Aim and stakeholders of the research ......................................................................................................... 5

1.2 Structure of the report and research question ............................................................................................. 6

2. PRIVATE EQUITY LITERATURE REVIEW ........................................................................................ 9

2.1 Introduction to private equity ...................................................................................................................... 9

2.2 Current debate on the nature of private equity ......................................................................................... 16

2.3 Private equity firm motivations and shock therapy ................................................................................ 17

2.4 Sources of return in PE and the misalignment of interests between PE firms and portfolio companies ... 20

2.5 The unknown limiting factor: PE motivations, the misalignment of interests and shock therapy ........ 44

2.6 Firm skill as the limiting factor to private equity shock therapy ......................................................... 45

3. RESEARCH QUESTION........................................................................................................................ 47

3.1 Research question and hypothesis ............................................................................................................. 47

3.2 Existing research surrounding the research question ............................................................................... 49

4. RESEARCH METHODS ........................................................................................................................ 52

4.1 Definitions ................................................................................................................................................. 52

4.2 Data ........................................................................................................................................................... 53

4.3 Methods for investigating a return and duration relationship .................................................................. 54

4.4 Methods for investigating the role of firm size/skill in a return/duration relationship ............................. 55

4.5 Methods for investigating the characteristics of high return transactions and shock therapy ............... 57

5. RESULTS AND ANALYSIS ................................................................................................................... 60

5.1 Relationship between return and duration ................................................................................................ 60

5.2 Role of firm size/skill in the return/duration relationship ......................................................................... 61

5.3 Characteristics of high return transactions and shock therapy .............................................................. 64

5.4 Conjecture ................................................................................................................................................. 71

5.5 Implications of conjecture and practical recommendations ..................................................................... 72

6. LIMITATIONS AND FURTHER RESEARCH ..................................................................................... 74

6.1 Checking the return/duration relationship and the limitations of IRR ...................................................... 74

6.2 Case-study codification limitations ........................................................................................................... 76

7. CONCLUSION ........................................................................................................................................ 80

8. REFERENCES ........................................................................................................................................ 84

A. APPENDICES ........................................................................................................................................ 88

A.1 Checking negative return/duration relationship for money multiples ...................................................... 88

A.2 Testing the representativeness of Sample C with respect to Sample B ..................................................... 90

A.3 Case-study codification results ................................................................................................................. 92

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1. INTRODUCTION

1.1 Aim and stakeholders of the research

This study was written at the Oxford Private Equity Institute of the Said Business School.

The objective of the Institute is to be the leading academic institution in the field of private

equity1. Given the academic nature of the organisation, this paper aims to contribute to the

research conducted by the Institute in its mission to expand the knowledge pool on the private

equity industry.

Over the last 30 years the private equity industry has grown into a trillion dollar industry with

some of the worlds largest and best-known companies such as EMI Music, Tommy Hilfiger,

Burger King, and Hilton Hotels passing through private equity ownership. A debate has

ensued on the nature of private equity and whether it is a superior organisational form to that

of the public corporation or a short-term form of shock therapy, designed to allow

inefficient, badly performing companies with inferior corporate governance to enter quick

and intense periods of corporate restructuring prior to retuning to public ownership. The

current conclusion to this debate simultaneously favours and disfavours both and neither of

these views using evidence based on an analysis of private equity transaction durations.

Through an examination of secondary literature, empirical research on a proprietary global

database of 11,704 private equity transactions and case-study analysis, this study aims to

suggest that the existing conclusion to the debate on the nature of private equity is flawed,

and suggests that a different conclusion with different implications for corporate governance

can be reached when accounting for private equity transaction returns, motivations and firm

size/skill.

1 About the Oxford Private Equity Institute. http://www.sbs.ox.ac.uk/centres/privateequity/Pages/about.aspx

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The study posits a conjecture and a series of practical recommendations that hold relevance

for three different stakeholders:

1. The Oxford Private Equity Institute - for whom a better understanding on the nature

of private equity is of academic importance in developing a framework for private

equity as alternative form of corporate governance to the public corporation.

2. Private equity practitioners for whom this study aims to suggest ways in which

private equity firm investment objectives and motivations can be better fulfilled.

3. Corporations for whom a better understanding of the nature of private equity would

allow a better understanding of whether private equity ownership is in their best long-

term interests or not.

1.2 Structure of the report and research question

The structure of this study is designed, in order: to lead the reader through the development

of the research question, the research methods used to investigate the research question, the

results and analysis of the research questions investigation, and the conjecture and practical

recommendations for the stakeholders of this research.

Chapter 2 constitutes the literature review of this study from which the research question was

born. It will provide the reader with the relevant information necessary to understand the

context of the research question, and is structured to lead the reader through to its

development in Chapter 3. This structure is illustrated below with the chapter divided into its

sub-sections and key high-level findings detailed to provide the reader with an overview of

the arguments that led to the research question. It is intended that the chapter be read with this

structure in mind.

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Introduction to private equity (2.1)

-Background on the private equity industry, firms and

funds.

Private equity as a long-term

'superior organisational form'

view

Private equity as short-term

'shock therapy' view

Existing conclusion: 'heterogenous view'

of private equity

-Private equity transactions are 'neither short nor long'.

-View agrees with both and neither view, but is based

solely on transaction durations evidence.

-Does not account for evidence on private equity firm

motivations or returns, why?

Private equity firm motivations

(2.3)

-Private equity firms desire high return,

short durations in transactions.

-Theoretically private equity would act as

'shock therapy' if it could.

-Value creation in private equity-owned

companies is likely not a major source of

returns for private equity funds.

-In practice heterogeneous view shows

transaction durations are neither short nor

long so it doesn't.

-Suggests misalignment of interests between

private equity firms and the companies they

own.

-'Limiting factor' likely at play preventing

theory from becoming reality.

-Interests of private equity-owned

companies are not the 'limiting factor'

preventing private equity from behaving as

'shock therapy'.

Probable existence of an unknown

'limiting factor' (2.5)

Firm 'skill' as the probable 'limiting

factor' (2.6)

-Possible that the existing conclusion to the debate on the

nature of private equity does not account for all factors

and should account for private equity transaction returns,

motivations and firm 'skill'.

-Firm size/maturity can be a proxy measure for firm 'skill'.

Development of the Research Question from the Literature Review

Current debate on the nature of private equity (2.2)

Sources of return in private

equity and the misalignment of

interests between PE firms and

portfolio companies (2.4)

Research question: "What is the relationship between private equity transaction return, duration and firm

size/skill, and should one exist, what are its implications for the current understanding on the nature of

private equity?" and hypothesis (3.1)

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Chapter 3 outlines the research question, the research hypothesis and existing research

surrounding the research question.

Chapter 4 details the research methods used to investigate the research question. The

investigation was conducted empirically through the analysis of investment-level data for a

large and global sample of private equity transactions, along with the case-study analysis for

certain aspects of the study.

Chapter 5 details the results and analysis of the study and develops a conjecture and practical

recommendations based on findings. This chapter represents the novel contribution of this

research and is intended to be of direct use to this studys stakeholders.

Chapter 6 outlines the studys limitations and possibilities for further research.

Chapter 7 present a conclusion summarising the main research findings followed by

references in Chapter 8 and Appendices thereafter.

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2. PRIVATE EQUITY LITERATURE REVIEW

2.1 Introduction to private equity

2.1.1 Private equity firms and funds

Private equity (PE) investments/transactions, also known as leveraged buyouts (LBOs), refer

to the acquisition of the majority control of a publicly or privately held company by a private

equity firm, using a small portion of equity financing (typically 10-40%) and a large portion

of debt financing or leverage (typically 60-90%) (Kaplan and Stromberg, 2009). This is

illustrated by Figure 1 which shows how the post-LBO capital structure of a target company

(in grey and blue) is typically more debt-heavy than its pre-LBO capital structure (in green).

Figure 1

Caption: Basic structure of a leveraged buyout transaction. Source: Oxford Private Equity Institute

A private equity firm raises equity capital for investments through a private equity fund

organised as a limited partnership. Institutional investors (pension funds, insurance

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companies, university endowments and sovereign wealth funds) act as passive limited

partners who contribute the majority of a funds capital, and the private equity firm acts as

the general partner, typically contributing around 1% of the total capital; but being charged

with the responsibility of all the investment decisions of the fund. (Ang and Sorensen, 2012).

The structure of a typical private equity fund is illustrated by Figure 2.

Figure 2

Caption: Structure of ownership of a typical private equity fund.

Source: Oxford Private Equity Institute

Each fund typically has a fixed life of ten years with the general partner managing the funds

acquisitions of individual companies, known as portfolio companies. The general partner

normally has up to five years to make acquisitions and then an additional five years to

monetise investments and return capital to limited partners. Private equity firms usually

manage several funds at a time depending on the size of the firm and attempt to raise new

funds every 2-4 years. The size of private equity funds can vary widely from US$100m or

less to US$10bn or more depending on the type of fund, the reputation of the general partner

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and the geographical region of the fund2. (Lopez-de-Silanes et. al, 2009; Kaplan and

Stromberg, 2009)

For managing a fund a private equity firm is compensated in three ways: by charging an

annual management fee to the fund (typically 1.5-2% of the committed fund size), earning a

share of the profits of the fund (called carried interest, typically 20%), and by charging deal

and monitoring fees directly to portfolio companies (typically 1-2% of a firms value each).

(Metrick and Yasuda, 2010; Kaplan and Stromberg, 2009)

2.1.2 Private equitys growth

Capital commitments to private equity funds have risen exponentially from US$0.2bn in

1980 to US$200bn in 2007. Fundraising is the lifeblood of private equity and as such global

transaction volumes have increased exponentially from under 50 per year in 1985 to over

2,000 in 2006. Given the exponential trend it is not surprising that transaction volumes are

skewed towards recent years with more than 40% of total acquisitions occurring between

2004 and 2007. (Figure 3; Figure 4; Stromberg, 2008)

2 Reuters, Apollo launches $12 billion private equity fund, http://www.reuters.com/article/2012/11/13/us-

apolloglobal-fund-idUSBRE8AC12Q20121113

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Figure 3

Caption: Global private equity transaction volumes have grown exponentially over the last 40 years.

Source: Kaplan and Stromberg (2009)

Figure 4

Caption: Private equity transaction volumes are dependent on private equity fundraising which is cyclical by nature.


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Over time the prevalent types of LBOs have changed and private equity has spread

throughout the world.

In the 1980s, fuelled by the availability of cheap debt financing from overly favourable terms

in high-yield bond markets, private equity firms were able to compete with cash-rich

corporate buyers to purchase large public companies. At the time private equity concentrated

on investing in manufacturing and retail firms and was primarily a North American

phenomenon, with the region accounting for 87% of global transaction volumes. (Table 1;

Kaplan and Stein, 1993; Kaplan and Stromberg, 2009; Stromberg, 2008)

With the collapse of the high-yield bond market in the 1990s, private equity declined and

smaller, mid-size buyouts of private companies and buyouts of divisions of larger companies

became more popular; requiring less capital for acquisitions. In the late 1990s private equity

began to recover, experiencing stable growth, investing in new industries such as technology,

infrastructure and services, and spreading to Western Europe. The region eventually

accounted for 49% of global transaction value in the early 2000s. (Stromberg, 2008)

In 2005 private equity experienced a second boom, once again fuelled by favourable credit

market conditions. A resurgence of public-to-private transactions ensued, private equity firms

began selling portfolio companies to other private equity firms, and the industry spread to

Asia and other parts of the world prior to the financial crisis of 2007 to 2009. The two private

equity booms highlight the industrys dependence on fundraising. (Figure 4; Table 1;

Shivdasani and Wang, 2011; Stromberg, 2008)

Overall, private equity has evolved from a North American-based industry investing

primarily in large mature public retail and manufacturing firms, to an industry investing in

companies of all sizes, from all types of sellers, in many industries around the world. The

industry is therefore a global asset class with a large role in the global economy.

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Table 1

Caption: Table shows a) the growth in the private equity transaction values and numbers over last 40 years, b) the change in

types of private equity transactions from primarily public-to-private to a mix of types, and c) a gradual spreading of private

equity from North America across the world over time.


2.1.3 Private equity exits and deal duration

As general partners of their funds, private equity firms have a responsibility to generate

returns for their limited partners. As funds have limited contractual lifetimes, selling

(exiting) investments is the foremost way in which funds liquidate their investments and

generate returns. Companies are bought with a view to selling them at a higher price.

There are different types of exit buyers who purchase portfolio companies and the

prominence of different exit routes have changed over time along with transaction durations

(see Table 2).

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Table 2

Caption: Table shows the types of buyers private equity-backed companies are sold to and how these have changed over

time. Sales to strategic buyers (corporates) have always been the most common, while other exit routes have varied in

significance. The average holding period of private equity-backed companies is between 5-6 years and deal of

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2.2 Current debate on the nature of private equity

In order to understand private equitys role in the global economy, it is important to

understand its nature. Though this topic is large, the debate can be summarised by two

opposing views which are currently in a stalemate based on empirical evidence on transaction

durations.

The first view, provided by Jensen (1989), argues that the LBO is a long-term superior

governance structure that solves public company agency problems by imposing strong

investor monitoring and managerial discipline through a combination of ownership

concentration and substantial leverage. This is known as the long-term superior

organisational form view.

The second view, provided by Rappaport (1990), views LBOs as short-term shock therapy

allowing inefficient, badly performing firms with inferior corporate governance to enter quick

but intense periods of corporate and governance restructuring in order to return to public

ownership after a few years. This is known as the short-term shock therapy view.

The current conclusion to this debate and the answer to which of the superior organisational

form view and the shock therapy view is more accurate in describing the nature of private

equity was proposed by Kaplan (1991). Kaplan noted that the theoretical frameworks of the

two views centred on assumptions regarding the durations of LBOs. As such, in an empirical

analysis of U.S. private equity transaction durations he found that the median time in private

equity ownership was 6.8 years and that on average LBOs were neither short-lived nor

permanent. This was supported by Stromberg (2008)s more up-to-date and global analysis,

and together these studies propose that neither the superior organisational form view nor the

shock therapy view is entirely correct and neither is entirely wrong. This stalemate

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conclusion to the debate on the nature of private equity is known as the heterogeneous

view of private equity.

Interestingly, both opposing views and the existing conclusion define the nature of private

equity from the perspective of portfolio companies. It is surprising that evidence on the

returns or motivations of private equity firms have not been incorporated into the debate

regarding the nature of their own industry. It is thus possible that there are factors other than

transaction durations at play which could impact a conclusion to the debate surrounding the

nature of private equity. An investigation of these could help to provide a better conclusion to

the debate than is currently provided by the heterogeneous view.

2.3 Private equity firm motivations and shock therapy

This section will discuss private equity firm motivations and will suggest that an ideal

private equity transaction would lean more towards behaving like a form of short-term shock

therapy than a long-term superior organisational form, but that a limiting factor is likely to

exist which prevents this from occurring in the majority of transactions and pushes

transaction durations to medium, not short durations as is found by the heterogeneous view of

private equity.

Private equity firms have two primary motivations: to generate high returns, and to generate

those returns in as short a time as possible.

Private equity firms are businesses, and naturally individuals with vested interests in their

success such as the partners and professionals who share in their profits want to continuously

earn more money. In the private equity industry this is often achieved by increasing a firms

size, and it is found that private equity firms build on their prior experience by increasing the

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size of their funds, which lead to higher revenues per partner/professional in later funds

(Metrick and Yasuda, 2010).

However in order to invest and generate any returns, funds must first be raised. It is found

that investors follow returns and that the private equity industry is one where a firms past

returns are a good indicator of its future returns (Kaplan, 1991; Kaplan and Schoar, 2005).

Therefore private equity firms will look to generate as high returns as possible in their current

funds to out-compete other firms and secure greater capital commitments for their future

funds, ultimately for their own benefit (Nikoskelainen and Wright, 2005). Indeed Chung et. al

(2011) find empirical evidence that the lifetime incomes of private equity firms are positively

correlated to current fund returns and are affected by the effect of these on private equity

firms abilities to raise future funds. Thus a primary motivation of private equity firms is to

generate high returns.

Private equity firms are also motivated to exit their investments quickly due to the need to

secure fundraising every 2-4 years. When fundraising, firms issue private placement

memoranda (PPMs or investment prospectuses) to prospective investors that, amongst

things, detail the size of a fund to be raised and all of the returns and durations of a firms

prior investments. In particular, investors are interested in information regarding the internal

rates of return (IRR, a measure of return) of recent investments. Reporting high IRRs is

important but reporting on-paper IRRs on unrealised investments in a firms active funds is

of little use when fundraising. An investments valuation moves with the ebbs and flows of

the global equity markets3, making projected returns an unreliable measure of actual returns.

For example if a firm issues a PPM now that details a positive unrealised return on an

investment, it may not be able to realise that return if in practice market conditions deteriorate

3 April 1, 2013. Pensions and Investments Online. Largest private equity firms rule the roast.

http://www.pionline.com/article/20130401/PRINTSUB/130329874/largest-private-equity-firms-rule-the-roost

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by the time it wants to sell that investment. Given this, it is important for firms to report high

returns on as many recently realised investments (thereby reflecting the firms ability to

generate returns in the current economic climate) as possible when seeking to raise funds

from investors. Therefore there is a high motivation to exit investments quickly.

This is supported by Wright (1994) who states that the more rapidly changing is the market,

with consequent implications for capital investment to achieve critical mass (a threshold

level of return), the earlier exit is likely to be and the more a private equity firm is driven

by a need to earn high internal rates of return on its investments, the sooner it will wish to

exit. Given this and the fact that private equity firms are opportunistic by nature - that is

whenever a good exit opportunity arises, private equity firms are interested in exploring it

even if all planned strategic actions in a portfolio company have not been completed

(Nikoskelainen and Wright, 2005) - private equity firms are not only motivated to generate

high returns, but also to keep their transaction durations short.

Knowing these motivations, one might expect that if private equity firms had their way

ideal private equity investments would be those of high returns and short durations, with

firms striving to achieve this combination in all transactions a reality which would be more

in line with private equity as a form of short-term shock therapy than private equity as a

long-term superior organisational form given the short durations desired.

However, the empirical evidence supporting the heterogeneous view of private equity shows

that in practice this does not come to pass for the majority of transactions; with the majority

being of medium, not short durations. It is likely then that there is a limiting factor at play

which prevents the majority of private equity transactions from reaching this ideal and

embodying a shock therapy organisational form.

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2.4 Sources of return in PE and the misalignment of interests

between PE firms and portfolio companies

In light of the possibility of a limiting factor being at play which prevents the majority of

private equity transactions from behaving as short-term shock therapy, this section seeks to

investigate what this limiting factor might be.

There are three major stakeholders in private equity investments: private equity firms, limited

partners and portfolio companies. Given that the interests of private equity firms and their

limited partners are generally aligned due to private equitys dependence on fundraising for

survival and fundraisings dependence on a private equity firms performance, it would stand

that the interests/influences of limited partners would not impede private equity from

behaving as a form of short-term shock therapy. However, the answer to the question of

whether the interests of private equity firms and their portfolio companies are aligned is not

immediately obvious, and testing whether this is the case might suggest whether portfolio

companies are directly or indirectly capable of influencing a private equity firms investment

decisions. Since private equity funds own portfolio companies there is little direct influence

that portfolio companies can have on investment decisions. However one can investigate

whether portfolio companies have indirect influence.

When a private equity fund buys a portfolio company it implements various

actions/initiatives to create value in the company to generate returns by improving the

companys operating performance and thus its market value. If value creation in portfolio

companies or operating performance gains represent the majority source of returns for

private equity funds, then it would be possible that the limits in how quickly various value-

creating initiatives could be implemented could restrict the quickness with which transactions

are exited, and would push average transaction durations to longer lengths as found by the

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heterogeneous view. The alignment of interests between private equity firms and portfolio

companies could thus restrict the majority of transactions from embodying a form of short-

term shock therapy by virtue of private equity firms having to generate returns through the

slow process of improving companies.

On the other hand if operating performance gains are a minority source of returns for

private equity funds, then this would suggest that a) the interests of private equity firms and

their portfolio companies would likely be misaligned, with implications for corporations as to

whether accepting private equity investment is in their best long-term interests, and b) the

interests/influences of portfolio companies would likely not be the limiting factor

preventing the majority of private equity transactions from behaving as a form of short-term

shock therapy. Indeed the literature examined in this section will suggest the latter to be the

case, thereby implying that an unknown limiting factor is at play.

In order to investigate the presence of a misalignment of interests between private equity

firms and portfolio companies, it is necessary to understand the various sources of returns for

private equity funds and their relative significances. As such this section will detail these

sources and their relative significances in return generation. This section will not focus on

how private equity returns compare to other asset classes (see Kaplan and Schoar, 2005;

Phalippou and Gottschalg, 2007; Harris, Jenkinson and Kaplan, 2012; Higson and Stucke,

2012), nor how the total value of a fund is distributed between private equity firms and

limited partners at the end of a funds life (see Metrick and Yasuda, 2010; Chung et. al,

2011).

A companys total value is given by its enterprise value or the market value of all of its

assets. Figure 5 shows the components of a typical portfolio companys enterprise value;

consisting of its book-value and off-book-value. The company has assets, both current and

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long-term, which are financed by debt and equity financing. The book-value of the

companys assets is the total historical cost paid for them (e.g. amount paid for property,

equipment etc), while the off-book-value is the value in excess of the book-value which the

market assigns to assets; usually consisting of the value of intangibles, a companys

reputation, client lists, future growth potential etc. The book and off-book-values of the

companys assets correspond to the book and off-book-values of debt and equity financing.

Figure 5

Caption: Figure shows typical capital structure of a portfolio company including off-book-value. The market value of

equity constitutes the proceeds a private equity firm would earn if it were to sell the company.

A private equity fund owns the equity of a portfolio company and if this equity is sold to a

buyer willing to pay the prevailing market price, the fund would receive the market value of

equity in proceeds, consisting of both its book and off-book-values. Thus in order to

generate returns a private equity firm must increase the market value of a portfolio

companys equity, either by increasing its book or off-book-values or both. This is achieved

through five sources of return generation:

AssetsLiabilities

(Financing)

Book value of

equity

Off-book value of

assets

Off-book value of

equity

Value PE firm

receives upon

sale of equity

Enterprise

value of

company

Book value of

assets

Typical Portfolio Company Capital Structure

Market value

of equity

Enterprise

value of

company

Short-term debt

Long-term debtLong-term assets

(e.g. Property)

Current assets (e.g.

Cash)

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1) Operating performance gains (book-value of equity increases)

2) Debt pay-down (book-value of equity increases)

3) Tax-shields (book-value of equity increases)

4) Valuation multiple increases (off-book-value of equity increases)

5) Favourable purchase prices (off-book-value of equity is underpriced by seller

allowing arbitrage)

Each of these sources of return increases the market value of equity in different ways. Their

theoretical frameworks and empirical evidence on their relative significances are detailed in

the following five sub-sections. Attention should be paid to operating performance gains

which is the only source of return which adds real value to portfolio companies but which

literature suggests is likely a minority source of return.

2.4.1 Operating performance gains: the first source of return

Operating performance gains stem from increases in a portfolio companys profitability and

productivity, and these are influenced by the channels through which private equity firms

create value for their portfolio companies. There are three primary channels of value creation:

governance, financial and operational engineering; and the proposed benefits of these

channels spawned the superior organisational form view of private equity.

Governance engineering

Governance engineering refers to changes implemented by private equity firms upon

acquiring control of a company, and their resulting benefits in improving its governance and

reducing agency problems caused by a separation of ownership and management. (Jensen,

1989)

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Jensen (1989) argued that the established control mechanisms meant to address agency

problems in public corporations were failing due to: product markets being undermined by

strong incumbent market positions, internal control systems being enfeebled by board

members with little equity stakes in their companies, and capital markets being weakened by

disbursed public ownership and restrictions/costs imposed on large shareholders. As a result

he suggested that the long-term effect has been to insulate management from effective

monitoring and to set the stage for the eclipse of the public corporation; highlighting that

the fact that takeover and LBO premiums average 50% above market price illustrates how

much value public company managers can destroy before they face a serious threat of

disturbance.

Jensen suggested that private equity provided the solution and argued that LBOs resulted in

superior board control and CEO monitoring, higher equity stakes and incentives for

management which aligned shareholder/management interests, and a greater likelihood of

positive management changes being made where necessary as outlined below.

Board control and CEO monitoring

Private equity firms reduce agency problems in their portfolio companies through more

effective board monitoring of CEOs.

A companys board of directors has access to internal company information to monitor its on-

going activities, direct strategy and evaluate management for an increase in compensation or

removal. As such a company whose board of directors monitor its CEO more effectively will

have fewer agency problems and will ensure a better alignment of interests between

shareholders and management. (Cotter and Peck, 2001)

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Private equity firms have greater board representation in their portfolio companies than do

other types of investors, often replacing directors where necessary. Portfolio companies also

have small boards who meet more frequently and their interests are better aligned with those

of shareholders by directors being given higher equity stakes than their public company

counterparts. This improves board monitoring of CEOs and reduces the reliance on short-

term performance as a measure of CEO performance; allowing CEOs to concentrate on the

long-term strategic objectives of a company and reducing agency problems in the process.

(Cotter and Peck, 2001; Cornelli and Karakas, 2012; Cornelli, Kominek and Ljungqvist,

2012; Gertner and Kaplan, 1996; Acharya and Kehoe, 2008)

Management equity and incentives

Private equity firms further reduce agency problems in portfolio companies by issuing

management teams with large minority equity stakes in their companies. (Jensen and

Murphy, 1990)

Management have higher stakes in portfolio companies than their public company

counterparts (Gertner and Kaplan, 1996); Leslie and Oyer, 2008). One study found that the

median portfolio company CEO had a 5.4% equity stake in his/her company, and that the

median management team had 16% in total (Kaplan and Stromberg, 2009). Another study

found that 61.7% of transactions had significant management equity participation (Guo et. al,

2009).

An example of management equity participations effectiveness in solving agency problems

in practice is outlined by Denis (1994) through a comparison of the leveraged recapitalisation

of Kroger Co. with the LBO of Safeway Stores (Denis, 1994). The two companies were very

similar in their business lines and while both transactions significantly increased the leverage

of the two companies, Safeway also altered managerial ownership and executive

26

compensation; leading to large differences in its restructuring actions and value creation.

Denis concluded that the improved incentive structure provided by Safeways private equity

owner led managers to generate cash in a more productive way than the organisational

structure employed by Kroger Co.

Management changes

Private equity firms actively replace poorly performing portfolio company CEOs where

necessary and it is found that these changes have a positive effect in creating value for

portfolio companies.

Acharya and Kehoe (2008) in a large sample of Western European buyouts found that one-

third of portfolio company CEOs were replaced within the first 100 days of acquisition and

two-thirds were replaced at some point over the first four years of private equity ownership.

This is echoed by Guo et. al (2009) who found similar data for U.S. buyouts.

Cornelli, Kominek and Ljungqvist (2012) find a causal link between forced CEO turnover

and performance improvements for buyouts across 19 economies. This is supported by Guo

et. al (2009) who find that gains in operating cash-flows are much greater in portfolio

companies where the CEO was replaced at or soon after the buyout.

Overall, evidence suggests that governance engineering has a positive effect on reducing

agency problems in portfolio companies and better aligning the interests of shareholders and

management than do public corporations.

Financial engineering

Jensen (1989) states that a central weakness and source of waste in public corporations is the

conflict between shareholders and managers over the pay-out of free cash-flow; that is cash-

flow in excess of that required to fund all investment projects with positive net present values

27

when discounted at the relevant cost of capital. For a company to operate efficiently and

maximise value, free cash-flow must be distributed to shareholders rather than retained; but

this happens infrequently, senior management has few incentives to distribute the funds, and

there exist few mechanisms to compel distribution.

Jensen proposed that private equity was the solution to this problem and stated equity is a

pillow, debt is a sword. If a companys capital structure consists primarily of debt, managers

are compelled to pay out free cash-flow they would otherwise retain. Payments to equity

owners such as dividends can be issued at managements discretion, but failing to service

debt payments can result in companies being declared insolvent and management being

called into bankruptcy court. As a result debt, so long as its service payments do not exceed

the capability of a portfolio company to pay them, can in theory provide a disciplining effect

on management. This can create an atmosphere managers require to slash unsound

investment programs, shrink overhead, and dispose of assets that are more valuable outside

the company.

Empirical evidence finds that portfolio companies have substantially higher debt levels than

public companies (Leslie and Oyer, 2008), and largely supports the idea that this results in a

more efficient dissipation of free cash-flows. Indeed, Gao, Harford and Li (2013) find that

portfolio companies on average have approximately half as large cash-holdings compared to

their public counterparts.

Evidence on the managerial effects of leverage is less conclusive. A study of U.S. public-to-

private LBOs found that improvements in cash-flows were greater after an LBO. However a

similar study of UK LBOs found no conclusive evidence that the disciplinary nature of debt

resulted in operating margin improvements, citing differences in its effects by geography.

(Guo et. al, 2009; Nikoskelainen and Wright, 2005)

28

In general private equity ownership results in a more efficient dissipation of free cash-flows

by companies and may have positive disciplinary effects on management which improves

operating performance.

Operational engineering

Operational engineering refers to private equity firms inducing acquisitions, growth plans,

cost-cutting, strategic changes and productivity improvements in their portfolio companies

with a view to improving their operating performance. (Acharya and Kehoe, 2008)

The concept was pioneered by Bain Capital4 in the 1990s and involved top private equity

firms reorganising themselves around industries and hiring industrial and operational

executives to advise on transactions. For example Jack Welch, former CEO of General

Electric is affiliated with CD&R and Lou Gerstner, former CEO of IBM with The Carlyle

Group; both leading private equity firms (Kaplan and Stromberg, 2009). Some typical

methods of operational engineering are outlined below.

Cost cutting

Private equity firms regularly cut costs and alter the investment policies of their portfolio

companies to create value.

An example of the positive effects of cost cutting on a portfolio company is the buyout of

Sealy Corporation by Bain Capital. Orit Gadiesh, Chairman of Bain & Company summarises

its impact as follows. When Bain Capital and Charlesbank Capital bought Sealy

Corporation, they aimed both big and realistically: seeking to increase the value of their

equity investment fivefold in a few years. They knew they could after probing every corner of

Sealy's business. Their main finding was that the complexity of its product line was not the

4 Kaplan. S, Private equity: past, present and future,

http://faculty.chicagobooth.edu/steven.kaplan/research/kpe.pdf

29

primary margin problem, differentiation was. Sealy had been making a costly, two-sided

design that allowed mattress owners to do something most don't actually do: flip mattresses.

The company shifted to a no-flip mattress design whose technology improved Sealy's

margins and leapfrogged its rivals technology. Sealy did not go ahead with former plans to

boost the volume of its mid-price mattresses, concentrating instead on higher price points. As

a result the new mattress design improved earnings by 22%.5

On the other hand, investment policies in portfolio companies are made more efficient by

either reducing or increasing capital expenditures where necessary. In the U.S., private equity

firms decrease their portfolio companies capital expenditures by on average 1% of assets. It

is found that this reduction is conducive towards eliminating waste and improving their long-

term performance (Harford and Kolasinki, 2012; Kaplan, 1989b). In some European

countries increases in capital expenditures are more common, with French LBOs in particular

having 24% higher capital expenditures than their public counterparts with a correlated

increase in sales. (Boucly et. al, 2011)

Organic growth

Private equity firms often look to help the companies they acquire grow internally, either

through the introduction of new products or expansion into new markets. Case-studies

outlining such actions are numerous but generalised empirical data is less common.

One study that is useful in this regard however is a study of 839 French LBOs by Boucly et.

al (2011). The authors suggest that portfolio companies grow significantly more than

comparable firms in terms of employment (18% higher), sales (12% higher) and capital

employed (12% higher). Furthermore, they find that a third of the average asset growth

5 Gadiesh. O, MacArthur. H, Lessons from private equity any company can use,

http://blogs.hbr.org/hbr/ceomemo/2008/03/lessons_from_private_equity_an.html

30

experienced by portfolio companies is financed by the issuance of additional debt, suggesting

that much of the value created by portfolio companies is based on making existing growth

opportunities easier to exploit by reducing credit constraints rather than offering new ones.

Though Boucly et. al only study LBOs in one country, France is an economy with many

sleeping beauties, i.e. potential targets with significant margins of improvements and

growth and is thus useful in highlighting how private equity firms add value through organic

growth where opportunities for it exist.

Acquisitions and external growth

Private equity firms regularly implement initiatives for external growth in their portfolio

companies, primary through add-on acquisitions - acquisitions of other companies which

may help to fill out a product line, achieve economies of scope in marketing or distribution,

co-opt operating synergies, expand service offerings, or capture economies of scale of similar

businesses. Guo et. al (2009) found that 50% of U.S. portfolio companies had made

significant acquisitions during private equity ownership, and Nikoskelainen and Wright

(2005) in a study of UK buyouts find that return characteristics and the probability of a

positive return in a transaction were related to the acquisitions carried out by portfolio

companies during private equity ownership.

Innovation

Private equity firms are found to improve the quality of innovation in their portfolio

companies. Literature on innovation in portfolio companies is uncommon; mainly because

innovation is difficult to quantify. However, Lerner et. al (2011) in a study of 495 buyouts,

using patenting-levels in portfolio companies as a proxy for private equity firms effects on

innovation, find that LBOs lead to significant increases in long-term innovation. Patents

31

applied for portfolio companies are more frequently cited (a proxy for economic importance),

show no significant shifts in the fundamental nature of the research activities of the

companies, and are more concentrated in the most important and prominent areas of

companies innovative portfolios. In essence, though the quantity of innovation in portfolio

companies does not increase, the quality of it does.

Governance, financial and operating engineerings impact on profitability and

productivity

It has been shown that private equity firms create value in portfolio companies through

governance, financial and operational engineering. Bottom-line value creation is primarily

measured by improvements in a portfolio companys operating performance which in turn is

measured by improvements in profitability and productivity.

Impact on profitability

The impact of private equity ownership on portfolio companies profitability has varied in

different time periods due to the industrys spreading across the world. Before 1990 private

equity was primarily a U.S. phenomenon with portfolio company profitability gains being

common and significant. After 1990 the industry spread to Western Europe and profitability

gains in the region appear to have been superior to those in the U.S. since. Given the majority

of total LBOs occurred after 1990, pre-1990 data is not so useful in forming generalisations

about the private equity industry but it will be discussed for contextual understanding

nonetheless. (Kaplan and Stromberg, 2009; Stromberg, 2008, Bernstein et. al, 2010)

Before 1990 U.S. buyouts, constituting 87% of global LBO transaction value in the 1980s,

experienced significant gains in profitability. Operating income/sales, a widely used measure

of profitability, was on average 10-20% higher in portfolio companies than their public

32

company counterparts. Net cash-flows (operating income minus capital expenditures) were

also 22%, 43% and 81% higher in the first three years post-buyout than in the last year pre-

buyout (Kaplan and Stromberg, 2009; Kaplan, 1989b). These effects are likely to have

stemmed from governance and financial engineering as operational engineering was not

common-place before 1990.

After 1990, profitability improvements in U.S. buyouts were weaker. Guo et. al (2009) find

that the profitability gains that did exist were substantially smaller than those documented for

transactions in the 1980s, and that depending on the measure, median performance was not

always significantly different from the performance of benchmark firms. This is echoed by

Leslie and Oyer (2008) who find generally no evidence that private equity-owned firms

outperform public firms in profitability in a sample of primarily post-1990 transactions. The

reasons for this decline are not clear; however it may be correlated to the decline of large

public-to-private transactions in the region post-1990 and the rise of other types of smaller

LBOs which may not have had as much potential for operating performance gains.

Evidence on profitability gains in Western European portfolio companies after 1990 is much

stronger. Acharya and Kehoe (2010) examined 395 LBOs from 1991-2007 and found that

higher abnormal performance is associated with a stronger operating improvement in all

operating measures relative to quoted peers and that this related to greater growth in sales

and greater improvement in the EBITDA to sales ratio (higher profitability). The authors

interpret these profitability improvements as causal private equity impact [...] there is

nothing inherent in the companies targeted by the private equity firms that would have caused

their operating performance to improve without being acquired by private equity.

Profitability gains also tend to vary with the type of private equity firm portfolio companies

are owned by. Cressy et. al (2007) find that industry-specialised firms confer an 8.5%

33

profitability advantage to portfolio companies while buyout-specialised firms appear to

confer no advantage but may provide a spur to growth. This provides indirect support for the

effects of operational engineering; with firms that reorganise themselves around industries

conferring superior value to their portfolio companies.

Impact on productivity

Private equitys impact on the productivity of portfolio companies, unlike profitability, is

generally positive across geographies but differences are noted in their magnitudes.

A study of 8,596 LBOs across 20 industries and 26 nations including the U.S., UK and

countries from continental Europe from 1991-2007 find that industries where private equity

invests grow more quickly in terms of productivity and employment. The total production of

an average private equity industry grows at a rate 0.9% higher than a non-private equity

industry. Geographically, Western European buyouts are found to confer superior

productivity gains to portfolio companies than their U.S. counterparts. (Bernstein et. al, 2010,

Lichtenberg and Siegel, 1991; Harris, et. al, 2005)

These productivity gains are not found to be due to reductions in advertising, maintenance

and repairs, research and development, or property, plant and equipment (Smith, 1990) or by

a reduction in factors of production in general. Instead gains are made by the improving the

return generated by factors of production, and the reallocation of a companys resources to

more efficient uses and better managers. (Smith, 1990; Harris et. al, 2005)

Operating performance as a return generator

Operating performance gains through improvements in the profitability and productivity of

portfolio companies generate returns by increasing the book-value of a companys assets by

improving their cash-generating abilities. This in turn increases its market value. As a result,

34

a private equity firm who owns this equity can sell it at a higher price than it was bought for

and return can be generated. This is illustrated by Figure 6.

Figure 6

Caption: Figure shows how both operating performance gains and tax shields act as sources of return by increasing the

market value of a companys equity by increasing its cash-generating capabilities, albeit through different means; one

through increases in profitability and productivity and the other through cost-savings from favourable regulatory treatments

of debt in LBOs.

Guo et. al (2009) in a study of U.S. buyouts estimated that operating performance

improvements account for only 18.5% of post-buyout return. This value is likely to be higher

for Western European buyouts which represent just under half of all buyouts, however it

highlights that operating performance gains are likely a minority source of return generation

for private equity funds.

Given this, it is likely that though the interests of portfolio companies are aligned with their

private equity owners, the relationship is not reciprocated; in essence an inherent

misalignment of interests between private equity firms and their portfolio companies exists.

Thus if a limiting factor exists that prevents the majority of private equity transactions from

behaving as short-term shock therapy, given the misalignment of interests, portfolio

companies are likely to have little direct or indirect influence on the investment decisions of

AssetsLiabilities

(Financing)

Book value of

equity

Book value of

equity increase

Off-book value of

assets

Off-book value of

equity

Value PE firm

receives upon

sale of equity

Book value of

assetsEnterprise

value of

company

Enterprise

value of

company

Higher market

value of equity


Current assets (e.g.

Cash)

Short-term debt

Long-term assets

(e.g. Property)

Cash increase

Long-term debt

35

private equity firms and the interests or influences of portfolio companies are not likely to be

the factor question.

2.4.2 Debt pay-down: the second source of return

The second way a private equity transaction is designed to generate return is by having a

portfolio company pay-down its own debt and increase the equity portion (book-value) of its

capital structure in proportion.

A private equity investment can be likened to buying a residential property with a mortgage

and then renting-out the property to generate income to service debt payments. A private

equity fund finances a LBO with a minority of equity financing and a majority of debt

financing. The private equity fund then looks to pay interest and principal payments on a

portfolio companys debt in order to decrease the quantity of debt in its capital structure and

increase the book-value of its equity in proportion. However it is not the private equity firm

that makes these payments, instead portfolio companies service their own debt through their

own free cash-flow generation at no extra cost to the private equity fund.

This is akin to an individual buying a residential property with a minority of equity and a

majority of debt (the mortgage) and using income from letting the property to pay-down the

propertys debt. Over time this results in the equity value of the property increasing in until it

accounts for its entire capital structure. Assuming house prices remain constant during

ownership, the individual will generate a healthy return upon selling the property. The same

is true of a LBO and this is illustrated by Figure 7.

36

Figure 7

Caption: Figure shows how debt pay-down acts as a source of return by increasing the book-value of a companys equity in

proportion to its debt at constant enterprise value.

The magnitude of this source of return generation is dependent on three factors:

1) Transaction duration - the longer a portfolio company is held by a fund, the more

payments it will make and thus the higher the book-value of its equity will be before

exit.

2) Free cash-flow generation - the higher the free cash-flow generating ability of a

portfolio company, the greater the quantity of debt it will be able to service in a given

time, and the higher the book-value of its equity will become in that time.

3) Interest rates - the lower the interest rate on a portfolio companys debt, the greater

the size of debt payments it will be able to manage, and the higher the debt a private

equity firm will place on its capital structure in order to magnify returns. This factor

will be influenced by a private equity firms size and maturity as larger, more mature

firms are capable of securing better terms on debt financing for their portfolio

companies than smaller firms. (Demiroglu and James, 2010; Ivashina and Kovner,

2010)

AssetsLiabilities

(Financing)

Liabilities

(Financing)

Long-term

debt

Equity (owned

by PE firm)

Off-book value

of assets

Off-book value

of equity

Off-book value

of equity

Value PE

firm receives

upon sale of

equity


Book value of

equity

Debt

paydown

Final higher

market value

of equity

Book

value of

assets

Current assets

(e.g. Cash)

Short-term

debt

Enterprise

value of

company

Long-term

assets (e.g.

Property)

Long-term

debt

Initial

market

value of

equity

Short-term

debt

Enterprise

value of

company

37

The significance of this source of return in relation to the others is hard to quantify as due to

2), it can be affected by other sources such as operating performance gains and tax-

shields. As such its significance varies between portfolio companies and empirical research

quantifying this significance is scarce.

Interestingly, the fact that transaction durations influence this source of return gives some

incentive to private equity firms to lengthen transaction durations to generate higher returns.

However, this would go against the second motivation of private equity firms to achieve short

transaction durations and as will be seen from reviewing all five sources of return generation,

debt pay-down is at best a minority source of return with the cumulative effects of the other

source being larger. As such the role this source plays in influencing a private equity firms

investment decisions is likely to be small.

2.4.3 Tax-shields: the third source of return

The third way private equity funds generate return stems from the different treatments of debt

and equity by various countries tax codes. Many countries codes, and in particular the U.S.

code6 allow businesses to deduct interest payments from their tax obligations, known as the

tax deductibility of interest. As a result highly leveraged capital structures such as those

present in LBOs allow portfolio companies to pay less tax. This generates benefits to private

equity funds by a boosting of returns by increasing the cash-flows available to the providers

of capital. (Guo et. al, 2009)

This process has the same effect on a increasing the book-value of a companys equity as

operating performance gains do by acting as a form of cost-saving (Figure 6). The

difference is that the benefits of tax-shields originate from government regulations rather than

6 Private Equity Growth Capital Council, Interest Deductibility, http://www.pegcc.org/issues/private-equity-

and-tax-policy/private-equity-interest-deductibility/

38

any internal changes private equity firms make to portfolio companies. As such they improve

free cash-flows and generate returns without any real benefits to the operating performance of

portfolio companies in terms of profitability or productivity.

Guo et. al (2009) estimate that the effects of tax-shields account for 44.5% of post-buyout

return to private equity funds. This is echoed by an earlier study by Kaplan (1989a) who

estimated an upper value of 40%. It is likely that this sources significance is smaller in

Western European countries where returns from operating performance gains are likely to be

larger.

Overall, the literature suggests that tax benefits are a significant source of return for private

equity funds which add little real value to portfolio companies in terms of operating

performance. As such their significance adds to the idea that the interests of private equity

firms and their portfolio companies are likely misaligned.

2.4.4 Valuation multiple increases: the fourth source of return

The fourth way in which private equity funds generate return is from valuation multiple

increases. Portfolio companies are valued using valuation multiples; ratios used to estimate

the value of a company based on the multiple of the market value of comparable publicly-

listed companies to their earnings. Private equity firms can generate returns by capitalising on

increases in these valuation multiples which depend on prevailing market conditions.

For example, if a group of similar publicly-listed companies trade on a stock exchange at an

enterprise value to earnings ratio of 6x, this would indicate that the free-market values the

companies - accounting for both their book and off-book-values - at $6 for every $1 of

earnings. Company A could generate $10m in earnings while Company B could generate

$100m, valuing them at $600m and $6bn respectively, but both would have the same

39

valuation multiple of 6x. This valuation multiple would be applied to portfolio companies in

the same business line in order to gauge their market values.

In poor market conditions valuation multiples decrease; decreasing the off-book-value of a

companys assets. Conversely, in strong market conditions valuation multiples increase;

increasing the off-book-value of their assets. Given this it is possible that a private equity

firm could acquire a portfolio company when market conditions are poor, implement no

changes to the company and after a period of time sell it under stronger market conditions

and generate a return. As Michael Fisch, CEO of the private equity firm American Securities

states: rising stock markets increase the value of listed companies used as benchmarks to

arrive at private company valuations [...] valuations are disconnected with a flat earnings

reality7. Thus, like housing prices, company prices fluctuate over time regardless of whether

any changes have been made to the house/company, and this presents opportunities for

private equity firms to generate returns as illustrated by Figure 8.

7 April 1, 2013. Pensions & Investments Online. Largest private equity firms rule the roast.

http://www.pionline.com/article/20130401/PRINTSUB/130329874/largest-private-equity-firms-rule-the-roost

40

Figure 8

Caption: Figure shows valuation multiple increases acts as a source of return by increasing the off-book-value of a

companys assets, thereby increasing the market value of its equity.

Guo et. al (2009) in a sample of U.S. LBOs estimate that valuation multiple increases account

for 5.8% of post-buyout return for private equity funds. This figure, though smaller than the

estimated effects of operating performance gains and tax-shields, makes valuation

multiple increases a meaningful source of return generation which creates no value for

portfolio companies in terms of operating performance.

2.4.5 Favourable purchase prices: the fifth source of return

The fifth and final source of return for private equity funds, though less well documented, is

the favourable pricing of companies, or arbitrage.

Renneboog, Simons and Wright (2007) in a study UK public-to-private transactions find that

one of the main sources of post-buyout return for private equity funds was the undervaluation

AssetsLiabilities

(Financing)

Book value of

equity

Off-book value

of assets

Off-book value

of equity

Off-book value

of assets

increase

Off-book value

of equity

increase

Value PE

firm

receives

upon sale

of equity

Enterprise

value of

company

Current assets

(e.g. Cash)

Long-term debt

Higher

market

value of

equity

Long-term

assets (e.g.

Property)


Enterprise

value of

company

Short-term debt

Book

value of

assets

41

of the pre-buyout target firms. In essence, for some reason, companies were bought at a price

cheaper than their market value at the time of purchase, generating instant on-paper return for

their private equity buyers through a mispricing of the off-book-value of their assets.

Unfortunately there is little research estimating the significance of this source of return,

however there have been a number of well documented cases outlining its effects in practice,

two of which are outlined below:

1) Information Partners and Gartner Group - Information Partners8 invested in IT

research company Gartner Group in 1990.9 One of the aspects of their investment

strategy was to provide the management and employees of Gartner a 25%10

ownership

stake in the company11

while continuing the managements existing strategy for the

growth and operations of the company12

.

Information Partners seemed to have benefited from a favourable acquisition price as

ex-parent Saatchi&Saatchi was burdened with debt and analysts felt that they had to

sell Gartner for a low price. Furthermore it was suggested that given the Gartner

Group was a people-intensive business, the company was intended to be sold only to

an investor with which management could work with. The threat that management

may have left the company if they were not satisfied with a prospective investor

deterred a number of bidders from making offers, which lowered the eventual price of

8 Bain Capital, 2013. Portfolio companies by industry. Retrieved from

http://www.baincapitalventures.com/Portfolio/ByIndustry.aspx?industryid=3 9 Business Wire, July 5, 1990, Information Partners acquisition of Gartner Group Inc. . Retrieved from

LexisNexis Academic database. 10

The Times, July 5, 1990, Saatchi in $16m loss on sale of Gartner, Martin Waller. Retrieved from LexisNexis Academic database. 11

Business Wire, July 5, 1990, Information Partners acquisition of Gartner Group Inc. . Retrieved from LexisNexis Academic database. 12

Business Wire, July 5, 1990, Information Partners acquisition of Gartner Group Inc. . Retrieved from LexisNexis Academic database.

42

the business.13

In April 1993 Information Partners sold their stake to Dun &

Bradstreet for a healthy return.14

2) 3i Group and Great Western Trains - Great Western Trains was one of the 25

operating companies which were created for the privatization of the British Rail.15

It

was acquired as part of the privatization process in 1996 by a consortium of investors

in which private equity firm 3i Group had 24.5%, bus company FirstBus had 24.5%

and the management buyout team had 51% of the equity stake in Great Western.16

3i

Group realized the investment when shareholder FirstBus acquired 100% of Great

Western in March 1998. The sale meant great profits for 3i and the managers of Great

Western, which outraged the press and analysts because the huge profits realized were

reported to have been the outcome of a low acquisition price offered by the British

government or high subsidies offered at the expense of the British tax payer.17

2.4.6 Quick-flips and the misalignment of interests in practice

The relative significances of the five sources of return generation have been outlined and

operating performance gains - the only source of return generation that stems from value

creation in portfolio companies is likely a minority source of return for private equity funds.

This suggests that irrespective of whether private equity firms work to align the interests of

their portfolio companies with themselves, their own wider interests are likely not aligned

with those of their portfolio companies. In essence, portfolio companies may act in the best

13

Daily Mail, October 11, 1990, Saatchi sells for a song. . Retrieved from LexisNexis Academic database. 14

Fairfield County Business Journal, March 21, 1994, Gartner Group revenues climb as market's thirst for research intensifies, Stephanie Finucane, Vol 33; No 12; Sec 1; pg 7. Retrieved from LexisNexis Academic database. 15

The Independent (London). October 7, 1996, Monday. The final shunt for British Rail as the privatisation express steams in on time, Christian Wolmar. Retrieved from LexisNexis Academic database. 16

AFX News, December 20, 1995, Wednesday, 3i to match FirstBus' 5.6 mln stg investment in Great Western Trains. Retrieved from LexisNexis Academic database. 17

The Herald (Glasgow), March 5, 1998, Gravy train rolls in. ; Millions in store for seven Great Western directors as FirstGroup takes the throttle, Ian Mcconnell, Pg. 22. Retrieved from LexisNexis Academic database.

43

interests of their private equity owners, but there is little incentive for this to be reciprocated,

especially with regards to investment decisions such as when to exit an investment. Indeed

Nikoskelainen and Wright (2005) suggest that buyout markets are opportunistic; that is,

whenever a good exit opportunity arises, private equity firms are interested in exploring it,

even if all planned strategic actions in a target portfolio company have not been completed.

An example of this misalignment at work could be the case of quick-flips, a minority of

private equity transactions (12%, Table 2) of very short duration (usually less than 2 years)

which generate spectacular returns for private equity funds but appear to create little

discernible value for portfolio companies.

A press article18

in 2005, argues that over the last three years, private equity firms have had

record returns through a series of quick flips. In recent months, several high-profile quick

flips have left critics wondering whether buyout firms were using such offerings to line their

pockets, rather than using the proceeds to support companies. Examples of such investments

include:

1) Thomas H. Lee Partners and Snapple - the Boston private equity firm bought

Snapple for $135 million in 1992 and sold it two years later to Quaker Oats for $1.7

billion.19

2) Blackstone Group and the Celanese Corporation the Blackstone Group sold a

German chemicals company, the Celanese Corporation, to the public after owning it

for less than 12 months. The firm quadrupled its money and all of the proceeds from

the offering were used to pay out a special dividend to Blackstone.20

18

November 13, 2005. New York Times. The Great Global Buyout Bubble. http://www.nytimes.com/2005/11/13/business/yourmoney/13buyout.html? 19

See 18. 20

See 18.

44

3) KKR and PanAmSat KKR, a private equity firm, quadrupled its money by

flipping PanAmSat, the satellite company it owned for less than a year. 21

4) 3i Group and Go - British Airways sold Go to 3i for 100m, 3i sold Go to EasyJet

for 374m the following year.22

Though quick-flips represent a minority of transactions they do not appear to show that

private equity acted as a superior organisational form but rather point to private equity

fulfilling the role of short-term shock therapy and highlight its opportunistic nature.

2.5 The unknown limiting factor: PE motivations, the

misalignment of interests and shock therapy

Section 2.3 detailed how private equity firms are primarily motivated to achieve high returns

and short durations in transactions. This suggests that if there were no limiting factors at play,

private equitys intrinsic nature would push the majority of transactions to embody a state of

short-term shock therapy with short durations over that of a superior organisational form

with long durations. Empirical evidence provided by the heterogeneous view however finds

that the majority of private equity transactions have medium, not short durations, suggesting

that a limiting factor is at play which prevents most private equity transactions from fulfilling

their firms motivations and behaving as a form of short-term shock therapy.

Section 2.4 found that value creation in portfolio companies via operating performance gains

is likely a minority source of return for private equity funds. This suggests that though private

equity firms may implement changes in their portfolio companies to better align such

companies interests with their own, private equity firms wider interests are likely not

aligned with their portfolio companies. This misalignment suggests that the

21

See 18. 22

See 18.

45

interests/influences of portfolio companies (as the only other direct stakeholder of private

equity investments apart from funds and their investors) are not likely impact private equity

investment decisions and are thus not likely to be the limiting factor that prevents the

majority of private equity transactions from behaving as a form of short-term shock therapy.

As such it is likely that an unknown limiting factor is at play. It is important to investigate

what this might be in order to potentially develop a better understanding of the nature of

private equity and the factors influencing it.

2.6 Firm skill as the limiting factor to private equity shock

therapy

Existing literature may unknowingly suggest that a private equity firms skill in generating

high transaction returns and short transaction durations is the limiting factor that hinders

private equity from behaving as a form of short-term shock therapy in the majority of

transactions.

Private equity returns are persistent; that is that the past returns of a firms funds are a good

indicator of its future funds returns. This is based on the idea that private equity is a skill-

based industry, where the experience of generating high return develops a fund managers

skill, allowing him/her to generate even higher returns in future funds. (Kaplan and Schoar,

2005)

Investors follow returns and therefore so does fundraising (Kaplan, 1991). Firms build on

their prior experience by increasing the size of their funds to increase the lifetime incomes of

their fund managers (Metrick and Yasuda, 2010; Chung et. al, 2011). As a result firm sizes

increase in proportion to a firms skill.

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Empirical evidence finds that large, mature firms have higher returns than average firms (a

median performance of 150% vs. 80% of S&P500 returns) (Kaplan and Schoar, 2005). In

addition, when firms get larger and more mature they are able to obtain cheaper debt and

looser loan covenants which magnify the returns they generate (Ivashina and Kovner, 2010;

Demiroglu and James, 2010). As a result a virtuous cycle develops where the experience and

skill developed in generating high returns in one fund allows a private equity firm to generate

even higher returns in the next fund, along with an attainment of greater fundraising

opportunities and an increase in firm size.

Given that return is dependent on a firms skill and that its motivations are to achieve high

returns and short durations in transactions, it is not surprising then that only a minority of

transactions are of short duration or high return, as the skill required to achieve such

characteristics is rare and likely possessed by only a handful of large, mature private equity

firms. This could point to firm skill, and by proxy, firm size, being the limiting factor that

hinders most private equity firms from realising their motivations and behaving as short-term

shock therapists. If this were the case then it would naturally skew the majority of

transaction durations towards medium, not short durations as found by the heterogeneous

view of private equity; with firms resorting to slower, more ineffective methods of return

generation due to their lack of skill in being able to generate higher returns and do so through

quick means. This could easily result in a surface impression of private equity being

both/neither a form of short-term shock therapy and/nor a long-term superior

organisational form, but this impression would ignore the forces influencing transaction

durations resulting in it lacking depth and holism.

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3. RESEARCH QUESTION

3.1 Research question and hypothesis

The debate on the nature of private equity consists of two disparate views; that private equity

is either a long-term superior organisational form, or a form of short-term shock therapy.

The existing conclusion to this debate, the heterogeneous view is based upon an empirical

finding that the majority of private equity transactions have medium (neither short nor long)

durations, and this fact is used to conclude that neither view is entirely correct and neither

view is entirely wrong.

However, based on the wider findings of the literature review, one could theorise a different

conclusion to the debate: that private equity is by nature a form of short-term shock therapy,

but the majority of transactions are prevented from embodying this state due to the limitations

in their sponsoring private equity firms skill in achieving high returns and short durations

in transactions. In essence, if private equity firms had a choice they would act as short-term

shock therapists, achieving high returns and short durations in all of their transactions.

However, most are limited in doing so by their skill in achieving these two characteristics;

forcing the majority of transactions to generate lower returns and to be of longer (medium)

durations than desired.

This alternative conclusion has been developed from the combination of various concepts

discussed in the literature review; it has no validity in practice unless it is tested for. As such

the research question of this paper is as follows:

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Research question: What is the relationship between private equity

transaction return, duration and firm size/skill? And should one exist, what

are its implications for the current understanding of the nature of private

equity?

Note: firm size is used in this question as a proxy for firm skill as firm skill is difficult to quantify and

the literature review suggests that the two are directly related.

Given this research question, if private equity firm motivations are to achieve high returns

and short durations in transactions, but their abilities to fulfil them are limited by their firm

skill/sizes, then across a global sample of transactions one could hypothesise that the

following would be true:

Hypothesis: Private equity transaction returns and durations are negatively related,

with high return, short duration transactions representing a minority of transactions,

but with the majority of these transactions being sponsored by a small minority of large,

mature private equity firms.

Testing this hypothesis and finding positive results would not dispute existing evidence that

the majority of private equity transactions have medium durations; as short duration (and

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The Relationship Between Private Equity Returns, Duration and Firm Size & Skill