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The most successful private equity ﬁrms drive returns by transforming their portfolio companies, not rejiggering bottom lines.
This is one of the most challenging markets in private equity’s 30-plus-year history. Competition from corporate acquirers and record levels of dry powder have driven acquisition multiples to new heights.
While many of the things that made the private equity model successful in the past will not work in the future, its innovative value creation — the ability to move faster, drive rapid and strategic growth, and create greater value throughout the transaction life cycle — will remain key. Accelerating returns through operational improvements is now front and center for private equity firms.
“There has been a shift in the way private equity generates returns — from financial engineering and leverage to creating durable value through the period of ownership,” says John van Rossen, EY UK & Ireland Private Equity Leader. Those who fail to do this face disappointing returns he warns, “As exit multiples won’t be higher than those available in public markets.”
Back to our roots
To offset high valuations, currently more than 10 times earnings, private equity firms are under pressure to refocus on their core strengths: growing revenues, improving margins and driving greater efficiencies across the business. This means implementing strategic and operational improvements early and effectively. “PE firms now need a line of sight to measurable EBITDA growth,” van Rossen says.
EY research found that growth in earnings before interest, tax, depreciation and appreciation (EBITDA) is the primary driver of value creation. This has been the case for pre-recession, recessionary and post-recession periods. Indeed, since the recession, nearly all private equity value creation has been driven by EBITDA growth — not leverage, and certainly not multiple expansion.
There’s a significant amount of integration and value creation work needed to generate returns.
Driving this growth comes about by looking across the business — top line, bottom line and fully enabling all functions. It is an evolving process, taking place on a global scale. Tony Tsang, EY Greater China Private Equity Leader, explains how the situation has changed in the market: “The traditional model was basically take a deal from the mainland to Hong Kong and exit. There’s now a significant amount of integration and value creation work needed to generate returns.”
Such value creation covers all areas of the business. EY breaks its drivers down into three broad areas:
- Revenue enhancement, through such measures as pricing strategies and customer and product segmentation.
- Margin improvement, which can be vital to freeing up much-needed cash, through optimizing the supply chain, IT and financial transformation, and process redesign.
- Capital efficiency, from real estate efficiency to working capital improvements.
In concrete terms, value creation requires focusing resources on operational expertise, helping firms access new markets or open doors to new customers, helping them access a new network of relationships and realizing a company vision that aligns with the owner or management team.
The right people and the right support
There’s a vast difference between a good management team and the right management team.
Indeed, having the right team at the start of the deal is one of the factors most strongly correlated with success, according to EY research, resulting in higher EBITDA growth and, consequently, higher equity multiples.
While the right management team is critical, providing that team with the right toolkit to execute successfully is just as essential. To that end, firms are building out and refining their operating resources. Overall, the private equity industry has about one-third more operating resources than it had just four years ago.
While such resources used to be concentrated at bigger houses, mid-market firms now are catching up. They are adding both generalists, who can help CEOs think holistically about the business, and specialists, who can bring concentrated insights and deep experience in a specific discipline or sector.
EY has a strong track record of sourcing this experience. Fredrik Bürger, private equity operating partner at EY UK & Ireland, says: “In many cases, the professionals we bring in to advise a business have experience of executing the plans we recommend and, in many cases, will have done it as principal.”
Providing firms with the necessary analytics about how an asset and its competitors are positioned is also invaluable, he argues. “We look at how competitors are working across JVs, contractors and so on. This analytical output helps determine why a company is, or isn’t, adopting certain practices and enables us to identify early on what needs to be changed.”
With the right management team in place and the right support from the private equity fund, businesses are in a strong position to move up the value chain. The private equity process tends to shift people from lower to higher value and skilled employment. For example, implementing new technology facilitates the reallocation of jobs from the back office to the front office, which can be much more productive.
Bryan Zekulich, EY Oceania Managing Partner for Private Equity, talks about the “buy-and-build” approach, “where PE firms start with a smaller platform of assets and aggregate up. This gives the PEs the ability to deal with fragmented markets, while maintaining flexible operational structures, allowing them to be nimble.” Such an approach enables private equity firms to buy down their multiple over time and then exit when the opportunity arises.
Those private equity firms that are the most successful will be those that are able to drive returns by fundamentally transforming businesses, rather than rejiggering bottom lines through financial engineering. Drawing on private equity’s roots, this doesn’t just help a company’s investors, it improves society as a whole.
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Those private equity firms that are the most successful will be those that are able to drive returns by fundamentally transforming businesses, rather than rejiggering bottom lines through financial engineering.
EY EMEIA Private Equity Value Creation Leader