In private equity, we hear the term Value Creation all the time, especially when we’re talking about growth equity and buyout investing. For these strategies, GPs usually deploy a “hands-on” approach to achieve value-add or value creation. This means the GP will work closely with the portfolio company and its management team to make the necessary changes to improve the company’s revenue and operating efficiency (a.k.a. operating profit), with the end result of creating tangible value for the company and its investors.
In fact, the GP may employ an external Operating Partner to embed them into the company as a full-time team member, with the responsibility of helping the team implement the changes to create value. These changes, or “operational improvements” as they are also commonly known, can include rolling out new sales and marketing initiatives; penetrating new markets to grow the customer base; leveraging potential synergies with the GP’s other portfolio companies, customers, suppliers, and vendors.
Ultimately, their goal is to streamline existing processes or establish a new business, management, and manufacturing process. They might also be responsible for onboarding new departments, team members and equipment, or developing new products and service offerings for customers. They may even recommend going back to the drawing board to revamp the company’s business model. The GP, the Operating Partner and the Management Team play crucial, collaborative roles in developing the company to create value.
Private Equity Value Creation - It’s about growing companies
Private equity sometimes gets a bad rap because of a historic perception of cutting costs (like laying off workers and staff) to improve profits. This is an extremely limited view—modern private equity is more focused on growth, including hiring new talent, developing new products and services, expanding production facilities and the workforce, and growing the company’s footprint and business as a whole.
Making these operational improvements to create value requires capital investment and expertise, and that’s where GPs, and indirectly LPs, come into play. Although your average small, medium, or even large-sized company, many of which are family-owned, may well have extensive experience in its particular industry or business, they would not necessarily have the know-how or resources to make these types of operational improvements on their own. The private equity value creation process is about growing and making existing companies better.
Why is Value Creation so important?
Private equity investment strategies that have a defined approach to value creation are important because making operational improvements to portfolio companies and then selling them at a higher value for investment returns is a more durable and robust strategy than the alternative: relying on clever deal structuring, financial engineering (leverage), and/or multiple arbitrage (buy low, sell high).
Under certain market or business conditions, these latter techniques may generate attractive private equity returns, but if pre-investment assumptions do not go according to plan, then the likelihood of achieving the target return diminishes. Due to the illiquid nature of the private equity asset class, investment returns should not rely on mathematical probabilities of assumptions and scenarios materializing. Rather, a strong and healthy portfolio company that has come out on the other end of value creation can command a higher exit value even if the market is in a down-cycle so you aren’t relying on market conditions.
Alternatively, the GP could also postpone divestment until market conditions are more conducive, without fear of the portfolio company imploding. Regardless, private equity value creation is the way to go.
Tangible Drivers of Value Creation
The operational improvements described above ultimately materialize in the form of top-line revenue growth and higher operating margins that translate into stronger operating profit, which is usually measured in EBITDA. Value creation as an analysis is commonly expressed in terms of company enterprise value, or the overall value of the company and the key drivers of enterprise value in a value creation context are revenue growth, (EBITDA) margin expansion, and multiple expansion.
While the first two terms are self-explanatory, the latter relates to EBITDA valuation multiples or purchase multiples. This reflects the change in the EBITDA valuation multiple between at the time of initial investment and at the time of divestment (or the most recent reporting period if the company is unrealized from the GP’s fund portfolio).
Since private companies are valued at a multiple of their EBITDA, for example, 8 times trailing-twelve-month (TTM) EBITDA, then a company generating $12 million of TTM EBITDA would have an enterprise value of $96 million. To determine the contribution of EBITDA multiple fluctuations on an enterprise value for a value creation analysis, we can hold the entry EBITDA constant and multiply it by the change in EBITDA multiple between entry and exit to calculate the corresponding change in enterprise value due to this EBITDA multiple impacts.
The calculations for determining the impact of revenue growth and EBITDA margin expansion on enterprise value are similar: calculate the change in revenue and EBITDA margin, while holding the other corresponding parameters constant, to derive the equivalent enterprise value contribution components for these two drivers.
What Is Leverage Effect?
Indulge me in a short tangent for a worthy cause. We need to discuss leverage effect. There is a common misconception that the debt applied on a private equity deal would have a leverage effect on the enterprise value creation, but in fact, the leverage effect only has an impact on a portfolio company’s equity value.
A private equity fund can acquire a company for $100 million consisting of $30 million of equity from the fund and the remaining $70 million financed with external debt. After servicing half of the debt and then selling the company a few years later at the exact same $100 million price tag, the fund can retire the last $35 million of debt from the sale amount and the resulting $65 million balance is equity, which equates to a 2.2x return on equity for the fund.
Despite selling the company at the same price as the initial purchase price, the investment return was more than double the fund’s equity investment of $30 million! Now imagine if the exit valuation was even higher than $100 million. Now imagine if the exit valuation was much lower than $100 million and yet the debt still needs to be retired. That is the leverage effect!
Private Equity Value Creation Bridge and its Interpretation
A value creation bridge, a.k.a. the value creation step-chart, is a visualization of the analysis described above and it provides a clear view of the main drivers of enterprise value creation. If the investment strategy involved operational improvements and these worked out well for the portfolio company, then the two “steps” for revenue growth and margin expansion would be the largest steps shown on the bridge.
Conversely, if valuation multiple fluctuations provided the highest contribution to enterprise value, then this too would be represented on the value creation bridge. Investors are increasingly cognizant of the underlying operating performance of portfolio companies and performing value creation analysis to understand the drivers of investment returns.
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