Private Equity Value Creation

Overview

The business model for private equity is changing, and the ripple effects are being felt far and wide. From its early days (1960s and 1970s) as a response to inefficiency in the capital markets, through a heady expansion phase (1980s and 1990s) that saw an extension of the model to sub-specialties (industry, situation, size, etc.), and the institutionalization of the asset class (2000s and 2010s), private equity has become an established force in the market, a driver of M&A activity, and a factor that must be considered by executives in every industry and niche.

Theory vs. Practice

A working paper by professors Paul Gompers of Harvard Business School and Steven Kaplan of the University of Chicago, investigates the broad philosophical approaches, deal sourcing activities, and key value creation activities of established private equity firms post-transaction.

The fruits of this academic labor are a treasure trove of data. Key points include:

  • Valuation. Private equity valuation approaches deviate from academia, with the former focusing on comparable transactions, while the later emphasizes the discounted cash flow methodology. This finding may cause consternation in academia but is utterly unsurprising to any finance professional.

 

  • Staffing. Despite a growing appreciation for the value of governance and operational engineering in generating strong returns, the largest private equity firms continue to be staffed primarily with deal professionals. This finding highlights a challenge that private equity firms will continue to struggle with as the source of value creation migrates from financial engineering to operational improvement.

 

  • Sourcing. Deal sourcing appears to be an area of weakness for even the largest and most established PE firms, with over well over 50% of closed transactions having come from non-proprietary sources.

Emerging Changes

As private equity returns experience mean reversion and the amount of private equity capital under management continues to expand, the traditional business model of private equity firms will shift as well.

Key areas of change include:

Precedence of Operational Value Drivers. The large amounts of capital under management and limited number of attractive investment opportunities has driven up deal multiples as private equity firms find themselves bidding against one another as well as growth hungry strategic acquirers for nearly every opportunity. In the face of these competitive pressures, Private equity firms will increasingly need to focus on governance and operational issues to drive compelling value creation in their investments.

 

Investment Hold Times. The irony of private equity is that an asset class that was originally created in response to market inefficiency has become a driver of inefficiency, as private equity firms have been challenged to deliver value in a traditional 3 to 5-year investment horizon or, alternatively, have been loath to divest attractive portfolio companies at the end of that span when additional upside is perceived.

Pipeline Management. Even the largest and most established private equity firms evaluate far more investment opportunities than they ultimately close on. The institutionalization of the asset class will continue to push these firms to reassess their internal processes as they look to more efficiently manage their resources in assessing and pursuing investment opportunities.

 

Deal Sourcing. Deal flow is an increasingly vexing challenge for PE firms, especially the challenge of developing anything close to proprietary deal flow. As private equity continues to mature, PE firms (especially those active in the middle market) will look to expand their partnerships with executives able to provide contacts and insight that may lead to an edge in sourcing investment opportunities in a given industry. While many firms have taken steps along this path, the number and intensity of these partnerships is only likely to increase in the years to come.

Structural Changes. Private equity firms have incurred the wrath of many of their limited partners with adherence to a committed capital structure that some LPs now see as being at odds with their own best interests. As a result, co-investment opportunities and fund less sponsor (private equity investors who source their transaction capital on a deal by deal basis) structures have grown considerably in number and sophistication in recent years.

Source: “What Private Equity Firms Say They Do”, April 2015, Harvard Business School Working Paper. Paul Gompers, Steven N. Kaplan, Vladimir Mukharlyamov.

Performance in Distress

While the model is changing, private equity firms have long generated returns through financial engineering. As any MBA student can tell you, an increase in debt, all things being equal, increases the risk of bankruptcy. And yet, private equity portfolio companies outperform comparable companies when they do find themselves in a turnaround situation. How?

A study by McKinsey & Company shed some light on this phenomenon.

Simply put, private equity firms align management incentives and structure governance in their portfolio companies in such a way that problems are likely to be recognized earlier, and addressed more comprehensively, than in other companies.

Governance in particular is a strong factor. The study’s authors break this factor into three components:

  • Alignment. The Board of Directors engages with senior management to sets goals and timelines. CEO guidance is useful, but lack of CEO involvement does not slow the process.

 

  • Planning. The Board of Directors drives for information and sets reporting requirements. Management is held accountable and specific goals are set for the turnaround.

 

  • Execution. The Board of Directors works with the CEO to make decisions on senior management, then supports the senior management team as it seeks to execute the turnaround. Throughout this stage board involvement is much more proactive than it would be for a healthy company.

As a veteran of dozens of distressed situations, in roles including advisor, board member, and interim executive, I can definitively say that the overwhelming determinant of success in a distressed situation is prompt and decisive action.

Conclusion

Private equity has grown to be a major asset class and a force to be reckoned with across geographies, industries, and situations. As the asset class reaches middle age, private equity firms will need to address points of tension in their model, and the ripple effects for advisors, executives, portfolio companies, prospective targets, and strategic acquirers will be considerable. Understanding the roots of this asset class, the ways it generates values, and the changes that are in progress, is crucial for any market participant.

About the Author

David Johnson (@TurnaroundDavid) is founder and Managing Partner of Abraxas Group, a boutique advisory firm focused on providing transformational leadership to middle market companies in transition. Over the course of his career David has served as financial advisor and interim executive to dozens of middle market companies. David is also a recognized thought leader on the topics of business transformation, change management, interim leadership, restructuring, turnaround, and value creation. He can be contacted at: david@abraxasgp.com

Burger King Revival

burger-king

For years, Burger King was the sick man of the quick service restaurant industry.  A perennial laggard to McDonald’s in scale, the company was also widely seen as hamstrung by poor execution, a revolving door of leadership (Joe Nocera noted in 2012 that the company had had 13 chief executives in the prior 25 years) and an unclear strategic vision.

The company’s purchase for $1.5 billion by a private equity consortium of Bain Capital, Goldman Sachs and TPG in 2002 marked a brief resurgence, but when private equity firm 3G, acquired the company in 2010 (for $3.3 billion), Burger King was still seen as a troubled operator.

What a difference focused ownership can make.  Burger is now setting a grueling pace that its fellow quick service restaurant competitors are being pressured by Wall Street to match. 

3G’s playbook has been heavy on the fundamentals, and laser focused on solid execution. 

  • By refranchising restaurants, Burger King is challenging industry orthodoxy that a franchisor should operate a large number of its own restaurants.  Also, divesting those company owned restaurants has allowed Burger King to offload the capex requirements for those locations onto franchisees, boosting free cash flow.
  • Increased focus has been placed on international expansion, an area where Burger King had long been seen to be badly trailing McDonald’s and others. 
  • General and Administrative costs have been rationalized, creating further operating leverage to the business model. 
  • Increased focus has been placed on advertising and marketing. 

This approach is simple, but not easy.  The focus and clarity of vision that 3G seems to have infused into Burger King is generating excitement on Wall Street, while driving competitors (in particular McDonald’s, Wendy’s and Yum! Brands) to adopt similar approaches.

The example of Burger King highlights the value potential of an outside perspective paired with a simple yet audacious strategic plan.  In a market awash in capital, private equity firms will increasingly seek to execute value creation strategies premised not on simple financial engineering but on re-envisioning their portfolio companies, as 3G has done with Burger King.

About the Author

David Johnson is the founder of Abraxas Group, a boutique advisory firm focused on providing transformational leadership to companies in transition.  David has served as advisor or interim manager on over $5 Billion of distressed transactions, and is a recognized expert on the topics of value creation, change management, performance improvement, turnaround, and restructuring.  He can be contacted at david@abraxasgp.com or 312-505-7238.

The Demise of a Bad Deal

This post originally appeared in Business Insider

Victory has a thousand fathers, but defeat is an orphan.

– John F. Kennedy

Things seemed so simple in 2007. Energy company TXU looked like a sure-thing. Demand for energy was climbing. The company’s robust profitability suggested an ability to service a substantial debt burden. Throw in some operational efficiencies and TXU had the appearance of a golden opportunity for some of the biggest PE firms in the U.S. to ride increasing energy demands to riches.

It has not worked out quite that way. Following its purchase in 2007 in a $48 billion buyout, the company, now renamed Energy Future Holdings had its profitability crushed by the unset of large scale fracking and the accompanying collapse in natural gas prices. Arguably good management and savvy financial engineering are the only reasons that the day of reckoning has been put off as long as it has. Natural gas hedges minimized the pain in the early years after the buyout. And on the balance sheet side there have been several distressed exchanges and refinancings in specific tranches of the company’s $43.6 billion debt structure. But there is only so much that good management and creative financial engineering can do when faced with an investment thesis that has been proven false, and market expectations are that a bankruptcy filing is imminent.

Losses happen in investing, but it is interesting to see in this case the maneuverings of savvy investors on all sides.
• PE firms KKR and TPG Capital contributed $3.5 billion in equity to the original deal
• Goldman Sachs Capital Partners contributed $1.5 billion in equity
• $3.3 billion of equity was contributed by clients of KKR, TPG and Goldman, as well as Lehman Brothers, Citigroup and Morgan Stanley
• Investor Apollo Management Group, Oaktree Capital Group and Centerbridge Partners have taken considerable stakes in various tranches of the company’s debt, positioning themselves for an eventual ownership stake following a restructuring

Recent news suggests that that $8.3 billion equity commitment may, post-restructuring, shrink to an ownership stake of less than 3 percent. The pain is not limited to the equity in this deal, though. Moody’s recently reported that due to the sheer size and complexity of Energy Future Holdings’ restructuring, it would likely result in lowered recoveries across the capital structure.

With $270 million in interest payments due November 1, one of the largest non-financial bankruptcies in U.S. history is likely about to be filed. A successful chapter 11 reorganization will allow a way forward for the over-indebted company, but will be a black eye for investors floored by the punch they did not see coming.

About the Author

David Johnson (@TurnaroundDavid) is a partner with ACM Partners, a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services. He can be reached at 312-505-7238 or at david@acm-partners.com.

Private Equity: A New Approach

This article originally appeared in Business Insider

July 20, 2011

By David Johnson, ACM Partners

The markets have opened up enough that deals are getting done, but challenges remain for private equity investors looking down the road and asking the obvious question: how to generate attractive returns in this environment?  Increasingly the answer has been a heightened focus on operations.

This pivot from the traditional (though somewhat dated) view of private equity as being an industry composed of senior deal makers and junior model monkeys has been driven by a number of developments:

  • The diffusion of key deal-making skills has eliminated any competitive advantage based on deal-making / financial engineering acumen (at least in mature private equity markets).
  • As Adley Bowen at Pitch Book has noted, there are currently 4,500 private equity portfolio companies.  Many of those companies are not alone in their niche but find themselves competing against other well-funded private equity portfolio companies.
  • The recession of 2008-9 forced many private equity firms to implement significant operational changes in their portfolio companies.  This trying experience instilled an appreciation for the centrality of an operations focus in an entire generation of private equity professionals.

Private equity firms are managing this dynamic in different ways.  Larger firms such as KKR have developed in-house units, as KKR has done with Capstone.  Across the PE spectrum the role of operating partner has become increasingly common.  And of course advisors are often relied on to either provide this core competency or supplement private equity firms’ in-house resources.

In the face of low-growth in developed economies the impact of boring but impactful initiatives such as book of business analyses, centralized purchasing, increased IT infrastructure, etc. has shown itself to be a significant driver of value.  Growth stories are more exciting, and it is always nice when the blocking and tackling of performance improvement can be combined with a return to growth, but sometimes that is not possible.

At the end of the day, style points matter less in investing than returns, and returns generated from making portfolio companies leaner still count.