Four years ago, BCG identified a shift in the private-equity industry away from leverage and toward operational improvement as the primary source of value creation. (See The Advantage of Persistence: How the Best Private-Equity Firms “Beat the Fade,” BCG report, February 2008.) Since then, private-equity firms have been experimenting with a variety of operating models in order to increase their capacity to create value by improving the operations of their portfolio companies.
So far, their efforts have been extraordinarily successful. We recently analyzed the operational performance of 89 U.S. and European private-equity deals that were closed between 1998 and 2008 and exited between 2005 and 2011. This sample represents all deals with a minimum enterprise value of €500 million (approximately $670 million) at exit and for which data were available from entry to exit. We found that more than two-thirds of these deals (70 percent) generated an absolute increase in annual earnings before interest, taxes, depreciation, and amortization (EBITDA) of at least 20 percent—and nearly half the deals generated annual EBITDA growth of 50 percent or more.
Exhibit 1 clusters these 89 deals into eight groups on the basis of the change in the amount of annual EBITDA each deal generated and shows both the average multiple the private-equity firms paid to acquire the companies in each group (the right-hand vertical axis and orange line) and the change in that multiple at the time the firms exited the deals (the left-hand vertical axis and green line). This analysis demonstrates that the deals with the highest absolute EBITDA growth were also those for which private-equity firms paid the highest multiples—suggesting that the firms already had a clear idea before the deal about how they would improve the target company’s EBITDA, how much EBITDA growth they were likely to generate, and therefore what a “fair” premium would be, on the basis of the target’s EBITDA growth potential. Because of the relatively high average premium, the median deal in this group created no value through multiple expansion.
We believe that market conditions are accelerating this trend toward making operational value the primary source of value created by private-equity firms. Exhibit 2 portrays three key trends in the private-equity market. First, premiums paid by firms are rising. This trend is driven in part by all the “dry powder” that has built up in private-equity funds during the global crisis and that is competing for a relatively small number of deals. Only about 13 percent of the money raised in vintage year 2010 funds—and just 1 percent of vintage year 2011 funds—has been invested so far. Second, when one combines these uninvested funds with the trillions of dollars that public companies have accumulated on their balance sheets and that are also available for use in the M&A market, it is unlikely that premiums will come down anytime soon. Third, while leverage levels (measured as a ratio of debt to EBITDA) have recovered from their postcrisis lows, the market remains challenging at the end of 2011.
Low levels of debt and ever higher acquisition premiums mean that private-equity firms will be unable to count on leverage or multiple expansion as major sources of value in the immediate future. Thus, improvements in fundamental value, as reflected in growth in EBITDA, are the only sure source of value creation. What’s more, the wave of cost cutting at companies in response to the Great Recession has led to a paucity of opportunities in which fundamental value can be generated rapidly by cutting costs. Thus, a successful private-equity firm will increasingly have to generate EBITDA growth by growing its portfolio businesses.
How much EBITDA growth? We developed a simple model to estimate the amount of EBITDA growth that would be necessary in the current market environment for private-equity firms to realize an internal rate of return (IRR) of 25 percent.
We assumed an entry multiple of 8.5 times EBITDA (the average of reported deals in the first half of 2011) and assumed that that multiple would remain unchanged at exit, a practice that is typical in private-equity investment plans. We also assumed a debt multiple of 4.5 times EBITDA and an interest rate on that debt of 400 basis points over the London interbank offered rate (LIBOR). We assumed capital expenditures of 2.5 percent of net revenue. Finally, for simplicity’s sake, we assumed an all-cash tax rate of 26 percent of income, and no additional investment in working-capital productivity.
Using these relatively conservative assumptions, a firm would have to generate a compound annual EBITDA growth rate in its portfolio companies of 11 percent over a five-year period. To understand just how challenging a hurdle that figure is, consider that the only times in recent history that the earnings of either the S&P 500 or London’s FTSE index surpassed this five-year compound annual growth rate were in the five-year periods ending in 2006 and 2007 (for the S&P 500) and 2006 through 2008 (for FTSE), during the bubble that preceded the 2008 global financial crisis. Given the likelihood that the global economy (and, in particular, the developed world) has entered an extended period of below-average economic growth, this hurdle represents a substantial challenge to the private-equity industry.
The limited partners who invest in private-equity funds realize that the operational capabilities of individual private-equity firms will be critical in meeting this goal—and the firms themselves realize that these capabilities are under increasingly intense scrutiny.
In order to learn how private-equity firms are organizing to deliver that degree of operational value, BCG recently interviewed more than 25 general partners, operating partners, and associated portfolio-company CEOs at 15 private-equity firms in the United States and Europe. (See Exhibit 3.) We identified three major developments in the industry:
Private-equity firms have been experimenting with a range of models for delivering operational value, reflecting different organization structures and divergent understandings of the fundamental relationship between the private-equity firm and its portfolio companies.
Irrespective of the operating model, there is a growing standardization of operational-improvement practices at some private-equity firms. That standardization, however, is limited mainly to initiatives that improve the bottom line at portfolio companies. When it comes to business-building activities that grow the top line and are critical for the future, most private-equity firms are still struggling to develop a replicable approach.
Successfully creating operational value will require a new kind of partnership between general partners (also commonly known as deal partners), operating personnel, and portfolio company CEOs. That partnership will involve new ways of teaming, with more explicitly defined roles and responsibilities. And it will require the professionalization of key management processes at private-equity firms. Increased professionalization is critical to the long-term sustainability of the private-equity business model.
In this report, we describe private equity’s growth challenge, discuss the strengths and weaknesses of the various operating models currently found in the industry, and make the case for why even more standardization and professionalization are in the industry’s future.
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