Corporate Governance and Value Creation

In the paper, Corporate Governance and Value Creation: Evidence from Private Equity, forthcoming in the Review of Financial Studies, my co-authors (Oliver Gottschalg, Moritz Hahn, and Conor Kehoe) and I attempt to bridge two strands of literature concerning PE, the first of which analyzes the operating performance of acquired companies, and the second that analyzes fund IRRs. In addition, we investigate how human capital factors are associated with value creation in PE deals. We focus on the following questions: (i) Are the returns to equity investments by large, mature PE houses simply due to financial leverage and luck or market timing from investing in well-performing sectors, or do these returns represent the value created at the enterprise level in the so-called portfolio companies, over and above the value created by the quoted sector peers? (ii) What is the effect of ownership by large, mature PE houses on the operating performance of portfolio companies relative to that of quoted peers, and how does this operating performance relate to the financial value created (if any) by these houses? (iii) Are there any distinguishing characteristics based on the background and experience of PE houses or partners involved in a deal that are best associated with value creation?

To answer the first question, we account for the impact of leverage on returns by breaking down the deal-level equity return, measured by the IRR, into two components: the un-levered return, and an amplification of this un-levered return by deal leverage. Next, we subtract from the un-levered deal return the un-levered return that the quoted peers of the deal generated over the life of the deal, the latter representing luck or the ability to time markets in PE investments. The difference between these two un-levered returns is what we call “abnormal performance”: a measure of a deal’s enterprise-level outperformance relative to its quoted peers, removing the effects of financial leverage. We hypothesize, and later show, that a deal’s abnormal performance captures the return associated with changes in operating performance of the portfolio company, as well as human capital factors such as a deal partner’s skill.

We apply this methodology to 395 deals closed during the period 1991 to 2007 in Western Europe by thirty-seven large, mature PE houses (each with funds larger than ~$300 mil) with a mean, gross IRR of 56.1%. We find that, on average, about 34% (19.8% out of 56.1%) of average deal IRR comes from abnormal performance, another 50% (27.9% out of 56.1%) is due to higher financial leverage, and the remaining portion (16% out of 56.1%) is due to exposure to the quoted sector itself. Although abnormal performance has substantial variation across deals, it is positive and statistically significant on average, even during periods of low sector returns. This is consistent with the view that large, mature PE houses generate higher (enterprise-level) returns compared with benchmarks. Regarding the second question, we find that ownership by large, mature PE houses has a positive impact on the operating performance of portfolio companies, relative to that of the sector. In particular, during PE ownership the deal margin (EBITDA/Sales) increases by around 0.4% p.a. above the sector median, and the deal multiple (EBITDA/Enterprise Value) increases by around 1 (or 16%) above the sector median.

We interpret the operational improvements as causal PE impact, since we find no evidence for a violation of the strict exogeneity assumption of the PE acquisition decision. That is, we assume—and later confirm—that there is nothing inherent in the companies targeted by the PE firms in our sample that would have caused their operating performance to improve without being acquired by private equity. In addition, we examine the impact of major merger and acquisitions (M&A) events during the private phase on operational performance during the same period, since M&A events can generate—due to their direct impact on the operational measures—a considerable distortion of underlying operational performance. However, we still find margin and multiple improvements above sector when we separately analyze deals with and without M&A events. We then provide evidence that higher abnormal performance is associated with a stronger operating improvement in all operating measures relative to quoted peers: we find that sales growth, EBITDA margin, and multiple improvement are important explanatory factors for abnormal performance.

Overall, this evidence is consistent with the assertion that top, mature PE houses create economic value through operational improvements. Such improvements require skill, and the return to this skill may explain the persistent returns these funds generate for their investors (Kaplan and Schoar 2005). This brings us to our final question, in which we study whether characteristics of the deal partner affect deal performance. We use deal partner background and experience as a human capital or skill factor that may be relevant to deal success; the econometric advantage of using this factor is that it is fixed, or time invariant, and hence exogenous (except for the matching of deal partners to specific deals).

We find evidence that there are combinations of value creation strategies and partner backgrounds that correlate with deal-level abnormal performance. Deal partners with a strong operational background (e.g., ex-consultants or ex–industry managers) generate significantly higher outperformance in “organic” deals. In other words, partners who work as managers in the industry or as management consultants before joining a PE house appear to accumulate skills to improve a company internally by, for example, cutting costs or expanding to new customers and new geographies. In contrast, it appears that partners with a background in finance (e.g., ex-bankers or ex-accountants) more successfully follow an M&A-driven, “inorganic” strategy.

One could argue that we studied deals only from the funds we sampled, which might have been cherry-picked by the PE fund. We show that this is not the case. While we have a bias in our sample for large PE funds, this is by design given that we wished to understand what drives their persistent outperformance. However, within the funds we sampled for our deals, we find no statistically significant bias between the performance of deals sampled and those not sampled.

The full paper is available for download here.