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E-MailVladimir Mukharlyamov is Assistant Professor of Finance at the McDonough School of Business at Georgetown University. This post is based on a forthcoming article by Professor Mukharlyamov; Paul A. Gompers, Eugene Holman Professor of Business Administration at Harvard Business School; and Steven N. Kaplan, Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business.
Our new article, What Do Private Equity Firms Say They Do?, is the largest survey of private equity (PE) investors to date. While there has been much academic work on the effects of private equity, there has been relatively little analysis of actions taken by PE fund managers. We seek to fill this gap by surveying 79 private equity investors with combined assets under management of more than $750 billion about their practices in firm valuation, capital structure, governance, and value creation. Because PE investors are highly educated, have strong incentives to maximize value, and have been very successful, their practices likely also have been successful. We ask a simple question—do private equity investors do what the academy says are best practices?
Our sample represents private equity firms across a spectrum of investment strategies, size, industry specialization, and geographic focus. We ask the PE investors questions about financial engineering—how they value companies and how they think about portfolio company capital structures and management incentives; governance engineering—how they think about governance and monitoring; and operational engineering—how they think about value creation, both before and after closing the transaction. We also ask questions about the organization of the private equity firms themselves. Finally, we explore how the actions that PE managers say they take group into specific firm strategies and how those strategies are related to firm founder characteristics.
Our main conclusions are as follows:
- Despite the prominent role that discounted cash flow valuation methods play in academic finance courses, few PE investors use discounted cash flow or net present value techniques to evaluate investments. Instead, they rely on internal rates of return (IRRs) and multiples of invested capital (MOICs).
- Surprisingly, the PE investors believe that their limited partners (LPs) are more focused on absolute performance than on relative performance or alphas. This is puzzling given that private equity investments are often equity investments for which equity-based benchmarks such as public market equivalents (PMEs) are appropriate.
- Our results on capital structure are more consistent with academic theory and teaching. In choosing the capital structures for their portfolio companies, PE investors appear to rely equally on factors that are consistent with capital structure trade-off theories and those that are consistent with market timing.
- PE investors are focused on providing strong equity incentives to their management teams and reorganizing governance structures of their portfolio companies. They regularly replace top management, both before and after they invest. And they structure smaller boards of directors with a mix of insiders, PE investors, and outsiders.
- PE investors say they place a heavy emphasis on adding value by increasing revenue, improving incentives and governance, facilitating a high-value exit or sale, making additional acquisitions, replacing management, and reducing costs.
- Different firms employ a different mix of financial, governance, and operational engineering. These investment strategies are strongly influenced by the career histories of the private equity firm founders. It will be interesting (and, with our data, possible) to see which of these strategies, if any, exhibit superior performance in the future.
The full article is available for download here.
