Value Creation in Private Equity

Markus Biesinger is Associate, Private Equity at the European Bank for Reconstruction and Development; Çağatay Bircan is Senior Research Economist at the European Bank for Reconstruction and Development; and Alexander Ljungqvist is the Stefan Persson Family Chair in Entrepreneurial Finance at the Stockholm School of Economics. This post is based on their recent paper.

Private equity (PE) firms are often said to use their industry expertise and operational know-how to identify attractive investments, to develop value creation plans for those investments, and to generate attractive investors returns by implementing their value creation plans. Although many studies refer to such value creation plans, there is no systematic evidence on what these plans typically look like or whether they help improve company operations or investor returns.

In a recent paper, we open up the black box of value creation in private equity with the help of confidential information on value creation plans and their execution. We find that plans are tailored to each portfolio company’s needs and circumstances and have become more hands-on. Successful execution varies systematically across funds and is a key driver of investor returns. Company operations and profitability improve in ways consistent with successful execution, even beyond PE funds’ exit.

We draw on a sample of 1,580 emerging-markets deals by 171 PE funds raised between 1992 and 2017 to provide systematic evidence on value creation. The unique advantage of our data is that we have access not only to precisely dated cash flows and other quantitative data about the portfolio companies but also to rich textual information in the form of proprietary pre-deal investment memos and investment-committee presentations and confidential quarterly post-investment reports provided to a fund’s limited partners (LPs). We combine the quantitative data with the textual information to document what PE firms’ value creation plans look like, what determines whether or not a plan is achieved, and which value-creation strategies are associated with higher returns to investors.

A value creation plan (VCP) consists of one or more “action items.” We track 23 distinct action items, which we group into five strategies: operational improvements (84% of sample deals), top-line growth (74%), governance engineering (48%), financial engineering (35%), and cash management (14%). We document systematic variation in VCPs over time and by deal type, fund ownership, growth strategy, and geographic focus. All five strategies have become more popular over time, suggesting that PE firms have become more hands-on.

Our data allow us to track the implementation and achievement (or otherwise) of each action item over time. PE firms typically manage to implement the majority of their action items and strategies, though we see variation in achievement rates. Our findings suggest that successful execution is subject to resource constraints. PE firms typically employ highly skilled “operating partners” who help with implementation and whose skills are plausibly in scarce supply in the short term. We find evidence of economies of specialization, in the sense that an action item is more likely to be successfully implemented if the fund’s other deals pursue related actions. We also see diminishing returns to making plans ever more detailed. Finally, we find systematic variation in achievement rates across funds. Specifically, funds with focused, homogeneous portfolios of predominantly minority positions are systematically better at implementing their value creation plans than are other funds.

We link investor returns to VCPs to examine whether some strategies are associated with higher returns to investors than others. This analysis reveals a novel finding: it is not the ex ante selection of strategies that matters so much as the successful implementation of the chosen strategies. In other words, execution is the key to achieving high returns for investors. We base this conclusion on the results of two complementary analyses. The first is a LASSO analysis, a popular machine-learning prediction model which we use to identify the ex ante and the ex post strategy combinations that best predict investor returns out of sample. The LASSO analysis shows that no single strategy is systematically associated with higher or lower returns; instead, returns depend on how strategies are combined. Our second analysis, which focuses on identifying return drivers in-sample rather than on predicting returns out-of-sample, reinforces this conclusion. We find that successful implementation of planned action items is strongly associated with higher investor returns in the cross-section, especially in growth, buyout, and secondary deals.

We take seriously the possibility that PE firms may strategically skew their reporting to their investors in ways that falsely attribute deal success to superior execution and deal failure to external circumstances beyond their control. To this end, we benchmark portfolio companies to observably similar propensity-score-matched control firms. Using this matched sample, we show that during the investment period, portfolio companies experience the kinds of changes in operational metrics, top-line growth, financial metrics, and cash management that would reflect the successful implementation of PE firms’ value creation plans. A novel finding is that most of these changes turn out not to be temporary: they persist even after the PE firms exit their investments.

As further corroborating evidence against strategic reporting, we investigate whether the changes portfolio companies experience during the holding period help explain the cross-section of realized investor returns. This reveals that investors earn higher returns the more a portfolio company increases its sales, EBITDA, employment, and capital intensity during the holding period.

The complete paper is available here.

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One Comment

  1. MJR
    Posted Friday, June 5, 2020 at 2:16 pm | Permalink

    I have a question on the findings related to minority funds (paraphrased) being systematically better at implementing their value creation plans – was anything done to control for CEO or executive ownership? I would think that additional executive ownership (specifically CEO ownership) would improve outcomes. Minority funds tend to have management teams that own more of the business and therefor are more incentivized to execute on the value creation plan. I saw that ownership concentration and number of owners were evaluated but did not see an evaluation of executive ownership and the impact that has on returns.