What do Private Equity Firms Do?

Gompers, Paul, Steven N. Kaplan, and Vladimir Mukharlyomov, “What do Private Equity Firms Do?” The American Finance Association 75th Annual Meeting, Boston (2015).

Purpose:  To describe the investment behavior of private equity firms (not including venture capital), and compare that behavior to academic theory.

Findings:

  • P/E firms use internal rates of return and multiples of invested capital, rather than discounted cash flows and the CAPM, to value acquisition targets.
  • They usually look for internal rates of return between 20% and 25%,
  • P/E firms use comparable company multiples to calculate exit value, instead of discounted cash flows.
  • P/E firms choose the capital structure of their portfolio companies based on
    • The company’s industry (100% of P/E firms)
    • current interest rates (100%)
    • the tradeoff between the debt tax shield and default risk (67%)
    • the maximum amount of debt the market will buy (67%)
    • the ability of debt to force operational improvements (40%)
  • They plan to improve the operations of their acquisitions, but do so more by increasing growth than by cutting costs.
    • management incentives
      • P/E firms give 8% of company equity to the CEO, and 9% to the remaining managers and employees.
    • Governance
      • P/E firms prefer boards of directors of between 5 and 7 members, with the P/E firm supplying 3 of those.
      • 58% supply their own management teams after the acquisition.
    • Deal Selection
      • Of 100 opportunities, P/E firms deeply investigate 24 and close on 6.
      • Almost half of closed deals are “proprietary,” meaning the P/E executives sourced the deal themselves.
      • Criteria for evaluating investment opportunities, in order of importance, are
        • the business model and competitive position
        • the management team
        • the P/E firm’s ability to add value
        • the target’s valuation
    • Value Creation
      • Increasing revenue is important in 70% of deals.
      • Follow-on acquisitions are important in 50%.
      • Reducing costs is important in 36% of deals.
      • Changing company’s business model or strategy is key in 33%

Conclusions

  • P/E firms in the 1980s focused on cost-cutting and decreasing agency costs through very high leverage.
  • P/E firms today prefer to increase revenue and improve governance, and do not use so much leverage.
  • P/E firms are more industry-focused today than they were in the 1980s.
  • They devote significant resources to improving operations in their portfolio companies.
  • P/E firms have outperformed benchmarks for 30 years, and their executives tend to be educated at the best business schools, so their behavior likely identifies best-practices.
  • They do not use DCF valuation techniques, suggesting that DCF methods are either made redundant by IRR-based valuation, or that they are deficient.
  • P/E firms’ limited partners care more about absolute return than performance relative to a benchmark.

Data is from a survey of 79 private equity firms (64 of whom responded in full, representing $600 billion in assets).