Understanding Private Equity 3.0
In this article, we explore returns achieved throughout the different eras of Private Equity’s evolution. We also detail various strategies that firms can take to successfully transition into the third stage of the industry, “PE 3.0.”
Private Equity Since Its Inception
Leveraged buy outs (LBO’s) became popular in the 1980’s, as high yield debt became more accessible for private equity companies. The start of the boom is typically marked by the buyout of Gibson Greeting in 1982, and the peak is marked by the takeover of RJR Nabisco by KKR, one of the defining moments of the first boom. The RJR Nabisco takeover was, at the time, the largest ever LBO, giving rise to private equity in the public consciousness.
In the late 1980’s and early 1990’s the high-yield debt market, which was used to finance these acquisitions collapsed, due to the high rate of default among junk bond issuing companies. After this, yields on junk bonds greatly increased, reducing the viability of leveraged strategies. Many of these high-profile buyouts did not end up being successful, but introduced the idea of financial engineering to the private equity world; something that many different firms ran with as a means of producing high IRR’s.
These early PE firms typically went after mid-size public companies in a variety of industries, taking profits through financial engineering, and exiting via IPO’s. However due to the high leverage used on these transactions, typically in the 85-90% range, deals regularly failed. Money, however, kept coming in, as successful deals had high rates of return. The strategies most prevalent around this time involved significant restructuring and asset stripping, to pay down debt, leading to the moniker of “corporate raiders,” or from the RJR Nabisco merger, popularized through the well-known book and film, Barbarians at the Gate.
Around 1993, private equity began to take off again, during this time the industry began to change. Gone was the period of hostile take overs and asset stripping, as it began to take the shape of modern PE. During this time, leverage in deals went from the 85-95% seen in the 1980’s to a more manageable 60-80%. Firms also began to invest more in capital expenditures, and started positioning companies more towards growth, providing management incentives to build long term value. This also corresponded with debt being provided by more syndicated leveraged finance units inside banks, than by private junk bond operators.
The early 2000’s started with the bursting of the tech bubble, and with it, tight credit markets. An overall pessimistic view pervaded most parts of the economy during this period, especially limiting the growth of private equity firms. As the crash faded, however, credit markets started to open up again, ushering a new PE boom.
This second boom had similar aspects to the last one. Now, however, more emphasis was placed on smaller companies, including those in the middle market. The biggest change during this time resulted in leverage being priced into companies. As a result of heightened public awareness of the industry, firms across all sectors now realized that funding acquisitions with debt made sense, and the move became standard to sophisticated financial players. As a result, PE firms realized that success in the field would require more than just loads of debt, leading them to focus more on operational and governance engineering.
At its core, operational and governance engineering, starts with aligning the incentives of the management teams of portfolio companies and their investors, putting everyone on the same footing. In addition to that, on the governance engineering side, PE investors control the boards of the companies they are on, and take a strong, active management role inside those companies. And in operational engineering, PE firms de-risk companies by building platforms and expanding their customer and supplier bases, leveraging both organic and inorganic means. They further de-risk by adding in new management and professionalizing the company, thereby transitioning the company from a more entrepreneurial culture to a corporate one (this is especially pronounced when PE companies buy founder-led firms).
The issue with these different strategies being disseminated across the market is that as they become more known, they also become less effective. Returns are priced into the companies themselves, and average EBITDA multiples go up. This requires companies to implement other strategies to increase returns in the PE space. While this is especially true at the upper end of the spectrum, it is still possible to find deals in the lower middle market based on financial, operational, and governance engineering.
Today the PE space is looking a little different than it did during the boom years that followed the depths of the financial crisis. With rates rising, and expected to stay at an elevated level, deal flow is has slowed down. Easy credit has ended, and taking high levels of debt is now cost prohibitive to firms that need an abundance of leverage. This means that more and more firms are now having to look more towards EBITDA multiple expansion and EBITDA growth to create returns that outperform the market.
As interest rates have risen, a credit crunch has come into play. This is being especially exacerbated by the regional banking crisis. Historically, as banks become concerned, they tend to focus more heavily on quality of loans. Currently this is affecting the syndicated credit market and pushing PE debt to come from more private credit shops rather than traded debt. In the short term the tightening credit conditions will lead to lower leverage multiples on purchase prices. Additionally, due to the regional nature of the current banking crisis, middle-market firms look like they will be most affected based on the fact that they often receive funding from regional banking players.
Current financial research suggests that the historic boom and bust cycles of private equity are closely linked to the credit market. The prevailing belief is that for private equity to be in boom, earnings yield for portfolio companies must be higher than high yield debt. There are two primary reasons for this thinking. The first is based on the inherent risk profile of PE. If, for example, a relatively safe liquid asset is returning a higher yield than what can reasonably be made in a more illiquid and risky asset class, funds will flow into the former. The second is predicated on the fact that PE firms, and especially buyout funds, tend to use a large portion of high yield debt to fund their purchases. Intuitively if operating returns are lower than the debt yields, it does not make sense to use debt to make these purchases. It is also important to note here that historically, multiple expansion has been a driver, albeit a spotty one, to drive growth for portfolio companies. With the valuations of firms coming down in today’s uncertain environment, this can be a useful play for PE firms.
Moving forward in PE 3.0, as funds can no longer drive returns from leverage and a rising market, they will need to look towards different options. Right now, when trying to maintain high levels of IRR, there are two main options to consider. The first is to increase the operational efficacy of the firm. This can be accomplished either in the traditional way, through an operating partner arrangement, or by using a more aggressive approach involving a team of specialized workers, either internally or externally. The second is to take on more risk in deals done. This can be achieved through several different strategies, including specializing, moving into more special situations, buying back debt, and holding portfolio firms for longer.
Improving the operations of portfolio companies is complex work that takes time, energy, experience and resources. The most common solution that private equity firms utilize is a top-down approach anchored by an operating partner, typically an individual that has experience in an executive level operating role at a large company. Some PE firms, however, utilize a bottom-up approach, which allows for more aggressive improvements to be made in a shorter time. For added perspective, this approach is most like the method that global conglomerate, Danaher Corporation, has successfully used to improve operations at the companies it acquires.
In the top-down approach, PE firms sacrifice total operational improvements for the cost and ease of implementing changes. Typically, the firms that use operating partners only have a handful of those individuals (about equal to the number of directors and managing directors that the firm has on the investment side). This approach can, and does, generate returns in the form of EBITDA revenue expansion, and professionalization of the company. Returns in a top-down approach are often limited, however, by the composition and cost associated with the very senior level internal operating partner staff required for such efforts.
The bottom-up approach to improving operations in a portfolio company entails having a team of consultants, either internal to the PE firm or contracted out to help build up the operations of different firms that a company buys. The internal team is more common in large organizations and is especially prevalent in firms that buy and hold companies for a long period of time, or ones with plans to integrate the firm into their broader company.
As referenced earlier, Danaher is among the most notable companies that successfully leverage a bottom-up approach. Its strategy is typically to buy a company and send in a team of consultants to help professionalize and align the business with their culture, as well as to add lean and continuous improvement to those businesses.
Though this is a costly approach in the short term, the results that it can provide are exceptional, given that culture and efficiency can make or break a firm. The bottom-up approach allows for a focus on improving EBITA and revenue growth, as opposed to the financial and governance engineering seen in the earlier methods of private equity.
Beyond the use of a PE firm’s own internal teams to achieve these goals, identifying and leveraging proven external resources can enable funds with lower deal flow to scale up relatively quickly and maintain a lower fixed cost for these services. At Hilco Performance Solutions, we have frequently served in this capacity, leveraging the many resources of the Hilco Global platform of companies to drive value for PE firms and their portfolio businesses. The following chart illustrates the depth and breadth of expertise that such an approach can provide.
Additional Strategies for PE Firms
In addition to improving the operations of portfolio companies, pursuing strategies other than the stock Leveraged Buyout (LBO) can also increase returns. Some of the more common alternatives that firms pursue are 1) holding portfolio firms for a longer period than the standard 5-7 years, 2) investing in special situations, such as winddowns or distressed companies, and 3) buying back the debt of portfolio companies.
Holding a portfolio business for longer than typical 5 to 7 years is a move that can help PE firms maintain a higher level of return while using less leverage, as the cashflows from the business are maintained for longer. This is common in family offices, where committed capital is held for a longer period. This option is, of course, also available to PE firms and aligns with the bottom-up growth strategy as it provides more time to make significant changes to the operational structure of the portfolio firm.
There are risks to this strategy as well. Perhaps most notable among these is that when holding a company for a longer period, unless cashflows are high and consistent, PE firm IRR can be driven down. Additionally, holding a business over an extended timeframe makes it more susceptible to risks from the macro environment. This can, in some cases, result in a need to either hold the business past the intended sell date, or sell the business at a lower than intended multiple.
Special situations make up a unique segment of the PE world, and typically involve businesses that are experiencing inflection points. PE’s role in these situations can vary from running a distressed business as a going concern, buying bulk assets from a company to sell, or conducting a winding down. Versatility and adaptability are essential attributes for firms that seek to successfully navigate these special situations with the end goal of driving value and maximum return.
Working with distressed companies is usually a complicated endeavor but can often lead to very rewarding outcomes. Typically, these special situations involve companies in need of significant work before they can turn a positive cashflow, let alone be sold. This type of work is well suited to PE firm with specific internal experience working with management and to those who align themselves with proven third-party operational partners to enhance the operations of portfolio firms. This need and the associated expertise is particularly relevant now, during the current economic softening.
Acquiring assets can typically fall under the purview of liquidators or wholesale asset sellers. Partnering with a firm that not only specializes in these efforts but also has proven expertise providing a range of other complementary solutions can be of tremendous value to PE firms. The ability to precisely value these assets up front and efficiently market them to known, qualified buyers can greatly enhance outcomes. Additionally, access to the dry powder of a third-party partner firm can enable assets to be sold more slowly and strategically as part of winding down a going concern business.
Unlike more traditional deals where a PE firm has limited control over the capital stack, private capital deals provide a firm with full control over the entire capital stack of the company. This provides a strategic advantage through optimization of the financing mix, making it a unique and appealing strategy for firms seeking diversity in their investment returns.
In a typical private capital deal, when a company is purchased by a firm at around an 8x EBITDA multiple, the multiple will generally include the following components: two turns of ABL, two turns of cash-based lending, two turns of mezzanine debt (typically funded by private credit), and two turns of equity financing. This strategy is often utilized during credit crunches when banks are pushing for lower levels of leverage in deals.
Private capital provides the PE firms with the autonomy to choose their own capital stack. This results in a reduction debt level requirement while still maintaining a high amount of leverage. Consequently, this reduces the reliance on external capital from LPs and enhances returns. As a result, PE firms are strategically positioned in the shadow banking realm, operating discreetly beyond the capabilities of traditional banks. A subset of this strategy involves companies buying back the debt after market conditions change, which will address in the following section.
Buying back portfolio debt is a strategy that is gaining popularity in today’s rising interest rate environment. As interest rates have risen, debt taken out at the rock bottom rates seen during the pandemic is becoming an unattractive asset for banks. This is leading some firms to buy back portfolio debt from their lender at steep discounts to face value. Though this is a more common play in the syndicated loan market, there seem to be such opportunities at all levels of debt, and capitalizing on those now can be especially attractive for firms with excess dry powder and a lack of available investment options.
The Right Expertise is Critical
For the many reasons outlined above, engaging an experienced third-party partner is essential to successful portfolio company value creation for a wide range of PE firms. Hilco Performance Solutions (HPS) is a comprehensive consulting service providing third party business transformation expertise in the areas of operations, supply chain, people, mergers & acquisitions and commercial lending.
By combining our advisory experts with highly qualified industry veterans from across the Hilco Global platform of companies (including those from Hilco Corporate Finance, our registered investment banking affiliate) we are able to provide an unmatched and ideally suited combination of talent to get any portfolio company assignment done efficiently and effectively. While many in our industry focus on strategy and leading theory, Hilco Performance Solutions focuses on operationalizing business strategy through action, working in the trenches alongside our clients, and translating strategy into actual results. We encourage you to reach out to our team to confidentially discuss any challenges you may currently be facing within your PE portfolio businesses. We are here to help.