Private Equity Value Creation
It is commonly believed that private equity firms have an ability to add more value to their portfolio companies than do publicly governed firms. The sources of this increased value is assumed to come from three different sources:
- The ability to re-engineer the portfolio company and operate it more efficiently
- The ability to obtain debt financing on more advantageous terms
- Superior alignment of interests between management and private equity ownership
On this page, we discuss these sources of value creation in private equity in more detail. Together they explain why private equity is able to generate exceptional returns with low volatility.
Re-engineering the portfolio company
The first source of value creation is re-engineering the portfolio company. In order to financially re-engineer a company, many PE firms have an in-house staff of experienced former industry CEOs, CFOs, and other former C-member executives. These executives can share their expertise and contacts with portfolio company management.
Obtaining favourable debt financing
A second source of added value comes from achieving more favourable terms on debt financing. During the period before the great financial crisis (GFC), the availability of cheap credit with few covenants led many private equity firms to use debt for buyout transactions.
In PE firms, debt is more heavily used. It is typically quoted as a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) as opposed to a multiple of equity, as for public firms.
Traditional finance, in particular the Modigliani-Miller theorem, states that the use of debt versus equity is inconsequential for firm value. However, once the assumption of no taxes is removed from this particular model, then the tax savings from the use of debt (interest tax shield) increases firm value. The use of greater amounts of financial leverage may increase firm value in the case of private equity firms.
Because private equity firms have a reputation for efficient management and timely payment of debt interest, this helps to alleviate concerns over their highly leveraged positions and helps maintain their access to debt markets.
The use of debt is thought to make PE portfolio companies more efficient. According to this view, the requirement to make interest payments forces the portfolio companies to use free cash flow more efficiently because interest payments must be made on the debt.
Much of the debt financing for PE comes from the syndicated loan market, but the debt is often repackaged and sold as collateralized loan obligations (CLOs). Private equity firms may also issue high-yield bonds which are repackaged as collateralized debt obligations (CDOs). Both types of derivatives played a central role during the global financial crisis.
Alignment of interests
The third source of value added for PE firms is the alignment of interests between private equity owners and the managers of the portfolio companies they own. This is typically done using covenants and bonuses to ensure that the management of the portfolio company tries to manage the company as efficiently as possible.
Summary
We discussed the three main sources of value creation in private equity.