How Well Do GPs Bargain? Empirical Evidence On Private Equity Discounts In M&A Transactions

Stefan Morkoetter

University of St. Gallen – SoF: School of Finance

Thomas Wetzer

University of St. Gallen (HSG)

October 24, 2015

Abstract:

We assess the performance of private equity (PE) funds in M&A transactions in comparison to their strategic peers. Controlling for company and deal characteristics, we show that PE funds pay less, on average, than strategic buyers for comparable target corporations. This discount is consistent for all GP and fund characteristics. However, it is stronger for club deals and it disappears for acquisitions of private, non-listed targets. When selling their portfolio companies, PE firms receive only a premium compared to their strategic peers when selling in club deals, otherwise, they sell at comparable pricing levels to other strategic divestitures.

How Well Do GPs Bargain? Empirical Evidence On Private Equity Discounts In M&A Transactions – Introduction

Private equity (PE) funds outperform public equity markets by generating higher returns for their investors (see, for example, Kaplan and Schoar, 2005; Harris et al., 2014). In exchange for these superior returns, general partners (GPs) (e.g., the managers of PE funds) are richly compensated. In addition to a 1-2% management fee, GPs typically benefit from a carried interest of 20% for all realized returns. However, how do GPs actually generate these returns? Generally speaking, GPs can achieve these high returns at three different points of time: (i) when they acquire a portfolio company, (ii) during the holding period of a portfolio company or (iii) when they ultimately sell their investment. During the holding period, GPs create value for their funds’ investors by improving operational performance (e.g., EBITDA increases) or by using the company’s cash flow to pay back its debt (which increases the equity stake). Several studies (e.g., Achleitner et al. 2013; Axelson et al., 2013; Cumming et al., 2007) have targeted these two sources of value creation during the holding period; yet, we know little about whether and how PE funds buy portfolio companies for a comparably low price and sell them for a comparably high price. If PE funds are, indeed, able to buy a company at a discount and sell it at a premium in comparison to other (strategic) acquirers, this helps to explain the superior performance of PE funds in comparison to equity markets. Why might PE funds be better at buying and selling companies for low/high valuation levels than other acquirers (e.g., strategic firms)? In contrast to the model of most strategic M&A players, the very heart of the PE business model is buying and selling companies. Most GPs are involved in numerous deals per year; this allows them to acquire a high level of deal-making experience as well as relevant relationships and industry networks. In addition, strategic acquirers are often willing to pay a surcharge due to the prospect that they will achieve synergies in the acquired company. Potential synergies result in higher future cash flows, which in turn increase a company’s present value. PE funds do not benefit from such increases limiting the pricing level they are willing or able to pay.

Against this background, the main aim of our paper is to investigate whether PE funds, indeed, buy/sell companies ceteris paribus for a lower/higher valuation compared to strategic buyers/sellers. Based on deal level of 20,643 M&A transactions (including 4,402 PE transactions), we compare the M&A performance of PE funds and strategic buyers (sellers). Moving beyond existing research (e.g., Bargeron et al., 2008), which focuses on abnormal stock returns experienced by the shareholders of the acquirers or targets, we use the actual Enterprise Value (EV)/EBITDA multiples paid in M&A transactions to assess the performance of private equity buyers. The use of EV/EBITDA multiples allows us to (i) extend the empirical analysis beyond existing research to private non-listed companies and to (ii) assess the M&A performance of PE funds also on the exit side (the sale of a portfolio company). Moreover, it enables us to directly identify M&A performance by analyzing the exact transaction value paid rather than indirectly identifying such performance via abnormal stock returns.

Controlling for deal-related characteristics (volume, investment year, deal attitude, etc.) and company characteristics (industry, profit, asset size, etc.), we find that PE buyers enforce a discount for their portfolio companies compared to strategic buyers. We obtain a logarithmized discount of 0.23, which translates into a 20% discount received by PE firms1. The discount in-creases in club deal situations (PE funds join forces to acquire a company). PE funds do not suc-cessfully bargain for a discount in private transactions but only in public transactions. This is of interest because private transactions are often proprietary transactions and because PE funds ar-gue that these situations are particularly beneficial for achieving high returns. Due to the required public disclosure provisions, the takeover of a publicly listed entity in turn is never a proprietary transaction. On the exit side, we observe a different picture: in contrast to the results for purchas-es, PE funds do not achieve higher multiples compared to sell-offs initiated by strategic sellers. PE funds may not be able to receive a premium for their investors when selling their portfolio companies; however, because they sell at market values (and not, for example, at a discount), they are able to lock in the discount generated on the entry side for their investors. This, in turn, positively correlates with higher fund returns and helps to explain PE’s outperformance of pub-licly listed equity. In the second step of our empirical analysis, we link deal-level information to PE fund- and PE firm-level characteristics (e.g., fund size or fund strategy) to understand wheth-er the observed PE discount relates to specific funds or holds for all PE funds/PE firms. Our re-sults confirm that the observed discount is an industry-wide pattern that is not limited to a set of specific PE funds.

M&A Transactions

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