What Do Private Equity Firms Say They Do? via SSRN
Harvard Business School – Finance Unit; Harvard University – Entrepreneurial Management Unit; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)
University of Chicago – Booth School of Business; National Bureau of Economic Research (NBER)
April 27, 2015
Harvard Business School Entrepreneurial Management Working Paper No. 15-081
We survey 79 private equity investors with combined AUM of over $750B about their practices in firm valuation, capital structure, governance, and value creation. Investors rely primarily on IRR and multiples to evaluate investments. Their LPs focus more on absolute performance. Capital structure choice is based equally on optimal trade-off and market timing considerations. PE investors anticipate adding value to portfolio companies, with a greater focus on increasing growth than on reducing costs. We also explore how the actions that PE managers say they take group into specific firm strategies and how those strategies are related to firm founder characteristics.
What Do Private Equity Firms Say They Do?- Introduction
The private equity (buyout)1 industry has grown markedly in the last twenty years and academic research has increasingly focused on the effects of private equity. What has been less explored are the specific analyses and actions taken by private equity (PE) fund managers. This paper seeks to fill that gap. In a survey of 79 private equity firms managing more than $750 billion in capital, we provide granular information on PE managers’ practices in determining capital structure, valuing transactions, sourcing deals, governance and operational engineering. We also explore how the actions that private equity managers say they take group into specific firm strategies and how those strategies are related to firm founder characteristics.
Recent academic research has provided accumulating evidence that private equity investors have performed well relative to reasonable benchmarks. At the private equity fund level, Harris, Jenkinson and Kaplan (2014), Higson and Stucke (2013), Robinson and Sensoy (2013) and Ang et al. (2013) all find that private equity funds have outperformed public equity markets net of fees over the last three decades. The outperformance versus the S&P 500 in Harris et al. is on the order of 20% over the life of a fund and roughly 4% per year. Consistent with that net of fee performance, Axelson, Sorensen, and Strömberg (2013) find outperformance of over 8% per year gross of fees.
At the private equity portfolio company level, Davis et al. (2014) find significant increases in productivity in a large sample of U.S. buyouts from the 1980s to early 2000s. Cohn and Towery (2013) find significant increases in operating performance in a large sample of U.S. buyouts of private firms. Kaplan (1989) finds significant increases in public to private deals in the 1980s. Cohn et al. (2014) and Guo et al. (2011) find modest increases in operating performance for public to private buyouts in the 1990s and early 2000s, although Guo et al. find large increases in company values.
From Gompers and Lerner (1999), Metrick and Yasuda (2010), and Chung et al. (2012), we also know that the compensation of the partners at the private equity funds creates strong incentives to generate high returns, both directly and through the ability to raise subsequent funds. Strong performance for some funds has led to very high compensation for those investors.
The high-powered incentives combined with the largely positive empirical results are consistent with PE investors taking actions that are value increasing or maximizing. Kaplan and Strömberg (2009) classify three types of value increasing actions—financial engineering, governance engineering, and operational engineering. These value-increasing actions are not necessarily mutually exclusive, but it is likely that certain firms emphasize some of the actions more than others.
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