In an environment that is ever more technical and demanding1, private equity (PE) practitioners must apply best-in-class investment practices to meet investors’ expectations.
Here I highlight five major elements of a successful approach to PE deal making: management selection, due diligence, exit considerations, buy-and-build strategies, and financial innovation.
For practitioners, the stakes in this post are directly tied to return outcomes, downside risk, and the quality of decision-making across the full deal lifecycle. With leverage amplifying both gains and losses, and execution risk leaving little room for error, disciplined practice is essential to avoiding underperformance and protecting capital.
It’s All About Management
PE owners have earned a bad reputation as asset-strippers for the way they sometimes ruthlessly execute reorganization plans, including sweeping rounds of layoffs.
Frequently, staff cuts affect senior management. Although there is limited public data available, it is estimated that between two-thirds and three-quarters of corporate teams running a portfolio company on behalf of PE backers will be reshuffled or re-scaled (meaning that one or several executives will be replaced) during the period of ownership.
The main challenge is to identify the best management team to implement a business plan capable of coping with a leveraged capital structure that often leaves little room for error.
Indeed, the execution risk of a debt-financed company is much higher when its C-suite is inadequately staffed. A fast-growing business will require senior executives to accelerate innovation and find new markets, while a business neglected by its previous owners might need a turnaround plan, in which case a management team focused on operational efficiency would be best suited.
It is no coincidence that leveraged buyouts (LBO) were originally called management buyouts. Yet there is no secret formula in selecting corporate executives. Over time, fund managers learn to identify executives with the right blend of doggedness and flexibility to tackle whatever obstacles and economic conditions the business will face throughout the holding period.
The biggest test that a PE firm faces when backing incumbent managers or hiring new candidates is to decide how much time to allow these individuals to deliver on a business plan. At which point must PE owners determine that a management team is no longer the right one and must go?
Pulling the trigger too early without giving the CEO and other senior colleagues sufficient time would be counterproductive, sending the message across the organization that the owners are unrealistic in their expectations.
Failing to act at all is equally damaging and is called “going native.” Procrastination will not only impact investment returns. It would imply that under-performance is tolerated, with the risk of institutionalizing failure.
Thorough Due Diligence
Before closing a deal, a conscientious fund manager must carry out a deep preliminary analysis. Success might legitimately be due to luck. But as Benjamin Franklin once wrote, “Diligence is the mother of good luck.”
Fund managers do not implement due diligence (DD) to satisfy their own curiosity. They do so because, without professional inspection, they would not be able to raise debt. An LBO makes economic sense if it is funded primarily with loans. These sums are borrowed from bankers and private debt firms requesting DD reports covering every risk element of the transaction: the macroeconomic situation, market landscape, competitive positioning, financial performance, litigation, and other parameters that could endanger cash flow generation, and thereby creditworthiness.
What often happens is that the ceaseless toil of analysis becomes more superficial when the economy and the M&A market become bullish. Between 2014 and 2017, for instance, the duration of due diligence work dropped from an average of 7.4 months to 6.1 months2. While there were various reasons behind such a trend, including the adoption of M&A insurance and the rise in pre-deal analysis, the main factor was increased competition during the auction process.
During the rampant 2006-08 period, many transactions, including the acquisition of banking group ABN AMRO by its rival Royal Bank of Scotland, were completed after only weeks of negotiations, not giving the acquirer sufficient time to perform a thorough assessment.
What also became prevalent in those days was the production of vendor-instructed due diligence (VDD) reports (meaning that the seller was analyzing its own business), which were in some instances heavily doctored. Note that VDD has now become standard practice.
While proper due diligence cannot guarantee strong returns, cursory analysis often leaves many blind spots and can be a precursor to failure.
Exit First
PE firms try very hard to portray themselves as business builders, but they are essentially traders. The proof lies in one of the quintessential rules of PE investing. A key condition for a financial sponsor to invest in a business is to identify at the outset, before completing the buyout, a clear route to exit.
Without a well-defined disposal strategy, a diligent PE firm should not invest. Some fund managers, when desperate to deploy capital, fail to heed that rule and are prepared to leave the exit stage in the hands of fate.
Still, the necessary corollary is that if devising an exit plan before even acquiring a business is considered best practice, it follows that PE fund managers are very much short-term business merchants rather than long-term builders. But every rule has exceptions. Buy-and-build strategies aim to counteract the worst trading tendencies.
Buy And Build
PE firms are often described as investors that acquire struggling companies with the aim of turning them around. Nevertheless, this image is not a true reflection of today’s marketplace.
When it all began in the 1970s, many buyout candidates were non-core corporate carve-outs that had been starved of cash and management attention for a while and needed urgent and intense restructuring efforts. But distressed candidates today form a very small part of the deal flow.
The implication is that the low hanging fruit of cost reductions, offshoring, and operational improvements have sometimes already been harvested by previous owners, especially when the latter were themselves PE fund managers.
Instead, the most common way to create value in today’s environment is by using a portfolio company as a platform to make add-on acquisitions, taking an active role in industry consolidation.
When completed at a lower entry valuation multiple than the price paid for an investee company, bolt-ons can be accretive before synergies are even factored in. Not to mention that they are a more durable way to create value than excessive leverage will ever be.
While operational and strategic discipline drive value creation, capital structure plays a critical role in how those outcomes translate into returns.
Handle Leverage With Care
Innovations are rarely just about superior performance. They are also about experimentation. And all new experiments breed their fair share of miscarriages.
Given the extraordinary impact that financial leverage has on equity returns, PE fund managers have spent the past 40 years sharpening their use of debt funding. It is the area where the industry has witnessed the most innovation, because leverage is the principal means through which PE fund managers maximize returns3.
Since the 2008 financial crisis, institutional lenders and PE firms have greatly benefited from increased regulation of the banking industry. In the past 15 years, they have grown their share of the corporate debt market.
Large-cap PE firms are now among the largest corporate lenders: Apollo, Ares, Blackstone, Carlyle, and KKR all play on both sides of the capital structure4. That allows them to do two things. They can use their private debt divisions’ ability to underwrite loans as a bargaining tool when negotiating terms with third-party lenders, and they can acquire companies on the cheap by buying distressed debt at a discount, with the option of taking full control of the leveraged business if the latter defaults on its debt. Lender-led buyouts have become common.
With so much spare capital in the financial system, borrowers are frequently granted exceedingly generous terms, including the ability to draw interest-only loans (meaning that the principal is only repayable upon the sale of the business or when the loans reach maturity) or without the need to meet strict financial ratios (debt covenants).
Today, most buyouts with an enterprise value above $100 million are financed with covenant-lite bullet loans, meaning that the debt raised is not amortized but only repayable in full upon maturity or change of control, giving the borrower years to operate without constraint from its lenders.
The golden rule is to keep debt as a proportion of total funding at a manageable level. Up to 60% seems to work for most sectors, unless they are subject to sudden regulatory changes, technological disruption, or fierce cyclical downturns, in which case leverage ratios should be set much lower5.
The risk of default on debt obligations for many LBOs can be unusually high. Lengthy renegotiations with lenders, to amend covenants and extend maturities or, increasingly, via liability management exercises6, are just the start. Default can also lead to bankruptcy.
That makes the adoption of best practice principles imperative. Since few deal targets ever meet all the criteria to qualify as perfect LBO candidates7, practitioners must embrace investment and management discipline that can weather the test of time.
Parts of this post were adapted from The Good, the Bad and the Ugly of Private Equity by Sebastien Canderle.
Citations
2. Merrill Corporation, 19 January 2018
5. https://www.amazon.com/Debt-Trap-leverage-private-equity-performance-ebook/dp/B01KTVJLO0/ref=sr_1_2
6. https://pitchbook.com/news/articles/european-market-contends-with-repeat-defaults-as-lmes-enter-fray
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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