Aurora Borealis
1 March 2016 CFA Institute Journal Review

Private Equity Minority Investments (Digest Summary)

  1. Paul Danis, CFA

Private equity minority investments deliver significantly lower returns than those where a majority stake is acquired. Margin improvements are superior when a majority is held by a private equity sponsor, most likely because control over the business is limited in minority investments. Nevertheless, minority investments perform better on a risk-adjusted basis.

What’s Inside?

With the maturation of the PE (private equity) industry, minority share PE investment (MIN) as a percentage of all buyouts has increased. Against this backdrop—and because there has been little research that analyzes MIN versus majority share PE investment (MAJ) on a deal level—the authors seek to provide an initial understanding of the MIN landscape from an investor perspective.

How Is This Research Useful to Practitioners?

The authors find that MIN deals deliver significantly lower returns for investors than their MAJ counterparts when measured on public market equivalent (PME), money multiple (MM), and times multiple (TM) bases. (TM is the net capital gain as a multiple of invested capital.) The internal rate of return (IRR) measure is similar for MIN and MAJ owing to the longer holding period of the latter in the study. Moreover, the authors’ results show lower value creation in MIN in all value-creation effects.

In terms of the source of the returns, the authors find that MIN deals gain more of their EBITDA (earnings before interest, taxes, depreciation, and amortization) improvement from sales growth and less from margin expansion. This finding is in line with the authors’ expectations given that a minority investor’s influence is limited compared with that of a majority investor. As a result, the investor is not able to finance the transaction with as much debt as usual. To address the constraints that stem from not holding a majority stake, minority investors should ensure they have a good fit and close connection with their majority partner.

The key advantage of MIN is its lower risk. Furthermore, the lower risk more than compensates for the weaker returns. Sharpe ratios of MIN deals are higher than those of MAJ deals—for both the general partner directly investing in a minority stake and the limited partners investing in a fund that invests in a MIN deal.

How Did the Authors Conduct This Research?

The dataset used for the analysis includes 920 unique PE transactions, 96 of which are MIN and 824 of which are MAJ. Investments where the PE firm owns less than 50% of the equity are classified as MIN, and investments where the PE firm owns more than 50% are classified as MAJ. Club deals are treated as MAJ because, when combined, the general partners usually hold a majority of the equity and have very similar incentives/objectives. The dataset runs from the late 1980s until 2013. The data are obtained from three large institutional investors that invest in PE funds serving as limited partners. The sample contains only fully realized transactions; unrealized or only partially realized deals are excluded. MAJ deals are held on average for 5.0 years, and MIN deals are held on average for 4.6 years. The mean ownership structures for MAJ and MIN are 58% and 32% of the equity, respectively.

The authors compare MIN and MAJ deals in three areas: (1) returns, (2) sources of value creation, and (3) volatility of returns. Returns are measured using the IRR, MM, PME, and TM metrics. “Value creation” is defined as the net capital gain to investors compared with invested capital.

One limitation of the study is that the MIN deals in the sample are, on average, held six months less than the MAJ deals. As such, this difference could contribute to the observed variations in risk/return.

Abstractor’s Viewpoint

The authors shed light on an area where very little research has been performed and show that MIN deals underperform MAJ deals using some methods. From a return perspective, the most valid measure considered is IRR, and there is no difference using that measure. From a risk-adjusted performance point of view (the perspective all investors are supposed to take), the Sharpe ratio is higher for MIN deals. The authors show that the higher returns of MAJ deals come with a disproportionately higher risk. Thus, they suggest that MIN deals are an attractive choice for more risk-averse investors or for investors willing to reduce overall portfolio risk by including MIN deals.

Investment professionals would be well served by additional, more detailed research on MIN, which could include the importance of MIN over time, by region, and by deal size.

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