Private equity is notorious for focusing only on investors’ gains. Though ideally, it’s not possible to just gain for investors sans company generating revenue, a large number of investors can profit from their investment without a company generating revenue. Boutique private equity firms sometimes can be too bullish on their investment to generate profit, leading to scenarios where they sell their equity before a company starts making a substantial profit.
However, this may not be the case anymore. A new study thrashes this notion and presents a compelling case of the private equity industry, where firms thrive on improving the sales and operational performance of a company. The study has revealed that private equity firms improve the operating performance of the companies they buy. Critics, however, still claim that returns are due to financial engineering.
The latest report is a justification for the private equity industry, which has repeatedly been asked about returns on their latest investments. Further, a few academic studies reveal that though PE firms charge a hefty fee from investors, they have failed to get the stock exchange. The report analyzed more than 800 European cases where private equity firms have made an initial acquisition and then built on it with further add-on deals.
The firms increased return on sales of the enlarged group by 27% over the first five years (or exit if earlier) compared with what would have been expected for the individual businesses, according to the researchers from Erasmus University Rotterdam.
In the past decade or two, the private equity industry made fat returns by acquiring small businesses using high-level debt. Now the scene has changed significantly. As the competition of deals is increasing, private equity firms are focused on buy and build strategies. According to Bain & Company, these strategies are close to the approaches taken by corporate and strategic purchasers.
Ludovic Phalippou, Professor, Oxford University’s Said Business School, a critic of the private equity industry, says, “PE firms use these transactions to dress their track records, raise more capital, or justify spending already committed capital, without operational improvement”.
On the other hand, Erasmus researcher’s analysis of PE deals across seven European countries found that buy and build strategies achieve significant improvement in sales and profits due to synergy in operations. The analysis included PE deals since 1997.
The report cites the example of Activa Capital, a French private equity firm. The firm bought a photographic services provider, marriage and birth celebrations invitations manufacturer, and an online family planning service. The firm merged them together and assessed the performance of the combined group against rival businesses in each separate market. “This result supports the positive view that PE funds are acting similarly to strategic buyers that aim to realize operating synergies,” the report says.
Further, the report found that the average holding period for “buy and build” strategies among chosen PE firms was more than five years, significantly longer than has been typical for traditional leveraged buyouts.
For a long time, PE funds have been believed to be only money-oriented, with no interest in solving real-life problems. As investors become more interested in solving problems and think of creative ways to improve performance and business-critical metrics, the relationship will hopefully get stronger.