Tricks of the Private Equity Trade: Value Drivers

Private Equity Trade: Investor confidence in the genius of private equity (PE). Fund managers have reached ever greater heights thanks to new records in fundraising. Deal volume and asset valuations. These trends continued in 2022 despite – or perhaps because of – global public market losses.

In addition to maximizing fee income, the ultimate goal of leveraged buyout operators (LBOs). It is to optimize returns on the capital they manage on behalf of LP investors. While the finesse of the craft is not limited to financial tricks success in PE has long been sold through masterful delivery. And subtle refinement of the Internal Rate of Return (IRR).

What is IRR?

PE firms have a repertoire of tools at their disposal to achieve their target returns. The following factors represent the five pillars of value creation from a fund manager’s perspective:

Maximize leverage early on and refinance your capital structure often

That is, to recapitalize by raising additional debt in order to pay dividends – hence the term “dividend recap”. With this step, the PE firm partially realizes its investment. This can be controversial. Excessive indebtedness and frequent recapitalizations can stretch a borrower’s. Balance sheet and slow its ability to meet credit obligations or adequately finance growth.

Private Equity Trade: Complete Bolt-On Acquisitions

This is best done at lower entry multiples than originally paid to purchase the portfolio company, thereby increasing the value of these additions. Value can then be harvested through the achievement achieved by merging the acquirer and the targets. This is often the main rationale behind buy-build strategies for LBOs in the $50 million to $500 million enterprise value range.Private Equity Trade

Improving performance and strengthening cash flows

This is important during the ownership period. Operating profits can be achieved by:

  • Increased margins through better cost management. For example by moving production facilities to lower-cost countries – and economies of scale through increased volume.
  • We are enhancing cash generation by reducing working capital requirements, reducing capital expenditures. Minimizing cash outflows, and entering into sale and leaseback agreements.
  • Termination or liquidation of unprofitable or low-margin activities. The practice earned some early LBO players the nickname “asset stripper”. And as common in the 1970s and 1980s when conglomerates with unrelated and underperforming divisions were sold off piecemeal. Few goals these days suffer from the same lack of attention.
  • Sales growth through refined pricing strategies, new product launches, etc.

Private Equity Trade: Focus on positive multiple arbitrages

This means exiting a portfolio company with a higher valuation multiple than the value paid at the initial investment stage. Such arbitrage depends on the economic cycle. In subsequent cycles, PE managers will emphasize their skills in securing any profit. Frankly, multiple expansion is heavily cycle-dependent.

Optimize your investment holding period

This is perhaps the most important pillar. Due to the time value of money, most fund managers try to partially or completely exit investments as soon as possible. What does the time value of money mean? That time has value and that a dollar today is worth more than a dollar a year from now. Why? Because that dollar can work for another 12 months. Earn interest or grow to more than one dollar through productive investments during the year. It may also lose some of its purchasing power due to the rise in the cost of living over. The same period – a critical point today amid rising interest rates and high inflation.

While all experienced PE firms put this parameter at the core of their investment strategy, it is controversial and paradoxical. How can PE firms claim to be long-term value creators? When they are looking for a quick exit at the first opportunity? Timely realization of the portfolio, whether full or partial, contributes significantly to excellent returns.

Private Equity Trade: Building a value bridge

PE firms include a “value bridge” chart in private placement memoranda. Fund managers use these documents to raise money by demonstrating. How they will use the above factors to create value for their LP investors.

One of my previous employers. Candover, was a top 10 European PE business before it was liquidated four years ago. Candover used slightly different metrics from the five pillars above in its value bridges. Preferring to divide value accretion into four dimensions: revenue growth. Margin improvement, cash generation, multiple arbitrages, or some combination thereof. Data are from Ben Carlson. Also, many more blogs are there on investments here.


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