"Value Creation" - it's one of the most common terms in private equity today. Increasingly, more private equity firms have in-house value creation teams, and specialist value creation roles. Firms try to differentiate on their ‘value creation playbook’ and capabilities. But what does value creation actually mean in the context of private equity (“PE”)? And what does that look like in practice if you are part of a private equity-backed management team?
When I started working in private equity in 2017, I joined a ‘Value strategy team’ in the mid-market. Having a strategy consulting background but no private equity experience, it was a steep learning curve, and it took me a long time to really get my head around the private equity context and how my role and the work I was doing with each portfolio company fitted in with that.
This two-part series is intended as a simple overview of value creation in private equity, which I hope will demystify some of what goes on ‘behind the curtain’ at a private equity firm and how it can impact management teams on the ground.
As I was often told when navigating those early days in PE, “there is no manual for value creation” and there’s no framework that covers everything (much to the disappointment of the strategy consultant within me!). This article will be mainly from the perspective of the lower and mid-market (typically businesses with annual revenue between £5-100m) and mostly focused on growth investments rather than carve out and turnaround situations.
Part 1 will explain the mechanics behind an individual deal, the structure and maths of a deal, and the key levers for value creation. In this context value creation is about shareholder value in an individual portfolio company, where ‘value’ includes the equity held by the private equity firm, management team and any other shareholders.
Part 2 will be about what ‘value creation’ looks like from the perspective of a private equity firm: what’s the role of a value creation team, what processes are involved on the PE side, what’s happening back at base and what that means for management teams working with PE.
Part 1
The maths
A private equity firm’s goal is to generate a return for their investors, by buying companies and selling them at a profit. A bit like buying a house with a down-payment plus a mortgage, private equity firms tend to buy companies with a combination of upfront cash (‘Sponsor initial equity’ in the example below) and debt. The use of debt in these structures is why this model is called a Leveraged Buyout (LBO), but not all PE deals have to include debt, and the amount of debt vs EBITDA (the leverage ratio) can vary widely and tends to be higher for larger companies which are often a more attractive credit risk for lenders.
We’ll walk through an example purchase and sale of a business below and include the model at the end for those who’d like to reference it. Note, some key terms and calculations:
Enterprise value: ‘the measure of a company’s total value’ – typically calculated based on profit, but could also be based on a multiple of revenue (more common in early stage and venture capital deals)
= (EBITDA) x (Multiple)
Net debt: the debt owed by a company, net of any cash balances or other cash equivalents
= (Debt) – (Cash)
Equity value: the market value of the company that is attributable to shareholders
= (Enterprise value) – (Net debt)
MOIC - Multiple on invested capital: (Investment’s final value) / (Initial investment)
IRR - Internal rate of return: The annualised rate of return, a bit like an interest rate on a savings account
On average, most private equity firms target an IRR of around 20-25% which translates to a 2.0x - 3.5x MOIC (dependent on how long they hold a company for).
Worked example of a private equity deal
Company A makes £20m a year EBITDA. For simplicity, in this example the private equity investor buys 100% of the equity. In practice this could be any percentage, although ‘majority’ deals, where PE own at least 50%, are most common. Typically, around 20% of the equity is owned by management and employees, and the remainder by the original founders or investors in the business.
1. Initial investment:
Company A makes £20m a year EBITDA and is valued at an 8x multiple. The private equity investor buys 100% of the equity and uses £60m of debt to help fund the deal (assuming no excess cash). They also have to pay £20m of fees.
Enterprise value = £20m x 8 = £160m
Sponsor initial equity = £160m – £60m net debt + £20m fees = £120m
2. Hold the business for 5 years:
The business achieves average EBITDA growth of 10% per year
Cash generated from the business is used to pay back the debt
A simplifying assumption used in this model is a £12m (20% of the original debt) decrease in net debt per year.
Debt packages (interest rates, payment schedules, covenants) vary depending on the market, with the current market being much more challenging than a few years ago, and interest rates significantly higher.
3. Selling the business:
EBITDA has grown to £32m, and the business is now valued at a 10x multiple. The seller also has fees associated with exit (e.g. DD reports) to cover.
Enterprise value = £32.2m x 10x = £322m
·Equity value = £322m – £3m net debt - £16m fees = £303m
The PE firm’s net return on equity = £303m - £120m = £183m
Money multiple: 2.5x return (£303m / £120m)
IRR = 20%
As you can see, there are 3 main levers in the ‘value creation playbook’
EBITDA growth: Driven by topline revenue growth, and/or margin expansion.
Multiple expansion: The multiple paid for a company reflects the perceived quality of the business and the opportunities for growth (i.e. the addressable market). Multiple is also driven by the industry, and the cycle of the market.
Debt paydown: Leverage in the initial private equity deal structure allows funds to enhance their returns (in an upside scenario). Free cash flow generated during the hold pays down interest and improves the net debt position.
As the market changes, PE firms have adapted their playbooks to emphasise different value creation levers. Leverage and financial structuring have become less important over the past 4 decades, with more emphasis on multiple expansion and EBITDA growth. In the last few years with inflated multiples, firms have not been able to rely on multiple expansion and are sometimes facing the headwind of reducing multiples, so there has been even more focus on EBITDA growth (see Figure 27 in the report from Bain)
Within each of those buckets, these are some of the most common levers a business can pull:
EBITDA growth
Revenue growth e.g. new customer acquisition, entering new markets, launching new products, increasing average lifetime value of existing customers through cross-sell and upsell.
Margin expansion e.g. pricing projects, operational improvements, negotiating input costs.
Acquisitions – step change in EBITDA by adding new customers/markets/products etc, and the opportunity for revenue and cost synergies.
Note: In the lower and mid-market there tends to be more emphasis on revenue and margin growth as there is relatively less to gain through operational efficiencies and cost cutting.
Multiple expansion
Positioning – is the business differentiated and leading the competition?
Market headroom e.g. repositioning target customers to access a faster growth market, opening International markets.
Growing to hit certain scale thresholds – there are often step changes in multiples when businesses hit a certain size (e.g. £20m+, £50m+ EBITDA) as they then become attractive to a new pool of investors and lenders. M&A can be a key value driver here if you can buy at a lower multiple than the ‘larger whole’ is valued at.
Quality of earnings e.g. increasing the proportion of recurring revenue, improving working capital and optimising revenue leakage.
Strength of the team and platform for scale – e.g. robust systems and processes, clear strategy with KPIs, well defined Ideal Client Profile, proven team set up for next stage of growth.
Approach to a sales process – e.g. quality of data, buyer education, timing.
Financial structure – net debt position
Strong cash conversion – allows rapid payback of debt to build up the equity position, plus any surplus cash contributes to equity value.
Efficient use of capital – evidence that the company can put capital to work for an attractive ROI.
When private equity invests in a company, they will have a view on the what the key value drivers will be during their hold period. This value creation plan should be directionally aligned with what the management team presented pre-deal, although will likely be more cautious on certain levers (e.g. organic growth where assumptions are often over-ambitious), and perhaps more ambitious on others (e.g. M&A). Once the deal is done, then the investors can really start to understand the company and over the first year they’ll refine (or completely rip up and start again) the value creation plan. It’s at this point that specialist value creation teams and/or operating partners start to get involved.
What does this mean if you are in a management team? Of course, management have responsibility for actually executing the strategy which underpins the value creation plan. From the investor’s perspective the first few months post-deal are all about getting a clear understanding of the business, performance, financials, team and aligning with management on the longer-term strategy. We’ll talk more in Part 2 about how the private equity investor’s lens on value creation planning, and their internal processes, can impact this strategy process.
Of course, things don’t always go to plan during the hold period and sometimes investments become a case of damage limitation rather than value creation. This might mean the PE investor is just trying to make their money back (i.e. avoid a loss), or if the company isn’t generating enough cash to meet its debt requirements it could mean that the lender takes over.
Unlike venture capital, where investors expect to lose money on the majority of their investments in a fund and make an outsized return on a few star performers, private equity relies on making a ‘decent’ return (of 2x - 4x) on most of its investments, perhaps having 1-2 outperformers making 4x+, and losing money or breaking even on just a few deals in each fund.
In Part 2 we’ll talk more about what’s involved in the value creation process from the PE firm’s side, including how value creation and return multiples for an individual company fit into the bigger picture of a fund.
If you’d like to discuss value creation planning and which levers we can support you with, please Contact Us.