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GLOBAL PRIVATE EQUITY
The Sustainability of Private
Equity Buyout Fund Returns
Thomas Kubr, CEO and Katharina Lichtner, Head of Research at Capital Dynamics
Private Equity returns in recent buyout space, especially in the last
years have been strong. This is two years. While the LBO segment
especially true of leveraged buyout received commitments of $324.5
investments (LBO) in the US and Essentially, we billion in the US and E104.5 billion
EU, where returns have soared
across the LBO spectrum, richly
believe that returns in the EU during 2000-2004, in the
last two years alone LBO funds were
rewarding those who have continued might come down able to raise $313.6 billion in the US
to commit post the venture capital and E106 billion in the EU.
bubble when many abandoned the as current levels This has not always been the case
asset class. The question that arises
now is: are these returns sustainable
are not sustainable and there are many years where the
LBO segment has not been the top
and, if not, where in the cycle is the performer, losing out to other strate-
industry? gies. Figure 2 shows each private
In order to address this question of Figure 1, distributions have reached equity strategy in a different colour.
the sustainability of returns, a closer record levels albeit with the amounts For each vintage year, the perform-
look at what drives returns is of capital committed in earlier years ance of a private equity strategy is
merited so that we can attempt to having been relatively moderate. shown with the best performer at the
establish whether these returns are Much of these distributions is driven top and the worst at the bottom. Two
driven by buyout professionals’ skill by LBOs. LBO returns have over- things need to be noted: (i) there is no
or merely by access to cheap debt. shadowed every other private equity obvious pattern - the colours seem to
We will look at the individual value investment style in recent years and be randomly distributed; (ii) in the
drivers and their impact and impor- have contributed to the steady last 15 years all strategies have been
tance for the overall generation of increase in commitments to the at the top or the bottom at least once
returns. We will address how
revenue expansion, margin expan-
sion, leverage and multiple arbitrage
contribute to the overall returns and
are affected by the current economic
climate. Finally, we will look at how
returns may develop in the future.
Essentially, we believe that returns
might come down as current levels
are not sustainable. However, we
expect a soft landing, rather than a
crash and associated destruction of
value. Furthermore, we still believe
that private equity will continue to
outperform the public markets and
remain an essential asset class.
All good things come together
Private equity returns in the
buyout segment have been high in
recent years. As can be seen in Figure 1: EU private equity distributions based on Venture Economics data
ALTERNATIVE INVESTMENT REVIEW 63
GLOBAL PRIVATE EQUITY
lished firms investing their third or
fourth funds, managers have become
very good at this. The top managers
have built up CEO networks and
used operating partners heavily -
experienced managers that they can
“parachute” into companies
whenever those companies need
short-term operational experience. In
recent years the favourable economy
and invigorated GDP growth have
reinforced the value contribution.
Capital Dynamics routinely uses a
value creation analysis to evaluate
LBO manager performance. In figure
4, a pooled analysis shows that
revenue growth and margin expan-
sion are still the most important
contributors to overall performance.
Figure 2: Capital Dynamics analysis based on Venture Economics data. Each of the This outcome is driven by skill rather
fund strategies that form part of the VE database is given an individual colour. All than a cycle, as shown in another
strategies are then ranked by their average performance for that vintage year from Capital Dynamics publication (Top
1 to 17. This is done for the last 16 vintage years Quartile Persistence, C. Rouvinez,
June 2006). Analysis of the Venture
(see also “Market-Timing von Private cleverly, strategically and tactically Economics database shows that
Equity”, Rouvinez, Mackewitz, use leverage in the course of the experienced GPs that have shown top
Diller; 2007). holding period. The fourth element, quartile or top half performance have
In order to understand LBO multiple arbitrage, is a measure that a high likelihood of delivering
returns, it is worth looking at the evaluates the spread between the superior returns in their subsequent
underlying parameters that drive EBITDA multiple at acquisition funds. As subsequent funds almost
these returns. In Figure 3, the four compared to the same multiple at exit. always span more than one economic
main elements of LBO value genera- cycle, this supports the argument
tion, which are discussed in this Revenue and margin expansion that it is the skill of the manager that
section, are laid out. Once a company These two parameters are largely generates the value.
has been acquired, a private equity driven by the creativity of the
manager (GP) has the ability to manager. Here experience and skill Leverage
increase revenues, work on a come into play. With the private In today’s market, structuring a
company’s EBITDA margin and equity industry maturing and estab- LBO transaction is a commodity and
is no longer a material differentiat-
ing factor except for a few managers
that have chosen to focus on bringing
in specific capital markets expertise
driven by an in-house team. The use
of leverage today is largely driven by
its availability and cost, which in
today’s markets is particularly
favourable for LBO deals.
The industry has experienced a
period of low interest rates which has
only recently returned to mid 1990s
levels. At the same time debt is
abundant. Not only are debt
providers willing to lend large sums
on “covenant lite” and cheap terms,
but the advent of hedge-fund money
Figure 3: Conceptual slide showing the parameters that drive the value created in a in private equity has made the
successful LBO investment supply of debt almost limitless on
64 ALTERNATIVE INVESTMENT REVIEW
GLOBAL PRIVATE EQUITY
were bought in the post-bubble reces-
sion show a positive multiple
arbitrage. For those companies that
were bought at the height of the
bubble and prior to the last market
correction, the multiple arbitrage
component is at least neutral.
A strong exit market further
contributes to the good returns. It is
one thing to generate value; it is
another to realise it. With public
markets rising relentlessly and the
high availability of liquidity in the
capital markets, it has been easier to
realise the values created.
In conclusion, strong LBO perform-
ance is the result of the rare situation
in which all of the critical drivers of
outperformance have occurred at the
same time:
• Experienced managers in the US
and the EU have developed a
greater ability to bring about
fundamental improvements to
Figure 4: Capital Dynamics analysis on 132 exited companies acquired after year their portfolio companies
2000 from various EU and US funds across the LBO spectrum. The analysis is • Many of the companies being
based on data of enterprise value, EBITDA-multiple, sales and EBITDA at acquisi- exited today were acquired at lower
tion as well as exit of each company in the sample. Write-offs have been excluded EBITDA multiples
from the sample. Despite the relatively limited size of the sample we believe the
results to be highly indicative and supportive of the argument.
• Abundant and cheap debt allows
substantial leverage levels as well
as active refinancing of companies
equally good terms. This abundance • Strong trading has generated
of debt has a positive effect on LBOs excellent liquidity for companies
as it adds to the value creation
without impacting negatively on any
In recent years the globally, sustaining a buoyant
M&A environment and enhancing
of the other parameters. favourable economy exit options
Another positive driver is the
ability to accelerate distributions
and invigorated GDP • Capital markets have seen steady
growth over the last few years with
through a high rate of re-financings, growth have rising price earnings, which have
which increases an investment’s IRR. enabled companies to be listed or
In addition, an increase in leverage reinforced the value sold into a rising market.
levels has supported the rise in
acquisition prices that we have
contribution What comes next?
witnessed in recent years. This has There is agreement in the industry
simultaneously facilitated the acqui- generated or destroyed when a that the level of performance is not
sition of companies despite company is sold at a higher or lower sustainable and we will see declining
increasing prices and enabled the EBITDA multiple than that paid at returns in the future. The critical
same levels of equity to be invested. the time of acquisition. EBITDA questions are: by how much will
In addition, the current debt climate multiples are cyclical and depend on returns decline; and will private
has ushered in the advent of the the overall economic climate. While equity become unattractive? Again it
mega-deal. acquisition multiples were very high is best to look at the key parameters
at the end of the 1990s, they in turn.
Multiple arbitrage collapsed after the bubble burst.
Multiple arbitrage is largely driven Multiples have been rising since the Top line and margin expansion
by external marked dynamics. pick-up in overall economic growth Going forward, there is still plenty
Multiple arbitrage is the value that is and today almost all companies that of potential to generate value here.
ALTERNATIVE INVESTMENT REVIEW 65
GLOBAL PRIVATE EQUITY
This is particularly the case in indirect effect on a manager’s Conclusion
Europe, where there are considerable ability to improve the top line as In summary, we expect future
opportunities in both the mid-cap well. The effect can be tempered to returns to be corrected downwards.
and the large-cap segment. Here we some extent by the inevitable Most of this downward correction
see performance enhancement oppor- decrease in EBITDA acquisition will be driven by a contraction of the
tunities through growing businesses multiples that can be expected in debt markets and a subsequent
and implementing structural reforms the wake of a correction of the debt downward correction of the EBITDA
which will make businesses more markets. To what extent lower multiples resulting in a less active
efficient and better prepared for a prices can mitigate the correction exit market. Nevertheless we expect
globalised future. There is plenty of remains to be seen. this to be a soft landing. Unlike the
deal flow available as private equity Furthermore, with debt markets technology bubble that largely
is still a small portion of overall M&A shrinking, we expect deal activity to financed ideas and concept-based
activity. However, as general slow which will lead to a capital companies (often without any
economic growth may slow down, it overhang that in turn will put revenue in sight), LBO managers
will be harder - and will probably pressure on pricing. finance real companies with stable
take longer - to grow a company. In cash flow generating characteristics,
addition, over-leveraging at the time healthy asset bases and real value.
of acquisition and imprudent
refinancing will cause the loss rate to
In today’s market, The fundamentals of LBO remain
strong - creating value in under-
rise as slow top-line growth and
depressed margins will cause some
structuring a LBO managed or poorly positioned
companies through active ownership.
companies to default. A further transaction is a It is the active ownership principle
question that remains to be
answered is how the relatively
commodity and no that leads us to believe that private
equity will continue to outperform
complex and novel financing struc- longer a material public equity and remain an attrac-
tures of mega deals will fare in a tive asset class (see: “Private equity
downturn, despite being financed differentiating factor benchmarking with PME+”,
“covenant lite”. Rouvinez, 2003; and “Looking for a
premium”, Rouvinez, 2007). Prudent
Leverage Multiple arbitrage portfolio diversification across
We expect leverage to have the As discussed above, a cooling of private equity investment styles,
biggest impact on LBO activity and economic growth, as well as a correc- geographies and vintage years, as
returns. With the currently low tion in the debt market, will lead to a well as investing with established
spreads even for junior high risk decrease in EBITDA multiples for teams with a proven track-record, is
debt tranches, the market is private as well as public companies. the best route to capturing the poten-
overheated and current activity is Consequently, any company bought tial returns going forward. ■
not sustainable. There is little today could very well face falling
disagreement about the fact that EBITDA multiples at the time it is
there is a debt bubble; the question ready for exit. Going forward, we
is when it will burst and what will expect to see a negative multiple
trigger the correction? When the arbitrage component in many of the
correction happens, debt prices will LBO deals which in turn will
go up and supply will contract negatively affect returns. Managers
rapidly and possibly dry up. This can compensate for this situation to
means that for LBOs the debt to some extent by holding onto compa-
equity ratio will come down, and nies longer in anticipation of the next
more equity will be required per market upturn. While this will be
deal. Additionally, debt will be more beneficial to the achieved cash on Thomas Kubr and Katharina
expensive, which will leave less free cash multiple, it can be devastating Lichtner are Managing Directors at
cash-flow to invest in the growth of for the IRR of the investments. At the Capital Dynamics, one of the
the company and, consequently, re- same time, there will almost world’s largest private equity asset
financings will become less certainly be a slowdown in the managers, with an exclusive focus
frequent. This will have a negative activity of the exit markets, which on private equity. Capital Dynamics
impact on both multiples and the means that it will be harder to has offices in Zug (Switzerland),
internal rate of return. The leverage realize the value that has been built Birmingham (UK), London,
component of LBO value generation in a portfolio company by the New York, San Francisco and
will deteriorate and will have an manager. Hong Kong.
66 ALTERNATIVE INVESTMENT REVIEW
