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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

                                                                                       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

                                                                                                 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

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.


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