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Leverage Takes a Backseat in Private Equity’s New Normal

Firms that emphasize growing portfolio companies will outperform their LBO counterparts, new research suggests.

Private equity has riveted yield-starved investors with its ability to deliver outsize returns. The asset class owes much of this reputation to megafunds, which have relied on leveraged buyouts to get where they are today. But according to recent academic research, future returns will come from managers that forgo LBOs in favor of building portfolio companies. At the same time, private equity may be losing the battle to pay less than other buyers do for acquisitions.

In an October paper, Stefan Morkoetter and Thomas Wetzer at the Singapore-based St. Gallen Institute of Management, an offshoot of Switzerland’s University of St. Gallen, found that when purchasing portfolio businesses, private equity firms tend to get a better price than do strategic buyers, such as holding companies and large corporations. Securing a lower entry price for a target has been one of the key advantages for private equity investors banking on higher returns, but the data suggest that this edge is eroding.

Institute head Morkoetter and research associate Wetzer analyzed the performance of private equity and strategic buyers for 20,643 transactions reported in four databases — FactSet Research Systems, Preqin, S&P Capital IQ and Thomson ONE — to see how much of an advantage private equity affords and if it holds for all types of deals.

Avoiding overpayment is critical in a frothy M&A environment like the one that has prevailed much of this decade. The discount advantage, however, appears to hold only for a subset of possible private equity transactions. “One of the things we noticed is that private equity loses its discount when the asset is owned by, say, a family,” Morkoetter tells Institutional Investor. “Those owners appear to be more motivated to get a full price in many cases.”

Michael Choe, president of Charlesbank Capital Partners, a $3.5 billion middle-market private equity firm based in Boston, questions those findings. “I don’t know that it is fair to compare GPs and strategic buyers, because the priorities are going to be different,” Choe says. “Strategics can take a long time to consider a deal and generally still have a hard time competing in auctions with compressed time frames.” In other cases, strategic investors might not want to participate in deals that take a public company private, or may pull back from the market altogether if their appetite for acquisitions changes.

When it comes to discussions in the boardroom, relationships can also change how a deal might go, according to Gene Yoon, a managing partner at another middle-market firm, $650 million New York–based Bregal Sagemount. “It depends on dynamics,” Yoon says. “Companies may feel that a [general partner] will do more for the company than a strategic buyer and may opt for the slightly lower sales price if they think the long-term gain is there.”

All of these factors count not just on individual deals but during fundraising too. General partners typically come to market for their next fund when the acquisitions in their current vehicle are performing the best. Getting a good entry price is the first step toward creating ideal conditions, but data from two other recent papers show that GPs who are new to the market or trying to raise a bigger follow-on fund may still be gaming their interim performance around fundraising time.

Interim performance includes exits realized to date in a current fund, as well as the net asset value of its remaining investments. GPs will almost always have their own way of calculating this number to their advantage, leaving investors to do the legwork to find out if they agree.

Pulling together all of the information required to compare performance can be daunting. “It is well known that the illiquid nature of underlying investments in private companies makes real-time adjustment of NAVs difficult or unrealistic, leading to infrequent price adjustments and stale prices,” write Brad Barber and Ayako Yasuda, professor and associate professor of finance, respectively, at the Graduate School of Management at the University of California, Davis, in an August 2014 paper called “Interim Fund Performance and Fundraising in Private Equity.” They, along with finance professor Gregory Brown of the University of North Carolina at Chapel Hill, assistant finance professor Oleg Gredil at Tulane University and entrepreneurship and finance professor Steven Kaplan at the University of Chicago, have shown that although it may seem advantageous to general partners to put the most positive spin possible on interim performance, investors are starting to see through those numbers.

Barber and Yasuda analyzed fund-level cash flow and quarterly net asset value numbers from Preqin for more than 800 U.S.-focused private equity funds raised between 1993 and 2009. In their March working paper, “Do Private Equity Funds Game Returns?,” Brown, Gredil and Kaplan relied on cash flow and NAV data provided by Burgiss, an investor research services firm based in Hoboken, New Jersey, for 2,071 funds. The takeaway: At the lower end of the market, general partners are slightly marking up the remaining assets in a fund during fundraising time, only to mark them back down at exit.

As investors and regulators get savvier at measuring factors like real earnings growth and other operational improvements, some of the better-performing managers are becoming more conservative in their valuations and finding organic ways to boost fund size, such as bringing in limited partner co-investments to create a track record of bigger-ticket deals. Both papers suggest that the successful private equity firms of tomorrow will use a model common in the middle market: building businesses, rather than relying on leverage or financial engineering.

“The slight positive you’re going to get from marking up an asset is never more than the pain you feel when you have to explain a markdown to an investor,” says Bregal’s Yoon. The numbers at midpoint of a fund life cycle can be a key way for investors to separate financial engineers from value creators, he explains. “The real way to move the needle with these companies is earnings growth.”

This shift isn’t only about maintaining limited partner and regulator relationships; it also speaks to the broader erosion of any financial engineering advantage that general partners might have. Leverage-based returns won’t work as well as the cost of capital increases, and more companies are now fixing their own problems to defend against shareholder activists.

In the middle market, financially engineering a leveraged return is even harder because these companies don’t have much in the way of assets to lever up. After an era of corporate deleveraging and a move toward cash-heavy balance sheets, fewer corporations across the board have assets to lever, and with cash on hand they don’t need to. Yoon and Charlesbank’s Choe argue that the way forward is finding companies with a long-term incremental growth opportunity, whether it’s through acquisitions or a clear strategy to improve earnings.

For investors in search of yield, identifying managers willing to do the heavy lifting may mean the difference between a well-performing private equity portfolio and a middling one. “Exit strategy is important because private equity [limited partners] ultimately want to judge managers by realized returns,” Choe says. “They want to see cash distributions within a fund life cycle, and to do that you have to find companies where you can get that exit, and it takes a manager who is good at creating earnings growth and equity value to make that happen.”

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