The Growing Private Equity Strategy Yielding Outperformance

Private equity-backed companies are increasingly turning to mergers and acquisitions as a source of growth – and this “buy-and-build” strategy is paying off for private equity investors, according to data firm PitchBook.

In a research note published Wednesday, PitchBook analysts evaluated how add-on transactions effected private equity fund performance. According to PitchBook, almost 30 percent of private equity-backed companies now make at least one add-on acquisition, compared from 20 percent of funds in the early 2000s.

A quarter of the total number of add-on deals were made by portfolio companies with at least five total acquisitions.

“As private equity becomes more competitive and prices remain elevated, the traditional tools of leverage and multiple expansion are unlikely to be sufficient for producing typical PE returns,” Dylan, Cox, a senior analyst at PitchBook and one of the report’s authors, said in a statement. “Managers are likely to use buy-and-build strategies as a selling point with potential LPs, which makes it important to understand how that strategy might effect fund returns.”

To do so, Cox and his co-authors, Pitchbook analysts Darren Klees and Bryan Hanson, compared the funds employing buy-and-build strategies to the overall private equity universe. Funds were divided into two categories: Sample 1, including managers that have completed at least 2.5 add-ons per portfolio company, and Sample 2, made up of general partners that have completed an add-on for at least 65 percent of their portfolio companies.

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Parthenon Capital Partners, Genstar Capital, KRG Capital Partners, Apax Partners, and Kelso Private Equity numbered among the Sample 1 firms. Genstar Capital and KRG Capital Partners also made the cut for Sample 2, alongside Vista Equity Partners, New Mountain Capital, Hellman & Friedman, and others.

When funds were analyzed based on the multiple of the total value produced to the amount paid in, the buy-and-build funds beat the PitchBook private equity benchmark in every vintage period between 2000 and 2011. The only vintage year period they haven’t outperformed in was the most recent of those analyzed, 2012 to 2015. Even then, add-on funds delivered roughly the same median return as the benchmark.

“PE funds which complete more add-on transactions generate better cash-on-cash returns,” Cox said. “And while some may assume this is due to longer hold periods, these ‘add-on funds’ also outperform on an IRR basis, indicating that buy-and-build strategies have a positive effect on fund performance.”