Private equity firms that invest internationally are overpaying for their portfolio companies, new research shows.
In a study of over 1,000 global private equity transactions, German researchers discovered that cross-border buyout deals tend to have “significantly higher” valuation multiples than domestic deals.
“When PE firms operate across borders, they face several obstacles that threaten buyout pricing,” wrote authors Benjamin Hammer, Nils Janssen, and Bernhard Schwetzler of Germany’s HHL Leipzig Graduate School of Management. “Most importantly, information production is poor due to lack of local ties and non-familiarity with the local business environment.”
According to the authors, this informational disadvantage can hurt foreign private equity firms in a number of ways, including limiting the pool of buyout targets — “thus reducing the chance to find targets that are available at attractive prices.” Communication barriers and cultural differences may also make it more difficult to judge “soft information” like a company’s local reputation and the quality of its management team, the authors said.
To test this thesis, the German researchers analyzed a global sample of 1,149 buyout deals conducted between 1997 and 2010. Using multiples of enterprise value to sales, they then determined which deals had the most expensive valuations.
They found that cross-border deals had valuation multiples that were 25 percent to 37 percent higher than the valuations of domestic deals. According to the study, this wide spread was best explained by information asymmetry: The difference between foreign and domestic deal valuations was “considerably smaller” when the buyout target operated in a county with more transparent accounting standards.
The authors suggested that private equity firms could mitigate this problem by partnering with local firms. In fact, they found that when a foreign and domestic firm joined forces in a syndicate, the resulting buyout deals had lower valuations than purely domestic deals.
“There are synergies between domestic PE firm’s knowledge of the local business environment as well as foreign PE firm’s international experience,” they wrote.
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Large buyout funds — which “exhibit advantages in information production” and “are more likely to internationalize their portfolio” — similarly appeared able to overcome information challenges, with the authors finding a “negligible” difference between domestic and cross-border deal valuations.
“While our study documents that a local syndicate partner serves as an effective remedy to avoid adverse pricing effects, foreign PE firms may achieve the same effect when hiring local staff,” the authors suggested. “Further research could therefore examine whether multiples of cross-border buyouts are lower when local lead partners are responsible for the deal.”