Is private equity an effective governance structure, or simply a means of transferring wealth from “Main Street” to “Wall Street”? How do buyouts affect target-company organization and strategy? How do deal characteristics such as size, industry, transaction complexity, buyer characteristics, holding period, and the like affect the performance of private-equity transactions? Are revenue improvements driven primarily by changes in employment and capital expenditures, or by changes in organization and strategy? Despite a healthy literature on buyouts, little is known about the details of private equity transactions, as most studies rely on publicly available data or confidential data from a single buyout firm.
We used a unique sample of 288 exited transactions over a 20-year period across 19 industries from 13 buyout firms, based on confidential data from detailed interviews with the general partners of several leading private-equity partnerships in an attempt to answer these questions.
While prior studies have focused on whole company, going-private buyouts, our sample includes transactions with minority stakes, syndicate deals, and consolidating roll-up or add-on strategies, and we have detailed information on internal rates of return, leverage, equity stakes, and other deal characteristics.
We find that the pursuit of ancillary consolidating acquisitions is the biggest driver of post-buyout revenue and profit growth, that solo deals and deals with controlling stakes outperform syndicated or “club” deals, that rates of return have declined over time as buyout markets have become more competitive, that mitigation of agency costs is critical for deal success, and more generally, that private equity can improve the performance even of sound businesses by providing access to resources, industry-specific expertise, capital for recombining assets (most often, consolidation in a fragmented industry), or recapitalization and ownership transition.
Mid-Size
Our focus is on small and mid-sized deals. This end of the buyout market features not only the investment goals found in larger public-company buyouts, which include cost elimination via consolidation and exploitation of scale and scope economies, but also a variety of strategies aimed at improved management coordination and control. The range of transaction rationales seen in smaller and middle-market buyouts forces PE investors to take on several roles including banker, operating executive, board member, strategist, headhunter, coach, union negotiator, and occasionally family therapist. There is thus perhaps a “fuller” view available here with respect to the manner by which PE professionals seek to create value in their deal-making.
Focusing on middle-market transactions highlights some interesting characteristics of the PE world that are hidden in studies of larger deals. Most prior work distinguishes between two types of buyouts: restructuring deals designed to mitigate agency costs in mature, low-growth, low-beta industries; and growth-equity transactions based on investments in high-growth industries. There is a third category as well, however, an intermediate type we might call coordination-improving deals. These typically involve sound businesses that can nonetheless benefit from PE firm ownership bringing access to resources, industry-specific expertise, capital for recombining assets (most often, consolidation in a fragmented industry), or recapitalization and ownership transition. The intended result in these transactions is better coordination of deployment of a firm’s assets, often in recombination with market-based resources. These kinds of transactions occur often in our sample, and would appear to manifest a major benefit of—and under-reported storyline about—private-equity governance.
Conclusions
More generally, our preliminary analysis of this sample of middle-market transactions suggests that, fundamentally, growth is the ultimate driver of wealth creation for smaller companies. Over three quarters of our sample experienced increases in revenues and operating profits, and, not surprisingly, those transactions with the highest revenue and profit growth rates have the highest rates of return. The same applies to increases in employment. For these deals, PE was a catalyst for exploiting scale and scope economies and providing operating leverage.
Second, for this sample, return on equity for PE transactions is negatively (and significantly) correlated with exit year, suggesting a secular decline in returns (and, the increasing competitiveness of the PE industry), even for the lower middle-market arena for small-cap transactions. This can be seen as part of the relentless Schumpeterian efficiency wrought from dynamic, innovative, and competitive markets.
Third, insights from agency theory (Jensen 1986, 1988) and transaction cost economics
(Williamson 1988, 1996) are substantiated in our sample transactions. The low-tech, slow-growth consumer-goods manufacturers have the highest-return transactions, highest average leverage, highest average levels of management equity and PE firm equity, and most of the controlling-stakes deals. More broadly, the slow-growth manufacturing businesses are more heavily leveraged and exhibit better returns than marketing and services businesses. Marketing and professional services firms have less average leverage, more syndicate club deals, more minority-stakes deals, and exhibit higher revenue and profit growth (and, more organic growth deals than those involving add-on acquisitions). IPOs have the highest returns as an exit type, followed in order by exit types characterized by progressively more knowledgeable buyers. These straight-line differences in results across exit types apply as well to leverage, holding time, revenue, profit and employment growth, capital expenditure growth, and management equity.
Fourth, controlling-stakes and solo deals are characterized by twice the return, one-third to one-fourth the size, shorter holding times, much higher leverage, and lower debt pay-down ratios than their counterparts. They are also far more heavily concentrated in slow-growth manufacturing industries. This is not to deny the growing importance of syndication in private equity. However, our data clearly show the long-term performance advantages of control transactions focused on low-beta industries that are amenable to leverage (and, the ability of the majority or sole owner to bring about a new, more focused, strategy).
In our sample, the pursuit of ancillary consolidating acquisitions is the single most important determinant of transaction IRR for equity. This shows the extent of available “slack” in fragmented industries ripe for exploitation by small- and mid-cap PE investors. Additionally, leverage affects equity IRRs positively and asset (or total firm) returns negatively, consistent with received theory. For improvements in operating performance, the presence of an add-on transaction and the amount of leverage are key to explaining revenue growth, and leverage is the main driver of growth in EBITDA. That is to say, the fastest-growing firms are burdened with the least amount of debt.
John L. Chapman, PhD is the NRI Fellow in Economics at the American Enterprise Institute. Peter G. Klein is Associate Professor in the Division of Applied SocialSciences at the University ofMissouri. The full paper can be downloaded from the CORI Working Paper Series Index.