Buyout funds are scoring higher exit multiples on improved revenues but also benefiting from market tail-winds
Buyout funds are scoring higher exit multiples on improved revenues but also benefiting from market tail-winds
The details behind private equity returns can be overshadowed by headline performance. Buyout funds, the largest strategy across private capital, have done well for LPs over time. Preqin benchmark data shows a median net IRR of 21.1% for fund vintages since 2015, with far less variance than venture capital or even the broader private capital universe as a whole. But what’s behind those returns?
Are funds buying companies and making them better, or are they simply selling them at a higher price than what they paid, or just saddling them with debt? And does it matter? If the investor gets paid, what’s left to think about?
How buyout funds drive value
A buyout fund can drive value for its LPs in a few ways. The first two are fundamentally driven and are indicators of a manager’s skill to add value to their assets. Revenue growth can point to both how the fund’s guidance has improved a company’s ability to generate revenues and/or how much the industry has grown overall. Margin growth points to how efficiently a company is being run since the fund’s acquisition. A look at a sample of the market shows diverging paths between the two.
Globally, approximately 150 deals taken from entry to exit between 2015 and 2019 added about half of their equity multiple, or 1.2x of the total 2.4x growth, through revenue growth (Fig. 1). From a due-diligence perspective, this is a good metric to look to. LPs can look to this degree of success, and assess if a potential GP can improve a portfolio company organically.
The other organic avenue for value creation is improving margins – notably the EBITDA margin, which measures how efficiently a company generates revenues. EBITDA margin improvement has had less of an influence on exit valuations. However, as revenues grow there is often a trade-off between volume and profitability. Growth from margin improvements contributed only about 11% to the aggregate equity growth over the sample of deals researched. That number goes down to 3.8% after looking at only US-based buyout deals.
Market forces have also had their hand in the mix. Multiple expansion, or the price the market values assets at, has contributed a lot to performance. About 45% of the overall equity growth of the aggregated deals was generated by the difference in sale price estimated by the enterprise value-to-EBITDA multiple. Across the five years of deals followed here, the average multiple increased from a 9.7x EV/EBITDA measure at entry to 12.7x. Even as this metric can be associated with upward returns, it can be volatile and driven by market forces that are out of a manager’s control. Those relying on upward market movements over fundamental improvement could get caught out in a down market.
The final lever that funds use to add value is debt. Debt can help fuel investment and scalability for a company, but it can also be a burden to profitability if too much is added. Globally, and particularly in the US, funds have used debt to finance equity growth.
Across the global data set, the added incremental amount of debt reduced exit equity multiples by a factor of 0.13x. That number more than doubles for US-based deals. But that number ignores the net impact on revenues. While debt can be taken on by a portfolio company for any reason, capital investment in expansion is typically the prime mover. To highlight this concept and its impact on the value creation bridge, leverage negatively impacted US-based equity values to a greater degree than the global sample. Yet a look at revenue’s contribution shows a comparatively higher add in value to the US sample.
Does what’s behind performance matter?
Above we asked if it even matters what’s behind the performance if it hits or exceeds LPs’ performance target? Yes. It matters because the data used here is at asset level or from deals that were only pieces in a larger strategy. The typical buyout fund has an investment period somewhere between five and seven years, meaning that a fund will be made up of many deals exposed to a myriad of unique market conditions. The impact of leverage, for instance, can reflect investment in revenue-driving projects that in aggregate have paid out a higher ROI than the cost of debt (Fig. 2), while strong exit environments can boost multiples. LPs should know how a potential fund manager has navigated portfolio companies in the past, and what it relies on to drive performance.