Managing a Portfolio Company and Creating Value
In this section we’ll look more in-depth at how PE firms interact with their portfolio companies, and what the benefits are for both the PE firm and the company itself.
Private equity firms provide their portfolio companies with expertise that they may otherwise not have. A majority of PE firms create a close working relationship with the management teams of their respective portfolio companies. For the most part, PE firms do not involve themselves directly in the day-to-day operations of their portfolio companies. Rather, the firms typically seek to create value by collaborating with management in identifying and executing financial, operating, and strategic priorities, and providing expertise in these tasks that the management team may not have. In addition, a PE firm typically will have a few seats on the company’s Board of Directors or Advisory Board. Through these seats, the PE firm can actively and directly influence the operational and strategic decision making of the company.
- Relationships in the industry: Portfolio companies can benefit from PE firm relationships, both in the finance and corporate community. PE firms have relationships with investment bankers, are able to make introductions to other key players on Wall Street and in the general business community, offer exposure at industry conferences, and provide access to expert corporate advisors to portfolio company management teams.
- Experience running companies: Due to their experience operating many companies, often across various industries, financial sponsors can educate management teams and help implement the industry’s best practices for portfolio companies. Sponsors can mold entrepreneurs into professional management teams, taking current teams “to the next level” by knowing the best strategies for sales optimization, pricing, cost efficiencies, and other vital management techniques. Additionally, a financial sponsor may decide to replace all or part of the current management team with a highly experienced executive or team within the sector. Other times, the PE firm will decide to retain the current management team, and incentivize its members to reach growth targets effectively. In either case, the PE firm can help the portfolio company attain superior results by improving the management team and its ability to run the business effectively. In addition, the firm will help to ensure that appropriate members are selected for the Board of Directors.
- Transformation of businesses: The firm could help change and improve the company through new products or helping the company to expand in various industries or countries. For example, a company may have to change its business orientation from a business-to-business (“B2B”) model to a business-to-consumer (“B2C”) model in order to navigate its changing industry landscape. Through these transformations, inefficient processes can be improved, supply chains and distribution channels can be streamlined, the number of required employees can be reduced to increase productivity, and margins and new products can be introduced.
- Bolt-on acquisitions and creation of platforms: PE firms have a lot of experience acquiring companies and typically have had success integrating acquisitions. Both of these factors can be extremely valuable to portfolio companies pursuing an acquisition-oriented growth strategy. The right acquisitions can help improve a company’s market position, can create strong partnerships in the industry, and can provide cost and/or revenue synergies, which ultimately increase the value of the company.
- Experienced sellers of businesses: The PE firms know how to maximize a company’s value. They are experts at how to pitch companies up for sale, and can provide invaluable expertise and resources when it comes time to sell (exit) an investment.
- Financial engineering: Financial sponsors help create value by optimizing a target company’s capital structure where they are able to attain more leverage so that less equity is needed to purchase the company originally. By understanding what the optimal capital structure is for a firm, private equity firms can maximize the returns for themselves and all other stakeholders.
Potential Exit Alternatives and Returns Analysis
PE firms acquire businesses with the intent to exit at a higher equity value than was initially invested. A typical timeframe of an exit ranges between five and seven years. Most private equity investors require an expected IRR in excess of 25% before considering undertaking an LBO of a potential target company. Typically, senior members of the investment team will be required to make critical assumptions on the potential exit multiple (EBITDA and P/E) and the maximum amount of debt load the target company can handle to achieve such high returns without taking on excessive risk. The focus is typically on the multiple of invested capital rather than the IRR, because the focus is on obtaining a higher total equity return more so than on receiving the investment back in a shorter time period (and thereby “juicing” the IRR of the investment).
- EBITDA/Earnings Growth: Increasing EBITDA or earnings is the most effective way to increase the equity value. Typical ways of increasing EBITDA or earnings include increasing sales, lowering overhead, and increasing gross margin. Even if the EBITDA multiple paid at entry does not change at exit, a higher EBITDA will increase the company’s value, and all of that value will accrue to equity holders. For example, if you purchase a company at 5.0x LTM EBITDA and exit at the same multiple, then the EBITDA will directly affect the exit price. If EBITDA grows from $110 million to $130 million, then the exit valuation is $650 million compared with an entry valuation of $550 million—and all $100 million of the increased value will accrue to the equity holders.
- Multiple Expansion: Valuation multiples are linked to a company’s growth prospects, operating performance, and competitive landscape, and can dramatically fluctuate depending on the market environment. Therefore, a PE firm may try to time the macro-environment and the growth trajectory of its portfolio company to sell at a higher multiple than what was paid at the initial investment. Multiples are generally very reliant on market conditions, so an ideal situation would be to purchase companies at a time when market multiples are lower than usual, and sell when multiples are higher than usual. Additionally, a PE firm may try to enhance a company’s exit multiple by shifting the company to a more attractive mix of business lines (potentially by targeted acquisitions) during the investment period, thereby allowing the company to be potentially sold for a higher EBITDA/earnings multiple than it was acquired for.
- Free Cash Flow Generation: All free cash flow can be used to pay down existing debt, which was used as part of the purchase price at the time of the initial investment. As the debt is paid down, the equity value will correspondingly increase. For this reason, a PE firm will attempt to increase growth and margins, which will increase the free cash flow generated by the respective portfolio company—thereby further accelerating the rate of growth in the equity’s value.
When initially evaluating an investment opportunity, PE investors must always keep in mind that the prospective exit strategy is crucial to the overall success of the investment. Therefore they must assess the likely scenarios for the common types of exits: typically, a trade sale (selling to a strategic buyer), an initial public offering, or a secondary buyout. The most desirable option typically is to sell to a strategic buyer, because strategic buyers can typically pay higher multiples for a business than financial buyers, and the investor would receive a return right away (upon closing of the sale), rather than waiting for a public offering to complete (and the subsequent “lock-up” period to expire—more on this later). Other exit options include refinancing, partial sales, and liquidations.
In deciding upon which exit strategy to pursue, the investor must consider the macroeconomic, legal, tax, and regulatory environment. Macroeconomic risks include the conditions of the public capital markets and the current trends in bank lending, such as interest rates and willingness to lend out capital. For example, if there is a period of tight credit, a bank might not be willing to lend financing to a potential buyer, thereby reducing exit opportunities for the company.
Trade (Strategic) Sale
A financial sponsor may realize gains in a portfolio company investment via a sale to a strategic acquirer. This allows for an immediate liquidity event for the financial sponsor. Strategic buyers typically intend to hold the acquisition over the long-term and thereby gain a greater competitive advantage and market share in its respective industry. A strategic buyer is usually a non-PE firm, and the acquisition is in the buyer’s strategic interest (whether it’s for market growth, trade secrets, new products, synergies, or other business improvements). Therefore the trade sale will usually command the highest sale price. For these reasons, the sale to a strategic buyer is generally the preferred exit option for an LBO investor.
Initial Public Offering (IPO)
The primary benefit of an IPO exit for a portfolio company is the potential for a high valuation, provided that there is investor demand for equity in the company and stable, favorable public market conditions. That being said, an IPO involves high transaction costs. Additionally, if the financial sponsor is looking to fully exit the portfolio company, potential public investors might view a full exit as a lack of confidence in the future prospects of the business. Furthermore, the terms of the IPO may prohibit the financial sponsor from exiting some or all of its position for a period of time (called a “lock-up” period). Other potential problems with an IPO exit include the risk of the quality of the overall public equity market environment, and the likelihood of a discounted price for the IPO. (An IPO generally is priced at a discount to the expected trading price of the stock once the IPO is completed—typically about 15%-20% of the equity’s expected market value. This discount is designed to help drum up demand for the new issuance, but it results in value left on the table by the issuer of the IPO, which directly impacts the achievable value for the PE firm’s equity holders.)
Secondary Buyout
A financial sponsor can often sell a portfolio company to another financial sponsor in a leveraged buyout transaction known as a secondary buyout. This name derives from the fact that the LBO is being sold to the next buyer in another, separate LBO.
One possible rationale for this type of exit can be that the financial sponsor and current management team believe a larger financial sponsor can add value to the portfolio company as it moves into the next stage of its development. Alternatively, a financial sponsor may decide to sell the company to another financial sponsor if it has reached its minimum investment time period and has already created a high rate of return on its initial investment. Other potential benefits of selling to another PE firm include increased flexibility in the structure of the sale (where, for example, the seller could potentially maintain a partial ownership stake and enable the company to continue conducting its business with the intent of growth in the long term).
However, a financial sponsor is almost always a sophisticated buyer, and thus will try to purchase the asset at a minimal valuation, typically at a much lower price than would a strategic buyer. In addition, the attainable sale price could be highly dependent upon debt market conditions.
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