Private Equity Operational Improvements
Measuring Value Creation in LBOs
By: Dan Rasmussen
Private equity firms earn high returns by improving the operations of the companies they buy. By taking majority stakes and installing an engaged board, private equity firms can add significant value to often undermanaged small companies. Or so goes the industry marketing spiel.
“The fundamental reason behind private equity’s growth and high rates of return is something that has received little attention, perhaps because it’s so obvious,” reads a popular Harvard Business Review article on private equity: “the firms’ standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement, selling them.”
We set out to diagnose just how significant this rapid performance improvement is to driving private equity’s returns. Is the private equity model of running companies materially different from how public companies tend to be run? And can we see that difference in the financials?
The challenge to answering this question is that private equity is, well, private. So obtaining lots of data on the underlying financials seems impossible. There is, however, one straightforward way to build a large sample of private equity deals. When private equity firms issue public debt as part of their financing packages, which they tend to do for many larger deals, the financials pre- and post-acquisition are disclosed in public filings.
We used Capital IQ to build a database of 993 deals from 1996 to 2021 in which both pre-acquisition and post-acquisition financials were publicly disclosed as a result of public debt issuance. This is, unfortunately, a small sample of the total number of transactions. The last decade has seen about 5–10K deals per year, while our database includes only 16–105 deals per year. But our data set does capture a meaningful percentage of the largest deals: the average revenue of a company in the dataset is $760M, average EBITDA is $96M, and most of the big headline-making deals like Dell, Staples, and Toys “R” Us are included.
Our data set is by no means comprehensive, but if private equity operational improvements are as essential to the model as some claim, we would expect to be able to see at least some evidence in this data. If private equity firms truly improve operating efficiency as they claim, we should see accelerated revenue growth, expanded profit margins, and increased capital expenditures in the acquired firms.
We analyzed six key metrics that we believe reflect operational efficiency (revenue growth, EBITDA margin, capex as a percentage of sales, gross profit to total assets, EBITDA to total assets, and debt to EBITDA) in the three years before and after the deal (buyout holding periods are about three years, on average). As a benchmark, we compared these metrics to the aggregate metrics for public companies in the same sector in the same year.
We first looked at revenue growth. The graph below shows the median difference between year-over-year growth in overall sales for the companies that were acquired by private equity firms and the benchmark.
Figure 1: Revenue Growth in PE-Owned Companies vs. Benchmarks
Source: Verdad, Capital IQ
We then looked at EBITDA margins. The graph below shows the median difference in EBITDA as a percentage of sales between the LBO companies and the benchmark.
Figure 2: EBITDA Margins in PE-Owned Companies vs. Benchmarks
Source: Verdad, Capital IQ
For both revenue growth and EBITDA margins, we notice that PE firms tend to target companies outperforming their industries: revenue growth is on average 1.7% above industry standard in the two years before the deal, and EBITDA margin is on average 0.5% above industry standard in the three years before the deal.
In the year the transaction is completed, both metrics drop sharply, creating a V shape in both charts. We hypothesize that major LBO transactions are distracting to management and lead to suboptimal outcomes from a sales and margin perspective during the deal year.
Once the deal has been completed, growth and margins recover, but do not on average return to pre-deal levels. In the three years after the deal, revenue growth is on average 1.1% above industry standard, 60bps lower than pre-acquisition. EBITDA margin averages out to exactly the industry standard, 50bps lower than pre-acquisition. While PE firms are typically praised for their efficiency and cost-control, the graph on EBITDA margins shows a negligible difference in actual profitability. The supposed efficiency and cost-cutting isn’t showing up in the numbers.
Revenue growth and margins do seem marginally better than sector benchmarks, but this does not appear to be a result of the transaction or any systematic operational improvements. Instead, PE firms appear to be buying slightly higher-performing companies that then experience some mean reversion post-acquisition.
We then looked at capital expenditures. Below we show the median difference from the benchmark in percentage of sales that these firms spent on capital expenditures pre- and post-acquisition.
Figure 3: Capex as % of Sales in PE-Owned Companies vs. Benchmark
Source: Verdad, Capital IQ
Private equity firms appear to be acquiring companies with lower capex/sales than industry averages. After acquisition, capex spending decreases marginally relative to pre-acquisition. We hypothesize that because leverage is important to most PE transactions, PE firms prefer companies that are less capital intensive and more cash flow generative, which is why capex spending is lower than industry benchmarks. But again, we see no evidence of a major change in strategy post-acquisition, no evidence that private equity is systematically investing dramatically more or dramatically less on average.
We can then look at profitability, in the academic sense of gross profit/assets and EBITDA/assets, which is essentially a measure of return on capital. We show both metrics in the charts below.
Figure 4: Gross Profit/Assets for PE-Owned Firms vs. Benchmark
Source: Verdad, Capital IQ
Figure 5: EBITDA/Assets for PE-Owned Firms vs. Benchmark
Source: Verdad, Capital IQ
In these charts, we see a very clear pattern: gross profit/assets and EBITDA/assets drop sharply at the time of the deal. This is, however, purely accounting. The spike down at the time of the deal can be explained fully by the write-up in total assets on the balance sheet caused by the incorporation of goodwill. But after the deal, companies that looked to be higher than industry benchmarks in terms of profitability and return on assets come almost perfectly in line with sector benchmarks, suggesting that PE firms are paying a full price for the higher-quality companies they are buying.
Having looked at revenue growth, EBITDA margins, capex spending, and return on assets, we don’t see any evidence in our sample for systematic operational improvements in PE-owned firms. These firms don’t seem to be growing businesses faster, investing more in growth, or gaining much operational efficiency. So what are they doing?
The graph shows the median difference between the LBO companies’ ratio of debt to EBITDA and that of the benchmark.
Figure 6: Debt to EBITDA
Source: Verdad, Capital IQ
PE firms are buying quality businesses, leveraging them up, and not significantly deleveraging in the years post-acquisition. Debt is not significantly decreased after the deal and is actually often higher three years on than at the time of the deal. The PE firms are consciously effecting a permanent change to the target company’s capital structure.
The industry mythology of savvy and efficient operators streamlining operations and directing strategy to increase growth just isn’t supported by data. Instead, there is a new paradigm to understand the PE model, and it’s very, very simple.
By and large, as an industry, PE firms take control of businesses to increase debt. As a result, or in tandem, the growth of the business and the rate of spending on capex slows. That’s a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management.
Investors should not take the industry’s word that PE firms are superior managers that drive superior performance at the firms they own. This is a myth akin to arguing that Republican presidents are better for the economy or Democratic presidents are better for the poor. It sounds plausible, but it’s very hard to prove with data. And investors should be motivated by data, not myths. As we have shown, this data is possible to obtain and analyze.
The PE industry has created an effective and pervasive marketing myth that they are superior to individual companies, operating more efficiently and earning greater returns. But, as we have seen, this is largely fiction. The real reason PE firms want control of the companies they buy is not because of superior strategic insight but because they want to significantly leverage them. Our sample is obviously not sufficient to say this is true of all PE firms, but we believe it’s representative enough to be able to justify significant skepticism of any claims of operational improvements being a major contributor to PE’s performance relative to public markets.
Acknowledgment: This piece was co-authored by Minje Kwun and Lila Alloula. Minje is a rising sophomore at Dartmouth College. She majors in applied mathematics and is an attacker on the Dartmouth varsity women’s lacrosse team. She is a chalice bearer at St. Michael and All Angels Episcopal Church in Dallas. Lila is a rising junior at Yale. She double majors in economics and mathematics and is not part of any sports team, though she maintains that she is pretty good at skiing. She is also French. Both are looking for internships in finance for summer 2024.