Q&A on Private Equity Operational Improvements
Answering reader questions
By: Dan Rasmussen
We received a large number of emails and questions about last week’s research, and so we thought we’d do a deeper dive into the data to try to provide further insight into the most controversial points. We have structured this as a Q&A.
Q: How does the size of the company affect operational improvements? Do smaller companies benefit more from PE management?
To answer this first question, we subsetted our database into quartiles based on total transaction value. We define large companies as the top quartile and small companies as the bottom quartile. In effect, the larger companies correspond to a median enterprise value of $2.6B, while the median enterprise value of the smaller companies amounts to about 1% of this, at $27M.
The most visible difference is in the debt-to-EBITDA ratio. Though both large and small companies experience an increase in debt-to-EBITDA relative to the benchmark at the time of the deal, this increase is much bigger for larger companies.
Figure 1: Debt / EBITDA by Size of the Acquired Companies vs. Benchmark
Source: Verdad, Capital IQ
The two most likely reasons for this difference are that the smaller companies might simply be less able to access leverage and/or they might be more likely to be growth investments that need less leverage.
In both cases, however, we notice that debt isn’t meaningfully paid down post-acquisition, potentially indicating a conscious decision to permanently change capital structure post-leveraged buyout.
We also observe big differences in margins between smaller and larger firms. The smaller companies tend to have lower margins than the industry average, while the larger companies tend to have higher margins. The trend for both is roughly similar, with no big differences pre- and post-acquisition.
Figure 2: EBITDA Margin by Size of the Acquired Companies vs. Benchmark
Source: Verdad, Capital IQ
The larger companies also tend to grow EBITDA at a faster rate than the smaller companies, which is interesting given our earlier hypothesis that the smaller companies might be more growth-oriented investments.
Figure 3: EBITDA Growth by Size of the Acquired Companies vs. Benchmark
Source: Verdad, Capital IQ
In terms of EBITDA growth, smaller companies do appear to benefit more from PE management than larger companies.
Q: How does the cheapness of a company affect operational improvements?
For this question, we operate within a similar logic, creating value quartiles based on the EV/EBITDA multiple at the time of the acquisition. The “cheap” quartile has a median EV/EBITDA multiple of 4.4x, while the “expensive” quartile is almost four times higher, at 16.0x. We excluded all companies with negative EBITDA.
Interestingly, both groups have similar EBITDAs at the time of the deal: $42M for the cheap group and $32M for the expensive group. However, the median transaction value of the expensive group is more than three times higher than that of the cheaper group at $554M versus $171M.
We see, unsurprisingly, that more expensive deals require significantly more leverage than cheaper deals.
Figure 4: Debt/EBITDA by Value of the Acquired Companies vs. Benchmark
Source: Verdad, Capital IQ
Although, on average, expensive and cheap companies have similar growth pre-acquisition, cheap companies overtake expensive ones after the deal. Expensive companies even drop below the benchmark three years on and are particularly harmed by the distraction of the acquisition in the year it takes place (with EBITDA growth falling to 10% below the benchmark).
Figure 5: EBITDA Growth by Value of the Acquired Companies vs. Benchmark
Source: Verdad, Capital IQ
This is particularly interesting, as the most common reason to pay higher prices for deals is the expectation of high future growth—growth that, at least in this data set, does not seem to materialize.
We didn’t see any other noticeable differences between cheap and expensive companies. Our view is that PE investors pay higher prices for some companies than others, but don’t appear to get materially better fundamental outcomes for the expensive deals than the cheaper ones—a point in favor of value investing.
Q. How do different sectors perform under PE?
Using our same seven metrics, we evaluated the four most common sectors within our data set of PE deals: consumer discretionary, industrials, information technology, and health care.
Our first chart shows leverage levels by sector. We see that healthcare and information technology – the darlings of the last decade – show the greatest increase in debt.
Figure 6: Debt/EBITDA by Sector vs. Benchmark
Source: Verdad, Capital IQ
Unsurprisingly, these sectors also see the greatest reduction in capital expenditures post-acquisition.
Figure 7: Capex as a % of Sales by Sector vs. Benchmark
Source: Verdad, Capital IQ
We don’t see any noticeable trends in EBITDA growth by sector after acquisition. Though we do notice that PE seems to be buying healthcare companies that were growing faster than the industry pre-acquisition and technology companies growing slower than the industry pre-acquisition. In all sectors, growth quickly mean reverts to benchmark.
Figure 8: EBITDA Growth by Sector vs. Benchmark
Source: Verdad, Capital IQ
Q: How does the PE sponsor affect these metrics? Do LBOs performed by top funds differ from LBOs of all other funds?
A question that kept coming back was: but don’t the top PE funds do better? We answered it by filtering our data set by the most frequent PE fund sponsors. We obtained a proxy for top firms, including: KKR, Apollo, The Carlyle Group, Bain Capital, J.P. Morgan, TPG Capital, Apax Partners, Blackstone, Clayton Dubilier & Rice, CVC Capital, Madison Dearborn.
The companies acquired by top PE funds have a debt/EBITDA that is similar to the industry standard before the LBO. In the year of the transaction, the top PE funds leverage their company more than the other companies in the database do.
Figure 9: Debt/EBITDA by PE Fund vs. Benchmark
Source: Verdad, Capital IQ
This could be because the top PE firms tend to invest in larger companies, which tend to be leveraged more than small companies. Median transaction value for the top PE funds amounted to $1.6B, compared to $335M for all PE funds.
We see that the larger sponsors buy companies with higher EBITDA growth both before and after the transaction.
Figure 10: EBITDA Growth by PE Fund vs. Benchmark
Source: Verdad, Capital IQ
Larger sponsors also tend to buy companies with higher margins.
Figure 11: EBITDA Margin by PE Fund vs. Benchmark
Source: Verdad, Capital IQ
Within the universe of private companies, we see that the larger deals, which tend to be the targets of the bigger sponsors, also tend to have more robust financials in terms of margins and growth. This makes a case that larger private equity firms tend to be able to buy higher quality businesses.
Acknowledgment: This piece was co-authored by Lila Alloula and Minje Kwun. You met them last week, but in case you forgot, Lila is a rising junior from France double-majoring in mathematics and economics at Yale, and Minje is a rising sophomore at Dartmouth, majoring in mathematics as well as pursuing lacrosse stardom on the varsity team. Lila hasn’t been picked up for a varsity sport since last week but is working on it. Both are looking for finance internships for summer 2024.