By Giuseppe Scavolo and Edoardo Cogliati
Financial sponsors tend to create value in LBO transactions in three different ways: Operational improvements, Debt and Multiple Expansion. The first two forms assume improvements of the target financial and operational performance. The last value creation option refers to the sponsor features instead of the target. Indeed, it does not modify the financial and operational performance of the target and comes from sponsors’ broader knowledge and expertise. The literature tends to focus on the first to ways since future valuations are too uncertain. Indeed, even sponsors’ financial models tend to concentrate on value enhancement coming from developments in the target operations and a better capital structure.
The divestment price widely relies on the EBITDA[EC1] at the exit. Sponsors make massive efforts to boost revenues and cut costs to sell a more profitable company within a larger equity value. EBITDA increase can be obtained by increasing the overall sales and margins of the target.
On the revenues side, the target may offer new products or enter new markets. Further, a faster way to boost sales is to make new acquisitions. At the same time, higher margins provide higher EBITDA all else being equal. More and more private equity funds try to lower target costs working on the headcount and managerial inefficiencies. In the end, the operational improvements label includes the following measures:
Costs cutting & margins improvement,
Reducing capital requirements,
Removing managerial inefficiencies,
Improving incentive alignments and
Improving monitoring & controlling.
Costs cutting & margins improvement
As soon as the deal is concluded, sponsors start tightening the control on corporate spending. The main impact refers to R&D[EC2] expenses and headcount. Surely, PE funds tend to make the target less bureaucratic and more efficient within reduced overheads as corporate centres and employees.
Reducing capital requirements
Cash flows are the key element of LBO transaction. As stated, lower NWC implies higher cash available to pay down debt. Thus, sponsors do not just try to eliminate the unnecessary costs but also try to reduce the capital needed for the day to day operations and increase the overall capital productivity. Indeed, a better inventory and accounts receivables management leads to lower NWC and higher cash flows. Private equity-backed companies are known to have a significantly smaller amount of net working capital than their competitors.
The same applies to CapEx. Sponsor attempt to minimise the maintenance CapEx by divesting the underutilised and unnecessary assets. However, significant changes can harm the ability of the target of competing in the marketplace and produce only short-term advantages. Thus, all the measures described have to be deeply considered by the management team to avoid value destruction.
Removing managerial inefficiencies
Moreover, companies’ poor performance may occur from management incapabilities. More and more buyouts are driven by the opportunity to replace the existing management and improve the candidate’s efficiency. Raised operational efficiency positively impacts both target cash flows and margins leading to a higher value at sale.
Buyouts create value also by increasing strategic distinctiveness by the common approach of refocusing on the target core activities. Sponsors tend to reduce the complexity of their portfolio companies by reducing the number of activities and inefficient subsidiaries. Usually, the so-called peripherical activities are sold to third parties.
The most common way to immediately increase the EBITDA is to buy new companies. Bolt-on acquisitions refer to the target acquiring new businesses to get benefits from a better market position and economies of scale.
Improving incentive alignments
Private-equity-backed firms are characterised by a higher equity share from the management team. Indeed, the investors encourage the management to increase its equity share in the enterprise to a significant level. Managers become owners, and their incentives are more aligned with the investors. The management seizes in the company both monetary and human capital within higher personal costs of inefficiency and more incentives to find smart strategic moves and larger gains.
Improving monitoring & controlling
Further, a better monitoring and controlling of the management driven by a more efficient corporate governance structure reduces agency costs. Sponsors have the significant part of the capital on their hands and are deeply incentivized to execute an active role on the board of directors. The role of active investors has benefits regarding better evaluation of long-term strategies and tighter control over ongoing operations. Incentives alignment plays a crucial role in the value creation process of LBO transactions and is a critical driver of lower agency costs and higher efficiency since motivates the management to extract the highest possible value from the target.
While financial arbitrage creates value without affecting the capital structure and the operations of the target and operational improvements generate value from enhancements in the target processes, financial leverage or the use of the debt creates value by changing the capital structure of the acquired company. Pe-backed firms leverage investors to network and knowledge to get better financial terms than they would have had as a stand-alone business.
Indeed, sponsors assist the management in negotiating bank loans, underwriting bonds, going public and even selling stocks. Lenders tend to deal more easily with financial sponsors according to them better treatments. Indeed, the marginal agency costs are reduced by the presence of pe funds since they establish long-term relationships with lenders and are less incentivized to transfer wealth from debt investors to the equity ones. Thus, pe-backed corporates show a higher debt to equity ratio than similar stand-alone firms. Debt provides benefits and risks. In particular, it generates value from:
Debt Tax Shield and Management discipline,
lower agency costs.
Debt Tax Shield and Management discipline
The cost of debt in the form of interest payments is – for the vast majority of the world countries – fiscally deductible. Instead, the cost of equity in the shape of dividends can not be deducted from taxable earnings. Thus, all else being equal, debt has a significant economic advantage over equity provided by the interests tax shield.
Lower agency costs
Moreover, a larger than the common amount of debt disciplines the existing management driving managers to utilise free cash flows properly. Indeed, the availability of discretional free cash flows lead managers to overinvest in negative NPV projects and tolerate more mistakes. Debt increases the mandatory interest payments and reduces the discretional cash flows within a control over management activities.
To conclude, sponsors have several ways to create value and usually, combine some or all of the to get the most out of the investment. Their knowledge, expertise and network lead to value creation opportunities and potentially high returns.
The label financial arbitrage indicates one of the three ways of LBOs value creation. Financial arbitrage means returns generated from differences in the valuation of the target occurring between the beginning of the investment and the disinvestment or exit. In particular, the term refers to all the returns obtained without the increase of the financial or operational performance of the target. The valuation of the target depends on: market valuation of the peer group of comparables, different expectations regarding the business or the industry, and the negotiation process. Financial arbitrage referring to these factors may generate value in LBOs.
The first type of financial arbitrage does not apply to the target but to the investors. Indeed, the value creation does not imply financial and operational improvements of the target. Sponsor predict future public valuation multiples better than their counterpart and generate value by selling at a higher price the same company. Moreover, sponsors have the knowledge to arbitrage successfully within private markets or between public and private markets.
The second type of financial arbitrage refers to the disinvestment phase and is an external lever of value creation since it does not affect the target performance. The sponsor becomes seller during the divestment period and has a broader knowledge of the company than the buyout investors.
Indeed, it captures value from deeper information regarding the expected financial performance of the portfolio company. The last type of financial arbitrage is linked to the excellent dealmaking abilities of financial sponsors. Sponsors have an established network of the private equity industry and huge expertise. They usually spend a significant amount of time searching the right candidate while trying to limit the competition. Indeed, broader the competition, higher the acquisition price.
Thus, the most established players in the private equity industry may use their expertise, knowledge and networks to identify suitable targets, limit financial and strategic competitors and manage the negotiation process to capture value from the target.