by Giuseppe Scavolo
Financial sponsors tend to create value in LBO transactions in three different ways: operational improvements, debt expansion and multiple expansion.
The first two forms concern improvements of the target’s financial and operational performance. The last value creation option, on the other hand, focuses on the features of the sponsor rather than on those of the target. Indeed, it does not modify the financial and operational performance of the target, and it comes from the sponsors’ broader knowledge and expertise. The literature tends to focus on the first two ways since exit multiples are too uncertain to rely on because of external factors affecting them. 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 at the exit. Sponsors make massive efforts to boost revenues and cut costs to sell a more profitable company with a larger equity value. An 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. Furthermore, 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 by 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,
- Corporate refocusing,
- Bolt-on acquisitions,
- 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 expenses and headcount. Surely, PE funds tend to make the target less bureaucratic and more efficient by reducing different expenses, such as corporate centres and employees.
Reducing capital requirements
Cash flows are the key element of an 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. Sponsors 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 they may, therefore, 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 through the common approach of refocusing on the target’s 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 those of 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
Better monitoring and control of the management driven by a more efficient corporate governance structure reduces agency costs. Sponsors have the significant part of the capital in their hands and are deeply incentivized to execute an active role on the board of directors. The role of active investors entails some benefits which include a 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 it 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 expertise 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 thanks to their 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 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 countries – fiscally deductible. Instead, the cost of equity in the shape of dividends cannot 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, an amount of debt greater than the ordinary disciplines the existing management, driving managers to utilise free cash flows properly. Indeed, the availability of discretional free cash flows leads managers to overinvest in negative NPV projects and tolerate more mistakes. Debt increases the mandatory interest payments and reduces the discretional cash flows which indirectly creates a tighter control over management activities. To conclude, sponsors have several ways to create value and usually, combine some or all of them to get the most out of the investment. Their knowledge, expertise and network lead to value creation opportunities and potentially high returns.
Financial arbitrage indicates returns generated from differences in the valuation of the target occurring between the beginning of the investment and the disinvestment or exit. 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.
Market valuation of the peer group of comparables
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. Sponsors predict future public valuation multiples better than their counterparts 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.
Different expectations regarding the business or the industry
The second type of financial arbitrage refers to the divestment 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 negotiation process
The last type of financial arbitrage is linked to the excellent dealmaking abilities of financial sponsors. Sponsors have an established network within the private equity industry and huge expertise. They usually spend a significant amount of time searching for the right candidate, while trying to limit the competition. Indeed, the broader the competition, the 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.
When all of these factors work together, the effects can be powerful for the LBO investors: