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Back to School: PE creates value by revenue growth, not leverage

Private equity pros often chafe against the notion that they generate returns by leverage and other financial engineering rather than by good old fashioned sales growth at a portfolio company.

Well it turns out that top-line expansion by GP-managed companies does in fact drive positive results and collectively help the economy, according to a new 16-page study by Pantheon called “Value Creations and the Business Cycle.”

The study of 450 realized deals from 2001 to 2010 also showed outperformance over public equities throughout business cycles, “which indicates skill rather than luck,” said Pantheon Senior Research Associate Ian Roberts, who did the study.

It is worth noting that the time period examined includes the collapse of the dot-com bubble, the housing crash, the Global Financial Crisis, the European sovereign debt crisis and unprecedented quantitative easing.

“After controlling for leverage, which involves adjusting returns down in proportion to the quantity of debt used by the GP, our sample offered substantial alpha when compared to the benchmark portfolio of publicly listed equities from the same sector and geography,” Roberts said.

Deploying original methodology, the study calculated an average annual return of 26 percent of the sample of 450 deals. The average annualized gross return was 9.8 percent above public equities. Sales growth comprised 71 percent of the gross alpha, followed by 28 percent from multiple expansion and 1 percent from margin growth.

Broken out by year, alpha varied between 3.3 percent and 17.4 percent.

“Every vintage witnessed market volatility, and some vintages experienced falling stock prices, but throughout all of this, our sample of deals has steadily delivered value creation versus public markets,” Roberts said.

The study also concluded that the traditional way of calculating performance by private equity — a method known as the value bridge technique — “neither tells whether GPs are delivering outperformance nor whether they are increasing the size of the economic pie by enhancing fundamentals,” Roberts said.

The GPs backing the deals in the study’s sample enhanced the quality and growth prospects of their portfolio company cash-flow streams to help outperform public companies, the study said.

The study concurs with past research that flags the tendency by management at public corporations to divert cash for empire-building projects that don’t maximize shareholder value and an aversion to efficient levels of risk by public company executives.

On the other hand, buyouts allow shareholders in a private company to control and manage the company, aligning the interests of owners and management and enforcing value-adding operational improvements. Meanwhile, the use of debt in a buyout may provide a company with tax shields and the incentive to generate cash, Roberts said.

Action item: Read the study here: