The gross IRR targeted by buyout firms is 27 percent on average, while the average gross multiple of invested capital targeted is 2.9x, according to the draft of a new academic study. Most sponsors adjust their target IRRs based on the perceived riskiness of the investment. Firms with lower assets under management tend to target higher returns.
As to how they get there, sponsors say that growing revenues at portfolio companies creates value in 70 percent of their deals on average; that is followed by improving incentives (65 percent), facilitating a high-value exit (59 percent), making follow-on acquisitions (48 percent), reducing costs in general (47 percent), changing senior management team other than the CEO or CFO (47 percent) and changing the CEO or CFO (43 percent).
Such are the preliminary results of a 92-question survey conducted from 2011 to 2013 and presented in the draft paper, “What Do Private Equity Firms (Say They) Do?” The three co-authors are Paul Gompers, professor at Harvard Business School, Steven N. Kaplan, professor at the University of Chicago Booth School of Business, and Vladimir Mukharlyamov, a graduate student at Harvard University. The researchers started with the premise that buyout firms outperform the public equity markets but that academic research on how they do it has been scant.
All told, the authors surveyed 79 buyout firms around the world with more than $750 billion in collective private equity assets under management; about 64 firms, managing more than $600 billion in private equity assets, filled out the survey completely, while the others did so partially. The median respondent had $3.4 billion in assets under management (bottom-quartile is $750 million; top-quartile is $11 billion) and had been in business for 19 years.
• The authors found a well-educated bunch of professionals working at the surveyed firms. Of the 767 partners identified at the surveyed firms (from websites), 57 percent have an MBA; 7 percent have a law degree. Of those with an MBA, 38 percent are from Harvard Business School, 12 percent are from the University of Chicago Booth School of Business, 9 percent are from Stanford Graduate School of Business, 7 percent are from the Wharton School and 5 percent are from Columbia Business School.
• On the subject of deal flow, sponsors report that nearly 36 percent of their closed deals are “pro-actively self-generated” on average, while another third (33 percent) come from investment banks, 9 percent from deal brokers and 9 percent from an executive network. Respondents considered 48 percent of their closed deals on average to have been proprietary. “Smaller and younger private equity firms generally tend to source more proprietary deals,” the authors wrote.
• Nearly a third of sponsors (31 percent) typically recruit a senior management team before investing, while about half typically recruit a senior management team after investing.
• Sponsors allocate 17 percent of company equity, on average, to management and other employees; 8 percent goes to the CEO on average. ”The percentages are slightly lower, at 15 percent and 6 percent, respectively, for the larger PE investors who invest in larger companies,” the authors wrote.
• Buyout firms tend to use IRRs and multiples of invested capital to value investments, rather than discounted cash flow or net present value methods; similarly, firms tend to look at comparables when forecasting exit valuations, rather than discounted cash flow methods.
• During due diligence sponsors tend not to take the forecasts of management teams entirely at face value. Respondents on average discount management EBITDA forecasts in their pro forma models by 20 percent.
• Sponsors “deeply” investigate fewer than 24 of every 100 opportunities considered on average and of those close on six. The authors found that ”larger and older private equity firms pass a greater fraction of their deals through to the next stage.”
• A target’s business model and competitive position is the most important factor in selecting deals, followed by roughly a tie between management team, sponsor’s ability to add value and valuation.