Making The Case: LBO Shops Do Create Value

While the bulk of today’s M&A activity remains strategic and driven by corporate buyers, buyout firms have grabbed most of the headlines in the past year. This is for good reason, as buyouts are clearly a driving factor in the M&A landscape.

In 2006, according to combined data from Buyouts and the European Venture Capital Association (EVCA), buyout firms invested a record $450 billion in U.S. and European businesses (based on deals with disclosed valuations), and buyout firms now account for over one-third of M&A activity.

Along with their heightened activity—and success—buyout firms are increasingly on the defensive to make the case that what they do, in fact, adds significant value to the companies they acquire. Recently, Ernst & Young undertook a study that started with the 100 largest buyout-backed exits (measured by enterprise value at entry) in the United States last year, and the 100 largest in Western Europe last year, and found that, in terms of growing corporate value, the buyout industry’s case is strong. The majority of buyout firms have improved the operations of the companies in which they invest, created jobs, aligned management with the interests of investors, and generated shareholder value. (The study involved about 120 buyout firms in the United States and 140 in Europe; enterprise values at entry ranged from about $25 million to $15 billion in the United States, and about $70 million to $7 billion in Europe.)

The key takeaway from our study is that buyout firms build sustainable value for the firms they acquire. Buyout-owned companies grew faster than comparable public businesses (in the same country, sector and timeframe). Over the average time period that buyout firms held the businesses (United State: three years; Europe: three and a half years), the average annual enterprise value of U.S. buyout-backed businesses included in the study grew to $2.2 billion at exit from $1.2 billion when acquired. That represents a total growth in enterprise value of 83 percent. Average annual enterprise value growth rates were 33 percent for buyout-owned firms in the United States and 23 percent in Europe, compared with 11 percent and 15 percent respectively for equivalent publicly held companies.

Buyout-backed firms are performing at a very high level. For instance, they achieved profit growth more quickly than comparable public businesses. In both the United States and in Europe, earnings before interest, taxes, depreciation, and amortization (EBITDA) grew at an average annual growth rate of 15 percent for buyout-owned businesses in the study— 17 percent higher than for equivalent public companies.

Cost-Cutting Plays Minor Role

A common complaint lodged against buyout funds is that they rely exclusively on cost-cutting in order to increase the value of the companies they acquire. According to our findings, however, it seems that revenue growth is the predominant way that buyout firms build value. Two-thirds of the increase in EBITDA in buyout-backed companies studied came from business expansion, with organic revenue growth accounting for the most significant portion. This included the benefits of buyout firms investing in sales and marketing as well as in new product launches. Acquisitions were also important, and it is worth noting that U.S. buyout firms tended to make smaller but a larger number of acquisitions than do their counterparts in Europe.

As for the cost-cutting claim, yes, cutting costs played a role, accounting for 23 percent of EBITDA growth in the United States, with half achieved by improvements in operational efficiency. Cost cutting, according to cynical M&A observers, is another way of saying job losses and layoffs. But job losses are not a major part of buyout firms’ track records in the sample studied. In fact, employment levels were the same or higher at exit versus entry in 80 percent of the U.S. deals studied (taking into account both organic job creation and job creation through acquisitions). In Europe, employment levels in businesses owned by buyout firms were the same or higher at exit in 60 percent of deals and job levels grew by 5 percent per year across the United Kingdom, France and Germany, compared to 3 percent for equivalent public company benchmarks.

Not only does enterprise value increase during buyout firms’ ownership, it continues growing after buyout firms exit the company. The study shows that in the United States, most buyout-backed exits were by IPO, and recent academic research has found that after their IPOs the stocks of buyout-owned businesses outperform public company benchmarks (2006 study by Cao and Lerner; Boston College, Harvard University, and National Bureau of Economic Research). In Europe, where most buyout exits resulted from secondary sales to new buyout firm owners, the 30 percent of the businesses in the study that had been acquired from buyout owners grew long-term EBITDA twice as fast as those that had been acquired from either corporate sellers or the public markets.

It’s clear that buyout firms in the study created value for the shareholders of the businesses they acquired, and acted as net generators of enterprise value. But the question remains, how do they do it? For the study, we interviewed the buyout-firm directors responsible for more than 40 percent of the largest exits in the United States (24 directors altogether) and Western Europe (60 directors) in 2006, and found the following keys to success.

They Buy Well

Buyout firms are highly selective and do their research when they make a decision to buy a business. They are prepared, build strong relationships with company management, and are sector-focused. Over three-quarters of the deals studied resulted from proactive origination, including company or sector tracking, building relationships with management, or leveraging introductions from established contacts. This was complemented by extensive evaluation of and due diligence on the target. A quote from one of the buyout firm executives we interviewed gives a sense of how lengthy and meticulous the buying process can be: “We had identified the opportunity and tracked the company for about eight years before finally signing the deal.”

They Operate Well

While buying well is important, the study indicates that success in creating lasting value greatly depends on growing the business—something at which buyout firms excel. They come in with an agenda that focuses on change—new or updated business plans, new incentives, new board members, and, often, new management.

There are two identifiable strategies that buyout firms employ regarding the management of their portfolio businesses. They either keep the incumbent team and existing business plan and support them with increased investment (used in 17 percent of U.S. deals done by the buyout executives we interviewed), or—more commonly—they bring in a new management team with a new plan for the company, then work closely with the team to implement it. Nearly three-fourths (74 percent) of the buyout executives we spoke with in the United States and Europe made some kind of management change, including changing the CEO 61 percent of the time. In Europe, CEO changes occurred in 45 percent of the deals according to the executives we interviewed.

Regardless of what management strategy they use, buyout investors are heavily involved as active board participants. If there is a shortcoming from an industry, regulatory, or financial standpoint, these investors either fill the need themselves or bring in the best talent available. Most tellingly, they make themselves available to shareholders. The study showed us that the level and frequency of interaction and reporting between buyout firms and management is often stronger and more intense than under previous owners. “Our control of the board helped to reinvigorate company growth with 13 new product launches in the first year of our ownership,” said one managing director of a U.S. buyout firm.

One of the most powerful tactics buyout firms use to drive business performance is to increase management compensation, through both cash and equity. In most deals, management was given equity in the business, typically in the range of 5 percent to 10 percent, which is greater than what managers in public companies are often offered. Buyout firms also spread the wealth to larger numbers of senior and middle management. “The top 125 employees were given attractive incentives based on EBITDA goals. All 10,000 employees were able to participate in an ESOP plan,” said the managing director of one European buyout firm.

They Sell Well

The true measure of a deal’s value is at exit. Buyout firms have honed their sales skills to the point where 80 percent of those interviewed for this study said their deals met or exceeded their expected results. Though 61 percent of U.S. exits we studied went the IPO route in 2006, enterprise value grew the most when a sale was made directly to a strategic or corporate buyer. U.S. buyout firms realized annual enterprise value growth rates of 68 percent when they sold to a trade buyer, and 21 percent when they exited via an IPO. European buyout firms generated annual growth rates of 18 percent when they sold the company directly to a buyer, and 42 percent when they did an exit via IPO.

In most cases, planning the exit strategy started early. Buyout firms give considerable thought to structuring and positioning the business to make it attractive to likely buyers. European buyout firms, especially, expended a great deal of effort “warming up” the market, making potential buyers aware of the upcoming sale several months before the formal process begins. “We identified a strategic buyer early and began to develop a relationship three years prior to exit,” said one U.S. managing director of a buyout firm.

Here to Stay

Though buyout firms are entering a more challenging environment with a credit squeeze affecting deal financing, our buyout firm clients strongly feel that by doing the right deal and by doing the deal right, the longer-term picture remains bright. There will be an even greater focus on driving operational improvements in their current businesses. Buyout firms will continue to identify good companies, develop robust plans for rapid growth, and are confident that, in most deals, the price at exit will exceed the price at acquisition.

John Vester and Brad Kuntz led Ernst & Young’s “How Do Private Equity Investors Create Value?” study in the United States and are members of Ernst & Young LLP’s Transaction Advisory Services practice. Copies of the report can be requested at The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.