Modern values and public perception

Are private equity portfolio companies worth more than their public market rivals at point of sale? Ernst & Young certainly thinks so, according to its report, ‘How do private equity investors create value? Beyond the credit crunch’ (see below), which suggests that private equity-owned businesses in 2007 outperformed the stock market for the third consecutive year.

“Our study counters the continuing myth that cheap debt and cost-cutting are the principal drivers of private equity success,” said Simon Perry, E&Y’s global head of private equity.

The lack of available debt of any kind and any magnitude has prompted many to suggest that private equity’s main calling card – outperforming the more transparent public markets – no longer applies in a credit-crunched market. Inability to load up the leverage on the buy-side (or overload if you’re a critic or Standard & Poor’s report writer) would inevitably impact on internal rates of return at exit.

Perry, though, suggests that private equity’s other selling point – operational improvement – comes into play here. With fewer opportunities to sell on an asset early, otherwise known as the quick flip, private equity firms will be forced to hold on to portfolio companies for nearer the advertised three to five years, meaning an increased focus on streamlining processes, trimming the fat and hiring new talent. An improved business should equate to a decent money multiple in the long run.

From a fund investors’ point of view, however, a three times money multiple in year two generates a bigger IRR than a six times multiple in year four. The numbers work out at 73% compared with 57%, according to Coller Capital’s internal rate of return (IRR) metrics.

The report is unlikely to muffle private equity’s critics, either, especially in the UK, where the report found the least evidence of outperformance with only a 14% rise in value. The concern has been that private equity and its investors reap the benefits of any inherent value and ensuing operation improvement: they gobble up the profits and capitalise on asset-stripping fire sales, leaving devalued husks unfit for return to the public markets.

Debenhams has been the industry’s bête noir on this issue. Merrill Lynch’s private equity unit, CVC Capital Partners and TPG Capital delisted the retailer in 2003 for £1.72bn, generated about £1.3bn for investors through two recapitalisations and then returned the business to the stock market with an offer price of 175p and a market cap of £1.7bn in 2006. Shares are now trading at 36.75p and the business is valued at about £315m.

Recent speculation that Blackstone might be considering making a return to Southern Cross is similarly ambiguous. Blackstone’s investors made a decent profit on a £536m flotation in summer 2006. A profit warning last week helped the UK care homes operator’s market value drop by three-quarters to about £160m, prompting speculation of private equity interest.

Can Blackstone be blamed for what happens after a company leaves its ownership? Do private equity firms create value? Will the credit crunch make a mockery of private equity’s claims to be a creator of value across all points of the cycle or highlight its resilience and adaptability? Whatever the reports say, the jury is still out – for now at least.