A PME Analysis of Private Equity

by Michael Roth

Before we move on to 2015, let’s take one final look at where private equity stands as of Q4 2014. Using our cash flow data, I compared the pooled net IRR for the 2000 through 2012 vintage years to the Bison PME for the Russell 2000®. I focused on North American and Global funds, where the Russell 2000 could be a relevant public market comp. Funds in this analysis account for close to $1 trillion of committed capital.

Buyout Funds vs. Russell 2000

North American and Global buyout funds have outperformed the public markets in nine out of the thirteen years analyzed.

Buyout funds enjoyed strong outperformance of the public markets from 2000 through 2005. Since then, buyout fund performance has been mixed with four of the last seven vintage years underperforming the markets. The reason for this is two-fold. Everyone knows how funds from these vintages, primarily 2006 – 2008, did some bad deals (think TXU) and have had to lengthen their holding periods to try and recoup their cost (think Freescale). A higher number of bad deals and longer holding periods have clearly hampered returns for these vintages.

What also can not be ignored is the incredible bull market in public equities over the last six years. The Russell 2000 has tripled since it bottomed out in 2009. This is not meant as an excuse for the private equity industry but an acknowledgement of the public market’s incredible, and probably unrepeatable, returns over the last six years.

More recent vintages seem to be showing favorable signs. However, it can be hard to draw definitive conclusions from PME analysis when funds are only nearing the end of their investment period and have not yet had time to mature.

Venture Capital & Growth Equity vs. Russell 2000

North American and Global VC/GE funds have outperformed the public markets in just six of the thirteen vintage years analyzed. However, four of the six years have occurred since 2007 – highlighting the VC/GE market’s recent strength.

The venture industry has also suffered due to the strong public markets while underperformance in the early 2000s can be attributed to the dot-com crash. Compared to the buyout industry, VC/GE performance against the public markets has been mixed, though there are encouraging signs in the more recent vintages.

Wrapping Up

Compared to each other, the buyout industry has bested the VC/GE industry in eight of the thirteen years. However, VC/GE have outperformed buyouts in four of the last six year through 2012. Whether or not VC/GE can sustain this recent strength will likely depend on their ability to exit these high momentum companies which have seen tremendous valuation increases over the last few years.

Here’s How To Use the Valuation Bridge

by Michael Roth

The valuation bridge is a valuable tool that both GPs and LPs can use to determine how and where “value creation” is coming from. In order to maximize the value of this analysis, it is important to understand what the valuation bridge tells you but also what it doesn’t tell you.

The valuation bridge identifies whether the total value of the fund has grown as the result of revenue growth, margin improvement, multiple expansion, or paying down debt.

Revenue growth and margin improvement, together, are the drivers of EBITDA growth.

• Revenue Growth – Revenue growth is the proportion of equity growth that can be attributed solely to revenue from the time of investment to the most recent/exit date. A positive number means the company has been able to execute on its growth strategy.
• Margin Improvement – Margin Improvement is the proportion of equity growth that can be attributed to the change in EBITDA margins from the time of investment to the most recent/exit date. A positive number means the company has been able to improve its operational efficiency and earn more of its revenue as EBITDA.

Multiple expansion is the proportion of equity growth that can be attributed to the change in the Enterprise Value / EBITDA multiple from the time of investment to the most recent/exit date. A positive number means the Firm was able to “buy low and sell high”. What an investor needs to determine is whether this is due to:

• Growth and/or operational improvements that make the company more attractive than its peers or
• Stock picking that is primarily due to market timing.

Fundamentally improving the company is the preferred source of multiple expansion. This is because it is more repeatable than timing the markets.

Debt Paydown is the proportion of equity growth that can be attributed to the change in net debt (total debt minus cash). A positive number means a company has reduced their net debt, which may be due to paying down debt or an increase in cash.

Other is frequently referred to as the “combination effect”. It aggregates the combined effects of EBITDA Growth (Revenue growth and margin improvement) and Multiple Expansion.

The valuation bridge does not tell you whether the portfolio companies outperformed the markets.

The valuation bridge does a good job dissecting the sources of equity growth. What is does not tell you is whether a company’s operational changes were better or worse than the public markets. This is important because viewing the operational changes in isolation does not tell you whether a manager added value or whether the portfolio companies benefitted from overall market trends.

This is why we developed the Market Bridge. Over the course of a fund’s life, a private equity manager earns a management fee of 1.5% – 2.0% during the investment period (first three to five years) and 1.0% – 1.5% during the remainder of the fund’s life. This is well above the average fee paid on an index mutual fund. Our Market Bridge allows user to determine whether GPs are actually earning their premium fees by adding value in excess of public market peers or just benefitting from financial engineering and/or market timing.

Closing Thoughts

The valuation bridge provides a powerful summary of the sources of value creation. However, the valuation bridge, viewed in isolation, does not identify whether a manager is truly adding value. If a GP invested in J. Crew, the valuation bridge will tell me how they created value and the Market Bridge will tell me if they added value in excess of their retail sector peers over the course of the investment.