Economic uncertainty, high inflation, and a tight credit market, compounded by a challenging political environment, have pressured valuations and private equity returns. However, private equity (PE) has shown resilience as an asset class. Historical performance data, including findings from Bain & Company (Bain) and Cambridge & Associates (C&A), reveals that PE investments made during recovery years consistently outperform the asset class’s long-term averages[1]. Investments following a downturn tend to excel, primarily due to the ability to acquire quality assets at depressed valuations and capitalize on economic recovery[2]. Less competition also enables more selective investment decisions. While history points to a future that seems promising, past performance is not indicative of future returns, and the current macro environment demands that general partners (GPs) have distinct value-creation strategies, as opposed to financial engineering, to achieve above-average returns. This article will outline the evolution of value creation in PE, and the emergence of sector specialist funds.
Value Creation – Financial Engineering:
Historically, PE’s has employed three fundamental methods to enhance the value of their investments:
- Deleveraging: This strategy involves reducing the significant debt associated with a company through measures like cost-cutting or selling non-core assets. It is akin to paying down a mortgage on a property, resulting in an increase in the ownership's worth.
- Multiple Expansion: A common valuation approach used in private equity is the market approach, where a valuation multiple is applied to a company’s earnings metric [i.e., earnings before interest, taxes, depreciation, and amortization (EBITDA)] to calculate its value. In general, the higher the valuation multiple, the higher the value of the company, and the better the returns are for equity investors. Multiple expansion refers to an increase in the valuation multiple, and it is generally accomplished by enhancing the growth prospects of a portfolio company through various means, including strategic improvement, risk mitigation, or building a credible growth narrative. Multiple expansion may sometimes have no correlation with the company or GP’s strategy and can be impacted by general investor sentiment. The higher a multiple, the higher the valuation of the underlying business, resulting in greater equity value.
- Operational Improvements: This approach involves strategies to grow revenue and enhance operating margins.
Leveraged Buyouts (LBOs) have been a cornerstone of the PE industry since the mid-20th century, with the practice dating back to the 1950s. The technique involves acquiring companies using borrowed funds to magnify returns on equity. The golden era of LBOs emerged in the 1980s, marked by the founding of KKR in 1976 by Bear Stearns financiers, Jerome Kohlberg Jr., Henry Kravis, and George Roberts.
During the early days of PE, from the 1970s through the 1980s, a significant focus was placed on value creation through deleveraging. PE firms acquired companies with significant debt and then restructured them into leaner, more focused entities. This process often entailed rigorous cost-cutting measures and divesting non-essential assets. Notably, KKR's investment in Safeway in 1986 serves as an example of this approach, involving extensive restructuring that included store closures and workforce reductions.
However, while leverage was a key driver of value during the 1980s, it also brought about challenges, including a heightened rate of bankruptcy.
As the economic landscape shifted into the 1990s, multiple expansion emerged as the main driver of returns. Changes in market conditions, business models, and broader macroeconomic variables led to an environment where multiple expansion played a more significant role in value creation. Over time, GPs began to adjust their underwriting approaches, placing a greater emphasis on growth and operational improvements. The above table illustrates this transition, highlighting how the value-creation strategies used by PE firms have evolved. In the past, deleveraging and multiple expansion were the dominant forces, making up 82% of the value generated by private equity ventures. However, by 2012, their combined contribution had shrunk to less than 53%, while the role of operational improvements had expanded to 48%[1]. This trend towards valuing operational improvements over other financial engineering has continued to the present day. According to a recent report by Bain, almost all of the value created between 2012 and 2022 in the private equity space can be attributed to revenue growth and continued multiple expansion[2].
Operational Improvements and Sector Specialist Funds:
As the PE industry matured, so did the level of competition for assets. To remain competitive, investment theses required robust growth plans that involved significant operational improvements. This included boosting revenue through new product development and geographic expansion (organic or through M&A), or margin expansion through cost reduction, effective pricing strategies, and technology enablement.
While not entirely clear when, sometime between the 1990s and early 2000s, the concept of sector specialist funds entered the market. We define sector specialist as those that have historically deployed the majority of their capital into one main sector. These include groups like Silver Lake, focused on the technology sector, and healthcare-focused groups such as Webster Equity Partners. Before the arrival of sector specialist funds, many private equity funds employed a more generalist approach, looking for investment opportunities across a broad range of industries.
C&A performed research on the performance of sector specialists across four sectors (consumer, financial services, healthcare, and technology) and found that investments executed by sector specialists across these four sectors returned an aggregate 2.2x multiple on invested capital (MOIC)[3] and 23.2% gross internal rate of return (IRR)[4], handily outperforming generalist investments that returned an aggregate 1.9x MOIC and 17.5% gross IRR[5]. Furthermore, the results show that sector specialist outperformance is very consistent, where they produced higher MOICs in nine of the 10 years in the study. While the research was conducted utilizing returns between 2001 to 2010, we believe that the reasons specialists outperform generalists are still applicable and relevant today.
The superior performance of sector specialist private equity funds can be attributed to several distinct advantages that collectively contribute to their success:
1. Sourcing and Portfolio Company Selection: Sector specialists leverage deep domain knowledge, extensive industry contacts, and repeated experiences in a particular field. This expertise allows them to access higher-quality deals and recognize patterns more effectively. Their focus on specific sectors enables them to spot unique investment opportunities that generalists might overlook. Furthermore, their specialized knowledge helps them avoid marginal investments, reflected in lower loss ratios.
2. Value Creation Beyond Capital Structure: For sector specialists, the focus extends beyond money matters. They bring industry-specific operational and strategic skills to the table, which are crucial for boosting the value of investments. This involves setting precise goals for a company's strategy and operations, recruiting top executives and advisors from the same industry, and efficiently developing and monitoring essential performance measures.
3. Exiting Investments: Sector specialists are well-equipped to determine the right time to sell an investment. They rely on thorough knowledge of the underlying company and broader market conditions. Moreover, they are skilled at identifying potential buyers and effectively engaging with them, ensuring a smoother transition when it's time to exit an investment.
These advantages collectively provide sector specialist private equity funds with a strong foundation for success. They are able to make well-informed investment choices, enhance the value of companies through industry-specific skills, and execute strategic exits effectively.
Conclusion:
The challenging macro environment certainly adds to the difficulty of navigating investment opportunities. However, PE remains an adaptive and robust asset class, with historical data underscoring the potential for positive returns, even during periods of uncertainty.
Looking ahead, the Nicola Private Equity Limited Partnership (NPELP) remains committed to partnering with GPs and industry specialists who have proven strategies for creating value. These strategies focus on making businesses operate more effectively, securing distinctive investment opportunities, bringing unique skills to the table, and showcasing a history of strong returns.
In 2022, NPELP committed to two sector specialist funds – Integrum Holdings (financial services specialists) and Webster Equity Partners (healthcare services specialist). By partnering with GPs that have unique value-added capabilities, we believe NPELP is well-positioned to deliver relatively strong returns amid current economic uncertainties.
Learn more about Nicola Wealth's Private Capital strategy on LinkedIn.
[1] https://www.bain.com/globalassets/noindex/2023/bain_report_global-private-equity-report-2023.pdf, and https://www.cambridgeassociates.com/insight/2023-outlook-private-investments/
[2] https://www.bain.com/insights/year-in-review-global-private-equity-report-2019/
[3] https://www.bcg.com/en-ca/publications/2016/private-equity-power-of-buy-build
[4] https://www.bain.com/insights/stuck-in-place-private-equity-midyear-report-2023/
[5] Multiple of invested capital (“MOIC”) measures investment returns by comparing the value of an investment at a specific date to the initial investment amount.
[6] Internal rate of return (“IRR”) is the annualized return earned on the investment.
