Advanced Introduction to Private Equity

by Paul a Gompers, Steven N Kaplan

Elgar Advanced Introductions are stimulating and thoughtful introductions to major fields in the social sciences, business and law, expertly written by the world’s leading scholars. Designed to be accessible yet rigorous, they offer concise and lucid surveys of the substantive and policy issues associated with discrete subject areas.

This Advanced Introduction provides an illustrative guide to private equity, integrating insights from academic research with examples to derive practical recommendations. Paul Gompers and Steven Kaplan begin by reviewing the history of private equity then exploring the evidence on performance of private equity investments at both the portfolio company level and fund level, documenting the creation of economic value. The book then presents a set of actionable frameworks for driving value creation in private equity investments. It concludes by examining how private equity investors raise funds and how they successfully manage their private equity firms.

Key






This Advanced Introduction is an excellent resource for investment bankers and consultants as well as prospective investors who are looking for a comprehensive yet succinct introduction to the topic. Scholars interested in the fields of finance and private equity will find the research and case studies informative and enlightening.

272 pages, Paperback

Published August 3, 2022

Reviews

[Mallet · Rating 5 out of 5]

Advanced Introduction to Private Equity offers a clear, detailed exploration of how private equity influences companies and the broader economy. The book explains practical strategies for enhancing company performance through operational improvements, financial engineering, and good governance. It also provides an honest look at employment effects, noting that while private equity doesn't typically lead to significant job growth, it does improve company efficiency and market performance. This guide will be valuable for readers seeking to understand the substantial, yet nuanced, impacts of private equity investments.

Here are the ideas from the text that resonated with me

Understanding Private Equity Transactions

Risk and Forecasting: Due diligence helps reduce uncertainty in business deals, making it easier to predict financial outcomes. This helps investors decide if a deal is good, at what price, and how much money it might involve.
Due Diligence: This process does two main things:

It minimizes the information gap between investors and sellers, making transactions clearer and fairer.
It helps check all aspects of a potential deal to ensure it's a sound investment.




Valuing Investments

Value Bridge: This is a tool used by investment firms to track how much value an investment has gained over time, both before they buy and after they sell it.
Driving Returns: Investors focus on three key areas to make money:

Improving how a company operates and its cash flow.
Increasing the company's value in the market.
Using borrowed money to enhance returns.




Creating and Understanding Value

Investment Mechanics: A general framework helps investors understand how actions they take increase a company's value, essential for smart investment choices and assessing how private equity helps the economy.
Operational Engineering: By advising companies on how to sell more and operate more efficiently, investors add value.
Team Incentives: Encouraging management to boost sales and efficiency can lead to sustainable value creation.
Ownership and Performance: Commonly, the management's ownership in a company increases, aligning their goals with business success.


Impact of Private Equity

Performance and Productivity: Research shows that companies owned by private equity investors generally perform better and are more productive than those not owned by such investors.
Broad Findings: Many studies support the idea that these companies outperform similar ones in their industries, with positive impacts observed across various business aspects.


Economic Value and Employment Impact

Creation of Economic Value: Private equity portfolio companies generally create economic value by operating more efficiently.
Impact on Employment:

The evidence suggests that while these companies don't cause significant job losses, they also don't always show strong job growth.
Private equity firms develop less mature companies, particularly in places like France, and consolidate more mature companies.




Value Creation Mechanisms

Overall Efficiency and Value Increase: Private equity investments typically make companies more efficient and increase their overall value.
Types of Changes Implemented:

Financial Engineering: Improves incentives and capital structures to optimize financial performance.
Governance Engineering: Enhances management and monitoring, leading to more effective corporate governance. Changes in leadership roles (e.g., CEO, CFO) are common strategies.
Operational Engineering: Introduces capabilities that help companies operate more efficiently, such as IT improvements and shared services.




Strategic Approaches and Outcomes

Strategic Planning and Implementation:

Plans may include cost-cutting, productivity enhancements, strategic repositioning, and management upgrades.
Acquisition strategies are also often part of the approach to create value.


Expected Sources of Value (Based on a study from GKM 2016):

Growing revenues is reported as the most crucial source of value.
Other important areas include reducing general costs, redefining business strategies, improving IT systems, and introducing shared services.




Investment and Market Dynamics

Continued Investment in Key Areas: There is ongoing investment in governance and operational improvements.
Market Dynamics and Competitive Bidding:

In competitive purchase situations, the gains from an acquisition might go to the seller, which can reduce the benefits for the buyer.
Performance at the company level doesn't always translate directly to performance at the fund level due to various market frictions and the fundamental process of acquiring the company.




Efficiency and Costs of Private Equity

Impact of Fees on Value Creation: Fees charged by private equity firms to their investors may offset the value created through private equity operations, leading to returns that are comparable to public market returns, according to Phalippou (2020).


Investment Performance Metrics

Important Benchmarks for Investors (LPs):

Net Internal Rate of Return (IRR) is critical, with over 25% of firms considering it the primary benchmark and an additional 27% considering Net IRR relative to the fund’s vintage year.
Net Multiple on Invested Capital (MOIC) was identified as the most important benchmark by 38% of firms.
The reliability of databases like Burgiss for measuring private equity performance is acknowledged, with it viewed as likely the most reliable.




Investment Strategy and Analysis (OUTSX-CUPID Framework)

OUTSX-CUPID Mnemonic:

Opportunity (O): Looks at the attractiveness of the industry dynamics and the company’s competitive position within the industry.
Uncertainty, Team, Structure, eXit (OUTSX): A comprehensive mnemonic covering all critical aspects from uncertainty assessment to the exit strategy planning.


CUPID Framework:

Competition/industry (C): Analyzes industry growth and its support for the investment thesis.
Undervalued (U): Assesses if the deal is undervalued or if the price is attractive.
Proprietary (P): Evaluates the proprietary aspects of the deal and its overall positive present value.
Improvements (I): Considers potential improvements within the company, such as cost reduction, tax reduction, and value-increasing acquisitions.
Debt Capacity (D): Determines the debt capacity of the company being acquired.


Note that these components interact and influence each other.
Industry Analysis: Focus on analyzing competition and industry trends forms a significant part of investment memos.


Competitive Advantage in Private Equity

Unique Edge in Deals: Bill Conway of Carlyle highlighted the importance of PE investors identifying a unique edge in every deal, which is essential to avoid overpaying, especially in auctioned deals.
Forms of Competitive Advantage:

Knowledge of the industry or subsegment.
Innovative initiatives.
Superior management team.
Stronger relationships with sellers.
Personal rapport with private company sellers.




Risk Management and Team Evaluation

Managing Uncertainty and Risks: All investments contain elements of uncertainty, acknowledging that even favorable CUPID components carry risks.
Importance of the Management Team: The capability of the management team to execute the strategy is crucial, with the team's ability often being a deciding factor in investment success.


Governance Engineering

Key Governance Drivers:

Ensuring the right management is in place.
Aligning managers' incentives with equity ownership to ensure their interests align with the firm's.
Active involvement of boards in oversight and guidance.


Increased Focus on Incentive Compensation: Increasing senior managers' equity ownership as a part of their compensation. This approach has long been a significant focus in governance research and is seen as crucial for aligning executives' actions with shareholder interests.
Addressing Information Asymmetries: Information gaps between managers and external capital providers can make external financing costly and lead to misalignments. An active and incentivized board helps mitigate these issues by ensuring effective monitoring and oversight.
Monitoring and Oversight: Investors taking board seats is crucial for effective governance and oversight in PE-backed companies.

[Tudor V · Rating 5 out of 5]

Well written, comprehensive and easy to read even for novices. It is rather an overview supported by data.