Mid-market leads value creation

A recent survey showing almost half of LPs believe private equity suffers from a bad reputation should come as little surprise to those who have followed media coverage over the last few years. While some of these reputational difficulties stem from selective reporting of bad deals – and others are even less affiliated with reality – lawmakers may undoubtedly enjoy the popular support in putting forward regulatory straitjackets and spurring tax collectors. A comprehensive review of these issues was published in the July/August edition of unquote" Analysis.

However, looking at the available empirical evidence, there is little support for the idea of reckless, debt-fuelled and job destroying LBOs. A recent study, Branching Out, by accountancy Ernst & Young and the EVCA, arrives at an entirely different conclusion.

Investing through the crisis
The study, which looked at development in private equity-backed businesses between 2005 and 2011, showed that the industry outperforms public equivalents by 3.6x, mainly through operational and strategic improvements – value creation – which in turn drives productivity and employment growth throughout Europe.

In fact, productivity (measured as EBITDA per employee) has enjoyed an entry-to-exit compound annual growth rate (CAGR) of 6.9% in Europe, with France and the UK taking the lead at 10.5% and 10.1%, respectively. Likewise, the employment CAGR stood at 2.2% in Europe, led by France at 5.8% and DACH at 2.9%. In other words, private equity-backed companies have hired throughout the crisis, and still achieved a higher profitability per employee.

Naturally, this type of growth is favourable for the economy and fund stakeholders alike. The report points out that 87% of the sampled investments have generated a positive return for investors. Moreover, exit volume is picking up again after the post-2007 depression, driven by trade players, 50% of which from the US and Asia Pacific.

The mid-market leads value creation
Looking at the full sample of 307 companies, only 1x above the stock market return was attributable to leverage, while the remaining 1.6x outperformance derived from effects linked to value creation. The degree to which value creation overtakes leverage seems to vary considerably between deal sizes. For deals with an enterprise value of less than €500m, the leverage component corresponded to a mere 13% relative to stock market return, whereas value creation represented an impressive 63%.

Faring a little worse, the adjacent market segment (€500m-€1bn) exhibited a marginally lower level of outperformance, with 32% of returns corresponding to stock market returns, 27% to value creation, and a less than impressive 42% attributed to the leverage effect. Admittedly, everything is relative and as long as the industry outperforms public alternatives, LPs remain incentivised to allocate a significant proportion of their portfolios to well-performing GPs.

The Ernst & Young report acutely explains the mid-market value creation phenomenon as "consistent with faster levels of profit, productivity and employment growth compared to larger deal-sizes." This level of value creation is the very unique selling point of private equity and precisely what LPs expect from their capital commitments.

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