PRINT THIS PAGE Corporate governance and value creation09/07/2008. Source: SJ Berwin. Simon Witney 
To those who work in private equity, it is almost trite to say that the governance model - shorter communication lines, and more accountable management with aligned incentives - makes it easier to grow successful companies, drive out inefficiency and make necessary structural changes. But, as the recent public and political storm about private equity has demonstrated, the value generated by that model is not so obvious to those outside the industry, writes Simon Witney of SJ Berwin. This is despite a significant volume of academic research which supports the view that superior governance is an important source of superior returns.
The European Private Equity and Venture Capital Association's (EVCA) Survey of Performance, published this month, confirms once again that the long term returns from buyout funds have outperformed comparable quoted indices. This echoes the 2007 Performance Measurement Survey published by the British Private Equity and Venture Capital Association (BVCA) in May. There is a discussion of the impact of governance on these returns. Many argue strongly that - especially in the current economic climate, when leverage and multiple arbitrage will be harder to come by - operational improvement will be a key source of value, and is something that private equity does very well.
The assertion of that, and particularly the use of case studies, is certainly an important way for the industry to make its case. But it is also welcome that a considered study, presented in draft form at a London Business School (LBS) Symposium earlier this month, has looked at actual data from a sample of private equity deals and analysed their returns in some detail. The results will probably not surprise many practitioners, or seasoned investors into the asset class, but they do provide powerful evidence that may be helpful in changing perceptions about what the industry does, and the sources of its outperformance.
The independent study, co-authored by McKinsey and LBS, analysed the returns to twelve large and mature private equity houses from 66 "relatively large" UK companies acquired between 1996 and 2004 and exited between 2000 and 2007. The deals varied in size, but all companies had an enterprise value of at least €100 million on acquisition, and the median enterprise value was around €470 million. The study is not finished - the authors anticipate that the final dataset will include around 80 companies.
So far, the study is showing that the returns to these deals outperformed quoted comparable companies. But, more importantly, it is demonstrating that the outperformance continued to exist even when controlling for leverage and sector risk. And when analysing the reasons for the superior returns, the outperformance - or "alpha" - is correlated with stronger operating performance and, more particularly, a focus on margins and efficiency. There was no evidence that superior returns were achieved by "asset stripping" - in fact, these companies grew revenue more than their quoted peers. Increases in capital expenditure were also demonstrated, as well as a greater efficiency of capital employed. The companies also increased employment, although more slowly than comparable public companies.
There is also some evidence of what contributes most to this alpha - with management changes (especially within the first 100 days), early use of external consultants and strong incentive structures correlating most strongly with better performance.
So strategic and structural changes, and active ownership, are critical to the private equity model, and these in turn deliver more productive and efficient companies to the European economy.
SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on the firm's services to the private equity industry please contact Simon Witney in the London office 020 7533 2222 or visit the website at www.sjberwin.com.
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