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Turn, turn, turn: a new season of private equity performance

Many of the factors that historically drove superior private equity performance in the past – proprietary deal flow, scarcity of financial engineering skills and scarcity of committed capital – are being eroded away. Neal Pomroy and Antonis Polemitis of Mercer Management Consulting discuss what needs to be done to successfully generate such returns in the future.

Private equity appears to be emerging from perhaps the most difficult period in recent memory. While there has been some improvement in the availability of attractive investment opportunities and more reasonable availability of financing alternatives, a tone of temperance remains. As a result of recent troubled investments and difficult exits, senior executives in the business are increasingly evaluating what changes are required to successfully generate superior returns in the future, specifically:

• how do we add value?
• what differentiates our ability to locate, identify and capitalise on superior opportunities?
• what is our strategy?

As we noted in the 10 September edition of Buyouts, there has been a slow erosion of the structural factors - proprietary deal flow, scarcity of financial engineering skills, and scarcity of committed capital - that drove superior returns for many years in the private equity business. The decline of these factors was partially masked in the second half of the 1990s by the expanding multiples of a booming economy.

As the stock market tide receded, the problems facing private equity funds became glaringly visible. And while the markets will continue to recover, the private equity business has entered a more mature and competitive environment. Just as their clients have had to do, fund leaders need to evolve their own business models if they expect to consistently create value.

What doesn't matter
In our latest research, Mercer Management Consulting examined transactions over the past decade to better understand where superior performance has and has not occurred. This proprietary study of nearly 600 private equity transactions at 28 above-average LBO funds, from 1985 to present, revealed several important trends. First, the traits commonly cited as competitive advantages - large fund size, large transaction size and long holding periods - do not appear related to superior performance. In particular:

• Larger funds did not enjoy a return advantage. There was no measurable correlation between overall fund size and either deal-level or fund-level returns.
• Deal size was not a differentiator, either. Realised deals that invested less than $25m in equity produced a median IRR of 33 per cent versus 31 per cent for deals that invested $25m or more.
• Investments that were held longer had a return disadvantage. Realised deals held three years or less generated a median IRR of 59 per cent, while deals held three to six years and more than six years produced median returns of 23 per cent and minus four per cent, respectively.

These findings are obviously influenced by the positive impact of quick flips during the late 1990s and the negative impact of troubled investments that tend to be held longer. Furthermore, on an absolute dollar returned basis, larger, longer transactions perform better. This should not be surprising, since there is a natural trade-off between higher percentage returns and putting large amounts of capital to work for long periods of time.

The ability to return substantial dollars and not just percentage points will remain important for limited partners as they continue to seek to concentrate capital in trusted hands.

What does matter
Perhaps more important are the traits that are associated with superior performance. We divided the funds in the study into three groups - upper, middle and lower - based on their overall IRR performance. The performance of these groups ranged from 79 per cent for the upper, 38 per cent for the middle and 28 per cent for the lower. It's worth noting that the characteristics of each group are quite similar: average size of investment, average holding period and the years in which investments were made varied little.

Given that the differential in overall returns is worth millions of dollars to fund management and investors, the source of performance for each group is important to identify. When the returns from the individual transactions within each group were divided into quartiles from low to high, a key insight emerges. Returns from ‘home runs' or ‘ten baggers' generate headlines, but do not separate the performance of upper (168 per cent) and middle funds (162 per cent) in pure return terms. Upper funds did, however, hold their winners longer and invested a larger proportion of their funds in their winners, which partially accounts for the differential in performance. Lower funds lag both groups with a mean return of 127 per cent from their top quartile investments.

The average return of ‘singles and doubles' - or the second and third quartile of investments - also distinguishes the upper performance funds (63 per cent, 32 per cent) from middle performance funds (46 per cent, 16 per cent). Finally, upper performers actually have higher losses from their worst quartile investments than do both middle and lower performers, suggesting a greater willingness either to take risks or to write off poor investments.

We al so examined the question of whether successful funds were industry timers that selected hot sectors, or deal pickers that generated value through individual investment selection. To do this, we compared the return of fund investments to the total return in public equities in comparable industries, during the timeframe of a fund investment, for more than 300 realised or revalued investments for which we could identify industry benchmarks. To calculate composite returns, we pooled investments by fund group, weighting for investment size and assuming a common starting point.

Two findings stood out. First of all, the group of funds as a whole demonstrated strong industry selection and timing. Our overall public equities benchmark of industries that these LBO funds invested in returned 25 per cent annually, while the Russell 3000, a proxy for the broader market, returned 12 per cent over the last 15 years. Second, the performance differentials between funds were primarily due to deal, not industry, selection. The upper group invested in industries where public equity markets averaged 27 per cent during the period of their investment, but their investments more than tripled this performance, achieving returns of 85 per cent. The middle group invested in industries with similar public equity returns of 27 per cent, and doubled industry performance, yielding investment returns of 58 per cent. The lowest group just matched their industry comparables: their public market equivalents had returns of 23 per cent, while their investments also returned 23 per cent.

Management implications for the next round of growth
Several useful conclusions can be drawn from these observations as funds consider their strategies and efforts to generate superior returns in the future:

More aggressively manage the post-acquisition portfolio. Simply put, funds must guide their investments more proactively, going beyond board representation or periodic add-on investments. Superior gains will come from identifying shifts in strategic opportunities and threats, then supporting portfolio companies to capitalise on those shifts. Turning singles into doubles may require additional capabilities to improve strategy, implementation, and operational improvement.

Divest more strategically. Private equity firms are above-average sellers of businesses that have performed well, but they must now look to capture additional gains. All too often, poor or middling investments are divested hastily to reduce the drain on partner time. The opportunity exists, however, to reposition the business model of an entire business, or of non-core assets within a business. This can represent significant latent value if repositioned for specific strategic buyers. The ability to divest strategically becomes even more valuable when it is more difficult to gain access to public capital markets.

Increase the strategic dimension within due diligence. Private equity firms have a long tradition of thorough due diligence, identifying unacceptable issues, evaluating historical economics, and establishing competitive position. It is increasingly important to enhance these skills with a forward-looking perspective - one that asks: where is value within a given industry likely to migrate? How durable is the competitive model of the investment in the face of emerging and potential entrants? What is the degree of overall strategic risk?

Source deals more aggressively. Funds are rediscovering the importance of active efforts to identify opportunities. Initiatives range from the creation of strong industry counsels to solicitation of CEO or executive talent to evaluate and run investments, to cooperative efforts with corporate business development partners in order to facilitate spin-outs, to industry-level analysis and prioritisation of investment themes.

Embrace an increased, but manageable, level of risk. Many funds are seeking a return to the traditional intersection of companies with strong income statements and weak balance sheets, a model that funds moved away from in the late 1990s. Some leaders are thinking ahead and equipping themselves to operate where potential risks and returns are higher, yet can be managed. Increasingly, this will include carefully selected turnarounds, opportunities with select issues that can be reduced through innovative risk management techniques, and identification of hidden gems within larger businesses.

Improve fund management. Funds are increasingly being run more like traditional businesses. To be sure, the partnership model will endure, but it will have to address traditional management issues such as retention, systems and information management, research, marketing, branding, and development of key skills. This trend will be accentuated by the emerging generational change facing many funds and the industry overall as many veterans retire.

Conclusion
Private equity will continue to play an important role as a catalyst for change and as a valuable financier of growth and innovation. As the economy regains its footing, financing becomes more reason-able, and as multiples stabilize and grow, the number of attractive investment opportunities will rebound. However, our research suggests that funds that simply await the return of the glory years in terms of returns and business success will have failed to recognise and respond to the structural changes that are changing the industry. Traditional approaches will likely prove insufficient in what may be a maturing market. Like the companies in which they invest, private equity funds must develop differentiated strengths, new strategies and a new set of capabilities to generate superior returns and sustained growth.

Copyright © 2003 Mercer Management Consulting

Neal Pomroy is a vice president and Antonis Polemitis is a principal of Mercer Management Consulting based in New York.

As one of the world's premier corporate strategy and operations firms, Mercer Management Consulting helps leading enterprises develop, build, and operate strong businesses that deliver sustained shareholder value growth. For more information please visit www.mercermc.com