Thinking about: Frameworks for Measuring Value Creation in Private Equity Investments

A recent report by INSEAD's Global Private Equity Institute (GPEI) and global valuation and corporate finance advisors, Duff & Phelps, critiqued a number of commonly used frameworks for measuring value created by Private Equity investors. The paper can be found here. The critique sought to break down and explain the drivers of private equity value creation and isolate and explain in which areas the PE and investee managers were directly responsible for the value created. This company specific, Private Equity manager impact was called 'Alpha'.

Using Duff & Phelps' Created Value Attribution (CVA) Framework, a basket of 28 mostly North American PE investments, were analysed. More than half of the investments were $100m or less. The holding period for investments averaged 5 years. Across the basket of deals, the analysis showed that:

• The average change in investment value across the sample was 145% - or a money multiple of 2.45x - while Enterprise Value saw a 230% increase of invested capital.
• Changes in revenues represented the largest single category of value creation (62%). The majority of revenue growth came from a combination of industry growth plus acquisitions (contributing 90% of the growth). The component of revenue growth attributable to investment manager and company specific factors (Alpha) during the holding period was 10%.
• Improved margins accounted for 16% of EV growth across the sample, with half of that being attributed to operating improvements unique to the company (Alpha) and the other half to industry performance and the impact of acquisitions.
• Improvements in the valuation multiple achieved on exit accounted for 22% of EV created. Company specific activities underpinning improved exit multiples represented the largest single driver of Enterprise Value growth across all categories. This Alpha effect on improved exit multiples more than offset a negative impact of industry specific factors on changes in the multiples achieved at exit.

What can private company owners learn from these Value Creation frameworks and analyses?

Activist private company owners seek to protect and grow the equity value they have built up in their business - to appreciate their equity. Thinking about the INSEAD analyses, a key takeaway for owners is to recognise that the creation of equity value in private companies is primarily a function of two things:

1. The industry you operate in and the average effects over time of industry and macroeconomic trends on your company revenues, margins and cashflows, and on exit multiples.
2. The 'Alpha' effect: The unique company factors that derive from the actions and decisions you make that have a positive or negative impact on changes in Revenues, Margins, Cashflows and Risk. The impact of these unique factors are independent of the effects of industry and market trends and of capital structure or leverage decisions.

The INSEAD analysis also supports and reinforces views I expressed in my previous article 'What drives your Equity Value - an #EVHack for private company owners'.

The lesson for private company owners remains the same....

Focus on influencing those factors under your control that directly impact on your Equity Value. As priority, focus on two things:

1. Strategic and operational initiatives designed to produce sustainable increases in revenues, margins and ultimately free cash flows over the long term, at a rate that is ahead of industry average improvements.
2. Risk management oversight and strategies that systematically reduce the level of company specific risks to cashflows - over time - in turn reducing the next investor's risk adjusted rate of return and ultimately driving improvement in your valuation multiple.