An investor in a private equity fund invests on the pretense of relatively high returns (usually 20%+ per annum). When a potential portfolio company learns of this target, he/she often adopts a look of, “There is no way I can guarantee 20% as founder.” This is because many entrepreneurs don’t fully understand the value creation tools employed by private equity firms.

The Core Concept

Understanding this topic is essential for any private equity professional. Let’s break down the fundamentals.

The following three points discuss the major themes for drivers of investment returns and value creation in private equity. I would like to think they’re exhaustive and all encompassing, but please let me know if you believe otherwise.

1. Earnings growth: this is achieved either through organic revenue growth, acquisitive revenue growth, cost cutting (thus, improved margins), reduced taxation, variablising the cost base, etc. Earnings growth links to value creation by creating a higher implied exit price and higher cash flow, which can lead to higher dividends and quicker debt repayment.
2. Increased leverage: this refers to an increase in interest-bearing debt, which can amplify the gains (and losses) to equity holders. A business with no debt can be conservatively geared and subsequently provide much higher returns to equity holders. Additionally, private equity firms pay down debt as quickly as possible with excess cash to decrease risk and increase proceeds to equity holders at exit.
3. Multiple expansion: this is a simple arbitrage between the purchase multiple and sale multiple. Even with the same earnings, if market conditions become favourable and/or risk decreases, a higher sale price results from a higher multiple. While it is difficult to control the market, decreased risk results from reaching a greater size, reducing debt, diversifying the offering, increasing customer/supplier fragmentation, implementing exclusive arrangements and contracts, and/or anything else that may lead to more stable earnings.

Although this summary seems simplistic, I can’t think of any drivers of investment returns and value creation initiative that doesn’t apply to these three themes; everything else is a subset of one of these drivers. If there’s anything I’ve missed, please let me know through the comments section for this post.