Sources of Value Creation in Private Equity

Generally, private equity firms are believed to have the ability to add substantial value to their portfolio firms compared to publicly governed companies. Thanks to this aspect of private equity firms, they form a critical component of the financial system.

The value creation capacity of private equity firms is attributed to:

The Ability to Re-engineer Private Equity Firms to Generate Greater Returns

It is assumed that private equity firms have a more remarkable ability to re-engineer companies. This means that public companies are essentially less able to re-engineer themselves or institute organizational changes than companies owned by private equity firms. Private equity firms pride themselves on having experienced top industry management staff, e.g., CEOs, CFOs, etc., who can share their expertise and contacts with company portfolio management.

The Ability to Access Debt Markets on Favorable Terms

Debt is more greatly utilized in private equity firms. It is a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization) instead of a multiple of equity, as is commonly the case in public firms. The Modigliani-Miller theorems’ central proposition is that the use of debt versus equity is insignificant for firm value. Nevertheless, when the assumption of no taxes is excluded from their model, the tax savings from using debt (i.e., the interest tax shield) increase a firm’s value due to the tax-deductibility of interest.

The use of more significant sums of financial leverage may grow firm value in private equity companies. This is because these companies have a reputation for efficient management and timely payment of debt interest. It helps alleviate concerns over their highly leveraged positions and maintain their access to the debt markets. The utilization of debt is believed to make private equity portfolio firms more efficient. The requirement to make interest payments, therefore, pushes portfolio firms to use free cash flow more efficiently since interest payments must be made on the debt.

Debt financing for private equity firms mostly comes from the syndicated loan market. Still, the debt is often repackaged and sold as collateralized loan obligations (CLOs) that comprise a leveraged loan portfolio. Private equity firms are likely to issue high-yield bonds processed as collateralized debt obligations (CDOs) whose transactions have resulted in a considerable risk transfer.

The Alignment of Economic Interests

It occurs when both private equity owners’ interests align with those of the portfolio managers of the firms they control. Results-driven managers are paid packages and various contractual clauses to ensure they get proper incentives to achieve their targets. They will not be left behind after the private equity house exits their investment, e.g., tag-along, drag-along rights.

Question

Which of the following is least likely to be a source of value creation for private equity firms?

1. The ability to re-engineer the private firm to generate superior returns.
2. Better alignment of interest between target firm management and private equity firm owners.
3. The inability to access credit.

Solution

The correct answer is C.

The inability to access credit greatly impairs private equity firms’ purchasing power. They will, therefore, not be able to increase value.

Reading 38: Private Equity Investments

LOS 38 (a) Explain sources of value creation in private equity.