A decade or two ago, a private equity fund could scan the landscape, pick off companies at bargain prices, tidy them up and then sell them at a profit amplified by leverage. Simple. But today, the industry is more mature, and each firm faces more competitors scouring the market. Underpriced firms are harder to find, or sometimes impossible. Money is harder to borrow. Flipping bargains for profits is not so easy.
So, how do successful private equity firms make money in this increasingly efficient environment?
Today, many firms agree that value creation begins with due diligence – the research that identifies a target firm’s unrealised potential before the acquisition is made, says Bob Juneja, senior managing director of Irving Place Capital, speaking on the “Value Creation” panel at the 2012 Wharton Private Equity & Venture Capital Conference.
“You have to be right,” added Andy Africk, senior partner of Apollo Global Management. “You cannot make money on the buy-side as you could in the early days – but you can hurt yourself.”
Nor can a private equity firm step in and create value by simply cutting costs, says David Hooper, a partner at Centerview Capital. “I think most of the [private equity] companies have gotten aggressive on costs, but now the focus is on ‘How do we grow the top line?'”
It’s not that purchase price doesn’t matter. The private equity firm, says Africk, must pay a “safe and sane price” to acquire a company. But the real value is created afterwards through operational improvements. Apollo, he recalled, once bought a satellite company for a reasonable price of 6.5x EBITDA (earnings before interest, taxes, depreciation and amortization) and later sold it at a multiple of 9.5. The gain came from major upgrades like adding cellular and internet service to the system, not from a bargain price.
“The only way to really create value is by having operational expertise, insights [and] contacts,” says Hooper. To achieve that, Centerview draws on a stable of executives with deep experience in the industries it invests in, such as consumer products.