ADVEQ Research Series on Private Equity

Transcription

1 ADVEQ Research Series on Private Equity Value Creation in Buyout Deals: European Evidence* Aleksander A. Aleszczyk Emmanuel T. De George Aytekin Ertan Florin Vasvari 1 September 216

2 Title Executive Summary This report investigates the pricing and post-transaction performance of a large sample of European private equity deals executed between 1998 and 214. These deals are benchmarked to similar corporate deals and to alternative samples of European companies that are not private equity owned and are matched on important characteristics. Our evidence provides an insight into how value is created at the portfolio company level thus providing an explanation of why private equity funds outperform public markets. Our main findings are as follows: On average, private equity funds pay EBITDA valuation multiples that are lower by about 8.3 percent than the valuation multiples paid by corporate acquirers that target similar European deals during the same year. This finding suggests that GPs are either skilled negotiators or target undervalued entities or both. In addition, univariate analyses indicate that the valuation discounts of private equity deals relative to their corporate peers are larger when the deals are smaller. We find that the valuation discounts of private equity initiated deals are present both before and after the credit crisis. In contrast, during the credit crisis, we observe virtually no difference in valuation multiples between PE initiated buyouts and other corporate acquisitions. This result is potentially driven by a low number of transactions during this period. We document that, relative to benchmark nonprivate equity owned firms matched by year, industry and other characteristics, companies acquired by private equity firms increase their leverage, operating profitability, assets, and sales over the first three years of private equity ownership. These results indicate that while GPs are focused on growth they also generate significant operational improvements. GPs with good prior fund performance are able to improve portfolio companies operations more relative to the GPs whose funds did not perform as well thus providing some evidence that the implementation of growth strategies at the portfolio company level may lead to persistence in funds outperformance. Smaller funds (with a fund size below $5 million) generate the most significant post-buyout sales growth, consistent with GPs of smaller funds targeting higher growth targets. In contrast, we document that GPs managing large funds pursue greater operational improvements (as opposed to growth strategies) as their companies show much greater EBITDA growth than the companies owned by smaller funds. Established GPs (i.e., those that manage 1 funds or more) achieve significantly higher EBITDA and asset growth than the less established GPs. They also make greater investments that are funded partly with leverage. This evidence indicates that GPs with more funds under management have developed deeper knowledge on the operational side. In contrast, newly established GPs with fewer funds under management appear to focus on sales growth. * We gratefully acknowledge the generous financial support for this research provided by Adveq Management. We are also grateful to Preqin for sharing with us the private equity fund performance data. Aleszczyk acknowledges funding from the Economic and Social Research Council. We appreciate the helpful comments and suggestions received from Jan Willem Bakker and Nils Rode. Contacts: Aleksander A. Aleszczyk: aaleszczyk@london.edu Emmanuel T. De George: edegeorge@london.edu Aytekin Ertan: aertan@london.edu Florin Vasvari: fvasvari@london.edu 2 Private Equity at London Business School

3 1. Introduction Empirical evidence indicates that the average private equity ( PE ) fund has performed well relative to public equity market benchmarks over the last 3 years (e.g., Higson and Stucke (212), Robinson and Sensoy (213), Harris, Jenkinson and Kaplan (214)). While this outperformance at the fund level is well documented, due to data unavailability, little is known about how private equity fund managers or general partners (GPs) generate returns for their investors at the portfolio company level. 1 This report provides a deal-level investigation of value creation drivers from a large sample of European buyout deals initiated by private equity funds from 1998 to 214. We shed light on this topic through an analysis of the deals pricing and post-deal financial and operational indicators of performance. We also examine the extent to which the characteristics of the private equity funds and the GPs that manage them play a role in deal valuations and the performance of portfolio companies. To assess the influence of GPs on the performance of their funds, one certainly needs to understand return drivers at the deal level. GPs generate value for their investors both through careful deal selection and structuring but also by managing the portfolio companies efficiently. The general view is that GPs enhance equity returns in a deal by (1) leveraging the transaction and repaying the debt before selling the portfolio company, (2) improving the operations of the portfolio company, and (3) selling the company at a higher valuation multiple relative to the multiple at the time of investment. In this report we investigate private equity deals valuation at the time of the transaction to provide an insight into how the valuation multiple expansion is achieved. We also analyse the evolution of financial and operational performance indicators of private equity initiated deals in the period right after the transaction to highlight how GPs operational strategies differ relative to those of managers of similar but non-private equity owned companies. This latter analysis highlights GPs contribution to value creation through the second channel. 2 We start by benchmarking the valuations of deals initiated by private equity firms in Europe with the valuations of European deals initiated by corporate acquirers in the same industry and calendar year. In both univariate and multivariate analyses we document that EBITDA valuation multiples of private equity deals are significantly lower than the valuation multiples of corporate acquisitions. Private equity funds pay about 8.3 percent less than corporate acquirers for similar deals in Europe executed in the same year, after accounting for deal characteristics, percentage ownership as well as inherent country, industry, and macroeconomic trends. These results indicate that 1) GPs are either skilled negotiators and are able to close deals at significant discounts relative to corporate acquirers, 2) GPs are better able to identify cheaper targets that are potentially undervalued, or 3) corporate prices may include synergy premiums that are absent in the average PE deal. We also examine valuation differences before, during, and after the financial crisis. We find that valuation discounts of private equity initiated deals are present both before and after the credit crisis but not during. Specifically, we find that the valuation multiples of PE initiated deals are 1.6 percent lower than the multiples of similar non-pe corporate deals during the pre-crisis period. The discounts are economically meaningful also after the credit crisis (about 11.6 percent). In contrast, during the credit crisis, we observe virtually no difference in valuation multiples between PE initiated buyouts and other corporate acquisitions. Finally, our analyses indicate that the valuation discounts of private equity deals relative to their corporate peers are larger when the deals are smaller suggesting that funds targeting smaller companies generate more investor value from multiple arbitrage. 1 Throughout this report, we use we use the terms PE fund and fund when referring to private equity funds; the terms PE firm and firm when referring to the private equity firm or the general partner managing the funds; and the terms company, portfolio company, and target when referring to companies that receive investments from private equity funds. 2 Data unavailability prevents us from investigating how GPs use leverage at the deal level to enhance the returns of a deal. Buyout transactions are typically structured via holding companies and the leverage used to acquire portfolio companies is often reported on the holding companies balance sheets. We are not able to observe how this leverage is paid over time given that the holding companies are separate legal entities that very often have different names. We can only obtain debt data at the target portfolio company level. ADVEQ Applied Research Series 3

4 1. Introduction Continued We then examine the post-buyout financial and operational performance of European private equity owned companies relative to three sets of benchmarks: (1) all European companies that are not owned by private equity funds; (2) all European companies that are not owned by private equity funds matched by industry and year with our private equity initiated deals; and (3) all European companies that are not owned by private equity funds matched by industry, year, total assets and leverage with our private equity initiated deals. Our choice of benchmarks allows us to make direct comparisons between our private equity initiated deal sample and the population of European nonprivate equity owned companies that have similar characteristics over the same time periods. Univariate analyses reveal that, relative to the benchmarks described above, companies acquired by private equity firms increase their leverage significantly. Specifically, these target companies increase their debt by 9% over a three year period following the transaction while our benchmark European companies increase their debt by 3% or less. We observe increases in the level of leverage regardless of the size of the private equity owned company. We also find that private equity owned companies display significant growth in their operating profitability, assets, and sales over the first three years of private equity ownership. Specifically, sales grow significantly by about 11%, EBITDA by 1% and total assets (driven by investment in fixed assets) by close to 85%. We also conduct multivariate tests in which we control for various firm characteristics, country and industry-year fixed effects and find similar results. Our findings show that, ceteris paribus, private equity-owned companies experience significantly greater EBITDA, sales, leverage and asset growth post-acquisition than similar non-private equity owned companies. These results indicate that GPs are focused on growth with significant increases in sales and investments in tangible assets that are partly funded by taking on additional debt. Simultaneously, GPs also generate significant operational improvements, relative to other companies that are non-private equity owned, by enhancing the EBITDA of the target companies. These financial and operational developments provide a partial explanation for the outperformance of private equity funds relative to public equity benchmarks. In the final part of our analysis we assess how GP characteristics contribute to the valuation and post transaction performance of the private equity deals. We match our sample of deals with the Preqin database, which contains information on private equity fund performance and GPs. The handmatching procedure is done using the private equity firm name and its location and yields a reduced sample of 32 private equity transactions. The Preqin data allows us to measure the private equity funds size, the historical performance of the private equity funds managed by a GP (based on cash multiples) as well as the number of funds managed by a GP. We then replicate the analyses above by partitioning the sample on these characteristics. First, we split our sample of deals based on the historical performance of the GPs funds as measured by average cash multiples on previously managed funds. Results indicate that GPs whose funds experienced good past performance, are able to achieve higher sales and asset growth relative to the GPs whose funds did not perform as well, thus providing evidence that growth strategies at the portfolio company level may explain the persistence in the performance of successful private equity funds managed by the same GP. Interestingly, the data suggests that operational efficiencies, i.e., significant increases in EBITDA growth, are most 4 Private Equity at London Business School

5 1. Introduction Continued pronounced the case of GPs with the lowest past performance. Second, we split the analyses based on the average fund size which is measured using the fund size distribution in our sample. Small funds are defined as those in the bottom tercile of the distribution, with an average size of $191 million, while the large funds are in the top tercile of the distribution with an average size of $2.5 billion. Our results show that smaller funds generate the most significant post-buyout sales growth of 12%, relative to the large funds that report average sales growth of only 37%, consistent with GPs of smaller funds targeting higher growth targets. These targets have more scope for growth compared to the large companies owned by the bigger private equity funds despite. In contrast, we document that GPs managing large funds pursue greater operational improvements (as opposed to growth strategies) as their companies show much greater EBITDA growth than the companies owned by smaller funds. Third, we explore whether post-transaction operating performance varies with the extent to which the GPs are established. We find that established GPs (i.e., those that manage 1 funds or more) achieve significantly higher EBITDA and asset growth than the less established GPs. Specifically, established GPs boost EBITDA by close to 1% relative to the rest of the GPs who generate growth in EBITDA between 37% and 41%. Established GPs also make greater investments, growing the assets of the target companies by over 12% within three years of buyouts. These investments seem to be funded partly with leverage as these GPs are likely to leverage their reputation in the market to take more debt. However, established GPs manage to grow sales over the three-year period after the deal by about 63%, significantly lower than the sale growth of 118% achieved by the less established GPs. Overall, these results indicate GPs with more funds under management pursue operating efficiencies to generate value while GPs with few funds under management appear to focus on sales growth. These conclusions are in concert with our findings on fund size, as more established GPs tend to manage larger funds, which pursue different investment strategies than their smaller counterparts. The Adveq Applied Research Series 5

6 2. Background on the prior evidence GPs usually control the boards of their portfolio companies and are generally more actively involved in governance than the directors and shareholders of publicly listed companies. As part of their board activities, GPs structure strong equity incentives for the management teams of their portfolio companies and use their industry and operating expertise to add value to these companies. At the same time, some GPs might use leverage to acquire portfolio companies putting pressure on the managers of these firms not to waste money or misappropriate resources. Consistent with these arguments, several prior studies document that the performance of private equity owned companies is superior. Using buyout transactions in the 198s and 199s, Kaplan (1989), Smith (199), Lichtenberg and Siegel (199), and Cohn, Mills, and Towery (214) provide evidence that LBOs create value by significantly improving the operating performance of acquired companies. Also, Davis et al. (214) find significant increases in productivity in a large sample of U.S. buyouts that rely on leverage during the same periods. They attribute the performance to the disciplining effect of leverage used to fund the transactions and to the better governance instituted by the GPs. However, results using more recent U.S. data provide a mixed picture. Guo, Hotchkiss, and Song (211) use a sample of ninety-four U.S. publicto-private transactions between 199 and 26 and find that gains in operating performance are not statistically different from those observed for benchmark firms and that GPs create value by primarily exploiting post-buyout tax benefits. Similarly, Leslie and Oyer (28) find weak or no evidence of greater profitability or operating efficiency for 144 leveraged buyout transactions between 1996 and 24, relative to public companies. 3 In contrast, Lerner, Sorensen, and Stromberg (28) find significant increases in longterm innovation for a sample of 495 buyouts. The private equity owned companies generate patents that are more frequently cited a proxy for the novelty and the level of innovation provided by the patents. In addition, Gao, Harford, and Li (213) document that the private equity owned firms hold, on average, only about half as much cash on their balance sheet as their public counterparts suggesting that GPs optimize the use of capital at the portfolio company level. Finally, Boucly, Sraer and Thesmar (211) focus on a data set of large French deals executed between (with an average enterprise value of EUR4 million) and find that PE targets become more profitable, grow much faster, issue additional debt, and increase capital expenditures relative to a carefully selected peer group, especially if they are credit constrained. This paper yields similar results to Acharya, Gottschalg, Hahn, and Kehoe (213) who also analyse big deals initiated by large private equity houses. They document that the higher abnormal performance of private equity funds is related to sales and margin improvements at the deal level and that ownership by large and mature PE houses has a positive impact on the operating performance of portfolio companies, relative to the overall performance of their sector. While this recent evidence is relevant, there is still very limited evidence on the performance of small and medium sized deals initiated by GPs other than those that are part of large PE firms. Previous research further highlights the influence of leverage on the returns of private equity funds. Engel, Braun, and Achleitner (212) find a positive relationship between leverage and deal returns. In contrast, Axelson, Jenkinson, Stromberg and Weisbach (213) use a large sample of private equity initiated buyouts and find that higher deal leverage is associated with lower buyout fund returns. Their results suggest that buyers tend to overpay when access to credit is easier. Nevertheless, GPs are likely to generate value for their funds by negotiating favourable debt terms for their deals. Ivashina and Kovner (211) examine a 3 Cohn, Mills, and Towery (214) obtain corporate tax return data to examine the evolution of firms' financial structure and performance after leveraged buyouts. For a comprehensive sample of 317 leveraged buyouts taking place between 1995 and 27 in the U.S. the authors find little evidence of operating improvements subsequent to a buyout overall. 6 Private Equity at London Business School

7 2. Background on the prior evidence Continued sample of 1,59 loans used to finance private equity sponsored leverage buyouts and find that bank relationships formed through repeated interactions allow GPs to obtain much more favourable loan terms, in some cases translating to an additional 4% return on invested capital. Similarly, Demiroglu and James (21) provide evidence that GPs reputations are related to the financing structure of their deals suggesting that reputable GPs are more likely to take advantage of market timing in credit markets. In addition, more reputable GPs benefit from narrower bank and institutional loan spreads and obtain longer loan maturities. Leverage and operational improvements are not the only drivers of private equity deal returns. Another factor that drives the returns is the purchase price paid for the portfolio company at the time of its acquisition. We argue that the literature has provided very limited evidence on this dimension despite its importance in understanding how prices are achieved in the market for private equity transactions and the extent to which GPs manage to achieve multiple expansions. 4 It is not clear whether private equity funds continue to achieve favourable pricing for their deals as proprietary deals have become less frequent. Company owners, M&A advisory boutiques, and the banks funding private equity transactions have become more professional and connected thus a large number of transactions are decided in auction processes with several investors involved. This could cause private equity funds to pay significantly more to acquire their portfolio companies. Nevertheless, we expect that the extent to which private equity funds obtain favourable pricing to be a function of the deal size. For instance, the level of competition has increased significantly over time, especially for the very big deals which are chased by the large global buyout funds. Our report adds to the body of research described above by investigating the pricing and posttransaction performance of a large sample of European private equity deals spanning a long period from 1998 and 214 and covering a wide set of deal sizes. About a third of our sample of deals are below $5 million. We benchmark the valuation of private equity deals to similar corporate deals and the operational performance of PE deals to alternative samples of European companies that are not private equity owned and are matched on important characteristics. This empirical methodology allows us to assess whether private equity fund managers, on average, are able to generate significant value for their investors relative the managers of non-private equity owned firms. Such evidence could potentially explain the outperformance of public markets by private equity funds that has been documented in recent research (Higson and Stucke (212), Robinson and Sensoy (213), Harris, Jenkinson and Kaplan (214)). 4 Guo, Hotchkiss, and Song (211) document that the public-to-private buyouts completed between 199 and 26 are more conservatively priced and less levered than their predecessors from the 198s. ADVEQ Applied Research Series 7

8 3. Data and Methodology In order to obtain a comprehensive sample of European buyout deals we collect data from several sources. We first identify private equity initiated buyouts in Europe between 1998 and 214 from Standard & Poor s Capital IQ database. We choose Capital IQ as our primary data source because it has the most expansive coverage of European deals. Another benefit of Capital IQ is that it includes private-company financial data that enables us to empirically examine post-buyout company performance and capital structure. Beginning with our initial sample of 4,754 deal observations from Capital IQ, we append non-duplicate private equity deals from the SDC (3,31 deals) and Mergermarket datasets (2,69 deals). This yields a total sample of 9,854 private equity firm (PE) initiated deals. We classify transactions as PE initiated in the following way. First, we identify all deals for which the acquiring entity is currently managing (or has previously managed) a private equity or venture capital fund. We then keep only those deals for which (1) the acquiring entity has an investment style described as either: private equity, venture capital, or growth ; or (2) the phrase private equity appears in the business description or the entity s name. 5 While Capital IQ, SDC and Mergermarket provide dealspecific valuation data and basic financial statement information of both the target and acquirer, we also collect financial statement data from Bureau van Dijk databases BvD Amadeus for continental Europe, and BvD Fame for UK targets matched on company name and country of incorporation. We remove deal observations with missing industry membership, valuation details, or financial information. In addition, we exclude firms operating in regulated markets (i.e., financial and agricultural firms) and those in unclassified industries. To mitigate the effect of outliers on our empirical analysis we truncate all continuous variables at the 1st and 99th percentiles of their sample distributions. This yields a final sample of 1,552 PE-initiated European buyouts between 1998 and 214. We run a series of tests to examine (1) differences in the valuation of PE-initiated deals relative to other corporate deals; (2) differences in the future performance and capital structure of PE owned companies relative to non-pe owned companies; and (3) whether PE firm characteristics, i.e., prior performance, strategy, and maturity, explain cross-sectional differences in performance and valuation. Due to data restrictions, our analyses employ three overlapping samples. Our primary and most comprehensive sample of 1,552 PEinitiated buyouts is used for the valuation analysis, while a reduced sample of 778 PE-initiated deals is employed in the post-transaction performance analyses. The reduction in sample size is due to additional data requirements of post-transaction financial information. Finally, we match our primary sample to the Preqin database, which contains timeseries information on PE firm characteristics and fund performance. This results in a further reduced sample of 32 PE-initiated buyouts for our crosssectional analysis of PE firm characteristics and deal performance. 5 To ensure the validity of our classification system we hand-check a sub-sample of PEinitiated deals to ensure the acquirer is indeed a private equity entity. 8 Private Equity at London Business School

9 3. Data and Methodology Continued In the post-transaction performance and capital structure analyses, we employ four benchmark samples: (1) all non-pe owned European companies; (2) all non-pe owned European companies within the same industry and year of our PE-initiated buyout sample; (3) all non-pe owned companies within the same industry and year matched on opening assets and leverage; and (4) similar non-pe corporate M&A target companies. 6 Our choice of benchmarks allows us to compare the PE-initiated buyout sample with the population of European non-pe owned companies, an industryyear matched benchmark of companies, and an industry-year matched benchmark of companies of a similar size and capital structure. In Panels A C of Table 1 we describe our sampling procedure. Panel D of the same table shows the frequency distribution of the number of PE-initiated deals per year. We see a clear uptick in PE buyout activity beginning in 25 and a peak of 178 deals in 27, consistent with the record level of PE initiated investment activity documented in prior literature (e.g. Wilson et al. 212; Guo et al. 211). This pattern matches the surge in M&A activity beginning in 25, with the total number of completed deals tripling from 24 to 27. We note that a large portion of PE targets (5) are UK based firms, consistent with prior studies that document the UK as the largest private equity market in Europe (e.g. Groh et al. 21). Finally, Panel E shows the frequency of the deals based on their size. We note that a significant proportion of the sample used for the valuation analyses (slightly over 45 deals) covers small deals below $5 million. 6 We employ a propensity score matching based on opening assets and leverage. We ensure that opening assets and leverage do not differ by more than 2.5% between our treatment and benchmark firms. ADVEQ Applied Research Series 9

10 3. Data and Methodology Continued Table I: This table presents information on sample selection. The unit of observation is an individual deal. Panel A, B, and C detail the sample selection procedure for the analysis of valuation multiple, post-deal operating performance, and PE fund characteristics, respectively. Panel D describes the yearly breakdown of each of the three samples. Panel A: Analysis of valuation multiples S&P Capital IQ 4,754 Thomson Reuters SDC 3,31 Mergermarket 2,69 Less: missing industry (1,795) Less: missing enterprise value to EBITDA (5,531) Less: missing basic financials (748) Less: unmatched observations by PSM (228) 9,854 8,59 2,528 1,78 ==> Final Sample 1,552 Panel B: Analysis of post-deal operating performance Panel C: Analysis of fund characteristics S&P Capital IQ 4,754 Thomson Reuters SDC 3,31 Mergermarket 2,69 9,854 S&P Capital IQ 4,754 Thomson Reuters SDC 3,31 Mergermarket 2,69 9,854 Less: missing industry (1,795) Less: unmatched to BvD Amadeus (3,784) Less: missing financials at year t+3 (3,397) Less: unmatched observations by portfolio sorting (1) 8,59 4, Less: missing industry (1,795) Less: unmatched to Preqin (6,451) Less: missing financials at year t+3 (1,227) Less: missing Preqin data (79) 8,59 1, ==> Final Sample 778 ==> Final Sample 32 1 Private Equity at London Business School

11 Panel D: Number of sample deals by year Sample for the analysis of: Year Valuation multiples Post-deal performance PE fund characteristics Panel E: Number of sample deals by target size Sample for the analysis of: Target Assets in $MM Valuation multiples Post-deal performance PE fund characteristics < , ,-2, >2, The Adveq Applied Research Series 11

12 3. Data and Methodology Continued In Panel A of Table 2 we provide distributional statistics describing our pooled sample of private equity deals and the matched sample of non-pe corporate deals. The mean (median) deal size in our sample is $477mm ($11mm), with the majority of PE transactions occurring in the Manufacturing and Wholesale and Retail industries. The distribution of the size of deals is highly skewed with mean deal size over three times the median, reflecting the presence in our sample of some very large deals. These are relatively smaller than previously documented buyouts in the United States. 7 The average PE-owned company also tends to be fairly profitable and highly levered prior to the PE acquisition. Table 2: This table presents descriptive statistics. Panel A describes the sample that is used for the analysis of valuation multiples. Panel B details the sample that is used to examine post-deal operating performance. Panel C reports statistics pertaining this sample by industry. Panel A. Valuation multiples EV to EBITDA EV Deal Size Total Assets Total Leverage PE Corp PE Corp PE Corp PE Corp PE Corp N mean Q Q Q Stdev Panel B. Post-deal operating performance Sales Growth EBITDA Growth Leverage Growth Asset Growth PE Corp PE Corp PE Corp PE Corp N mean Q Q Q Stdev For a sample of 192 LBOs between , Guo et al. (211) document an average deal size of $463mm. 12 Private Equity at London Business School

13 Panel C. Post-deal operating performance: sectoral distribution EV to EBITDA Sales Growth EBITDA Growth Leverage Growth Total Assets Growth PE Corp PE Corp PE Corp PE Corp PE Corp Mining and Construction (SIC 1) N mean Q Manufacturing (SIC 2) N mean Q Manufacturing (SIC 3) N mean Q Transportation, Communications, Electric, Gas, And Sanitary Services (SIC 4) Wholesale and Retail Trade (SIC 5) N mean Q N mean Q Services (SIC 7) N mean Q Services (SIC 8) N mean Q The Adveq Applied Research Series 13

14 4. Results 4.1. Valuation analysis We begin our analyses by benchmarking the valuations of deals initiated by buyout funds in Europe with the valuations of other European deals initiated by corporate acquirers within the same industry and year. Univariate results indicate that, on balance, PE target companies tend to have lower multiples at the time of acquisition relative to corporate M&A target companies. Figure 1A reveals fairly pronounced discounts for PE firms in the pre-crisis years of our sample period, i.e , and continuing immediately after the crisis period (21 212). Interestingly, in the final two years of our sample ( ) PE firms appear to pay slightly more for target firms relative to similar corporate acquisition targets. Figure 1B presents support for this observation in a summarized fashion: The average EV-to-EBITDA ratio for PE targets is, on balance, smaller than those for corporate M&A targets before, during, and after the crisis. Further, we extend this analysis with a cross-sectional investigation of the deal size to ascertain whether the documented discrepancy is clustered among certain deals. Specifically, we partition the sample based on target firm size (i.e. small is defined as those deals with total assets less than $2 million; medium are those deals with total assets between $2 and $1 million, and large deals are those where target total assets are in excess of $1 million). As detailed in Figure 1C, regardless of target size, we document that private equity funds pay significantly less relative to their corporate counterparts. More interestingly, the valuation discounts of private equity deals are larger for the smaller sized deals (7%) versus the medium and large deals (3.6% and 3.1%, respectively). Figure 1A Average EV/EBITDA multiple for PE-targets versus Corporate M&A targets, Multiple Years PE Targets Corporate M&A targets 14 Private Equity at London Business School

15 4. Results Continued Figure 1B Average EV/EBITDA multiple for PE-targets versus Corporate M&A targets, by period 25 2 Multpiple Pre-crisis Crisis Post Crisis Period PE Targets Corporate M&A targets Figure 1C Average EV/EBITDA mutliple for PE-targets versus Corporate M&A targets, by target size ($MM Assets) Multpiple <$2m <$1m >$1m Total assets PE Targets Corporate M&A targets The Adveq Applied Research Series 15

16 4. Results Continued While the above analysis provides interesting insights, it may be susceptible to inherent differences between PE and corporate deals that one needs to take into account before comparing one another. Switching to a multivariate setting that facilitates such comparisons, we regress our valuation multiple EV divided by EBITDA on an indicator variable that flags PE initiated deals, controls for size, leverage, profitability, debt levels, percentage ownership, as well as country and industry-year fixed effects. We control for target firm characteristics to hold these constant before comparing PE deals to corporate deals. We consider country and industry-year effects to account for inherent country characteristics as well as industry and macro trends that might drive PE investment and the corresponding EBITDA multiple. We report our multivariate analysis in Table 3. When comparing to a pooled benchmark sample of all corporate acquisitions, consistent with our univariate results, we find a strong negative coefficient on our PE indicator (-.57; t-stat = 2.3), while results strengthen when we employ a matched benchmark sample, with a coefficient of -.83 (t-stat = 2.61) on our PE indicator variable (Columns I and II, respectively). Economically speaking, PE deals are associated with a relative discount of 5.7 to 8.3 percent even after controlling for a number of determinants of deal valuation. These results suggest that European buyout deals have economically significantly lower multiples than similar corporate acquisitions. Our findings are consistent with the view that GPs are either skilled negotiators that can close deals at significant discounts relative to corporate acquirers, or that GPs are better able to identify undervalued targets than their corporate peers. We also recognize the possibility that potential synergies in corporate deals, which are absent in the average PE deal, may also explain the difference in multiples. We then examine valuation differences before, during, and after the financial crisis defined as the period between June 27 and June 29. As depicted in Columns (III) and (V), the PE discount is prevalent before and after the recent financial crisis, while it is insignificant during the crisis. Specifically, we find valuation multiples attached to European buyout deals to be lower by 1.6 and 11.6 percent compared to similar corporate acquisitions preand post-crisis, respectively. Results in column (IV) reveal no significant differences in valuations between the private equity initiated deals and the corporate acquisitions during the financial crisis. Overall, our findings suggest that PE firms are capable to identify undervalued firms or negotiate better pricing terms when the market is in an upswing (as reflected by both our pre- and postcrisis results). In a final analysis in Column (VI) we investigate whether the valuation discount that private equity funds obtain relative to corporate peers is a function of the deal size. We document that small deals have significantly larger discounts of 12% compared to the average discount of medium and large deals which show discounts of only 7%. Small deals are deals that are in the bottom tercile of the deal size distribution in our sample while the medium and large deals are deals in the middle and top terciles. This evidence indicates that GPs that target smaller deals face less competition from other GPs or corporate. In turn, lower competition potentially allows them to bid less for their portfolio companies. 16 Private Equity at London Business School

17 Table 3. Multivariate Analysis of PE Valuations The unit of observation is an individual deal. This table presents results from multivariate regressions of EBITDA multiple, Enterprise value divided by Target EBITDA. The independent variables are a private equity indicator, PE initiated, as well as a vector of controls and fixed effects. Model (I) is estimated on the pooled sample, and a matched sample is used for Models includes all firms. Variables are defined in the text. T-statistics (in parentheses) are robust to within-industry-year correlation and heteroscedasticity. ***, **, and * denote statistical significance at the 1%, 5%, and 1% levels. Model (I) (II) (III) (IV) (V) (VI) Time period All years All years Pre-crisis Crisis Post-crisis All years Sample Pooled Matched Matched Matched Matched Matched EBITDA Multiple EBITDA Multiple EBITDA Multiple EBITDA Multiple EBITDA Multiple EBITDA Multiple PE initiated -.572** (-2.3) -.831** (-2.61) -.163** (-2.32).157 (.19) ** (-2.53) PE initiated, small target size tercile -.111** (-2.23) PE initiated, other target size -.79* (-1.92) Total assets (log) -.148*** (-14.7) *** (-11.54) -.127*** (-5.52) *** (-6.4) *** (-6.89) -.12*** (-9.57) Leverage (log D/A).4375*** (4.7).3271** (2.12).2183 (.76).8929** (2.12).1375 (.66).324** -2.7 Net Income Margin (log) *** (-3.48) ** (-2.27) ** (-2.43) ** (-2.2) (-1.48) -2.55** (-2.23) Net Debt (log) -.73 (-.13).991 (1.13) -.28 (-.15) (-.16).2412** (2.8) %+ stake (dummy) *** (-4.64) *** (-3.88) -.731* (-1.81) * (-1.73) ** (-2.64) -.119*** (-3.86) Observations 7,197 2,838 1, ,229 2,838 Adjusted R- squared Country FE YES YES YES YES YES YES Industry-Year FE YES YES YES YES YES YES The Adveq Applied Research Series 17

18 4. Results Continued 4.2 Analysis of post-buyout operating performance and capital structure We now turn our attention to examining the postbuyout performance and capital structure of European PE owned companies relative to three sets of benchmarks: (1) all European firms that are not owned by private equity funds; (2) all European firms that are not owned by private equity funds matched by industry and year with our private equity initiated deals; and (3) all European firms that are not owned by private equity funds matched by industry, year, opening assets and leverage with our private equity initiated deals Leverage We first examine univariate evidence on the trend in portfolio company leverage measured as long-term debt to total assets for our sample of 778 private equity owned firms. As a point of comparison, we provide the contemporaneous trend in leverage for the benchmark samples described above. Figure 2A depicts the mean reported leverage for the sample of European PE initiated deals and all benchmark samples in the year prior to acquisition, up to three years posttransaction (i.e. t= through t=3). We find that GPs significantly increase the leverage of target firms, relative to all benchmark sample firms, in the three years following the buyout. Specifically, European buyout targets increase leverage from 9.64% pre-acquisition to almost 13.5% in the three years post-buyout, while our matched sample of European companies that are not owned by private equity firms exhibit no discernible change in leverage, i.e. 9.5% in t= to 9.8% in t=3. One potential explanation for this finding is GPs adjust capital structures to utilize unused debt capacities of portfolio companies to finance their growth and investments. Figure 2B illustrates trends in post-buyout leverage, partitioned on target size, i.e., last reported total assets (in $millions) before acquisition. We replicate Figure 2A across three size categories based on target total assets: large deals (the target s total assets exceed $1m); medium deals (target s assets between $2m and $1m), and small deals (target s assets less than $2m). Our analysis indicates that the leverage differences between PE buyouts and non-pe owned benchmark companies are driven by large and medium size targets. On average, larger private equity owned companies increase their leverage by 28% in the three years post-buyout, while larger non-pe owned matched companies actually exhibit a contemporaneous decrease in leverage of only 17%. In addition, medium size PE buyout companies exhibit almost a 5% increase in leverage, relative to benchmark sample of similar medium size companies that exhibit no significant change. Un-tabulated results of the median leverage offers even sharper differences in leverage trends between PE and non- PE owned companies among large and medium firms. In contrast, smaller PE owned companies use less leverage and there are no discernible differences between their leverage and the leverage of similar benchmark non-private equity owned companies, suggesting that smaller deals bear less financial risk. This result is consistent with anecdotal evidence that private equity funds that invest in smaller companies use less leverage to pursue these companies growth opportunities. Figure 2C presents a comprehensive view of the aggregate leverage growth over the three years post-acquisition across PE-initiated deals and our benchmark groups, which now includes similar corporate M&A targets. Consistent with earlier results, PE deals seem to experience the largest three-year increase in leverage (over 9%), even compared to corporate M&A targets that increase their leverage by only about 7%. Even more striking, our traditional benchmark groups (i.e. matched non-pe owned companies) display modest rises in leverage of just 2.5% to 3.5%. The sustained increased in the post-transaction leverage of the PE owned companies raises several questions. 18 Private Equity at London Business School

19 Are these leverage increases funding the existing operations, or are they supporting a growth in operations? Moreover, does the change in these firms capital structure translate into future operating performance improvements? To shed light on these issues we now switch our attention to several indicators of post-transaction performance. Figure 2A Mean leverage of PE-target companies post-acquisition Leverage (debt as % of total assets) t= t=1 t=2 t=3 Years relative to acquisition PE Matched Non PE Matched All Two digit industry year Figure 2B Mean leverage of PE-target companies post-acquisition, by target size ($MM Assets).2 Leverage (debt as % of total assets) t= t=1 t=2 t=3 Years relative to acquisition <$2m <1m >1m <$2m Non PE <1m Non PE >1m Non PE The Adveq Applied Research Series 19

20 4. Results Continued Figure 2C 3-year growth in leverage of PE-target firms, relative to non-pe benchmarks 1 9 3yr lev growth PE targets Non-PE matched All Industry-year matched Corporate M&A Operating performance We examine two indicators of operating performance that are traditionally viewed as economically important in assessing portfolio firm performance: return on assets (ROA) and EBITDA margin or the operational margin (OPMAR). We define ROA as net income divided by ending total assets, and OPMAR as earnings before interest, tax, depreciation and amortization divided by total sales. Figure 3A shows a significant decline in ROA for private equity owned firms post-buyout relative to all three non-private equity benchmark samples. However, PE targets exhibit much higher ROA relative to non-pe owned firms pre-acquisition, hence the decline in ROA simply brings ROA levels in-line with benchmark firms in the postbuyout period. In contrast to the documented trend in leverage, the decline in ROA is much more pronounced in our small and medium size target firms. For example, Figure 3B shows a dramatic decrease in ROA from 7.7 to 3.9 in the three years post-buyout. 2 Private Equity at London Business School

21 Figure 3A Mean ROA for PE-target companies post-acquisition ROA t= t=1 t=2 t=3 Years relative to acquisition PE Corporate All Two digit industry year Figure 3B Mean ROA for PE-target companies post-acquisition, by target size ($MM Assets) ROA t= t=1 t=2 t=3 Years relative to acquisition <$2m <1m >1m <$2m Non PE <1m Non PE >1m Non PE The Adveq Applied Research Series 21

22 4. Results Continued There are two potential explanations for the observed declines in the post-transaction ROA. These firms could experience a reduction in their profits (i.e. a numerator effect) or they may be expanding their asset base (i.e. a denominator effect) due to, say, increased investments. While the former is a reason to worry, the latter may reflect a GP s shift in strategy towards investing in growth which may generate future significant returns. To this end, we examine several performance metrics over the post-acquisition period to uncover the source of the observed ROA declines within our buyout sample, namely OPMAR, sales growth, asset growth, EBITDA growth. Notably, in Figure 4A, while the average OPMAR exhibits little change post-acquisition, PE buyout targets are still able to maintain significantly higher operating margins than non-pe owned firms, i.e. 11% versus 9%, respectively. The results are similar regardless of the size of the private equity owned companies (Figure 4B). Moreover, in un-tabulated results we find that GPs are able to grow their portfolio firms EBIT by almost 2% in the three years postacquisition, while non-pe owned companies exhibit significantly smaller profitability improvements, i.e. approximately only 12%. Figure 5 further illustrates that documented EBITDA growth is likely driven by significant growth in sales and operating efficiencies. Indeed, PE owned companies seem to more than double their sales in three years, compared to more modest increases experienced by corporate M&A targets. We also notice that the companies in our matched benchmark samples exhibit only a minor (about 5%) three-year increase in sales. These operational improvements are consistent with the recent work (e.g., Boston Consulting Group, 212) that finds that half of private equity returns are attributable to increases in sales growth alone, while the remaining half are shared among increases in operating efficiencies, exits, and leverage effects; speaking to the importance of sales growth in generating value to PE firms. More strikingly, the observed post-acquisition operating performance of PE targets significantly outstrips the post-acquisition performance of corporate acquisitions for the same period across all dimensions of growth. The total asset growth and fixed asset growth of PE firms are significantly higher than all benchmark samples, including corporate deals. The above results suggest that GPs increase leverage following acquisitions to pursue growth strategies through significant capital investments. Table 2, panels B and C provide univariate evidence of the three-year growth rates of our chosen metrics: sales growth, EBITDA growth, EBIT growth, total asset growth, fixed assets growth, and EVto-EBITDA. Panel A describes the distribution of growth rates for our full sample of 778 deals, while Panel C provides growth rates across our 7 industries (SIC single digit). Sales, EBITDA, EBIT and total asset growth are highly skewed with mean growth rates 3 to 4 times higher than the median. While the Service industry SIC 8 exhibits the highest average sales growth of any industry, these firms rank much lower in operating efficiencies. Not surprisingly, Mining and Construction targets top the list of growth in fixed assets indicating the PE firms who target these firms engage in significant capital expenditures. Wholesale and Retail Trade firms tend to rely on operational efficiencies, exhibiting the greatest increase in EBITDA and EBIT growth. Overall, our univariate analysis reveals that, relative to the benchmarks described above, firms acquired by private equity funds increase their leverage, exhibit significant improvements in operating profitability, invest more in assets, and grow sales faster over the first three years of private equity ownership. One may infer that PE firms may be able to generate stronger return performance, relative to corporate acquirers, by levering up their portfolio firms when investing in capital assets. In turn, a larger capital base will help grow sales and generate higher valuations as the buyers of these companies will likely pay more for the growth potential. 22 Private Equity at London Business School