Operational Improvement: The Key to Value Creation in Private Equity

With credit tightening having reduced the availability of leverage and intensified the competition for new deals, the economic recession has caused many companies in private equity firm portfolios to under-perform. These changes are forcing the private equity firms to depend even more on their ability to improve operating performance to achieve their investment goals and generate attractive returns. But few PE firms have proved capable of achieving such improvements in portfolio companies consistently over time.
In this paper, the authors discuss several ways that private equity firms use their operating expertise to drive value in their portfolio companies. They also examine the analytical framework used by some PE firms when assessing and prioritizing the many operational initiatives that could be undertaken within a newly acquired company. Part of that examination involves a detailed look at how private equity firms assemble an attractive mix of operational improvement projects in their initial 100-day plans. Finally, the authors explore one of the challenges faced by private equity firms when attempting to implement operational enhancements in newly acquired companies: bringing about change without alienating company management.
The real-world application of this approach is demonstrated with a case study that shows how one private equity buyer put its operational skills into practice to help create value within a mid-sized portfolio company.     

Every employee an owner. Really

Surveys indicate that when new rules on expensing stock options take effect, many companies are likely to limit the number of employees who can receive equity compensation. But companies that reserve equity for executives are bound to suffer in the long run. Study after study proves that broad-based ownership, when done right, leads to higher productivity, lower workforce turnover, better recruits, and bigger profits. "Done right" is the key. Here are the four most important factors in implementing a broad-based employee equity plan: A significant portion of the workforce--generally, most of the full-time people--must hold equity; employees must think the amounts they hold can significantly improve their financial prospects; managerial practices and policies must reinforce the plan; and employees must feel a true sense of company ownership. Those factors add up to an ownership culture in which employees' interests are aligned with the company's. The result is a workforce that is loyal, cooperative, and willing to go above and beyond to make the organization successful. A wide variety of companies have recorded exceptional business performance with the help of employee-ownership programs supported by management policies. The authors examine two: Science Applications International, a research and development contractor, and Scot Forge, which shapes metal and other materials for industrial machinery. At both companies, every employee with a year or so of service holds equity, and employees who stay on can accumulate a comfortable nest egg. Management's sharing of financial information reinforces workers' sense of ownership. So does the expectation that employees will accept the responsibilities of ownership. Workers with an ownership stake internalize their responsibilities and feel they have an obligation not only to management but to one another.     

Wealth Effects of Private Equity Placements: Evidence from Singapore

We examine institutional characteristics and the wealth effects of private equity placements in Singapore. Our findings show that private placements in Singapore generally result in a negative wealth effect and a reduction in ownership concentration. We find that at high levels of ownership concentration, the relation between abnormal returns and changes in ownership concentration is significantly negative. We also show that the market reacts less favorably to placements in which management ownership falls below 50%, but more favorably to issues to single investors. We do not find evidence suggesting that our results are due to an information effect.     

Group affiliation, identity of managers, and the relation between managerial ownership and performance

Two features in Taiwan's companies complicate the ownership-performance relationship. First, the firm's management is usually controlled, either directly or indirectly via equity interlocks, by the controlling family. The shareholding of managers is an access through which the controlling owners can secure control and entrench their private benefits. Second, the management generally consists of individual managers and representatives appointed to top managerial positions by institutions that hold a substantial percentage of shares. The role of corporate managers played by institutions is important in Taiwan's companies. Echoing these two features, empirical results suggest a low inflection point for the nonlinear relation between managerial ownership and performance. Moreover, the impact of managerial ownership on performance varies between different identities of managers and depends on whether the firm is group-affiliated or independent. There is also evidence to show that the relation between individual and institutional managerial ownership is complementary at low levels of ownership and becomes substitutive as ownership gets higher.     

Housing Finance Arrangements,Wealth Positioning and Housing Consumption in Japan: An Analysis of Built-for-sale Homeowners

Home purchase is financed through equity and debt. Housing finance arrangements require initial downpayments and impose monthly repayments. Similar to many countries, Japanese households accumulate savings out of their current income and receive private transfers from parents or relatives. From the survey conducted by the Ministry of Land, Transportation and Infrastructure from 1992 to 2000, the paper analyses the time spell until built-for sale homebuyers have amassed sufficient equity to meet the downpayment requirement. For the first-time buyers, private aid in form of cash was the dominant component of equity besides own savings. The innovative feature of our paper is to categorize the households into four classes of positive versus negative excess savings and positive versus negative excess “luck” as other equity sources including private transfers get termed here. For each category we estimate the duration of the accumulation process, and perform a sensitivity analysis that compares the spells under varying amounts of GHLC-loans with other types of mortgages. Since GHLC-loans are means-tested, they can effectively counteract the regressive effects arising from income; but as we will show they cannot really speed up the access in favour of the poorer strata. This finding sheds light on a growing wealth disparity that causes self-selection in ownership access.     

Equity financing in a Myers–Majluf framework with private benefits of control

This paper generalizes the Myers and Majluf (1984) model by introducing an agency cost structure based on private benefits of control. This new model predicts that many corporate finance variables each have opposing effects on under- and overinvestment. Private benefits exacerbate overinvestment but, interestingly, a small amount of private benefits can enhance firm value by alleviating underinvestment. Likewise, an increase in insider ownership alleviates overinvestment but aggravates underinvestment. When private benefits are small, the adverse effect of insider ownership on underinvestment tends to dominate. When there are considerable private benefits, the incentive-alignment effect of insider ownership is pronounced. Additionally, this model reconciles existing equity financing theories on announcement effects. It helps resolve the puzzle that small-growth firms do not seem to have an asymmetric information disadvantage when they issue new equity.     

Public Equity and Audit Pricing in the United States

To what degree are audit fees for U.S. firms with publicly traded equity higher than fees for otherwise similar firms with private equity? The answer is potentially important for evaluating regulatory regime design efficiency and for understanding audit demand and production economics. For U.S. firms with publicly traded debt, we hold constant the regulatory regime, including mandated issuer reporting and auditor responsibilities. We vary equity ownership and thus public securities market contextual factors, including any related public firm audit fees from increased audit effort to reduce audit litigation risk and/or pure litigation risk premium (litigation channel effects). In cross‐section, we find that audit fees for public equity firms are 20–22% higher than fees for otherwise similar private equity firms. Time‐series comparisons for firms that change ownership status yield larger percentage fee increases (decreases) for those going public (private). Results are consistent with litigation channel effects giving rise to substantial incremental audit fees for U.S. firms with public equity ownership.     

The Impact of Stock Transfer Restrictions on the Private Placement Discount

The literature contains four explanations for the private placement discount. I find that all four contribute to the discount: loss of option value due to transfer restrictions, equity ownership concentration, information gathering, and overvaluation and expected underperformance post‐issue. An average‐strike put option model calculates marketability discounts that are consistent with empirical private placement discounts when observed discounts are adjusted for equity ownership concentration, information, and overvaluation effects. In contrast to the positive signaling effect of traditional private placement announcements, there is a negative signaling effect for private investments in public equity when the firm commits to register the shares promptly.     

Buyout Transactions in the German‐speaking Region: Determinants of Abnormal Performance and Unlevered Returns

This is one of the first comprehensive studies of drivers of private equity performance in the German‐speaking region known as the DACH, made up of Germany, Austria, and Switzerland. It contributes three things to private equity research: First, it explains how operational value drivers affect operational performance (operational alpha) and unlevered rates of return. Second, it whether the same relationships hold across different kinds of private equity business models (those with either organic or inorganic growth strategies; or whether PE investments are small‐cap or mid‐to‐large‐cap). Third, it distinguished between the periods before and after the global financial crisis of 2008. The authors found that (1) annualised benchmark‐adjusted EBITDA margin growth (i.e. improvement in EBITDA margin) is the most significant determinant in abnormal operational performance and unlevered returns, regardless of the business model; (2) private equity firms executing a buy‐and‐build strategy generate lower unlevered returns than those executing an organic growth strategy when the benchmark company is clearly outperformed, most likely because of limited PE managerial resources; (3) mid‐to‐large‐cap private equity firms generate higher unlevered returns and operational alphas than small‐cap private equity firms when the benchmark company is clearly outperformed, because, we believe, larger companies have a higher fixed cost leverage than smaller ones; and we have found that (4) buyout transactions exited during or after the financial crisis yield higher operational alphas but lower unlevered returns compared to buyout transactions exited before the crisis, when the portfolio company underperforms its benchmark company.     

The initial private placement of equity and changes in operating performance in Taiwan

We propose the corporate governance hypothesis which suggests that the outside blockholders arising from the private placement of equity are more likely to have a significantly positive effect on firms with poor corporate governance. Using a sample of Taiwan‐listed firms with initial private placements of equity, our study’s results indicate that an improvement in operating performance is more likely to be seen after a private placement for those firms that are without independent directors, are controlled by a family, have lower insider shareholdings or are characterized by a pyramidal ownership structure. These findings are consistent with our hypothesis.     

PRIVATE EQUITY: SOURCES AND USES

Private equity capital is playing a large and growing role in the funding of small to medium-sized, high-growth businesses. Today's private equity investment typically takes the form of purchase of a minority interest in a post-start-up, high-technology company followed by an IPO a few years later. A large number of such investors are scouring the markets for new investment possibilities and the competitive pressures are growing.
Although private equity investors can and often do add significant value to a company, private equity is potentially expensive, in terms of both loss of ownership and loss of control over long-term strategic decisions of the company. Owner-managers who want to retain as much of both as possible are advised to install more formalized business procedures, expand the company's outside relationships, and become more familiar with the company's financial needs and options. These changes should reduce capital needs, reduce the costs of private equity funding, and increase negotiating leverage when dealing with large, sophisticated private capital investors.     

Morgan Stanley Roundtable on Private Equity and Its Import for Public Companies

The role of private equity in global capital markets appears to be expanding at an extraordinary rate. Morgan Stanley estimates that there are now some 2,700 private equity funds that either have raised, or are in the process of raising, a total of $500 billion. With this abundance of available equity capital, the willingness of private equity firms to participate in “club” deals, and the leverage that can be put on top of the equity, private equity buyers now appear able and willing to pay higher prices for assets than ever before. And thanks in part to this new purchasing power, private equity transactions reportedly account for a quarter of all global M&A activity as well as a third of the high yield and IPO markets. The stock of capital now devoted to private equity reflects the demonstrated ability of at least the most reputable buyout firms to produce consistently high rates of returns for their limited partners. Although a talent for identifying and purchasing undervalued assets may be part of the story, the ability to produce such returns on a consistent basis implies an ability to add value, to improve the performance of the operating companies they invest in and control. And in this round‐table, a small group of academics and practitioners address two main questions: How does private equity add value? And are there lessons for public companies in the success of private companies? According to the panelists, the answer to the first question appears to have changed somewhat over time. The consensus was that most of the value added by the LBO firms of the‘80s was created during the initial structuring of the deals, a process described by Steve Kaplan as “financial and governance engineering,” which includes not only aggressive use of leverage and powerful equity incentives for operating managements, but active oversight by a small, intensely interested board of directors. In the past ten years, however, these standard LBO features have been complemented by increased attention to “operational engineering,” to the point where today's buyout firms feel obligated, like classic venture capitalists, to acquire and tout their own operating expertise. In response to the second of the two questions, Michael Jensen argues that much of the approach and benefits of private equity‐particularly the adjustments of financial policies and stronger managerial incentives‐can be replicated by public companies. And although some of these benefits have already been realized, much more remains to be done. Perhaps the biggest challenge, however, is finding a way to transfer to public companies the board‐level expertise, incentives, and degree of engagement that characterize companies run by private equity investors.     

Optimal capital structures for private firms

This article shows how to construct an optimal capital structure for a private firm. Since the agents who supply the firm’s capital are risk averse, they diversify by holding both debt and equity. This can mitigate, or even eliminate, the classical risk shifting problem. There is a wealth effect since the optimal capital structure, which can involve multiple types of debt, depends on the amount of wealth that each agent contributes to the firm. However, it is shown that the agents’ equity holdings do not depend on the contributed amounts of wealth. Thus the model can produce a wedge between ownership rights and equity cashflow rights. These features are illustrated in a firm with three agents.     

CEO contract design: How do strong principals do it?

We study changes in chief executive officer (CEO) contracts when firms transition from public ownership with dispersed owners to private ownership with strong principals in the form of private equity sponsors. The most significant changes are that a significant portion of equity grants performance-vests based on prespecified measures and that unvested equity is forfeited by fired CEOs. Private equity sponsors do not reduce base salaries, bonuses, and perks, but redesign contracts away from qualitative measures. They use some subjective performance evaluation, do not use indexed or premium options, and do not condition vesting on relative industry performance. We compare the contracts to predictions from contracting theories, and relate our results to discussions of executive compensation reform.     

境内外私募股权基金比较研究

在亚洲等新型市场国家,私募股权基金投资并帮助那些优质的公司进一步拓展发展空间,并提供就业机会,引入先进的财务管理经验,且为其投资者提供高额回报,进而促进经济的发展,这使得亚洲尤其是中国地区的私募股权投资得到大幅度发展。本文的研究正是基于全球私募股权市场热火朝天的发展和我国私募股权交易数额呈级数增长的背景下进行。     

Information asymmetry around operational risk announcements

Operational risk incidences are likely to increase the degree of information asymmetry between firms and investors. We analyze operational risk disclosures by US financial firms during 1995–2009 and their impact on different measures of information asymmetry in the firms’ equity markets. Effective spreads and the price impact of trades are shown to increase around the first announcements of such events and to revert after the announcement of their settlement. This is especially pronounced for internal fraud and business practices related events. Market makers respond to higher information risk around the first press cutting date by increasing the quoted depth to accommodate an increase in trading volumes.The degree of information asymmetry around operational risk events may be influenced by the bank’s risk management function and the bank’s governance structure. We indeed find that information asymmetry increases more strongly after events’ first announcements when firms have weaker governance structures—lower board independence ratios, lower equity incentives of executive directors, and lower levels of institutional ownership. In contrast, the firms’ risk management function has little to no impact on information asymmetry. We interpret this as evidence that the risk management function is primarily driven by regulatory compliance needs. The results of this study contribute to our understanding of information asymmetry around operational risk announcements. They help to shed light on the role that regulation and corporate governance can play in order to establish effective disclosure practices and to promote a liquid and transparent securities market.     

Public vs. Private Equity*

Many corporate executives view private equity as a last resort, as expensive capital that should be tapped only by companies that don't have access to presumably cheaper public equity. The reality of private equity, however, is more complex, and potentially quite rewarding, for both shareholders and management. This paper surveys some of the academic work on the costs and benefits of public vs. private equity, contrasting the private equity investment process with its public counterpart and exploring how such a process may add value. The importance of public equity, particularly for very large companies and growth companies with large capital requirements, is indisputable. But as investment bankers and other practitioners have noted, under certain circumstances the public markets effectively become “closed” to some public companies. Moreover, the cost of equity raised in public markets involves much more than the direct costs of underwriters, attorneys, and accountants. Some indication of the indirect costs is provided by the market's typically negative reaction to announcements of seasoned equity offerings. Although the negative reaction averages about 3%, in some cases stock prices drop by as much as 10%, thereby diluting the value of existing stockholders. Most academics attribute this reaction to the informational disadvantage of public stockholders. Private equity is designed in large part to overcome this information problem by replacing the monitoring performed by the typical public company board with the oversight of better informed and more highly motivated owners. A growing body of academic research suggests that private equity investors add value to the companies they invest in, and that the best investors are consistently effective in so doing. What's more, even public companies that tap private equity seem to benefit. As the author found in his own research on PIPES (Private Investment in Public Equity Securities) transactions, even though such securities are issued to private equity investors at a discount to the prevailing market price, the average market response to the announcement of such transactions is a positive 10%. In short, the participation of private equity investors is perceived to create value, and some of this value is shared with the rest of the market.     

Private equity exits after IPOs

We examine post-IPO exits of private equity sponsors of portfolio firms via follow-on secondary equity offerings and third party takeovers. Sponsors retain considerable ownership in listed portfolio firms for lengthy periods after IPOs, well beyond lockup expiration. After private equity post-IPO secondary offerings, corporate profitability is strongly superior to benchmark firms, indicating portfolio firms are successfully prepared for private equity's subsequent exit. Nevertheless, share prices fall at offering announcements, reflecting the failure of private equity sponsors to exit stakes in listed entities at the high premiums paid in third party takeovers, premiums that are invariably shared equally with public shareholders.     

Private company finance and financial reporting

This article provides a comprehensive assessment of private firms’ financing sources and their relation with financial reporting practices. We consider debt financing (bank financing, leasing, and government guarantees), equity financing (family ownership, government ownership, employee ownership, and private-equity financing), and trade credit (supplier credit and factoring). Our primary conclusions are that there is significant heterogeneity in the way in which private companies are financed that is influenced by their specific business contexts, and that this heterogeneity in financing is associated with differential demand for and supply of financial reporting.     

Earnings management and long-run stock performance following private equity placements

We investigate whether the documented earnings management preceding public equity offerings applies to private placements of equity. We also investigate whether earnings management can help explain long-run stock performance following private placements. Our main findings are: (1) little evidence of upward earnings management around private equity placements, and (2) little predictive power of abnormal accruals for long-run stock performance following private equity placements. These results suggest that earnings management is not responsible for post-offering underperformance, if any, for firms issuing equity privately. Our results are robust to two alternative measures of earnings management and three measures of abnormal returns estimated over two sample periods.