The private equity (PE) business model is to buy companies which need improving and provide the capital, expertise, knowledge and networks to enhance the value of the business and ultimately sell it at a higher price. PE firms add value to their portfolio companies through multiple strategies, which in academic literature, are grouped into three main themes and categorised as financial, operational and governance engineering practices. Value creation starts right at deal sourcing and selection, and is not tied to the post-investment period.
The following section presents recent literature on value creation strategies implemented by PE investors to improve portfolio company performance, but also on activities conducted by venture capital firms to enable success.
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Biesinger, Bircan and Ljungqvist (2020) analysed over 1,300 value creation plans put in place by various European private equity investors covering a 26-year period. They found that PE creates value for investors by choosing companies that are about to outperform their matched peers, emphasising the importance of due diligence and deal selection, but also through post-investment activities, particularly through operational improvements.
Gompers, Kaplan, Mukharlyamov (2016) studied in detail private equity value creation strategies through surveys targeting PE investors. According to results, investors view EBITDA growth as the primary source of value creation, and particularly within that component, place greater emphasis on revenue growth than on reducing cost. The study shows that different PE firms prefer different strategies. The extent to which certain strategies are deployed by PE firms appears to be related to the career background of their founders.
Acharaya, Gotschalg, Hahn and Kehoe (2011) show that the heterogenous background of a PE firm’s partners is correlated with deal-level outperformance. PE partners with strong operational expertise (e.g. former consultants or industry managers) tend to be more successful in organic deals that emphasise operational improvements and organic growth strategies (e.g., incorporating new products, and customers, or expanding into different geographies). Conversely, partners with a financial background demonstrate higher success rates in buy-and-build strategies.
Cohn, Hotchkiss and Towery (2022) analysed the potential sources of value creation in PE buyouts of private firms in the US. They defined those sources as operational improvements, relaxation of financing constraints and financial engineering. They document that PE buyers primarily add value to their portfolio companies by relaxing financing constraints for firms with strong growth opportunities and by improving the performance/profitability of struggling companies. They find little evidence of financial engineering being an important driver of value creation in private firm buyouts.
Brown and Yi (2023) analyse value creation at the portfolio company level using a proprietary dataset of around 3,000 fully-exited global buyout deals between 1984 and 2018. The study, which focuses on operational and financial strategies, notes that value creation stems from multiple sources and that it varies greatly across time, industry and geography. For example, they report that PE investors significantly increase the value of their portfolio companies relative to public markets using both value creation strategies, with a shift towards a greater emphasis on operational improvements in recent years.
Gompers, Gornal, Kaplan and Strebulaev (2016) conducted a comprehensive study of over 600 venture capital firms in the US. Their results show that while deal sourcing, deal selection and post-investment value-added strategies, all contribute to value creation, deal selection is regarded as the primary driver. The study finds that in choosing their investments, VCs prioritise the management team over business–related characteristics such as product or technology. In addition, VC investors ascribe higher significance to the team than to the business itself, when assessing the likelihood of ultimate investment success or failure.
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Bibliography
Acharya, Viral V. and Acharya, Viral V. and Gottschalg, Oliver and Hahn, Moritz and Kehoe, Conor, Corporate Governance and Value Creation: Evidence from Private Equity (February 17, 2010). European Corporate Governance Institute (ECGI) - Finance Working Paper No. 232/2009. Available at SSRN: https://ssrn.com/abstract=1324016
Biesinger, Markus and Bircan, Cagatay and Ljungqvist, Alexander, Value Creation in Private Equity (May 22, 2020). EBRD Working Paper No. 242, Swedish House of Finance Research Paper No. 20-17. Available at SSRN: https://ssrn.com/abstract=3607996
Brown, Gregory and Yi, Lu (2023), How do private equity create value? Available at luluyi.net: https://www.luluyi.net/How_do_private_equity_firms_create_value_.pdf
Cohn, Jonathan B. and Hotchkiss, Edith S. and Towery, Erin, Sources of value creation in private equity buyouts of private firms (January 3, 2022). Available at SSRN: https://ssrn.com/abstract=2318916
Gompers, Paul A. and Kaplan, Steven Neil and Mukharlyamov, Vladimir, What Do Private Equity Firms Say They Do? (June 1, 2016). Journal of Financial Economics (JFE), Vol. 121, No. 3, 2016. Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2447605
Gompers, Paul A. and Gornall, Will and Kaplan, Steven Neil and Strebulaev, Ilya A., How Do Venture Capitalists Make Decisions? (August 1, 2016). Stanford University Graduate School of Business Research Paper No. 16-33, European Corporate Governance Institute (ECGI) - Finance Working Paper No. 477/2016. Available at SSRN: https://ssrn.com/abstract=2801385
Learn more about the BVCA's Research Advisory Group
These studies have been compiled with the support of the BVCA Research Advisory Group, a committee of senior academics and practitioners who enable us to access a wider pool of research. The BVCA Research team would like to thank all members of the Group for their input, guidance and advice.