Corporate Governance and Value Creation: Evidence from Private Equity 1

Transcription

1 Corporate Governance and Value Creaton: Evdence from Prvate Equty 1 by Vral V. Acharya, Olver Gottschalg, Mortz Hahn and Conor Kehoe Frst draft: 7 Aprl 2008 Ths draft: 2 June 2011 Contact nformaton: Vral V. Acharya NYU-Stern, NBER, CEPR and ECGI Stern School of Busness, 44 West 4 th St, New York, NY Tel: e-mal: vacharya@stern.nyu.edu Olver F. Gottschalg HEC School of Management, Pars Jouy-en-Josas, France Tel: +33 (0) e-mal: gottschalg@hec.fr Mortz Hahn Schellngstr. 88, Munch, Germany Tel: +49 (0) e-mal: mortz.m.hahn@googlemal.com Conor Kehoe McKnsey & Company, Inc. 1 Jermyn Street, London SW1Y 4UH, UK Tel: +44 (0) e-mal: Conor_Kehoe@mcknsey.com 1 A part of ths study was undertaken whle Vral Acharya was at London Busness School and partly whle vstng Stanford-GSB. We are especally grateful to the PE frms who assembled and gave us access to senstve deal data. Vral Acharya was supported durng ths study by the London Busness School Governance Center and Prvate Equty Insttute, the Leverhulme Foundaton, INQUIRE Europe, and London Busness School's Research and Materals Development (RAMD) grant. Olver Gottschalg was supported by the HEC Foundaton. McKnsey & Company also devoted sgnfcant human resources to carryng out the feldwork and analyss, not for any clent but on ts own account. We are grateful to excellent assstance and management of data collecton and ntervews by Amth Karan, Rcardo Martnell, Prashanth Reddy and Davd Wood of McKnsey & Co. Ramn Bagha- Wadj, Ann Iveson, Hanh Le, Chao Wang and Yl Zhang also provded valuable research assstance. The study has benefted from comments of two anonymous referees, Laura Starks (edtor), Yael Hochberg (dscussant), Steve Kaplan (dscussant), Tm Kelly (dscussant) and semnar partcpants at European Central Bank and Centre for Fnancal Studes Conference (2008) n Frankfurt, Inaugural Symposum (2008) at London Busness School s Coller Insttute of Prvate Equty, Unversty of Chcago and Unversty of Illnos at Chcago jont conference, London Busness School, McKnsey & Co., Western Fnance Assocaton Meetngs (2008), and partcpatng PE frms. All errors reman our own. 0

2 Corporate Governance and Value Creaton: Evdence from Prvate Equty Abstract We examne deal-level data from 395 prvate equty transactons n Western Europe ntated by large prvate equty houses durng the perod 1991 to We un-lever the deallevel equty return and adjust for un-levered return to quoted peers to extract a measure of abnormal performance of the deal. The abnormal performance s sgnfcantly postve on average, and stays postve n perods wth low sector returns. In the cross-secton of deals, hgher abnormal performance s related to greater growth n sales and greater mprovement n EBITDA to sales rato (margn) durng the prvate phase, relatve to those of quoted peers. Fnally, we show that general partners wth an operatonal background (ex-consultants or exndustry-managers) generate sgnfcantly hgher outperformance n organc deals that focus exclusvely on nternal value creaton programs; n contrast, general partners wth a background n fnance (ex-bankers or ex-accountants) generate hgher outperformance n deals wth sgnfcant M&A events. We nterpret these fndngs as evdence, on average, of postve, but heterogeneous sklls at deal partner level n prvate equty transactons. JEL: G31, G32, G34, G23, G24. Keywords: leveraged buyouts (LBO), management buyouts (MBO), actve ownershp, actvsm 1

3 1. Introducton In a semnal pece on prvate equty, Jensen (1989) argued that leveraged buyouts (LBOs) create value through hgh leverage and powerful ncentves. He proposed that publc corporatons are often characterzed by entrenched management that s prone to cash-flow dverson and averse to takng on effcent levels of rsk. Consstent wth Jensen s vew, Kaplan (1989), Smth (1990), Lchtenberg and Segel (1990), and others provde evdence that LBOs create value by sgnfcantly mprovng the operatng performance of acqured companes and by dstrbutng cash n the form of hgh debt payments. By contrast, the recent lterature has focused on the returns that prvate equty (PE) funds whch usually ntate the LBO and own, or more precsely manage, at least a majorty of the resultng prvate entty generate for ther end nvestors such as penson funds. In partcular, Kaplan and Schoar (2005) studed nternal rates of return (IRRs) net of management fees for 746 funds durng and found that the medan fund generated only 80% of S&P500 return and the mean was only slghtly hgher, at around 90%. 2 However, the evdence suggests that returns are better for the largest and most mature houses those that have been around for at least 5 years. Kaplan and Schoar note that, for funds n ths sub-set of PE houses, the medan performance s 150% of S&P500 return and the mean s even hgher at 170%. Furthermore, ths performance s persstent, a characterstc that s generally assocated wth potental exstence of skll n a fund manager. It s nterestng to note that such persstence has rarely been found n mutual funds, and when found has generally been n the worst performers (Carhart, 1997). Our paper s an attempt to brdge these two strands of lterature concernng PE, the frst of whch analyses the operatng performance of acqured companes, and the second that analyzes fund IRRs. In addton, we nvestgate how human captal factors are assocated wth 2 Ths evdence have been replcated by studes n Europe (Phalppou and Gottschalg, 2009, Phalppou, 2007), though they rase the ssue of certan survvorshp bases n data employed whch mght mply no medan outperformance relatve to the market even for large and mature PE houses. Ths by tself does not necessarly refute Jensen s orgnal clam; t could smply be that PE funds keep the value they create through fees. The puzzle that the evdence on medan return of PE funds rases s thus more about why ther nvestors (the lmted partners) choose to nvest n ths asset class as a whole, an ssue nvestgated by Lerner and Schoar (2004) and Lerner, Schoar and Wong (2007). 2

4 value creaton n PE deals. We focus on the followng questons: (1) Are the returns to large, mature PE houses smply due to fnancal leverage over and above comparable quoted sector peers, or do these returns represent the value created n enterprses they engage wth (socalled portfolo companes ), over and above the value created by the quoted sector peers? (2) What s the effect of ownershp by large, mature PE houses on the operatng performance of portfolo companes relatve to that of quoted peers, and how does ths operatng performance relate to the fnancal value created (f any) by these houses? (3) Are there any dstngushng characterstcs of PE houses or partners nvolved n a deal that are best assocated wth value creaton? To answer the frst queston, we develop a methodology to break down the deal-level equty return, measured by the IRR, nto two components: the un-levered return, and amplfcaton of ths un-levered return by deal leverage. Next, we subtract from the unlevered deal return, the un-levered return that the quoted peers of the deal generated over the lfe of the deal. The dfference between these two un-levered returns s what we call abnormal performance : a measure of enterprse-level outperformance of the deal relatve to ts quoted peers, after removng the effects of fnancal leverage. We hypothesze, and later show, that the abnormal performance of a deal captures the return assocated wth changes n operatng performance of the portfolo company, and human captal factors such as deal partner sklls. We apply ths methodology to 395 deals closed durng the perod 1991 to 2007 n Western Europe by 37 large, mature PE houses (each wth funds larger than ~$300mln) 3 ; the mean, gross IRR for ths sample s 56.1%. We fnd that, on average, about 34% (19.8 out of 56.1%) of average deal IRR comes from abnormal performance, another 50% (27.9 out of 56.1%) s due to hgher fnancal leverage, and the remanng porton (16 out of 56.1%) s due to exposure to the quoted sector tself. Although abnormal performance has substantal varaton across deals, t s on average postve and statstcally sgnfcant, even durng 3 We beleve ths tme perod s partcularly well-suted for studyng value creaton through operatonal engneerng. Kaplan and Stromberg (2008) note that operatonal engneerng became a key prvate equty nput to portfolo companes prmarly n the last decade. 3

5 perods of low sector returns; ths s consstent wth the vew that large, mature PE houses generate hgher (enterprse-level) returns compared to benchmarks. In the cross-secton of deals, abnormal performance has a postve, albet mperfect, correlaton to IRR and to the publc-market equvalent (PME) measures employed by Kaplan and Schoar (2005), and a negatve correlaton to sector returns. Regardng the second queston, we fnd a postve mpact of ownershp by large, mature PE houses on the operatng performance of portfolo companes, relatve to that of the sector. In partcular, durng PE ownershp the deal margn (EBITDA/Sales) ncreases by around 0.4% p.a. above the sector medan; and the deal multple (EBITDA/Enterprse Value) ncreases by around 1 (or 16%) above the sector medan. We nterpret the operatonal mprovements as causal PE mpact, snce we fnd no evdence for a volaton of the strct exogenety assumpton of the PE acquston decson. That s, we assume and later confrm that there s nothng nherent n the companes targeted by the PE frms n our sample, that would have caused ther operatng performance to mprove wthout beng acqured by Prvate Equty. 4 In addton, we examne the mpact of major M&A events durng the prvate phase on operatonal performance durng the same perod, snce M&A events can generate due to ther drect mpact on the operatonal measures a consderable dstorton of underlyng operatonal performance. However, we stll fnd margn and multple mprovements above sector when we analyze deals wth and wthout M&A events separately. We then provde evdence that hgher abnormal performance s assocated wth a stronger operatng mprovement n all operatng measures relatve to quoted peers: we fnd 4 For example, n theory, what we label as operatonal mprovements could n fact be the reverson of the acqured deals performance to the mean. However, we fnd evdence aganst the mean-reverson argument: although the sample sze of deals wth more than 2 years of pre-acquston data s small, they show no dfference to ther respectve sector companes n performance trends pre-acquston: both targeted and sector companes show nearly the same ncrease n nomnal sales and constant proftablty. Yet, PE mght stll be able to dentfy companes that wll be subject to a postve future shock. Ths s somethng we can not rule out. However, a systematc relatonshp between PEownershp and antcpated future performance shocks can nduce abnormal performance n PE deals. To fnancally explot ndvdual shocks on a company, a PE house must have a systematc nformatonal advantage n forecastng the future n comparson to the seller and other bddng PE houses. Ths systematc nformatonal advantage appears questonable n a compettve buyout market, such as that for the large szed frms n Western Europe. 4

6 that sales growth, EBITDA margn and multple mprovement are mportant explanatory factors for abnormal performance. Overall, ths evdence s consstent wth top, mature PE houses creatng fnancal value through operatonal mprovements. Such mprovements requre skll, and the return to such skll may explan the persstent returns generated by these funds for ther nvestors (Kaplan and Schoar, 2005). Ths brngs us to our fnal queston where we study whether deal partner characterstcs affect the performance of PE deals. We use deal partner background as a human captal, or skll, factor that may be relevant to deal success; the econometrc advantage of usng ths factor s that t s fxed, or tme-nvarant, and hence exogenous (except for the matchng of deal partners to specfc deals). We fnd evdence that there are combnatons of value creaton strateges and partner backgrounds that correlate wth deal-level abnormal performance. Deal partners wth a strong operatonal background (e.g., ex-consultants or ex-ndustry-managers) generate sgnfcantly hgher outperformance n organc deals. In other words, partners who worked as managers n the ndustry or as management consultants before jonng a PE house seem to have gathered sklls to mprove a company nternally, for example, through cost-cuttng, or expanson to new customers and new geographes. In contrast, partners wth a background n fnance (e.g., ex-bankers or ex-accountants) more successfully follow an M&A-drven, or norganc, strategy. One could argue that we only studed deals from the funds we sampled, whch mght have been cherry-pcked by the PE fund. We show that ths s not the case. Whle we have a bas n our sample for large PE funds, ths s by desgn gven that we wshed to understand drvers of ther persstent out-performance. However, wthn the funds we sampled for our deals, we fnd no statstcally sgnfcant bas between the performance of deals sampled and those not sampled. 5 5 Moreover, n contrast to the extant lterature that manly focuses on publc-to-prvate deals, our data set also covers deals where only part of a company s acqured (e.g., carve-out deals), and prvate-to- 5

7 In Secton 2, we revew the related lterature. In Secton 3, we provde a descrpton of the data we collected and some summary statstcs. In Secton 4, we descrbe the methodology for calculatng abnormal performance. In Secton 5, we dscuss operatng performance. In Secton 6, we lnk abnormal performance and operatng performance. Secton 7 dscusses the role of deal partner background. Secton 8 concludes. 2. Related lterature Followng the semnal work of Jensen (1989) on LBOs, the early emprcal contrbutons verfed the mpact of PE ownershp on frms (Kaplan, 1989; Smth, 1990; Lchtenberg and Segel, 1990). 6 However, the most recent wave of PE transactons (2001- md-2007) has prompted researchers to re-examne whether buyouts are stll creatng value n ths new era. Guo, Hotchkss and Song (2009) answer ths queston wth a sample of 94 US publc-to-prvate transactons between 1990 and They fnd that gans n operatng performance are not statstcally dfferent from those observed for benchmark frms. Also Lesle and Oyer (2008) fnd weak or generally no evdence of greater proftablty or operatng effcency of 144 LBOs n the US between 1996 and 2004, relatve to publc companes. However, Lerner, Sorensen and Stromberg (2008) provde evdence wth a sample of 495 buyouts that, n contrast to the oft-cted clam that PE has short-term ncentves, buyout deals n fact lead to sgnfcant ncreases n long-term nnovaton. They fnd that patents appled for by frms n PE transactons are more frequently cted (a proxy for economc mportance), show no sgnfcant shfts n the fundamental nature of the research, and are more concentrated n the most mportant and promnent areas of companes' nnovatve portfolos. prvate deals, where a non-lsted busness s acqured. Usng carve-out and prvate-to-prvate deals s mportant, because they comprse 74% of PE deals n Western Europe over the last decade, and they are dfferent n sze (enterprse value) and proftablty (EBITDA margn) from publc-to-prvate deals (accordng to a smple, non-statstcal, analyss of data provded by Prvate Equty Insght). 6 Note that Kaplan (1989), Smth (1990), and Lchtenberg and Segel (1990) also nvestgate whether LBOs mproved operatng performance at the expense of workers. They fnd that the wealth gans from LBOs were not a result of sgnfcant employee layoffs or wage reductons (see Palepu (1990) for a detaled survey of these papers and Kaplan and Stromberg (2008) also for a comprehensve survey). 6

8 Ths lterature has focused manly on the data from the US whereas our data are based on PE deals n the UK and Europe. Several studes have examned LBOs n the UK, whch also experenced a tremendous ncrease n buyout actvty pror to the crss of Nkoskelanen and Wrght (2005) study 321 exted buyouts n the UK n the perod 1995 to On average, these deals generated a 22% return to enterprse value and 71% return to equty, after adjustng for market return. In a related paper, Renneboog, Smons, and Wrght (2007) examne both the magntude and sources of the expected shareholder gans n 177 UK publc-to-prvate, transactons from 1997 to They fnd that pre-transacton shareholders receve a premum of 40%. They also fnd that the man sources of post-transacton gans n shareholder wealth are undervaluaton of the pre-transacton target frm, ncreased nterest tax shelds, and realgnment of ncentves. Harrs, Segel, and Wrght (2005) study the productvty of UK manufacturng plants subject to management buyouts (MBO). Such plants experenced substantal ncreases n productvty, the post-mbo magntudes of whch are substantally hgher than those reported n the US, for example, by Lchtenberg and Segel (1990). In lmted evdence regardng human captal or skll factor n PE nvestments, Kaplan et al. (2008) analyze the relatonshp between 316 portfolo company managers (CEOs) and the success of buyouts. They fnd that executon sklls appear to be more strongly related to success than nterpersonal sklls. To our knowledge, wth the excepton of ths study, there has been no systematc analyss of the lnk between fnancal returns of LBOs and human captal factors. As Cummng et al. (2007) state there s a need to understand the human captal expertse that successful PE frms requre. There appears to be a need to broaden the tradtonal fnancal sklls base of prvate equty executves to nclude more product and operatons expertse. Our evdence regardng the relevance of human captal factors and, n partcular, regardng task-specfc deal partner sklls (operatonal or fnancal) flls ths mportant gap n the lterature for PE nvestments. We post that task-specfc sklls attrbutable to deal partner background are one sgnfcant part of the persstent abnormal fnancal return generated by 7

9 large, mature PE houses for ther nvestors (Kaplan and Schoar, 2007). 7 PE partners seem to add value to portfolo companes by applyng sklls they have accumulated over tme. In contrast, for venture captal (VC) nvestments, t seems to n be an establshed fact that VC funds have an mpact on the development of new companes, and that expertse of the fund matters for performance. Hellmann and Pur (2002), for example, show that VC funds add professonal structure and rgor to the start-ups n whch they nvest, namely that: startups backed by VC funds replace ther CEOs more frequently; ntroduce stock opton plans; and hre a VP of sales and marketng. Dmov and Shepard (2005) fnd a postve relatonshp between successful, VC-backed IPOs and the educaton of senor managers n the VC fund n scence or humantes. Moreover, experence of management consultng reduces the share of bankruptces for ndvdual funds. Bottazz et al. (2008) go one step further and provde evdence that experence n consultng or ndustry on the part of VC fund managers predcts nvestor actvsm for nstance the frequency of nteracton between the VC fund and start-up and seems to correlate wth performance. Most recently, Zarutske (2010) argues that, not only s pror busness experence relevant to the performance of VC fund nvestments, but also longevty n the VC ndustry. Accordng to the author, task-specfc human captal factors seem to be most mportant and depend on the type of nvestment: fund managers wth scence backgrounds only excel n hgh-tech nvestments; whle those wth fnance backgrounds excel n later-stage nvestments. Agan, t s mportant to note that such returns to task-specfc sklls gathered over tme are not found for mutual fund managers, whch seldom hold majorty stakes and therefore engage less actvely n the management of the portfolo company (Chevaler and Ellson, 1999). 3. Data and sample selecton Our sample combnes two data sets. Frst, we use propretary deal-level data collected together wth McKnsey (McKnsey sample), a consultng company whch serves large PE 7 We note that our paper s slent about the conflcts of nterest between prvate equty houses and ther nvestors. Axelson et al. (2009), Ljunqvst et al. (2007) and Metrck and Yasuda (2007) provde good coverage of theoretcal as well as emprcal ssues on ths front. 8

10 houses. The McKnsey sample s relatvely small (n=110), but gves detaled deal-level nformaton, e.g., operatonal performance measures pror to PE ownershp. The second data set was provded by a major nvestor n PE funds (LP sample), that has tracked the detaled performance of PE nvestments over the last two decades. The LP sample s larger (n=285), but covers less nformaton. The McKnsey sample represents relatvely large deals, wth enterprse values greater than roughly 50 mllon and all acqured by fourteen large, mature PE houses from 1995 to To collect the data, we approached 40 large, well establshed, European mult-fund houses, actve n ether md-cap or large-cap markets, of whch 14 (35%) agreed to provde data subject to confdentalty (all data heren are aggregated and not attrbutable to any sngle deal or PE house). Together, these frms provded data for 110 deals, wth each group of deals pertanng to a specfc fund checked by us to ensure the performance, or average IRR, of each group was representatve of the fund from whch they were drawn. Where groups of deals faled ths test, we removed or replaced a small number of deals to meet ths condton. For ndvdual deals, we rgorously checked data, lookng for dscrepances (e.g., n currences, sales, cash flows, etc.) and followed up wth PE houses when necessary. The LP data set s drawn from hand-collected track records of prvate equty frms reported n fund rasng documents (PPM) of the PE funds. In the PPMs, we observe the lst of the nvestments made by each PE frm. Out of the pool of PPMs collected by the LP, we selected 34 from large, well establshed, European mult-fund houses, actve n ether mdcap or large-cap markets. The LP data set has the addtonal advantage of beng audted rather than self-reported. Importantly, buyout frms generally dsclose n PPMs all the nvestments they made ncludng the ones that do not perform well. As a consequence, ths sample contans numerous poorly performng nvestments. From these 34 PPMs, we collected all 285 realzed transactons for whch both cash flows and operatng performance were avalable. Agan each group of deals pertanng to a specfc fund was checked by us to ensure 9

11 the performance, or average IRR, of each group was representatve of the fund from whch they were drawn. The fnal combned dataset comprses 395 deals from 48 funds coverng nearly two decades. For each deal, we have the exact structure of cash flows, from and to the parent fund, and detaled data on fnancal and operatng measures. We do not have all enterprse level cash flows, whch would nclude for example also taxes or nterest and prncpal pad on debt. 8 To compare our sample to a set of publcly lsted peers we collected data, suppled by Datastream, for crca 7,000 publcly lsted corporatons (PLCs) n Europe, from whch we constructed sector ndces based on ICB (Industry Classfcaton Benchmark)_sector codes; these codes group publcly lsted peers nto 10 ndustres and 39 sectors. We collected data on TRS (Total Returns to Shareholders); enterprse value; net debt; equty; sales; and EBITDA(E) the latter to remove the effects of exceptonal tems, whch are not ncluded n EBITDA fgures provded by the frms n our sample. Table 1, Panel A shows that, wthn our sample perod ( ), our deals are well spread-out over tme, although there s some concentraton n n terms of deal entry or acquston. Table 1, Panel B provdes addtonal summary statstcs for the deals. Deals n our sample have a hgh mean, gross IRR (56.1%) and cash multple (4.4), wth large values on the rght tal, even wnsorzng our sample (we replace the lowest 5% of values wth the 5 th percentle value, and the hghest 5% wth the 95 th percentle value). However, a hgh value for average IRR s to be expected from a sample of deals from large, mature PE houses (Kaplan and Schoar, 2005). We also report an average duraton of 3.9 years. 8 We also do not have all cash flows for 6 un-exted deals n the McKnsey data set because there s no ext cash flow from sale, nor can t be deemed to be zero as n the case of bankruptces. Therefore, the end enterprse-value cash flow was smulated usng the EV / EBITDA multple at the start of the deal and applyng that number to 2006 or 2007 year-end EBITDA. Our results are robust to alternatve assumptons, ncludng one assumpton that they produced no termnal cash flow whatsoever. However, we have verfed that such a pessmstc scenaro s unlkely to be approprate for these deals. 10

12 In the second half of Table 1, Panel B we compare fnancal ratos at the entry and ext date. The medan entry EV/EBITDA multple s 6.5, whereas the correspondng ext multple s 7.9, whch ndcates that on average, assumng stable or rsng EBITDA(E), our deals mproved ther market valuatons (consstent wth the fndngs of Kaplan, 1989). The medan debt-to-equty (D/E) rato at entry s 1.9, whch s n lne wth the usual LBO captal structure, beleved to be 70% debt and 30% equty (Axelson et al., 2008). However, the medan D/E rato at ext s much smaller (0.5). In percentage terms, the medan debt-to- EBITDA rato, whch falls from 4.1 at entry to 2.5 at ext, does not fall as much as the medan D/E rato. Consstent wth Groh and Gottschalg (2011), t appears that the debt to equty rato falls for PE deals durng ther lfe only partly due to mprovements n coverage rato (Debt/EBITDA), and manly due to mprovements n equty value over deal lfe. Next, we come to the mportant sample-selecton ssues. Table 2, Panel A-C provdes several relevant comparsons between our sample and the PE unverse. Overall, we conclude that our sample covers manly large funds, but seems to be representatve n terms of performance, and ncludes all dfferent vendor types, that s, not just publc-to-prvate deals but also the frequent prvate-to-prvate deals. Frst, Table 2, Panel A shows that the sampled funds are a good representaton of funds n Western Europe, also when we take nto account the fact that we are focusng on funds whose szes are above $300 mllon. All 146 funds n Western Europe wth the vntage year n as our sample have a smple average net IRR of 23.5% (based on 146 funds for whch Preqn reports IRRs), whch s not dfferent to the net IRR of our funds (tstatstc = for the dfference). Also large funds n the PE unverse (agan, for whch Preqn reports IRRs) have smlar returns than our funds (t= for the dfference). In Table 2, Panels B and C provde evdence that we have not cherry-pcked the deals out of the funds we have sampled. Table 2, Panel B compares the average performance of the deals n the McKnsey sample, per fund (n terms of net IRR), to the performance of the same 32 funds from whch our deals were drawn; average fund IRRs are based on Preqn fgures. We show that the funds n the McKnsey sample do not appear to have cherry-pcked the 11

13 deals that they reported: the dfference between the average publcly reported net fund IRR of 28.1% and the average net IRR of our deals, per fund, of 26.3% s not statstcally sgnfcant (t=0.43). In terms of deal performance, therefore, we have an unbased representaton of deals wthn the funds we sampled. For the comparson, because publcly avalable data on fund performance s based on net IRRs, we had to convert our gross deal-level IRRs, pror to fees and carry pad to the PE funds by nvestors, to net IRRs or IRRs from the vewpont of fund nvestors 9. We deduct from the gross IRR a 2% annual fee and 20% carry for IRR above the typcal benchmark, market return, of 8% 10. Table 2, Panel C shows a smlar result for the LP data set. That s, there s no statstcal dfference between the LP deals we selected (n=285) and those made by the same PE houses we ddn t select (n=892), both n terms of performance (t=-0.42 for the dfference) and sze (t=0.35 for the dfference); the deals we selected were chosen because they provded us wth the requste fnancal data, and because the names of the deal partners were avalable, allowng us to determne ther backgrounds. Fnally, as prevously mentoned, our sample ncludes all types of deals, whch s mportant to get a full perspectve on the effects of PE ownershp. The extant lterature manly focuses on publc-to-prvate transactons, whch s only a part of the total buyout actvty n Western Europe. By contrast, the majorty of deals are carve-outs where only part of a company s acqured, or prvate-to-prvate deals, where PE frms acqure a non-lsted busness. For example, n Western Europe carve-out and prvate-to-prvate deals comprse more than two-thrds of all PE transactons (between 1995 and 2005) and they are smaller n sze and dfferent n proftablty (EBITDA margn) from publc-to-prvate deals n the 9 To perform ths converson, we also construct an artfcal fund of our sample deals and calculate ts IRR. The pseudo-fund starts n 1995 and lasts for 13 years, untl Investments or cash nflows take place n years 1-9 (wth small nvestments n years 10 and 11 as well). The bulk of the nvestments occur n years 3-9. Cash payouts start n year 5; n the last 3 years, the fund only has cash payouts. Usng ths pattern of cash nflows and outflows, we calculate the gross IRR of the pseudofund. 10 More specfcally, f a) gross IRR<=10%, then LPs keep all return except 2% fees, so that net IRR = gross IRR - 2% fees; b) 10%<gross IRR<12.5%, then LPs keep all return up to 10% except for 2% fees and GPs keep all return from 10% to 12.5%, so that net IRR = gross IRR - 2% fees (Gross IRR 10%) = 8%; and c) gross IRR>=12.5%, then LPs and GPs share n 80:20 rato the return exceedng 12.5%, so that net IRR = gross IRR - 2% fees - 2.5% - 20%*(gross IRR %). The pooled net IRR for our deals s 23.9%, whch s close to the average net deal IRR of 26.2%. 12

14 Western European unverse (accordng to a smple, non-statstcal, analyss of data provded by Prvate Equty Insght). 4. A measure of abnormal fnancal performance 4.1 Methodology One of the key questons we want to answer n ths study s how much of the excess returns generated by PE frms, relatve to quoted peers, comes from pure fnancal leverage, and how much comes from genune operatonal mprovements. To dsentangle the effect of leverage from that of operatonal mprovements, we frst calculate the IRR of the deal і ts levered return (R L, ) usng the entre tme seres of gross cash flows for the deal (.e. before fees), both from and to the fund as recorded by the PE house. Then we un-lever ths IRR. and benchmark ths un-levered return (R U, ) to returns for the quoted peers of the deal, unlevered n the same way (R SU, ). The resultng dfference n un-levered returns s what we call the abnormal performance of the deal (also referred to as alpha n earler drafts of the paper). To arrve at the unlevered return R U,I we use: R U, RL, + RD, (1 t)( D / E ) = (1) (1 + D / E ) The un-levered IRR, R U,, corresponds to the return generated at the enterprse level. Snce the PE houses n our sample dd not report R D,, the average cost of debt D, we use the base rate and nterest margn spread reported n Dealogc for each deal. 11 The leverage rato D/E s the average of the entry and ext debt-to-equty rato of the deal; that s, snce the startng D/E s hgher than ext D/E for most deals we employ the average of the two to reflect 11 Dealogc provdes nformaton on the base rate and the nterest margn spread for only 67 deals (out of 110) n our sample. For 19 deals we can fnd only the base rate (Lbor vs. Eurbor) and for the remanng 24 deals we fnd no nformaton. If the margn spread s unknown, we use the medan spread of all PE deals n Western Europe n the same year. If the base rate s unknown, we use LIBOR for the UK deals and Eurbor for all other deals. We made sure that the assumpton on the spread does not have a large mpact on our results. Frst, the spread does not vary much n the cross-secton. In our sample perod and for all deals covered n Dealogc, the standard devaton of the weghted (by rsk tranches) average spread s 1.1%, wth an average (medan) spread of 2.6 (2.3) % (n=984). Second, the senstvty of the abnormal performance of a deal to dfferent nterest rate assumptons s less than 1. It vares accordng the un-leverng formula by (D/E)/ (1+D/E) * Δ. For example, wth a D/E rato of 2, a Δ of 1 bp ncrease of the nterest rate only changes the abnormal performance by 2/3 bp. 13

15 the pattern of declnng leverage for most deals. Fnally, for tax rate t, we use the average corporate tax rate durng the holdng perod for the country n whch the portfolo company s headquarters s located. We also apply (1) to calculate un-levered sector IRRs, R SU,I, from the benchmark levered sector return, R S,. In ths case, a sector s defned as contanng all quoted European peer companes sharng the deal s 3-dgt ICB (Industry Classfcaton Benchmark) code n Datastream. To do so, we frst calculate R S, the medan annualzed total return to shareholders (TRS) for the sector over the lfe of each deal, whch we un-lever usng (1) and the medan D/E for the sector over a three-year average from the deal s entry date onwards. We further assume the same tax rate and cost of debt for the sector as for the deal. From (1), t follows that hgher values of R D, result n greater un-levered return for the same levered return. Snce R D, for the sector companes s potentally lower than for the deals (due to lower leverage and hence lower rsk), we overestmate the un-levered sector returns and are therefore conservatve n attrbutng postve abnormal performance to PE deals. After obtanng the un-levered returns for both the deal (R U, ) and sector (R SU, ), whch are strpped of the effects of fnancal leverage, the next key step s to measure the amount of excess PE return that s brought about by genune operatonal mprovements. For ths purpose, we defne the abnormal performance of the deal, U, SU, α, as: α = R R (2) In essence, applyng (1) and (2) allows us to make the followng decomposton or performance attrbuton of each deal IRR: () Deal-level abnormal performance: α () Unlevered sector performance: R SU, () Total leverage effect: R L, RU, ( L, U, The leverage effect R R ) measures the total effect of leverage on deal return. However, we are more nterested n measurng the effect of the addtonal leverage that 14

16 companes take on after ther acquston by PE. To arrve at the ncremental effect of ncreased leverage, we frst re-wrte (1) n terms of R L, as follows: R = R Then, we substture for R U, based on (2): ( 1+ D / E ) R, (1 t)( D / E ) L, U, D R L, = ( α + R SU, = α (1 + D / E ) + R )(1 + D / E ) R SU, D, (1 t)( D / E ) (1 + D / E ) R D, (1 t)( D / E ) And fnally, substtute for D/E n terms of ncremental leverage: D / E = D / ES, + ( D / E D / ES, ) To arrve at the followng decomposton of deal IRR: R L, = α + [ R [( R SU, SU, (1 + D / E R D, S, ) R D, (1 t))( D / E (1 t)( D / E D / E S, S, )] + ) + α ( D / E )] Ths equaton provdes an alternatve decomposton of each deal IRR: () Deal-level abnormal performance: α measures the excess asset return generated at the enterprse level of the portfolo company for PE nvestors, purged of the effect of leverage. () Levered sector return: RSU, (1 + D/ ES, ) RD, (1 t)( D/ ES, ) measures the effect of contemporaneous sector returns, ncludng the effect of leverage nherent n the sector. () Return from ncremental leverage: ( RSU, RD, (1 t))( D/ E D/ ES, ) + α ( D/ E ) captures the amplfcaton effect that a) the ncremental deal leverage beyond the sector leverage, (D/E D/E S, ), has on sector returns and b) the total leverage has on abnormal performance. Fnally the decomposton also allows us to quantfy the tax benefts of the ncremental leverage n prvate equty transactons, whch s t RD, ( D/ E D/ ES, ). The purpose of performng such a decomposton, or return attrbuton, s three-fold. Frst, t s to see f the sample deals from mature PE houses generated a sgnfcantly postve abnormal performance on average or not. Second f we beleve that the abnormal performance s attrbutable to operatng strateges and changes attempted by the PE frms 15

17 what s the cross-sectonal dstrbuton of ths abnormal performance? And thrd and perhaps most mportantly s there evdence at the ndvdual deal level that abnormal performance s related to measures of operatonal mprovement, and to the characterstcs of PE houses or ther deal partners? Before we proceed to dscussng our results, t s useful to note some of the lmtatons of our methodology. Frst, t treats leverage as havng a purely fnancal effect rather than havng some ncentve effect. Second, our methodology s subject to the usual problems assocated wth IRRs, namely that they are a way of descrbng cash flows rather than actual, realzed returns, and that they translate nto returns only under extreme assumptons of constant and common dscount rates and renvestment rates. To address the second ssue, another approach we adopted was to calculate a publc market equvalent (PME) for each deal. As a benchmark, we used the sector return to dscount all cash flows and then calculated the rato of dscounted cash flows to the largest cash nflow for the deal (n the sprt of Kaplan and Schoar, 2005). We dscuss the relatonshp between our measure of abnormal performance, IRR and PME n the next secton. Fnally, snce we do not have the exact cash payouts on debt, we are unable to employ the methodology of Kaplan (1989), whch s to smulate the enterprse-level (not equty) cash flows that would be obtaned by nvestng these cash nflows n the quoted sector and examnng the cash outflows thus generated. We chose to use IRR, gven ts smplcty and also because t s easly broken down nto abnormal performance and related components Average abnormal performance and ts characterstcs Table 3, Panel A summarzes the results from employng the decomposton method of Secton 4.1. It presents results for (1) the overall sample of 395 deals; (2) (6) for dfferent tme perods; and (7) the set of 67 deals out of the McKnsey sample for whch we were able to fnd the exact cost of debt for the deals n Dealogc. The key fndngs are as follows: Out of the average IRR of 56.1% for all 395 deals, sector rsk and leverage amplfcaton on ths accounts for a total of 8.5%. In other words, less than one ffth of the 16

18 total return s attrbutable to ether the sector-pckng ablty of PE houses or smply to pure luck. The ncremental leverage effect of 27.9% s due to hgh deal leverage, relatve to comparatvely low sector leverage. The average abnormal performance of 19.8% s statstcally sgnfcant (at a 1% level), confrmng that large, mature PE houses do n fact generate hgher (enterprse-level) returns compared to benchmarks, and that not all of these are attrbutable to sector exposure and fnancal leverage. The medans tell a smlar story. Abnormal performance stays statstcally sgnfcant (at a 1% level), when we cluster the deals by entry date. Even n years wth very low sector returns as n row (4), PE was able to generate abnormal performance. The hgh return from ncremental leverage n row (6) mght correspond to avalablty of cheap debt fnancng, a phenomenon beleved to be at work especally for PE deals struck durng 2003 to md-2007 and lkely responsble for the somewhat hgh valuaton multples pad by PE houses durng (Acharya, Franks and Servaes, 2007; and Kaplan and Stromberg, 2008) Abnormal performance s also postve and statstcally sgnfcant for the 67 deals for whch we have data on the cost of debt (va Dealogc) although the abnormal performance of 11.0% for these deals s lower than that for all deals (19.8%). Ths s partly explaned by trends n the avalablty of data; that s, cost of debt s typcally only avalable for later deals, and, on the whole, abnormal performance declnes over our sample perod. Overall, the evdence ponts to outperformance of PE deals n our sample n a manner that s robust to alternatve measures. In Table 3, Panel B we provde IRR and PME, alternatve measures of deal performance. Consstent wth our earler results whch showed that PE frms n our sample generate postve abnormal performance our deals also dsplay hgh IRRs and PME returns relatve to both the sector and overall market e.g. the average sector PME s 188%. In Table 3, Panel C, as one mght expect abnormal performance s postvely correlated wth both IRR and sector PME, albet mperfectly, wth correlaton coeffcents of 0.73 and 0.53 respectvely. Interestngly, though, abnormal performance s negatvely correlated wth sector returns. 17

19 5. Operatng performance 5.1. Operatng measures The next step n our analyss s to see f, at the enterprse level, abnormal fnancal performance s related to abnormal operatng performance. Abnormal operatng performance can be dsplayed n two ways: as a larger EBITDA growth rate of the portfolo company durng PE ownershp compared to pre-acquston; or as a larger EBITDA growth rate after PE ownershp compared to the sector. To dsentangle the PE mpact on EBITDA durng PE ownershp, we focus on the effects on (1) sales and (2) proftablty (margn=ebitda/sales). We capture the mpact on the company after the PE ownershp perod by analyzng (3) the EBITDA multple (Enterprse Value/EBITDA) at tme of ext from the deal. Here, we have to rely on the assumpton that market expectatons are ratonal at ext, snce we do not have operatonal fgures after the PE phase for many of the deals (trade sales, for example). The three measures we analyze n detal are: 12 (1) Sales, equal to operatng revenues earned n the course of ordnary operatng actvtes. (2) Margn (EBITDA/Sales). EBITDA (Earnngs before Interest, Taxes, Deprecaton and Amortzaton) s equal to Operatng revenues - COGS (cost of goods sold) - SG&A (sellng, general and admnstratve expenses) - Other (e.g., R&D) = Operatng ncome. Note that EBITDA s commonly used as t shows a company's fundamental operatonal earnngs potental. However, EBITDA s not a defned measure accordng to Generally Accepted Accountng Prncples (GAAP) or IFRS/IAS. In the present paper, we defne EBITDA excludng Non-operatng ncome. 13 Often ths measure s more precsely referred to as EBITDA(E): Earnngs Before Interest, Taxes, Deprecaton, Amortzaton (and Exceptonals). 12 Snce we work wth operatonal numbers n, we convert all fgures nto at the exchange rate applcable n that year. 13 The reason for the excluson of Non-operatng ncome s that ths measure contans ncome derved from a source other than a company's regular actvtes and s by defnton nonrecurrng. For example, a company may record as non-operatng ncome the proft ganed from the sale of an asset other than nventory (whch can be large n relaton to the operatng ncome). From a practtoner's perspectve, an EBITDA multple ncludng Non-operatng ncome, would not be a helpful measure to understand the prce pad n relaton to the current performance capablty. From our perspectve, the operatonal performance ndcator EBITDA would then be subject to a measurement error. 18

20 (3) EBITDA multple (Enterprse Value/EBITDA). In our data, Enterprse Values (EV) are avalable only at acquston and at ext; PE frms also gave values for equty (E) and net debt (D) at entry and ext, where E + D = EV. For the 5 bankrupt deals, equty values are assumed to be 0 at the tme of bankruptcy (ext). Note that to dentfy the mpact of PE on operatng performance between preacquston and durng PE ownershp, t s crucal to have access to a consstent dataset for both perods. Probably the only data wthout a structural nconsstency are those collected by the PE frms themselves, durng the course of due dlgence pror to, and through montorng efforts durng, ther ownershp. These are the data we collected from PE houses and whch we use n ths paper PE mpact on operatng performance Table 4, Panel A provdes a snapshot of the operatng performance change for the deals n our sample pror to acquston and hence, for the three operatng measures (x), reports: the dfference (Δx, pre = x t - x t-1 ) from two years before PE ownershp (t-1) to last the pre-acquston year (t). We also show these fgures for the correspondng sector companes (Δx s, pre = x s t - x s t-1 ) and use medan sector changes, gven that there are generally fewer than 100 companes n each three dgt, ICB sector. As descrbed n Kaplan (1989), and also accordng to the deals n our sample wth suffcent operatonal data avalable (n=69), PE does not seem to pck companes that were exposed to a negatve dosyncratc shock, whch n better tmes would revert to the mean, potentally allowng the target to be sold wth an upsde. Target companes show a robust pre-acquston ncrease n nomnal sales, together wth constant proftablty. Importantly, n terms of performance trends, PE owned companes do not dffer n a statstcally sgnfcant way from ther sector peers n the pre-acquston phase. Table 4, Panel B captures the change durng PE ownershp and shows the dfference (Δx = x T - x t ) from the last pre-acquston year (t) to the last PE-ownershp year (T);.we analyse the annual change by dvdng the dfference, Δx, by the number of years of PE ownershp (T-t). 19

21 In the frst set of columns, we report the changes for all deals wth suffcent operatonal data avalable (n=255). In the second and thrd column, we separate deals wth organc strateges (n=151) from those wth norganc strateges (n=104), the latter of whch nclude major, follow-on M&A events durng the prvate phase, so that we can analyze Δx by strategy. Ths also allows us to control for the effects of M&A events, whch cause sales to ncrease, and EBITDA margn and multple to ether ncrease or decrease, subject to the ratos of the acqured entty. It s mportant to note that the frst M&A event tends to happen after one year, on average, for deals n the McKnsey sample (for whch detaled nformaton on M&A events s avalable) ths tends to suggest that, gven the plannng requred to execute an acquston, M&A events are planned rather than a reacton to better- or worse-than antcpated performance. We also test f the changes are dfferent from zero and, n the sprt of a dfference-ndfference (DD), also test for dfferences between deal and medan sector changes. Overall, PE ownershp tends to have a postve mpact on the operatng performance n our sample. As shown n Table 4, Panel B, column () on average, all deals show a margn mprovement of 1% and a multple mprovement of 1.1 durng PE ownershp, relatve to ther sector peers. Interestngly, the margn mprovements of the deals n our sample are slghtly lower than the 1.4%-3.8% reported n Kaplan (1989). In contrast, deals do not outperform the sector n terms of annual sales growth, although portfolo company sales do grow by a statstcally sgnfcant 7.9% durng PE ownershp. Another mportant result of Table 4, Panel B s that large M&A transactons do not cause our fndngs on underlyng operatng mprovements to change: separately, both organc and norganc deals, columns () and () respectvely, dsplay mprovements n both EBITDA margn and multple, relatve to ther sector peers. 14 Only norganc deals seem to 14 In a robustness check n the McKnsey data set, we also nclude deals wth M&A events after 2 years of PE ownershp n the organc deal set and fnd our results qualtatvely unchanged. We nclude those deals, snce late M&A events mght be endogenously determned by the observed performance of the deal. M&A events n the frst 2 years can be treated as exogenous, f we assume that t takes at least one year to fnd out that a deal s underperformng and at least another year to dentfy and buy another company. 20

22 ncrease sales above sector, but ths sn t surprsng due to the large, post-deal M&A transactons nvolved whch naturally boost revenue. 6. Abnormal performance and operatng performance Havng separately dentfed abnormal fnancal and operatng performance of PE deals relatve to quoted peers, we nvestgate the relatonshp between the two measures n Table 5, Panel A. Specfcally, we regress abnormal performance on the ncrease n EBITDA margn, growth n sales and change n EBITDA multple. Columns (1) and (2) present results for the whole sample but once more we dstngush between organc (Columns 3 and 4) and norganc deals (Columns 5 and 6). We also control for duraton and deal sze at entry date, and nclude dummes for dfferent entry tme perods and PE houses, n order to control for tme and the fxed effects of PE frms on ther acqustons. 15 Another potental drver of abnormal performance s that PE houses may have been lucky on some deals smply because they bought them at the rght tme when the margns or multples n the sector were growng. We therefore nclude the change above sector for all three operatng measures. Of the three measures of operatng performance, the two whch we dentfed as beng mproved durng PE ownershp EBITDA margn and multple also appear to be sgnfcant determnants of abnormal performance: changes n ether measure have a postve and economcally meanngful mpact on abnormal performance (Columns 1 and 2). Sales growth, also relates to abnormal performance, even though t s not mproved by PE n general above sector (as shown prevously n Table 4, Panel B), For organc deals, Table 5, panel A, regresson (3), abnormal performance s drven by changes n all three operatng measures: a 1% mprovement n EBITDA margn above sector ncreases abnormal performance by roughly 2.1%; a growth of the multple from entry to ext by 1 ncreases abnormal performance by roughly 2.5%; and a 1% sales growth above 15 However, n unreported results, we fnd that the sgnfcance and sze of the estmates on operatng mprovements s mnmally affected by omttng tme dummes for entry years. We do not nclude dummes for the sze of the deals snce sze does not show up as sgnfcant and does not ncrease the explanatory power. Ths s potentally due to a lack of varaton n sze n our sample that conssts solely of large deals. 21

23 sector alters abnormal performance by 0.8%. Our results are qualtatvely unchanged when we nclude duraton n the regresson n column (4). For norganc deals, however, there s lttle evdence to suggest that changes n operatonal performance drve abnormal performance: only margn mprovements seem to contrbute to abnormal performance (although the sze and sgnfcance s lower than for organc deals), but the result s nconclusve, as deals wth sgnfcant, follow-on M&A are subject to an error term due to dstorton by the acqured entty. The economc contrbuton of these operatng mprovements s substantal n explanng abnormal performance. In the prevous sectons we dentfed a medan abnormal performance of 15.4% for all deals (Table 3, Panel A) and, for organc deals, a typcal EBITDA margn ncrease of crca 1% and a multple ncrease of crca 1 above sector (Table 4, Panel B()). Based on the estmated coeffcents n regresson (3), operatonal performance changes explan nearly one thrd of the abnormal performance (4.6/15.4). Our fndngs are also robust to alternatve measures of fnancal performance. In Table 5, Panel B, we smply replace the dependent varable abnormal performance wth IRR and, n Panel C wth, PME based on sector. In Panel C, regresson (3), margn, multple and sales mprovements above sector are sgnfcant explanatory factors of PME based on sector. We conclude that operatonal mprovements explan abnormal performance and dstngush good deals from others n terms of fnancal value creaton. Ths s a potentally mportant result: t provdes nsght that operatng value creaton strateges mght be at play n dfferent PE deals, as we explore below. 7. Human captal factors of deal partners 7.1. Fnancal performance and deal partner background We now show that the ft between a deal partner s background (professonal experence n fnance vs. operatons) and deal strategy (organc vs. norganc) correlates wth deal performance. Ths could be consdered as evdence that task-specfc sklls of the PE 22