Private Equity Growth Continues as Industry Matures, Adapts
Investor returns from private equity as a whole are comparable to the public market, but the best PE firms are able to outperform by “beating the fade” - avoiding the reversion to average returns over time. Now, the onset of the world-wide credit crunch has raised serious questions about the future of private equity. Some of the sector’s biggest and most well-known players have recently had to cancel highly-publicized deals due to the lack of available credit. A new study by the University of Navarra’s IESE Business School and Boston Consulting Group, (BCG) focuses on the “distinct organizational capabilities” of private equity’s top performers, and holds out hope that the sector will maintain “sustainable competitive advantages” over public companies.
One of the main premises of the study: “Although the credit crunch has caused a drop in the largest private-equity deals, it is unlikely to significantly retard the long-term growth of the sector. Indeed, another BCG report estimates that the private equity sector will grow by 15 to 20 percent a year until 2011.”
Many pension funds and other types of large, institutional investors are also increasing the role of “alternative” investments in their portfolios. Notable examples include the Teacher Retirement System of Texas and the California Public Employees Retirement System. Similarly, Sovereign Wealth Funds and other government-run enterprises have grown interested in private equity recently.
The study found a “growing emphasis on fundamentals” in the private equity sector. The authors “analyzed the sources of value at 32 companies in the portfolios of seven European private-equity firms. [They] compared the enterprise value of the businesses at the time they were purchased with the value realized upon exit, and quantified the relative contribution of key value drivers. Almost half the value created (22 percentage points out of a total… IRR of 48 percent) was attributable to sales growth, and an additional 5 percentage points to improvement in margins… Change in leverage was only responsible for 11 percent.
This finding, the authors argue, is part of a larger historical trend.
“Adjusted for risk,” the authors note, “the returns from private equity are roughly equal to those from public markets.”
The study’s authors argue that a few key lessons can be learned from the top earners in the private equity market. Such firms:
- have domain expertise
- recognize “the relative unimportance of structural factors”
- use strategies of “capabilities-based value creation”
- have strong networks of industry insiders in the sectors that they operate.
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