The Impact of Private Equity Investors on their

Portfolio Companies

Mike WrightCentre for Management Buyout ResearchNottingham University Business School

www.cmbor.org

Centre for Management Buy-out Research

Identified emergence of UK buy-out and private equity market early 1980s

Organised first European buy-out conference in 1981

Centre for Management Buy-out Research (CMBOR)

Established in 1986 at Nottingham University Business School

To examine developments in UK & European buy-out markets in comprehensive and independent manner

25 years of research into MBO/MBIs

Established world leading database of buy-outs

Currently >25,000 buy-outs in UK and Europe

Number of publications generated from database including:

UK Quarterly Review and European MBO Review

Academic Articles

Private Equity & Portfolio Companies

From Folklore to Science

Summarize main themes from over 100 studies covering US and Europe (Gilligan and Wright, 2010)

Performance, growth and their drivers

Role of Boards

Employment and employee relations

Asset sales, Longevity and distress

Source: CMBOR

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Source: CMBOR/Barclays Private Equity/Deloitte

Do Buyouts Improve Firm Performance?

Buy-outs improve profitability

Operating profitability of PE backed buy-outs greater than for comparable non-buyouts by 4.5% over first three buy- out years

Industry specialisation of private equity firm important

Similar evidence from France & NL

BUT Public to Privates [PTPs]

Emerging US and UK evidence suggests accounting returns on 1990s/2000s deals are not as great as for 1980s deals [Guo et al., 2009; Weir et al., 2008]

Do Buyouts Improve Firm Performance?

Buy-outs improve productivity

Total factor productivity (TFP) assessed 36,000 UK manufacturing establishments

4,877 experienced MBO between 1994-8

MBO establishments were approx. 2% less productive than comparable plants before transfer ownership

After MBO substantial productivity increase

[see also Davis et al., 2009 for US]

Does PE Affect Growth & Investment?

Refocusing & divestment greater than non-buyouts

Buy-outs improve entrepreneurial actions

New product development

Role of private equity firms

CAPEX & R&D mixed evidence

Divisional buyouts greater growth in sales, efficiency & profits (Meuleman et al., 2009)

PE backed buyouts increase patent cites (Lerner et al., 2008)

Strategic control systems enable growth

What Drives Performance Changes?

Management team shareholding has largest impact on equity returns

After adjusting for management selecting an attractive deal

Paying a lower price gives greater scope for greater equity for management

Gains in LBOs > Gains in Leveraged Recapitalizations

What is the role of PE and the Board?

Active PE firm monitoring important

Industry specialism & experience of deals done

Boards:

in PE buyouts active, non-bureaucratic boards that help lead strategies to create value

in listed corporations accompany management’s strategy and tend to focus on risk management

What is the role of PE boards in distress deals?

Listed corporation non-executive directors appear generally less involved than boards in PE-backed buyouts when restructuring becomes necessary

PE firm boards more rigorous and timely in distress

PE firms have an important role in restructuring distressed portfolio firms and their strategies even following debt/equity swaps

Listed corporations can face greater problems in injecting new cash as they need to issue a formal investment proposal

[Wilson, Wright, Cressy, 2010]

Does PE adversely affect employment & wages?Years relative to year of deal

Variables t + 1 t + 2 t + 3 t + 4 t + 5MBO Employment -2.28% 2.96% 7.46% 21.43% 26.02%MBI Employment -10.22% -9.70% -11.10% -3.35% -5.02%Source: Wright et al. (2007)/CMBOR

Employment

Now many studies – employment effect contingent

Davis et al. (2008) employment grows more slowly & declines more rapidly in PE until t+4; greenfield growth (US)

Boucly et al. (2009) 3 years following LBO, targets grow faster than peers by 13% (France)

(Amess & Wright, 2007, 2010; Amess, Girma & Wright, 2008) (UK)

Majority of deals increase employment after initial fall

Employment growth in MBOs higher than non-LBOs but lower in MBIs

Buyouts whether PE or not no different employment change compared to matched firms

M&A has more negative effect than PE on employment

Wage growth in MBOs & MBIs, lower than non-LBOs

What is Impact of PE Buyouts on Employee Relations?

Occupational pension schemes: increase but shift to defined contribution schemes based on investment performance and contributions open to new members

Increase in regular team briefings; Internal promotion as norm; work organised around team working for the majority of the staff; Formal grievance procedure; incentive pay schemes; non- managerial training

Little change in union representation; 2/3 unions in favor neutral towards buyout

More consultative committees, more influential; increased focus on employment issues and especially on discussing company’s future

Evidence of direct meetings between PE firms and employee representatives

[Bacon et al., 2008a, b]

What is Impact of PE Buyouts in Different Social Contexts on Employee Relations?

Differences in Portfolio company context

All contexts show increase in new high performance work practices (HPWPs) after buyout; significant differences between contexts disappear after buyout

Differences in PE firm origin

Buy-outs backed by Anglo-American firms are as likely to introduce HPWPs (except for more financial incentives) as those backed by non-Anglo-American PE firms, suggesting some adaptation to local institutional contexts.

Time-scale

PE investment results in greater increases in HPWPs longer the anticipated time to exit.

The impact of PE on HPWPs is affected more by length of the investment relationship (heterogeneity of PE firm effect) than the countries where PE is going to or is coming from

[Bacon et al., 2010a, b]

What is the Extent of Asset Sales?

Substantial sell-offs mainly in few large & PTP deals

Number & value of partial sales small share of deal volume and value

Partial Sale Year CE UKNo. Val. (€m) No. Val. (£m)

2000 36 420 78 4352

2001 30 51 94 8905

2002 32 2644 69 4837

2003 35 922 76 2974

2004 49 2938 73 8619

2005 54 2236 99 9145

2006 44 3786 72 6688

2007 49 6472 60 5379

2008 30 5654 44 495

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Overall increasing time to exit but heterogeneous longevity

(see also Stromberg, 2008)

Secondary buy-outs take longer to exit

PE-backed MBOs IPO sooner; those backed by active PE exit sooner & perform better

Source: CMBOR

Do PE Deals Involve Short Term Flipping of Assets?

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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

£50‐500m

Over £500m

Can PE provide a role in distressed firms? Receiverships Increasing Source of Buy-outs

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What is happening to Leverage & Pricing in PE Buyouts?

Dramatic fall in senior debt in financing structures in 2008 over above £10m deals

Substantial increase in senior debt pricing above LIBOR, especially for less traditional layers

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Equity Mezzanine Debt Loan Note Other Finance

Note: Data shows basis points above LIBOR

Type of Senior Debt 04 05 06 07 08

Tranche A 225 218 224 217 285

Tranche B 275 250 262 265 338

Tranche C 327 283 308 303 396

Does Higher Leverage Increase Likelihood of Failure?

Failed vs non-failed buyouts

Failure rate affected by leverage, timing of deal & by default probability on buyout (Wright et al., 1996)

PE buyout failure vs non-buyout failure (Wilson, Wright & Altanlar, 2010)

7million firm years 1995-2009 including all UK companies

PE-backed buyouts have a significantly better coverage ratio (the ability to pay interest on debt from profit and cash-flow) than non-private equity backed businesses.

Leveraged firms [of any kind] more likely to fail

After taking into account leverage and other factors:

Private Equity backed buyouts post 2003 not significantly different in failure likelihood than non-buyouts

Buyouts and buyins without private equity more likely to fail

What is the recovery rate in failed PE deals? ?

Secured creditors recover 62% average on bankruptcy; 30% sold as going concerns (Citron, Wright, 2008)

Recovery rates from failed PE buyouts (63%) more than twice those in failed listed corporations (26-30%) [Wilson,Wright & Cressy, 2010)

Dependent on proactive working between PE firms and banks

Banks may soon seek to recover value through equity sales, which may increase receiverships or sales to distress funds.

Deal Types and Involvement of PE Firms

Need strategies to grow portfolio firms organically or build-up

Need to acquire expertise to add value & be sector focused

Select portfolio management with business skills who can identify and deliver on innovative development strategies

Need to be involved in portfolio firms beyond initial ‘100 days’

PE Model/ Portfolio Mgt

Managerial Expertise

Managers’ Innovative Skills

Leverage & Financial Monitoring

Constrained Buy-outs [weak complements]

Conflicted Buy-outs [strong negative substitutes]

Lower Leverage & Close Value Adding

Operational Buy-outs [weak substitutes]

Radical Buy-outs[strong positive complements]

Conclusions

Widespread evidence of positive impact of PE

Need for recalibration of traditional PE model rather than fixing a broken one

Elements of best practice detectable worldwide but believe have identified general challenges for a significant swathe of less experienced PE firms

Potential danger with pressure upon PE funds to invest

Deals completed at entry prices posing major challenges to the generation of target returns

Questioning of whether the lessons from the ending of the golden age have indeed been learnt