Private Equity firms have some of the highest returns in the investment landscape.
While the concept appears simple - buy a company, improve it, and sell it for a profit - the magic happens in how Buyout firms specifically go about enhancing value.
In this article, we will focus on Buyout firms, which target established companies with a focus on improving their profitability, but not on VC firms, who have a very different playbook as they invest in much smaller companies with a strong focus on growth, sometimes at the detriment of profitability.
At the end of the day, the price of a company can be thought of as the sum of discounted cash flows, or as an industry-specific multiple of a financial indicator like Revenue or EBITDA.
This is why Buyout firms focus on improving the different drivers of value with actions such as these.
For each driver, we provide a real-life example from a public company, as they have a larger press coverage than private ones, and these drivers are not only used by private companies.
- Repositioning in the Market: By repositioning a company within its market, Buyout firms can earn a higher valuation multiple. For instance, transforming a traditional retailer into an e-commerce company might increase its market valuation, because the multiples for e-commerce companies are larger than brick and mortar ones, due to anticipated higher perspective of growth.
Example: IBM’s transition from a hardware business to a cloud and AI software business. This repositioning helped improve IBM's valuation multiple.
- Creating build-ups: In fragmented industries, Buyout firms can build up or roll up smaller companies into larger actors. The consolidated entities can often achieve economies of scale, streamline operations, increase pricing power, or have access to cheaper capital, which will all be captured in higher multiples.
Example: Berkshire Hathaway’s strategy of consolidating companies to achieve economies of scale.
- Entering New Markets: Buyout firms can drive revenue growth by helping portfolio companies expand geographically or by targeting new customer segments.
Example: McDonald’s introduction to local markets with tailored products, for instance in India or China.
- Product and Service Expansion: Introducing new products and services, or pivoting to a different product line to grow market share.
Example: Apple is a leader in introducing new product lines, such as smartphones, tablets, wearable devices, etc.
- Strategic Partnerships: Establishing alliances or joint ventures with other industry players can create synergies and lead to increased sales.
Example: Microsoft and OpenAI’s partnership. OpenAI gets preferred access to Azure resources, and Microsoft gains a strong headstart in AI research.
- Operational Efficiency: Streamlining operations, optimizing supply chains, or implementing lean management practices can reduce costs and improve profitability.
Example: Toyota has long been the best in class in operational efficiency with its “Just In Time” production.
- Financial Engineering: Optimizing the capital structure and refinancing high-cost debt can lead to savings.
Example: Verizon’s $49bn bond emission to refinance short-term loans that had been taken out to finance its $130 billion acquisition of Vodafone's stake in Verizon Wireless. It allowed them to lock in low interest rates over the long term, and save billions in interest payments.
- Strategic Cost Cutting: Divesting non-core assets or automating certain business processes to reduce overheads can also lead to savings.
Example: eBay’s sale of StubHub to focus on its core e-commerce operations.
In summary, value creation in Buyout firms involves financial, operational, and strategic levers. When properly executed, this playbook can significantly amplify the value of target companies, and lead to high exits and strong returns.