Private equity's road map to profits - Audio slideshow with text transcript

Since they burst on the scene more than two decades ago, private equity firms have pioneered new corporate financing techniques, reshaped global capital markets, and transformed how mergers and acquisitions are done. In the process, they have rewarded their investors with market-beating returns, and they continue to ratchet up expectations that they can unlock value that eludes other owners.

But success has bred new competition which, in turn, has turned up the heat on private equity firms to find new ways to differentiate themselves from their rivals. Today, I will describe how the private equity investment climate is changing and the new path to profits being blazed by leading private equity firms.

Let's begin by looking at the vast increase in the scale of private equity deals in recent years. In the US, the buyout industry currently finds itself at the pinnacle of a third wave of dramatically expanding deal activity-what looks to be private equity's "golden age." Through the end of 2006, dealmakers closed buyout acquisitions totalling a record of more than $300 billion. That accounted for more than a quarter of all M&A activity for the year.

But even as the pace of investment has gone from hot to torrid, the inflow of new capital into private equity coffers has exploded. In just the past two years, new fundraising rounds by US-based firms have brought in $350 billion of capital-almost as much as what was raised cumulatively over the previous decade.

Buyout firms now have roughly $300 billion of equity capital available to invest. With private equity transactions typically financed with $2 of debt for every dollar of equity, the total value of buyout firm war chests is closing in on a total of $1 trillion.

With so much capital at their disposal, it is no surprise that PE firms have been on the trail of bigger prey, as shown in the list on the left of recent deals with acquisition prices surpassing $10 billion. In fact, three private equity transactions announced in 2006-the acquisition of Equity Office Properties by Blackstone Group, the purchase of HCA by a PE consortium, and the buyout of Harrah's by TPG/Apollo-cracked the top-ten list of M&A deals worldwide.

Not surprisingly, in view of the large sums of capital they have to deploy, private equity firms are finding themselves pitted against one another and against strategic buyers in high-stake auctions that drive up acquisition prices.

The ready availability of inexpensive debt has also played a major role in fuelling private equity activity and pushing prices up.

On average, PE firms in both the US and Europe are now paying eight times earnings before interest, taxes, depreciation and amortization-another record high.

But the benign conditions that have nourished private equity's growth will not last forever. Inevitably, the debt markets will turn, interest rates will climb, and lending conditions will tighten. This means that private equity firms buying at today's high multiples will no longer be able to count on selling their investments at an equivalent or better multiple.

To illustrate this dynamic, let's take a hypothetical acquisition scenario. A company acquired in 2000, that grew earnings at the rate of GDP growth, would have returned a 2.9X multiple on equity in 2005, driven largely by multiple expansion. That same investment made at 2005 multiples might well struggle to return more than it's original capital if multiples return to their historic norms.

Simply stated, today's private equity firms can no longer count on the magic of leverage and expanding multiples to deliver the exceptional returns their investors have come to expect.

Private equity firms that expect to prosper going forward are going to have to follow a radically different game plan. They must replace passive stewardship with an activist, hands-on approach to building value in their portfolio companies.

Activist private equity owners follow five disciplines that set them apart from their peers.

They start by rolling up their sleeves soon after close to flesh out their investment thesis, taking a detailed inventory of the best opportunities to improve the value of their newly acquired company. They then work with company management to draw up a blueprint for action-prioritizing key initiatives, assessing the resources needed to accomplish them, and transferring processes and tools that help management teams to get more done, more quickly.

Activist owners recruit and empower strong management teams, supporting them with operational expertise and incentives for meeting ambitious targets.

They monitor results closely by measuring what matters-zeroing in on a few key performance measures—and they intervene at the first sign that the plan is drifting off track.

Finally, they defy the knock that private equity owners are interested only in short-term profits by thinking long-term. They plant the seeds for future growth that the company's next set of owners can harvest.

The rewards from early activism can be extraordinary. Our experience confirms that dealmakers who develop a value creation blueprint, and implement the plan within the first year following an acquisition reap an average return that is 3.4 times their initial investment. That is double the return earned by their peers who bring a hands-on approach but wait to do so until the later stages of their holding period, and it far outperforms the industry average of a 1.3x return on equity.