At a glance
Successful LBOs require EBITDA growth. But Europe offers a low-growth environment. In order to thrive, tomorrow’s PE leaders will have to work a lot harder to pass that carry hurdle.
The good news? A lot of growth opportunities remain. Underneath sluggish overall GDP rates there is a healthily growing private asset pool which can be supplemented through buy-and-build plays.
The willingness and ability of PE players to capture both organic and acquisitive growth strongly varies. While there is no right or wrong strategy, data shows IRR leaders are typically good at both.
The PE growth imperative
LBOs, or leveraged buyouts, require a certain level of growth to work their magic. However, passing the carry hurdle on a flat-ish topline case can be challenging, especially given the persistently full valuations and increased cost of financing in today’s market. For European deal makers, this presents a worrying prospect, particularly when considering the macroeconomic challenges facing the region's economic growth.
Reflecting on the history of the industry, it's clear that the 80s and 90s were the pioneer stage when the industry was invented and household names were established. The 00s represented a golden age of high returns, which in turn attracted a significant amount of capital inflow that may have commoditized the industry in the 2010s. Fortunately for carry holders, the monetary expansion policy of Draghi led to a market multiple uplift that proved to be a windfall for virtually everyone in the industry. Looking ahead to the 20s, however, the reversal of QE combined with broader macro headwinds is unlikely to make the average returns on invested vintages particularly strong. This may mean a very meager decade is ahead for today's emerging PE talent, especially those in the middle layer primarily invested in recently deployed funds. This becomes even more clear when considering just how much of recent returns have been driven by multiple expansion.
Now, imagine trying to achieve similar returns but this time with multiple contraction. Overall, the challenging market conditions and uncertain economic outlook in Europe and beyond suggest that private equity will require innovative thinking and creative strategies in order to continue to yield hurdle-passing results. In all likelihood, top-quartile investors will still do great. Where the mediocre will struggle, outperformers will continue to thrive. But what are their options to drive outperformance? We summarize them in the following framework.
It is clear from this framework that while the ‘market multiple’ uplift may fall away, many opportunities to generate returns remain. This actually includes multiple expansion. While the monetary component of that may be falling away or even reversing now, PEs also benefit massively from small-vs-large multiple arbitrage (i.e. buy-and-build). This also remains with macro headwinds. Also, a higher rating from profile enhancement (divest non-core, lower client concentration, etc.) should still work. So the colloquial reasoning 'over half of PE value creation comes from multiple arbitrage and that's gone now' is probably largely true but not entirely. With hard work, there are paths to remain successful.
There is still growth
When looking for growth, a simple place to start is to assess GDP growth rates. The following chart represents this data for the world’s main economies.
It is clear that GDP growth in industrialized countries has been relatively slow and has been slowing down in years. Zooming in on the EU, countries averaged 1.3% from 2000-2022E reaching a record low within the last two decades from 2017-2022E with 1.0% average growth. This is also lower than the US and China, the world’s other major economic blocs. Looking ahead - tighter monetary policies, higher interest rates, persistently high energy prices and declining confidence are all expected to sap growth in Europe in the decade ahead. These specific European weaknesses delayed recoveries in past decades and continue to keep the EU in a more vulnerable position compared to other large economies such as the US. However, this overall GDP perspective does hide a lot of healthy performance in the underlying private company asset pool.
As we can see, European companies still managed to grow around 7% on average over the last 6 years. Pre-COVID, we saw stable growth rates ranging from 6-8%. This may come as a surprise given the overall GDP growth rates and even more so given that the business sector contributes to the vast majority of total GDP (the remainder comes from government spending, nonprofit and household real estate incomes). So how is it possible that European companies in our sample set consistently outperformed GDP growth? Part of the difference between the 1% GDP growth and 7% company growth in Europe can be explained by buy-and-build. Combining companies will have an impact on individual company growth as captured in our analysis but not on overall GDP growth. Another reason is the numerous companies that face bankruptcy every year which has a strong negative impact on GDP growth. Lastly, our analysis of the ‘investable asset pool’ of private companies focuses on companies above €5m EBITDA. This has a positive impact on growth rates as those companies are well-established companies that demonstrated certain growth levels in the past. The main point to take away, though, is that in spite of overall sluggish growth, there is a vast pool of potential investment opportunities that do grow at decent rates.
Moreover, our data shows that financial sponsors are differentially good at buying into growth and creating it. Analyzing revenue growth by ownership type, VC- and PE-backed companies outperform privately owned companies by a factor of 2-4x. VC-backed companies grew around 20% whereas PE-backed companies grew between 10-12% in the past years. Private companies on the other hand only managed to grow around 5%, slightly below the average of 7% across all ownership types. This vindicates the added value of VC and PE ownership in selecting growth assets and (likely) accelerating performance through financial resources and expertise.
It then becomes very interesting to decompose growth. As we find in our data, the median total growth of 8-10% is almost twice as high as the median organic growth of 4-6%. In the segment for the highest growth rates of above 15%, this becomes also evident where 24% of companies grow above 15% organically vs. 34% of companies growing above 15% in total. Buy-and-build is clearly a large component of overall topline expansion across the pool of European companies.
As alluded previously, PE-backed companies are better at capturing growth than privately owned companies. That begs the question of whether this is due to the higher buy-and-build activity for PE-backed companies or if it is driven by organic performance. Separately comparing the organic growth distribution of privately owned companies and PE-backed companies, it can be observed that PE-backed companies are in fact also better at capturing organic growth. Roughly 41% of privately owned companies grow above 4-6% organically whereas around 52% of PE-backed companies make that threshold. This can be due to both selection preferences by institutional investors as well as an ability to stimulate growth endogenously.
Looking at the second growth avenue – inorganic growth – PE-backed companies are also more active than their privately held peers. Almost half of the latter do not engage in buy-and-build whereas this share is around 10% lower for PE-backed companies. An active buy-and-build strategy is applied by 28% of PE-backed companies, meaning they acquire at least one company per year. This compares to only 12% for privately owned companies.
When does a PE investor rely on buy-and-build vs. other growth strategies such as organic growth? Companies showing mediocre organic growth especially show the highest buy-and-build activity, with roughly 5 add-on acquisitions per platform deal on average. Once companies reach an organic growth threshold of 8-10%, they rely less on buy-and-build to make their investment case. We do observe some buy-and-build activity even in the low-growth buckets of sub-2% organic growth. Digging into the underlying data, it links mostly to platform deals done by PEs with a focus on distressed deals and special situations. There, operational synergies and capacity utilization may be key drivers of acquisitions. Example investors include Mutares, Aurelius and Nimbus.
We now know that PE-backed companies are better at capturing growth both organically and through acquisitions. As there are more avenues for generating value than topline, it is also important to look at operational improvements. Crunching the data, PE and VC-backed companies are also better at realizing margin expansion. During a 4-year time horizon (2017 to 2021), PE-backed companies were able to improve their EBITDA margins by 1.1 percentage points whereas privately owned companies were only able to realize an improvement of 0.6 percentage points. VC-backed and minority PE-backed companies were able to realize an improvement of 1.6 percentage points.
Part of the higher margin expansion can be explained by organic growth and buy-and-build. The higher organic revenue growth can translate into lower operating leverage and therefore better margins. Furthermore, buy-and-build can translate into cost synergies which can also result in a margin improvement. Lastly, the higher margin expansion of PE-backed companies can be explained by the overall focus on operational improvements by investors. While we cannot decompose the relative contributions of these elements, an interplay of such factors is most likely. Interestingly, longhold assets (held by PEs without a fund structure and/or typical exit window) do not show margin improvement outperformance. This may imply the pressure of an exit is an important stimulus for operational enhancement.
Until now we have looked at averages. But what if we go into the granular detail of individual investors? Which ones are leading the way? Below, we highlight players by segment that, within their segment, perform differentially well at capturing organic growth. Importantly, we analyzed these players at the level of investment strategies rather than looking at PE houses overall or at individual funds. At their strategy-level, we analyze the mean performance of their underlying portfolios. Doing so through this methodology for both organic growth and buy-and-build, we unearth two respective sets of leaders in capturing these forms of topline growth.
Now, it is even more interesting to plot both the elements of organic growth and buy-and-build against each other. This offers a detailed perspective on how investment strategies differ across virtually all investors.
We subsequently repeat the plotting, but now replace the buy-and-build rating with the average EBITDA margin of portfolio companies. This offers a further perspective of how PEs vary in their investment preferences.
At this point, it is important to point out that being bottom left or top right at face value says nothing about being a good or bad investor. It merely analyzes the quality of the portfolios. But of course, bottom right can be filled by great turnaround investors or value buyers. On the flip side, top right houses might be overpaying for growth and margin. However, while there are certainly some great investors in the bottom right quadrant, we do find that being exposed to organic growth and driving buy-and-build often correlates with strong historical performance. In fact, when showing the top-10 performers in HEC’s well-cited performance ranking, we find that they are exclusively top right. When checking the same when bringing in the EBITDA margin-axis, the point on outperformance holds.
Further research confirms this notion. In fact, the vast majority of the HEC Paris-DownJones 2022 large buyout performance rankings winners demonstrate those characteristics: organic revenue growth, an active buy-and-build strategy and focus on profitability. This again does not mean every investor should follow the same strategy, but it surely proves that looking closely at unearthing growth and consolidation opportunities is a worthwhile pursuit.
Notes: Ranking refers to investors whose portfolios comprise at least 5 companies. Additionally, the calculation is based on portfolio companies’ last 5-year buy-and-build activity and average organic revenue growth. Source: Gain.pro; HEC Paris
Notes: Ranking refers to investors whose portfolios comprise at least 5 companies. Additionally, the average organic revenue growth and average EBITDA margin calculation is based on portfolio companies’ last 5-year financial statements. Source: Gain.pro; HEC Paris