Private equity returns: It’s all about alpha
Private equity (PE) firms have worked hard since the 2008 market meltdown to spruce up beaten-down assets they had paid dearly for at the top of the PE cycle and extract far more value than what most of their limited partners (LPs) and outside observers expected. But they also got a big boost from a warming economic climate, strengthening public equity and debt markets, and other favourable external factors beyond their direct control to help push up valuations. In the yin-yang dance between market beta and the unique alpha-generating capabilities of general partners (GPs) themselves, each played an important part in driving the recovery of short- and long-term returns. But as we discuss in Bain & Company’s latest Company Global Private Equity Report, GPs will increasingly need alpha-generating capabilities to steer their way to winning deals in a more complex and intertwined global economy.
While the specific talents for generating alpha may vary from GP to GP, the results do not: those that can successfully develop and deploy the skills that consistently create alpha at every link of the value chain do deals that produce more hits and fewer misses. Bain’s in-depth analysis reveals that the benefits of alpha show up in three ways that explain the variance in the returns earned by GPs that can and cannot generate it.
Avoiding deals that are losers. Top-performing funds are far better able to steer clear of deals that lose money than their lower-performing peers. Bain evaluated the return multiple on invested capital of nearly 2,700 deals made by a sample of US, European and Asian buyout funds, from the mature 1995 through 2006 vintages, and sorted them into four categories by performance, from worst (net fund IRR of less than five per cent) to best (net fund IRR of greater than 15 per cent). The weakest performers lost money on better than half of their deals; the top performers, by contrast, booked return multiples below breakeven on just 27 per cent of its deals – a little over half as many. The difference in the proportion of money-losing deals explains more than half the variance in the returns between the top-performing and weakest-performing funds.
Finding winning deals that win bigger. A second major performance difference between the top alpha-generating funds and the laggards is the size of their wins. Forty percent of the performance leaders’ winners (ie deals that returned more capital than GPs put into them) earned a multiple that was better than three times the invested capital versus just 13 per cent among the weakest performers. The advantage of investing in winning deals that won bigger explained 30 per cent of the performance variance between funds that were leaders and the rest.
Backing winning deals that are bigger deals. Most PE funds have demonstrated a proven ability to convert small deals into winners that return a high multiple on invested capital. It is simply easier to grow a small company into a much larger one than it is to do the same with an enterprise that is already fairly big. But Bain’s analysis discovered that top-performing funds consistently take bigger companies and make them still bigger. Among the performance leaders, deals that returned a multiple of more than three times their invested capital were 20 per cent smaller than the average deal size in their fund’s portfolio, while the winners of the performance laggards were just half as big as their average deal. This third advantage helps to explain the remaining 15 per cent performance gap between top and bottom performers.
Bain’s analysis of performance-leading PE funds also found that there is no one path to top returns. Segmenting the sample of funds we examined that achieved better than 15 per cent net IRR by their pattern of winning and losing deals revealed three distinct routes to success. Funds in the first cluster, representing 29 per cent of the total, appear to rely on sheer luck, having invested in one or two exceptional deals that more than compensated for many money-losing ones. However, GPs managing the funds in the other two clusters followed what appears to be a repeatable process for creating alpha.
The first of these groups (38 per cent of our sample) comprised funds and their hallmark investing style can best be described as ‘consistent’. With better than two thirds of the deals in their portfolios achieving a multiple of between one and five times their invested capitals, they managed to steer clear of deals that end up losing money. They were also less likely than their high-performing peers to back deals that generate exceptional multiples exceeding five times their invested capitals.
The second cluster of top performers swing for the fences on every deal they do – but like big-league sluggers, they strike out a lot. Comprising one third of the funds in our sample, these heavy hitters earned multiples exceeding five times their invested capitals on 15 per cent of the deals they did, but they ended up with about as many money losers.
There are important lessons for GPs in these findings. With asset prices high and showing no signs of coming down, they will need to stretch every link of the value chain – from deal sourcing to exit – to steer clear of bad deals and spot deals that have peak-performance potential and to find ways to consistently reap their full value.