Would love to hear about what the 'levers' are a PE firm can use to generate returns (e.g. add-on M&A, dividend recap, capital structure)? Would be great if you could go into some level of detail / specifics about how the lever/method works (e.g. with a simplified example) from setup to execution.
As I understand, there are 100s of levers / methods a PE firm could use to generate returns in various market conditions to meet IRR/MOIC targets. This is a genuine question out of interest as opposed to needing it for an interview response, etc. If there are any resources I could read instead, please do point them out to me.
Thank you in advance!
Levered to the tits
Hah! I was hoping for a more insightful response than debt, debt and more debt!
Avoiding the taxman
Operational improvement - this involves 1) institutionalising the company and 2) cost outs. In MM space, there's many SMB or corporate carve outs which needs a reset of head office cost base. Distressed businesses with poorly implemented IT systems to irregular accounting/financial reporting are abundant. Fixing these companies and building capabilities often leads to multiple expansion when these businesses are more stable. With cost-outs, you usually work with management to restructure organisational structure to remove cost inefficiencies on corporate level along with store level (ie. closing/exiting unprofitable stores)
Bolt ons - basically buying smaller businesses at lower multiples and selling consolidated platform at a higher multiple as business gains scale. Frequently used to grow EBITDA inorganically in fragmented industries.
Capex - spending capital on new equipment/technologies and rationalising cost base. Essentially investing cash now to reduce opex and grow EBITDA for exit.
Working capital and liquidity levers - stretching out creditors and having hard negotiations with landlords to free up cash liquidity in the short term during distressed situations.
Not a lever but investing in both equity and debt. Putting in capital through structured instruments provide downside protection and claim against fixed/floating assets.
As I said below to MikeRoss824, thanks for taking the time to write-up a response! I
Really seems to be about the basics and there's no "unique" (secret sauce) to engineer returns. I suppose it's about have the right people in management to be able to spot these opportunities and execute well.
Most levers in buyout will come down to the following 3 categories:
- Increase earnings during holding period
- Increase multiple on exit
- Reduce net debt (this would include all the working capital optimisation, capex optimisation etc as that throws off cash).
The best way to think about this is to consider what drives valuation and work backwards from there. In PE a business is typically purchased for a multiple of EBITDA, so you want to grow EBITDA and/or increase your exit multiple. How do you do that?
EBITDA: You can grow revenues and/or cut expenses to increase your EBITDA.
Multiple: Multiples are funny but they're generally driven by business growth/performance, industry dynamics, and general macro environment. Some of this is out of your control, but if you can make the business grow faster at the same EBITDA margins you'll get a higher multiple. Similarly if you can change the dynamics of the industry your business operates in (i.e., consolidate the market through M&A to give you a competitive moat, launch a new business segment in a faster growth/higher multiple adjacent market, lobby legislators to make for a more favorable regulatory environment, etc.) you can increase your multiple. Then you have to hope the macro environment improves / doesn't deteriorate when you're looking to exit.
Finally once you understand the drivers of valuation you can think about capital structure. As others have said debt will amplify your returns by allowing you to make the above changes using less cash on hand. Use the cashflow to pay down the debt and you have more of the proceeds from an eventual sale going into your pocket.
Thanks for taking the time to write-up a response! It's interesting that it really is about the basics and there's no "unique" (secret sauce) to engineer returns. I suppose it's about have the right people in management to be able to spot these opportunities and execute well.
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