Heads-Up Private Equity: Fresh Approach to Value Growth Needed
Rory Jones, Partner
Business Value Associates
March 2009
For too long, private equity firms have been managed as investment vehicles, and not enough like businesses that need to succeed in a maturing market. The time is ripe for that to change and, to a large extent, that change is being foisted on today’s players. In fact there is a good case to be made for today’s private equity to take some of the medicine they have for so long told others to swallow.
The Old Business Model Did Well – For Then
Historically, private equity firms have operated a simple business model, comprising three basic components; find undervalued or poorly managed businesses, acquire them using cheap capital (primarily debt), and drop in big-name/known-quantity business leaders to clean up the acquired business. An elegant approach, and one that has delivered multiples on acquisition prices, has drawn in subsequent funds; and so perpetuated the success of most private equity firms to-date.
The value growth potential in buying an undervalued business is obvious, as is hiring known-quantity business leaders. However, it is the value growth in debt leverage that has really delivered for the private equity sector. Everyone knows that by taking on large amounts of debt in each deal, equity capital has been used to extend each fund’s portfolio capacity, while at the same time delivering each acquiree’s cash flow using only a relatively small equity capital outlay – leading to a highly magnified return on equity. A true win-win situation.
