Margins Vs. Multiples

The traditional industry playbook for driving strong private equity returns was relatively simple: Buy companies using low-cost debt and then sell for a healthy profit several years later. It was primarily about expanding multiples.

That straightforward approach doesn’t always work anymore. Rising interest rates to tame soaring inflation severely dampened deal activity in recent years. This is forcing managers to work harder to generate returns. Today, driving returns requires expanding margins—and investing for value.

Over the past 25 years, we have found that take-private transactions and corporate carveouts consistently provide significant pockets of value with an opportunity to expand margins. The problem is the degree of difficulty involved. Managers need to roll up their sleeves and dive deep into their portfolio company’s product lineup, staffing and manufacturing processes. And because few managers are willing and able to put in the necessary sweat and tears, we find that competition for these deals tends to melt away. 

Private Equity’s Boom and Bust

Traditionally, investing in private equity markets was largely an exercise in buying high and selling higher. Many sponsors were able to drive great returns through “multiple arbitrage” rather than fundamental operating enhancements (see Figure 1). They benefited from highly liquid markets and a growing appetite for private equity among both institutional and retail investors seeking returns in a low-yield environment, with established sponsors raising ever-larger funds. Meanwhile, a proliferation of emerging managers chose to strike out on their own, resulting in even more sponsors and capital that created a highly competitive deal environment.

Take-Privates

In a classic buyout, an investment banker serves as an intermediary and reaches out to an often-long list of financial sponsors to stoke interest—a reactive process. But in a take-private situation, the manager should proactively approach the target company’s board of directors with a plan to unlock potential value in the business.

In our experience, public companies move at a slower pace and with less urgency than we see in the private markets. When things aren’t going well for a publicly traded company, the CEO and the board tend to hesitate to make necessary drastic or transformational changes out of fear of dampening the stock price and further eroding shareholder value.

This initial outreach follows many months and, in some cases, years of tracking a specific company and industry. In addition to combing through public filings and financial statements, the buyer should engage with industry experts and advisors to gain further insights into a company, its competitive positioning and longer-term outlook. The buyer would need to undertake all of this “outside-in” work not knowing if it will get a response from the acquisition target’s board, let alone an agreement to meet. In our experience, most other sponsors, particularly those in the middle market, wouldn’t see this as a risk worth taking.
  
If the buyer makes the case that a company is better suited as a private enterprise, it would then need the approval of multiple constituents: the board of directors, management, local works councils and, ultimately, public shareholders. Take-privates are also closely scrutinized by regulators, necessitating extensive legal work during the entire process through mandatory filings and ad-hoc requests.

As is often the case, activist shareholders may also become involved over the course of a take-private transaction to drive up the price or block the deal entirely. If that happens, they represent yet another constituent with whom the buyer may need to engage and whose support we will need to win.

It is also not unusual for an acquisition target to invoke a “go-shop” provision—a fiduciary obligation to its shareholders to explore all options from other potential buyers. However, from our experience, it is usually not feasible for another party that makes a higher bid at the last minute to have a better understanding of and plan for the company. Unlike a last-minute bidder, the original sponsor spent much time conducting due diligence and meeting extensively with management to gain deeper knowledge and insights.
 
With multiple stages that are often complex, time-consuming and subject to change, take-private processes do not always travel in a straight line. They require extensive resources, capital and patience.

Corporate Carveouts

As companies look to divest businesses, another key strategy that private equity managers are employing is the corporate carveout. In a carveout, a parent company sells a business unit, division or subsidiary to a private equity firm. The private manager will then implement a comprehensive plan to “stand up” the divested business as an independent entity.

If classic buyouts—in the form of acquiring a company through a sponsor-to-sponsor transaction or directly from a family or a founder-led business—are simply getting “handed the keys,” a corporate carveout is like “building the plane while flying it.” The sheer complexity of standing up a company as an independent entity is an arduous process with the buyer at a disadvantage due to information asymmetry around the most important factor: business continuity.

While negotiating the parameters of a carveout, the seller will often understate the expenses and resources needed to stand up the business. Once that hurdle is cleared, interacting with the seller is not over when the transaction closes. The buyer will need to work with the seller, often for several years, to disentangle the business. Both sides must trust each other, and the buyer must demonstrate that it has the expertise and capabilities to successfully execute the carveout.

Transition service agreements (TSAs) are the lifeblood of a carveout. A TSA is a contract between the seller and buyer that guides the multitude of functions the seller will provide during the period of disentanglement—and is critical to business continuity. While the buyer implements its plan to stand up the business as an independent entity, it’s imperative that critical departments and systems continue operating smoothly on the first day of new ownership, including human resources, paycheck processing, insurance coverage and information technology. Additionally, all contracts with external vendors—from freight shipments to office supplies—must be scrutinized and, if necessary, put out to bid. The new business must be able to operate without interruption in the eyes of customers, employees and other stakeholders.

After the carveout, the newly independent company must develop a fresh brand with associated trademarks, labels and signage, and it will need to hire new people for jobs that were previously done by employees of the parent company. The new company will also undoubtedly have a more complex capital structure and key performance indicators in its financial reporting that will necessitate changing and upgrading the corporate treasury department. And it may be necessary to build out an entirely new senior executive team that is capable of implementing a new corporate strategy instead of taking direction within a larger organization.

Well Worth the Effort

While buyout transactions of all varieties require significant effort, we have found that take-privates and corporate carveouts present degrees of difficulty and effort that many private equity firms will simply choose to avoid. Effectively undertaking either of these types of transactions at scale—while simultaneously managing the remainder of the portfolio and an active pipeline—requires both an oversize team and a high level of sophistication.

In our view, only the managers with these resources are well positioned to pursue these more complex transaction types—and, ultimately, capture the return potential they offer. Maintaining a value discipline requires taking the roads less traveled. But, in our experience, it is a journey worth taking.