1.6 Value Creation in PE Flashcards

1
Q

What does VCP stand for and mean?

A

Value creation plan. The strategy for PE firm to unlock superior returns by monetizing their industry and operational expertise (e.g. cost cutting, productivity improvements, operational change, leverage).

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2
Q

Highly skilled employees at a PE firm are known as _____

A

Operating partners

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3
Q

What are 5 categories of action items in a VCP?
1. OI
2. TLG
3. GE
4. FE
5. CM

A
  1. Operational improvements (reduce costs or improve assets)
  2. Top line growth (sales)
  3. Governance engineering (changing mgmt team/processes - this is 3x more popular now than 20 years ago). The strategy of changing the CEO, CFO, or senior managers is equally deployed.
  4. Financial engineering - optimising cap structure. Adjusting leverage or refinancing current obligations. But there is a balance between reducing taxes paid (through higher interest expenses) and the firm’s weighted average cost of capital and not too increase interest cost too much risking bankruptcy. Changing the firm’s capital structure (i.e., adding debt) is used more frequently than imposing incentive-based compensation
  5. Cash management - focuses on reducing working capital needs. Such as through reducing credit extended to customers (i.e. receivables outstanding), increasing credit provided by suppliers, and improving inventory management (the latter is used less than the 2 former).
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4
Q

Examples of operational improvements included in a VCP

A
  • reducing costs
  • buying/upgrading assets
  • employee related (size of employee base, wage structures, labour productivity, and capital intensity)
  • buying or selling firm assets or divisions/ restructuring business units
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5
Q

What is top line growth and how (in VCP):

A

Aims to increase sales. Such as through increasing market share, changing product or service mix, pursuing international expansion (or new markets more broadly), changing the pricing or marketing strategy, improving product quality, and adjusting margins.

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6
Q

What are the most commonly used action items in the VCP?

A

Operational improvement and top line growth are the most commonly employed. Financial engineering and cash management are the least used although they are still viable approaches

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7
Q

The use of VCPs varies based onwhat four things?
1. DT
2. FO
3. GS
4. GF

A
  1. deal type
  2. fund ownership
  3. growth strategy
  4. geographic focus
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8
Q

Deal types can be split into 5 categories:
1. ES
2. G
3. B
4. S
5. T

A
  1. early stage - traditional venture capital deals
  2. growth - involve external financing, not acquisition, of firms with high sales or profit growth
  3. buyout - acquisition (full or partial) of a mature company with stable cash flows
  4. secondaries - one PE firm buys a deal from another PE firm
  5. focus on struggling or underperforming companies
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9
Q

Popularity of VCP action items by deal type?
1. OI
2. TLG
3. GE
4. FE
5. CM

A
  1. op improvement - buying or upgrading firm assets and reducing costs are the most common VCPs across all deal types
  2. top line growth - changing the product or service mix popular across all, for turnarounds, pursuing international expansion is also popular. Growth, buyout, and secondaries may focus on add-on acquisitions, while early-stage deals most commonly improve marketing efforts.
  3. governance engineering - all deal types pursue changing CEO and other managers. for early stage, changing the CFO may be a less popular option than for the other deal types, and instead more likely to change the board’s structure
  4. financial engineering - optimising cap structure is the most popular across deal types
  5. cash management - improving the management of receivables and payablesis the most popular action item across all deal types
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10
Q

Fund ownership categories in a PE deal (2)

A

Fund ownership in a PE deal can be either a majority stake or a minority stake

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11
Q

Popularity of VCP action items by fund ownership type?
1. OI
2. TLG
3. GE
4. FE
5. CM

A
  1. OI - both maj and min stakes focus on buying or upgrading assets, reducing costs, and improving IT systems. Buying/upgrading assets is by far the most important.
  2. TLG - both maj and min focus on changing the product or service mix, pursuing add-on acquisitions, and improving marketing efforts. Changing product or service mix is most important activity.
  3. GE - both min and maj stakes focus on replacing management with less emphasis on attempting to replace the CEO and CFO.
  4. FE - both focus on optimizing capital structure
  5. CM - both focus on improving the management of receivables and payables
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12
Q

Two types of growth strategy for a PE deal?

A

The growth strategy for a PE deal can be either organic (i.e., focus on internal growth drivers) or inorganic (i.e., acquisitions).

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13
Q

Popularity of VCP action items by growth strategy?
1. OI
2. TLG
3. GE
4. FE
5. CM

A
  1. OI - Both organic and inorganic growth strategies focus on buying or upgrading assets and reducing costs. The emphasis is on buying or upgrading assets.
  2. TLG - for inorganic, the focus is pursuing add-on acquisitions - this is not pursued at all by the organic type. Shared strategies are changing the product or service mix, improving marketing efforts, and pursuing international expansion (in that order).
  3. GE - both focus replacing management with less emphasis on attempting to replace the CEO and CFO
  4. FE - both focus on optimizing capital structure
  5. CM - both focus on improving the management of receivables and payables
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14
Q

Popularity of VCP action items by geographic focus (single country or regional)?
1. OI
2. TLG
3. GE
4. FE
5. CM

A
  1. OI - Both single country and regional strategies focus on buying or upgrading assets and reducing costs. The emphasis is on buying or upgrading assets.
  2. TLG - both focus on changing the product or service mix, pursuing add-on acquisitions, and improving marketing efforts
  3. GE - both single country and regional strategies focus on replacing management
  4. FE - both focus on optimizing capital structure
  5. CM - both focus on improving the management of receivables and payables
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15
Q

Popularity of VCP action items by deal type:

A
  1. early stage - OI (80%), TLG (56%), GE (39%), FE (29%), CM (5%) - smallest focus on CM than any deal type.
  2. growth - OI (85%), TLG (77%), GE (47%), FE (32%), CM (15%)
  3. buyout - OI (82%), TLG (88%), GE (62%), FE (54%), CM (18%) - stand out due to high FE focus relative to other deal types
  4. secondaries - OI (85%), TLG (72%), GE (56%), FE (32%), CM (13%)
  5. turnaround - OI (88%), TLG (53%), GE (41%), FE (56%), CM (14%) - OI very important, as is financial and gov engineering
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16
Q

Success rates of VCP categories:

A
  1. OI - buying/selling assets and reducing costs c. 95% success. Less successful at divesting or spinning off a division, but still successful at 80%
  2. TLG - Less certain than OI. There is a 90% deal success rate for changing the product or service mix and an 87% success for both changing the pricing strategy and marketing improvements. There is only a 74% success rate for pursuing add-on acquisitions, a 73% success rate for pursuing international expansion, and a 62% success rate for targeting market share expansion.
  3. GE - Changes to mgmt team are v successful (between 93-96% depending on which managers are being changed. Suitable new managers are typically identified before the deal ever closes. Improving corporate governance (71% success rate) is the most difficult activity in governance engineering.
  4. FE - Changes to capital structure have a success rate of 88%. This action item is fairly easy to implement (e.g., take out a loan).
  5. CM - Improving receivables or payables has a success rate of 90% while improving inventory management has a success rate of 82%.
17
Q

Often PE firms combine several action items into one VCP - what impact does evidence suggest this has on success rate of the VCP? Why?

A

Evidence suggests that as the number of action items pursued at the same time increases, the success rate of the VCP decreases. A logical explanation for this is resource constraints. The skills required to successfully implement the VCP is in limited supply. Taking on too many action items at once will spread PE managers too thin and lower the chance of success when the deal is exited.

18
Q

Deal duration and deal size - larger means? Why?
What about ownership? %?
Growth strategy? Why?

A

Larger deal duration and deal size = ore chance of success. This is most likely due to longer deals and larger deals receiving more attention from PE managers.

Ownership: majority ownership increases the likelihood of success by 3.6%

Growth strategy: inorganic growth strategy decreases the chance of success. This may be due to paying too much for inorganic growth targets.

19
Q

What variable has the greatest impact on the success of a deal? (FFE)

A

Fund fixed effects (i.e., unique factors affecting a specific fund)

20
Q

At fund level, more success is achieved when:
- size
- number
- diversification

A
  • deals are homogenous in terms of deal size - means they will give the same level of attention to all deals
  • success is higher when funds focus on a smaller number of deals
  • diversification across multiple sectors of the economy appears to not have any impact on the successful implementation of action items

In summary, resource constraints, specialization, and diminishing returns from elevated deal complexity all have an impact on deal implementation. At the fund level, the primary concerns are a portfolio of a smaller number of deals that are homogenous in size coupled with a minority stake. Vintage year impact cannot be controlled because it is linked to time-period sensitive macroeconomic factors.

21
Q

What four combinations of VCP APs earned ABOVE average returns? (%)

A
  1. TLG, GE, FE - 1.3%
  2. OI, TLG, CM - 1.8%
  3. TL,GE - 3.6%
    4.OI, TLG, GE - 15.3%
22
Q

What FIVE combinations of VCP APs earned BELOW average returns? (%)

A
  1. OI, TLG, GE, CM - 4.2%
  2. OI, TLG, GE, FE - 11.1%
  3. OI, FE - 3.4%
  4. OI, GE - 3.4%
  5. TLG, CM - 0.2%
23
Q

What TWO standalone VCP APs earned BELOW average returns? (%)

A

GE - 1.2%
CM - 0.2%

24
Q

Broadly speaking, combining WHICH TWO APs is generally a good thing for benchmark-relative returns?

Which combination is generally a bad thing benchmark-relative returns?

A

Combining top-line growth and governance engineering was generally a good thing for benchmark-relative returns

While combining operational improvements with any other VCP action item was not.

25
Q

What two combinations of VCPs earnedsuperior benchmark-relative returns?

A

Top-line growth, governance engineering, and financial engineering.
Top-line growth and governance engineering.

26
Q

What two combinations of VCPs earnedbelow average benchmark-relative returns?

A

Operational improvements, top-line growth, governance engineering, and financial engineering.
Operational improvements and governance engineering.

27
Q

VCPs:

The common themes that earned above average returns were combining ____________. Below average returns often (but not always) resulted from combining (1) or (2) with other VCPs or by (3).

A

Combining top-line growth and governance engineering.

  1. cash management
  2. operational improvements
  3. focusing on more than three VCPs at the same time
28
Q

What four company-level items can be targeted to have the best long-run return effects?
1. e
2. s
3. e
4. ci

A
  1. employment - as total number of full-time employees increases, long-run returns respond favourably
  2. sales - increasing revenue from operations
  3. EBITDA - measure of the firm’s profitability relative to operating expenses. This is sometimes seen as a proxy for cash flow
  4. capital intensity - defined as the ratio of fixed assets to employment. The idea is to increase the productivity of firm assets
29
Q
A