Navigating
Private Equity
Value Creation Primer
Private Equity’s Sustainable
Value Creation
Since the private equity heyday of the 1980s, when financial
engineering ruled the playbook for this novel type of investing,
a lot has changed.
This white paper outlines this shift and explains the way the industry developed, diving into the
intricacies of private equity value creation. Our thesis is simple, that there is a fundamental difference
between strategies that directly alter the operating dynamics of portfolio companies and other
types of value creation, such as leverage and multiple expansion. The difference lies in the fact that
successful operational value creation drives persistent returns.
We present private equity’s value creation strategies in four
sections:
1 What Makes Private Equity Unique?
2 Private Equity Focusing on the Fundamentals
3 Persistence in Value Creation
4 Case Study: Phadia
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1
What Makes Private Equity
Unique?
Private equity is a unique asset class, often distinguished from
public equities due to the asset’s illiquidity. This illiquidity has a
clear rationale and direct consequences.
A fund lifetime of 10 years allows private equity managers to maintain a multi-year horizon for their
investment thesis to play out. In turn, private equity managers’ control position and active ownership of
underlying companies materialize over an extended timeline, allowing better alignment interest between
shareholders and management.
How do private equity funds create the value increase identified in their investment theses and how are
they often able to outperform public markets?1 In general, sources of value creation can be divided into
three categories:
1. Operational Improvements
Successful private equity managers often apply their deep industry and functional expertise to
make substantive operational changes and improve a company’s efficiency and bottom line. Such
improvements translate into value creation via revenue growth and margin growth, thereby driving
increases in EBITDA. Some of the most important operational adjustments a GP can make to improve
organic revenue growth are optimizing the supply chain, implementing more effective pricing, revamping
marketing strategies, and driving international as well as digital expansion, among others.
1. Operational Improvements
Enterprise Value
Financial Value
EBITDA
2. Multiple Expansion
There are two main ways in which private equity managers can create value through multiple
expansion. First, managers may attempt to increase the valuation multiples of their underlying assets
through strategic re-positioning. This includes growing synergies and market share through mergers &
acquisitions as well as increasing efficiencies and management focus through carve-outs and spin-offs.
In addition, managers can drive multiple expansion via market timing. This strategy depends on the
regions and sectors in which the manager chooses to deploy capital and the timing chosen for exiting
the underlying deals. This type of value creation leads to gains via improved valuation through growing
the EV/EBITDA multiple at which the underlying asset is valued.
2. Multiple Expansion
Enterprise Value
Valuation Multiple
EBITDA
3. Leverage Effect
The use of leverage is a third method for creating value within portfolio companies. By financing a
proportion of the acquisition through debt, a generally less expensive source of capital, fund managers
enhance the return on equity for investors. In successful deals, and as management de-leverages the
company over time, the equity value owned by the fund grows in proportion.
3. Leverage Effect
Return on Financial Return on
× Equity
Assets Leverage
1 As of Cambridge Associates’ Q3 2019 index figures, the Private Equity Index has outperformed the S&P 500 by 5.9%. Please refer
to the Cambridge Associates report for further info on the calculation methodology.
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A hypothetical value bridge of a private equity fund is shown in Figure 1, whereby the 2.5x Gross Multiple
of Invested Capital (MOIC) realised through the life of the fund is attributed to the three categories. The
graph shows that from the invested capital, a gain of 0.9x is attributed to EBITDA growth, a gain of 0.3x
to leverage, and a gain of 0.3x to multiple expansion.
Figure 1: Indicative Value Creation Bridge
Operational 0.3x 2.5x
2.5x Improvements
0.3x
0.4x
2.0x
0.5x
1.5x
1.0x
1.0x
0.5x
0.0x
Invested Revenue Margin Leverage Multiple Gross Equity
Cost Growth Expansion Expansion
Note: Illustrative numbers
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2
Private Equity Focusing on the
Fundamentals
In the wake of strong competition and rising valuation multiples,
successful fund managers have differentiated themselves by
focusing on operational value creation, as a more persistent and
replicable way of creating value within their portfolio companies.
Research carried out by BCG and IESE sheds light on these shifting priorities, indicating the change
in value attributed to leverage, multiple expansion, and operational improvements (see Figure 2). Since
the 1980s, when leverage contributed over half of the value creation, there has been an evident trend
towards operational improvements – despite a strong availability of debt as well as a low interest rate
environment.
Not only have private equity fund managers shifted their attention to operational value creation,
their capacity to take active ownership and leverage their informational advantage has also resulted
in consistently higher revenue growth compared to broad market trends in both North America and
Western Europe (see Figure 3). One hypothesis is that this is why private equity has outperformed public
markets across most time horizons and why, in our opinion, it is likely to continue to do so.
Figure 2: Private Equity has Shifted Away from Leverage As Share of Value Creation
Source of Value (%)
2.5x
25% 17% Leverage
2.0x 32%
51%
27% Multiple Expansion
1.5x
39%
46% Operational Improvements
1.0x
31%
54%
0.5x 36%
18% 22%
0.0x
Leverage era Multiple Earnings Operational
(1980s) expansion growth era improvement
era (1990s) (2000s) era (2010s)
Sources: Goldman Sachs; BCG-IESE estimate
Figure 3: Revenue growth of PE-owned companies compared with underlying market growth
North America Western Europe
2000-06 2% 2% 2000-06 2% 5%
2007-11 0% 11% 2007-11 0% 8%
2012-14 3% 11% 2012-14 0% 13%
Market PE-Owned
Source: CEPRES, IHS, Bain analysis
We can see the shift to operational value creation and top-line growth over the past decades. A natural
question is whether the development is a strategic evolution of the industry or if the development is
less well-founded. Both leverage and multiple expansion prove to be skills that are heavily dependent
on the ability to time the market, a skill that has been proven to be extremely difficult and unreliable.
On the other hand, the skill required to improve a company’s bottom line is operational in nature and
qualitatively different.
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3
Persistence in Value Creation
Whilst the persistence of performance in private equity funds is
a highly debated topic, research has shown that only operational
improvement is a replicable source of value creation as compared
to the other performance components.
“Only operational improvement is a
replicable source of value creation”
One such study, conducted by Dr. Gottschalg of HEC Paris, explored the different performance
components’ impact on persistent value creation amongst 1,119 private equity funds. The study
proposed a novel methodology to measure a private equity fund’s performance, by comparing data on
tens of thousands of underlying investments and controlling for three different factors: the time period
in which the funds were raised; the timing of the investment deals based on acquisition years; and the
sector, size and geographic location of the underlying target companies.
Controlling for fund vintage, the other two factors enable the evaluation of peer funds across two of the
most important investment decisions of a private equity firm: the When, i.e. how is capital deployed over
the investment period of the fund; and the What, i.e. what type of investment targets were acquired.
These two factors comprise what we call the strategic positioning of the fund.
Gottschalg’s study, therefore, assumed that the difference in performance between funds with similar
Whens and Whats must be attributable to the How, i.e. the operational improvements implemented by
a fund manager which enable the fund to differentiate itself from its peers and hopefully outperform.
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Gottschalg found that fund managers differ most in their ability to create value during the “implementation
phase”, which refers to the phase in which operational improvements are affected at the company level.
The research concluded that a statistically significant positive performance persistence occurred only
in the implementation-related performance component. Conversely, after controlling for other factors,
timing and strategy had no significant or even positive level of persistence.
2.03x The impact of this factor is profound; had an investor picked 25 of the 257 fund pairs studied using
only those whose previous fund iteration had the highest “implementation-based” returns, the portfolio
would have yielded a total value to paid-in (TVPI) multiple of 2.03x, which is significantly higher than
the sample average TVPI of 1.73x. Given the large returns dispersion between median and top quartile
net portfolio return if an investor funds - which on average since 2000 (based on Cambridge Associates’ Q3 2019 index figures) have
would have picked 25 of the amount to a larger than 7% IRR difference - even small improvements in fund selection can have a
257 funds studied by Gottschalg notable impact on a portfolio’s expected risk-return profile. In other words, managers that have proven
using only those with the highest they can roll up their sleeves will be in position to separate their funds from the rest of the pack.
previous “implementation-based”
returns Figure 5: Improved fund selection based on operational value creation
TVPI performance
1.73x 2.03x
Average sample of The average subsequent fund of the 25
257 fund pairs funds with the best operational value
creation
Source: Gottschalg, 2016
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4
Phadia Case Study
Based in Sweden, Phadia is a leading in-vitro allergy diagnostics
and autoimmunity diagnostics business. Private equity firm Cinven
acquired the company in 2007 with a strategy to assist Phadia in
growing its core business in order to reach its full strategic and
operational potential.
Under Cinven’s ownership, Phadia transformed into a global leader in the healthcare sector by the time
the company was acquired by Thermo Fisher in 2011. Cinven accomplished this through a programme
of investments in people, geographic expansion and products.
— The roll out of Phadia’s full product suite and revamped marketing campaigns in the U.S. was
accompanied by an expansion and optimization of the U.S. sales force from 40 outsourced
representatives at acquisition to nearly 200 representatives at exit. As a result, U.S. sales grew at
a 23% CAGR since 2007-2011.
— Cinven’s Asia team developed a number of initiatives, including the acquisition of Phadia’s main
distributor in China and a roll out of products in India.
— In 2011, Cinven’s investment into product development led to the release of two new allergy and
autoimmunity testing instruments. Capable of combining allergy and autoimmunity testing, these
new allergology technologies delivered a throughput 4 to 5 times higher than any other combined
instrument at the time. This was one of the many ways Cinven aided Phadia in meeting high volume
clinical laboratories demand with shorter lead times and higher efficiency.
These initiatives successfully translated to building Phadia into a lucrative business and attractive target.
During Cinven’s ownership, EBITDA increased by over 50% from €96m to €146m, despite operating
in a recession. In a strategic move by a leading biotech product development company, Thermo Fisher
acquired Phadia in 2011 - a testament to the significant value Cinven had helped create. The €2.47bn
sale of the company resulted in a €1bn capital gain and 3.4x return for investors. Value created: check.
Figure 6: Phadia’s revenue and EBITDA growth during Cinven’s ownership
CAGR = 12%
360
320
290
260
CAGR = 14%
146
135
120
96
2007 2008 2009 2010
Revenue (€m) EBITDA (€m)
Source: Invest Europe: Phadia Case Study
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References
Bain & Company, Global Private Equity Report 2016.
BCG, 2008. The Advantage of Persistence; How the Best Private-Equity Firms “Beat the Fade”.
Cambridge Associates, Private Equity: Index and Selected Benchmark Statistics, Q3 2019.
“Cinven to Sell Phadia to Thermo Fisher for €2.47 Billion.” Cinven, 19 May 2011,
www.cinven.com/media/news/110519-cinven-to-sell-phadia-to-thermo-fisher-for-247-billion/.
HEC Paris, 2016, Beyond the Quartiles… Understanding the “How” of Private Equity Value
Creation to Spot Likely Future Outperformers.
Invest Europe, “Phadia Case Study”. Invest Europe, www.investeurope.eu/about-private-equity/
private-equity-in-action/case-studies/phadia/.
About Us
Moonfare is a private equity and alternatives investment platform focused on providing qualified
professional investors access to top-tier funds. Whilst these asset classes have traditionally only been
within reach of institutional investors, Moonfare’s deep private equity experience and due diligence
process, coupled with platform driven onboarding and subscription, enables qualified professional
investors to access funds with the potential for significant returns. Headquartered in Berlin, it currently
accepts investors in the UK, Germany, Luxembourg, Switzerland, and Hong Kong.
Private Equity Insights is a dedicated Private Equity platform operating across Europe, the United
States and South-East Asia. We are a network of investor, fund managers and advisors of more than
150,000. At our distinguished, regionally focused events, we gather top tier firms in private equity for
a day of enriching panel discussions, inspiring keynotes, and highly valuable networking opportunities.
We now organize 12 conferences per year in New York City, Germany, France, Benelux, Poland &
CEE, DACH, Switzerland, Iberia, Italy, UK, the Nordics, and South-East Asia.
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Magnus Grufman
Head of Investments
Tony Cotzias
Supply Analyst
Disclaimer
Moonfare is a technology platform that enables individuals and their advisors to invest in top-tier
private equity funds. Moonfare does not make investment recommendations and no communication,
in this publication or in any other medium should be construed as a recommendation for any
security offered on or off its investment platform. Alternative investments in private placements, and
private equity investments via feeder funds in particular, are speculative and involve a high degree
of risk and those investors who cannot afford to lose their entire investment should not invest. The
value of an investment may go down as well as up and investors may not get back their money
originally invested. An investment in a fund or investment vehicle is not the same as a deposit with
a banking institution. Please refer to the respective fund documentation for details about potential
risks, charges and expenses. Investments in private equity are highly illiquid and those investors who
cannot hold an investment for the long term (at least 10 years) should not invest. Past performance
information contained in this document is not an indication of future performance. Actual events
and circumstances are difficult or impossible to predict and will differ from assumptions. Forward-
Looking Information must not be construed as an indication of future results and are included
for discussion purposes only. Forward-Looking Information is calculated based on a number of
subjective assumptions and estimates dependent on the type of investment concerned. There can
be no assurance that private equity will achieve comparable results or be able to avoid losses. The
performance of each private equity investment may vary substantially over time and may not achieve
its target returns.
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