Do PE Firms Manage Portfolio Firms, or Just Manipulate Balance Sheets?

PE firms often are described as nothing more than financial engineers - according to their detractors, they buy firm, load them up with debt, pay out recapitalization dividends, and leave lifeless, over levered shells.

Or do they?

A couple of reports by accounting firm Ernst & Young over the last two years give some indications otherwise. According to a summary of last year's report published in the Wall Street Journal's Deal Journal:
Ernst & Young found that the average enterprise value of the companies studied in both Europe and U.S. jumped more than 80% from the time they were acquired. The growth in enterprise value was driven in part by the fact that private-equity-owned companies achieved faster profit growth, two-thirds of which came from business expansion — while a third in Europe — and 23% came from cost reductions.

What does that mean for jobs? The study found that employment was at the same or higher level at the time of exit in 80% of U.S. buyouts and 60% of European buyouts. In the United Kingdom, France and Germany, where fears that the industry will slash jobs has spurred strong opposition and scathing criticism, employment at businesses owned by private-equity firms rose 5% annually. That compares to 3% for equivalent publicly traded companies.

And, in a summary of this year's E&Y report (again in Deal Journal):
...companies being sold off by private-equity firms increased in enterprise value at an annual compound rate of 24% during the time they were in a PE firm’s portfolio, double the rate of comparable publicly traded companies. Buyout firms also increased the earnings before interest, taxes, depreciation and amortization of these portfolio companies 33% faster than their publicly traded counterparts did. Finally, these companies had productivity levels 33% higher than publicly traded company benchmarks.

The out performance wasn’t confined to a specific geographic region or particular industry. Private-equity-owned businesses outperformed their publicly traded counterparts in almost every sector and market as well.

I'd take the result with at least a little grain of salt, though. One reason is that the report was done on "successful" PE deals - those companies taken private that were eventually brought public again in a subsequent IPO. These are likely to be the ones with the biggest increases in market value, and the ones that had the best overall performance (unsuccessful portfolio companies don't get taken back public down the road). So, the results most likely overstate the performance of LBO firms.

Second, there's a big agency problem inherent with the report. E&Y did this report for the PE industry. Since they get a significant amount of fees from doing transactions advisory work (due diligence, forensic accounting, etc...), they have a vested interest in keeping their client companies (i.e. the PE firms) happy. So, there are some biases that could be present in the report (What, the accounting firm could be biased, I'm shocked. Shocked, I say!).

Read Deal Journal's article on last year's report here and on this year's report here.

So what does this mean? That in at least SOME cases, PE firms create value by making substantive operational changes that increase the quality of the portfolio company's business. In other words, they're not "just" restructuring the right hand side of the balance sheet.

Looks like another piece for class...