Building value in Europe - Ernst & Young - United States

Building value in Europe

The study has reviewed and analyzed nearly 300 of the largest European PE exits in the four calendar years from January 2005 to December 2008. Compared to similar public companies over the same time frames, PE-owned and exited portfolio businesses achieved greater increases in value, through such means as organic growth, cost reduction, operational improvement, business model change, acquisitions and better cash management.

Growth measures. Across Europe, profits of large PE-owned enterprises grew, on average, 15% per annum from acquisition to realization. The employment picture improved as well: the study found the average company increased its employment of around 5,000 at acquisition by 5% per annum. Productivity also grew by a 9% CAGR. Finally, the average valuation multiple — the ratio of business enterprise value to profits — grew by two turns compared to one-half a turn for their public counterparts.

Strategies. The study indicates that PE acquires with one of three investment objectives or strategies in mind:

• Focus on improving the core business
• Grow the company organically
• Grow via acquisition

Of the exits examined in the study, 38% were purchased with the objective of improving the core business, and 36% were acquired with a focus on organic growth. The remaining 26% were bought with plans to build through acquisition. The drivers of value creation vary by investment strategy.

Businesses where PE owners intended to “improve the core” experienced slower profit and employment growth, but the largest increase in valuation multiple as their future prospects improved. Some 50% of their profitability growth came from operational efficiency improvements, and 40% from initiatives focused on enhancing revenue growth. Businesses in this category, many of them corporate spinoffs, were often turnarounds and had the longest hold periods and slowest profit and employment growth in the sample.

As for businesses acquired with an organic growth strategy, these experienced consistent and strong expansion across key indicators: profits, employment and productivity. These businesses were often acquired from private sellers who had demonstrated a track record of growth prior to sale.

The “buy and build” investments grew profits and employment the most, 21% and 15% per annum respectively over the average 3½ year hold time — as much of the growth was acquired. However, productivity growth, while positive, was slowest, and this group saw the smallest increase in valuation multiple.

Regardless of PE’s initial investment objectives, organic growth initiatives were the most powerful driver of profitability increases for the largest portfolio companies. Initiatives such as improved selling, geographical expansion and introduction of new products and services explained 40% of the growth in profits.

A cautionary trend. Market weakness drove a steep decline in PE exits in 2008 — a 66% drop-off from 2007. PE exits by IPO, which have typically accounted for 10–15% of exits, literally disappeared in Europe during 2008. This downward trend is expected to continue through 2009.

Given the high returns that PE exits achieved in 2008 (consistent with 2005–07), it is clear that PE firms sold off strong businesses in the face of market turbulence. But fewer exits mean greater pressures on PE as investments linger in the portfolio beyond their appointed time and investors demand returns.

In reality, the PE sector will have to accelerate exits of existing investments or create strong cash flows to reduce its debt levels. The Ernst & Young study shows that the industry has succeeded in creating value in the largest businesses it has owned. Continuing to implement performance improvement initiatives effectively and continuing to innovate will be the key to PE’s success in the challenging times ahead.

John Harley •Ernst & Young LLP (UK) •London
Transaction Advisory Services

Harry Nicholson •Ernst & Young LLP (UK) •London
Transaction Advisory Services