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Why do Private Equity make better returns?

Private Equity’s ability to achieve far higher returns than other private businesses is typically attributed to a number of factors: high-powered incentives both for private equity portfolio managers and for the operating managers of businesses in the portfolio; the aggressive use of debt; a determined focus on cash flow and margin improvement; freedom from restrictive public company regulations; but most importantly a laser focus on a period of time to quickly make the improvements and then sell the business.


Incentives

  • The PE investor and Senior management teams have perfectly aligned interests. They know with absolute certainty that the business will (normally) be put up for sale in 3 to 5 years and are handsomely incentivized through equity to achieve the best returns possible

  • In contrast other private businesses are run for long term interests  and may include an ‘agency risk’ where management are not fully  aligned with shareholders interests

Growth

  • The business must grow but not just any old growth. In fact, one of the first steps is to remove underperformance and refocus on value enhancing products and services while ‘cutting the tail’ of low  performance

  • Growth is also important for ‘multiple arbitrage’ meaning achieving a higher sales multiple than on entry.  A higher quality pipeline at Exit compared with entry will support this.

Margins

  • The number one focus is to grow EBITDA margins as this is the primary driver of value

  • Doing more of the most profitable type of business and getting rid of low value business is important

  • Like wise reconfiguring the supply chain, the cost of goods sold and overheads to improve operational efficiency are critical

Cash

  • Managing cash in a far more efficient way and where possible making early returns to investors by way of dividend is a focus

  • To do this requires improvements to working capital and more intelligent use of capex

  • Reducing Inventory and debtors days, while (reasonably!) increasing creditors days  should be a priority

  • A laser focus on reducing expensive borrowings and facilities is also in focus


While there is nothing proprietary or unique about the way Private Equity super charges its returns, the key is a clear plan and fastidious execution in a set period of time accompanied by alignment of all interests to achieve a successful Exit.


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