Value Creation in Private Equity in Emerging Markets

This dissertation provides new evidence on the black box of value creation through private equity (PE) investments in private small and medium-sized companies operating in emerging markets. Specifically, this dissertation addresses the following key research questions: How do PE firms create value? How does a value creation plan (VCP) look like? Is there a typical VCP containing certain elements or do PE firms tailor their VCPs to individual portfolio companies’ needs and circumstances? Do portfolio companies improve while being under PE ownership? If so, do these improvements reflect the plans and actions of the PE firm? Do company-level changes persist beyond the PE firm’s ownership? Do PE firms and other stakeholders benefit too? If so, how? How are PE returns affected if a VCP is not achieved? Do certain VCPs lead to higher returns? The answers to these questions can shed light on the actual underlying sources of value creation through PE and have profound implications for assessing the overall impact PE has on economic welfare. The analyses and results in this dissertation are based on a unique dataset comprising 1,580 deals by 178 PE funds over a 25-year period and in 20 transition economies in Central and Eastern Europe, Central Asia, North Africa and the Middle East. Data come from one of the largest investors in PE funds covering these regions and constitute confidential summaries of soft and hard information PE firms collect on their portfolio companies and the conclusions they draw from them. Soft information comprise hand-collected data from pre-deal investment committee papers on a PE firm’s intended strategy to create value. Soft information also constitute self-reported comments on how well a PE firm does during the implementation of their VCP. Soft information are complemented with hard information on portfolio companies’ annual balance sheets and income statements. Those data are used to calculate changes in company-level outcomes and create matched control companies. Hard information also comprise confidential and precisely dated cash flows between PE funds and their portfolio companies, and thus allow calculating returns. The first main chapter of this dissertation is of descriptive nature and provides new evidence on how VCPs look like across over 1,000 PE deals. To this end, individual VCPs are hand-collected from confidential pre-deal investment committee papers and systematized into 23 different elements, which can be grouped into five strategies: Financial engineering, operational engineering, cash management, revenue growth, and corporate governance. By quantifying textual information, this dissertation contributes to the literature on value creation based on evidence collected from surveys and qualitative studies and sidesteps potential issues related to these methodologies. Tabulation of the data shows that PE firms follow a rich variety of plans to add value to their portfolio companies. In each deal a PE firm sets out to achieve 2.5 strategies and 4.5 elements on average. The three most popular VCP elements are buying or upgrading fixed assets, changing the mix of products or services, and pursuing inorganic growth through acquisitions. Which VCP a PE firm plans to implement depends on the type of the deal, the PE firm’s percentage ownership, and whether the PE firm plans to grow the portfolio company inorganically through acquisitions or replace its management. PE firms in the sample self-report achieving most of their VCPs. However, some VCP elements appear easier to achieve than others. For instance, PE firms managed to sell existing assets or replace the CFO in 95% of the deals in the sample in which these elements were part of the VCP. But they were able to increase market share, improve corporate governance, pursue international expansion or grow inorganically in less than 75% of the deals. PE firms also actively monitor their investments and introduce new VCP elements to create additional value or turn around deals that are not performing according to their initial plan. New VCP elements introduced post-investment differ from the pre-investment VCP elements, and include among others cutting costs, optimizing the capital structure, and replacing the CEO. The second main chapter discusses the real effects of receiving PE funding by considering a broad range of company-level economic outcomes and analyzing the changes in these measures during and after the PE firm’s ownership and relative to a group of matched control companies. Using detailed annual data on companies’ financial statements and employment, this dissertation adds to the growing evidence on the operational implications of receiving PE funding and by providing new evidence on key outcomes such as total factor productivity and market power. Results of the difference in differences regressions confirm prior findings in the literature on portfolio companies established in developed markets and generalize these findings to portfolio companies established in emerging markets. PE-backed companies in the sample observe an increase in their use of debt and a reduction in their effective tax rate. They see substantial improvements in their operations: Employment, average wages, productivity, and capital intensity increase over and above contemporaneous changes at matched control companies. PE-backed companies also develop improved methods of cash management, as their working capital needs decrease. During the time a company spends in a PE fund’s portfolio, its revenues and profitability increase substantially, while price-cost markups fall. These results suggest that cost reductions achieved through operational improvements are passed on to consumers via lower prices. Unlike previous studies, this dissertation provides new evidence on whether operational changes persist beyond the PE ownership period. Results suggest that a PE investment has long-lasting (and positive) effects on portfolio companies. Findings support Kaplan and Strömberg’s (2009) early conjecture that PE “has a substantial permanent component”. The third main chapter establishes the links between PE firms’ VCPs and their achievement, changes in company-level economic outcomes, and financial success of a PE deal (as measured by PE returns between a PE firm and its portfolio company). Thereby, this dissertation provides new evidence on the conditions under which PE creates value and the level of risk and return such efforts entail. To this end, PE firms’ self-reported achievements are examined by relating VCPs to changes in company-level economic outcomes. Using a sample of matched control companies, results suggest that during a PE firm’s ownership, portfolio companies experience the kinds of changes that reflect the successful implementation of a VCP. PE firms planning to introduce a value creation strategy and not achieving it see a lower or decreasing effect in their company-level outcomes compared to PE firms planning to introduce and achieving a related value creation strategy. As a next step, this dissertation documents whether certain VCP elements or strategies are associated with higher PE returns. Results suggest that the successful implementation of a VCP is a key driver of PE returns. Conclusions are drawn from two complementary analyses: Least absolute shrinkage and selection operator (LASSO) - a popular machine learning algorithm - and traditional ordinary least squares (OLS). Results of the LASSO regressions indicate that no single value creation strategy emerges on its own as the best predictor for eventual success or failure. Instead what matters more is how certain strategies are combined. Results of the OLS regressions confirm that the successful implementation of VCP elements is a strong predictor of PE returns. Neither the number of VCP elements nor the number of new VCP elements introduced post-investment correlate significantly with PE returns. In the very last part, this dissertation investigates whether the changes a portfolio company experiences under PE ownership can help predict PE returns. This analysis reveals that PE firms earn higher returns the more a portfolio company increases its employment, capital intensity, sales, and earnings before interest, taxes, depreciation, and amortization (EBITDA) during the holding period. Sales growth has the highest explanatory power amongst all outcome variables to explain the variation in PE returns. When benchmarked to observably similar matched control companies, this effect vanishes. However, an increase in EBITDA above and above contemporaneous changes at the control companies remains a strong predictor of PE returns.