3.3 Creating value in portfolio companies

Buying a company is only the start. Over a holding period of several years, a private equity owner tries to make the business more valuable than when it bought it. How it does that, and how much of the final gain came from real improvements rather than debt or market conditions, is one of the most important questions investors ask.

If you work in investor relations or on the LP side, you will see these ideas in quarterly letters and fundraising materials, often as a chart called a "value creation bridge." If you work in fund accounting or valuation, the same drivers explain why a portfolio company's value moves from quarter to quarter. This lesson continues the illustrative example of Ashcombe Capital Fund I and Northfield Components.

The drivers of value

Lesson 3.2 showed that a buyout's equity value depends on three things:

Equity value = EBITDA × multiple − debt

So there are three broad ways to make the equity worth more:

EBITDA (earnings before interest, taxes, depreciation and amortization) is a rough measure of cash profit. The multiple is the price divided by EBITDA.

Operational levers

Most of the owner's effort goes into growing EBITDA. The main levers are:

• Revenue growth. Selling more to existing customers, winning new ones, launching products, or entering new regions. For Northfield, that might mean selling its parts to a new industry or opening a sales office abroad.
• Pricing. Many companies under-price, or have never reviewed prices in a structured way. A careful review can raise revenue with little extra cost, though it risks losing customers if pushed too far.
• Margin improvement. Raising the share of revenue kept as profit: better purchasing, more efficient factories, simpler processes, or new systems. Cost cutting is part of this, but it has limits: cutting too deep can damage the business.
• Cash management. Collecting from customers faster and holding less stock frees up cash, which can repay debt or fund growth. This is often called improving working capital.
• Add-on acquisitions. Buying smaller companies and combining them with the original one, called the platform. This strategy is known as buy-and-build. It can add revenue, customers and capabilities quickly, and the combined business may earn more than the parts did alone. Smaller companies can sometimes be bought at lower multiples than the platform is worth, which adds value when they become part of it. This is sometimes called multiple arbitrage. But integration is hard, and acquisitions paid for with more debt add risk. Lenders often provide a delayed-draw facility for this purpose (see PC101 2.1).

At Northfield, Ashcombe's plan was built around a few of these levers. Management would sell its existing parts to customers in a neighbouring industry, review prices product by product for the first time, and invest in one factory to cut waste and overtime. The plan was deliberately modest on acquisitions, so that cash could go towards repaying the loan. Over five years, those steps helped lift EBITDA from $20m to $26m.

Many firms write these levers into a value creation plan agreed with management soon after closing, sometimes as a "100-day plan" covering the first priorities. Some firms have operating partners or in-house specialists, experienced executives who help companies with areas such as pricing, purchasing, digital and hiring.

Governance: the board and management incentives

Private equity owners work through the company's board of directors, not by running the business day to day. As the controlling owner, the fund appoints most of the board. A typical board might include members of the deal team, an operating partner, one or more independent directors with industry experience, and the chief executive.

The board approves the budget and the value creation plan, monitors results closely, often monthly, approves major decisions such as acquisitions and new debt, and hires, or replaces, the senior managers. Because the owner has control and full information, it can act faster than a typical shareholder in a listed company. Replacing the chief executive or finance director is not unusual when the plan calls for different skills.

Good governance depends on good information. Portfolio companies commonly send the owner monthly management accounts and a set of key performance indicators (KPIs), such as orders, prices, margins and cash, tracked against the plan. The same information feeds the fund's quarterly valuation of each company (lesson 4.3), so the reporting set up by the deal team matters to fund accounting and investor relations teams too.

Management incentives are the other half of governance. A portfolio company's management team commonly receives an equity stake or an option pool, and senior managers are often asked to invest some of their own money alongside the fund. The details vary by deal, but most of the value usually comes when the company is sold, and only if equity value has grown. The aim is alignment: managers do well when the fund's investors do well, and they think like owners about cash, debt and the eventual sale.

The value creation bridge

A value creation bridge splits a deal's gain into the drivers that produced it. Here is Northfield, using the numbers from lesson 3.2. As before, this is illustrative, in $m, and ignores fees, taxes and interest.

• Entry: EBITDA $20m × 10.0x = $200m enterprise value, with $100m of debt and $100m of equity.
• Exit, five years later: EBITDA $26m × 10.0x = $260m, with $60m of debt left. Equity = $200m.
• Gain: $200m − $100m = $100m.

The bridge values EBITDA growth at the entry multiple and applies any change in multiple to exit EBITDA:

The bridge tells a clear story: 60% of Northfield's gain came from growing the business, and 40% from using its cash to repay debt. None came from the market paying a higher price.

Now suppose Ashcombe had sold at 11.0x instead. The enterprise value would be 11.0 × $26m = $286m, equity $286m − $60m = $226m, and the gain $126m.

A bar can also be negative. Had Northfield sold at 9.0x, the enterprise value would be $234m and equity $174m, a gain of $74m: $60m from EBITDA growth, minus $26m of multiple contraction ((9.0x − 10.0x) × $26m), plus $40m of debt paydown. Good operational work can be partly undone by a weaker market.

Back in the 11.0x case, the extra $26m looks just as good in the fund's returns, but it is the least controllable driver. Exit multiples depend on interest rates, investor appetite and how many buyers want the company when it is sold. They can just as easily fall, as the downside case in lesson 3.2 showed. An experienced LP will ask how much of a manager's track record came from multiple expansion, because gains driven by rising markets are harder to repeat than gains from improving businesses.

Bridges are simplified. Firms split the drivers in slightly different ways, EBITDA growth is often broken down further into revenue and margin, and fees, interest and add-on acquisitions all complicate the picture. So when comparing bridges from different managers, check how each one was built.

Key terms

• Value creation: increasing a company's equity value during ownership.
• EBITDA growth: an increase in a company's earnings, from higher revenue, better margins or acquisitions.
• Multiple expansion: selling at a higher EBITDA multiple than was paid.
• Debt paydown: using cash flow to repay debt, increasing the owners' share of enterprise value.
• Working capital: the cash tied up in day-to-day operations, such as stock and money owed by customers.
• Buy-and-build: growing a platform company by buying and integrating smaller add-on companies.
• Platform company: the first company bought in a buy-and-build strategy.
• Value creation plan: the owner's and management's agreed plan for improving the business.
• Key performance indicators (KPIs): the measures an owner tracks to judge progress against the plan.
• Management incentives: equity stakes or options that reward managers when equity value grows.
• Value creation bridge: a breakdown of a deal's gain into its drivers.

Key takeaways

• Equity value = EBITDA × multiple − debt, so value comes from EBITDA growth, debt paydown and multiple expansion.
• Owners grow EBITDA through revenue growth, pricing, margin improvement and add-on acquisitions.
• The board and management equity incentives are how owners drive the plan and align managers with investors.
• In the illustrative Northfield bridge, the $100m gain came from $60m of EBITDA growth and $40m of debt paydown.
• Multiple expansion depends on markets and is the least controllable driver, so investors look closely at how much of a return it explains.