The Relationship Between Private Equity Returns, Duration and Firm Size & Skill

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What is the relationship between private equity

transaction return, duration and firm size/skill?

What are its implications for the current
understanding of the nature of private equity?

HEMAL THAKER
ST EDMUND HALL

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ABSTRACT
This paper investigates the relationship between private equity transaction returns, durations,
firm motivations and firm size/skill to suggest that the existing conclusion to the debate on
the nature of private equity - the heterogeneous view - is limited, shallow and incomplete.
The paper argues that a private equity firms skill is the most important factor that
determines its success and suggests that private equitys nature is one of short-term shock
therapy; but that the majority of private equity transactions are prevented from embodying
this state to the limitations of their sponsoring private equity firms skill in achieving high
transaction returns and short transaction durations.
A three-pronged approach is taken to provide evidence for this theory: examining secondary
literature on the private equity industry and corporate governance to develop the context of
the research question; analysing empirical evidence on a global database of 11,704 private
equity transactions from 1969-2012 to investigate it; and analysing case-study evidence to
provide supplementary information on specific aspects of the study. Practical
recommendations for the Oxford Private Equity Institute, private equity firms and
corporations are proposed along with further research possibilities.

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ACKNOWLEDGEMENTS
I would like to thank my supervisor, Dr. Ludovic Phalippou for his advice and feedback
throughout my project at the Oxford Private Equity Institute, Said Business School.
I would also like to thank the anonymous limited partners who provided the Institute with
their private placement memoranda, without which the empirical research within this study
would not have been possible.
This paper does not necessarily reflect the views of the Institute.

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TABLE OF CONTENTS
1. INTRODUCTION ..................................................................................................................................... 5
1.1 Aim and stakeholders of the research ......................................................................................................... 5
1.2 Structure of the report and research question ............................................................................................. 6
2. PRIVATE EQUITY LITERATURE REVIEW ........................................................................................ 9
2.1 Introduction to private equity ...................................................................................................................... 9
2.2 Current debate on the nature of private equity ......................................................................................... 16
2.3 Private equity firm motivations and shock therapy ................................................................................ 17
2.4 Sources of return in PE and the misalignment of interests between PE firms and portfolio companies ... 20
2.5 The unknown limiting factor: PE motivations, the misalignment of interests and shock therapy ........ 44
2.6 Firm skill as the limiting factor to private equity shock therapy ......................................................... 45
3. RESEARCH QUESTION........................................................................................................................ 47
3.1 Research question and hypothesis ............................................................................................................. 47
3.2 Existing research surrounding the research question ............................................................................... 49
4. RESEARCH METHODS ........................................................................................................................ 52
4.1 Definitions ................................................................................................................................................. 52
4.2 Data ........................................................................................................................................................... 53
4.3 Methods for investigating a return and duration relationship .................................................................. 54
4.4 Methods for investigating the role of firm size/skill in a return/duration relationship ............................. 55
4.5 Methods for investigating the characteristics of high return transactions and shock therapy ............... 57
5. RESULTS AND ANALYSIS ................................................................................................................... 60
5.1 Relationship between return and duration ................................................................................................ 60
5.2 Role of firm size/skill in the return/duration relationship ......................................................................... 61
5.3 Characteristics of high return transactions and shock therapy .............................................................. 64
5.4 Conjecture ................................................................................................................................................. 71
5.5 Implications of conjecture and practical recommendations ..................................................................... 72
6. LIMITATIONS AND FURTHER RESEARCH ..................................................................................... 74
6.1 Checking the return/duration relationship and the limitations of IRR ...................................................... 74
6.2 Case-study codification limitations ........................................................................................................... 76
7. CONCLUSION ........................................................................................................................................ 80
8. REFERENCES ........................................................................................................................................ 84
A. APPENDICES ........................................................................................................................................ 88
A.1 Checking negative return/duration relationship for money multiples ...................................................... 88
A.2 Testing the representativeness of Sample C with respect to Sample B ..................................................... 90
A.3 Case-study codification results ................................................................................................................. 92

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1. INTRODUCTION
1.1 Aim and stakeholders of the research
This study was written at the Oxford Private Equity Institute of the Said Business School.
The objective of the Institute is to be the leading academic institution in the field of private
equity
1
. Given the academic nature of the organisation, this paper aims to contribute to the
research conducted by the Institute in its mission to expand the knowledge pool on the private
equity industry.
Over the last 30 years the private equity industry has grown into a trillion dollar industry with
some of the worlds largest and best-known companies such as EMI Music, Tommy Hilfiger,
Burger King, and Hilton Hotels passing through private equity ownership. A debate has
ensued on the nature of private equity and whether it is a superior organisational form to that
of the public corporation or a short-term form of shock therapy, designed to allow
inefficient, badly performing companies with inferior corporate governance to enter quick
and intense periods of corporate restructuring prior to retuning to public ownership. The
current conclusion to this debate simultaneously favours and disfavours both and neither of
these views using evidence based on an analysis of private equity transaction durations.
Through an examination of secondary literature, empirical research on a proprietary global
database of 11,704 private equity transactions and case-study analysis, this study aims to
suggest that the existing conclusion to the debate on the nature of private equity is flawed,
and suggests that a different conclusion with different implications for corporate governance
can be reached when accounting for private equity transaction returns, motivations and firm
size/skill.

1
About the Oxford Private Equity Institute. http://www.sbs.ox.ac.uk/centres/privateequity/Pages/about.aspx

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The study posits a conjecture and a series of practical recommendations that hold relevance
for three different stakeholders:
1. The Oxford Private Equity Institute - for whom a better understanding on the nature
of private equity is of academic importance in developing a framework for private
equity as alternative form of corporate governance to the public corporation.
2. Private equity practitioners for whom this study aims to suggest ways in which
private equity firm investment objectives and motivations can be better fulfilled.
3. Corporations for whom a better understanding of the nature of private equity would
allow a better understanding of whether private equity ownership is in their best long-
term interests or not.
1.2 Structure of the report and research question
The structure of this study is designed, in order: to lead the reader through the development
of the research question, the research methods used to investigate the research question, the
results and analysis of the research questions investigation, and the conjecture and practical
recommendations for the stakeholders of this research.
Chapter 2 constitutes the literature review of this study from which the research question was
born. It will provide the reader with the relevant information necessary to understand the
context of the research question, and is structured to lead the reader through to its
development in Chapter 3. This structure is illustrated below with the chapter divided into its
sub-sections and key high-level findings detailed to provide the reader with an overview of
the arguments that led to the research question. It is intended that the chapter be read with this
structure in mind.

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Introduction to private equity (2.1)
-Background on the private equity industry, firms and
funds.
Private equity as a long-term
'superior organisational form'
view
Private equity as short-term
'shock therapy' view
Existing conclusion: 'heterogenous view'
of private equity
-Private equity transactions are 'neither short nor long'.
-View agrees with both and neither view, but is based
solely on transaction durations evidence.
-Does not account for evidence on private equity firm
motivations or returns, why?
Private equity firm motivations
(2.3)
-Private equity firms desire high return,
short durations in transactions.
-Theoretically private equity would act as
'shock therapy' if it could.
-Value creation in private equity-owned
companies is likely not a major source of
returns for private equity funds.
-In practice heterogeneous view shows
transaction durations are neither short nor
long so it doesn't.
-Suggests misalignment of interests between
private equity firms and the companies they
own.
-'Limiting factor' likely at play preventing
theory from becoming reality.
-Interests of private equity-owned
companies are not the 'limiting factor'
preventing private equity from behaving as
'shock therapy'.
Probable existence of an unknown
'limiting factor' (2.5)
Firm 'skill' as the probable 'limiting
factor' (2.6)
-Possible that the existing conclusion to the debate on the
nature of private equity does not account for all factors
and should account for private equity transaction returns,
motivations and firm 'skill'.
-Firm size/maturity can be a proxy measure for firm 'skill'.
Development of the Research Question from the Literature Review
Current debate on the nature of private equity (2.2)
Sources of return in private
equity and the misalignment of
interests between PE firms and
portfolio companies (2.4)
Research question: "What is the relationship between private equity transaction return, duration and firm
size/skill, and should one exist, what are its implications for the current understanding on the nature of
private equity?" and hypothesis (3.1)

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Chapter 3 outlines the research question, the research hypothesis and existing research
surrounding the research question.
Chapter 4 details the research methods used to investigate the research question. The
investigation was conducted empirically through the analysis of investment-level data for a
large and global sample of private equity transactions, along with the case-study analysis for
certain aspects of the study.
Chapter 5 details the results and analysis of the study and develops a conjecture and practical
recommendations based on findings. This chapter represents the novel contribution of this
research and is intended to be of direct use to this studys stakeholders.
Chapter 6 outlines the studys limitations and possibilities for further research.
Chapter 7 present a conclusion summarising the main research findings followed by
references in Chapter 8 and Appendices thereafter.

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2. PRIVATE EQUITY LITERATURE REVIEW
2.1 Introduction to private equity
2.1.1 Private equity firms and funds
Private equity (PE) investments/transactions, also known as leveraged buyouts (LBOs), refer
to the acquisition of the majority control of a publicly or privately held company by a private
equity firm, using a small portion of equity financing (typically 10-40%) and a large portion
of debt financing or leverage (typically 60-90%) (Kaplan and Stromberg, 2009). This is
illustrated by Figure 1 which shows how the post-LBO capital structure of a target company
(in grey and blue) is typically more debt-heavy than its pre-LBO capital structure (in green).
Figure 1
Caption: Basic structure of a leveraged buyout transaction.
Source: Oxford Private Equity Institute
A private equity firm raises equity capital for investments through a private equity fund
organised as a limited partnership. Institutional investors (pension funds, insurance

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companies, university endowments and sovereign wealth funds) act as passive limited
partners who contribute the majority of a funds capital, and the private equity firm acts as
the general partner, typically contributing around 1% of the total capital; but being charged
with the responsibility of all the investment decisions of the fund. (Ang and Sorensen, 2012).
The structure of a typical private equity fund is illustrated by Figure 2.
Figure 2

Caption: Structure of ownership of a typical private equity fund.
Source: Oxford Private Equity Institute
Each fund typically has a fixed life of ten years with the general partner managing the funds
acquisitions of individual companies, known as portfolio companies. The general partner
normally has up to five years to make acquisitions and then an additional five years to
monetise investments and return capital to limited partners. Private equity firms usually
manage several funds at a time depending on the size of the firm and attempt to raise new
funds every 2-4 years. The size of private equity funds can vary widely from US$100m or
less to US$10bn or more depending on the type of fund, the reputation of the general partner

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and the geographical region of the fund
2
. (Lopez-de-Silanes et. al, 2009; Kaplan and
Stromberg, 2009)
For managing a fund a private equity firm is compensated in three ways: by charging an
annual management fee to the fund (typically 1.5-2% of the committed fund size), earning a
share of the profits of the fund (called carried interest, typically 20%), and by charging deal
and monitoring fees directly to portfolio companies (typically 1-2% of a firms value each).
(Metrick and Yasuda, 2010; Kaplan and Stromberg, 2009)
2.1.2 Private equitys growth
Capital commitments to private equity funds have risen exponentially from US$0.2bn in
1980 to US$200bn in 2007. Fundraising is the lifeblood of private equity and as such global
transaction volumes have increased exponentially from under 50 per year in 1985 to over
2,000 in 2006. Given the exponential trend it is not surprising that transaction volumes are
skewed towards recent years with more than 40% of total acquisitions occurring between
2004 and 2007. (Figure 3; Figure 4; Stromberg, 2008)

2
Reuters, Apollo launches $12 billion private equity fund, http://www.reuters.com/article/2012/11/13/us-
apolloglobal-fund-idUSBRE8AC12Q20121113

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Figure 3

Caption: Global private equity transaction volumes have grown exponentially over the last 40 years.
Source: Kaplan and Stromberg (2009)
Figure 4

Caption: Private equity transaction volumes are dependent on private equity fundraising which is cyclical by nature.

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Over time the prevalent types of LBOs have changed and private equity has spread
throughout the world.
In the 1980s, fuelled by the availability of cheap debt financing from overly favourable terms
in high-yield bond markets, private equity firms were able to compete with cash-rich
corporate buyers to purchase large public companies. At the time private equity concentrated
on investing in manufacturing and retail firms and was primarily a North American
phenomenon, with the region accounting for 87% of global transaction volumes. (Table 1;
Kaplan and Stein, 1993; Kaplan and Stromberg, 2009; Stromberg, 2008)
With the collapse of the high-yield bond market in the 1990s, private equity declined and
smaller, mid-size buyouts of private companies and buyouts of divisions of larger companies
became more popular; requiring less capital for acquisitions. In the late 1990s private equity
began to recover, experiencing stable growth, investing in new industries such as technology,
infrastructure and services, and spreading to Western Europe. The region eventually
accounted for 49% of global transaction value in the early 2000s. (Stromberg, 2008)
In 2005 private equity experienced a second boom, once again fuelled by favourable credit
market conditions. A resurgence of public-to-private transactions ensued, private equity firms
began selling portfolio companies to other private equity firms, and the industry spread to
Asia and other parts of the world prior to the financial crisis of 2007 to 2009. The two private
equity booms highlight the industrys dependence on fundraising. (Figure 4; Table 1;
Shivdasani and Wang, 2011; Stromberg, 2008)
Overall, private equity has evolved from a North American-based industry investing
primarily in large mature public retail and manufacturing firms, to an industry investing in
companies of all sizes, from all types of sellers, in many industries around the world. The
industry is therefore a global asset class with a large role in the global economy.

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Table 1

Caption: Table shows a) the growth in the private equity transaction values and numbers over last 40 years, b) the change in
types of private equity transactions from primarily public-to-private to a mix of types, and c) a gradual spreading of private
equity from North America across the world over time.
2.1.3 Private equity exits and deal duration
As general partners of their funds, private equity firms have a responsibility to generate
returns for their limited partners. As funds have limited contractual lifetimes, selling
(exiting) investments is the foremost way in which funds liquidate their investments and
generate returns. Companies are bought with a view to selling them at a higher price.
There are different types of exit buyers who purchase portfolio companies and the
prominence of different exit routes have changed over time along with transaction durations
(see Table 2).

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Table 2

Caption: Table shows the types of buyers private equity-backed companies are sold to and how these have changed over
time. Sales to strategic buyers (corporates) have always been the most common, while other exit routes have varied in
significance. The average holding period of private equity-backed companies is between 5-6 years and deal of <2 years
duration are a rarity.
The most common type of buyers are strategic corporate buyers, accounting for 38% of
transactions on average. Companies are also sold to other private equity firms (secondary
buyouts) or their shares issued on public stock exchanges (IPOs), and some exit through
bankruptcy. (Table 2)
On median, portfolio companies are held for 6 years before exit, but their longevity has
decreased over time. Transactions of short duration, such as those of less than 2 years
(quick-flips) are rare, accounting for only 12% of transactions. (Table 2; Stromberg, 2008)

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2.2 Current debate on the nature of private equity
In order to understand private equitys role in the global economy, it is important to
understand its nature. Though this topic is large, the debate can be summarised by two
opposing views which are currently in a stalemate based on empirical evidence on transaction
durations.
The first view, provided by Jensen (1989), argues that the LBO is a long-term superior
governance structure that solves public company agency problems by imposing strong
investor monitoring and managerial discipline through a combination of ownership
concentration and substantial leverage. This is known as the long-term superior
organisational form view.
The second view, provided by Rappaport (1990), views LBOs as short-term shock therapy
allowing inefficient, badly performing firms with inferior corporate governance to enter quick
but intense periods of corporate and governance restructuring in order to return to public
ownership after a few years. This is known as the short-term shock therapy view.
The current conclusion to this debate and the answer to which of the superior organisational
form view and the shock therapy view is more accurate in describing the nature of private
equity was proposed by Kaplan (1991). Kaplan noted that the theoretical frameworks of the
two views centred on assumptions regarding the durations of LBOs. As such, in an empirical
analysis of U.S. private equity transaction durations he found that the median time in private
equity ownership was 6.8 years and that on average LBOs were neither short-lived nor
permanent. This was supported by Stromberg (2008)s more up-to-date and global analysis,
and together these studies propose that neither the superior organisational form view nor the
shock therapy view is entirely correct and neither is entirely wrong. This stalemate

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conclusion to the debate on the nature of private equity is known as the heterogeneous
view of private equity.
Interestingly, both opposing views and the existing conclusion define the nature of private
equity from the perspective of portfolio companies. It is surprising that evidence on the
returns or motivations of private equity firms have not been incorporated into the debate
regarding the nature of their own industry. It is thus possible that there are factors other than
transaction durations at play which could impact a conclusion to the debate surrounding the
nature of private equity. An investigation of these could help to provide a better conclusion to
the debate than is currently provided by the heterogeneous view.
2.3 Private equity firm motivations and shock therapy
This section will discuss private equity firm motivations and will suggest that an ideal
private equity transaction would lean more towards behaving like a form of short-term shock
therapy than a long-term superior organisational form, but that a limiting factor is likely to
exist which prevents this from occurring in the majority of transactions and pushes
transaction durations to medium, not short durations as is found by the heterogeneous view of
private equity.
Private equity firms have two primary motivations: to generate high returns, and to generate
those returns in as short a time as possible.
Private equity firms are businesses, and naturally individuals with vested interests in their
success such as the partners and professionals who share in their profits want to continuously
earn more money. In the private equity industry this is often achieved by increasing a firms
size, and it is found that private equity firms build on their prior experience by increasing the

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size of their funds, which lead to higher revenues per partner/professional in later funds
(Metrick and Yasuda, 2010).
However in order to invest and generate any returns, funds must first be raised. It is found
that investors follow returns and that the private equity industry is one where a firms past
returns are a good indicator of its future returns (Kaplan, 1991; Kaplan and Schoar, 2005).
Therefore private equity firms will look to generate as high returns as possible in their current
funds to out-compete other firms and secure greater capital commitments for their future
funds, ultimately for their own benefit (Nikoskelainen and Wright, 2005). Indeed Chung et. al
(2011) find empirical evidence that the lifetime incomes of private equity firms are positively
correlated to current fund returns and are affected by the effect of these on private equity
firms abilities to raise future funds. Thus a primary motivation of private equity firms is to
generate high returns.
Private equity firms are also motivated to exit their investments quickly due to the need to
secure fundraising every 2-4 years. When fundraising, firms issue private placement
memoranda (PPMs or investment prospectuses) to prospective investors that, amongst
things, detail the size of a fund to be raised and all of the returns and durations of a firms
prior investments. In particular, investors are interested in information regarding the internal
rates of return (IRR, a measure of return) of recent investments. Reporting high IRRs is
important but reporting on-paper IRRs on unrealised investments in a firms active funds is
of little use when fundraising. An investments valuation moves with the ebbs and flows of
the global equity markets
3
, making projected returns an unreliable measure of actual returns.
For example if a firm issues a PPM now that details a positive unrealised return on an
investment, it may not be able to realise that return if in practice market conditions deteriorate

3
April 1, 2013. Pensions and Investments Online. Largest private equity firms rule the roast.
http://www.pionline.com/article/20130401/PRINTSUB/130329874/largest-private-equity-firms-rule-the-roost

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by the time it wants to sell that investment. Given this, it is important for firms to report high
returns on as many recently realised investments (thereby reflecting the firms ability to
generate returns in the current economic climate) as possible when seeking to raise funds
from investors. Therefore there is a high motivation to exit investments quickly.
This is supported by Wright (1994) who states that the more rapidly changing is the market,
with consequent implications for capital investment to achieve critical mass (a threshold
level of return), the earlier exit is likely to be and the more a private equity firm is driven
by a need to earn high internal rates of return on its investments, the sooner it will wish to
exit. Given this and the fact that private equity firms are opportunistic by nature - that is
whenever a good exit opportunity arises, private equity firms are interested in exploring it
even if all planned strategic actions in a portfolio company have not been completed
(Nikoskelainen and Wright, 2005) - private equity firms are not only motivated to generate
high returns, but also to keep their transaction durations short.
Knowing these motivations, one might expect that if private equity firms had their way
ideal private equity investments would be those of high returns and short durations, with
firms striving to achieve this combination in all transactions a reality which would be more
in line with private equity as a form of short-term shock therapy than private equity as a
long-term superior organisational form given the short durations desired.
However, the empirical evidence supporting the heterogeneous view of private equity shows
that in practice this does not come to pass for the majority of transactions; with the majority
being of medium, not short durations. It is likely then that there is a limiting factor at play
which prevents the majority of private equity transactions from reaching this ideal and
embodying a shock therapy organisational form.

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2.4 Sources of return in PE and the misalignment of interests
between PE firms and portfolio companies
In light of the possibility of a limiting factor being at play which prevents the majority of
private equity transactions from behaving as short-term shock therapy, this section seeks to
investigate what this limiting factor might be.
There are three major stakeholders in private equity investments: private equity firms, limited
partners and portfolio companies. Given that the interests of private equity firms and their
limited partners are generally aligned due to private equitys dependence on fundraising for
survival and fundraisings dependence on a private equity firms performance, it would stand
that the interests/influences of limited partners would not impede private equity from
behaving as a form of short-term shock therapy. However, the answer to the question of
whether the interests of private equity firms and their portfolio companies are aligned is not
immediately obvious, and testing whether this is the case might suggest whether portfolio
companies are directly or indirectly capable of influencing a private equity firms investment
decisions. Since private equity funds own portfolio companies there is little direct influence
that portfolio companies can have on investment decisions. However one can investigate
whether portfolio companies have indirect influence.
When a private equity fund buys a portfolio company it implements various
actions/initiatives to create value in the company to generate returns by improving the
companys operating performance and thus its market value. If value creation in portfolio
companies or operating performance gains represent the majority source of returns for
private equity funds, then it would be possible that the limits in how quickly various value-
creating initiatives could be implemented could restrict the quickness with which transactions
are exited, and would push average transaction durations to longer lengths as found by the

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heterogeneous view. The alignment of interests between private equity firms and portfolio
companies could thus restrict the majority of transactions from embodying a form of short-
term shock therapy by virtue of private equity firms having to generate returns through the
slow process of improving companies.
On the other hand if operating performance gains are a minority source of returns for
private equity funds, then this would suggest that a) the interests of private equity firms and
their portfolio companies would likely be misaligned, with implications for corporations as to
whether accepting private equity investment is in their best long-term interests, and b) the
interests/influences of portfolio companies would likely not be the limiting factor
preventing the majority of private equity transactions from behaving as a form of short-term
shock therapy. Indeed the literature examined in this section will suggest the latter to be the
case, thereby implying that an unknown limiting factor is at play.
In order to investigate the presence of a misalignment of interests between private equity
firms and portfolio companies, it is necessary to understand the various sources of returns for
private equity funds and their relative significances. As such this section will detail these
sources and their relative significances in return generation. This section will not focus on
how private equity returns compare to other asset classes (see Kaplan and Schoar, 2005;
Phalippou and Gottschalg, 2007; Harris, Jenkinson and Kaplan, 2012; Higson and Stucke,
2012), nor how the total value of a fund is distributed between private equity firms and
limited partners at the end of a funds life (see Metrick and Yasuda, 2010; Chung et. al,
2011).
A companys total value is given by its enterprise value or the market value of all of its
assets. Figure 5 shows the components of a typical portfolio companys enterprise value;
consisting of its book-value and off-book-value. The company has assets, both current and

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long-term, which are financed by debt and equity financing. The book-value of the
companys assets is the total historical cost paid for them (e.g. amount paid for property,
equipment etc), while the off-book-value is the value in excess of the book-value which the
market assigns to assets; usually consisting of the value of intangibles, a companys
reputation, client lists, future growth potential etc. The book and off-book-values of the
companys assets correspond to the book and off-book-values of debt and equity financing.
Figure 5

Caption: Figure shows typical capital structure of a portfolio company including off-book-value. The market value of
equity constitutes the proceeds a private equity firm would earn if it were to sell the company.

A private equity fund owns the equity of a portfolio company and if this equity is sold to a
buyer willing to pay the prevailing market price, the fund would receive the market value of
equity in proceeds, consisting of both its book and off-book-values. Thus in order to
generate returns a private equity firm must increase the market value of a portfolio
companys equity, either by increasing its book or off-book-values or both. This is achieved
through five sources of return generation:

Assets
Liabilities
(Financing)
Book value of
equity
Off-book value of
assets
Off-book value of
equity
Value PE firm
receives upon
sale of equity
Enterprise
value of
company
Book value of
assets
Typical Portfolio Company Capital Structure
Market value
of equity
Enterprise
value of
company
Short-term debt
Long-term debt
Long-term assets
(e.g. Property)
Current assets (e.g.
Cash)

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1) Operating performance gains (book-value of equity increases)
2) Debt pay-down (book-value of equity increases)
3) Tax-shields (book-value of equity increases)
4) Valuation multiple increases (off-book-value of equity increases)
5) Favourable purchase prices (off-book-value of equity is underpriced by seller
allowing arbitrage)
Each of these sources of return increases the market value of equity in different ways. Their
theoretical frameworks and empirical evidence on their relative significances are detailed in
the following five sub-sections. Attention should be paid to operating performance gains
which is the only source of return which adds real value to portfolio companies but which
literature suggests is likely a minority source of return.
2.4.1 Operating performance gains: the first source of return
Operating performance gains stem from increases in a portfolio companys profitability and
productivity, and these are influenced by the channels through which private equity firms
create value for their portfolio companies. There are three primary channels of value creation:
governance, financial and operational engineering; and the proposed benefits of these
channels spawned the superior organisational form view of private equity.
Governance engineering
Governance engineering refers to changes implemented by private equity firms upon
acquiring control of a company, and their resulting benefits in improving its governance and
reducing agency problems caused by a separation of ownership and management. (Jensen,
1989)

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Jensen (1989) argued that the established control mechanisms meant to address agency
problems in public corporations were failing due to: product markets being undermined by
strong incumbent market positions, internal control systems being enfeebled by board
members with little equity stakes in their companies, and capital markets being weakened by
disbursed public ownership and restrictions/costs imposed on large shareholders. As a result
he suggested that the long-term effect has been to insulate management from effective
monitoring and to set the stage for the eclipse of the public corporation; highlighting that
the fact that takeover and LBO premiums average 50% above market price illustrates how
much value public company managers can destroy before they face a serious threat of
disturbance.
Jensen suggested that private equity provided the solution and argued that LBOs resulted in
superior board control and CEO monitoring, higher equity stakes and incentives for
management which aligned shareholder/management interests, and a greater likelihood of
positive management changes being made where necessary as outlined below.
Board control and CEO monitoring
Private equity firms reduce agency problems in their portfolio companies through more
effective board monitoring of CEOs.
A companys board of directors has access to internal company information to monitor its on-
going activities, direct strategy and evaluate management for an increase in compensation or
removal. As such a company whose board of directors monitor its CEO more effectively will
have fewer agency problems and will ensure a better alignment of interests between
shareholders and management. (Cotter and Peck, 2001)

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Private equity firms have greater board representation in their portfolio companies than do
other types of investors, often replacing directors where necessary. Portfolio companies also
have small boards who meet more frequently and their interests are better aligned with those
of shareholders by directors being given higher equity stakes than their public company
counterparts. This improves board monitoring of CEOs and reduces the reliance on short-
term performance as a measure of CEO performance; allowing CEOs to concentrate on the
long-term strategic objectives of a company and reducing agency problems in the process.
(Cotter and Peck, 2001; Cornelli and Karakas, 2012; Cornelli, Kominek and Ljungqvist,
2012; Gertner and Kaplan, 1996; Acharya and Kehoe, 2008)
Management equity and incentives
Private equity firms further reduce agency problems in portfolio companies by issuing
management teams with large minority equity stakes in their companies. (Jensen and
Murphy, 1990)
Management have higher stakes in portfolio companies than their public company
counterparts (Gertner and Kaplan, 1996); Leslie and Oyer, 2008). One study found that the
median portfolio company CEO had a 5.4% equity stake in his/her company, and that the
median management team had 16% in total (Kaplan and Stromberg, 2009). Another study
found that 61.7% of transactions had significant management equity participation (Guo et. al,
2009).
An example of management equity participations effectiveness in solving agency problems
in practice is outlined by Denis (1994) through a comparison of the leveraged recapitalisation
of Kroger Co. with the LBO of Safeway Stores (Denis, 1994). The two companies were very
similar in their business lines and while both transactions significantly increased the leverage
of the two companies, Safeway also altered managerial ownership and executive

26

compensation; leading to large differences in its restructuring actions and value creation.
Denis concluded that the improved incentive structure provided by Safeways private equity
owner led managers to generate cash in a more productive way than the organisational
structure employed by Kroger Co.
Management changes
Private equity firms actively replace poorly performing portfolio company CEOs where
necessary and it is found that these changes have a positive effect in creating value for
portfolio companies.
Acharya and Kehoe (2008) in a large sample of Western European buyouts found that one-
third of portfolio company CEOs were replaced within the first 100 days of acquisition and
two-thirds were replaced at some point over the first four years of private equity ownership.
This is echoed by Guo et. al (2009) who found similar data for U.S. buyouts.
Cornelli, Kominek and Ljungqvist (2012) find a causal link between forced CEO turnover
and performance improvements for buyouts across 19 economies. This is supported by Guo
et. al (2009) who find that gains in operating cash-flows are much greater in portfolio
companies where the CEO was replaced at or soon after the buyout.
Overall, evidence suggests that governance engineering has a positive effect on reducing
agency problems in portfolio companies and better aligning the interests of shareholders and
management than do public corporations.
Financial engineering
Jensen (1989) states that a central weakness and source of waste in public corporations is the
conflict between shareholders and managers over the pay-out of free cash-flow; that is cash-
flow in excess of that required to fund all investment projects with positive net present values

27

when discounted at the relevant cost of capital. For a company to operate efficiently and
maximise value, free cash-flow must be distributed to shareholders rather than retained; but
this happens infrequently, senior management has few incentives to distribute the funds, and
there exist few mechanisms to compel distribution.
Jensen proposed that private equity was the solution to this problem and stated equity is a
pillow, debt is a sword. If a companys capital structure consists primarily of debt, managers
are compelled to pay out free cash-flow they would otherwise retain. Payments to equity
owners such as dividends can be issued at managements discretion, but failing to service
debt payments can result in companies being declared insolvent and management being
called into bankruptcy court. As a result debt, so long as its service payments do not exceed
the capability of a portfolio company to pay them, can in theory provide a disciplining effect
on management. This can create an atmosphere managers require to slash unsound
investment programs, shrink overhead, and dispose of assets that are more valuable outside
the company.
Empirical evidence finds that portfolio companies have substantially higher debt levels than
public companies (Leslie and Oyer, 2008), and largely supports the idea that this results in a
more efficient dissipation of free cash-flows. Indeed, Gao, Harford and Li (2013) find that
portfolio companies on average have approximately half as large cash-holdings compared to
their public counterparts.
Evidence on the managerial effects of leverage is less conclusive. A study of U.S. public-to-
private LBOs found that improvements in cash-flows were greater after an LBO. However a
similar study of UK LBOs found no conclusive evidence that the disciplinary nature of debt
resulted in operating margin improvements, citing differences in its effects by geography.
(Guo et. al, 2009; Nikoskelainen and Wright, 2005)

28

In general private equity ownership results in a more efficient dissipation of free cash-flows
by companies and may have positive disciplinary effects on management which improves
operating performance.
Operational engineering
Operational engineering refers to private equity firms inducing acquisitions, growth plans,
cost-cutting, strategic changes and productivity improvements in their portfolio companies
with a view to improving their operating performance. (Acharya and Kehoe, 2008)
The concept was pioneered by Bain Capital
4
in the 1990s and involved top private equity
firms reorganising themselves around industries and hiring industrial and operational
executives to advise on transactions. For example Jack Welch, former CEO of General
Electric is affiliated with CD&R and Lou Gerstner, former CEO of IBM with The Carlyle
Group; both leading private equity firms (Kaplan and Stromberg, 2009). Some typical
methods of operational engineering are outlined below.
Cost cutting
Private equity firms regularly cut costs and alter the investment policies of their portfolio
companies to create value.
An example of the positive effects of cost cutting on a portfolio company is the buyout of
Sealy Corporation by Bain Capital. Orit Gadiesh, Chairman of Bain & Company summarises
its impact as follows. When Bain Capital and Charlesbank Capital bought Sealy
Corporation, they aimed both big and realistically: seeking to increase the value of their
equity investment fivefold in a few years. They knew they could after probing every corner of
Sealy's business. Their main finding was that the complexity of its product line was not the

4
Kaplan. S, Private equity: past, present and future,
http://faculty.chicagobooth.edu/steven.kaplan/research/kpe.pdf

29

primary margin problem, differentiation was. Sealy had been making a costly, two-sided
design that allowed mattress owners to do something most don't actually do: flip mattresses.
The company shifted to a no-flip mattress design whose technology improved Sealy's
margins and leapfrogged its rivals technology. Sealy did not go ahead with former plans to
boost the volume of its mid-price mattresses, concentrating instead on higher price points. As
a result the new mattress design improved earnings by 22%.
5

On the other hand, investment policies in portfolio companies are made more efficient by
either reducing or increasing capital expenditures where necessary. In the U.S., private equity
firms decrease their portfolio companies capital expenditures by on average 1% of assets. It
is found that this reduction is conducive towards eliminating waste and improving their long-
term performance (Harford and Kolasinki, 2012; Kaplan, 1989b). In some European
countries increases in capital expenditures are more common, with French LBOs in particular
having 24% higher capital expenditures than their public counterparts with a correlated
increase in sales. (Boucly et. al, 2011)
Organic growth
Private equity firms often look to help the companies they acquire grow internally, either
through the introduction of new products or expansion into new markets. Case-studies
outlining such actions are numerous but generalised empirical data is less common.
One study that is useful in this regard however is a study of 839 French LBOs by Boucly et.
al (2011). The authors suggest that portfolio companies grow significantly more than
comparable firms in terms of employment (18% higher), sales (12% higher) and capital
employed (12% higher). Furthermore, they find that a third of the average asset growth

5
Gadiesh. O, MacArthur. H, Lessons from private equity any company can use,
http://blogs.hbr.org/hbr/ceomemo/2008/03/lessons_from_private_equity_an.html

30

experienced by portfolio companies is financed by the issuance of additional debt, suggesting
that much of the value created by portfolio companies is based on making existing growth
opportunities easier to exploit by reducing credit constraints rather than offering new ones.
Though Boucly et. al only study LBOs in one country, France is an economy with many
sleeping beauties, i.e. potential targets with significant margins of improvements and
growth and is thus useful in highlighting how private equity firms add value through organic
growth where opportunities for it exist.
Acquisitions and external growth
Private equity firms regularly implement initiatives for external growth in their portfolio
companies, primary through add-on acquisitions - acquisitions of other companies which
may help to fill out a product line, achieve economies of scope in marketing or distribution,
co-opt operating synergies, expand service offerings, or capture economies of scale of similar
businesses. Guo et. al (2009) found that 50% of U.S. portfolio companies had made
significant acquisitions during private equity ownership, and Nikoskelainen and Wright
(2005) in a study of UK buyouts find that return characteristics and the probability of a
positive return in a transaction were related to the acquisitions carried out by portfolio
companies during private equity ownership.
Innovation
Private equity firms are found to improve the quality of innovation in their portfolio
companies. Literature on innovation in portfolio companies is uncommon; mainly because
innovation is difficult to quantify. However, Lerner et. al (2011) in a study of 495 buyouts,
using patenting-levels in portfolio companies as a proxy for private equity firms effects on
innovation, find that LBOs lead to significant increases in long-term innovation. Patents

31

applied for portfolio companies are more frequently cited (a proxy for economic importance),
show no significant shifts in the fundamental nature of the research activities of the
companies, and are more concentrated in the most important and prominent areas of
companies innovative portfolios. In essence, though the quantity of innovation in portfolio
companies does not increase, the quality of it does.
Governance, financial and operating engineerings impact on profitability and
productivity
It has been shown that private equity firms create value in portfolio companies through
governance, financial and operational engineering. Bottom-line value creation is primarily
measured by improvements in a portfolio companys operating performance which in turn is
measured by improvements in profitability and productivity.
Impact on profitability
The impact of private equity ownership on portfolio companies profitability has varied in
different time periods due to the industrys spreading across the world. Before 1990 private
equity was primarily a U.S. phenomenon with portfolio company profitability gains being
common and significant. After 1990 the industry spread to Western Europe and profitability
gains in the region appear to have been superior to those in the U.S. since. Given the majority
of total LBOs occurred after 1990, pre-1990 data is not so useful in forming generalisations
about the private equity industry but it will be discussed for contextual understanding
nonetheless. (Kaplan and Stromberg, 2009; Stromberg, 2008, Bernstein et. al, 2010)
Before 1990 U.S. buyouts, constituting 87% of global LBO transaction value in the 1980s,
experienced significant gains in profitability. Operating income/sales, a widely used measure
of profitability, was on average 10-20% higher in portfolio companies than their public

32

company counterparts. Net cash-flows (operating income minus capital expenditures) were
also 22%, 43% and 81% higher in the first three years post-buyout than in the last year pre-
buyout (Kaplan and Stromberg, 2009; Kaplan, 1989b). These effects are likely to have
stemmed from governance and financial engineering as operational engineering was not
common-place before 1990.
After 1990, profitability improvements in U.S. buyouts were weaker. Guo et. al (2009) find
that the profitability gains that did exist were substantially smaller than those documented for
transactions in the 1980s, and that depending on the measure, median performance was not
always significantly different from the performance of benchmark firms. This is echoed by
Leslie and Oyer (2008) who find generally no evidence that private equity-owned firms
outperform public firms in profitability in a sample of primarily post-1990 transactions. The
reasons for this decline are not clear; however it may be correlated to the decline of large
public-to-private transactions in the region post-1990 and the rise of other types of smaller
LBOs which may not have had as much potential for operating performance gains.
Evidence on profitability gains in Western European portfolio companies after 1990 is much
stronger. Acharya and Kehoe (2010) examined 395 LBOs from 1991-2007 and found that
higher abnormal performance is associated with a stronger operating improvement in all
operating measures relative to quoted peers and that this related to greater growth in sales
and greater improvement in the EBITDA to sales ratio (higher profitability). The authors
interpret these profitability improvements as causal private equity impact [...] there is
nothing inherent in the companies targeted by the private equity firms that would have caused
their operating performance to improve without being acquired by private equity.
Profitability gains also tend to vary with the type of private equity firm portfolio companies
are owned by. Cressy et. al (2007) find that industry-specialised firms confer an 8.5%

33

profitability advantage to portfolio companies while buyout-specialised firms appear to
confer no advantage but may provide a spur to growth. This provides indirect support for the
effects of operational engineering; with firms that reorganise themselves around industries
conferring superior value to their portfolio companies.
Impact on productivity
Private equitys impact on the productivity of portfolio companies, unlike profitability, is
generally positive across geographies but differences are noted in their magnitudes.
A study of 8,596 LBOs across 20 industries and 26 nations including the U.S., UK and
countries from continental Europe from 1991-2007 find that industries where private equity
invests grow more quickly in terms of productivity and employment. The total production of
an average private equity industry grows at a rate 0.9% higher than a non-private equity
industry. Geographically, Western European buyouts are found to confer superior
productivity gains to portfolio companies than their U.S. counterparts. (Bernstein et. al, 2010,
Lichtenberg and Siegel, 1991; Harris, et. al, 2005)
These productivity gains are not found to be due to reductions in advertising, maintenance
and repairs, research and development, or property, plant and equipment (Smith, 1990) or by
a reduction in factors of production in general. Instead gains are made by the improving the
return generated by factors of production, and the reallocation of a companys resources to
more efficient uses and better managers. (Smith, 1990; Harris et. al, 2005)
Operating performance as a return generator
Operating performance gains through improvements in the profitability and productivity of
portfolio companies generate returns by increasing the book-value of a companys assets by
improving their cash-generating abilities. This in turn increases its market value. As a result,

34

a private equity firm who owns this equity can sell it at a higher price than it was bought for
and return can be generated. This is illustrated by Figure 6.
Figure 6

Caption: Figure shows how both operating performance gains and tax shields act as sources of return by increasing the
market value of a companys equity by increasing its cash-generating capabilities, albeit through different means; one
through increases in profitability and productivity and the other through cost-savings from favourable regulatory treatments
of debt in LBOs.

Guo et. al (2009) in a study of U.S. buyouts estimated that operating performance
improvements account for only 18.5% of post-buyout return. This value is likely to be higher
for Western European buyouts which represent just under half of all buyouts, however it
highlights that operating performance gains are likely a minority source of return generation
for private equity funds.
Given this, it is likely that though the interests of portfolio companies are aligned with their
private equity owners, the relationship is not reciprocated; in essence an inherent
misalignment of interests between private equity firms and their portfolio companies exists.
Thus if a limiting factor exists that prevents the majority of private equity transactions from
behaving as short-term shock therapy, given the misalignment of interests, portfolio
companies are likely to have little direct or indirect influence on the investment decisions of
Assets
Liabilities
(Financing)
Book value of
equity
Book value of
equity increase
Off-book value of
assets
Off-book value of
equity
Value PE firm
receives upon
sale of equity
Book value of
assets
Enterprise
value of
company
Enterprise
value of
company
Higher market
value of equity
Current assets (e.g.
Cash)
Short-term debt
Long-term assets
(e.g. Property)
Cash increase
Long-term debt

35

private equity firms and the interests or influences of portfolio companies are not likely to be
the factor question.
2.4.2 Debt pay-down: the second source of return
The second way a private equity transaction is designed to generate return is by having a
portfolio company pay-down its own debt and increase the equity portion (book-value) of its
capital structure in proportion.
A private equity investment can be likened to buying a residential property with a mortgage
and then renting-out the property to generate income to service debt payments. A private
equity fund finances a LBO with a minority of equity financing and a majority of debt
financing. The private equity fund then looks to pay interest and principal payments on a
portfolio companys debt in order to decrease the quantity of debt in its capital structure and
increase the book-value of its equity in proportion. However it is not the private equity firm
that makes these payments, instead portfolio companies service their own debt through their
own free cash-flow generation at no extra cost to the private equity fund.
This is akin to an individual buying a residential property with a minority of equity and a
majority of debt (the mortgage) and using income from letting the property to pay-down the
propertys debt. Over time this results in the equity value of the property increasing in until it
accounts for its entire capital structure. Assuming house prices remain constant during
ownership, the individual will generate a healthy return upon selling the property. The same
is true of a LBO and this is illustrated by Figure 7.

36

Figure 7

Caption: Figure shows how debt pay-down acts as a source of return by increasing the book-value of a companys equity in
proportion to its debt at constant enterprise value.

The magnitude of this source of return generation is dependent on three factors:
1) Transaction duration - the longer a portfolio company is held by a fund, the more
payments it will make and thus the higher the book-value of its equity will be before
exit.
2) Free cash-flow generation - the higher the free cash-flow generating ability of a
portfolio company, the greater the quantity of debt it will be able to service in a given
time, and the higher the book-value of its equity will become in that time.
3) Interest rates - the lower the interest rate on a portfolio companys debt, the greater
the size of debt payments it will be able to manage, and the higher the debt a private
equity firm will place on its capital structure in order to magnify returns. This factor
will be influenced by a private equity firms size and maturity as larger, more mature
firms are capable of securing better terms on debt financing for their portfolio
companies than smaller firms. (Demiroglu and James, 2010; Ivashina and Kovner,
2010)
Assets
Liabilities
(Financing)
Liabilities
(Financing)
Long-term
debt
Equity (owned
by PE firm)
Off-book value
of assets
Off-book value
of equity
Off-book value
of equity
Value PE
firm receives
upon sale of
equity
Book value of
equity
Debt
paydown
Final higher
market value
of equity
Book
value of
assets
Current assets
(e.g. Cash)
Short-term
debt
Enterprise
value of
company
Long-term
assets (e.g.
Property)
Long-term
debt
Initial
market
value of
equity
Short-term
debt
Enterprise
value of
company

37

The significance of this source of return in relation to the others is hard to quantify as due to
2), it can be affected by other sources such as operating performance gains and tax-
shields. As such its significance varies between portfolio companies and empirical research
quantifying this significance is scarce.
Interestingly, the fact that transaction durations influence this source of return gives some
incentive to private equity firms to lengthen transaction durations to generate higher returns.
However, this would go against the second motivation of private equity firms to achieve short
transaction durations and as will be seen from reviewing all five sources of return generation,
debt pay-down is at best a minority source of return with the cumulative effects of the other
source being larger. As such the role this source plays in influencing a private equity firms
investment decisions is likely to be small.
2.4.3 Tax-shields: the third source of return
The third way private equity funds generate return stems from the different treatments of debt
and equity by various countries tax codes. Many countries codes, and in particular the U.S.
code
6
allow businesses to deduct interest payments from their tax obligations, known as the
tax deductibility of interest. As a result highly leveraged capital structures such as those
present in LBOs allow portfolio companies to pay less tax. This generates benefits to private
equity funds by a boosting of returns by increasing the cash-flows available to the providers
of capital. (Guo et. al, 2009)
This process has the same effect on a increasing the book-value of a companys equity as
operating performance gains do by acting as a form of cost-saving (Figure 6). The
difference is that the benefits of tax-shields originate from government regulations rather than

6
Private Equity Growth Capital Council, Interest Deductibility, http://www.pegcc.org/issues/private-equity-
and-tax-policy/private-equity-interest-deductibility/

38

any internal changes private equity firms make to portfolio companies. As such they improve
free cash-flows and generate returns without any real benefits to the operating performance of
portfolio companies in terms of profitability or productivity.
Guo et. al (2009) estimate that the effects of tax-shields account for 44.5% of post-buyout
return to private equity funds. This is echoed by an earlier study by Kaplan (1989a) who
estimated an upper value of 40%. It is likely that this sources significance is smaller in
Western European countries where returns from operating performance gains are likely to be
larger.
Overall, the literature suggests that tax benefits are a significant source of return for private
equity funds which add little real value to portfolio companies in terms of operating
performance. As such their significance adds to the idea that the interests of private equity
firms and their portfolio companies are likely misaligned.
2.4.4 Valuation multiple increases: the fourth source of return
The fourth way in which private equity funds generate return is from valuation multiple
increases. Portfolio companies are valued using valuation multiples; ratios used to estimate
the value of a company based on the multiple of the market value of comparable publicly-
listed companies to their earnings. Private equity firms can generate returns by capitalising on
increases in these valuation multiples which depend on prevailing market conditions.
For example, if a group of similar publicly-listed companies trade on a stock exchange at an
enterprise value to earnings ratio of 6x, this would indicate that the free-market values the
companies - accounting for both their book and off-book-values - at $6 for every $1 of
earnings. Company A could generate $10m in earnings while Company B could generate
$100m, valuing them at $600m and $6bn respectively, but both would have the same

39

valuation multiple of 6x. This valuation multiple would be applied to portfolio companies in
the same business line in order to gauge their market values.
In poor market conditions valuation multiples decrease; decreasing the off-book-value of a
companys assets. Conversely, in strong market conditions valuation multiples increase;
increasing the off-book-value of their assets. Given this it is possible that a private equity
firm could acquire a portfolio company when market conditions are poor, implement no
changes to the company and after a period of time sell it under stronger market conditions
and generate a return. As Michael Fisch, CEO of the private equity firm American Securities
states: rising stock markets increase the value of listed companies used as benchmarks to
arrive at private company valuations [...] valuations are disconnected with a flat earnings
reality
7
. Thus, like housing prices, company prices fluctuate over time regardless of whether
any changes have been made to the house/company, and this presents opportunities for
private equity firms to generate returns as illustrated by Figure 8.

7
April 1, 2013. Pensions & Investments Online. Largest private equity firms rule the roast.
http://www.pionline.com/article/20130401/PRINTSUB/130329874/largest-private-equity-firms-rule-the-roost

40

Figure 8

Caption: Figure shows valuation multiple increases acts as a source of return by increasing the off-book-value of a
companys assets, thereby increasing the market value of its equity.

Guo et. al (2009) in a sample of U.S. LBOs estimate that valuation multiple increases account
for 5.8% of post-buyout return for private equity funds. This figure, though smaller than the
estimated effects of operating performance gains and tax-shields, makes valuation
multiple increases a meaningful source of return generation which creates no value for
portfolio companies in terms of operating performance.
2.4.5 Favourable purchase prices: the fifth source of return
The fifth and final source of return for private equity funds, though less well documented, is
the favourable pricing of companies, or arbitrage.
Renneboog, Simons and Wright (2007) in a study UK public-to-private transactions find that
one of the main sources of post-buyout return for private equity funds was the undervaluation
Assets
Liabilities
(Financing)
Book value of
equity
Off-book value
of assets
Off-book value
of equity
Off-book value
of assets
increase
Off-book value
of equity
increase
Value PE
firm
receives
upon sale
of equity
Enterprise
value of
company
Current assets
(e.g. Cash)
Long-term debt
Higher
market
value of
equity
Long-term
assets (e.g.
Property)
Enterprise
value of
company
Short-term debt
Book
value of
assets

41

of the pre-buyout target firms. In essence, for some reason, companies were bought at a price
cheaper than their market value at the time of purchase, generating instant on-paper return for
their private equity buyers through a mispricing of the off-book-value of their assets.
Unfortunately there is little research estimating the significance of this source of return,
however there have been a number of well documented cases outlining its effects in practice,
two of which are outlined below:
1) Information Partners and Gartner Group - Information Partners
8
invested in IT
research company Gartner Group in 1990.
9
One of the aspects of their investment
strategy was to provide the management and employees of Gartner a 25%
10
ownership
stake in the company
11
while continuing the managements existing strategy for the
growth and operations of the company
12
.
Information Partners seemed to have benefited from a favourable acquisition price as
ex-parent Saatchi&Saatchi was burdened with debt and analysts felt that they had to
sell Gartner for a low price. Furthermore it was suggested that given the Gartner
Group was a people-intensive business, the company was intended to be sold only to
an investor with which management could work with. The threat that management
may have left the company if they were not satisfied with a prospective investor
deterred a number of bidders from making offers, which lowered the eventual price of

8
Bain Capital, 2013. Portfolio companies by industry. Retrieved from
http://www.baincapitalventures.com/Portfolio/ByIndustry.aspx?industryid=3
9
Business Wire, July 5, 1990, Information Partners acquisition of Gartner Group Inc. . Retrieved from
LexisNexis Academic database.
10
The Times, July 5, 1990, Saatchi in $16m loss on sale of Gartner, Martin Waller. Retrieved from LexisNexis
Academic database.
11
12

42

the business.
13
In April 1993 Information Partners sold their stake to Dun &
Bradstreet for a healthy return.
14

2) 3i Group and Great Western Trains - Great Western Trains was one of the 25
operating companies which were created for the privatization of the British Rail.
15
It
was acquired as part of the privatization process in 1996 by a consortium of investors
in which private equity firm 3i Group had 24.5%, bus company FirstBus had 24.5%
and the management buyout team had 51% of the equity stake in Great Western.
16
3i
Group realized the investment when shareholder FirstBus acquired 100% of Great
Western in March 1998. The sale meant great profits for 3i and the managers of Great
Western, which outraged the press and analysts because the huge profits realized were
reported to have been the outcome of a low acquisition price offered by the British
government or high subsidies offered at the expense of the British tax payer.
17

2.4.6 Quick-flips and the misalignment of interests in practice
The relative significances of the five sources of return generation have been outlined and
operating performance gains - the only source of return generation that stems from value
creation in portfolio companies is likely a minority source of return for private equity funds.
This suggests that irrespective of whether private equity firms work to align the interests of
their portfolio companies with themselves, their own wider interests are likely not aligned
with those of their portfolio companies. In essence, portfolio companies may act in the best

13
Daily Mail, October 11, 1990, Saatchi sells for a song. . Retrieved from LexisNexis Academic database.
14
Fairfield County Business Journal, March 21, 1994, Gartner Group revenues climb as market's thirst for
research intensifies, Stephanie Finucane, Vol 33; No 12; Sec 1; pg 7. Retrieved from LexisNexis Academic
database.
15
The Independent (London). October 7, 1996, Monday. The final shunt for British Rail as the privatisation
express steams in on time, Christian Wolmar. Retrieved from LexisNexis Academic database.
16
AFX News, December 20, 1995, Wednesday, 3i to match FirstBus' 5.6 mln stg investment in Great Western
Trains. Retrieved from LexisNexis Academic database.
17
The Herald (Glasgow), March 5, 1998, Gravy train rolls in. ; Millions in store for seven Great Western
directors as FirstGroup takes the throttle, Ian Mcconnell, Pg. 22. Retrieved from LexisNexis Academic database.

43

interests of their private equity owners, but there is little incentive for this to be reciprocated,
especially with regards to investment decisions such as when to exit an investment. Indeed
Nikoskelainen and Wright (2005) suggest that buyout markets are opportunistic; that is,
whenever a good exit opportunity arises, private equity firms are interested in exploring it,
even if all planned strategic actions in a target portfolio company have not been completed.
An example of this misalignment at work could be the case of quick-flips, a minority of
private equity transactions (12%, Table 2) of very short duration (usually less than 2 years)
which generate spectacular returns for private equity funds but appear to create little
discernible value for portfolio companies.
A press article
18
in 2005, argues that over the last three years, private equity firms have had
record returns through a series of quick flips. In recent months, several high-profile quick
flips have left critics wondering whether buyout firms were using such offerings to line their
pockets, rather than using the proceeds to support companies. Examples of such investments
include:
1) Thomas H. Lee Partners and Snapple - the Boston private equity firm bought
Snapple for $135 million in 1992 and sold it two years later to Quaker Oats for $1.7
billion.
19

2) Blackstone Group and the Celanese Corporation the Blackstone Group sold a
German chemicals company, the Celanese Corporation, to the public after owning it
for less than 12 months. The firm quadrupled its money and all of the proceeds from
the offering were used to pay out a special dividend to Blackstone.
20

18
November 13, 2005. New York Times. The Great Global Buyout Bubble.
http://www.nytimes.com/2005/11/13/business/yourmoney/13buyout.html?
19
See 18.
20
See 18.

44

3) KKR and PanAmSat KKR, a private equity firm, quadrupled its money by
flipping PanAmSat, the satellite company it owned for less than a year.
21

4) 3i Group and Go - British Airways sold Go to 3i for 100m, 3i sold Go to EasyJet
for 374m the following year.
22

Though quick-flips represent a minority of transactions they do not appear to show that
private equity acted as a superior organisational form but rather point to private equity
fulfilling the role of short-term shock therapy and highlight its opportunistic nature.
2.5 The unknown limiting factor: PE motivations, the
misalignment of interests and shock therapy
Section 2.3 detailed how private equity firms are primarily motivated to achieve high returns
and short durations in transactions. This suggests that if there were no limiting factors at play,
private equitys intrinsic nature would push the majority of transactions to embody a state of
short-term shock therapy with short durations over that of a superior organisational form
with long durations. Empirical evidence provided by the heterogeneous view however finds
that the majority of private equity transactions have medium, not short durations, suggesting
that a limiting factor is at play which prevents most private equity transactions from fulfilling
their firms motivations and behaving as a form of short-term shock therapy.
Section 2.4 found that value creation in portfolio companies via operating performance gains
is likely a minority source of return for private equity funds. This suggests that though private
equity firms may implement changes in their portfolio companies to better align such
companies interests with their own, private equity firms wider interests are likely not
aligned with their portfolio companies. This misalignment suggests that the

21
See 18.
22
See 18.

45

interests/influences of portfolio companies (as the only other direct stakeholder of private
equity investments apart from funds and their investors) are not likely impact private equity
investment decisions and are thus not likely to be the limiting factor that prevents the
majority of private equity transactions from behaving as a form of short-term shock therapy.
As such it is likely that an unknown limiting factor is at play. It is important to investigate
what this might be in order to potentially develop a better understanding of the nature of
private equity and the factors influencing it.
2.6 Firm skill as the limiting factor to private equity shock
therapy
Existing literature may unknowingly suggest that a private equity firms skill in generating
high transaction returns and short transaction durations is the limiting factor that hinders
private equity from behaving as a form of short-term shock therapy in the majority of
transactions.
Private equity returns are persistent; that is that the past returns of a firms funds are a good
indicator of its future funds returns. This is based on the idea that private equity is a skill-
based industry, where the experience of generating high return develops a fund managers
skill, allowing him/her to generate even higher returns in future funds. (Kaplan and Schoar,
2005)
Investors follow returns and therefore so does fundraising (Kaplan, 1991). Firms build on
their prior experience by increasing the size of their funds to increase the lifetime incomes of
their fund managers (Metrick and Yasuda, 2010; Chung et. al, 2011). As a result firm sizes
increase in proportion to a firms skill.

46

Empirical evidence finds that large, mature firms have higher returns than average firms (a
median performance of 150% vs. 80% of S&P500 returns) (Kaplan and Schoar, 2005). In
addition, when firms get larger and more mature they are able to obtain cheaper debt and
looser loan covenants which magnify the returns they generate (Ivashina and Kovner, 2010;
Demiroglu and James, 2010). As a result a virtuous cycle develops where the experience and
skill developed in generating high returns in one fund allows a private equity firm to generate
even higher returns in the next fund, along with an attainment of greater fundraising
opportunities and an increase in firm size.
Given that return is dependent on a firms skill and that its motivations are to achieve high
returns and short durations in transactions, it is not surprising then that only a minority of
transactions are of short duration or high return, as the skill required to achieve such
characteristics is rare and likely possessed by only a handful of large, mature private equity
firms. This could point to firm skill, and by proxy, firm size, being the limiting factor that
hinders most private equity firms from realising their motivations and behaving as short-term
shock therapists. If this were the case then it would naturally skew the majority of
transaction durations towards medium, not short durations as found by the heterogeneous
view of private equity; with firms resorting to slower, more ineffective methods of return
generation due to their lack of skill in being able to generate higher returns and do so through
quick means. This could easily result in a surface impression of private equity being
both/neither a form of short-term shock therapy and/nor a long-term superior
organisational form, but this impression would ignore the forces influencing transaction
durations resulting in it lacking depth and holism.

47

3. RESEARCH QUESTION
3.1 Research question and hypothesis
The debate on the nature of private equity consists of two disparate views; that private equity
is either a long-term superior organisational form, or a form of short-term shock therapy.
The existing conclusion to this debate, the heterogeneous view is based upon an empirical
finding that the majority of private equity transactions have medium (neither short nor long)
durations, and this fact is used to conclude that neither view is entirely correct and neither
view is entirely wrong.
However, based on the wider findings of the literature review, one could theorise a different
conclusion to the debate: that private equity is by nature a form of short-term shock therapy,
but the majority of transactions are prevented from embodying this state due to the limitations
in their sponsoring private equity firms skill in achieving high returns and short durations
in transactions. In essence, if private equity firms had a choice they would act as short-term
shock therapists, achieving high returns and short durations in all of their transactions.
However, most are limited in doing so by their skill in achieving these two characteristics;
forcing the majority of transactions to generate lower returns and to be of longer (medium)
durations than desired.
This alternative conclusion has been developed from the combination of various concepts
discussed in the literature review; it has no validity in practice unless it is tested for. As such
the research question of this paper is as follows:

48

Research question: What is the relationship between private equity
transaction return, duration and firm size/skill? And should one exist, what
are its implications for the current understanding of the nature of private
equity?
Note: firm size is used in this question as a proxy for firm skill as firm skill is difficult to quantify and
the literature review suggests that the two are directly related.
Given this research question, if private equity firm motivations are to achieve high returns
and short durations in transactions, but their abilities to fulfil them are limited by their firm
skill/sizes, then across a global sample of transactions one could hypothesise that the
following would be true:
Hypothesis: Private equity transaction returns and durations are negatively related,
with high return, short duration transactions representing a minority of transactions,
but with the majority of these transactions being sponsored by a small minority of large,
mature private equity firms.
Testing this hypothesis and finding positive results would not dispute existing evidence that
the majority of private equity transactions have medium durations; as short duration (and
simultaneously high return) transactions would be a minority of transactions and medium
duration transaction the majority. However the results would show that high return, short
duration transactions are sponsored primarily by large, mature private equity firms who are
the only firms who possess the skill necessary to achieve these characteristics. This would
highlight an important trend regarding private equitys nature that is incorporated by the
alternative conclusion proposed above, but entirely missed by the heterogeneous view due to
the latters sole reliance on transaction duration evidence and lack of incorporation of

49

evidence on transaction returns, firm motivations and firm size/skill. This would highlight the
limitations and shallowness of the heterogeneous view as a conclusion to the debate on the
nature of private equity and would show that by incorporating a wider array of evidence a
deeper and more holistic conclusion could be reached.
To test the hypothesis the following supplementary questions must be answered and shown to
be true:
Questions investigated to determine the validity of the hypothesis
1. Does a negative relationship between private equity transaction return and duration
exist?
2. In the event of the existence of a negative relationship between return and duration,
does this relationship:
a. Show that high return, short duration transactions represent a minority of
transactions?
b. Show that the majority of high return transactions are sponsored by a small
minority of large, mature private equity firms?
c. Show that the characteristics of high return and/or short duration transactions
are more short-termist than those of average transactions?
3.2 Existing research surrounding the research question
Existing research surrounding the research question is limited and a detailed investigation of
the question using a global sample of transactions is warranted (see below).

50

3.2.1 Return and duration
Though there is potential for developing a better understanding of the private equity industry
by investigating the relationship between transaction returns and durations, there is
surprisingly little research on the topic. There are three disparate views in existing literature:
1. No relationship - under Jensen (1989)s view that LBOs represent a superior
organisational form there should be no relationship between transaction returns and
duration. However, this view does not account for motivations of private equity firms,
firm size/skill nor empirical evidence on transaction returns.
2. Positive relationship evidence regarding tax-shields as a source of return for
private equity funds due to the tax deductibility of interest has been discussed. Kaplan
(1989a) states that the value of this deductibility depends on how long the high LBO
debt-load is maintained, suggesting that a positive relationship between returns and
duration could exist. However no study investigating tax-shields also investigates the
relationship between returns and duration. Furthermore tax-shields is only one source
of return generation, and though it is likely the largest it is not conducive to realising
private equitys motivations for short transaction durations.
3. Negative relationship - the only view for which empirical evidence on the
relationship between return and duration is available is that of a negative relationship.
Acharya and Kehoe (2010) find a statistically large negative relationship between
duration and return with 85 observations but do not elaborate on the trend further.
Though useful, this study is limited by its small and European-centric sample size.
Thus, it can be seen that of the three distinct views on a possible relationship between return
and duration, none but the last (which provides evidence for the hypothesis) has directly

51

investigated the topic. However even this evidence is not substantial and doesnt investigate
the interplay of firm size/skill.
3.2.2 Role of firm size/skill
Evidence on the interplay of firm size (both alone and as a proxy for firm skill) in a
return/duration relationship is limited. Wright et al. (1994, 1995) find that the principal factor
influencing the duration of UK buyouts is the size of the transaction, and in particular larger
investments have shorter durations. This would appear to provide some evidence in favour of
the hypothesis. However these papers do not investigate the effect of return in this
relationship and their samples are limited to UK-only buyouts. The literature review has
suggested that European buyouts, particularly with regards to operating performance gains,
have different characteristics than U.S. buyouts. Thus this evidence on the interplay of firm
size in a return/duration relationship is not substantial enough for generalisations to be made
regarding the private equity industry as a whole. Therefore, further research is warranted.

52

4. RESEARCH METHODS
4.1 Definitions
Prior to discussing the research methodologies used to investigate the research question it is
important to define the word return in the context of this research. There are two important
and different measures of return that are used at different points of the research methodology
and these must be kept in mind when reviewing the results.
1. Money multiple (multiple) or absolute return this is the ratio of the total cash
received from an investment plus its current valuation (if not fully liquidated) to the
total cash invested. The measure is usually gross-of-fees-paid to private equity firms
by a private equity fund, and it indicates what a private equity funds absolute cash
increase was on an investment. It is therefore a measure of absolute return.
(Grabenwarter and Weidig, 2005)
2. Internal Rate of Return (IRR) IRR adds a time dimension to the absolute return
generated on an investment; taking into account how long capital was put to work to
generate a cash increase. IRR is thus a measure of return that accounts for the time
value of money. (Grabenwarter and Weidig, 2005)
The reason two measures of return are used in this research rather than one is because
individually both the money multiple and IRR provide incomplete views on the return of an
investment. For example, a multiple on an investment could be high but may look much less
impressive if the duration of the investment was very long. Conversely, an investment with
high IRR could have very low absolute return but could have generated its IRR by exiting a
company very quickly after acquisition. Hence, for a better judgement to be made as to an

53

investments true return, the two measures should be used in conjunction with each other.
(Grabenwarter and Weidig, 2005)
4.2 Data
The data samples used to investigate different aspects of the research question were drawn
from a comprehensive and global investment-level database of private equity transactions.
The data was assembled by researchers at the Oxford Private Equity Institute by collecting
and extracting information from fund-raising prospectuses, generally referred to as private
placement memorandums (PPMs), which contain the characteristics and performance data
of all prior investments made by a private equity firm. By analysing investment-level data
this research differs and is more suited to analysing private equity transactions than existing
research that uses fund-level data (e.g. Kaplan and Schoar, 2005).
A total of 317 unique PPMs were collected from U.S. and European investors who had
received them as prospective limited partners from private equity firms.
23
Together these
PPMs contained the track records of 334 different private equity firms with a total of 11,704
individual investments made from 1969-2012 in 124 countries around the world. U.S.
transactions accounted for 52.7% of transactions; consistent with the global sample analysed
by Kaplan and Stromberg (2009) in Table 1.
Though not all PPMs come in the same format, the information they provide is generally the
same, of which eleven pieces are particularly useful: (1) month and year of an investments
acquisition; (2) month and year of exit; (3) industry of an investment; (4) countries where an
investment and private equity firms are located; (5) value of equity invested (private equity
investment size); (6) total amount distributed (realised value); (7) current valuation of any

23
Investors gave access to their prospectuses to the Oxford Private Equity Institute under signed
confidentiality agreements, which prohibit me from disclosing information about the identity of the private
equity firms and their investments.

54

unsold stake (unrealised value); (8) total value (sum of (6) and (7)); (9) money multiple (ratio
of (8) to (5)); (10) IRR; and (11) exit route (strategic buyer, financial buyer, IPO etc).
4.3 Investigating a return and duration relationship
4.3.1 Sample construction: Sample A
The database in its raw form was not conducive towards analysing a relationship between
transaction returns and durations. The database needed to be cleaned by applying filters to
create a sample suitable for analysis.
The following filters were applied resulting in a sample of 2,128 investments, referred to as
Sample A:
1. Only buyouts were considered the database contained venture capital and other
minority investments which did not involve firms acquiring majority ownership of
portfolio companies. These investments did not fulfil the definition of a LBO and
were excluded.
2. Month and year of acquisition and exit for a transaction was known to ensure
the duration data of investments was as accurate as possible.
3. Year of acquisition was between 1981 and 2005 investments prior to 1981 were
insignificant in the history of LBOs and investments following 2005 would have
resulted in skewed return data due to the financial crisis of 2007 to 2009.
4. Investment size of US$5m or more to ensure investments were of a reasonable
size.
5. Liquidated investments (unliquidated part <10%) only to ensure that return data
was not subject to biases present in unrealised investment valuations.

55

6. Money multiple and IRR (measures of return) were known to ensure the return
data of investments was complete.
7. IRRs at the 99
th
percentile were winsorised to eliminate anomalous and extremely
high IRR data points which were primarily driven by large dividend payouts early in
an investments life and are thus not economically meaningful.
8. No duplicates transactions were considered
4.3.2 Method: internal rate of return vs. duration
Sample A was used to investigate the correlation between private equity transaction return
and duration by plotting IRR against duration. The objective as given by the hypothesis
was to find whether a negative relationship existed between the two and whether high IRR,
short duration transactions constituted a minority of total transactions.
IRR was chosen here as a measure of return over money multiples because private equity
fundraising is often driven by a private equity firms transaction IRRs and thus the measure is
more conducive to analysing the behaviour of private equity firms with respect to their
motivations.
4.4 Investigating the role of firm size/skill in a return/duration
relationship
4.4.1 Sample construction: Sample B
To investigate the interplay of firm size in a return/duration relationship it was necessary to
construct a sample of high return transactions. This allowed analysis to be performed which
could determine whether the majority of high return transactions were sponsored by a small
minority of large, mature private equity firms as would be in agreement with the hypothesis.

56

The sample, referred to as Sample B was constructed by filtering for the top 25% or 532
transactions in Sample A by their money multiples.
Money multiples were chosen as a filter over IRR as IRR accounts for the time value of
money. Some transactions have high IRRs due to very short transaction durations rather than
due to any meaningful absolute return. Therefore a sample of high return transactions
constructed by filtering for high IRRs would not have been conducive towards investigating
high return transactions. Conversely, filtering by money multiples ensured that all
transactions in Sample B had a high level of absolute return, albeit with different durations.
The transactions in Sample B all had money multiples of at least 3, which according to
investors is a suitable level for successful private equity fundraising
24
.
An important caveat to choosing money multiples as a filter in constructing Sample B was to
ensure that any relationship found between IRR and duration was also valid for money
multiples and duration. This was necessary because any analysis on the role of firm size in
high money multiple transactions would only be of use if the relationship found between one
measure of return (IRR) and duration was also valid for the other (money multiples). Details
of how this was successfully tested for can be found in Appendix A.1.
4.4.2 Method: firm analysis of high-return transactions
Sample B was analysed with a view to determining the proportion of its transactions that
were sponsored by large, mature private equity firms and to determine whether this
constituted a majority.
For all transactions in Sample B the sponsoring firms founding year was investigated and
noted to determine firm maturity. Sponsor-firm names for each transaction were cross-

24
January 22, 2002. Financial News. Hands is overselling his record, rivals claim.
http://www.efinancialnews.com/digest/2002-01-22/guy-hands-10

57

checked against a list of the top 50 private equity firms in the world by 5-year fundraising
25

to determine the size of the firm. A tally was taken of the number of firms which had greater
than or equal to 5, 10 and 15 investments in the sample respectively. Together this
information allowed analysis to determine to what extent the samples transactions were
sponsored by a small minority of large/mature private equity firms.
4.5 Investigating the characteristics of high return transactions and
shock therapy
4.5.1 Sample construction: Sample C
Following a determination of the relationship between transaction return and duration and the
interplay of firm size/skill in that relationship, it was important to determine the
characteristics of high return and short duration transaction in general and to investigate
whether they were more short-termist than in other transactions. If this was found to be the
case, it would suggest that for those transactions in which high return was generated, it was
generated through methods more consistent with private equity shock therapy than private
equity behaving as a superior organisational form. Such results would be in agreement with
the hypothesis.
Sample B provided a base sample of high return transactions however the information
provided in PPMs on these transactions was not useful for determining the characteristics to
which their high returns were attributed. Information had to be found through other means to
determine this. Private equity is a secretive industry and information regarding the details of
initiatives private equity firms implement in their portfolio companies is only publicly
available through two channels: private equity firm websites and the press. Information was

25
Top 50 Private Equity Firms by 5-Year Fundraising, Private equity international 300,
http://www.peimedia.com/resources/PEI%20300/2012/PEI300_Top50_new.pdf

58

collected through three sources within these channels and then collated to form case-studies
for each transaction in Sample B. The three sources were: (1) company websites
26
; (2)
LexisNexis Academic database
27
; and (3) AltAssets.net
28
; together searching over 15,000
business, legal and news sources and ensuring that the maximum possible quantity of
information was collected given the time restrictions of this research. Information of a
sizeable quantity was found for 217, or 41% of the 532 transactions in Sample B, referred to
as Sample C.
Prior to analysing trends amongst the case-studies in Sample C it was important to ensure that
the sample was representative of Sample B. This was to ensure that any trends observed
across Sample C could be generalised for all high return transactions covered by its parent
sample; Sample B. An outline of how this representativeness was successfully tested for is
detailed Appendix A.2.
4.5.2 Method: case-study codification
Analysing the characteristics of an individual transaction through its case-study was not
useful for determining general trends across many transactions. Case-study information
would only be useful if information was extracted from many cases (transactions) and trends
analysed across them. A technique known as case-study codification was used to achieve
this.
Case-study codification involves the use of tallies to determine the frequency with which
various actions/initiatives commonly implemented by private equity firms on their portfolio
companies appear in a large number of case-studies. A list of these common

26
There were 130 firms represented in Sample B and each company website was reviewed. Full referencing of
these websites has not been provided due to impracticality.
27
LexisNexis Academic provides access to more than 15,000 of the most credible business, legal, and news
sources available in a single location. http://academic.lexisnexis.com
28
A global provider of private equity and venture capital news and research. http://www.altassets.net

59

actions/initiatives was created (see Appendix A.3), the case-study for each transaction in
Sample C read, and the characteristics which returns were attributed to recorded and tallied
over the entire sample. This provided information as to how commonly the success of high
return transactions was attributed to various actions/initiatives (characteristics) across all
transactions in Sample C.
Once case-study codification was complete it was necessary to analyse the resulting data to
determine whether the characteristics of high return/short duration transactions were more
short-termist and more in line with shock therapy than other transactions. This required
two forms of analysis:
1. Comparative analysis - the characteristics of high absolute return transactions
detailed by codification had to be compared to those of average transactions to
determine whether they were more short-termist by nature. For this to be possible
existing literature had to be reviewed to find similar codification data on average
transactions which the results of this research could be compared to.
2. Variation analysis - if through the earlier aspects of this research a negative
relationship between IRR and duration was found to exist, Sample C had to be split
into different quadrants to analyse the variation of characteristics with different
IRRs and durations in order to determine the differences between the characteristics
of high IRR, short duration transactions and those of other transactions. This would
allow one to determine whether the returns and durations of high IRR, short duration
transactions (as the ideal type of transactions that fulfil private equity firm
motivations) were achieved through means that were more short-termist and
conducive to short-term shock therapy than lower IRR and longer duration
transactions. The details of the quadrant method are explained with the relevant
results in Section 5.3.3.

60

5. RESULTS AND ANALYSIS
5.1 Relationship between return and duration
In determining whether a relationship between return and duration exists, IRR and duration
data from Sample A was plotted to give Figure 9 shown below. The figure shows graphically
that a negative relationship between private equity transaction IRR and duration exists
for a large global sample of private equity transactions spanning over two decades.
Figure 9

Caption: Figure shows a negative relationship between the IRR and duration of 2,128 private equity transactions. Suitable
axes have been chosen to prevent skewing from anomalies in both axes.
Figure 9 also shows that the high return and simultaneously short duration transactions
in the data represent a minority of transactions. Thus though a negative relationship is
found between IRR and duration, the results remain consistent with the empirical data on
transaction durations found by heterogeneous view where transactions with short durations
represent a minority of total transactions. Indeed transactions in Sample A with an IRR
0%
50%
100%
150%
200%
250%
300%
350%
400%
0 1 2 3 4 5 6 7 8 9 10
I
R
R

(
%
)
Duration (Years)
Sample A: IRR vs. Duration - 2,128 Global Private Equity Transactions, 1981-
2005

61

greater than 100% account for only 16.4% of the sample and transactions with durations of 2
years or less account for only 21.8%. These results are therefore in agreement with the
hypothesis and show that though the heterogeneous view is accurate in stating that the
majority of transactions are neither of short duration nor long duration (Kaplan, 1991), it is
likely inadequate as a conclusion to the debate on the nature of private equity as it does not
discuss the negative relationship found between transaction returns and durations and in turn
does not investigate the forces driving this relationship.
5.2 Role of firm size/skill in the return/duration relationship
Table 3 highlights that of the top 25% (532) highest returning deals of the 2,128 deals in
Sample A filtered from a database of 11,704 deals undertaken by 334 firms, 70% were
undertaken by only 37 firms. Of these firms, 97% were founded before 1990 with a mean
founding year of 1983 (30 years ago at the time of this research), and 59% were members of
the 50 largest private equity firms in the world.
This shows that the vast majority of the top quartile of transactions by return in a global
sample of private equity transactions from 1981-2005 were sponsored by a minority of 11%
of private equity firms which are all well reputed, mature, and the vast majority some of the
largest private equity firms in the world. Based on the data analysed this presents global
investment-level evidence suggesting that the vast majority of high return private equity
transactions are sponsored by a small minority of large, mature private equity firms.

62

Table 3

These results are therefore in agreement with the hypothesis and suggest three things:
1) The likelihood of a transaction having a high return and a short duration is directly
related to its sponsoring private equity firms skill; using firm size/maturity as a proxy
measure for skill.
2) Given that only a small minority of large, mature private equity firms are likely to
possess the skill necessary to achieve high returns and short durations in transactions, it is
not surprising that such types of transactions represent only a minority of total
transactions.
3) Given the majority of private equity firms likely do not possess the skill necessary to
achieve high returns and short durations in their transactions, it is likely that the majority
of private equity transactions are forced to generate lower returns and stay in private
equity ownership for longer durations than their sponsoring firms would desire. This
likely contributes to the surface impression of the nature of private equity as both and
neither a form of short-term shock therapy and/nor a long-term superior organisational
form outlined by the heterogeneous view; but shows that by focusing solely on empirical
evidence on transaction durations and not incorporating evidence on transaction returns,
firm motivations and firm size/skill, the heterogeneous view is likely too shallow a
description of the nature of private equity.
Number of
Investments per Firm
Number of
Firms
Number of
Deals
% of Total
Deals
Mean Firm
Founding Year
Percentage of
Firms
Founded
Before 1990
Percentage in Top
50 Firms Globally
by 5 Year
Fundraising
Totals*
15 7 139 26% 1980 100% 71%
10 12 202 38% 1981 100% 67%
5 37 374 70% 1983 97% 59%
Any 130 532 100% - - -
Sample B - High Return Transactions Firm Distribution
*As of 2012. Source: Private Equity International 300 -
http://www.peimedia.com/resources/PEI%20300/2012/PEI300_Top50_new.pdf

63

As such this evidence suggests that the heterogeneous view of private equity is flawed as a
conclusion to the debate on the nature of private equity, and simultaneously provides
evidence for the alternative conclusion proposed by this study: that a more accurate
conclusion would be to describe private equitys intrinsic nature as one of short-term shock
therapy, but with the majority of private equity transactions being prevented from
embodying this state due to limitations in their sponsoring private equity firms skill in
achieving high transaction returns and short transaction durations. The difference between the
heterogeneous view and this alternative conclusion is illustrated by Figures 10 and 11.
Figure 10

64

Figure 11

5.3 Characteristics of high return transactions and shock therapy
Evidence has been found in support of the shock therapy view of private equity through an
analysis of the relationship between transaction returns, durations and firm size/skill. This
section will provide additional evidence analysing the characteristics of high return
transactions; finding that high return, short duration transactions (or ideal private equity
transactions) have more characteristics attributable to short-term shock therapy than other
types of transactions.
5.3.1 Notable characteristics of high absolute return transactions
Excluding exceptions (see Note, Appendix A.3) the top 10 characteristics of high absolute
return transactions which returns are attributed to are outlined in Table 4.

65

Table 4

The top 10 ranking should not be mistaken for a ranking of the most effective sources of
return generation in private equity transactions as case-study codification was limited in its
analysis of certain types of return generation (see Note, Appendix A.3). However it is useful
for identifying the most important characteristics to focus ones attention to when comparing
the characteristics of high absolute return transactions with those of average transactions, and
when analysing their variations with respect to IRR and duration. Here it can be seen that
certain forms of governance engineering (management equity stakes, changes in
management) and certain forms of operational engineering (add-on acquisitions, new
products, process efficiency initiatives) form the basis from which comparative and variation
and analysis should be performed.
1.
High management
equity stake (57%)
6.
New geography
expansion (28%)
2.
Add-on
acquisitions (56%)
7.
Strategic
repositioning
(27%)
3.
New products
(45%)
8. Cost cutting (26%)
4.
Management
changes
(CEO/CFO/COO)
(42%)
9.
Capital
improvements
(25%)
5.
Process efficiency
initiatives (31%)
10.
Growth in sales of
existing products
(23%)
Top 10 Characteristics of High Absolute Return
Private Equity Transactions by Frequency of
Mention in Case Studies* (% of Cases)
*Derived from Appendix A.3

66

5.3.2 Comparison of characteristics of high absolute return transactions and
average private equity transactions
Comparing the characteristics of high absolute return transactions with those of average
private equity transactions was limited by the limited quantity of similar research in existing
literature. However some results of use were found (see Appendix A.3 for detailed table of
results):
1) Governance engineering and add-on acquisitions (operational engineering)
The frequency of add-on acquisitions and various forms of governance engineering being
implemented in high absolute return transactions are similar to their frequencies in average
private equity transactions (management changes 42% vs. 37% of cases, management equity
stakes 57% vs. 62%, add-on acquisitions 57% vs. 50%) as reported by Guo et. al (2009).
This suggests that differences between high absolute return transactions and average private
equity transactions likely do not stem from more or less active governance engineering or
add-on acquisitions.
2) Valuation multiples
Case-study codification provided no evidence as to the effects of increases in valuation
multiples on the returns generated in high money multiple transactions. However additional
research was performed (results in Appendix A.3) comparing the value of the S&P 500 index
at the date of entry and exit of the transactions in both Sample C (high absolute return
transactions) and Sample A (average private equity transactions). The S&P 500 index is a
good indicator of sentiment in equity markets which drive valuation multiples and as such if
the value of the S&P 500 was higher at an investments exit than it was at entry it was
assumed that its valuation multiple increased and contributed to the returns of the transaction.

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In Sample C this was found to be true for 75% of cases while for Sample A this was true for
74% of cases. This suggests that a greater capitalisation on valuation multiple increases is not
likely a factor contributing to the differences in return between high absolute return
transactions and average transactions.
Overall the results that were found in this analysis did not suggest differences in the
frequencies of various characteristics occurring between high absolute return transactions and
average transactions. Therefore there was no evidence of characteristics being more or less
short-termist in high absolute return transactions. However due to the limited existing
evidence available for comparison this analysis cannot be considered useful or conclusive on
its own as it only provided evidence on 3 characteristics out of the 30 analysed through case-
study codification (see Appendix A.3). As such an analysis of how characteristics varied with
IRR and duration was warranted to provide a more holistic view, especially considering the
finding of a negative relationship between IRR and duration in Section 5.1.
5.3.3 Variation of characteristics of high absolute return transactions with
IRR and duration
A negative relationship between IRR and duration was found in Section 5.1 for Sample A.
This relationship pervaded into its high absolute return sub-sample Sample B and thus into
Sample C as a further sub-sample. Given this negative relationship, dividing Sample C into
quadrants by IRR and duration (see Figure 12) and analysing the variation in notable
characteristics across them was important to determine whether the characteristics of high
return, short duration transactions were more short-termist than those of other transactions.
Detailed results of the variation of characteristics across quadrants can be found in Appendix
A.3 but a number of important findings are discussed after Figure 12 which suggest that the
characteristics of high return, short duration transactions are indeed more short-termist.

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Figure 12

Caption: Figure shows the IRRs and durations of all high absolute return transactions for which case-studies were found. The
sample was split into quadrants for analysis of the variation of their characteristics with respect to IRR and duration.
1) Short-termism in high IRR, short duration transactions: improving efficiency
over revenue growth
When comparing high IRR, short duration transactions (quadrant 1) to lower IRR, long
duration transactions (quadrant 4) it was found that the former appeared to focus more on
process efficiency initiatives (37% vs. 30%) and less on growing sales of existing products
(18% vs. 24%), the introduction of new products (39% vs. 49%), expanding company
presence in new and existing geographies (18% vs. 30%, 16% vs. 20%), and capital
improvements (24% vs. 29%) than the latter.
This suggests that private equity transactions that generate the highest IRRs in the shortest
periods of time focus more on improving the efficiency of existing factors of production over
driving revenue growth or investing in the long-term growth of a company. This behaviour is
more in line with short-term shock therapy than that of a superior organisational form.

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Given the motivations of private equity firms it is understandable that improving efficiency
would be preferred over driving growth in portfolio companies as the former is under the
direct control of private equity firms and its effectiveness depends only on the skill of the
firm; while the latter depends on both its skill and on influencing/appealing to consumer
demand which is both more difficult to control and more time consuming. It is not surprising
then that high IRR, short duration transactions attribute their returns to more short-termist
sources of return generation than lower IRR, long duration transactions. This is compounded
by the fact that the former also show less emphasis on branding or marketing improvements
than the latter (16% vs. 20%), which would likely be part of any strategy intended to
influence consumer demand and improve sales while having little impact on efficiency gains.
2) Short-termism in high IRR, short duration transactions: valuation multiple
increases
Valuation multiple increases are more common in high IRR, short duration transactions
(quadrant 1, 84%) compared to lower IRR, long duration transactions (quadrant 4, 70%). This
suggests a much higher capitalisation on favourable exit opportunities and market timing to
generate returns in the former than in the latter; a distinguishing mark of shock therapy in
private equity transactions and the opportunistic nature of buyout markets.
3) Luck in high IRR, long duration transactions
High IRR, long duration transactions (quadrant 2) show more evidence of favourable industry
developments having influenced their returns than any other type of transaction, and this is
emphasised by the fact that this quadrant was the only one in which this characteristic was a
top 10 characteristic (see Appendix A.3).

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This suggests that luck plays a larger role in generating returns in high return transactions
with long durations than high return transactions with short durations. In essence, a number
of these transactions were likely to have had lower returns if it werent for exogenous, non-
private equity related factors that affected them. This strengthens the evidence of a negative
relationship between IRR and duration by suggesting that high return transactions with longer
durations can be considered somewhat anomalous by nature.
Overall, the analysis of the variations in the characteristics of high absolute return
transactions with respect to IRR and duration suggests that high IRR, short duration
transactions, which constitute ideal private equity transactions from the perspective of
private equity firm motivations, use more short-termist methods consistent with
shock therapy in generating returns than other transactions. This finding suggests that
the most successful private equity transactions are those that enact short-term shock therapy
on portfolio companies rather than those that focus on behaving as a superior organisational
form.

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5.4 Conjecture
The results of the investigation of the research question have found that private equity
transaction returns and durations are negatively related, with high return, short duration
transactions representing a minority of transactions, but with the majority of these
transactions being sponsored by a small minority of large, mature private equity firms.
Furthermore it has been found that high return, short duration transactions have more short-
termist characteristics consistent with short-term shock therapy than other transactions. In
essence, evidence has been found in favour of the hypothesis.
Based on these findings and the findings from the literature review this research conjects an
alternative conclusion to the debate on the nature of private equity as follows:
Conjecture: Private equity is by nature a form of short-term shock therapy but for the
majority of private equity transactions, the limitations of a firms skill in achieving
high returns and short durations in transactions prevent them from embodying this
natural state.
This suggests that the existing conclusion to the debate on the nature of private equity
(the heterogeneous view, which argues that private equity is both and neither a form
of short-term shock therapy and/nor a long-term superior organisational form) is
limited, shallow and incomplete as by incorporating evidence on private equity returns,
firm motivations and firm skill/size into the duration-only evidence used by the
heterogeneous view, a different conclusion can be reached.
This conjecture must not be taken as a definitive conclusion to the debate on the nature of
private equity as there are limitations to this research discussed in Chapter 6. Therefore this
research must be checked, expanded upon and corrected if necessary.

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5.5 Implications of conjecture and practical recommendations
There are a number of implications of the conjecture / alternative conclusion and practical
recommendations that can be made for different stakeholders of this research when
considering it:
Oxford Private Equity Institute and private equity academics for academics this
research is of importance as the conjecture suggests that the current conclusion to the debate
on the nature of private equity is incomplete. It is recommended that further research on this
topic be conducted as developing a better understanding on the nature of private equity is
critical for understanding private equitys role in the economy and its purpose as an
organisational form touted to be a solution to public corporation agency problems. It is likely
that publishing research on this topic would provide positive reputational value to the
organisation in its quest to become the leading academic institution in the field of private
equity.
Private equity firms/practitioners this research is useful for private equity
practitioners in highlighting that a firms ability to fulfil its motivations to generate high
returns and do so in short periods of time for a) successful future fundraising, and b) greater
lifetime incomes for its partners and investors, is likely dependent on its skill. Hence, unlike
other asset classes such as the mutual fund industry (Carhart, 1997) where returns have a
weaker dependence on skill, a private equity firm seeking to improve its returns and shorten
its transaction durations should place utmost importance on its human capital, and seek to
invest in growing the experience and learning/skill of its deal partners either organically or
through acquisition in order to best position itself for long-term success and survival.
Portfolio companies this research is useful for portfolio companies from a
governance perspective as a gentle warning to their board of directors when considering

73

whether a proposal for acquisition by a private equity firm is in the best long-term interests of
their companies. It is likely that the interests of private equity firms and portfolio companies
are misaligned, and that the larger and more mature a private equity firm is, the greater the
risk for portfolio companies in their new owners implementing changes to them which do not
improve operating performance but simply generate high returns for equity investors.

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6. LIMITATIONS AND FURTHER RESEARCH
6.1 Checking the return/duration relationship and the limitations of
IRR
6.1.1 Limitations of the research
This research is limited in its finding a negative relationship between IRR and duration as it
only details this relationship graphically and does not quantify its strength. The same is true
for the relationship between money multiples and duration detailed in Appendix A.1. Further
research is recommended to check the robustness of the negative relationship as the
conjecture and recommendations of this study are based on this relationship being true.
Traditional robustness checks include regression analysis and other statistical methods. Such
research would solidify the findings of this research and quantify the strength of the negative
return/duration relationship.
6.1.2 Limitations of the research method
The research method is limited by having chosen IRR as a measure of return. Using both
money multiples and IRR together in measuring an investments return was used to mitigate
this problem somewhat, however by nature IRR is a hypothetical and fairly abstract rate of
return despite it being favoured by limited partners as a measure of return. The calculation of
an investments IRR is based on the assumption that all of a portfolio companys interim
distributions of profits (dividends) are re-invested into the company at the IRR rate. In reality
this is rarely the case and thus IRR is not an ideal measure of return.
There are two superior methods for measuring return outlined below which like IRR account
for the time value of money but improve upon its accuracy. It is recommended that further

75

research be undertaken to verify the negative return/duration relationship found using these
measures of return.
1) Modified IRR
Here the re-investment of interim distributions at the IRR rate is not assumed and instead an
assumption of re-investment is made at a fixed rate, e.g. the return of the S&P 500 over the
duration of the investment. This measure of return was not used in this research as the data
manipulation capabilities to generate it for this studys transactions were limited.
2) Net present value NPV
Academics suggest that determining changes in an investments net present value is the best
way to measure its return. This method implicitly assumes that all distributions are re-
invested at the transactions cost of capital rather than at the IRR rate or a fixed rate. As a
result it represents a serious improvement in accuracy when measuring return over IRR for
any given transaction.
Though the NPV method is superior to IRR it requires that the cost of capital for any given
transaction be known. However, this value differs between transactions and accurate
information regarding it is only available from sponsoring private equity firms or debt
financiers. Unfortunately this information was not provided in the PPMs used in this research
and it was not feasible to contact 334 private equity firms to request this information for all
2,128 transactions in Sample A; nor would this information have likely been provided.
There are methods for estimating the cost of capital that could be used in NPV calculations
but these were beyond the scope of this research due to time restrictions. It is likely that if
such methods were used they would prove useful in verifying and improving upon the
findings in this research. This would likely be a difficult and time-consuming task for any

76

researcher but given the importance of this research topic and its relevance to the private
equity industry it may be an avenue of further research worth considering.
Overall, given the time limitations of this research and the information available, IRR was the
most reasonable available method of measuring return in this study. However given that
modified IRR and NPV were not used as cross-checks, the results and findings of this
research can only be considered as suggestive until such a time that these results are verified
and corrected where necessary.
6.2 Case-study codification limitations
6.2.1 Limitations of the research
In comparing the results of the case-study codification process for high return transactions
with data from existing literature on average private equity transactions it was found that
there was little research available to compare the results to. As such though analysis of the
variations of the characteristics of high return transactions with respect to IRR and duration
proved fruitful, the comparison of characteristics between high return transactions and
average private equity transactions did not; with comparative evidence being found for only 3
of the 30 characteristics analysed. Greater comparison of the characteristics of these two
types of transactions would be useful for determining whether the characteristics of high
return transactions are more short-termist than average transactions. As such there is
potential for further research.
As existing literature does not shed much light on the characteristics of average private equity
transactions it is recommended that the Oxford Private Equity Institute consider conducting
case-study codification on Sample A (2,128 transactions) to compare the existing results of
the codification of Sample C (217 high absolute return transactions) to.

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6.2.2 Limitations of the research method
Aside from the limitations of the results of case-study codification, the case-study
codification process itself had some limitations. Due to the private equity industry being a
secretive one there are limited ways to improve upon the case-study codification process.
Nevertheless its limitations and some methods of improvement are discussed below.
It must be noted however that the case-study codification process only provided bonus
evidence for the development of this studys conjecture and it was not critical in this regard.
As such improvements in the case-study codification process would improve the robustness
of the conjecture, but discontinuing further research would not invalidate it.
1) Case-studies are qualitative
Case-studies are not quantitative by nature and therefore though they are useful in
determining the most popularly attributed sources of returns in high return transactions, they
provide no information as to their relative effectiveness on a general or individual transaction
basis.
Unfortunately case-studies are the best available source of information regarding private
equity transactions as ultimately the industry is secretive. As such no recommendations can
be made on a superior quantitative method for analysing the characteristics of transactions.
2) Level of information in case-studies varies
The codification possible for any given case-study is dependent on the level of information
obtained on the transaction at hand. Given that information is gathered from what private
equity firms and the press choose to disclose and report respectively, there are variations in
the level of detail available for any given case on what changes private equity firms make to

78

their portfolio companies. In this research for example there was less publicly available
information for older transactions or less exciting or controversial transactions.
Every reasonable step was taken to mitigate this problem by using two large databases and
company websites which in total searched over 15,000 news sources for transaction
information. Furthermore only cases for which significant information was found were
codified. However, ultimately case-studies are limited in one-to-one comparisons as the
information they provide will never reflect all the initiatives private equity firms implement
on their portfolio companies and will thus vary in detail.
3) Case-studies suffer from bias
Due to the codification process being based on what private equity firms choose to disclose
about their transactions, there is a tendency for this information to be biased towards the
reporting of socially acceptable methods of return generation. That is, private equity firms are
more willing to report the generation of returns from for example synergies from an add-on
acquisition than from the laying-off of a portfolio companys employees. As such there was
limited information available regarding some characteristics of return generation which may
have been more widely occurring than the codification process could determine.
The codification process was thus limited to only being able to provide useful information on
certain characteristics of high return transactions, in particular the top 10 characteristics for
which information was widely found. Analysis of these characteristics proved useful in
suggesting the short-termist nature of high return transactions but it is likely that far more
analysis could have been performed had more information on other non-reported
characteristics been available. Therefore there is potential for further research on the lesser
reported characteristics of case-study codification from which further evidence for the
conjecture of this research could be found. Obtaining information on transactions in addition

79

to what is already publicly available would be difficult but could be achieved for example
through rigorous interviewing of portfolio company exit buyers or employees.
Overall, given the difficulties in finding a superior method than case-study codification for
analysing the characteristics of private equity transactions, it can be said that every
reasonable measure was taken to ensure the findings of this research were as accurate and
useful as possible. That is not to say however that there was not much to be desired when
comparing codification to the quantitative methods used to analyse the return / duration / firm
size/skill relationship.

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7. CONCLUSION
Defining the nature of private equity has become a topic of heated debate in academic circles
as the industry has grown into one with over a trillion dollars in assets-under-management
over the last thirty years, and one through which the ownership of some of the worlds largest
corporations has passed.
The existing debate regarding private equitys nature can be summarised by two disparate
views: The first view argues that private equity is a long-term superior organisational form
that provides a superior governance structure to that of the public corporation by solving
agency problems through stronger investor monitoring, and improving managerial discipline
through a combination of ownership concentration and substantial leverage. The second view
argues that private equity is a form of short-term shock therapy that allows inefficient and
badly performing companies with inferior corporate governance to enter quick but intense
periods of corporate and governance restructuring in order to return to public ownership after
a few years. As of the writing of this paper the existing conclusion to this debate, based solely
upon empirical evidence on private equity transaction durations is the heterogeneous view
of private equity, which argues that neither view is entirely correct and neither is entirely
wrong.
This study has sought to suggest that the heterogeneous view is flawed as a conclusion to the
debate on the nature of private equity due to its not incorporating evidence on private equity
transaction returns, firm motivations and firm size/skill. This was achieved by:
1) An examination of existing literature to suggest the possible failings of the
heterogeneous view. In turn this allowed the development of the research question
and hypothesis.

81

2) Analysing a global database of private equity transactions and case-studies to find
evidence in support of the hypothesis and to posit an alternative conclusion to the
debate on the nature of private equity, along with practical recommendations for the
stakeholders of this research.
An examination of existing literature found that private equity firms are motivated to achieve
high returns and short durations in their transactions; desires more characteristic of short-term
shock therapy than those of a long-term superior organisational form. However it was
found that few transactions fulfil these motivations in practice with the majority of
transactions being of medium, not short durations. It was thus suggested that a limiting
factor might have been at play which prevented the majority of private equity transactions
from embodying their natural state of short-term shock therapy and fulfilling private equity
motivations. In order to discover what this limiting factor might have been two avenues of
research were examined:
1) Literature on private equity returns was reviewed; finding that the interests of private
equity firms and their portfolio companies were likely misaligned. This suggested that
the interests/influences of portfolio companies on private equity investment decisions
were not likely to be the limiting factor in question.
2) Literature on the relationship between private equity firm size, skill and returns was
reviewed; finding that a private equity firms skill in achieving high transaction
returns and short transaction durations could have been the limiting factor in question.
Empirical analysis was conducted to test whether in practice firm skill was indeed the
limiting factor in question through an analysis of a global sample of 2,128 private equity
transactions from 1981-2005. It was found that a negative relationship existed between
private equity transaction returns and durations; with high return, short duration transactions

82

representing a minority of transactions. Furthermore it was found that of the top 25% highest
returning transactions from this sample, 70% were undertaken by a small minority of 11% of
private equity firms; 97% of whom were highly mature firms and 59% of who were members
of the top 50 largest private equity firms in the world. This suggested that:
1) The likelihood of a transaction having a high return and short duration was directly
related to its sponsoring private equity firms skill; using firm size/maturity as a
proxy measure.
2) Given that only a small minority of large, mature private equity firms were likely to
possess the skill necessary to achieve high returns and short durations in transactions,
it was not surprising that such types of transactions represented only a minority of
total transactions.
3) Given the majority of private equity firms likely did not possess the skill necessary to
achieve high returns and short durations in their transactions, it was likely that the
majority of private equity transactions were forced to generate lower returns and stay
in private equity ownership for longer durations than their sponsoring firms would
have desired; a factor likely contributing to the surface impression of private equity
provided by the heterogeneous view that private equity is both and neither a form of
short-term shock therapy and/nor a long-term superior organisational form. This
suggested that by not incorporating empirical evidence on returns, firm motivations
and firm size/skill, the heterogeneous view was likely too shallow a description of the
nature of private equity.
These findings were supported by case-study analysis which found that high return, short
duration transactions had more short-term shock therapy characteristics than other
transactions; focusing on improving efficiency over driving sales growth or long-term

83

investment in portfolio companies, and taking greater advantage of favourable market
conditions to exit investments when opportunities arose.
Therefore, this study conjected that the heterogeneous view of private equity is flawed as a
conclusion to the debate on the nature of private equity, and suggested that a more accurate
alternative conclusion would be to describe its nature as a form of short-term shock therapy,
but with the majority of private equity transactions being prevented from embodying this
state due to the limitations of their sponsoring private equity firms skills in achieving high
transaction returns and short transaction durations.
This alternative conclusion to the debate on the nature of private equity allowed a number of
practical recommendations to be made for academics, private equity practitioners and
companies considering accepting private equity investments. The limitations of this research
and further research possibilities were also discussed and it was noted that the findings of this
research must be considered as suggestive until such a time that they are verified for
robustness and expanded upon where necessary.

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A. APPENDICES
A.1 Checking negative return/duration relationship for money
multiples
Checking that the negative relationship found between IRR and duration also held between
money multiples and duration was important as the entirety of research - including the role of
firm size in a return/duration relationship - centred on a negative relationship being found
between all measures of return and duration.
Figure 13 shows that after filtering Sample A by money multiples to construct Sample B, the
negative relationship found between IRR and duration for the former pervades into the latter.
This would not be expected if a negative relationship existed between money multiples and
duration as data points of long duration would not exist. Thus it was likely that either no, or a
less strong negative relationship existed.
Figure 13

0%
50%
100%
150%
200%
250%
300%
350%
400%
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0
I
R
R

(
%
)
Duration (Years)
Sample B: IRR Vs. Duration - 532 (Top 25%) Highest Absolute Return
Transactions from Sample A

89

To test for which was true a cumulative distribution of transaction durations in Sample B was
compared to the cumulative distribution of durations of a universal sample of LBOs
constructed from data from Kaplan and Stromberg (2009). This is illustrated by Figure 14.
The figure shows that the transactions in Sample B have a distribution of durations that are
skewed towards shorter durations than their universal counterparts. This suggests that a
negative relationship between money multiples and duration does exist, but that it is less
strong than for IRR and duration. This shows that Sample B is an appropriate sample through
which to test the role of firm size in a negative return/duration relationship.
Figure 14

17.3%
68.0%
81.4%
86.8%
97.4%
12.0%
42.0%
51.0%
58.0%
76.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
90.0%
100.0%
<2 years <5 years <6 years <7 years <10 years
C
u
m
u
l
a
t
i
v
e

%

o
f

T
r
a
n
s
a
c
t
i
o
n
s
Duration
Sample B: Cumulative Distribution of Transaction Durations
Sample B (532 transactions 1981-2005) - 3.8 year Median Duration
Kaplan & Stromberg 2009 (17,171 transactions 1970-2007) - ~6 year Median Duration

90

A.2 Testing the representativeness of Sample C with respect to
Sample B
In searching for case-study information on transactions in Sample B, sizeable information
was only found for 41% of transactions Sample C. Case-study codification performed on
Sample Cs transactions was undertaken with a view to developing generalisations that could
be applied to its the transactions of its parent, Sample B. For this to be possible it was
necessary for Sample C to be representative of Sample B.
Representativeness was tested for using two methods:
1. By a comparison of the cumulative distribution of durations of the two Samples as
shown by Figure 15.
2. By a comparison of the median IRRs of transactions of various duration ranges as
shown by Table 5.
Figure 14 shows that Sample C has a similar cumulative distribution of transaction durations
to Sample B. This is supported by Table 5 which shows how the median IRRs of transactions
of various duration ranges, and the manner in which they decrease in Samples B and C are
similar as duration ranges are shifted towards larger values. Thus from two perspectives
that of durations and that of IRRs Sample C can to a reasonable extent be considered
representative of Sample B. As such any results, analysis and trends gathered regarding
Sample C can be applied to Sample B.

91

Figure 15

Table 5

17.3%
68.0%
81.4%
86.8%
97.4%
20.3%
73.7%
85.3%
89.9%
98.2%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
90.0%
100.0%
<2 years <5 years <6 years <7 years <10 years
C
u
m
u
l
a
t
i
v
e

%

o
f

T
r
a
n
s
a
c
t
i
o
n
s
Duration
Samples B & C: Cumulative Distribution of Transaction Durations
Sample B (532 transactions 1981-2005) - 3.8 year Median Duration
Sample C (217 transactions 1981-2005) - 3.7 year Median Duration
% of Total Median IRR % of Total Median IRR
0-1 years 3.4% 245.1% 4.1% 245.1%
1-2 years 13.0% 154.6% 15.2% 180.7%
2-3 years 19.2% 94.2% 18.0% 94.9%
3-4 years 17.1% 65.6% 18.0% 60.4%
4-5 years 14.1% 51.6% 16.6% 52.4%
5-6 years 13.5% 41.3% 12.0% 47.1%
6-7 years 6.4% 33.4% 5.5% 45.5%
7-8 years 4.7% 33.7% 5.1% 39.1%
8-9 years 3.2% 34.1% 2.3% 24.4%
9-10 years 2.4% 22.0% 1.4% 40.6%
>10 years 3.0% 29.2% 1.8% 48.5%
0-2 years
(Quickflips)
17.3% 164.8% 20.3% 183.3%
>2 years 82.7% 55.0% 79.7% 57.0%
Total 100% - 100% -
Sample C (217 transactions) Sample B (532 transactions)
Duration

92

A.3 Case-study codification results

Continued overleaf.
Quadrant
Duration, IRR%s in Quadrant
All Durations, All
IRRs
<2 years, All
IRRs
>2 years, All
IRRs
<2 years, >100% >2 years, >100% <2 years, <100% >2 years, <100%
Number of Cases 217 44 173 38 35 6 138
Median IRR 70% 183% 57% 205% 134% 77% 51%
Characteristics to which Return is Explicitly Attributed in Cases
Studies
% of Cases % of Cases % of Cases % of Cases % of Cases % of Cases % of Cases
DEBT PAY-DOWN** 100% 100% 100% 100% 100% 100% 100%
OPERATING PERFORMANCE GAINS
Governance Engineering
Private equity is majority shareholder (implies board
control)
98% 95% 98% 95% 100% 100% 98%
Management changes (new CEO/CFO/COO) 42% 41% 42% 42% 43% 33% 42%
Additional management appointments 9% 16% 8% 11% 11% 50% 7%
Management has high equity stake 57% 57% 57% 58% 63% 50% 56%
Employee stock ownership 4% 9% 3% 11% 9% 0% 1%
Financial Engineering
Leverage >50% of capital structure** 100% 100% 100% 100% 100% 100% 100%
Dividend recapitalization (increase leverage to pay
dividends to private equity owners)
9% 9% 9% 11% 20% 0% 6%
Operational Engineering
External Growth Mechanisms
Acquisitions 56% 52% 57% 55% 51% 33% 58%
Divestments 8% 5% 9% 5% 0% 0% 12%
Sample C - Case Study Codification Results
Quadrant 3
(medium return,
short duration)*
Quadrant 4
(medium return,
long duration)
All Quadrants
Quandrants 1 &
3 (short
duration)
Quadrants 2 &
4 (long
duration)
Quadrant 1 (high
return, short
duration)
Quadrant 2 (high
return, long
duration)

93

Notes overleaf.
Organic / Internal Growth Mechanisms
Strategic repositioning / reorganisation / turnaround 27% 27% 27% 29% 26% 17% 27%
Refocus on core business lines / products 6% 7% 6% 8% 6% 0% 7%
Growth in sales of existing products / services 23% 18% 24% 18% 26% 17% 24%
Introduction of new products / services 45% 45% 45% 39% 31% 83% 49%
Growth in existing geography selling points (new stores) 19% 20% 18% 16% 14% 50% 20%
Growth in new geography selling points (new stores) 28% 23% 29% 18% 23% 50% 30%
Develop customer service 5% 2% 5% 3% 3% 0% 6%
More or improved branding / marketing 18% 16% 19% 16% 17% 17% 20%
New partnerships / joint ventures 5% 7% 4% 8% 6% 0% 4%
Innovation (e.g. R&D) 7% 9% 7% 8% 3% 17% 8%
Pricing review 1% 2% 1% 3% 3% 0% 1%
Cost cutting (labour, capital, overhead reduction) 26% 27% 25% 26% 23% 33% 26%
Capital improvements 25% 20% 26% 24% 14% 0% 29%
Purchasing initiatives (e.g. supplier consolidation,
changes to contracts)
9% 5% 10% 3% 9% 17% 10%
Selling initiatives (e.g. distributor consolidation,
changes to contracts)
7% 5% 8% 0% 9% 33% 7%
Process efficiency initiatives 31% 36% 29% 37% 26% 33% 30%
TAX SHIELDS*** n/a n/a n/a n/a n/a n/a n/a
VALUATION MULTIPLES INCREASES
S&P 500 index is higher at exit than at entry**** 75% 84% 72% 84% 83% 83% 70%
Favourable industry developments 13% 14% 13% 16% 23% 0% 10%
FAVORABLE ENTRY PRICES 2% 7% 1% 5% 3% 17% 1%

94

Note: Red values represent the top 10 most commonly mentioned characteristics in each column excluding 'private equity as a majority shareholder',
'leverage>50%', 'debt pay-down' and 'S&P 500 index higher at exit than at entry'; the first three of which are implicit in LBOs (see ** for the latter two) and
the fourth as it was added to this table and not derived from case-studies (see ****).
* Quadrant 3 was considered anomalous as the sample size was too small. The results have been shaded in gray and excluded from any analysis.
** All transactions in Sample C are LBOs and thus by definition have high leverage. Thus free cash-flow efficiency benefits and improved managerial
discipline from leverage are assumed in all transactions. Similarly 'debt pay-down' as a source of returns is assumed in all transactions as it is implicit that
debt-service payments occur in an LBO to increase the equity value of a company. Hence this row is valued as 100% across all columns.
*** 'Tax-shields' as a source of returns were not mentioned explicitly in any case-studies though they are implicit in LBOs due to government and accounting
regulations. The significance of tax-shields in individual transactions is not generally public knowledge, would not be disclosed by private equity firms and
thus would not be available to press for reporting. Hence this row is highlighted 'n/a'.
**** The S&P 500 index is used here as a proxy for global public equity markets' sentiment as it is regarded as a gauge of the large-cap US equities market;
the largest in the world. Use of this method as a proxy for valuation multiples increases rests on the assumption that a rise in the S&P 500 will constitute a
rise in the valuation multiples of companies. Data regarding S&P 500 Index values at various entry and exit dates was acquired from Standard & Poors.

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