Creation Stories

Brace yourself for the attack of the ‘value creation analysis template,’ a rigorous form of private-funds due diligence that asks investment managers to detail exactly where their returns came from, and an exercise that some managers find to be excruciating.

In the good old days, a fund manager would make an investment, things would go well, the investment would then be sold for a profit, and the investment manager would deliver the good news to his limited partners. And the LPs would say, “Gee, that’s nice.”

Well it’s not the good old days anymore. In fact, LPs are questioning whether the old days were even that good. Investors are now demanding much more information around private fund performance, including a breakdown of exactly how profits were created in the past. They believe that fund managers who merely rode macroeconomic momentum to good returns should not deserve pats on the back. In fact, they believe that general partners who can’t prove an ability to “add value” should probably be fired.

The financial meltdown has forced many institutional investors with significant alternative investment portfolios to pare down the number of GP relationships they maintain. There simply isn’t enough money to commit to everyone’s next fund. More importantly, these limited partners have taken the view that the only managers worth backing are those that do creative things with the assets they oversee.

Enter the “value creation analysis template.” According to several private fund-market participants, these forms have begun to circulate widely among fund managers trying to raise their next offering. They are submitted by investors or their advisors as part of a standard package of pre-commitment due diligence materials. They require fund managers to specify, portfolio company by portfolio company, exactly how value was created, and the “right answer” is evidence that at least part of the returns came from the strenuous efforts of the GP team members themselves, as opposed to market dynamics beyond the control of the managers.

Value creation analysis has been done as part of due diligence in private equity since at least the late 1990s. But now this job increasingly is being pushed to the GPs themselves, and in standardized formats designed to minimize fudging.

Private investment fund track records are comprised of a series of discrete portfolio investments over time, mostly positions in private companies. A fund invests in a company, and then months or years later exits that investment at what hopefully is a higher value. The combined result of these “round trip” investments is the total realized performance of the fund.

Each portfolio investment has its own story. A GP might say, here’s a deal we did in 2003 where we bought a German dental-equipment distributor for €100 million in equity. After five years we sold it to a big Swiss medical conglomerate and got back €150 million. So that was a 1.5x return. You’re welcome. Then there was the Tennessee door-knob maker we bought in 2004 for $50 million down. In 2006 we sold it to a big home-building products company and turned our equity into $100 million. We-e-e-e are the champions. . .

Deal “stories” like these have always been scrutinized in the due diligence process for insight into what makes each private investment firm unique. But whereas previously investors might have accepted a more anecdotal version for the success of each investment, they now want to see a much more quantitative breakdown of “value drivers.” For example, in the German deal, what percentage of the 1.5x return was due to an expansion in the average purchase-price multiples paid for dental-equipment distributors over the life of the investment? How much was due to the company’s earnings being used to pay down debt? How much was due to currency shifts? And here’s the big one – how much was due to growth in the company’s earnings?

It could be that the success of the door-knob maker had mostly to do with the incredible housing construction boom that took place between the 2004 investment and the 2006 exit. That would be expressed in a greatly expanded purchase-price multiple-of-earnings for door-knob makers and their ilk, indicating increased bullishness on the part of buyers in the heady real estate market of 2006 (a buyer who pays 8 times earnings expects a company to grow fairly fast; a buyer who pays 11 times earnings expects it to grow very fast). If, over the same time period, earnings at the door-knob portfolio company were flat, it might mean that exactly zero percent of the success of the deal came from an improvement in the company itself. Instead, much of the success seems to have been driven by bubble dynamics beyond the control of the investment managers. You could argue that these GPs bought the asset at the right time and sold at the right time, and that this feat is indicative of repeatable skill. But you could also say that these guys got lucky, and in the meantime they didn’t do a damn thing to improve the fortunes of the Tennessee door-knob maker, despite having owned it for two years. Would you commit your money to such a group again?

Even in cases where earnings growth is shown to have been a primary driver of value creation, investment managers are being asked to explain what they had to do with this growth. It’s the classic question of causality – is the party fun because I’m here? Or would it have been fun anyway? Would the company have grown just as well without the involvement of its private equity owners? What this means for GPs is that they must reconstruct the events, programs and changes that they put in place that (they claim) caused earnings to grow. To wit: They fired the German dental-equipment-distribution CEO and replaced him with a better one. They improved the inventory management process. The created a superior incentive program for the sales team. They changed the corporate logo from brown to red.

Armed with this kind of granular information, investors are better able to determine which fund managers have been truly adding value, and which have been merely the beneficiaries of market forces. But merely having data in a template doesn’t make investors perfectly able to make these determinations.

More context please

Breaking down the value drivers of each deal in a firm’s historic track record is hugely, hugely time consuming. “It’s been the bane of my existence,” admits one GP, who has the dubious honor within his firm of responding to the wave of incoming value creation analysis templates. He notes that over the past year the number of such templates sent through by investors has increased exponentially.

The process is not only time consuming, but fraught with incomplete information and the frequent requirement to give sound bites where longer stories would be better. In some cases, exits that happened years ago simply cannot be analyzed for value drivers because the firm has not retained the relevant data. In other cases, the GP charged with submitting the information worries that without more context, an attribution of value-creation might make the firm look merely lucky when in fact it deserves to look smart. For example, a firm might find itself having to attribute much of its success with an investment to an increase in purchase-price multiples, where in reality it may have worked feverishly with management to grow a business division within the company that the GPs knew would allow the company to fetch a higher multiple. Maybe the total earnings ultimately were flat over the hold period, but the source of the earnings changed, and therefore this change was rewarded in the market with a higher multiple. In this case, the GPs would have clearly “added value,” but on paper it would look like market momentum did all the work.

One template that I viewed asks the manager to calculate how much of the value creation came in the form of debt paydown. And yet in many cases, only improvements in operations can allow meaningful debt paydowns to take place. Without the story behind what the debt paydown figures, an investor might make decisions based on flawed assumptions.

The solution to the problems created by all this new information is, unfortunately, even more information. Investor insistence on value creation analysis is a step in the right direction for the private investment industry. Absent such information, investors will have trouble identifying the only skills worth paying for in alterative investing. But absent further context, these value creation analysis templates (can someone create shorthand term, please?) don’t tell the full story. An investor who takes these documents at face value might end up making decisions based on a somewhat arbitrary set of numbers crafted in an information vacuum. Or an investor might write off a very capable investment management team that faithfully filled out the form but was denied the opportunity to paint a more nuanced picture.

I’ve recently written that private equity without operational value-add is like rock and roll played by air guitarists – when the music stops, the would-be “musicians” don’t have much to offer. These proof-of-value-add exercises are good only if they truly sort the posers from the real rockers.