What Are PE Investors Thinking?

A new research paper based on surveys of 79 private equity investors gives insight into how they approach things like deal selection and management. Steven Kaplan of the University of Chicago, along with two other researchers, gained some insights into the inner workings of PE firms and the strategies of their founders.

In surveying a broad cross section of private equity, a recent paper written and researched by three academics tries to answer questions about what exactly those inside private equity do in relation to things like firm valuation, capital structure, governance, and value creation.

Steven N. Kaplan, Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago, researched and wrote the paper What Do Private Equity Firms Say They Do? along with Paul Gompers of Harvard Business School and Vladimir Mukharlyamov, a graduate student at Harvard University.

They surveyed 79 PE investors, found through their various networks, with combined assets under management of more than $750B. More than three-quarters of those respondents were senior executives. Kaplan says that relative to academic papers, “none have asked these questions to a broad cross section of private equity.”

Kaplan says he talks regularly with co-author Gompers, and they hatched the idea for the topic sometime in 2011, with the surveys going out in 2012 to 2013. Some of the results were surprising.

“In terms of value creation, about a third of [participants] replaced management going into a deal. That was higher than expected,” says Kaplan. Some of the GPs surveyed were more focused on growing revenues of the businesses they acquired than on cutting costs. A third survey finding that Kaplan sees as interesting was how some PE firms use financial engineering while others use operational engineering.

“We were finding that they more or less do what they learn in business school,” he says, adding that they do what they learn in business school on capital structure but not on valuation. Also included in the research paper were findings that people with investment-banking backgrounds tend to make the PE firm they found financial-engineering oriented. Others with an operational background who may be spun out into their own PE firm unsurprisingly make the shop more operationally focused.

The paper addresses how PE investors evaluate deals, including choices of metrics (the vast majority of PE investors rely on gross IRR and multiple of invested capital), forecasting cash flows over a period of time (almost 96 percent of respondents used five years as the guideline), and management forecasts (it’s typical for PE investors to discount these forecasts).

Another topic Kaplan, Gompers, and Mukharlyamov found was that when GPs looked at a deal, they cared about the business model first, and the management team and ability to add value second. “The valuation mattered, the industry mattered,” Kaplan says. “The thing they cared most about in the business model was its competitive advantage. In terms of the value added, if they were looking to improve the business operationally, they were looking at more ways to increase revenue rather than to cut costs.” Another finding was that in all of the firms that were surveyed, “it’s still the case that deal people are banking types,” he adds, with a number of the shops making operational investments.

The paper is now in the publication process. Kaplan says he had no expectations of what the findings would be when he began researching a topic. “In my case…why bother writing a paper when you know what the answer is? There’s no point.”