Another aspect of private equity that has also been discussed previously in this newsletter are the three levers of value generation: i) organic growth or operational improvement, ii) leverage, and iii) multiple arbitrage. However, these are not equally applicable to all strategies, and therefore, it is necessary to discern the usefulness of each one depending on the fund’s strategy.

For example, as we saw in the last publication of the newsletter, in the lower end of the market (Lower-Mid Market or LMM), operational improvement and multiple arbitrage are usually emphasized, given that the small size of the companies makes access to bank financing difficult, and therefore, it is harder to generate value from leverage. Often, in this segment, the contribution of leverage to the value creation of an operation is even negative due to the debt financing required after entry to grow the company.

Figure 1: Value creation waterfall according to the weight of each lever (multiple on invested capital). Source: Qualitas Insight¹.

One of the things we must bear in mind if we focus on the LMM is that the last lever, the arbitrage between the entry and exit multiple, depends on external factors to the management of the company or the fund. That is, generating multiple arbitrage will depend on whether the market is willing to pay more at exit than what was paid when buying it. As is true in the public market, these multiples are usually closely linked to the economic cycle, especially in the middle and upper parts of the market (the LMM is less sensitive to market noise).

Therefore, it seems reasonable that in the LMM the value creation lever par excellence is organic growth. Organic growth or operational improvement is simply growth in a company’s EBITDA, usually due to an increase in sales. This organic sales growth is typically driven by one of three factors: i) gain of market share, ii) increase in the price of products or services, and iii) increase of volume without gaining market share or changing prices. The first two of these three paths to growth require direct competition with the market. Gaining market share is a zero-sum game that assumes that a company can beat out its competitors for customer demand. Sales growth through a price increase also involves some risk- namely the response of competitors and the elasticity of demand.

However, the third form of growth is much simpler and more sustainable since it implies generalized growth in the market as a result of an increase in demand. Therefore, players in such markets are capable of growing without stealing market share and without the need to modify the price of their products and services. In this case, growth does not depend solely on relative company performance, but on the market in which it operates. This leaves us with the question, then- where does this growth come from?

Long term market growth can be attributed to what we call tailwinds which are macro-trends that will endure in the long term regardless of what happens in the economic cycle. To illustrate the effect of tailwinds on the market, consider the examples of two sectors with strong tailwinds at present day: information technology (IT) and healthcare.

The tailwinds of the IT sector can be attributed to the widespread increase in data usage and the great efficiencies offered by technology. We have all seen how humans have become increasingly dependent on technology in our everyday lives, and this trend is not likely to stop any time soon. The recent development and popularization of powerful softwares like ChatGPT provide further reason to believe that our future will be increasingly dependent on technologies like artificial intelligence.

The healthcare sector also enjoys significant tailwinds. The increase in population implies that more people will need access to medication and treatment services. Furthermore, the development of emerging geographies makes it increasingly feasible for pharmaceutical companies to research and treat diseases in these regions in a way that was previously impossible from a commercial perspective. Finally, improvements in healthcare quality, coupled with trends towards healthier lifestyles, result in increasing life expectancies. Longer life expectancies imply that the elderly will require more years of healthcare services than previous generations, thereby increasing overall market demand.

Figure 2: Average gross MoC of transactions carried out in Europe by sector from 2012 to 2020. Source: Qualitas Insight².

In summary, both IT and healthcare are markets in which“a rising tide lifts all boats”, A macro trend allows companies that operate both in the sector and in its periphery to grow ceteris paribus due to the sheer momentum of the market..Similarly, it seems reasonable to conclude that investing in companies that operate in tailwind markets carries less risk than investing in companies that are in markets without such high intrinsic growth.

Furthermore, investing in companies that operate in markets with this type of growth carries particularly tangible benefits in the LMM as it facilitates multiple arbitrage. Since market inertia may assist company growth, a company is likely to be at larger scale at exit than at entry. Larger companies tend to fetch higher valuation multiples than their small counterparts, thereby creating an opportunity for multiple arbitrage.

Therefore, from the perspective of a fund of funds that invests in private equity , it is advantageous to seek out managers who position themselves in tailwind markets. The potential benefit to be enjoyed from this strategy is especially pronounced if the GP invests in the LMM and buys assets at reasonable valuation multiples.

This analysis does not mean to say, however, that all other strategies are incapable of generating extraordinary results without organic growth. Other approaches like buy & build(buying a leading company in a fragmented market and expanding it while consolidating smaller competitors) or special situations (buying companies in difficult situations with the aim of fixing those problems and subsequently selling them) are also strong, market-tested strategies This analysis simply aims to demonstrate that investing in companies in tailwind markets reduces implicit risk since the operation starts from a market context in which there is “guaranteed” baseline growth.

Notes:

[1] Investment data collected in Qualitas Insight. Median of each segment. Operational improvement refers to EBITDA growth. N=1.584.

[2] Investment data collected in Qualitas Insight. Excluye outliers (e.g. operations of more than 30x gross MoC).