PE firms can’t cut their way to prosperity in perpetuity.
We applaud when strategic acquirers defeat PE buyers for coveted assets (for a list of strategic acquirers that do M&A well click here). Our rationale is that strategic acquirers are typically motivated to optimize acquired assets so as to maximize ROIC over the long-term. This effort begins with post-deal integration where Sales teams are cross-trained, customer lists are shared and product integrations occur. Long-term revenue and operating income growth is the goal.
Conversely, PE buyers are not motivated to optimize acquired companies for long-term growth. Rather, the PE model is to acquire company X with someone else’s money and to subsequently take a dull blade to operating expenses.
PE firms increasingly finance deals with ever higher debt levels, utilizing new financing instruments such as “subscription” credit facilities”. These debt instruments enable PE firms to expend less of their equity, boosting fund returns in the process.
PE’s mission is to generate modest revenue growth accompanied by fat EBITDA margins so as to maximize exit valuations 3-5 years down the road. This practice is in direct conflict with long-term value creation and often in conflict with LPs. Add to this brew the fact that there is more dry powder on the sidelines than ever which is a recipe for higher deal valuations. Higher valuations incentivize PE firms to increase deal leverage which subsequently provides incentive to make steeper operational cuts. A vicious and unsustainable circle if there ever was one. This makes BlackRock’s “Long-Term Private Capital” fund an interesting value creation experiment.