The success of an investment is measured by the gain in value which has been created over the life of the investment. The gain in value is the difference between the purchase and selling prices plus the cash flow which has been generated during the period. The opportunities to create gains in value can be identified as:
Exiting at a Higher Earnings Multiple than the Entry Multiple
Many successful buy-outs have an element of this. However, it is very unpredictable and open to the vagaries of the markets. Many deals which exited in the last ten years enjoyed this phenomenon due to rising stock markets. Because it is such an unpredictable factor, financiers will not invest if this is cited as the main driver of the projected gain in value. It is very nice to have it but people do not like relying on it happening.
Increasing the Earnings of the Business
This can be achieved by any or a combination of:
- Increasing sales
- Increasing gross margins
- Reducing direct costs
- Reducing central overheads
This is seen as more predictable and more under the control of management. However, unpredictability is not confined to the stock market.
Generating Cash Flow
Cash generated by the business can be used to repay acquisition debt leaving a greater share of the proceeds for the equity investors. In some cases, the equity may be repaid early which is very beneficial to the private equity firm.
The principal drivers to generating cash are :
- Increasing profits
- Tighter management of working capital
- Controlling capital expenditure
Selling Assets at a higher price than their purchase price.
Selling loss making or low yielding assets are examples and the benefits can be greatest if the assets are disposed of early on.
Leverage
Leveraging a business benefits the equity holders if the value increases. If the value declines it works the other way. The equity holders take greater risk.
