Private equity transformational buyouts turn complexity into outperformance

In the crowded generalist private equity buyout market, achieving superior investment returns has become increasingly difficult. Tough competition for deals, resulting in higher entry prices, has suppressed the possibility of outperformance. The value creation playbook of business professionalisation, internationalisation and expansion has been homogenised to the point that it’s near impossible for fund managers to differentiate themselves and outperform.  

It's often the case that excellence - i.e. the drive to excel and exceed all others – comes not just from skills and talent, but from the willingness and dedication to work hard and overcome difficulties, and where necessary, take a different approach from the rest. One way to shine in the private equity space is to embrace complexity in the form of transactions where transformational change is necessary to generate value. This is a specialist area, but one which offers plenty of scope, especially in the current macro-economic climate. Particularly for those managers who can spot the potential to create value where others do not and who possess the requisite skillset to identify opportunities and have the in-house expertise and experience to deliver business transformation.  

What are transformational buyouts in private equity? 

Private equity transformational buyouts are transactions that have a heightened degree of complexity in terms of how to unlock investment returns. These are fundamentally strong, attractive businesses, but they may have been mis-managed in some way. Sellers may want to offload them for organisational reasons, or they may simply not be flourishing under current ownership.  

A hypothetical example: 

Take, for instance, a global telecoms business, XYZ Global, with a core focus on providing cloud networking services to multinational clients. As XYZ Global grows, so does its capability to build additional services for its target market that complement the firm’s core cloud networking service. These additional business lines, while valuable, are ‘non-core assets’ as they are the not the core focus for XYZ Global. Now, say XYZ Global adds in a European infrastructure division, which provides fibre network and data centre infrastructure services to customers as part of its growth strategy. During several years of good growth, the infrastructure division forms a profitable and additive revenue stream for XYZ Global. However, because of severe market volatility and rising macro-economic pressures such as rising interest rates, labour costs and raw material costs, XYZ Global faces higher balance pressures than ever before and requires additional capital to focus on the growth of its core cloud networking services. A strategic approach for XYZ Global would be to sell its ‘non-core asset’, the profitable and high-quality infrastructure division, to get the capital to invest in their core business line which they deem more effective in delivering long-term growth.  

For a generalist private equity buyout firm, the skillset required to successfully identify this infrastructure division as a high-quality asset and to unlock the business’ true value potential is beyond their remit. However, a specialist transformational private equity buyout manager with the necessary pre-requisite skillset identifies the opportunity and knows that XYZ Global needs capital quickly to be able to alleviate its financial pressures and wants to invest in strengthening its core cloud networking services, is able to acquire the high-quality business at a 50% discount through creative deal structuring. It can then transform it to a market-leading transatlantic infrastructure business at a quicker pace than a private equity generalist with a traditional buyout deal. And so, rather than making the traditional 2x-3x multiple return in six years, due to the attractive entry 50% discount and significant value transformation with incredible efficiency, is able to achieve a 6x multiple return in just four years.  

Since these assets are not easy targets, they can usually be acquired at a significant discount to comparable transactions. Then, by deploying the appropriate value creation techniques as part of an active ownership approach, they can be sold at an expanded multiple on exit – delivering a “complexity premium”. Essentially, these companies are something of a rough diamond that, in the right hands, can be polished up and sold for a much higher value. Therefore, deep, specific expertise is essential. 

Private equity funds operating a transformational buyout strategy are often sector-agnostic: managers apply a similar playbook whatever the business, although the levers they choose to deploy to unlock returns may differ, depending on the unique circumstances of each transaction. What is important here is that no two deals (even in the same sector or of the same type) are identical – each will have its own dynamics and nuances which can sometimes be very subtle.  

What forms can deals take? 

There are three main transformational deal types: 

• Complex private equity carve-outs – Where a large company wants to divest non-core assets in order to focus on its core business. These may be profitable parts of the business that simply don’t fit comfortably into the current business model or are seen as a cash drag on the main business and are therefore being spun out. Especially in challenging economic times as pressure on margins increases and companies look to consolidate, realising value in this way is a growing trend.
• Broken processes – Where a private equity exit process has failed perhaps because potential bidders have been put off by an aspect of the deal or the complexity of the business’ needs following initial due diligence. They then may be reluctant to proceed either because they do not have the skills or the inclination to take on the challenge. This creates a need for experts with both those attributes to step in.  
• Private equity take-privates – Where listed companies are struggling to perform to expectations under public ownership, for instance due to market volatility or because they have listed too soon or in the wrong jurisdictions or are finding shareholder demands or listing requirements hard to satisfy. These companies may benefit from being taken into private hands to ease the burden and so they can attract more patient capital to help transform their fortunes.

How favourable are current market dynamics for transformational buyouts? 

Given today’s macro-economic outlook, complex deals are becoming more prevalent. The value of carve outs backed by private equity firms more than tripled last year to £13.4bn from £3.8bn the year before, according to the law firm Mayer Brown[1], while data from White & Case show that the value of global private equity backed take-private transactions hit $245bn in 20224 compared to the previous record of $239bn in 2021$239bn in 2021[2]. And the Harvard Business Review puts the failure rate of M&A deals as high as 70-90%[3].

Examples of recent deals include Cinven’s acquisition last year of Bayer AG’s Environmental Science Professional Business unit for $2.6bn in a carve-out transaction[4], and the take-private of cloud software company Citrix Systems, acquired by Vista Equity Partners and others in a $16.5bn deal[5].

At a time when markets are turbulent, borrowing is expensive and corporate cost-cutting is a high priority, we would expect to see the trend for corporates divesting non-core assets to pick up pace, an upswing in acquisitions failing to be completed, and more public companies seeking to move into the private sphere. 

There are far fewer players in the transformational buyout space than in the generalist arena, so specialist funds with the requisite skillsets and experience to take on these overlooked and unloved opportunities should have their pick of deals to choose from and be able to achieve even steeper entry discounts than ever. After time, once they’ve completed their transformational strategies, we would expect the markets to have improved from the current conditions. So, managers are likely to be selling in a much more favourable environment than the one in which they acquired the assets – driving performance even higher. 

What are we looking for in private equity transformational buyout strategies? 

Transformational buyout funds are typically smaller than normal buyout funds (comprising around 10-12 portfolio companies) and should be run by teams of experts with long experience in transformative strategies. Importantly for investors, these managers will know how to create value from complexity quickly, meaning that despite the inherent difficulties, transformational buyout strategies can be expected to have similar investment timeframes to traditional private equity buyout strategies. 

This kind of niche, value-adding approach is exactly what we look for in a fund because we know that managers who focus on a specific area and have developed unique expertise in their field will be well-placed to capitalise on the opportunities that are emerging to deliver superior returns. As ever, we look for managers with a proven track record, and we have the network connections to access these kinds of strategies on behalf of our clients. 

When times are tough, most people become more risk-averse and stick to what they know. But for investors who are prepared to be bold, investing in strategies that play to current trends and that stand out from the norm should pay off. Transformational buyouts are by no means an easy option – but achieving outsize returns is rarely easy. It’s those who are prepared to square up to challenge and solve complexity in order to add real value that deserve to be the star performers. 

Find out more about alternative investment funds or our investment strategy. 

[1]https://www.cityam.com/value-of-private-equity-backed-carve-outs-triples-due-to-covid-and-war-in-ukraine/

[2]https://mergers.whitecase.com/highlights/take-privates-boom-amid-the-equity-bear-market#!

[3]https://hbr.org/2020/03/dont-make-this-common-ma-mistake

[4]https://www.cinven.com/media/news/cinven-agrees-to-acquire-bayer-environmental-science-professional/

[5]https://www.reuters.com/technology/elliott-vista-equity-buy-software-firm-citrix-165-bln-deal-2022-01-31/