While it may be fashionable for sponsors to assert, “We’re all about operating improvements and not financial engineering” – a little secret of private equity investing remains: Done correctly, the management of leverage through financial engineering remains a key component of differentiated returns from most investments. Ultimately, a pragmatic approach to financial engineering drives benefits to the general partners, the limited partners, and a properly incentivized portfolio management team.
Our experience shows that high-performing business owners actively manage both sides of their balance sheets – both assets (left side) and capital (right side). So it should not be a surprise, in fact it is internally consistent, that this is no different for successful private equity investors. On the other hand, we would assert that limited partners and operating company management should both be wary when evaluating future equity sponsors if that GP does not (or cannot) make financial engineering explicit in their investment theses.
Complicating any rational discussion on the use of leverage, there is confusion as to what financial engineering actually means at the portfolio company level. Prof. Oliver Gottschalg provides one of the better definitions of financial engineering relevant to PE investing: “[Financial Engineering is] optimization of capital structure and minimization of after tax cost of capital of the portfolio company as a consequence of the utilization of financial knowledge and expertise” (Gottschalg ). As a former middle market financial executive, I submit that this notion is sensible and value accretive for any business, regardless of ownership.
We are often asked: “Are there financial engineering tactics more specific to private equity investors?” Yes. And though not exhaustive, the following action items are foundational:
- Constructing and maintaining a capital structure that reflects the thesis of the specific investment – considering idiosyncratic elements of risk and opportunity of the given deal (and as those may evolve over the investment hold period)
- Identifying tradeoffs inherent in financing deal terms, structural flexibility, capabilities of capital providers, and relative position in a complex capital structure.
- Proactively managing the right side of the balance sheet considering cycles of capital markets over time (e.g. accommodative debt markets, debt provider retrenchment, etc.)
Our research and experience show that “operating improvement versus financial engineering” is a false dichotomy. There should not be bright lines between the efforts; indeed, we find that the two are most often mutually beneficial. To be sure, operating improvements drive the lion’s share of value creation in the average private equity deal. However, research of private equity investments in US and Europe shows the impact of leverage to be materially positive, driving 20-35% of overall value creation (see our website for more detailed study analysis). Beyond the amplification of returns to equity, we have seen properly used financial engineering support effective development and broadening of a portfolio company’s opportunity set: from geographic expansion, to platform acquisitions, and even to dividends for owners as deal-specific events warrant. In an age of increasingly competitive fundraising and laser-like focus on investment performance, the management of leverage specifically – and the balance sheet, overall – is too meaningful to underinvest.
Rather, GPs should embrace their relative expertise of managing higher leverage situations, differentiate their capabilities (debt sourcing, etc.), and articulate their role in financial engineering across the investment horizon. Our Group has worked with several private equity groups that have debt capital market professionals on staff to address leverage elements at the front end of a deal. On the other hand, some firms leave this to deal teams replete with investment banking skill sets but potentially overly focused on the mechanics of the initial transaction. In the latter case, too often the attention is on driving the lowest attainable fees and rate on debt facilities – and too little consideration devoted to fitting the capital structure to the investment thesis. As we have noted before, while one might be able to work a really good pricing arrangement out of an inexperienced lender – it often comes at an implicit cost elsewhere in the deal.
The above in no way diminishes the importance and ‘heavy lifting’ of operating improvements – but is designed to contribute to the discussion of effective use and management of leverage through financial engineering. The effective oversight of complex capital structures across amendments, extensions, and the inevitable performance speed bumps benefits everyone from the LPs to GPs to company management. Our view is that private equity sponsors should not run from financial engineering: “debt-is-a-four-letter-word” is a political construct – not an effective investment strategy.