An Inside Look at the Strategies of Private Equity

Private-equity funds have established a reputation for strong returns, having outperformed the S&P 500 by roughly 4 percent annually over the past three decades. What they have done to achieve those returns, however, has been less well documented. So Harvard’s Paul Gompers and Vladimir Mukharlyamov, along with Chicago Booth’s Steve Kaplan, went right to the source to ask private-equity-fund managers about their strategies and practices. In analyzing responses from 79 fund managers collectively managing more than $750 billion in assets, the researchers find that real-world private-equity approaches don’t always match the financial-theory best practices taught at leading business schools—or the practices for which private equity is most notorious in the public imagination. Among other things, private-equity investors favor some metrics far more than others when evaluating investments (they rely heavily on internal rate of return, or IRR, and multiples of invested capital in comparison to net present value and discounted cash flow); they use absolute performance targets; and they tend to add value by focusing on growth. Here are a few more snapshots taken from within the black box of private equity.

A circular sunburst-style bar chart split into eight sections. First, some methods used by private equity investors to evaluate attractiveness of an investment include multiple of invested capital at ninety-four-point-eight percent of deals, grocery I.R.R. with ninety-two-point-seven, and discounted cashflow with twenty-point-two. Second, some of the methods used by limited partners to evaluate private-equity funds include multiple of invested capital net of fees at thirty-eight-point-one percent of partners, net I.R.R. with respect the fund vintage year at twenty-seven, I.R.R. net of fees at twenty-five-point-four, and I.R.R. versus S and P Five Hundred at seven-point-nine. Third, factors that private equity investors consider important in determining how much debt to raise for a transaction include the industry in which the firm operates at ninety-six-point-nine percent of investors, current interest rates and how much the company can pay at ninety-five-point-three, maximum trade-off between tax benefits and default risk at sixty-seven-point-two, amount market will allow at sixty-five-point-six, and ability of debt to force operational improvements at thirty-nine-point-one. Fourth, specializations include industry at fifty-four-point-four percent of investors, general at thirty-six-point-seven, product at sixteen-point-five, and criteria at eleven-point-four. Fifth, size of board of directors includes four or fewer members at four-point-seven percent of investors, five members at thirty-two-point-eight, six members at ten-point-nine, seven members at forty-six-point-nine, and eight or more members at four-point-seven. Sixth, private equity investors who recruit their own senior management before or after investing include include fifty-seven-point-eight percent who do and forty-two-point-two who don’t. Seventh, some of the expected sources of value prior to investment include increased revenue in seventy-point-three percent of deals, improved incentives in sixty-one-point-one, reduced costs including introducing shared services in fifty-one-point-two, follow-on acquisitions in fifty-one-point-one, improved corporate governance in forty seven, and redefined business model or strategy in thirty-three-point-eight. And eighth, types of exit targeted include strategic sale to a similar company in fifty-one percent of deals, financial sale to another private-equity investor in twenty-nine-point-five, and initial public offering in eighteen-point-eight.

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