Note: The following is a guest post by Axial Member Mark Gaffin of The Gaffin Group, an independent research firm providing analytics, consultation, and implementation services to private equity investors, debt capital providers, and middle market companies. View their Axial profile here.
We have reached a point in the maturity of the private equity industry where wheat is being cut from chaff. Overall, LPs are more sophisticated in their due diligence of funds and general partners – and the latter strive to differentiate themselves.
One compelling differentiator is a replicable approach to maximizing market value of portfolio companies through sustainable long-term value creation. Many firms inappropriately focus on the mechanics of IRR maximization, and ignore the fact that value creation at the company level can be the key to unlocking more exceptional, consistent performance.
Successful PE firms focus on evaluating, selecting, and prioritizing activities that drive long-term value creation across their portfolios. More specifically, firms that are able to achieve superior outcomes inherently instill market value maximization as the only ‘corporate objective function’ (see Michael Jensen’s “enlightened shareholder theory”, 2001). And this objective function underlies the entire investment process from opportunity search to screening to due diligence to active investment management.
Note: The objective function is simply the goal by which decisions, prioritization, and resources allocation are measured against:
- What is the ultimate aim of the company?
- How do we know if one approach or strategy is better or not?
- How can I evaluate management of my portfolio company – against what objective?
Whether the investment is debt, equity, or quasi-equity, LPs should want firms and company managers to seek value maximization as the backdrop for all elements of an investment. The dominant corporate objective function is market value maximization of the portfolio company.
A coherent corporate objective function provides principals and agents the means to evaluate the decisions and opportunities that will confront them over the investment’s hold horizon. Conversely, with no central objective function, the company is left rudderless without actionable direction.
A careful appreciation of a portfolio company’s value drivers allows the PE firm to have a much better understanding of the true investment value at purchase – and the activities that can build that investment’s value. To drive strong performance at the PE firm level, GPs infuse the philosophy of value creation across deal teams, deals, and funds.
Understanding the Terms
Being clear on what is meant by market value maximization and long-term value creation is essential to getting it right – from investment thesis design, to ongoing communication, to prioritized execution.
Total Market Value Maximization: Jensen best explained that total value, “is not just the value of equity but also includes the market values of all other financial claims including debt, preferred stock and warrants.” This point is essential in establishing an appropriate method to evaluate opportunities, decisions, and outcomes. Maximization will not be achieved with programs that exclusively accrue to certain stakeholders at the expense of future performance (i.e., gouging R&D and marketing budgets to fund a dividend or to pay excessive compensation). Current market value includes the discounted value of all value creation (or destruction) elements. As an example, excessive or poorly structured leverage will increase the expected cost of financial distress and thereby drive increases in equity return demands (more simply, a riskier investment requires a higher discount rate).
Long-term: It is important to keep a long time frame perspective when considering value creation. The period of improvement will likely run the gamut from the gains achieved through immediate wins from low-hanging fruit (e.g., cost rationalization) to fundamental course corrections that may take years to realize (e.g., product market strategy). Again, the latter should be designed to improve the long-term value creation trajectory and, therefore, be justifiably discounted into the current market value.
Anecdotally, one PE investor told us that he considers the impact of any program at the portfolio company level over a 10-year horizon — roughly twice as long as the expected hold period. His point was that while one should always buy with the exit in mind, the next buyer (more and more likely a secondary sale) must believe there is a growth story in place for a high multiple to be paid. This is consistent with valuation techniques where 60-80 percent of ascribed value resides in the post-hold terminal value of the asset being modeled.
Value: Performance attribution studies show value is typically unlocked through strategic and operating improvements, sector selection, market timing, and financial engineering. While certain levers may be more politically appropriate to discuss openly, a common theme across the research is that all levers are important. A firm that cannot address all of the levers will suffer mediocre (or worse) returns over the long run.
Creation: Especially in the middle market, PEGs will likely need to create or enhance many of the value drivers, including product market strategy, procurement programs, focused R&D efforts, effective governance, etc. The more robust and replicable these value creation programs, the more a PEG ‘moves down a learning curve’ to implement these efforts with increasing efficiency across new investments.
Why a single objective function?
A single corporate objective function of market value maximization allows the PEG and company management to have a common platform for communication, execution, and evaluation of opportunities, activities, and outcomes. It helps acknowledge the often-conflicting interests of various constituents and it provides a means to evaluate alternative courses of action.
Some will argue that value maximization is overly focused on shareholders and not all stakeholders. However, long-run value creation has to account for stakeholders with real interests: products and services that meet customer expectations; market-facing compensation of employees; environmental awareness and stewardship that preserves value; effective use of debt and equity capital; and other investments into priorities that push the company toward value maximization.
Although the debate between shareholder and stakeholder ideologies is ongoing, Jensen’s discussion is applicable to successful PE investing in that long-term value creation requires consideration of key stakeholders, but from a rational, economic perspective. Many stakeholders (employees, customers, suppliers, etc.) contribute to long-term value creation. But to maximize value, tradeoffs (of often competing stakeholder demands) have to be made in the context of long-term value creation – and that is where an objective function is critical.
In his 2001 paper “Value Maximization, Stakeholder Theory, and the Corporate Objective Function” Jensen illustrates a failure in the stakeholder argument:
“Stakeholder theory, while not totally without content, is fundamentally flawed because it violates the proposition that a single-valued objective is a prerequisite for purposeful or rational behavior by any organization. In particular a firm that adopts stakeholder theory will be handicapped in the competition for survival because, as a basis for action, stakeholder theory politicizes the corporation and leaves its managers empowered to exercise their own preferences in spending the firm’s resources…Without the clarity of mission provided by a single-valued objective function, companies embracing stakeholder theory will experience managerial confusion, conflict, inefficiency, and perhaps even competitive failure.”
Effective use of value maximization as the objective function provides the most attractive outcomes for the principal investors – but also benefits reasonable claims of other stakeholders by creating a company fit for long-term survival.