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It’s the operational leverage, stupid! 20 Oct 2011

Bill Clinton's 1992 presidential campaign coined the phrase "It's the economy, stupid!" to remind staffers that they would win if they focused on the obvious areas where the competition was weak. Well, since the demise of the debt markets - and the disappearance of the financial leverage used to deliver returns in many private equity deals - we, along with many others, have been saying: "It's the operational leverage, stupid!" to remind ourselves that being a better business is the best way to create value, not financial engineering.

And now the message seems stronger than ever, thanks to research (download here) conducted by Professor Christoph Kaserer of the Technical University of Munich and presented at the European Venture Capital Association's (EVCA) conference. He claims mid-market private equity profits have always been driven by earnings growth at portfolio companies and not by the leverage used to fund buyouts. According to the report in the Wall Street Journal: "The research... analysed some 330 European companies bought by private equity firms between 1990 and 2011... Secondary buyouts, where private equity firms sell to each other, generated the highest returns making on average 3 times the amount of capital put into the investment. Sales to trade buyers and initial public offerings produced an average money multiple of 2.4, the research showed." Sales growth (15%) and earnings enhancement (30%) are the big IRR contributors; and although leverage is third (14%), it's followed closely by cash flow improvements with a 10% boost to IRR.

That's important for FDs and FCs in backed businesses for two reasons. First, it emphasises that the finance function has to do a lot more than simply keep score and hold management's feet to the fire (a common misconception about life under PE). You have to work out ways to support and lead operational transformation using your vast knowledge, only part of which is gleaned from the financials. (Although, obviously, that cash flow thing remains a biggie...) And second, you have to play a long game. Even if you plan to cash out when your PE backer exits, there's a good chance that anything swept under the carpet or massaged numbers will be found out during that secondary deal. Even trade buyers are super-hot on due diligence these days.

As one PE partner put it to me the other day: "You have to leave something on the table for the next guy." That means a clear path to further growth - and more opportunity for greater operational leverage.