A Framework for Measuring PE Deal Success

The Analyst Exchange and Marquee group showed us how to build LBO models and the basic framework for showing how LBOs generate returns to private equity holders through 3 mechanisms:

1. Leverage arbitrage – Increasing leverage and paying down through cash sweeps
2. Operational arbitrage – Improving operations to generate higher earnings / EBITDA
3. Multiple arbitrage – Selling the company for a higher exit multiple

Of the three, the most meaningful method of generating returns is the second, operational arbitrage. Leverage arbitrage can generate returns, but is not a strategic differentiator when it comes to a bidding process (unless you have some unusual advantage in raising capital) and multiple arbitrage is simply based on market conditions. However, operational arbitrage is directly related to value creation and is the reason why a strategic buyer can afford to pay more than a financial one.

While this is useful notionally, how can we use this to build a framework to understand how each dimension performs in a deal? In my Private Equity and Venture Capital class, they proposed the following framework and example:

So the total gain in equity value is 78.9 (112.9 – 34.0)

1. Return from leverage arbitrage is actually negative because debt increased rather than decreased at -9.2 or (4 - 13.2) and contributes to the equity gain by -12% (-9.2 / 78.9).
2. Return from multiple expansion is 27.3 or (13 x (9.7 - 7.6)) and contributes 35% (28.6 / 78.9)
3. Return from operational improvement is 60.8 or (7.6 x (13 – 5)) and contributes 77%

Using this information, you can benchmark the deal against different performance metrics and determine if the deal generates equity gain simply because of leverage or multiple expansion versus creating value by improving operations.