At a recent gathering of limited partners (LPs), one asked, “Can fund managers influence Indian promoters?’’ In a tone that oscillated between an unproven suspicion and an open secret, another quipped, “Some operating teams are a little more than window dressing for LPs.”
In an industry where persistence in performance has fallen and available data is selective, this is not an easy question to answer. We got down to the business of comparing the performance of private equity (PE)-backed companies, and what we found may surprise you.
PE advocates active governance. Empirical research demonstrates that ‘active ownership’ over strategy, executive appointments, operational improvement and acting early contribute to better returns. The converse holds true too—not acting, or doing so late, produces worse returns.
Our survey of LPs and portfolio company CEOs shows investors get credit for selection, exercising controls over capital decisions and improving board efficiency. However, the operating team’s role varies widely.
When it’s all about the numbers, PE delivers. Comparing PE-backed and non-PE backed company performance, PE outperforms on revenue and earnings growth. Simply put, they grow faster and deliver higher margins while doing so—this appears to be true from the first year through the fifth year of ownership (t=1 to 5). Although performance and relative outperformance diminish over time, the results are clear. So, what capabilities are being built here?
• Willingness to engage in cross-border mergers and acquisitions (M&As): over 80% of PE-backed companies clinched their first cross-border deal after PE investment. Many portfolio companies see PE as a vehicle to make acquisitions.
• Stronger export growth: At an average, PE-backed companies grow exports over 2x their non-PE backed counterparts in every sector, with the exception of pharma—where they grow exports in line with non-PE backed companies.
• More jobs, better talent: PE-backed companies created more jobs. Indexed to 100 at the time of investment, over a five- year period, they grew jobs 1.5x versus 1.15x for non-PE backed companies of similar sectors and size. Clearly an outcome of higher revenue growth.
Why does outperformance diminish over time? You can cut costs and introduce productivity initiatives to improve margins within 12-18 months. Quick improvements offer rapid top-line improvements. Yet, most short-term fixes, even if structural, offer short-lived advantages.
Return on Invested Capital (ROIC) outperformance requires more frequent capital re-allocation. Companies often defer these strategic actions and investments, since they have a longer horizon to impact than most PE investors are willing to underwrite. There is clear evidence that with sufficient granularity in strategy, these investments pay off over time.
Company outperformance needs to translate into returns for investors. This is a challenge. Where there is pricing discipline and early intervention, we are optimistic it will, especially as greater experience settles into PE teams in India.
Vivek Pandit is a senior partner of McKinsey & Co. in India and is based in Mumbai.