Four tenets of creating value.

Author:de Janosi, Paul
Position:PRIVATE EQUITY
 
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Changes are coming to the private equity industry that will remake the size and shape of deals in 2013 and beyond. The new paradigm calls for an emphasis on operational improvement as one key to optimizing the margins and increasing the value of portfolio companies.

The clock is already ticking for many private equity managers. Based on commitments made before the 2008 downturn, funds are approaching deadlines to provide returns to limited partners. Firms have approximately $200 billion of capital that needs to be put to work in 2013, according to an article by Dan Primack in Fortune magazine.

Limited partners may ease the pressure by extending the investment window, allowing funds to focus on finding value instead of shedding capital. In the meantime, firms are busier than ever.

The need for speed is showing as deals ticked up in the third quarter of 2012. According to an article by Andrew Ross Sorkin in The New York Times, private equity firms spent $45 billion, up from $17.1 billion in the previous quarter, and they are already paying multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of 10.6 this year, up from 10.3 in 2011.

The focus is on finding smaller deals, which reflects a widely accepted stance against returning to the "megadeals" that fueled the industry in the mid-2000s.

Failed buyouts executed in 2007--such as TXU Energy, First Data Corp. and Chrysler Group LLC--emphasized the unnecessary risk inherent in large-scale deals. In light of those disappointments, the common wisdom today is to avoid establishing bad buying behavior to alleviate the short-term pressure.

Those that need to invest quickly will have to contend with the rise of strategic buyers in addition to difficult market conditions. Over the past several years, corporations have accrued significant cash on their balance sheets. With capital to spend and many competitors weakened by the global economic struggles, they have pursued acquisitions more aggressively.

As a result, private equity firms must consider whether a prospective investment is likely to be pursued by a strategic buyer. If so, the purchase price will likely increase dramatically, reducing the value that firms can cultivate prior to an exit.

These macro developments have limited the venues through which firms can increase the value of their acquisitions. Gross domestic product growth continues to be flat or down in different regions, and the leverage multiples tend to...

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