Valuation of Coporations from Private Equity and Governance - Research Paper Example

Private Equity and Corporate Governance of the Executive Summary This research paper has been prepared based on the article “Corporate governance and value creation: Evidence from private equity” (Acharya, et. al., 2013). The objective of analysis is the effect of private equity upon the value of the corporations and the effect of governance on corporate valuation. Corporate firm today around the world recognize the importance of private equity funding and incorporate it in the capital structure formation. This research aims at analyzing the significance of private equity funding from the perspective of operating firms who opt for such a funding method. It also throws light on the influence of corporate governance that such a system brings along with it into an industry. Contents Executive Summary 2 Introduction 4 Research question 4 Literature review 4 Data and Sample selection 5 Measures of Abnormal financial performance 6 Operating Performance 7 Abnormal performance and operating performance 7 Human Capital factors of deal partners 8 Conclusion 8 References 10 Introduction Private equity is the process of raising equity capital by gathering investments from individuals and institution that are known to have high net worth and have supreme financial strength. The investing firms are called the Private equity firms. Most of the top companies follow the private equity concept. On the other hand it is seen that good corporate governance raises the overall value of the firm. The general assumption to this concept is that, firms with good internal practice will be able to meet their goals and objectives effectively, thereby raising a company’s value. The research aims to analyze the operating performance of acquired companies and the internal rate of returns that the funds generate through private equity. In addition a brief study about human factors impacting the value of the firm will also be covered (Acharya, et. al., 2013). Research question The main question dealt with in this research is: How private equity creates value for the Corporation and how different governance effects the valuation of corporations? The research work emphasizes on the in the in depth analysis of corporate valuation based on the criteria of private equity and corporate governance. The purpose here is to identify the importance of equity funding in the overall performance of a firm and the benefits of private equity funding in the long run. Literature review The work of Kaplan is mainly used for this literature review (Kaplan & Stromberg, 2008). According to his opinion it was observed that leveraged buyouts (LBO) in the UK were significantly high before the recession period that started since 2010. Buyouts are a way by which funds can be invested in a firm. Buyouts are a type of private equity investment. It has been a matter of debate between many experts to decide whether it is buyouts that create greater value for the firm or is it equity investment in general. However research has shown that private equity only leads to short term gains where as buyouts have been seen to provide companies with long term results. There is however less difference between private equity investments and buyouts as both help to provide fund to a company and are specifically a type of investment. However the main difference lies in the time span and in the distribution of profits. In case of Leveraged buyouts which are a combination of debt and equity, a firm will have to pay a fixed installment periodically whereas, in case of equity funding, a portion of the profit earned by the firm is distributed to the investors. The amount of profit that gets distributed depends upon the amount of profit earned by the company. Although it is claimed that buyouts can be a risky venture, it been noticed to create greater productivity in the operations. In relation to the governance and human capital factor, it has been seen that execution skills play a more important role than interpersonal skills. In case of private equity, there is a greater involvement of the partners in the operations of the firms. Their skill contribution helps a firm significantly. In buyouts, there is not much relation between the human enterprise factors and the financial gains. Hence, two different types of corporate governance styles are noticed here. It can be therefore said that private equity leads to greater performance of operations due to the involvement of shareholders (Acharya, et. al., 2013). Data and Sample selection The data for this analysis has primarily been collected from McKingsey which is a consulting company for a number of large private equity firms. Data has also been collected from other private equity investors. The research includes both quantitative and qualitative research. The quantitative research has helped to analyze the financial performance of the private equity firms so as understand how private equity has helped to obtain increased profits and high performance. Data relating to the Cash flows and operational performance of different companies was thoroughly examined in the quantitative analysis. The research also involves the analysis of internal rates of return for each of the company. Different financial statements which compare and analyze the trend of movement in sales, profits and expenses are also taken. The investments made by these private equity firms were also analyzed. The data that was collected from McKingsey and other private equity firms were compared with other public listed companies. Different ratios such as EBITDA to debt ratio, debt to equity ratio, sales ration and net worth ratios and so on were analyzed. The qualitative analysis involved the in depth detailed study of the corporate governance environment existing in these companies. It was checked whether changes influenced the behavior and performance of employees. Also it was seen that by implementing a good governance structure a firm can effectively improve performance and thereby the value of the company. The data collected have been studied on the parameters of the financial strength of the company before and after private funding (Acharya, et. al., 2013). Measures of Abnormal financial performance A private equity firm thoroughly analyzes a firm’s financial position before making investments in it. Operating companies raises its funds through a variety of strategies such as buyouts, venture capital and so on. The abnormal financial performance helps to identify the reason behind the successful performance of firms that are funded by private equity as compared to other types of firms and the increase of value of the firm with respect to private equity funding. The way in which private equity performance is analyzed in a firm is described below (Axelson, Stromberg and Weisbach, 2009): Methodology- In order to ascertain the impact of private equity over the value of the firm, a detailed analysis of IRR has been conducted. It is seen that prior to private equity funding, firms had managed to generate only a satisfactory level of revenue. Post the private equity investment its performance was seen to improve significantly, leading to a higher level of revenue, thereby increasing the value of the company. The IRR’s were seen to grow considerably while conducting a year to year comparative study. The analysis also involves measuring the overall financial position of the companies that are taken as samples. This involves the balance sheet analysis, forecasting returns, ratio analysis and so on. A complete analysis of the financial condition of the firms before and after private equity investment was conducted. Some of the reason behind the better performance of companies due to private equity funding is stated as follows (Kaplan and Stromberg, 2008)- Deep analysis of financial strength- A firm funded by the private equity method, undergoes a deep and thorough analysis conducted by the private equity firms. The financial capabilities of the company get thoroughly checked time after time so as to ensure that their performance remains good financially. For this the private equity firms undertake to study and analyze potential firm’s internal rates of returns and net present value of profits and other measures of budgeting. Hence a complete analysis of the company’s present and future cash inflows and outflows gets done. This not only helps the firm to understand its position but it also helps the investing firm to decide whether or not it should invest. Accountability- A privately funded firm requires being accountable to its investing firm in respect of its profits and revenue. Hence a firm generally performs well so that the private equity investors do not question them for lack of performance. Also because private equity investors monitor all the different activities of the firm, it becomes crucial for the operating firm to deliver a good performance. Involvement- Private equity paves way for the private investors to participate in the important financial operations of the firm. This helps to increase the skill and efficiency existing in the firm. This leads to better management and results, thereby increasing the value of the firm. Operating Performance The next step in this research is to see whether the abnormal financial performance is related to the operating performance of the firms in any way. The way by which this phenomenon is analyzed is discussed as follows- Operating measures- The most effective way to analyze the operating performance of a firm is by evaluating its EBITDA with sales and net worth. This analysis helps to identify the results of the operations of a firm and in the comparative study of its revenue. The results are analyzed on two parameters, the EBITDA position before private equity investment and after the same. Accordingly the performance of every firm is analyzed to gain knowledge regarding the operational performance of companies. It was seen in this analysis that firms showed an increased level of EBITDA and EBITDA ratios were significantly high post the private equity funding. The reasons for better operating performances are discussed below: Increased level of operating efficiency- Since there is a direct monitoring of the private equity firms, the costs and expenses of the company get regulated and therefore there is increased level of operational profits as cost of production gets lower. Efficient investments- The private equity firms effectively guide the operating firms to make potential investments. Hence the projects are carefully analyzed and are taken up only after the approval of the private equity holders. The private equity holding companies are equipped with a great level of expertise to analyze and evaluate projects and financial statements. Their support in the management proves to highly beneficial. Abnormal performance and operating performance A positive abnormal performance post the private equity funding leads to better operating performance. The projected forecasting based on which IRR analysis is conducted needs to be actually be achieved by the firm in order to earn profits. It is seen that the forecasted results match with the actual performance post the private equity investment. It has also been noticed that the increased level of innovation in this type of funding system leads to a higher level of corporate value. The high level of corporate governance also helps to develop and improve the operating results. Hence there is seen to be an overall efficiency in the performance of the firm both quantitatively and qualitatively. Human Capital factors of deal partners This segment deals with the corporate governance influences upon the valuation of firms. There exists a deep correlation between corporate governance and share holders wealth. The better the governance the higher is the shareholders wealth. In a firm that is funded by private equity, it is seen that the there is a greater involvement of the shareholders in the corporate matters. This leads to strict governance that prevents malpractices and also helps to improve the efficiency of the firm. There is also seen to be a significant transparency in the operations which leads to increased efficiency. Employees in such firms are required to follow specific codes of conduct and also deliver a high degree of performance. They are subject to high levels of training to improve their performance and are subject to appraisal programs consistently. While analyzing the employee performances post and after private equity funding, it was seen that they normally showed an increased level of efficiency. This was due to stricter management and control. The performance of the employees was analyzed on the basis of comparative analysis of appraisal reports. Good employee performance leads to effective results. There is a higher level of profits obtained due to better performance. Hence the saying that increased corporate governance serves towards increasing corporation value (Acharya, Franks and Servaes, 2007). Conclusion Based on the above analysis it can be concluded that firms have displayed an improved level of performance because of private equity funding. However critics have stated that private funding has led to greater involvement of shareholders within the corporate operations. The shareholders gain an increased level of control on the overall operations and regulate the overall operations. This makes the organization less liberal. On the other hand an organization tends to perform well under such a scenario. Regulation of work and monitoring leads to greater level of efficiency. This has been clear from the above analysis. At present firms are increasingly adopting the private equity method as this helps to obtain huge amounts of capital from private corporate giants who specialize in equity funding. Their expertise also comes as an added advantage to the company (Capitalist Exploits, 2013). References Acharya, V. V., Gottschalg, O. F., Hahn, M., & Kehoe, C. (2013). Corporate governance and value creation: Evidence from private equity. Retrieved from http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/20110702_text_clean_final_og.pdf. Acharya, V., Franks, J., & Servaes, H. (2007). Private Equity: Boom and Bust? Journal of Applied Corporate Finance, 19(4), 44-53. Axelson, U., Stromberg, P. & Weisbach, M. (2009). The Financial Structure of Private Equity Funds. Journal of Finance, 64(4), 1549-1582. Capitalist Exploits. (2013). Pros and cons of investing in private equity. Retrieved from http://capitalistexploits.at/2013/06/pros-and-cons-of-investing-in-private-equity/. Kaplan, S. & Stromberg, P. (2008). Leveraged Buyouts and Private Equity. Journal of Economic Perspectives, 23(1), 121-46. Read More